Merger mania and economic decline
Brand, H.
The "leveraged buyout," dramatized last fall by the struggle over RJR Nabisco and the $25 billion paid by a Wall Street firm mostly through debt instruments, has been only part of the wave...
...Business should be compelled to recognize values that outrank efficiency...
...How high this premium will go depends upon the estimated worth of the target firm's productive assets, and must largely be judged a matter of speculation on the part of the bidders...
...For intercity general freight, tariff data are not readily available, but there can be little doubt regarding increased market power from rising concentration ratios recently calculated: In 1985, the twenty largest over-the-road trucking firms accounted for close to 60 percent of all operating revenues, compared with just under 40 percent in 1978...
...That is partly determined by the price of its shares in the stock market...
...And then there is the emergence of the Federal Reserve Board as active lender of last resort over the past two decades or so, as well as the continuing efforts by federal government agencies to "bail out" savings and loan banks, all in turn promoted by the deregulatory climate and the laxity in supervision to which it has led...
...Jensen writes: Many sectors of the U.S...
...Its own reports bear eloquent witness to this...
...Bork has written that "antitrust policy should never concern itself with equity in income distribution" —yet historically this concern has been at the base of antitrust policy understood as an instrument to preserve populist democracy...
...We have indicated the answer: inasmuch as those gains cannot be attributed to shareholders' virtues as producers or innovators or even risk-taking entrepreneurs, they must derive from the actual and expected market power of the surviving (merged) firms, in addition to operating efficiencies frequently achieved at the expense of employees and communities...
...Minsky concludes that the intervention of the board makes a repetition of the Great Depression of the 1930s unlikely insofar as it was caused by a deflationary spiral that the monetary authorities had been unable or unwilling to halt...
...At least that ensures an experienced hand at the helm...
...A premium over the shares' market value will therefore be offered or demanded...
...Reading Hyman Minsky of Washington University, who has written extensively on the potentially destabilizing role of finance under post–World War II capitalism, we find three conditions that have facilitated the enormous growth of debt over the past ten to twenty years, and the speculative activity that 140 • DISSENT Comments and Opinions this growth has fed: (I) financial innovations, including the emergence of money market funds and other structural changes in the financial sector of the economy...
...It is no longer sufficient to curb the lending power of banks now that nonbank financial intermediaries have come to rival them, and at present no effective authority exists that can supervise these intermediaries...
...The rapid growth of pension funds of Wall Street players has been crucial in debt-financing the merger wave...
...Is it coincidental that prices and other user charges levied by these industries have risen significantly...
...charges for local phone service—the majority of households makes no or few long-distance calls—have increased 41 percent...
...They can threaten to withdraw their accounts from advertising agencies and the news media, and in a spectacular case, one of the two has done so...
...The unused borrowing power of a "target" firm (or of a firm retiring part or all of its publicly traded shares) "justifies," in the case of buyouts, the premium over the market value of its shares paid by the acquirer to the shareholders...
...In these instances, a crisis of liquidity threatened a swiftly widening cycle of bankruptcies or, in the case of the stock market collapse, a "free fall" of stock prices...
...The "reallocation of economic resources to the highestvalue use, a process which can improve efficiency and competition," has become the primary criterion in judging the market impact of mergers.m Although adoption of this criterion by the courts antedates the Reagan administration, the so-called Chicago school of antitrust regulators, brought in by the Reagan administration in 1980 as part of its effort to deregulate business, changed antitrust policy dramatically...
...16 Such confidence is not unreasonable...
...The merger wave of the eighties has vastly intensified the peril that large corporations pose to a democratic polity...
...The RJR directors favored KKR [Kohlberg, Kravis, Roberts & Co., the Wall Street firm that outbid RJR Nabisco management in the leveraged buyout offer] 138 • DISSENT Comments and Opinions because they believed the firm would treat employees better and dismantle less of RJR...
...2 Jensen holds that an important potential gain to shareholders is "free" cash flow, that is, the cash flow that remains after a firm's projects have been funded that over time yield a reasonable rate of return after accounting for the costs of capital...
...Wall Street Journal, December 5, 1988...
...Jensen recognizes only an obligation to shareholders in such restructuring...
...and "Monetary Policy Report," August 1988, various passages...
