Senin, Februari 27, 2017

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Parallels between the Modern and Historical Industrial Revolutions

            Fundamental technological, political, regulatory, and economic forces are radically changing the worldwide competitive environment. We have not seen such a metamorphosis of the economic landscape since the Industrial Revolution of the nineteenth century. The scope and pace of the changes over the past two decades qualify this period as a modern industrial revolution, and I predict it will take decades for these forces to be fully worked out in the worldwide economy.
Although the current and 19th-century transformation of the US economy are separated by almost 100 years, there are striking parallels between them-most notably, rapid technological and organizational change leading to declining production costs and increasing average (but decreasing marginal) productivity labor. During both periods, moreover, these developments resulted in widespread excess capacity, reduced rates of growth in labor income, and ultimately, downsizing and exit.
            The capital markets played a major role in eliminating excess capacity both in the 19th century and in the 1980s. The merger boom of the 1890s brought about a massive consolidation of independent firms and the closure of marginal facilities. In the 1980s the capital markets helped eliminate excess capacity through leveraged acquisitions, stock buybacks, hostile takeovers, leveraged buyouts, and divisional sales.
And much as takeover specialists of the 1980s were disparaged by managers, policy markets, and the press, their 19th-century counterparts were vilified as “robber barons.” In both case, the popular reaction against “financiers” was followed by public policy changes that restricted the capital markets. The turn of the century saw the passage of antitrust laws that restricted business combinations, the late 1980s gave rise to re-regulation of the credit markets, antitakeover legislation, and court decisions that all but shut down the market for corporate control.
Although the vast increases in productivity associated with the nineteenth century industrial revolution increased aggregate welfare, the large costs associated with the obsolescence of human and physical capital generated substantial hardship, misunderstanding, and bitterness. As noted in 1873 by Henry Ward Beecher, a well-known commentator and influential clergyman of the time,

The present period will always be memorable in the dark days of commerce in America. We have had commercial darkness at other times. There have been these depressions, but none so obstinate and none so universal … Great Britain has felt it; France has felt it; all Austria and her neighborhood has experienced it. It is cosmopolitan. It is distinguished by its obstinacy from former like periods of commercial depression. Remedies have no effect. Party confidence, all stimulating persuasion, have not lifted the pall, and practical men have waited, feeling that if they could tide over a year they could get along; but they could not tide over the year. If only one or two years could elapse they could save themselves. The years have lapsed, and they were worse off than they were before. What is the matter? What has happened? Why, from the very height of prosperity without any visible warning, without even a cloud the size of a man's hand visible on the horizon, has the cloud gathered, as it were, from the center first, spreading all over the sky?

            Almost 20 years later, on July 4, 1892, the Populist Party platform adopted at the party’s first convention in Omaha reflected continuing unrest while pointing to financiers as the cause of the current problems:

We meet in the midst of a nation brought to the verge of moral, political, and material ruin …. The fruits of the toil of millions are boldly stolen to build up colossal fortunes for the few, unprecedented in the history of mankind; and the possessors of these in turn despise the republic and endanger liberty. From the same prolific womb of government injustice are bred two great classes of tramps and millionaires.

            Technological and other developments that began in the mid-20th century have culminated in the past two decades in a similar situation: rapidly improving productivity, the creation of overcapacity and, consequently, the requirement for exit. Although efficient exit has profound import for productivity and social wealth, research on the topic has been relatively sparse since the 1942 publication of Joseph Schumpeter's famous description of capitalism as a process of “creative destruction.” In Schumpeter’s words,

Every piece of business strategy …. must be seen in its role in the perennial gale of creative destruction. The usual theorist's paper and the usual government commission's report practically never try to see that behavior, on the one hand, as a result of a piece of past history and, on the other hand, as an attempt to deal with a situation that is sure to change presently—as an attempt by those firms to keep on their feet, on ground that is slipping away from under them. In other words, the problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them.

Current technological and political changes are bringing the question of efficient exit to the fore front, and the adjustments necessary to cope with such changes will receive renewed attention from managers, policymakers, and researchers in the coming decade.


Outline of the Paper

In this paper, I begin by reviewing the industrial revolutions of the 19th century to shed light on the current economic trends. Drawing parallels with the 1800s, I discuss in the some detail worldwide change driving the demand for exit in today’s economy. I also describe the barriers to efficient exit in the US economy, ant the role of the market for corporate control – takeovers, LBOs, and other leveraged restructurings – in surmounting those barriers during the 1980s.
With shutdown of the capital markets in the 1990, the challenge of accomplishing efficient exit has been transferred to corporate internal control systems. With view exceptions, however, US management and boards have failed to bring about timely exit and downsizing without external pressure. Although product market competition will eventually eliminate overcapacity, this solution generates huge unnecessary costs. (The costs of this solution have now become especially apparent in Japan, where a virtual breakdown of the internal control systems, coupled with complete absence of capital market influence, has resulted in enormous overcapacity – a problem that Japanese companies are only beginning to address.)
At the close of the paper, I offer suggestions for reforming US internal corporate control mechanism. I particular, I hold up several features of venture capital and LBO firms such as Kleiner Perkins and KKR for emulation by large, public companies – notably (1) smaller, more active, and better informed boards; and (2) significant equity ownership by board members as well as managers. I also urge boards and managers to encourage larger holdings and greater participation by people I call “active” investors.


The Industrial Revolution was distinguished by a shift to capital-intensive production, rapid growth in productivity and living standards, the formation of large corporate hierarchies, overcapacity, and, eventually, closure of facilities. Originating in Britain in the late 18th century, the First Industrial Revolution witnessed the application of new energy sources to methods of production. The mid-19th century saw another wave of massive change with the birth of modern transportation and communication facilities, including the railroad, telegraph, steamship, and cable systems. Coupled with the invention of high-speed consumer packaging technology, these innovations gave rise to the mass production and distribution systems of the late 19th and early 20th centuries—the Second Industrial Revolution.
The dramatic changes that occurred from the middle to the end of the century clearly warranted the term “revolution.” Inventions such as the McCormick reaper in thr 1830s, the sewing machine in 1844, and high-volume canning and packaging devices in the 1880s exemplified a worldwide surge in productivity that “substituted machine tools for human craftsmen, interchangeable parts for hand-tooled components, and the energy of coal for that of wood, water, and animals”. New technology in the paper industry allowed wood pulp to replace rags as the primary input material. Continuous rod rolling transformed the wire industry: within a decade, wire nails replaced cut nails as the main source of supply. Worsted textiles resulting from advances in combining technology changed the woolen textile industry. Between 1869 and 1899, the capital invested per American manufacturer grew from about $700 to $2,000; in the period 1889 to 1919, the annual growth of total factor productivity was almost six times higher than that which had occurred for most of the 19th century.
As productivity climbed steadily, production costs and prices fell dramatically. The 1882 formation of the Standard Oil Trust, which concentrated nearly 25% of the world's kerosene production into three refineries, reduced the average cost of a gallon of kerosene by 70% between 1882 and 1885. In tobacco, the invention of the Bonsack machine in the early 1880s reduced the labor costs of cigarette production 98%. The Bessemer process reduced the cost of steel rails by 88% from the early 1870s to the late 1890s, and the electrolytic refining process invented in the 1880s reduced the price of a kilo of aluminum by 96% between 1888 and 1895. In chemicals, the mass production of synthetic dyes, alkalis, nitrates, fibers, plastics, and film occurred rapidly after 1880. Production costs of synthetic blue dye, for example, fell by 95% from the 1870s to 1886.
Such sharp declines in production costs and prices led to widespread excess capacity – a problem that was exacerbated by the fall in demand that accompanied the recession and panic of 1893. Although attempts were made to eliminate excess capacity through pools, associations, and cartels, the problem was not substantially resolved until the capital markets facilitated exit by means of the 1980s’ wave of mergers and acquisition. Capacity was reduced through consolidation and the closing of marginal facilities in the merged entities. From 1895 to 1904, over 1.800 firms were brought or combined by merger into 157 firms.


