Mergers and Acquisitions: Why Greed is Good
Dr. Klein is Assistant Professor of Economics at the University of Georgia, and an Adjunct Scholar of the Ludwig von Mises Institute.
In 1989 the New York investment banking firm of Kohlberg Kravis Roberts & Co. (KKR) shocked the corporate world by acquiring RJR-Nabisco, the food and cigarette giant ranking nineteenth on the Fortune 500 with $17 billion of annual sales. The final purchase price—an unheard-of $24.7 billion—was (and remains) the largest sum ever paid by one firm to buy out another. What’s more, KKR financed the acquisition through debt, by issuing high-risk, high-yield bonds. Highly visible “leveraged buy-outs” (LBOs) such as this one became the defining feature of the takeover wave of the 1980s. Suddenly, everyone was talking about LBOs, divestitures, repurchases, free cash flows, and other formerly exotic activities. Takeover specialists like Michael Milken and Ivan Boesky became regulars on the nightly news. Accompanying the unprecedented volume of takeover activity during this period was a new “official” name: the “Decade of Greed.”
Pundits and politicians, and even some professors, charged that these corporate restructurings did little but shuffle assets on paper, lining the pockets of clever financiers at the expense of workers and the average shareholder. The critics invented a new, colorful language to describe the proceedings: takeover specialists were “raiders”; high-yield bonds became “junk bonds”; tender offers resisted by incumbent management were deemed “hostile takeovers.” Popular books like Bryan Burrough and John Helyar’s Barbarians at the Gate (on the RJR-Nabisco deal) and James Stewart’s Den of Thieves became best sellers.
In Oliver Stone’s Wall Street, the financier Gordon Gecko (played by Michael Douglas) summarizes the ethical philosophy of the raiders with the famous words: “Greed is good.” This, we are told, was the spirit of the times. And the bigger the deal, the harder the criticism. The RJR buy-out is the one “people regard as the most symptomatic of the excesses on Wall Street,” according to one more sober account. It was “the culmination of a process that had gone badly out of control.”[1]
Not surprisingly, the truth about mergers and acquisitions is very different from what is portrayed in these accounts. Takeovers, LBOs, and other reorganizations are simply changes in the ownership of assets. As such, they serve an important social purpose; indeed, they are essential to the smooth operation of a market economy. When productive assets are privately owned and traded, these assets will tend to move toward their highest valued uses. Changes in the ownership of corporations, then, are just part of the market process of adjusting the structure of production to meet consumer wants. Resources are shifted from owners whose stewardship is poor to those the market believes can do a better job.
Corporate takeovers are an important part of this process. When a firm wants to expand, it can either increase its existing operations or acquire another firm. It will choose the latter if it believes it can buy and redeploy the assets of an existing firm more cheaply than it can purchase new capital equipment.
In this sense, a merger or takeover is a response to a valuation discrepancy: acquisition occurs when the value of an existing firm’s assets is greater to an outside party than to its current owners. This difference in valuation may be because the buying firm believes its management or a new management team it installs can operate the target firm more effectively than the target firm’s incumbent management. Hence we can also think of mergers as a kind of monitoring institution: takeover, or the threat thereof, serves to discipline managers. If they fail to maintain the market value of the firm, new owners will quickly arrive and replace them.
The Disciplinary Role of Takeovers
Since Adolph Berle and Gardiner Means published their 1932 book The Modern Corporation and Private Property, critics of the corporation have increasingly maintained that because the large modern firm is run not by its owners (the shareholders) but by salaried managers, these firms will not be run efficiently. Shareholders want the firm to maximize its profits, but the managers dislike hard work and prefer other things, like executive perks, prestige, paid vacations, and similar rewards. Because of this “separation of ownership and control”—what economists now call a principal-agent problem—managers will pursue their own goals at the expense of profits. Since the average stockholder owns few shares in any given firm, no owner will have sufficient incentive to engage in (costly) monitoring of these managers or to take action to replace them. The Berle-Means thesis implies that advanced market economies must be inefficient, even by the market’s own standard of profit maximization.
