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Active Investors and LBOs by MJensen

Active Investors and LBOs by MJensen

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Active Investors and Leveraged Buyouts
Active Investors and Leveraged Buyouts

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Active Investors, LBOS, andthe Privatization of Bankruptcy
Michael C. Jensen
Harvard Business SchoolMjensen@hbs.edu 
Abstract
From the 1960s to the 1980s the corporate control market generated considerable controversy, first withthe merger and acquisition movement of the 1960s, then with the hostile tender offers of the 1970s andmost recently, with the leveraged buyouts and leveraged restructurings of the 1980s.These control transactions are the manifestation of powerful underlying economic forces that, on thewhole, are productive for the economy. Thorough understanding is made difficult by the fact that change,as always, is threatening - and in this case the threats disturb many powerful interests.One popular hypothesis offered for the current activity is that Wall Street is engineering transactions to buy and sell fine old firms out of pure greed. The notion is that these transactions reduce productivity, butgenerate high fees for investment bankers and lawyers. The facts do not support this hypothesis eventhough mergers and acquisitions professionals undoubtedly prefer more deals to less, and thus sometimesencourage deals (like diversifying acquisitions) that are not productive.There has been much study of corporate control activity, and although the results are not uniform, theevidence indicates control transactions generate value for shareholders. The evidence also suggests that thisvalue comes from real increases in productivity rather than from simple wealth transfers to shareholdersfrom other parties such as creditors, labor, government, customers or suppliers.My purpose here is to outline an explanation of the fundamental underlying cause of this activity thathas to date received no attention. In this paper I define “active investors,” explain their fundamentallyimportant role in generating corporate efficiency, show how current corporate control activity is part of alarger set of economic changes sweeping the world, provide perspective on how LBOs, restructurings, andincreased leverage in the corporate sector fit into the overall picture, and discuss some reasons why highdebt ratios and insolvency are less costly now than in the past. Because of its topical relevance, I pay particular attention to LBOs and their role in the restoration of competitiveness in the Americancorporation.Keywords: active investors, investors, mergers & acquisitions, control transactions, corporate controlactivity, takeover activity, corporate efficiency, LBOs, restructuringsCopyright M. C. Jensen 1989Statement before the House Ways and Means Committee, February 1, 1989.Reprinted in
 Journal of Applied Corporate Finance
, Vol. 2, No. 1 (Spring 1989), pp. 35-44, and in Michael C.Jensen,
 A Theory of the Firm: Governance, Residual Claims and Organizational Forms
(Harvard University Press,December 2000) available athttp://hupress.harvard.edu/catalog/JENTHF.html You may redistribute this document freely, but please do not post the electronic file on the web. I welcome web linksto this document at
http://ssrn.com/abstract=244152.
I revise my papers regularly, and providing alink to the original ensures that readers will receive the most recent version. Thank you, Michael C. Jensen
 