The major restructuring of the American business community that began in the 1970s and is continuing in the 1990s is being brought about by a variety of factors, including changes in physical and management technology, global competition, regulation, taxes, and the conversion of formerly closed, centrally planned socialist and communist economies to capitalism, along with open participation in international trade. These changes are significant in scope and effect; indeed, they are bringing about the Third Industrial Revolution. To understand fully the challenges that current control systems face in light of this change, we must understand more about these general forces sweeping the world economy, and why they are generating excess capacity and thus the requirement for exit.
What has generally been referred to as the “decade of the 80s” in the United States actually began in the early 1970s with the ten-fold increase in energy prices from 1973 to 1979, and the emergence of the modern market for corporate control, and high-yield, non-investment-grade (junk) bonds in the mid-1970s. These events were associated with the beginnings of the Third Industrial Revolution which—if I were to pick a particular date—would be the time of the oil price increases beginning in 1973.


The Decade of the 80s: Capital Markets Provided an Early Response to the Modern Industrial Revolution

The macroeconomic data available for the 1980s shows major productivity gains. In fact, 1981 was in fact a watershed year. Total factor productivity growth in the manufacturing sector more than doubled after 1981 from 1.4% per year in the period 1950 to 1981 (including a period of zero growth from 1973-1980) to 3,3%t in the period 1981 to 1990. Over the same period, nominal unit labor costs stopped their 17-year rise, and real unit labor costs declined by 25%. These lower labor costs came not from reduced wages or employment, but from increased productivity: Nominal and real hourly compensation increased by a total of 4.2% and 0.3% per year, respectively, over the 1981 to 1989 period. Manufacturing employment reached a low in 1983, but by 1989 had experienced a small cumulative increase of 5.5%. Meanwhile, the annual growth in labor productivity increased from 2.3% between 1950-1981 to 3.8% between 1981 and 1990, while a 30-year decline in capital productivity was reversed when the annual change in the productivity of capital increased from −1.03% percent between 1950-1981 to 2.03% between 1981-1990.
Reflecting these increase in the productivity of US industry, the real value of public corporation equity more than doubled during 1980s from $1.4 to $3 trillion. In addition, real median income increased at the rate of 1.8% per year between 1982 and 1989, reversing the 1.0% per year decline that occurred from 1973 to 1982. Contrary to generally held beliefs, real R&D expenditures set record levels every year from 1975 to 1990, growing at an average annual rate of 5.8%. In one of the media's few accurate portrayals of this period, a 1990 issue of The Economist noted that from 1980 to 1985 “American industry went on an R&D spending spree, with few big successes to show for it.”
Regardless of the gains in productivity, efficiency, and welfare, the 1980s are generally portrayed by politicians, the media, and others as a “decade of greed and excess.” The media attack focused with special intensity on M&A transactions, 35,000 of which occurred from 1976 to 1990, with a total value of $2.6 trillion (in 1992 dollars). Contrary to common beliefs, only 364 of these offers were contested, and of those only 172 resulted in successful hostile take overs.
The popular verdict on takeovers was pronounced by prominent takeover defense lawyer Martin Lipton, when he said

“the takeover activity in the United States has imposed short-term profit maximization strategies on American Business at the expense of research, development and capital investment. This is minimizing our ability to compete in world markets and still maintain a growing standard of living at home”

But the evidence provided by financial economists, which I summarize briefly below, is starkly inconsistent with this view.
The most careful academic research strongly suggests that takeovers – along with leveraged restructuring prompted (in many, if not most cases) by the treat of takeover – have produced large gains for shareholders and for the economy as a whole. Based in the research, my estimates indicate that over the 14-year period from 1976 to 1990, the $1.8trillion volume of corporate control transactions – that is, merges, tender offers, divestitures, and LBOs – generated over $750 billion in market “premium” for selling investors. Given a reasonably efficient market, such premiums (the amount buyers are willing to pay sellers over current market value) represent, in effect the minimum increases in value forecast by the buyers. This $750 billion estimate of total shareholder gains thus neither includes the gains (or the losses) to the buyers in such transactions, nor does it account for the value of efficiency improvements by companies pressured by control market activity into reforming without a visible control transaction.  
Important sources of the expected gains from takeovers and leveraged restructurings include synergies from combining the assets of two or more organizations in the same or related industries (especially those with excess capacity) and the replacement of inefficient managers or governance systems. Another possible source of the premiums, however, are transfer of wealth from other corporate stakeholders such as employees, bondholders, and the IRS. To the extent the value gains are merely wealth transfer, they do not represent efficiency improvement. But little evidence has been found to date to support substantial wealth transfers from any group, and thus most of reported gains appear to represent increases in efficiency.
Part of the attack on M&A and LBO transactions has been directed at the high-yield (or so-called “junk”) bond market. Besides helping to provide capital for corporate newcomers to compete with existing firm in the product markets, junk bonds also eliminates mere size as an effective take over deterrent. This opened America’s largest companies to monitoring and discipline from the capital markets. The following statement by Richard Munro, while Chairman and CEO of Time Inc., is representative of top management’s hostile response to junk bonds and takeovers:

Notwithstanding television ads to the contrary, junk bonds are designed as the currency of “casino economics” … they've been used not to create new plants or jobs or products but to do the opposite: to dismantle existing companies so the players can make their profit …. This isn't the Seventh Cavalry coming to the rescue. It's a scalping party.