Henry Manne, then a young law professor and now Dean of the Law School at George Mason University, addressed the Berle-Means thesis in a seminal 1965 article, “Mergers and the Market for Corporate Control.”[2] Manne argued that managerial discretion will be limited as long as there exists an active market for control of corporations. When managers pursue their own goals at the expense of profit maximization, the share price of the firm falls. This invites takeover and subsequent replacement of incumbent management. Hence while managers may indeed hold considerable autonomy over the day-to-day operations of the firm, the stock market places strict limits on their behavior.[3]
Interestingly, the Austrian economist Ludwig von Mises had expressed the same basic insight sixteen years earlier, in his great work Human Action.[4] In a passage distinguishing what Mises calls “profit management” from “bureaucratic management,” he pointed out that despite the importance of the salaried manager in modern business life, the shareholders make the ultimate decisions about allocating resources to the firm in their decisions to buy and sell stock:
[The Berle-Means] doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the “market,” plays in the direction of corporate business. . . . The changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.[5]
Mises does not identify the takeover mech-nism per se as a means for capitalists to exercise control—takeovers were less popular before the late 1950s, when the tender offer began to replace the more cumbersome proxy contest as the acquisition method of choice—but his point is clear. The heart of a market system is not the consumer-goods market, the labor market, or even the market for managers. Instead, it is the capital market, where entrepreneurial judgments are exercised and decisions carried out.
Are Mergers Efficient?
Mergers and acquisitions, like other business practices that do not conform to textbook models of “perfect competition,” have long been viewed with suspicion by antitrust and regulatory authorities. The problem is that the notion of perfect competition is a hugely inappropriate guide to public policy. In the real world of uncertainty, error, and constant change, “efficiency” means nothing other than directing resources toward higher-valued uses. This can only be measured by the successes and failures of firms as determined by the market. What is good for the firm, then, is good for the consumer. Any merger that is not known to be a response to legal restrictions or incentives must be assumed to create value.
At the same time, several studies have found a sharp divergence between market participants’ pre-merger expectations about the post-merger performance of merging firms, and the firms’ actual performance rates. David Ravenscraft and F. M. Scherer’s (1987) large-scale study of manufacturing firms, for example, found that while the share prices of merging firms did on average rise with the announcement of the proposed restructuring, post-merger profit rates were unimpressive. Indeed, they find that nearly one-third of all acquisitions during the 1960s and 1970s were eventually divested.[6] Ravenscraft and Scherer conclude that mergers typically promote managerial “empire building” rather than efficiency, and they support increased restrictions on takeover activity. Michael Jensen, founder of the Journal of Financial Economics, suggests changes in the tax code to favor dividends and share repurchases over direct reinvestment, thus limiting managers’ ability to channel “free cash flow” into unproductive acquisitions.[7]
Public Policy and the Stock Market
But the fact that some mergers—indeed, many mergers, takeovers, and reorganizations—turn out to be unprofitable does not imply “market failure” or prescribe any policy response. Errors will always be made in a world of uncertainty. Even the financial markets, which aggregate the collective wisdom of the entrepreneurs, capitalists, and speculators who are the very basis of a market economy, will sometimes make the wrong judgment on a particular business transaction. Sometimes the market will reward, in advance, a proposed restructuring that has no efficiency rationale. But this is due not to capital market failure, but to imperfect knowledge. Final judgments about success and failure can be made only after the fact, as the market process plays itself out.[8]
Certainly, there is no reason to believe that courts or regulatory authorities can make better judgments than the financial markets. The decisions of courts and government agencies will in fact tend to be far worse: unlike market participants, judges and bureaucrats pursue a variety of private agendas, unrelated to the desires of market participants. Furthermore, the market is quick to penalize error as it is discovered; no hearings, committees, or fact-finding commissions are required. In short, that business often fails is surprising only to those committed to textbook models of competition in which the very notion of “failure” is defined away. Such models are surely no guide to public policy. []
1. Sarah Bartlett, The Money Machine (New York: Wagner Books, 1991), p. 237.
2. Henry G. Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy 73 (April 1965), pp. 110-20.
3. There are other mechanisms to limit managers’ discretionary activities, such as the market for managers itself. On this see Eugene F. Fama, “Agency Problems and the Theory of the Firm,” Journal of Political Economy 88 (April 1980), pp. 288-307. This article, along with Manne’s and several other important papers on this topic, are collected in Louis Putterman, ed., The Economic Nature of the Firm: A Reader (Cambridge: Cambridge University Press, 1986).