35
 V 
OLUME
2
 
N
UMBER 
1
 
S
PRING
1989
STATEMENT BY 
 Michael C. Jensen
EDSEL BRYANT FORD PROFESSOR OFBUSINESS ADMINISTRATION,HARVARD BUSINESS SCHOOL
BEFORE THE HOUSE WAYS AND MEANS COMMITTEEFebruary 1, 1989
The corporate sector of the U.S. economy hasbeen experiencing major change, and the rate of change continues as we head into the last year of the 198Os. Over the past two decades the corporatecontrol market has generated considerable contro- versy, first with the merger and acquisition move-ment of the 196Os, then with the hostile tenderoffers of the 197Os and, most recently, with theleveraged buyouts and leveraged restructurings of the 198Os. The controversy has been renewed withthe recent $25 billion KKR leveraged buyout of RJR-Nabisco, a transaction almost double the size of thelargest previous acquisition to date, the $13.2 billionChevron purchase of Gulf Oil in 1985.These control transactions are the most visibleaspect of a much larger phenomenon that is not yet well understood. Though controversy surroundsthem, and despite the fact that they are not allproductive, these transactions are the manifestationof powerful underlying economic forces that, on the whole, are productive for the economy. Thoroughunderstanding is made difficult by the fact thatchange, as always, is threatening-and in this case thethreats disturb many powerful interests.One popular hypothesis offered for the currentactivity is that Wall Street is engineering transactionsto buy and sell fine old firms out of pure greed. Thenotion is that these transactions reduce productivity,but generate high fees for investment bankers andlawyers. The facts do not support this hypothesiseven though mergers and acquisitions professionalsundoubtedly prefer more deals to less, and thussometimes encourage deals (like diversifyingacquisitions) that are not productive.There has been much study of corporate controlactivity, and although the results are not uniform, theevidence indicates control transactions generate value for shareholders. The evidence also suggeststhat this value comes from real increases in produc-tivity rather than from simple wealth transfers toshareholders from other parties such as creditors,labor, government, customers or suppliers.
1
I have analyzed the causes and consequences of takeover activity in the U.S. elsewhere.
2
My purposehere is to outline an explanation of the fundamentalunderlying cause of this activity that has to date re-ceived no attention. I propose to show how currentcorporate control activity is part of a larger develop-
“Active Investors, LBOs, and the Privatization of Bankruptcy*” 
Seigel (1987, 1989) analyze Census data on 18,000 plants and 33,000 auxiliary establishments in the U.S. manufacturing sector in the period 1972-81 and find thatchanges in ownership significantly increase productivity and reduce administrativeoverhead. See F. Lichtenberg and D. Seigel, “Productivity and Changes of Ownershipin Manufacturing Plants,” Brookings Papers on Economic Activity, 1987, and “TheEffect of Takeovers on the Employment and Wages of Central Office and OtherPersonnel,” unpublished manuscript, Columbia University, 1989.2. See Michael C. Jensen, “The Agency Costs of Free Cash Flow: CorporateFinance and Takeovers,”
American Economic Review 
, Vol. 76 No. 2 (May, 1986); seealso my articles “The Takeover Controversy: Analysis and Evidence,”
Midland Corporate Finance Journal 
, Vol. 4 No. 2 (Summer, 1986), pp.6-32, and “Takeovers:Their Causes and Consequences,” Journal of Economic Perspectives, Vol. 1, No. 1(Winter, 1988), pp. 21-48.
LBO
S
AND CORPORATE DEBT
 Selections from the Senate and House Hearings on
*This is part of an ongoing research effort that includes Clifford Holderness, Jay Light, Dennis Sheehan, and John Pound. General research support has been receivedfrom the Harvard Business School Division of Research and a grant has been awardedby Drexel Burnham Lambert to the University of Rochester.For the argument that takeover gains to shareholders come from wealthredistribution from other parties, see Andrei Shleifer and Lawrence Summers,“Breach of Trust in Hostile Takeovers,” in
Corporate Takeovers: Causes and Conse- quences 
, Alan Auerbach, ed. (University of Chicago Press, 1988). However, noevidence has yet been produced that supports this argument. For surveys of theevidence on the effects of control-related transactions, see Michael C. Jensen andRichard Ruback, “The Market for Corporate Control: The Scientific Evidence,”
 Journal of Financial Economics 
11 (1983) and Greg Jarrell, James Brickley, and Jeffrey Netter, “The Market for Corporate Control: The Empirical Evidence Since1980,” Journal of Economic Perspectives, (Winter, 1988), pp. 49-68. Lichtenberg and
 