As critics of levered restructuring have suggested, the high leverage incurred in the 1980s did contribute to a sharp increase in the bankruptcy rate of large firm in the early 1990s. Not widely recognized, however, is the major role played by other, the external factors in these bankruptcies. First, the recession that helped put many highly leveraged firms into financial distress can be attributed at least in part to new regulatory restrictions on credit markets such as FIRREA – restrictions that were implemented in late 1989 and 1990 to offset the trend toward higher leverage. And when companies did get into financial trouble, revisions in bankruptcy procedure and the tax code made it much more difficult to recognize outside the courts, thereby encouraging many firms to file Chapter 11 and increasing the “cost of financial distress.”
But, even with such interference by public policy and the courts with the normal process of private adjustment to financial distress, the general economic consequences of financial distress in the high-yield markets have been greatly exaggerated. While precise numbers are difficult to come by, I estimate that the total bankruptcy losses to junk bond and bank HLT loans from inception of the market in the mid-1970s through 1990 amounted to less than $500 billion. (In comparison, IBM alone lost $51 billion – almost 65% of the total market value its equity – from its 1991 high to its 1992 close. Perhaps the most telling evidence that losses have been exaggerated, however, is the current condition of high-yield market, which is now financing record levels of new issues.
Of course, mistakes were made in the takeover activity of the 1980s. Indeed, given the far reaching nature of the restructuring, it would be surprising if there were none. But, the popular negative assessment of leveraged restructuring is dramatically inconsistent with both the empirical evidence and the near universal view of finance scholars who have studied the phenomenon. In fact, takeover activities were addressing an important set of problems in corporate America, and doing it before the companies faced serious trouble in the product markets. They were, in effect, providing an early warning system that motivated healthy adjustments to the excess capacity that began to proliferate in the worldwide economy.


Causes of Excess Capacity

Excess capacity can arise in at least four ways, the most obvious of which occurs when market demand falls below the level required to yield returns that will support the currently installed production capacity. This demand-reduction scenario is most familiarly associated with recession episodes in the business cycle.
Excess capacity can also arise from two types of technological change. The first type, capacity-expanding technological change, increases the output of a given capital stock and organization. An example of the capacity-expanding type of change is the Reduced Instruction Set CPU (RISC) processor innovation in the computer workstation market. RISC processors bring about a ten-fold increase in power, but can be produced by adapting the current production technology. With no increase in the quantity demanded, this change implies that production capacity must fall by 90%. Of course, such price declines increase the quantity demanded in these situations, thereby reducing the extent of the capacity adjustment that would otherwise be required. Nevertheless, the new workstation technology has dramatically increased the effective output of existing production facilities, thereby generating excess capacity.
The second type is obsolescence-creating change – change that makes obsoletes the current capital stock and organization. For example, Wal-Mart and the wholesale clubs that are revolutionizing retailing are dominating old-line department stores, thereby eliminating the need for much current retail capacity. When Wal-Mart enters a new market, total retail capacity expands, and it is common for some of the existing high-cost retail capacity to go out of business. More intensive use of information and other technologies, direct dealing with manufacturers, and the replacement of high-cost, restrictive work-rule union labor are several sources of the competitive advantage of these new organizations.
Finally, excess capacity also results when many competitors simultaneously rush to implement new, highly productive technologies without considering whether the aggregate effects of all such investment will be greater capacity than can be supported by demand in the final product market. The winchester disk drive industry provides an example. Between 1977 and 1984, venture capitalists invested over $400 million in 43 different manufacturers of winchester disk drives; initial public offerings of common stock infused additional capital in excess of $800 million. In mid-1983, the capital markets assigned a value of $5.4 billion to twelve publicly traded, venture-capital-backed hard disk drive manufacturers—yet by the end of 1984, the value assigned to those companies had plummeted to $1.4 billion. My Harvard colleagues William Sahlman and Howard Stevenson have attributed this overcapacity to an “investment mania” based on implicit assumption about long-run growth and profitability “for each individual company (that) … had they been stated explicitly, would not have been acceptable to the rational investor.
Such “overshooting” has by no means been confined to the Winchester disk drive industry. Indeed, the 1980s saw boom-and-bust cycle in the venture capital market generally, and also in the commercial real estate and LBO markets. As Sahlman and Stevenson have also suggested, something more than “investment mania” and excessive “animal spirits” was at work here. Stated as simply as possible, my own analysis trace such overshooting to a gross misalignment of incentive between the “dealmakers” who promoted the transactions and the lenders, limited partners, and other investor who funded them. During the mid to late’80s, venture capitalists, LBO promoters, and real estate developers were all affectively being rewarded simply for doing deals rather than for putting together successful deals. Reforming the “contracts” between dealmaker and investor – most directly, by reducing front-end loaded fees and requiring the dealmakers to put up significant equity – would go far toward solving the problem of too many deals. (As I argue later, public corporations in mature industries face an analogous, though potentially far more costly (in term of shareholder value destroyed and social resources wasted), distortion of investment priorities and incentives when their managers and directors do not have significant stock ownership.)


Current Forces Leading to Excess Capacity and Exit

The ten-fold increase in crude oil prices between 1973 and 1979 had ubiquitous effects, forcing contraction in oil, chemicals, steel, aluminum, and international shipping, among other industries. In addition, the sharp crude oil price increases that motivated major changes to economize on energy had other, longer lasting consequences. The general corporate re-evaluation of organizational processes stimulated by the oil shock led the dramatic increase in efficiency above and beyond the original energy-saving projects. (In fact, I view the oil shock as initial impetus for corporate “process re-engineering” movement that still continues to accelerate throughout the world.)
Since the oil price increases of the 1970s, we again have seen systematic overcapacity problems in many industries similar to those of the 19th century. While the reasons for this overcapacity appear to differ somewhat among industries, there are a few common underlying causes.

Macro Policies

Major deregulation of the American economy (including trucking, rail, airlines, telecommunications, banking and financial services industries) under President Carter contributed to the requirements for exit in these industries, as did important changes in the U.S. tax laws that reduced tax advantages to real estate development, construction, and other activities. The end of the cold war has had obvious ramifications for the defense industry and its supplier. In addition, I suspect that two generations of managerial focus on growth as a recipe for success caused many firms to overshoot their optimal capacity, setting the stage for cutbacks. In the decade from 1979 to 1989, the Fortune 100 firms lost 1.5 million employees, or 14% of their workforce.