4. Ludwig von Mises, Human Action: A Treatise on Economics (New Haven, Conn.: Yale University Press, 1949; third revised edition, Chicago: Henry Regnery, 1966).
6. David Ravenscraft and F. M. Scherer, Mergers, Sell-Offs, and Economic Efficiency (Washington, D.C.: Brookings Institution, 1987).
7. Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American Economic Review 76 (May 1986), pp. 323-29.
8. Paradoxically, some critics also charge that unregulated financial markets engage in too few takeovers, due to a “free-rider” problem associated with tender offers. Even when an acquiring firm makes an attractive offer to the target firm’s shareholders, asking them to “tender” their shares for a substantial premium over the current share price, some shareholders will refuse to sell their shares, anticipating further share price increases accompanying a bidding war. These critics conclude that regulation, not the takeover market, should be used to discipline incumbent managers.
Comment by James on 9 August 2009:
There is a difference between having a healthy respect for one\’s personal needs and sick obsession with accumulating ever more resources than any individual needs for personal wellbeing.If you define greed as a normal concern for one\’s own wellbeing than greed is ceartainly not a undesirable character trait.However to suggest that greed is a good thing,\’\'according to the commonly accepted definition of greed\’\'is moraly reprehensible.
It has been said that something is amiss when governments begin to favor the interests of those who produce nothing over those who are productive.Generaly speaking there are realitivly few examples of non productive persons or behaviors taking precidence over industrial concerns.Visit the people of Appalachia who have lost their homes and livlihoods to the practice of mountain top removal and they will tell you that indeed those who produce do occasionaly need to be restrained.Those persons partial to continuous productivity should remember that for everything produced something must be destroyed.This is not my opinion but a basic law of physics.
Capitalists often insist that of all the known means of economic interaction that capitalism most readily promotes human freedom.Many capitalists go as far as even equating capitalism to freedom.These people would do well to consider the fact that the more of our needs which must be purchased or somehow earnend the less free we are ! Generaly speaking we do not buy things because we are free,we buy things we must. In reality it is only when needed resources are collectivly shared or accsesed that we humans are able to enjoy some degree of freedom.If you do not believe this already then consider for a moment one of our most vital resources,the sun.Each and every one of us accsess\’s the many benifits which the sun provides, even though no one amongst us produced or can claim ownership over the sun,\’\'although I am sure that someone at this very moment is searching for a way to claim ownership over the sun !\’\’ Only the most insane person would believe that they were free if tommorrow they were told they were going to be required to pay for their share of sun light ! It is of course impossible to be free if you are forced to pay even for the most basic of resources.Yet we Americans insist that we are free even as most of us are forced to do just that ,while a very small percentage of the population claims \’\'ownership\’\'over the resources needed by all to survive.I have heard a great number of people oraly celibrate\’\’ being free to earn a living\’\’.At this juncture let me stress the fact that I believe strongly in the value of people living upon this planet via their own efforts.However there is a huge difference between making a living and being forced to earn a living,\’\'because a ceartain small percentage of the population claims ownership even over the resources they have not produced.Land is prime example of a resource that like the sun none of us has produced and none of us can live without accsess to.However our culture has been duped into believing that \’\'instead of everyone having an equal right to accsess land in order to meet our needs\’\'land should be privately owned by those able to afford the purchase of the land,or those lucky enough to inherit land.While American\’s claim to believe in \’\'property rights\’\'what they instead believe in is property \’\'privaleges\’\',or perhaps I should say that Americans believe in obtaining privaledges of wealth,as oppossed to the enjoyment of true property rights.Rights, after all, if they must be paid for are not rights but privaleges ! Each and every person who out of nessesity is paying land rent to the owner of land is in fact not free ! Again it is impossible to be free if you are forced to pay for the resources provided freely by nature!An economy based upon the collective