...Government Printing Office, July 1987), p. 20...
...It is able to spread a sort of safety net under the financial system when it faces disarray but unable to prevent its corruption...
...cable television 42 percent...
...and the stock market collapse in October 1987 when the Board expanded the banks' reserve base so as to support the credit lines of stockbrokers...
...Whence the Growth in Debt...
...What's more, workers are often asked to pay part of the interest cost in a leveraged buyout by accepting lower wages...
...15 The transformation of Wall Street has also been premised on underlying changes in monetary and fiscal policies and on the repeated affirmation by the Federal Reserve Board of its role as lender of last resort in case "disorderly" conditions place the financial system at risk...
...I 3 So writes Charles Lindblom at the end of his Politics and Markets...
...But how much is the target firm worth...
...More than half of this sum was financed by banks (such as Bankers Trust and Chase Manhattan), and the other half by financial houses such as Merrill Lynch...
...It offered to pay a premium over the market-traded value of the shares...
...Yet the postulate about the discipline of the capital markets is necessary for Jensen in order to bolster his point...
...But outside directors work first and foremost for shareholders...
...9 Market power appears by and large to have diminished as a concern of antitrust policy...
...6 General Accounting Office, Plant Closings — Limited Advance Notice and Assistance Provided Dislocated Workers (Washington, D.C.: U.S...
...Conservatives and others who stress efficiency might consider that the visible evidence that inequity breeds —e.g., the fact that after-tax income of the top 20 percent of the income distribution runs to nearly ten times that of the bottom 20 percent—is bound to impair efficiency by the damage it does to what little sense of social solidarity remains in America...
...and Nabisco), the two new "conglomerate" giants control vast resources for advertising and promotion...
...7 Jensen, "The Free Cash Flow," p. 128...
...Finally, the prior rights of communities should be recognized before a plant can be closed because of "inefficiencies...
...The value gain must of course be judged by the bidder to run well in excess of the heavy burden of interest charges, estimated to range from 20 to 33 percent of the acquired firm's cash flow (after-tax profit plus depreciation set-asides), as well as to be sufficiently robust to absorb the pressures for quick repayment of the loans needed for the acquisition...
...One influential theory has been propounded by Michael Jensen, a professor at the Harvard Business School...
...Thus, the premium captures the "free" cash flow for the "target" firm's shareholders...
...Or why should its position not be enhanced as compared to the shareholder...
...142 • DISSENT...
...The political and social implications of conglomerate mergers (firms in noncompeting industries) clearly are no less weighty than horizontal mergers...
...With all its activism in preserving the stability of the financial system, the Federal Reserve has been unable to prevent the weakening of the capital structure of American industry...
...The efficiency gains from corporate "restructuring" carried by debt have often come at great cost to employees and communities...
...Jensen's theory possesses explanatory force but rests on premises not explicitly acknowledged by him (to be noted below...
...No doubt managers are frequently overpaid and too privileged, but that still recognizes competence in running the enterprise, something stockholders cannot usually boast...
...Finally, I will point to the reactionary redistributive effects that the combination of unfettered financial dealings and permissive antitrust and banking policies are having and the damage they inflict upon a democratic polity...
...But it follows from the conventional postulate (to which Jensen evidently adheres) that shareholders' interests diverge from those of managers (their presumed agents...
...They are disproportionately powerful...
...Where do the potential value gains come from...
...However, the acquiring investors may believe that Wall Street is undervaluing these shares, and so may the shareholders of the target firm...
...And this gives them the power effectively to "discourage media coverage of the hazards of smoking...
...encouraged stock retirements, also by means of debt, thus helping to decapitalize industry and impeding long-term productive investment...
...Such a payout of course "reduces the resources under managers' control...
...The large private corporation fits oddly into democratic theory and vision...
...All three conditions have tended to reduce the risk of indebtedness even though the second condition does not guarantee the success of any one leveraged corporate buyout or prevent the failure of any one bank (intervention by the Federal Reserve as lender of last resort depends upon the stakes involved...
...Whatever the extent of the divergence, however, it is greatly mitigated by the often extensive shareholdings held by the managers...
...Controls should be imposed on the liability structures of merging firms and firms proposed for buyouts...