Massive changes in technology are clearly part of the cause of the current industrial revolution and its associated excess capacity. Both within and across industries, technological developments have had far-reaching impact. To give some examples, the widespread acceptance of radial tires (which last three to five times longer than the older bias ply technology and providing better gas mileage) caused excess capacity in the tire industry; the personal computer revolution forced contraction of the market for mainframes; the advent of aluminum and plastic alternatives reduced demand for steel and glass containers; and fiberoptic, satellite, digital (ISDN), and new compression technologies dramatically increased capacity in telecommunication. Wireless personal communication such as cellular phones and their replacements promise to further extend this dramatic change.
The changes in computer technology, including miniaturization, have not only revamped the computer industry, but also redefined the capabilities of countless other industries. Some estimates indicate the price of computing capacity fell by a factor of 1,000 over the last decade. This means that computer production lines now produce boxes with 1,000 times the capacity for a given price. Consequently, computers are becoming commonplace—in cars, toasters, cameras, stereos, ovens, and so on. Nevertheless, the increase in quantity demanded has not been sufficient to avoid overcapacity, and we are therefore witnessing a dramatic shutdown of production lines in the industry—a force that has wracked IBM as a high-cost producer. A change of similar magnitude in auto production technology would have reduced the price of a $20,000 auto in 1980 to under $20 today. Such increases in capacity and productivity in a basic technology have unavoidably massive implications for the organization of work and society.
Fiberoptic and other telecommunications technologies such as compression algorithms are bringing about similarly vast increases in worldwide capacity and functionality. A Bell Laboratories study of excess capacity indicates, for example, that given three years and an additional expenditure of $3.1 billion, three of AT&T's new competitors (MCI, Sprint, and National Telecommunications Network) would be able to absorb the entire long distance switched service that was supplied by AT&T in 1990.


Organizational Innovation

Overcapacity can be caused not only by changes in the physical technology, but also by changes in organizational practices and management technology. The vast improvements in telecommunications, including computer networks, electronic mail, teleconferencing, and facsimile transmission are changing the workplace in major ways that affect the manner in which people work and interact. It is far less valuable for people to be in the same geographical location to work together effectively, and this is encouraging smaller, more efficient, entrepreneurial organizing units that cooperate through technology. This encourages even more fundamental changes. Through competition “virtual organizations” - networked or transitory organizations where people come together temporarily to complete a task, then separate to pursue their individual specialties - are changing the structure of the standard large bureaucratic organization and contributing to its shrinkage. Virtual organizations tap talented specialists, avoid many of the regulatory costs imposed on permanent structures, and bypass the inefficient work rules and high wages imposed by unions. In doing so, they increase efficiency and thereby further contribute to excess capacity.
In addition, Japanese management techniques such as total quality management, just-in-time production, and flexible manufacturing have significantly increased the efficiency of organizations where they have been successfully implemented throughout the world. Some experts argue that, properly implemented, these new management techniques can reduce defects and spoilage by an order of magnitude. These changes in managing and organizing principles have contributed significantly to the productivity of the world's capital stock and economized on the use of labor and raw materials, thus also contributing to the excess capacity problems.

Globalization of Trade

Over the last several decades, the entry of Japan and other Pacific Rim countries such as Hong Kong, Taiwan, Singapore, Thailand, Korea, Malaysia and China into the worldwide product markets has contributed to the required adjustments in Western economies. And competition form new entrants to the world product markets promises to only intensify.
With the globalization of markets, excess capacity tends to occur worldwide. The Japanese economy, for example, is currently suffering from enormous overcapacity caused in large part by what I view as the “breakdown” of its corporate control system. As a consequence, Japan now faces a massive and long-overdue restructuring one that include the prospect of unprecedented (for Japanese companies) layoffs, a pronounced shift of corporate focus from market share to profitability, and even the adoption of pay-for-performance executive compensation contracts (something heretofore believed to be profoundly “un-Japanese”).
Yet even if the requirement for exit were isolated in Japan and the United States, the interdependency of today's world economy would ensure that such overcapacity would have global implications. For example, the rise of efficient high-quality producers of steel and autos in Japan and Korea has contributed to excess capacity in those industries worldwide. Between 1973 and 1990 total capacity in the U.S. steel industry fell by 38% from 156.7 million tons to 97 million tons, and total employment fell over 50% from 509,000 to 252,000 (and had fallen further to 160,000 by 1993). From 1985 to 1989 multifactor productivity in the industry increased at an annual rate of 5.3% compared to 1.3% for the period 1958 to 1989.


Revolution in Political Economy

The rapid pace of development of capitalism, the opening of closed economies, and the dismantlement of central control in communist and socialist states is occurring to various degrees in China, India, Indonesia, Pakistan, other Asian economies, and Africa. In Asia and Africa alone, this development will place a potential labor force of almost a billion people—whose current average income is less than $2 per day—on world markets. The opening of Mexico and other Latin American countries and the transition of communist and socialist central and eastern European economies to open capitalist systems could add almost 200 million laborers with average incomes of less than $10 per day to the world market.
To put these numbers into perspective, the average daily U.S. income per worker is slightly over $90, and the total labor force numbers about 117 million, and the European Economic Community average wage is about $80 per day with a total labor force of about 130 million. The labor forces that have affected world trade extensively in the last several decades (those in Hong Kong, Japan, Korea, Malaysia, Singapore, and Taiwan) total about 90 million.
While the changes associated with bringing a potential 1.2 billion low-cost laborers onto world markets will significantly increase average living standards throughout the world, they will also bring massive obsolescence of capital (manifested in the form of excess capacity) in Western economies as the adjustments sweep through the system. Such adjustment will include a major redirection of Western labor and capital away from low-skilled, labor intensive industries and toward activities where they have a comparative advantage. While the opposition to such adjustments will be strong, the forces driving them will prove irresistible in this day of rapid and inexpensive communication, transportation, miniaturization, and migration.
One can also confidently forecast that the transition to open capitalist economies will generate great conflict over international trade as special interest in individual countries try to insulate themselves from the competition and the required exit. And the US, despite its long-professed commitment to “free trade”, will prove no exception. Just as US, managers and employees demanded protection from capital markets in the 1980s, some are now demanding protection from international competition in the product markets, generally under the guise of protecting jobs. The current dispute over the NAFTA (North American Free Trade Act, which will remove trade barriers between Canada, the United States, and Mexico) is but one general example of conflicts that are also occurring in the steel, automobile, computer chip, computer screen, and textile industries. It would not even surprise me to see a return to demands for protection from even domestic competition. This is currently happening in the deregulated airline industry, an industry that is faced with significant excess capacity.
We should not underestimate the strains this continuing change will place on worldwide social and political systems. In both the First and Second Industrial Revolutions, the demands for protection from competition and for redistribution of income became intense. It is conceivable that Western nations could face the modern equivalent of the English Luddites who destroyed industrial machinery (primarily knitting frames) in the period 1811 to 1816, and were eventually subdued by the militia. In the United States during the early 1890s, large groups of unemployed men (along with some vagrants and criminals), banded together in a cross-country march on Congress. The aim of “Coxey’s industrial army”, as the group became known, was to demand relief from “the evils of murderous competition; the supplanting of manual labor by machinery; the excessive Mongolian and pauper immigration; the curse of alien landlordism.”
Although Coxey’s army disbanded peacefully after arriving in Washington and submitting a petition to Congress, some democratic systems may not survive the strain of adjustment, and may revert under pressure to a more totalitarian system. We need look no farther than current developments in Mexico or Russia to see such threats to democracy in effect.
The bottom line, then, is that with worldwide excess capacity and thus greater requirement for exit, the strains put on the internal control mechanism of Western corporation are likely to worsen for decades to come. The experience of the U.S in the 1980s demonstrated that the capital markets can play an important role in forcing managers to address this problem. In the absence of capital market pressures, competition in product markets will eventually bring about exit. But when left to the product markets, the adjustment process is greatly protracted and ends up generating enormous additional costs. This is the clear lesson held out by the most recent restructuring of the US auto industry – and it’s one that many sectors of the Japanese economy are now experiencing firsthand.