sharing and or the right to accsess ,\’\'not nessacarly own\’\’ natural resources would go far to promote the cause of human freedom.I find it very telling that one of the primary arguments given in support of capitalism is that people would not have an incentive to work if we did not practice capitalism.Apparently these people believe that we humans have no reason to exist other than to work !With such a shallow estimation as to the purpose of life is it any wonder that our culture is plauged by crime,suicide,drug abuse,mental illness and other societal and personal ills ? The thought that we were born primarly to be workers like most of the bees in a bee hive is to say the least not very motivating.Besides this point,this is an argument with serious socialistic overtones ! Strangly enough many of the same people who adhere to this argument are the people who claim that capitalism and freedom are one and the same ! So I suppose that freedom to these people consist of nothing more than having the proper incentive to work ,or perhaps the assumption of responcibilities that are dictated by others and must be met in a manner dictated by others ? In summary the proponets of capitalism endorse not freedom but the subjugation to predetermined standards and conformity to the norms of scociety established for the benifit of the wealthy.
If capitalism promotes freedom I wonder then why is it that my neighbor who own\’s more than 325 acers of undeveloped land,\’\'which he inherited\’\'has at least 50 no tresspasing sighns around the perimiter of that land.How I ask is the cause of freedom furthered when one person,or a small group of persons can make large portions of the surface of the earth off limits to the rest of humanity.Of course people have a right to a reasonable degree of privacy,but when individuals are allowed to claim as their own enough space to establish a state park the rights of the many are violated for the sake of a few.How can people be free when large portions of the planet are in fact of limits to all but a handfull of wealthy people ? This planet I might remind you was not created by wealth or human effort.
Apparantly the proponets of capitalism forgot to tell the US.supream court that capitalism promotes freedom ? I am not sure of title of the case nor of the date of the ruling,however the supream court has in fact ruled that individuals when upon privately ownd property, no longer enjoy constitutionaly protected freedoms ! This is why when you are at work,\’\'unless you own the property where you work\’\’ your boss can tell you what to say or not to say and fire you for merly speaking your mind.Basicaly unless you are on your privatly owned property,or public property the bill of rights does not apply to you.God help you in the event of severe financial difficulties that cause you to loose what ever land you may \’\'own\’\’ ! In effect ,according to this ruling our natural rights are really not rights after all,being that you must own property,\’\'or be on public land\’\'in order to exercise at least some of our natural rights.Even renters, according to this ruling can not legitimatly claim to have constitutionly protected rights when residing in a rental home ! This my fellow American is not what the authors of the bill of rights had in mind.This is the result of a socioeconomic systyem which allows individuals to claim ownership over natural resources,\’\'land\’\'that rightfully belongs to everyone.Capitalism is but a precurser to corperate facism as government by the people for the people is replaced by the rule of wealth and the gradual enslavement of the masses.
Comment by John Anello on 10 August 2009:
James,
Your argument relies on faulty assumptions. First of all when something is psychically produced nothing is destroyed. The law of conservation of matter, a basic law of physics, states that “matter cannot be created nor destroyed, it just changes states.” Production does not destroy resources but rather changes them into forms more suitable for use in society.
Capitalism is the best economic system to promote individual freedom not because it alleviates the individual from the responsibility of providing for his needs; but because it allows the individual to prioritize his needs and provide for them through his own industry, based on his own desires.
A society based on collective sharing of property would not go far to promote human freedom but would rather stifle it. When property belongs to everybody property belongs to nobody. Land would not be developed nor could it be used for productive purposes. There would simply be too many interests jockeying for control of property they all would have a legitimate claim to; chaos and anarchy would soon follow. A civilized and free society recognizes that property rights are paramount to the survival of a free and industrious people and must be protected.
