Dynamic Explanation of Industry Structure and Performance
Cotterill
finance leveraged buyouts of large publicly held
corporations in the 1980s. These financial as opposed to
industrial capitalists (Veblen, 1919) became very, very
rich from the restructuring of industries. In the 1980s
mergers, LBOs, or defensive leveraged recapitalizations
affected 81% of the sales of the top 20 supermarket
chain (Cotterill 1993, p. 164). Safeway's 1986 LBO by
Kohlberg Kravis and Roberts (KKR) and Kroger's 1988
defensive recapitalization are two that were very
successful for investors. (See the stock performance
charts for them in the Appendix).
Michael Jensen, the intellectual god father of LBOs,
explained that corporate management should not have
discretionary control over their firm's free cash flow
because they tend to reinvest it in the business at rates
below stockholders' required rate of return, i.e. their next
best alternative in the stock market. Leveraging the firm
requires managers to pay free cash flow out to junk bond
holders who can their deploy their earnings elsewhere.
Stockholders in the leveraged firm can reduce their risk
by purchasing junk and investment grade debt securities
in the firm to construct whatever particular "strip
security" and risk return ratio they desire (Jensen, 1986).
More important, however is the fact that, with this
financial innovation, stockholders are now assured that
management is pushing relentlessly for cash flow and its
most important subcomponent, profits.
What is wrong with this significant tightening of
capital market supervision via corporate raiders,
mergers, and internal leveraging via debt to buy back
stock? Well, maybe not much on balance if the exercise
of market power is left out of the analysis. Then it
clearly constitutes a drive for technical and
organizational efficiency and these financial engineering
moves will succeed or fail based on their contribution to
organization efficiency and technical efficiency. Agency
theory works. The success of restructuring, however, in
most instances depended on the breaking of unions or
wage give backs, discounts, slotting fees and other give
backs by suppliers, and higher prices paid by consumers.
In short the exercise of market power was crucial for
their success.
The debate on the merits of LBO's, however,
focused on a larger issue in political economy. Recall
that in the late 1980's and early 1990's many observers,
including James Fallows, who at the time was an editor
of Atlantic and wrote a book on the Japanese economic
miracle, predicted the demise of Anglo-American market
capitalism and the triumph of managed economies. At
one point Michael Porter, in the employ of the top blue
chip American companies, completed a white paper
study that condemned LBO's and hostile takeovers as
shortsighted demands for immediate earnings at the
expense of long term profits that came from long term
investments (Porter, 1992). Porter extolled the virtues of
managed capitalism in Germany and feared that stock
market "inefficiencies" often depressed company prices
below their long run value. Investors seemed only
interested in the next few quarters earnings, without
considering long term gains. Such "dumped companies"
were according to Porter, doing the right thing by
looking long term at the expense of short run profits. If
you detect a resurfacing of Schumpeter's 1949 defense of
large corporations for progress in R&D you are correct.
In a managed capitalism, e.g. where a family, or a
foundation as in the Kellogg case, or a bank as in
Germany or Japan, has sufficient control to keep the
wolves at bay, Porter argued forcefully that the firm will
perform better long term.10 Note that this improvement
in performance can come from the exercise of market
power, as done in Japan's Keiretsu, as well as from
superior dynamic efficiency (Strom, 2000).
In retrospect, the re-engineering of American
corporations was accelerated by LBO and hostile
takeovers. The drive to maximize shareholder value in
the short run has clearly triumphed over the Japanese,
European, and Kellogg model of corporate control.
Michael Jensen seems closer to "the truth", or at least
superior stock market performance long term as well as
short term, than Michael Porter. Economic growth also
has been superior with steady expansion in the U.S.,
recession in Japan and stagflation in Europe through
most of the 1990s. Thus we now see Germany and other
developed economies moving to the Anglo-American
model of deep and unfettered capital markets (Andrews,
Daley, Strom).
Our point, however, is that Jensen's model ignored
the key role market power played in the process. This
transformation has had an impact on income distribution
and consumer welfare. Europeans, rightly so, are uneasy
that their social democratic societies will be dismantled
in pursuit of American efficiency and power by large
global or at least pan European Corporations (Andrews,
Daley). Just as in the late 1800's when investment
bankers such as J.P. Morgan "rationalized" industries by
building trusts to make production more profitable via
the avoidance of competition and the exercising of
power against input suppliers, investment bankers in the
late 1900's also put power as well as efficiency into the
reorganization effort. For example, when Safeway went
LBO with KKR, its new highly leveraged position
10 See Allen and Gale (2000) for a very good book that does
an in depth analysis of the alternative financial systems
including their implications for corporate governance. They
cover the U.S., U.K., Japan, France and Germany.
Food Marketing Policy Center Research Report No. 53