DIRK ZORN, FRANK DOBBIN,
JULIAN DIERKES, AND
MAN-SHAN KWOK
What
causes large numbers of firms to change strategy and structure in tandem?
Organizational institutionalists find that managerial and professional groups
that span organizations develop new models of organizational efficiency—models
that are typically in the interest of the group pushing them (DiMaggio and
Powell 1983; Baron, Jennings, and Dobbin 1988). These new models are often
framed as responses to wider economic or political changes, and they serve to
enhance the prestige and power of the groups behind them. The new models often
diffuse before the jury is in on whether they are more efficient than the
models they replace, suggesting that while changes are framed as efficiency-enhancing,
they are not really based on rational learning.
We find
that over the last three decades, experts promoted a new model of the firm. But
in this case the experts were not part of a rising management specialty that
hawked their new model from within the firm. They were outsiders. Institutional
investors, financial analysts, and hostile takeover firms began to articulate a
new ideal of the modern firm, an ideal that suited the professional interests
of these three groups. Executives paid attention to this new ideal, in part,
because firms were beginning to reward them differently. Executive pay had
largely been tied to the size of the firm—the bigger the firm, the higher the
chief executive officer (CEO) salary. Executives thus defined firm growth as
job one. Agency theory (Jensen and Meckling 1976) led firms to compensate CEOs
through stock options, tying CEO remuneration to stock price. Thus CEOs became
more and more sensitive to how financial markets valued their firms, and paid
more attention to institutional investors and securities analysts. We find that
the new ideal of the firm that institutional investors, securities analysts,
and takeover firms promoted led to a revolution in firm structure and strategy.
The story offers important insights for organizational theorists. Early
students of organizations traced practices to internal functional demands, such
as size and technological
complexity.
Open-systems theorists (Scott 2002) traced practices to networks of specialists
who spanned organizations, constructing management approaches. We show that
emergent extra-organizational networks can successfully promote new management
models. The power of those networks to discipline executives plays an important
role. The availability of rhetorical devices, notably new theories of agency,
core-competence, business process reengineering, and shareholder value, may
matter as well.
We look at the effects of
the new corporate ideal on the internal structure and strategy of over 400
large US firms for the period 1963-2000. Firms restructured their top
management teams, installing chief financial officers (CFOs) to manage stock
market valuation and eliminating the Chief Operating Officer (COO), a vestige
of the diversification strategy. Firms also embraced the preference of
institutional investors and securities analysts for focused firms, buying their
competitors and suppliers rather than buying far- flung industries.
Institutionalists
were among the first organizational scholars to argue that corporations follow
their peers—that groups of firms behave like herds of cattle (Meyer and Rowan
1977; DiMaggio and Powell 1983). Early studies covered practices that
symbolized a commitment to equality (Edelman 1990; Dobbin and Sutton 1998).
Recent studies (Fligstein 1990; Abrahamson 1991; Davis 1991; Dobbin and Dowd
2000; Davis and Robbins, Chapter 14, this volume) have examined core business
strategies, finding that the social environment shapes ideas about efficiency
just as it shapes ideas about equality.
Management
fads often strike at the heart of corporate practices, and they often involve
competing visions of how to best manage the firm. Fligstein (1990) has shown
this with considerable subtlety in his study of the corporate revolution that
put the conglomerate ideal of the firm into practice. For Fligstein (1990),
diversification was promoted between the 1950s and the 1970s by managers with
backgrounds in finance, as a replacement for the sales/marketing model of
corporate strategy. Fligstein’s argument was revolutionary, for it challenged
the received wisdom of America’s preeminent business historian, Alfred DuPont
Chandler (1977), who had argued that conglomeration represented the functional
evolution of American business, rather than the outcome of a power struggle
between management cliques.
We build
on the work of Fligstein and Markowitz (1993), Fligstein (2001), and Davis,
Diekmann, and Tinsley (1994), who show that when finance managers faced a wave
of hostile takeovers that disassembled undervalued conglomerates, they
installed the ‘core-competence’ model of the firm. We show that both the top
management team and the core business strategy were revolutionized. We
underscore the role of extra-organizational groups in constructing and
diffusing the new model of management. In the institutional tradition, we find
that a new management ideal arises among a network of experts, who see an
opening to push a strategy that serves their interests, but which they frame as
in the interest of investors and managers. Yet we find that the key networks
constructing and diffusing this new ideal were exogenous to the firm—they were
major financial market networks (Zuckerman 1999, 2000).