Eminent domain laws remain a grave threat to property rights in the US. The government can seize property almost at will for such fleeting and onerous causes as “social justice”, and “public good.” Fighting eminent domain in court is costly to the private citizen and outcome is often not is his favor. A most egregious example of eminent domain occurred in Florida just a few years ago. Here is a link.
http://www.foxnews.com/story/0,2933,222160,00.html
Lastly, private property is not the forum for exercising constitutionally protected freedoms. It would be absurd to allow people to exercise First Amendment rights on the private property of a citizen at his annoyance. The First Amendment is to protect citizens against government oppression by allowing them to voice their displeasures and petition the government if necessary. The proper venue for disputes between private citizens is civil court, not private property. As far as protecting constitutional freedoms the Supreme Court has been very adamant. See the 1989 Texas v. Johnson case, where the Supreme Court upheld a private citizens right to burn the American flag on public property.
Comment by James Madison Fan on 11 August 2009:
James,
The word “greed” as an economic concept is different than as an ethical one. In the case of economics “greed” is self interest. Alternate words would include “want” or “desire.”
For instance we might be able to survive the day on a bowl full of gruel and a liter of water but “greed” says that it is better to eat steak and drink wine. That does not mean the man eats at a good restaurant is “greedy” as typically thought of in lay terms only that his “greed” motivates him to invest in better food and drink rather than the life sustaining minimums.
You are correct that even in Capitalism “greed” is not always a good thing. While “greed” runs the market, excessive greed ruins the market. Oligopolies and monopolies reduce or eliminate choice and cause an unbalance in the market so the “invisible hand” cannot act to keep supply and demand in balance and that is when government must step in. The author of this article did not touch on these special circumstances and the role LBO and other mega mergers can play in the formation of these unhealthy corporate structures in a capitalistic market.
You lament paying a landlord rent. If citizens do not own the land then who does? The government? This means everyone is a renter. Why should I pay to improve a rental property especially if I cannot leave what I build on said property to my children? Why would I build a decent home much less a “JMF Enterprises” empire on property that is going to revert to the government? I am already paying 40% or more of my income to various governmental bodies as well as a death tax but that is not enough?
I also wanted to correct this statement:
“…after all, if they must be paid for are not rights but privaleges!”
There are many rights that are not free. You have the right to drink alcohol but that does not mean taxpayers should buy a six pack for you. You have the right to own a car (not to drive it) but that does not mean that taxpayers should buy one for you. You have the right to go skydiving but that does not mean taxpayers should pay for the parachute or the plane. You have the right to smoke but that does not mean taxpayers should buy the cigarettes for you. You have the right to buy a newspaper but that does not mean the taxpayers should provide a subscription to you favorite periodical. You have the right to wear a really ugly hat but that does not mean it should be free. A “Right” is having the authority to perform an action regardless of if it cost money or not. You have the right to own a home, unfortunately homes cost money. As soon as you get the bucks you have the right to buy a home anywhere you want regardless of race, creed, color, religion, or sexual preference (Equal Protection Clause).
If you want to know what it looks like when you do not have the right to do something, try to buy some crack with a cop watching. Once he cuffs you he will read you your Miranda Rights. Those are free.
Lastly the Supreme Court ruled that certain rights do not extend universally to privately owned property. For instance you may not like a customer and you retain the Constitutional right to call him a name but that right does not prevent me from exercising my right to fire you for violating company policy. You retain the right to call the customer any name you want but I retain the right to throw your unprofessional buttocks out the door. All the ruling does is define where your right to free speech ends and my right to enforce company policy begins.
With that said I do not like the concept that my right to fire someone extends to behavior outside and unrelated to the workplace. If one of my employee’s is a stripper or poses for an adult magazine after hours why should I be able to fire her? If someone has a mature “Myspace” or other social networking site it is none of my business. This I am far less comfortable with than on-site and business related behavior.
Comment by Pat on 22 March 2010:
Whether mergers and acquisitions are efficient market hypotheses or not, there is some related concern over whose expense they take place – showing little ingenuity or concern over the topic of equisition, a.k.a., the promotion of equality within the scope of using trade to create the general prosperity of all.