The Asymmetry between Growth and Decline
Exit problems appear to be particularly severe in companies that for long periods enjoyed rapid growth, commanding market positions, and high cash flow and profits. In these situations, the culture of the organization and the mindset of managers seem to make it extremely difficult for adjustment to take place until long after the problems have become severe, and in some cases even unsolvable. In a fundamental sense, there is an asymmetry between the growth stage and the contraction stage over the life of a firm. We have spent little time thinking about how to manage the contracting stage efficiently, or more importantly how to manage the growth stage to avoid sowing the seeds of decline.
In industry after industry with excess capacity, managers fail to recognize that they themselves must downsize; instead they leave the exit to others while they continue to invest. When all managers behave this way, exit is significantly delayed at substantial cost of real resources to society. The tire industry is an example. Widespread consumer acceptance of radial tires meant that worldwide tire capacity had to shrink by two-thirds (because radials last three to five times longer than bias ply tires). Nonetheless, the response by the managers of individual companies was often equivalent to: “This business is going through some rough times. We have to make major investments so that we will have a chair when the music stops.”
The case of Gencorp, William Reynolds, Chairman and CEO of GenCorp, the maker of General Tires, illustrates this reaction in his 1988 testimony before the U.S. House Committee on Energy and Commerce:

The tire business was the largest piece of GenCorp, both in terms of annual revenues and its asset base. Yet General Tire was not GenCorp's strongest performer. Its relatively poor earnings performance was due in part to conditions affecting all of the tire industry …. In 1985 worldwide tire manufacturing capacity substantially exceeded demand. At the same time, due to a series of technological improvements in the design of tires and the materials used to make them, the product life of tires had lengthened significantly. General Tire, and its competitors, faced an increasing imbalance between supply and demand. The economic pressure on our tire business was substantial. Because our unit volume was far below others in the industry, we had less competitive flexibility …. We made several moves to improve our competitive position: We increased our investment in research and development. We increased our involvement in the high performance and light truck tire categories, two market segments which offered faster growth opportunities. We developed new tire products for those segments and invested heavily in an aggressive marketing program designed to enhance our presence in both markets. We made the difficult decision to reduce our overall manufacturing capacity by closing one of our older, less modern plants in Waco, TX … I believe that the General Tire example illustrates that we were taking a rational, long-term approach to improving GenCorp's overall performance and shareholder value….

Like so many US CEOS, Reynolds then goes on to blame the capital markets for bringing about what he fails to recognize is a solution to the industry’s problem of excess capacity.

As a result of the takeover attempt, … [and] to meet the principal and interest payments on our vastly increased corporate debt, GenCorp had to quickly sell off valuable assets and abruptly lay-off approximately 550 important employees.

Without questioning the genuineness of Reynolds’ concerns about his company and employees, it nevertheless now seems clear that GenCorp’s increased investment was neither going to maximize the value of the firm nor to be a socially optimal response in a declining industry with excess capacity. In 1987, GenCorp ended up selling its General Tire subsidiary to Continental AG of Hannover, thus furthering the process of consolidation necessary to reduce overcapacity.
Information Problems
Information problems hinder exit because the high-cost capacity in the industry must be eliminated if resources are to be used efficiently. Firms often do not have good information on their own costs, much less the costs of their competitors. Thus, it is sometimes unclear to managers that they are the high-cost firm which should exit the industry.
But even when managers do acknowledge the requirement for exit, it is often difficult for them to accept and initiate the shutdown decision. For the managers who must implement these decisions, shutting plants or liquidating the firm causes personal pain, creates uncertainty, and interrupts or sidetracks careers. Rather than confronting this pain, managers generally resist such actions as long as they have the cash flow to subsidize the losing operations. Indeed, firms with large positive cash flow will often invest in even more money-losing capacity—situations that illustrate vividly what I call “the agency costs of free cash flow”.

Contracting Problems
Explicit and implicit contracts in the organization can become major obstacles to efficient exit. Unionization, restrictive work rules, and lucrative employee compensation and benefits are other ways in which the agency costs of free cash flow can manifest themselves in a growing, cash-rich organization. Formerly dominant firms became unionized in their heyday (or effectively unionized in organizations like IBM and Kodak) when managers spent some of the organization's free cash flow to buy labor peace. Faced with technical innovation and worldwide competition (often from new, more flexible, and nonunion organizations), these dominant firms cannot adjust fast enough to maintain their market dominance. Part of the problem is managerial and organizational defensiveness that inhibits learning and prevents managers from changing their model of the business.
Implicit contracts with unions, other employees, suppliers, and communities add to formal union barriers to change by reinforcing organizational defensiveness and inhibiting change long beyond the optimal time – often beyond the survival point for the organization. While casual breach of implicit contracts will destroy trust in an organization and seriously reduce efficiency, all organizations must retain the flexibility to modify contracts that are no longer optimal. In current environment, it takes nothing less than a major shock to bring about necessary change.


The Four Control Forces Operating on the Corporation
There are only four control forces bearing on the corporation that act to bring about convergence of manager’ decisions with those that are optimal from society’s standpoint. They are (1) capital markets, (2) legal/political/regulatory system, (3) product and factor markets, and (4) internal control system headed by the board of directors.
The capital markets were relatively constrained by law and regulatory practice from about 1940 until their resurrection through hostile tender offers in the 1970s. Prior to the 1970s capital market discipline took place primarily through the proxy process
The legal/political/regulatory system is far too blunt an instrument to handle the problems of wasteful managerial behavior effectively. (Nevertheless, the breakup and deregulation of AT&T, however, is one of the court system's outstanding successes. I estimate that it has helped create over $125 billion of increased value between AT&T and the Baby Bells.)
While the product and factor markets are slow to act as a control force, their discipline is inevitable-firms that do not supply the product that customer desire at a competitive price will not survive. Unfortunately, by the time product and factor market disciplines take effect, large amount of investor capital and other social resources have been wasted, and it can often be too late to save much of the enterprise.
Which bring us to the role of corporate internal control systems and the need to reform them. As started earlier, there is a large and growing body of studies documenting the shareholder gains from corporate restructuring of the 1980s. the size and consistency of such gains provide strong support for the proposition that the internal control systems of publicly held corporations have generally failed to cause managers to maximize efficiency and value in slow-growth or declining industries.
Perhaps more persuasive than the formal statistical evidence, however, is the scarcity of large, public firms that have voluntarily restructured or engaged in a major strategic redirection without either a challenge from the capital markets or a crisis in product markets. By contrast, partnerships and private or closely held firms such as investment banking, law, and consulting firms have generally responded far more quickly to changing market conditions.