Our core
argument is that three key groups in financial markets retheorized their own
interests, and the interests of investors at large, as synonymous. The
successful promulgation of a new theory of interest turned out to be key to
restructuring the firm. This is an important insight from institutional theory
(Dobbin et al. 1993; Strang and Meyer 1994). Three groups that were newly
powerful in financial markets theorized their own interests, and the interests
of others. First, hostile takeover firms broke conglomerates up, demonstrating
that the component parts could sometimes be sold for more than the previous
market valuation—that the parts were greater than the sum of the whole. They
argued forcefully that such break-ups were in the interest of investors, who
reaped higher share prices, and ultimately benefited the economy as a whole. In
the end, they convinced the world that what they did for a living, which was at
first construed as illicit, was in fact efficient. Second, institutional
investors, who controlled ever larger shares of corporate stock, had difficulty
placing a value on the huge conglomerate and saw it as their job—not the job of
the CEO—to diversify risk by building balanced portfolios. Thus they defined it
as in their professional interest to invest in focused firms. By shunning
conglomerates, they lowered their value. They defined focused firms as better
serving the interests of investors, because focused firms now had higher share
prices and because investors should, following financial economics, balance
their portfolios themselves. Third, securities analysts typically specialized
by industry, forcing diversified firms eager to attract analyst coverage to
sell-off businesses unrelated to their core (Zuckerman 2000). Analysts
preferred to evaluate single-industry firms, and they translated this
preference into a theory that single-industry firms were superior and into an
incentive for firms to focus their activities.
Management
specialists and economists sketched new theories of the firm that would help to
both explain and propel these changes. ‘Core-competence theory’ was given its
name in 1990 by C.K. Pralahad and Gary Hamel in a Harvard Business Review article titled ‘The Core
Competencies of the Firm’. But General Electric’s Jack Welch had argued since
the early 1980s for hands-on management. ‘Agency theory’ in economics (Jensen
and Meckling 1976) encouraged firms to tie executive compensation to stock
performance, through stock options that paid executives to focus on increasing
share price. The field of financial economists favored firms that were more
focused, and favored allowing investors to diversify their portfolios on their
own. The ‘business process reengineering’ (downsizing) movement (Hammer and
Champy 1993) suggested that firms should eliminate unnecessary layers of
management, including the conglomerate’s extra layer of finance experts who
handled acquisition strategy.
The new
core-competence/shareholder-value ideal suggested that the firm’s main job was
to focus on the core business and to manage stock price. This carried
implications for the structure of the top management team, and for acquisition
strategy. Now the top manager—the CEO—was supposed to spend his time managing
the core business. A COO signaled that the firm was still following the
antiquated strategy of portfolio diversification. Managing stock price was now
supposed to be the firm’s primary task, and so the treasurer was promoted to
the position of CFO, as part of the top management duo or troika. Because
portfolio diversification was now defined as the job of investors, diversifying
acquisitions gave way to horizontal and vertical acquisitions.
We chart changes over time
in the importance of hostile takeover firms, institutional investors, and
securities analysts. We also chart changes in the preferences in these
groups—in their articulation of what the ideal firm should look like. We tie
these changes to shifts in the top management team structures and acquisition
strategies of 429 large American corporations, for the period 1963-2000.
Over the past quarter
century, firms have paid more and more attention to financial markets. We find
that important actors in financial markets changed in character over time, as
individual investors gave way to large institutional investors, stock analysts
grew in number and in importance, and the activities of takeover firms,
particularly in the 1980s, heated up the market for corporate control. While
each group of actors articulated its own reasons for wanting firms that were
less diversified and that catered more to investors, executives became
increasingly attentive to share price. We present data from a sample of large
public American corporations to document these trends.
We
collected data from a stratified random sample of 429 public corporations for
the years 1963-2000. We stratified the sample by industry, collecting
information on firms in twenty-two industry categories. We sampled from annual
Fortune 500 lists and Fortune 100 lists, which cover the largest firms in each
industry. To avoid survivorship bias, the sample was drawn from all Fortune
lists published during the observation period rather than from a single Fortune
list. Consequently, the sample includes firms founded later than 1963 and firms
that cease to exist sometime before the year 2000.
We gathered information on
management structure and business strategy from Standard and Poor’s Register of
Corporations, Directors and Executives, Thomson Financial’s CDA Spectrum
database, Institutional Brokers Estimate System (I/B/E/S), Thomson Financial’s
FirstCall database and SDC Platinum.
