A previous section discussed the conditions – environmental, regulatory and management – that effectively facilitated and encouraged conglomeration. The following section discusses the erosion of those drivers and the effect on conglomerates. However, while each of the drivers of de-conglomeration has been considered individually, none of the extant literature appears to have drawn them together to provide an explanation of their combined influence on corporate strategy formulation and strategic change.
Failure to Reduce Risk
The issue of risk reduction is central to conglomeration. The quest for stability and low risk is a major aim of companies pursuing conglomeration with managements seeking to offer investors stability by creating low risk portfolios of business activities.
Levy & Sarnat (1970, p795) acknowledged prior research had identified a
"conglomerate effect" where "economic activities are unrelated" and where in the "purely conglomerate type" profits remain static "but only stabilized by
bringing together centres with zero or negative correlations". The theory is logical although in practice flawed by the difficulty of identifying businesses with the required cyclicality. Bettis and Hall (1982, p257) make the point that diversification would be expected to produce negative correlations as the investments would be, by definition, unrelated, and would reduce variations in performance. However, they are dismissive of the ability of conglomerates to stabilise earnings in practice: "Risk reduction (as defined herein) is not a valid rationale for selecting unrelated diversification instead of related
diversification. This result is supported further by the recent work of Salter &
Weinhold (1979), who propose that two of the common misconceptions about
diversification are that a related strategy is always safer than an unrelated
strategy and that adding countercyclical businesses to a company's portfolio
leads to a stabilised earning stream" (p262). Their view is summarised in the comment that unrelated firms "do not have superior risk pooling characteristics [to other types of firm]" (p263).
The risk reduction benefit of conglomeration is further undermined by the increased realisation by investors, especially professional and institutional, that they can create their own portfolios and can be equally as successful as their corporate counterparts in reducing unsystematic risk (Salter & Weinhold, 1979). While they would continue to face the same systematic risk – the level of risk inherent in the economy - as companies, investors can easily construct a portfolio of investments containing the same mix of business activities as a conglomerate could acquire and could probably do it more cheaply given that they would not have to pay acquisition premia. However, this is not as true for
international diversification which requires foreign investment which is less straightforward for individuals. As Dess, Gupta, Hennart & Hill (1995, p360) noted: "An assumption of the risk return model for international diversification must therefore be that individuals are more limited in their ability to diversify
than the firm. The second best solution is for individual investors to buy
shares in firms which diversify for them".
While the risk of investor and corporate portfolios may be similar, it 'may' still be the case that conglomerates can produce superior returns from their portfolio of businesses than investors could from the same individually held portfolio. Investors, especially individuals, are, despite recent increases in investor 'power', effectively passive, i.e. they have little or no influence on the day-to-day running or strategy of 'their' companies, whereas by bringing its superior management skills to bear, an acquirer may be able to increase the profitability of a business. Furthermore, as noted by Berg (1965, p83), conglomerates may be better placed to undertake high-risk high-return projects: their financial resources are greater and they would not be “putting
all their eggs in one basket”. BCG (2006, p13) support this view using a gambling analogy to highlight the risks to focused companies as compared to conglomerates: “this is the dilemma of focussing: putting all your chips on one
number has the potential to generate higher rewards than spreading your
bets, as conglomerates do, but the potential losses are also greater if your number doesn‟t come up”.
Risk-reduction through portfolio management is a sound theoretical basis for conglomeration. However, the practicalities and costs relative to investor portfolio selection, diminishes its success and attraction. However, especially for individual rather than institutional investors, conglomeration continues to offer the only practical way to risk-reduction (Williams, 2002).
Changes in Regulation
The introduction and use of competition legislation and regulatory processes to monitor and effectively limit market shares by precluding same industry acquisitions encouraged diversification and conglomeration through the 1970s and 1980s. In the US, Shleifer & Vishny (1991) lay a portion of the blame for what they refer to as the conglomerate „mistake‟ at the US government‟s door believing that “….aggressive governmental policy, in the case of antitrust
policy, can have large unintended effects” (p59).
Relaxation in the application of competition regulations in the late 1980s reduced the need for growth through diversification. Scoullar (1987) cites government reluctance to refer proposed transactions that would result in increased market shares in particular industries, i.e. non-diversifying transactions, to competition authorities as helping drive acquisition activity. In addition, in some industries globalisation and international expansion increased competition and reduced market shares meaning that fewer potential acquisitions would require competition authority clearance.
Fewer Opportunities
The UK and the US stock markets are amongst the most developed and efficient in the world. Brealey & Myers (1991) attribute the definition of three levels of stock market efficiency to Harry Roberts (1967): weak where prices reflect information from past prices, semi-strong where prices reflect past prices and other publicly available information and strong where prices reflect all information not only that publicly available. On this scale, the UK and the US stock markets are seen as being semi-strong with prices reflecting all known information suggesting prices are generally fair but with some opportunities to make gains.