...The RJR directors' concerns should not legitimize all calls for taking care of stakeholders.' One might ask, why should management not be entrenched...
...Horizontal mergers, completely taboo before 1980, have become common, even between huge public firms...
...Such accretions in market power are fostered by permissive antitrust policies that have been part of the deregulatory climate of the late seventies and eighties...
...16 Wall Street Journal, November 19, 1988...
...able in reimposing their control...
...It can raise the cash through banks or other investors...
...The retreat by the courts from antitrust since the sixties has been reinforced by the Reagan administration, fostering the enormous merger wave of the eighties...
...The other 92 percent represented the "leverage" by which it purchased RJR Nabisco...
...9 Robert W. Kling, "Trucking Deregulation: Evolution of a New Power Structure," Journal of Economic Issues (December 1988):1203...
...The debt incurred by the acquirer and the usually burdensome interest charges serve as disciplinary restraints: he is compelled to operate the acquired or the now merged firm as efficiently as possible...
...8 This has held, for example, for deregulated industries, such as the airlines, broadcasting, trucking, banking, and securities, where more than one half of all merger and acquisitions activity (by value of assets) has occurred since 1980...
...It is roughly equivalent to the "unused" borrowing power of the firm...
...We will find that these gains must be attributed essentially to the actual and potential market power of the merged firms...
...Also, I will briefly explore the institutional environment that has facilitated the merger wave...
...3 Business Week, December 19, 1988, p. 30...
...Business Week senior writer Judith Dobrzynski has the following to say regarding the RJR Nabisco buyout: Should directors consider the interests of employees, communities and other so-called stakeholders...
...27 percent cited consolidation of product line or service (a typical result of restructuring...
...It "does not believe that arbitrary controls on the use of credit can be desirable or effective...
...2) the active role of the Federal Reserve Board as lender of last resort...
...Put differently, the shareholder gains originate from a redistribution of income from two sources: (1) the employees and the local economies dependent upon them and (2) the consumers of the products and SPRING • 1989 • 139 Comments and Opinions services, prices of which are determined largely by market power...
...Because, says Jensen, "Managers have incentives to expand their firms beyond the size that maximizes shareholder wealth," that is, for bureaucratic or self-aggrandizing reasons, managers tend to overinvest...
...18 Federal Reserve Bulletin, January 1988, pp...
...William Adams, an antitrust expert at the University of Michigan, states it more circumspectly: "To the extent that market power affects the distribution of political influence as well as the distribution of income, antitrust authorities might properly be instructed to attack market power...
...That's often a smokescreen used to justify decisions to entrench them or enhance their positions...
...Parenthetically, it might be noted that the banks often sell the loans to nonbank investors, thereby reducing their own risk...
...The relaxation if not subversion of such regulation over the past two decades is unlikely to last indefinitely, although its reinvigoration hinges on popular pressure...
...Hence their income has become more dependent upon dividends, and the capital gain from speculative investment, than upon the fixed returns of bonds...
...They also earn enormous fees, estimated for the RJR buyout at $400 million, and shared by some two hundred participating banks...
...July 1988, p. 6. For details of the five instances, see the relevant passages in William Greider, Secrets of the Temple (New York: Simon and Schuster, 1987...
...Who Merges...
...Only to break a tie...
...Inasmuch as both firms merged earlier with two of the largest food manufacturers (Kraft, Inc...
...I will here offer a few sketchy answers...
...Enormously large, rich in resources, the big corporations . . . command more resources than do most government units...
...It also subjects them to the monitoring of the capital markets, since now being unable to finance projects from internally generated funds, they must turn to those markets instead...
...It was outbid, however, by the Wall Street firm which eventually became the new owner, and whose offer to shareholders doubled the shares' aggregate value to nearly $25 billion...
...These controls should first of all redirect the antitrust laws in the sense indicated by Walter Adams: The redistributive effects of mergers and acquisitions should be primary criteria in judging and challenging them...
...Although long-distance telecommunications service has been subject to competition since the breakup of Bell Telephone in 1983, the local or regional Bell companies have retained their monopolies but under much more relaxed public surveillance...
...In manufacturing, intensive restructuring by means of mergers and acquisitions is believed to have been highly cost-effective...
...I will discuss the source of the gains that accrue to shareholders of target companies as well as to acquiring investors...