Capital Markets and the Market for Corporate Control
Until they were shut down in 1989, the capital markets were providing one mechanism for accomplishing change before losses in the product markets generated a crisis. While the corporate control activity of the 1980s has been widely criticized as counterproductive to American industry, few have recognized that many of these transactions were necessary to accomplish exit over the objections of current managers and other corporate constituencies such as employees and communities.
For example, the solution to excess capacity in the tire industry came about through the market for corporate control. Every major U.S. tire firm was either taken over or restructured in the 1980s. In total, 37 tire plants were shut down in the period 1977 to 1987 and total employment in the industry fell by over 40%.
Capital market and corporate control transactions such as the repurchase of stock (or the purchase of another company) for cash or debt creates exit of resources in a very direct way. When Chevron acquired Gulf for $13.2 billion in cash and debt in 1984, the net assets devoted to the oil industry fell by $13.2 billion as soon as the checks were mailed out. In the 1980s the oil industry had to shrink to accommodate the reduction in the quantity of oil demanded and the reduced rate of growth of demand. This meant paying out to shareholders its huge cash inflows, reducing exploration and development expenditures to bring reserves in line with reduced demands, and closing refining and distribution facilities. The leveraged acquisitions and equity repurchases helped accomplish this end for virtually all major U.S. oil firms.
Exit also resulted when Kohlberg, Kravis, and Roberts (KKR) acquired RJR-Nabisco for $25 billion in cash and debt in its 1986 leveraged buyout (LBO). The tobacco industry must shrink, given the change in smoking habits in response to consumer awareness of cancer threats and the payout of RJR's cash accomplished this to some extent. RJR’s LBO debt also prevented the company from continuing to squander its cash flows on wasteful projects it had planned to undertake prior the buyout.  Thus, the buyout laid the groundwork for the efficient reduction of capacity and resources by one of the major firms in the industry. The recent sharp declines in the stock prices of RJR and Philip Morris are signs that there is much more downsizing to come.
The era of the control market came to an end, however, in late 1989 and 1990. Intense controversy and opposition from corporate managers - assisted by charges of fraud, the increase in default and bankruptcy rates, and insider trading prosecutions – let to the shutdown of the market through court decisions, state antitakeover amendments, and regulatory restrictions on the availability of financing. In 1991, the total value of transactions fell to $96 billion from $340 billion in 1988. Leveraged buyouts and management buyouts fell to slightly over $1 billion in 1991 from $80 billion in 1988.
The demise of the control market as an effective influence on American corporations has not ended the restructuring, but it has meant that organizations have typically postponed addressing the problems they face until forced to by financial difficulties generated by the product markets. Unfortunately the delay means that some of these organizations will not survive—or will survive as mere shadows of their former selves.


With the shutdown of the capital markets as an effective mechanism for motivating change, renewal, and exit, we are left to depend on the internal control system to act to preserve organizational assets, both human and nonhuman. Throughout corporate America, the problems that motivated much of the control activity of the 1980s are now reflected in lackluster performance, financial distress, and pressures for restructuring. Kodak, IBM, Xerox, ITT, and many others have faced or are now facing severe challenges in the product markets. We therefore must understand why these internal control systems have failed and learn how to make them work.
By nature, organizations abhor control systems, and ineffective governance is a major part of the problem with internal control mechanisms. They seldom respond in the absence of a crisis. The recent GM (General Motors) board “revolt”, which resulted in the firing of CEO Robert Stempel, exemplifies the failure, not the success, of GM's governance system. Though clearly, one of the world's high-cost producers in a market with substantial excess capacity, GM avoided making major changes in its strategy for over a decade. The revolt came too late; the board acted to remove the CEO only in 1992, after the company had reported losses of $6.5 billion in 1990 and 1991.
Unfortunately, GM is not an isolated example. IBM is another testimony to the failure of internal control systems. The company failed to adjust to the substitution away from its mainframe business following the revolution in the workstation and personal computer market—ironically enough a revolution that it helped launch with the invention of the RISC technology in 1974. Like GM, IBM is a high-cost producer in a market with substantial excess capacity. It too began to change its strategy significantly and removed its CEO only after reporting losses of $2.8 billion in 1991 and further losses in 1992 while losing almost 65% of its equity value.
Eastman Kodak, another major U.S. company formerly dominant in its market, also failed to adjust to competition and has performed poorly. Largely as a result of a disastrous diversification program designed to offset the maturing of its core film business, its $37 share price in 1992 was roughly unchanged from 1981. After several reorganizations, it only recently began to seriously change its incentives and strategies, the board finally replaced the CEO in October 1993.
General Electric (GE) is notable exception to my proposition about the failure of corporate internal control systems. Under CEO Jack Welch since 1981, GE has accomplished a major strategic redirection, eliminating 104,000 of its 402,000 person workforce (through layoffs or sales of divisions) in the period 1980 to 1990 without the motivation of a threat from capital or product markets. But there is little evidence to indicate this is due to anything more than the vision and persuasive powers of Jack Welch rather than the influence of GE's governance system, it appears attributable almost entirely to the vision and leadership of Jack Welch.
General Dynamics (GD) provides another exceptional case. The appointment of William Anders as CEO in September 1991 resulted in its rapid adjustment to excess capacity in the defense industry – again, with no apparent threat from any outside force. The company generated $3.4 billion of increased value on a $1 billion company in just over two years. One of the key elements in this success story, however, was a major change in the company’s management compensation system that tied bonuses directly to increases in stock value (a subject I return to later).
My colleague Gordon Donaldson’s account of General Mills’ strategic redirection is yet another case of largely voluntary restructuring. But the fact that it took more than ten years to accomplish raises serious questions about the social costs of continuing the waste caused by ineffective control. It appears that internal control systems have two faults: they react too late, and they take too long to effect major change. Changes motivated by the capital market are generally accomplished quickly, within one to three years. No one has yet demonstrated social benefits from relying on internally motivated change that would offset the costs of the decade-long delay in restructuring of General Mills.
In summary, it appears that the infrequency with which large corporate organizations restructure or redirect themselves solely on the basis of the internal control mechanisms – that is, in the absence of intervention by capital markets or a crisis in the product markets -  is strong testimony to the inadequacy of these control mechanisms.

[At this point, the original Journal of Finance paper contains a section, omitted here because of space constraints, called “Direct Evidence of the Failure of Internal Control System.” It presents estimates of the productivity of corporate capital expenditure and R&D spending programs of 432 firms that suggest “major inefficiencies in a substantial number of firms.”]