In addition to the efficiency of the stock market, the depth and breadth of financial analysis, especially by institutional investors, has increased significantly in line with global information technology developments. With most quoted and all FTSE100 companies covered by at least one leading broker and analysed by several institutional investors there is a greatly increased likelihood that a 'bargain' will be spotted by several potential acquirers who, should they decide to try to acquire the company, will compete for control and bid up the price reducing the scope to add-value post- acquisition. Porter (1987) argues that the potential 'value-added' by acquirers has been reduced making the concept of portfolio management redundant. In the UK the decisions of some of the largest UK conglomerates to break themselves up is, in effect, a tacit admission of their failure to add-value across the range of unrelated business activities in their portfolios.
Therefore, stock market efficiency and greater information/analysis result in increased acquisition costs making acquisitions, the preferred route to increased diversification, less favourable.
Reduced Management Effectiveness
As companies grow and encompass a greater range of unrelated activities, top management inevitably becomes increasingly generic, i.e. specialists with the necessary skills and attributes are employed to manage specific business activities while generalists manage corporately. Where this does not happen, management skill shortages may result in the specific needs of individual businesses being unsatisfied leading to sub-optimal performance at both business and corporate levels. Kay (1995) suggests that many of the large demergers of the early 1990s – including Courtauld‟s demerger of its textiles operations, Racal‟s demerger of its Vodafone mobile communications activities, BAT Industries‟ demergers of retailer Argos and paper manufacturer Wiggins Teape Appleton and ICI‟s demerger of its pharmaceuticals business as Zeneca – were driven by the inability of management to effectively manage unrelated activities.
The claim that „diversity cannot be managed‟ was explored by Leontiades (1989, p77) who included it in his „Six Deadly Management Myths‟ suggesting that appropriate choice of management structure could overcome problems of complexity inherent in conglomerates. He also noted that focused (single business) companies were also liable to management failures, e.g. companies misguidedly remaining focused on declining industries.
The issue of management effectiveness and diversification is more complex than that of management effectiveness and size. Penrose (1959) discussed the problems associated with growth and noted the ongoing debate as to whether a company can become 'too big' as regards its ability to adjust effectively and efficiently to both the short and long-term conditions it faces. Essentially, Penrose (1959) saw these problems as being management control issues; can management continue to operate effectively as the firm grows? Penrose (1959), took the optimistic view that companies would evolve as they grew and change their organisation and management structure appropriately. However, Penrose (1959) must be considered in light of the type of companies that existed in 1959; predominantly single and dominant business companies with few diversified companies and no real multi- business conglomerates.
Marris (1998, p67) referred to Penrose (1959) and her belief that diversification was a natural (and essential) part of growth: "It is Edith Penrose again who appears as the leading contemporary writer to emphasize the role
of continuous diversification in the normal process of growth. She points out
that by this means many firms have continued to grow over very long periods,
such as fifty or even seventy five years, although there is, apparently,
evidence of a tendency for the rate of growth themselves to decline over time.
The planning of diversification is 'par excellence' a typical function of high
management. Characteristically, it has been found, these decisions are taken
at higher levels within the management hierarchy than are, for example,
'the rate of diversification', intended to summarize the implication of the series
of individual decisions that lead up to the marketing of new products".
Undoubtedly, the development and, amongst diversified companies, widespread adoption of divisional management structures has contributed to the ability of companies to continue to diversify beyond the limitations of traditional structures.
Re-Assertion of Shareholder Power
The Market for Corporate Control (Jensen, 1986) has had great impact on the principal (shareholder)/agent (management) relationship. The increased risk of takeover - and its negative implications for the management team of an acquired company - faced by underperforming companies has led managers to rethink their strategies and to re-align their objectives with those of the shareholders who could decide to accept an offer made to acquire their company. This change has been exacerbated by an increased willingness, especially among institutional shareholders who often have informal contact with executives, to act to bring errant management into line. Faced with the possibility of losing their jobs, managers‟ instinct for self-preservation cannot be underestimated!
In addition, the development of corporate governance guidelines following the Cadbury, Greenbury and Hampel committees in the 1990s has reduced the potential for management to become „entrenched‟ to the point where they effectively become protected from the invisible hand of the Market for
Corporate Control. This remains more of an issue in the US where many anti- takeover provisions may be introduced by directors without recourse to shareholders.
