Abstract
The widespread waste and inefficiency of the public corporation and its inability to adapt to changing economic circumstances have generated a wave of organizational innovation over the last 15 years — innovation driven by the rebirth of ‘active investors’ (Jensen, 1989:63).
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Notes
Ownership of the firm means claims to the assets and cash flows of the firm. These claims can generally be sold without the permission of other individuals who also have property rights in the firm. Control means a degree of autonomous decision-making authority with respect to resource allocation. The separation of ownership and control arises if some claims to a firm are held by individuals who have no direct role in the management of the firm. These owners then have to delegate some decision-making authority to their agents who are managing the firm. The fusion of ownership and control reverses the process of separation and is only complete when one person owns and directly manages the firm.
It could be argued that the concentration in the ownership of UK quoted companies over the last decade by pension funds, local authority funds, insurance companies and unit trusts (Wilson Committee Report, 1980) allows these institutions to exert a measure of control. However, ‘historically British financial institutions have not been eager openly to involve themselves in management’ (Cuthbert and Dobbins, 19: 291).
There are other types of LBOs apart from the MBO variant. The purely financial LBO occurs when a company (or subsidiary) is taken private by an investment group which uses borrowed money to buy out public shareholders (or their corporate agents). There is also the Leveraged Employee Stock ownership plan (LESOP or ESOP) whereby a company borrows money and places it in a trust that invests in the company stock. Annual contributions are subsequently made to the trust which are used to pay down the loan and disburse proportionate amounts of stock to employees. (Often, the shares the trust purchases come from the company’s holding of its own stock or from new stock issues. Tax breaks exist for dividends paid on shares to employees, on dividends used to pay off an ESOP loan, and for lenders to ESOPs — a major factor accounting for their success in the US.)
The typology of control advanced by Berle and Means (1932) and adopted by much subsequent research, distinguishes five categories of corporate control: (1) privately owned, (2) controlled through the ownership of a majority of the voting stock, (3) controlled through the ownership of a dominant minority of the voting stock, (4) controlled by means of a legal device, (5) management controlled. To a large extent, these categories represent ideal types, for there are a whole host of institutional arrangements whereby salaried managers have a participative equity stake in the enterprises that they manage. And even in those instances when salaried managers become owners of the business they manage, they normally share equity control with financial institutions who take control if things go wrong. The boundary between owner control and manager control may, therefore, be somewhat opaque.
For example, the detailed work of Mike Wright and John Coyne at the Centre for Management Buy Out Research at the University of Nottingham, or of Steven Kaplan at the University of Chicago.
Throughout this discussion we have avoided the technical arguments about how to do the kinds of economic valuations we are discussing. There are widespread software packages for accomplishing this based on equally widespread empirical and theoretical studies. See Fruhan, 1979; Jensen, 1987; and Rappaport, 1986. The latter author has developed the ALCAR valuation software.
The Economist (1985: 75) argues that in buyouts, subordinate debt is really equity masquerading as debt. In view of the conversion rights frequently attached to the subordinate debt, there is much substance to this claim.
Dividends for preferred stock are taxable whereas interest payments on subordinated debt are tax deductible. Without public shareholders, buyouts need not pay dividends so all the company’s spare cash can go, tax free, to pay off the debt. In the US a further tax break is provided because in the ownership exchange, asset values are typically written up, thus increasing depreciation allowances over the next few years (see John Thackray, Management Today, August 1984: 43; Lowenstein, 1986).
In the main, however, managerial theories of the firm do not focus on ownership per se. While affirming that its separation from control creates the managerial organisation, they typically move on to consider how factors other than ownership such as uncertainty, or conflicting objectives, lead to non-profit maximising behaviour. Or they view ownership as just one of a range of factors affecting organisational outcomes. It is agency theory which has singled out ownership for special consideration although some writers, notably Williamson (1964), span both schools of thought.
A converse position with respect to the agency costs of the separation of ownership and control has been suggested by Fama. He argues first, that managerial discretion will be curtailed by the market for managers both within and outside the firm and second, that ownership, rather than encouraging innovation, may do the opposite. It may cause managers to be risk-averse because they have a greater concentration of their risk portfolio when not only their human capital but also their financial capital is tied up in the firm. A different line of argument, but with the same conclusion, is given by Demsetz. He argues that owner-managers may also wish to avoid the ‘personal costs and the anxieties’ that go with managing or learning about new technologies. While absentee shareholders may be expected to want the firm to maximise profits, owner-managers may well decide to trade off risk for a lower return (by using a higher personal discount rate than that prevailing in the market) or they may wish to trade off profits for other benefits such as an easy life: ‘Where is it written that the owner-manager of a closely held firm prefers to consume [e.g. leisure] only at home?’ (Demsetz, 1983).
Evidence suggests that large management-controlled firms are less concerned with profit maximisation or have inferior levels of performance (both in terms of profit rate and growth) than comparable owner-controlled ones (Monsen, Chiu and Cooley, 1986; Radice, 1971; Steer and Cable, 1978). Other research shows no apparent general relationship between ownership and company profitability (Kamerschen, 1968; Larner, 1970; Child, 1974). Blair and Kaserman (1983) suggest that on balance, however, ‘the evidence appears to lean slightly in the direction of supporting a conclusion of relative under-performance by manager-controlled firms’.
Some — but not all — of these control effects are a form of agency cost: ‘the opportunity cost associated with lost profit opportunities because the organisational structure does not permit managers to take actions on as timely a basis as would be possible if the managers were also the owners’ (Weston and Brigham, 1987: 16.) However, if an increment over the organisational structure cost needed to monitor and control managers arises because of poor structural arrangements, then this increment is not an inevitable agency cost. It can be removed by better structural arrangements.
Because of this subjectivity, we have resisted the temptation of presenting the perceptions quantitatively in order to give a false semblance of objectivity. There is no good way of measuring objectively different views about complex, multidimensional issues or of measuring the strength of feeling which different people attach to their views. Qualitative data are best interpreted qualitatively — a view long favoured by social anthropologists but often ignored by organisation researchers (Green and Willman, 1987).
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© 1991 Sebastian Green and Dean F. Berry
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Green, S., Berry, D.F. (1991). The Magic in Management Buyouts. In: Cultural, Structural and Strategic Change in Management Buyouts. Palgrave, London. https://doi.org/10.1007/978-1-349-21559-1_1
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