Remaking the Board as an Effective Control Mechanism
The problems with corporate internal control systems start with the board of directors. The board, at the apex of the internal control system, has the final responsibility for the functioning of the firm. Most importantly, it sets the rules of the game for the CEO. The job of the board is to hire, fire, and compensate the CEO, and to provide high-level counsel. Few boards in the past decades have done this job well in the absence of external crises. This is particularly unfortunate given that the very purpose of the internal control mechanism is to provide an early warning system to put the organization back on track before difficulties reach a crisis stage.
The reasons for the failure of the board are not completely understood, but we are making progress toward understanding these complex issues. The available evidence does suggest that CEOs are removed after poor performance, but the effect, while statistically significant, seems too late and too small to meet the obligations of the board. I believe bad systems or rules, not bad people, are at root of the general failings of boards of directors.
Board Culture
Board culture is an important component of board failure. The great emphasis on politeness and courtesy at the expense of truth and frankness in boardrooms is both a symptom and cause of failure in the control system. CEOs have the same insecurities and defense mechanisms as other human beings; few will accept, much less seek, the monitoring and criticism of an active and attentive board.
The following example illustrates the general problem. John Hanley, retired Monsanto CEO, accepted an invitation from a CEO

….to join his board—subject, Hanley wrote, to meeting with the company's general counsel and outside accountants as a kind of directorial due diligence. Says Hanley: “At the first board dinner the CEO got up and said, ‘I think Jack was a little bit confused whether we wanted him to be a director or the chief executive officer.’ I should have known right there that he wasn't going to pay a goddamn bit of attention to anything I said.” So it turned out, and after a year Hanley quit the board in disgust.

The result is a continuing cycle of ineffectiveness: by rewarding consent and discouraging conflicts, CEOs have the power to control the board, which in turn ultimately reduces the CEO's and the company's performance. This downward spiral makes the resulting difficulties likely to culminate in a crisis requiring drastic steps, as opposed to a series of small problems met by a continuous self-correcting mechanism.
Information Problems
Serious information problems limit the effectiveness of board members in the typical large corporation. For example, the CEO almost always determines the agenda and the information given to the board. This limitation on information severely hinders the ability of even highly talented board members to contribute effectively to the monitoring and evaluation of the CEO and the company's strategy.
Moreover, board member should have the financial expertise necessary to provide useful input into the corporate planning process – especially, in forming the corporate objective and determining the factors which affect corporate value. Yet such financial expertise is generally lacking on today's boards. And it is not only the inability of most board members to evaluate a company’s current business and financial strategy that is troubling. In many cases, boards (and management) fail to understand that their basic mission is to maximize the (long-run) market value of the enterprise.
Legal Liability
The incentives facing modern boards are generally not consistent with shareholder interests. Boards are motivated to serve shareholders primarily by substantial legal liabilities through class action suits initiated by shareholders, the plaintiff's bar, and others - lawsuits that are often triggered by unexpected declines in stock price. These legal incentives are more often consistent with minimizing downside risk rather than maximizing value. Boards are also concerned about threats of adverse publicity from the media or from the political or regulatory authorities. Again, while these incentives often provide motivation for board members to reduce potential liabilities, they do not necessarily provide strong incentives to take actions that create efficiency and value for the company.
Lack of Management and Board Member Equity Holdings
            Much of corporate America’s governance problem arises from the fact that neither managers nor board members typically own substantial fractions of their firm's equity. While the average CEO of the 1,000 largest firms (measured by market value of equity) holds 2.7% of his or her firm's equity in 1991, the median holding is only 0.2% and 75% of CEOs own less than 1.2%. Encouraging outside board members to hold substantial equity interests would provide better incentives.
Of course, achieving significant direct stock ownership in large firms would require huge dollar outlays by managers or board members. To get around this problem, Bennett Stewart has proposed an interesting approach called the “leveraged equity purchase plan” (LEPP) that amounts to the sale of slightly (say, 10%) in-the-money stock options. By requiring significant out-of-pocket contributions by managers and directors, and by having the exercise price of the options rise every year at the firm’s cost of capital, Stewart’s plan helps overcome the “free option” aspect (or lack of downside risk) that limits the effectiveness of standard corporate option plans. It also removes the problem with standard options that allows management to reap gains on their options while shareholders are losing.
Boards should have an implicit understanding or explicit requirement that new members must invest in the stock of the company. While the initial investment could vary, it should seldom be less than $100,000 from the new board member's personal funds; this investment would force new board members to recognize from the outset that their decisions affect their own wealth as well as that of remote shareholders. Over the long term the investment can be made much larger by options or other stock-based compensation. The recent trend to pay some board member fees in stock or options is a move in the right direction. Discouraging board members from selling this equity is important so that holdings will accumulate to a significant size over time.
Oversized Boards
            Keeping boards small can help improve their performance. When boards get beyond seven or eight people they are less likely to function effectively and are easier for the CEO to control. Since the possibility for animosity and retribution from the CEO is too great, it is almost impossible for those who report directly to the CEO to participate openly and critically in effective evaluation and monitoring of the CEO. Therefore, the only inside board member should be the CEO. Insiders other than the CEO can be regularly invited to attend board meetings in an ex officio capacity. Indeed, board members should be given regular opportunities to meet with and observe executives below the CEO—both to expand their knowledge of the company and CEO succession candidates, and to increase other top-level executives' understanding of the thinking of the board and the board process.
The CEO as Chairman of the Board
            It is common in U.S. corporations for the CEO to also hold the position of chairman of the board. The function of the chairman is to run board meetings and oversee the process of hiring, firing, evaluating, and compensating the CEO. Clearly, the CEO cannot perform this function apart from his or her personal interest. Without the direction of an independent leader, it is much more difficult for the board to perform its critical function. Therefore, for the board to be effective, it is important to separate the CEO and chairman positions. The independent chairman should, at a minimum, be given the rights to initiate board appointments, board committee assignments, and (jointly with the CEO) the setting of the board's agenda. All these recommendations, of course, will be made conditional on the ratification of the board.
            An effective board will often evidence tension among its members as well as with the CEO. But I hasten to add that I am not advocating continuous war in the boardroom. In fact, in well-functioning organizations the board will generally be relatively inactive and will exhibit little conflict. It becomes important primarily when the rest of the internal control system is failing, and this should be a relatively rare event. The challenge is to create a system that will not fall into complacency and inactivity during periods of prosperity and high-quality management, and therefore be unable to rise early to the challenge of correcting a failing management system. This is a difficult task because there are strong tendencies for boards to evolve a culture and social norms that reflect optimal behavior under prosperity, and these norms make it extremely difficult for the board to respond early to failure in its top management team.