Retirement of Dominant Personalities
The influence of some business leaders, e.g. Lords Hanson and White at Hanson and Owen Green at BTR, must not be under-estimated. By no means perfect, these business leaders were undoubtedly entrepreneurial, opportunist and a major driving force behind the largely successful conglomeration strategies pursued by their companies. The retirement of long-serving dominant personalities is frequently followed by changes in corporate culture as the company tries to adjust to a different style of leadership. Whittington & Mayer (2000, p17) describe the continuity of top management resource as being the "Achilles heel of conglomerates". Most have had to grapple with succession issues, some have been successful, e.g. Hanson‟s break-up after the retirement of Lord Hanson, while others have not, e.g. BTR struggled after the retirement of Sir Owen Green and several other long-serving directors credited with creating the company.
Similarly, there are instances in the US where a change in CEO proved the turning point for conglomerates. Leontiades (1980, p162) noted that several US conglomerates “….like American Standard, Boise Cascade, and
Whittaker which had pursued an aggressive acquisition program in the 1960s under one chief executive” changed strategic direction and entered a period
Development of New Corporate Forms
The late 1980s saw the development of new types of corporate transaction which increased the threat of takeover faced by underperforming companies, especially conglomerates, which could be broken up by their new owners (Morck, Shleifer & Vishny, 1990). Shleifer & Vishny (1991, p53) point to the rapid growth through the 1980s of these “radical new forms of control
changes” that provided a route back towards focus and specialisation. These new forms of control included leveraged buy-outs where the acquisition vehicle is overwhelmingly financed by debt and is usually privately owned, and break-up takeovers where the aim of the acquirer is to break the acquired business up into its component parts and sell them to focused buyers exploiting situations where „the sum of the parts exceeds that of the whole‟. These innovations in corporate forms, which were made possible principally by developments in debt markets, sit alongside more traditional approaches including management buy-outs and management buy-ins.
The new corporate forms were helped not only by the availability of finance but also by the appetite amongst focused firms for the unwanted businesses being sold post-acquisition. This demand was enhanced by the less restrictive antitrust environment prevailing in the 1980s especially in the US. Kaplan (1990) cited in Shleifer & Vishny (1991) showed that broadly 50% of assets acquired in leveraged buy-out transactions were sold off to buyers in the same industry within 3 years of the original transaction achieving greater focus for both the selling and buying companies.
Shareholder Sentiment
Whilst acknowledging the importance of market fundamentals in valuation, especially of quoted public limited companies, and the absence of randomness in their share prices, it must be remembered that valuations are a function not only of economics/financials and future expectations but also of market sentiment. The first two of these variables may be estimated with a degree of certainty and analysts will usually agree, broadly at least, on their direction, positive or negative. The third, market sentiment, is more difficult to assess objectively. Market fundamentals tell only half the story of a company‟s valuation.
Investors - professional and amateur alike - like to have clarity; to be able to see and understand how a company has performed. Conglomerates are an anathema to many investors: their complex management, accounting and tax structures do not help foster understanding of underlying performance. A clear and deliverable strategy is what investors want to see; a difficult task for a company with diverse business activities.
The lack of clarity is exacerbated by an increasing short-termism. The principal providers of finance - banks through loans and institutions through share and rights issues - have or have been perceived to have become increasingly short-term and conservative in their outlook (Miles, 1993; Demirag, 1995; Grinyer, Russell & Collison, 1998; Marston & Craven, 1998). They seek to maximise their short-run profitability to attract investment themselves from individuals who are able to compare their performance
through investment league tables compiled by publications such as Acquisitions Monthly and Investor‟s Chronicle. Short-termism amongst the investment community, in turn, drives companies to favour short-term rather than long-term capital investment opportunities to improve profits. Understandably major investors want to see strong stable performance and dividend growth. However, they want this immediately not in the uncertain future and will quickly re-direct their funds away from companies they feel are underperforming and towards those offering immediate superior returns. Furthermore, the cumulative effect of numerous studies showing very high rates of failure for acquisitions, has made the providers of finance consider proposed transactions more critically.
The adverse investor sentiment towards conglomerates in the 1990s manifested itself in share prices; conglomerates were effectively „on trial‟ in the late 1990s (Economist, 1997). Just as shareholders had encouraged and supported conglomeration in the 1960s and 1970s, they also encouraged and supported the return to focus. Where the shares of diversifying and conglomerate acquirers traded at premiums in the 1960s and 1970s it was the shares of focused acquirers that enjoyed similar premiums in the 1990s. There is a strong body of literature including Wernerfelt & Montgomery (1988), Lang & Stulz (1994), Berger & Ofek (1995), Servaes (1996), Bodnar, Tang & Weintrop (2003), Denis, Denis & Yost (2002) and Lins & Servaes (1999) which considered the existence and size of what has come to be known as the conglomerate discount.
3.3.3.3 Aftermath of Acquisitions