An Open Letter on Conglomerates

An Open Letter on Conglomerates

          
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An Open Letter on Conglomerates

1969
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    • BruceHenderson
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    • Those opposed to conglomerates are misguided and do not understand the business dynamics of a competitive economy.

    • The U.S. government should take a strong interest in conglomerates—after all, it is, effectively, the majority shareholder in all U.S. corporations.

    • Public policy should encourage development of conglomerates, use of debt, reinvestment of cash before taxes, and a concentration of production in the most efficient producers.

     

    To Our Clients and Friends:

    My associates and I feel that the recent and severe criticism of conglomerates is unjustified. It is based upon misconceptions of both business dynamics and the public interest. We believe that conglomerates are necessary. We believe that they strengthen competition and make it more effective. And we feel the government, as tax collector, is the principle beneficiary of conglomerates and should encourage them.

    Our reasoning is based upon the assumption that most American companies do not fully utilize their assets. Conglomerates seem to be one of the best ways not only of using assets but of arriving at a high level of utilization very fast. Diversification is essential to use assets fully. A conglomerate is merely a diversified company by means of merger.

    One aspect of government criticism of conglomerates focuses on concentration of business. The prevalent attitude is that any concentration of business is a thing of evil, without regard to whether it results in benefits or damage to the public interest. Public policy appears committed to preserving the maximum number of competitors regardless of cost. These assumptions are quite questionable in view of what we now know about business costs.

    To preserve (the artificial) equilibrium among many competitors, it is necessary to prevent efficient competitors from displacing less efficient ones. Prices must always be maintained in some fashion at a sufficiently high level to permit the least efficient competitor to preserve his market share. This is very expensive for the consumer. In fact, there is ample evidence that effective competition – in terms of lowering costs and prices – must result in the gradual concentration of competitors. Conversely, a lack of concentration is per se proof that the consumer is paying prices significantly higher than he needs to.

    The question of concentration is irrelevant with respect to conglomerates. Most of the criticism of conglomerates, in terms of concentration of power, is directed merely at the fact that they are big, not because of concentration in specific products or specific markets. To appreciate this criticism requires a rather bitter sense of humor since current U.S. antitrust administration already effectively blocks any merger or combination that would increase business efficiency or effectiveness in an operating sense. Under these circumstances, how can size be a threat if it does not increase effectiveness?

    Despite the foreclosure of operating synergies, conglomerates are potentially far more efficient in using resources than a single product line company. This is true because of the financial benefits of combined operations. These benefits can be very great to consumers, shareholders and the tax collector.

    Single line companies are financially handicapped in competing with conglomerates and diversified companies. All single product companies inevitably have one of two problems, if they are successful. Either they need more cash than they can generate from their customers while they are growing rapidly. Or, they generate more cash than they can profitably invest after they are mature and successful. Alone, such companies either restrict their growth when young or dissipate their resources when mature.

    This problem of matching the ability to use cash with the ability to generate cash has two solutions.

    One is the public capital market. The other is the conglomerate's way.

    Public capital markets have a fatal defect as a mechanism for redirecting and reinvesting capital. A large part of the reinvestable funds are almost always siphoned off by taxes, first corporate, then personal. The remainder is reduced even further when it is necessary to transfer funds from one company to another by a public underwriting. All this shrinks the investable capital before one company's profit can be reinvested in another company's products. The U.S. tax structure is not designed to encourage reinvestment in growth, regardless of the eventual benefits to the consumer.

    Conglomerates are a very efficient means of overcoming the obstacles to directing corporate funds into their most productive applications – if the conglomerate is well run. Competition between conglomerates takes the form of disinvesting from the least productive use of capital and redeploying it into the most productive uses. The most successful conglomerates obtain the highest return which is translated into the highest growth rate. This is very much in the public interest. Anything which interferes with this process interferes directly with the generation and preservation of national wealth as well as the reduction of cost to the consumer.

    It is noteworthy that much of the criticism of conglomerates has been directed against the mergers which create conglomerates, rather than the fact that the resulting diversification is already rather common in American business. Conglomerates are accused of using “funny money” and too much debt. This implies, of course, that the shareholders and directors who approve these exchanges need to be protected against their own bad judgment. Most mergers and acquisitions are dependent upon securities whose price is set by the public market. If SEC rules provide full disclosure, then it is hard to argue that investors should not be free to exercise their own judgment.

    The truth is that most conglomerate financing is possible because of the past unwillingness or inability of the merger candidate to do what needed to be done. Conglomerate financing is in fact a recapitalization which is often overdue. Every major merger or acquisition involves either the creation of added debt or an exchange of securities. Either of these is in effect a recapitalization.

    Two companies which already have the optimum debt/equity ratio are unlikely to use debt as a basis for their merger. Companies which do not already have the optimum debt/equity ratio are not fully using their resources. Interference with the use of debt in mergers is in effect interference with the reallocation of resources to their optimum level of productivity. It is against the public interest.