36
 J
OURNAL OF
 A
PPPLIED
C
ORPORATE
F
INANCE
ment, to provide perspective on how IBOs,restructurings, and increased leverage in the cor-porate sector fit into the overall picture, and todiscuss some reasons why high debt ratios andinsolvency are less costly now than in the pastBecause of its topical relevance, I pay particularattention to LBOs and their role in the restorationof competitiveness in the American corporation.
 ACTIVE INVESTORS AND THEIR IMPORTANCE
The role of institutional investors and financialinstitutions in the corporate sector has changed greatly over the last 50 years as institutions” have beendriven out of the role of active investors. By activeinvestor I don’t mean one who indulges in portfoliochurning. I mean an investor who actually monitorsmanagement, sits on boards, is sometimes involved indismissing management, is often intimately involvedin the strategic direction of the company, and onoccasion even manages. That description fits Carl Icahn,Irwin Jacobs, and Kohlberg, Kravis, Roberts (KKR).Before the mid-1930s, investment banks andcommercial banks played a much more important roleon boards of directors, monitoring management andoccasionally engineering changes in management. Atthe peak of their activities, J.P. Morgan and several of his partners served on boards of directors and playeda major role in the strategic direction of many firms.Bankers’ roles have changed over the past 50 years as a result of a number of factors. One importantsource of this change is a set of laws established inthe 1930s that increased the costs of being actively involved in the strategic direction of a company whilealso holding large amounts of its debt and equity. Forexample, under the definitions of the 1934 SEC Act,an institution or individual is considered an “insider”if it owns more than 10 percent of the shares of a compa-ny, serves on its board of directors, or holds a positionas officer. And the 16-b Short Swing Profit Rules in theSEC Act require an institution satisfying any insiderconditions to pay to the company 100 percent of theprofits earned on investments held less than sixmonths. Commercial bank equity holdings are signi-ficantly restricted and Glass Steagall restricts bankinvolvement in investment banking activities. TheChandler Act restricts the involvement by banks inthe reorganization of companies in which they havesubstantial debt holdings. In addition, the 1940Investment Company Act puts restrictions on themaximum holdings of investment funds. Thesefactors do much to explain why money managers donot serve on boards today, and seldom think of gettinginvolved in the strategy of their portfolio companies.The restrictive laws of the 1930s were passedafter an outpouring of populist attacks on theinvestment banking and financial community, asexemplified by the Pecora hearings of the 1930sand the Pujo hearings in 1913. Current attacks on Wall Street are reminiscent of that era.The result of these political and other forces overthe past 50 years has been to leave managersincreasingly unmonitored. In the U.S. at present, whenthe institutional holders of over 40 percent of corporateequity become dissatisfied with management, they have few options other than to sell their shares.Moreover, managers’ complaints about the churningof financial institutions’ portfolios ring hollow: One canguess they much prefer the churning system to onein which those institutions actually have direct powerto correct a management problem. Few CEOs lookkindly on the prospect of having institutions withsubstantial stock ownership sitting on their corporateboard. That would bring about the monitoring of managerial activities by people who more closely bearthe wealth consequences of managerial mistakes and who are not beholden to the CEO for their jobs. Asfinancial institution monitors left the scene in the post-1940 period, managers commonly came to believecompanies belonged to them and that stockholders were merely one of many stockholders the firm hadto serve.
3
This process took time, and the cultures of these organizations slowly changed as senior manag-ers brought up in the old regime were replaced with younger managers.The banning of financial institutions from fulfill-ing their critically important monitoring role hasresulted in major inefficiencies. The increase in“agency costs” (loosely speaking, the efficiency lossresulting from the separation between ownership andcontrol in widely held public corporations) appears tohave peaked in the mid to late 1960s when asubstantial part of corporate America generated large
3. Even the most voracious maximizer of stockholder wealth must care aboutthe other constituencies of the corporation. Value maximizing implies the corporationshould expend resources (to the point where marginal costs equal marginal benefits)in the service of customers, employees, communities, and other parties who affectfirm value by influencing the terms on which they contract with the organization orthrough the threat of restrictive regulation or decline in reputation. If this is themeaning of “stakeholder theory,” there is no conflict with value maximization as thecorporate objective.
BEFORE THE MID-1930S, BANKS PLAYED A MUCH MORE IMPORTANT ROLE ON BOARDS OFDIRECTORS. AS FINANCIAL INSTITUTION MONITORS LEFT THE SCENE IN THE POST-1940 PERIOD,MANAGERS COMMONLY CAME TO BELIEVE COMPANIES BELONGED TO THEM AND THATSTOCKHOLDERS WERE MERELY ONE OF MANY STOCKHOLDERS THE FIRM HAD TO SERVE.

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