...Mexico (1982...
...Such pressure was indispensable in creating the regulatory commissions and antitrust laws, and it will be no less indispensNotes David J. Ravenscraft, "The 1980s Merger Wave: An Industrial Organization Perspective," in The Merger Boom (Proceedings of a conference sponsored by the Federal Reserve Bank of Boston, in October 1987), Lynn E. Browne and Eric S. Rosengren, eds., p. 19...
...Much of that rise, however, has been applied to buying back shares by the issuing firms, so that their higher values are due wholly or in part to their relative scarcity rather than to a genuine appreciation in underlying (real) assets and potential yield...
...That rules out "social" investment of pension fund contributions, unless specifically prescribed...
...14 For Minsky's views, see his "The Evolution of Financial Institutions and the Performance of the Economy," Journal of Economic Issues (June 1986):345 354...
...A firm can finance the acquisition of another (or target) firm either by an exchange of shares or cash...
...The "leveraged buyout," dramatized last fall by the struggle over RJR Nabisco and the $25 billion paid by a Wall Street firm mostly through debt instruments, has been only part of the wave of mergers and acquisitions, by far the largest in American economic history, that began in 1981...
...and (3) the great weight of government in the economy and the recurring Federal budget deficit in supporting high levels of aggregate demand...
...he cannot afford "wasteful" expenditures...
...Opposition to antismoking legislation has been organized and amply funded by such cigarette manufacturers as Philip Morris and R. J. Reynolds...
...As the Wall Street Journal remarks: The economic history of the 1980s suggests that rapid growth of public and private debt is no longer a threat to prosperity but a guarantee that monetary and fiscal policy will be permissive enough to ensure that large borrowers do not default...
...2 Michael C. Jensen, "The Free Cash Flow Theory of Takeovers: A Financial Perspective on Mergers and Acquisitions and the Economy," in The Merger Boom, p. 102 ff...
...An Antitrust Perspective," in The Merger Boom, p. 176...
...The political influence that market power confers is exemplified by a recent front-page report in the New York Times (December 24, 1988...
...Far from becoming the socially responsible investors urged by knowledgeable persons on the left, pension funds have played a key role in corporate takeovers...
...Why should there be a remnant of cash flow, here termed "free...
...Among developments that confirm the increasing market power of corporations has been the virtually unhindered rise in horizontal mergers and acquisitions (i.e., of firms in the same industry that might otherwise be competitors...
...And the market value of the shares of corporations thus "restructured" rose by about 50 percent over the period, thus contributing to the overall increase in share prices, boosted also by the plant retirements mentioned above...
...On Wall Street today, investors believe that government itself will serve as a shock absorber reducing the danger of depression and default...
...8 Gregg A. Jarrell, "Financial Innovation and Corporate Mergers," in The Merger Boom, p. 55...
...economy have been experiencing slower growth and, in some cases, even retrenchment...
...19 Federal Reserve Bulletin, July 1985, p. 516...
...Notwithstanding the loss in productive capacity, the causes of which may to an extent have lain beyond the industry's control, the gains to shareholders from the efficiencies realized through such mergers as Gulf Oil and Chevron, Getty and Texaco, and Dupont and Conoco exceeded an estimated $17 billion...
...In terms of the constant-dollar value of assets (represented by shares of stock) acquired from target firms, this wave has been twice as great as the merger booms of 1965-70 and 1898-1901.' During the eighties nonfinancial corporate debt grew at a rate roughly half again as much as the national product (growth in the national product serves as a crude indicator of debt-servicing ability...
...The rationale of such transactions as the RJR Nabisco leveraged buyout or acquisition (the two terms are used interchangeably, although not all acquisitions are leveraged buyouts) is to realize gains from the value potential that inheres not merely in the productive plant but in the market power of the "target" firm...
...5 Also indicative are some of the factors cited by business officials as influencing plant-closure and layoff decisions...
...At RJR Nabisco, a large food and cigarette manufacturer and itself the product of an earlier merger of two mammoth firms, the incumbent management sought to "buy out" the firm's shareholders...
...according to certain econometric wage models, such restructuring caused wage increases to be lessened by about 1 percent per year between 1983 and 1986, even as productivity significantly improved, making for "dramatic" declines in unit labor costs...