    There remains the fact that investors may misperceive values, and conglomerate mergers may trade on this. This is true, and is as it should be. A free securities market place is the best insurance against incompetent or poorly advised investors – if you believe in competition and free enterprise.

    There is another criticism. Many merger arrangements are based upon the effect of the merger on reported earnings. This is unfortunate. This places a burden upon accounting practice that the accounting profession is in no position to assume. The real blame lies on the lack of understanding by investors of the significance of reported earnings, or their lack of significance to the shareholder in determining future values.

    Reported earnings are based on a forecast of the ability to convert the asset side of the balance sheet into cash. Unfortunately, reported earnings necessarily omit any forecast of the consequences of a large portion of current expenditures. Much expense is in part an investment. Present reported earnings are primarily a report of the consequences of investments long past. At best, reported earnings assume that the present assets will be converted into cash by a viable, stable firm which is neither disinvesting nor substantially investing in the future. These are very large assumptions which are rarely valid in a dynamic firm.

    The apparent overemphasis on near term reported earnings is a severe criticism of the sophistication of investors, including the professional and institutional investor. It is not a criticism of the accounting profession, which cannot be expected to use historical data to forecast the future. Nor is it a valid criticism of conglomerate management, as long as they are simply providing the shareholder with superior reported performance – i.e., as long as shareholders value near term reported performance more than future potential payouts.

    It is a fact that the conglomerate does offer the potential for superior performance. For the investor and his investment, the real and only determinant of performance is the relationship between cash put in and cash taken out. Conglomerates are attractive because they are potentially more productive in compounding the “cash in” until it becomes “cash out.” The beneficiaries are the consumer, the public welfare and the shareholder.

    There are people in business who are afraid of a raid or a takeover of their own companies. These fears of takeover are often justified. Usually, however, the takeovers are practical only because the company involved has not used its own assets and resources fully. When this is the case, the fear is justified and so is the takeover.

    Companies become takeover targets for certain obvious reasons.

    • The company is worth more, in fact, than the value set upon its shares by the public market.
    • The company has debt capacity that it is not utilizing or is not in a position to fully utilize.

    • The company has opportunities for investment in its business and a need for cash to do this, but it cannot obtain the cash.

    • The company is not effectively employing the assets which it owns at their highest level of productivity.

    These are all good reasons for takeover or merger. Everyone benefits from the takeover, including the public. It should be obvious that our national prosperity depends upon the maximum use of our existing resources and of our capital. National policy should direct funds into the hands of those who can and will invest them in a way to create the most productivity. If takeover accelerates this process and benefits stockholders, too, then who should protest?

    It seems clear that those who are opposed to conglomerates are misguided and do not understand the business dynamics of a competitive economy. This misperception is also indicative of a basic myopia on the part of both government and business regarding their mutual relationship. Their existing views of each other's roles appear to be quite obsolete. The government is exercising its very great power with rather limited insight and using assumptions that are no longer valid. Conversely, business on the whole is relying on largely outdated concepts and standards of measurement in managing its resources, and thus is failing to optimize its performance – and hence its contribution to the common good.

    In the context of the debate over conglomerates, businessmen should reevaluate their concepts of:
    • Optimum debt/equity ratios.
    • The effect of debt on price policy and growth rates.
    • Competitive risk versus risk of a monetary squeeze.
    • Reinvestment criteria in existing businesses – and disinvestment criteria as well.
    • “Expense investment” versus the value of short term reported profits.
    • Return on equity versus return on assets.
    • The tradeoff between near term and long term payouts – particularly in growth areas.  

    In the same light, government policy makers should reevaluate the effects on the consumer of preventing concentration in the most efficient producer and therefore:

    • The need for encouraging the retention and reinvestment of earnings before taxes (i.e. tax the actual payout, not the reported earnings). 

    • The need for increasing competition so that growth will be concentrated in the hands of the most efficient producers. 

    • The need for increasing the investment and the reinvestment rate in business until the potential return approaches the interest rate on government securities. 

    • The need for providing protection against liquidity crisis for corporate investors.

    The U.S. government should take a very great interest in encouraging conglomerates. After all, the government is effectively the majority shareholder in all U.S. corporations. It takes approximately 52 % to 75 % or more of most corporate profit before the other stockholders get anything at all. The more effective use of assets by conglomerates benefits the shareholder, the consumer – and most of all the U.S. government.

    Conglomerates should be the dominant business form in the U.S. The competition among conglomerates will be far more effective than among smaller less diversified companies. Other forms of business can be protected only at punitive cost to the consumer.

    Public policy should encourage

    • The development of conglomerates
    • The use of debt
    • The reinvestment of cash flows internally before taxes or dividends
    • The concentration of production in the most efficient producer.

    One of a series of informal statements on corporate strategy prepared by members of the staff of The Boston Consulting Group.

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