Attempts to Model the Process after Political Democracy
            There have been a number of proposals to model the board process after a democratic political model in which various constituencies are represented. Such a process, however, is likely to make the internal control system even less accountable to shareholders than it is now. To see why we need look no farther than the inefficiency of representative political democracies (whether at the local, state or federal level) and their attempts to manage quasi-business organizations such as the Post Office, schools, or power-generation entities such as the TVA.
            Nevertheless, there would likely be significant benefits to opening up the corporate governance process to the firm’s largest shareholders. Proxy regulations by the SEC severely restrict communications between management and shareholders, and among shareholders themselves. Until recently, for example, it was illegal for any shareholder to discuss company matters with more than ten other shareholders without prior filing with, and approval of the SEC. The November 1992 relaxation of this restriction allows an investor to communicate with an unlimited number of other stockholders provided the investor owns less than 5% of the shares, has no special interest in the issue being discussed, and is not seeking proxy authority. But, these remaining restrictions still have obvious drawback of limiting effective institutional action by those shareholders most likely to pursue it.
            As I discuss below, when equity holdings become concentrated in institutional hands, it is easier to resolve some of the free-rider problems that limit the ability of thousands of individual shareholders to engage in effective collective action. In principle, such institutions can therefore begin to exercise corporate control rights more effectively. Legal and regulatory restrictions, however, have prevented financial institutions from playing a major corporate monitoring role. Therefore, if institutions are to aid in effective governance, we must continue to dismantle the rules and regulations that have prevented them and other large investors from accomplishing this coordination.
Resurrecting Active Investors
            A major set of problems with internal control systems are associated with the curbing of what I call “active investors”. Active investors are individuals or institutions that simultaneously hold large debt and/or equity positions in a company and actively participate in its strategic direction. Active investors are important to a well-functioning governance system because they have the financial interest and independence to view firm management and policies in an unbiased way. They have the incentives to buck the system to correct problems early rather than late when the problems are obvious but difficult to correct. Financial institutions such as banks, pension funds, insurance companies, mutual funds, and money managers are natural active investors, but they have been shut out of board rooms and firm strategy by the legal structure, by custom, and by their own practices.
Active investors are important to a well-functioning governance system, and there is much we can do to dismantle the web of legal, tax, and regulatory apparatus that severely limits the scope of active investors in this country. But even absent these regulatory changes, CEOs and boards can take actions to encourage investors to hold large positions in their debt and equity and to play an active role in the strategic direction of the firm and in monitoring the CEO.
Wise CEOs can recruit large block investors to serve on the board, even selling new equity or debt to them to induce their commitment to the firm. Lazard Freres Corporate Partners Fund is an example of an institution set up specifically to perform this function, making new funds available to the firm and taking a board seat to advise and monitor management performance. Warren Buffet's activity through Berkshire Hathaway provides another example of a well-known active investor. He played an important role in helping Salomon Brothers through its recent legal and organizational difficulties following the government bond bidding scandal.

Learning from LBOs and Venture Capital Firms
            Organizational Experimentation in the 1980s. The evidence from LBOs, leveraged restructurings, takeovers, and venture capital firms has demonstrated dramatically that leverage, payout policy, and ownership structure (that is, who owns the firms securities) affect organizational efficiency, cash flow, and hence value. Such organizational changes show these effects are especially important in low-growth or declining firms where the agency costs of free cash flow are large.
Evidence from LBOs
LBOs provide a good source of estimates of value increase resulting from changing leverage, payout policies, and the control and governance system. After the transaction, the company has a different financial policy and control system, but essentially the same managers and the same assets. Leverage increases from about 18% of value to 90%, there are large payouts to prior shareholders, and the equity becomes concentrated in the hands of managers and the board (who own 20% and 60% on average, respectively), boards shrink to about seven or eight people, the sensitivity of managerial pay to performance rises, and the companies' equity usually become private (although debt is often publicly traded).
Studies of LBOs indicate that premiums to selling-firm shareholders are roughly 40% to 50% of the pre-buyout market value, cash flows increase by 96% from the year before the buyout to three years after the buyout, and value increases by 235% (96% adjusted for general market movements) from two months prior to the buyout offer to the time of going public, sale, or recapitalization about three years later on average. Large value increases have also been documented in voluntary recapitalizations –those in which the company stays public but buys back a significant fraction of its equity or pays out a significant dividend.

A proven Model of Governance Structure
LBO associations and venture capital funds provide a blueprint for managers and boards who wish to revamp their top-level control systems to make them more efficient. LBO firms like KKR and venture capital funds such as Kleiner Parkins are among the pre-eminent examples of active investors in recent US history, and they serve as models that can be emulated in part or in total by most public corporations. The two have similar governance structures, and have been successful in resolving the governance problems of both slow-growth or declining firms (LBO associations) and high-growth entrepreneurial firms (venture capital funds).
            Both LBO associations and venture capital funds tend to be organized as limited partnerships. In effect, the institutions which contribute the funds to these organizations are delegating the task of being active investors to the general partners of the organizations. Both governance systems are characterized by the following:
  • limited partnership agreements at the top level that prohibit headquarters from cross-subsidizing one division with the cash from another,
  • high equity ownership on the part of managers and board members,
  • board members (who are mostly the LBO association partners or the venture capitalists) who in their funds directly represent a large fraction of the equity owners of each subsidiary company,
  • small boards of directors (of the operating companies) typically consisting of no more than eight people,
  • CEOs who are typically the only insider on the board, and finally
  • CEOs who are seldom the chairman of the board.
            LBO associations and venture funds also solve many of the information problems facing typical boards of directors. First, as a result of the due diligence process at the time the deal is done, both the managers and the LBO and venture partners have extensive and detailed knowledge of virtually all aspects of the business. In addition, these boards have frequent contact with management, often weekly or even daily during times of difficult challenges. This contact and information flow is facilitated by the fact that LBO associations and venture funds both have their own staff. They also often perform the corporate finance function for the operating companies, providing the major interface with the capital markets and investment banking communities. Finally, the close relationship between the LBO partners or venture fund partners and the operating companies facilitates the infusion of expertise from the board during times of crisis. It is not unusual for a partner to join the management team, even as CEO, to help an organization through such emergencies.

Beginning with the oil price shock of the 1970s, technological, political, regulatory, and economic force have been transforming the worldwide economy in fashion comparable to the changes experienced during 19th-century Industrial Revolution. As in the 19th century, technological advances in many countries have led to sharply declining costs, increasing average (but declining marginal) productivity of labor, reduced growth rates of labor income, excess capacity and the requirement for downsizing and exit.
            Events of the last two decades indicate that corporate internal control systems have failed to deal efficiency with these changes, especially excess capacity and the requirement for exit. The corporate control transactions of the 1980 – mergers and acquisitions, LBOs, and other leveraged recapitalizations – represented a capital market solution to this problem of widespread overcapacity. But because of the regulatory shutdown of the corporate control markets beginning in 1989, finding a solution to the problem now rests once more with the internal control systems, with corporate boards and the problem now rests once more with the internal control system, with corporate boards, and to a lesser degree, with the large institutional shareholders who bear the consequences of corporate losses value. Making corporate internal control systems work is the major challenge facing us in the 1990s.

From: Corporate Governance at the Crossroads (Chew & Gillan)

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