...Consolidations aim at reducing productive capacity, and at concentrating this in the more efficient and hence profitable plants...
...The reality is that pension funds help provide "predatory pools of capital to facilitate the arbitrage process" that leads to buyouts and other kinds of corporate takeovers...
...A corporate takeover often disrupts this network, and can make for losses as well as gains, financiers being usually ignorant of or indifferent to the social setting of the business...
...and °Odom numerous reminders of the fragility of this type of situation ." 19 The Federal Reserve will not impose credit controls to at least make a stab at counteracting these trends...
...facilitated contractive consolidations implicit in most corporate takeovers and leveraged buyouts...
...The "free" cash flow "must be paid out to shareholders if the firm is to be efficient and to maximize value for shareholders...
...41-42...
...Of course, speculative gains, if any, remain his alone, and among steps he can and usually will take is the sale of divisions of the acquired firm (divestiture...
...Among reasons for the pension funds becoming important Wall Street players have been certain regulatory changes that permit them to invest much higher proportions of their funds than earlier in stocks rather than bonds...
...When managers start talking about having to balance the concerns of all stakeholders, hold on to your wallet...
...t 8 Furthermore, interest payments take a bite out of corporate cash flow that runs, again, near "historically high" levels...
...How then is "free" cash flow determined...
...This wave has been linked to an increase in corporate debt unprecedented in volume...
...The takeover bids of the eighties have averaged more than $325 million per bid, four times more than during the seventies, generating a huge debt burden...
...179 . 12 Ibid., p 13 Charles Lindblom, Politics and Markets (New York: Basic Books, 1977), p. 356...
...Minsky has listed five major interventions by the Federal Reserve Board since 1980: the Hunt brothers' silver affair (1980...
...20 Federal Reserve Bulletin, August 1988, p. 530...
...Paper prepared for Capitalist Development and Credit Theory: Accumulation, Regulation, and Spatial Restructuring, Mark Gottdiener and Nicos Komninos, eds...
...It is a bit puzzling why the cretinism of capital markets with their unvarying focus on short-term financial results should be relied on to substitute for managers' competence in judging the need for a given project...
...The pension manager's success is measured entirely by financial yardsticks (if within the bounds of "prudence"), and these yardsticks prescribe that the highest possible return be secured...
...Despite this possibility, between 1981 and 1986 premiums in the aggregate totaled an estimated $200 billion over and above the trading value of holdings at the time of the takeover...
...q 11 Quoted in William James Adams, "Should Merger Policy Be Changed...
...That is a question Jensen's theory does not reach...
...Such gain no longer arises from the innovation of new products or the creation of new markets—the historical sources of most capital gain...
...Nearly one-fourth of the capital committed to the loans extended for the RJR Nabisco buyout was provided by eleven state pension funds, with New York State contributing $1 billion...
...They have in effect validated rampant growth in debt, much of it lacking in socially redeeming purpose...
...Nor is his position exceptional...
...That has been the result of many takeovers and most other restructuring, and this latter term is in fact a euphemism for what really happens...
...The value gains are of course expected to exceed the premiums paid to shareholders of "target" companies—an expectation that may at times be disappointed...
...The case of Goodyear Tire and Rubber Co., which in 1987 eliminated nearly four thousand jobs, among other "cost-cutting" measures, so as to realize the cash it needed to buy off the British corporate raider, Sir James Goldsmith—measures which Goldsmith most likely would have taken himself, had he succeeded in acquiring the firm— strikingly demonstrates the lack of responsibility on the part of powerful shareholders, and of the damage they can inflict...
...And, finally, managers are at times quite capable of speaking for all stakeholders in a corporation—at least they bear witness on the spot to the likely damage caused by absentee shareholders and their Wall Street agents, driven as these often are by short-term and purely financial considerations...
...True, the rise in corporate debt has not impaired the value of corporate assets as expressed in the price of shares...
...Indeed it does not fit...
...and promoted a reactionary redistribution of income...
...For example, in the view of the one-time solicitor general of the United States, Robert Bork, horizontal mergers would hardly ever be curbed...
...The investor acquiring such firms would liquidate such overinvestment...
...Unquestionably this wave has contributed to the growing disparity in the distribution of income and wealth during this decade...
...Continental Illinois (1984...
...If your monthly home mortgage payment is equivalent to, say, 15 percent of your income, then your "unused" borrowing power represents an additional 10 percent of your income, on the assumption that, optimally, mortgage payments can take one-quarter of your income...
...6 Six percent of these officials cited "acquired by another company" as one of the factors in plant closure...
...The buying firm itself funded only around 8 percent of the purchase price from capital of its own...
...Airline fares rose 24 percent between 1982-84 and late 1987...
...20 This is demonstrably false inasmuch as controls have been applied more or less flexibly at various times since World War II, and have been effective...
...17 Hyman P. Minsky, "Financial Crises and the Evolution of Capitalism: The Crash of '87: What Does It Mean...
...our financial history provides SPRING • 1989 • 141 Comment...
...A downturn in earnings would place serious debt servicing strains on many individual firms...
...Those accretions of market power are usually twinned with a consolidation of industrial capacity and signify economic contraction...
...The United States has a history of business and financial regulation...
...The Federal Reserve Board, however, operates in the climate of business deregulation that has made the imposition of controls impolitic, and most of its members are themselves captives of aberrant freemarket ideologies...
...What does the enormous merger wave of the eighties signify...
...12 The very opposite of this view has prevailed...
...The increased operating efficiencies expected from leveraged buyouts and other kinds of corporate takeovers require "tough moves: cost cutting, asset sales, and rapid repayment of debt," states the Wall Street Journal.' No definitive research has appeared to my knowledge that links corporate takeovers to plant closings and other effects damaging to workers and communities, although Rudy Oswald, chief economist of the AFL-CIO, says, "Often workers lose their jobs as plants are closed or sold off...
...Nevertheless, we must consider the consequences of the authorities' activism in trying to sustain financial stability...
...mergers could capture up to two-fifths of given markets, and economic efficiency becomes the focus of antitrust guidelines...
...It arises from consolidation and increased market power (meaning increased pricing power, market share, and dominance over suppliers...
...Here the outstanding case has been the oil and gas industry, which accounted for more than one-quarter of all takeovers in terms of asset value between 1981 and 1984...
...3 "Discussion" by John D. Paulus and Stephen R. White of essay by Ravenscraft, The Merger Boom, pp...
...SPRING • 1989 • 137 Comments and Opini Who Profits, Who Loses...
...A business embodies a network of personnel, supplier, and customer relations, of government, banking, and investor connections, as well as physical plant...
...Drysdale Securities and Chase Bank (1982...
...15 Jarrell, "Financial Innovation," p. 57...
...Public-service warnings against smoking could in time disappear, and state and local legislatures could be intimidated in their antismoking efforts...
...I° Gregg A. Jarrell, "Financial Innovation," p. 55...
...14 Among the "most fundamental" structural changes on Wall Street (i.e., the complex of security exchanges, insurance companies, and banks) has been the rise of institutional investors, meaning largely the pension funds managed by professionals, and hence the "professionalization" of share ownership and trading...
...This phenomenon has many causes, including substantially increased foreign competition...
...It also reflects the contractive nature of corporate takeovers, as in fact do theories like Jensen's, trying to explain how shareholders gain...
...Pension funds accounted for about 25 percent of the ownership of corporate securities in 1988, compared with 5 percent in the sixties and 15 percent in the seventies, and for two-thirds to three-fourths of all trading in the stock markets...
...The slow growth has meant increased takeover activity because takeovers play an important role in facilitating exit from an industry...
...Those are valid concerns...
...I cannot here deal with this aspect of takeovers (e.g., the talk of differences in management "cultures" when firms experience postmerger difficulties...
...It has reported "historically high" delinquencies on commercial, industrial, and real estate loans, rising loan charge-offs by banks, an "unusually high number of bonds [that] have been downgraded, in that the number of downgradings typically falls as an expansion matures," and "downgradings of corporate debts that have continued to exceed upgradings by a large margin...
...7 Thus, Jensen confirms the contractive character of takeovers—but how explain why the loss to society implied by these contractive movements translates into substantial gains to shareholders...
...Minsky is surely right in this...
...other intercity public transportation, 34 percent...
Vol. 36 • April 1989 • No. 2