New
Financial Market Players: Takeover Firms,
Institutional
Investors, and Analysts
Important
actors in financial markets changed in character over time, as individual
investors gave way to large institutional investors, stock analysts grew in
number and in importance, and the hostile takeover firms grew in number and in
activity.
 |
Davis, Diekmann, and Tinsley (1994) have linked the demise of the conglomerate to takeover specialists who bought firms only to break them up and sell off the parts. Their data from a Fortune 500 sample show that about 30% of large corporations received takeover bids between 1980 and 1990. Our sample is comparable. To track the rising importance of takeover firms, we examine not all takeover bids, but unsolicited (hostile) takeover bids. Figure 13.1 shows that between 1980 and 1990, slightly more than 11% of the firms received hostile takeover bids. This suggests that about one-third of
the
takeover bids that Davis et al. document were hostile. Every large American
firm recognized the growing threat of hostile takeover. The phenomenon
declined significantly toward the 1990s, as firms took precautions ranging from
the poison pill (Davis 1991) to doing the job of takeover firms themselves,
spinning off unrelated businesses.
Institutional investors and
securities analysts were growing in importance at this time. Driven by both the
explosion of pension plans that allowed individuals to direct their own
investments and the democratization of stock market investment through mutual
funds, institutional investors grew from minor players to major players. We
document this in Figure 13.2, which displays the average percentage of shares
controlled by institutional investors for the firms in our sample. From
slightly more than 20% in 1980, the proportion grew almost threefold in twenty
years time. Among large firms, in other words, institutional investors came to
control the lion’s share of stock. Institutional investors began to try to
influence the internal workings of firms. Because they lost money when they
sold stock in companies that were performing poorly, they found the strategy of
voicing concerns rather than seeking exit more and more feasible. By sponsoring
shareholder resolutions, they lobbied for changes in corporate governance and
firm strategy. Davis and Robbins (Chapter 14, this volume) show how scrutiny by
institutional investors and shareholder activism have led to changes in the
board composition of large US corporations. We demonstrate the rise of this
strategy in Figure 13.3, which presents data from the Shareholder Proposal
Database
Year
Figure
13.2. Shares Held by Institutional Investors Source: CDA/Spectrum.
|
Year
Figure 13.3. Number of
Shareholder Proposals Sponsored by Institutional Investors (Three-Year
Centered Moving Average)
Source: Shareholder Proposal Database (Proffitt 2001).
|
(Proffitt
2001) on institutionally sponsored proxy votes. Between the mid- 1980s and the
mid-1990s, the number of proposals supported by pension funds and other
investment companies more than tripled.
The increasing role of
stock analysts can be seen in Figure 13.4, which graphs the average number of
stock analysts covering the firms in our sample over time. Between the late
1970s and the early 1990s, the average number of stock analysts following a
firm rose from eight to eighteen. The importance of stock analysts to firms has
been well documented in the studies of Ezra Zuckerman (1999, 2000). He shows
that the conventional wisdom that firms were restructured in the 1980s as
shareholders demanded the dismantling of diversified firms and their
reconfiguration into more focused firms misses a key process. In the late 1980s
and early 1990s, firms dediversified to please stock analysts, who had
difficulty valuing diversified firms. He also shows that firms that were not
covered by these industry specialists suffer, in terms of share price, relative
to their peers. Their CEOs, now dependent on stock options for income, suffered
as well.
These
newly influential groups in financial markets began to define a new way to
judge the firm. In the 1960s, investors believed that stock price would
Year
Figure
13.4. Securities Analyst Coverage
|
Source:
I/B/E/S.
reflect
profitability and dividends, and so firms that paid attention to the bottom
line would succeed on all fronts. Even before the bull market of the 1990s,
however, profits began to look like a poor measure of a firm’s value. As during
the heady days of railway expansion in the nineteenth century, prospects for
future profitability seemed more important than current accounts. This was
particularly the case for high technology firms. Institutional investors and
securities analysts turned their attention from current accounts to stock
price, particularly in growth industries.
This change was fueled by
accounting technologies that improved the quality of quarterly reports, and by
rise of services that provided data on analysts’ profit projections. Journalist
Joseph Nocera (1998: 59-60) notes that at Fidelity, a major institutional
investor, the focus shifted from actual performance to beating the consensus
estimates among analysts:
From time to time, young
Fidelity hands would rush into Lynch’s office to tell him some news about a
company. They would say things like, ‘Company X just reported a solid
quarter-up 20%’. Eleven years later, as I review my old notes, I’m struck by
the fact that no one said that Company X had ‘exceeded expectations’. There was
no mention of conference calls, pre-announcements or whisper numbers. Nor did
I ever hear Lynch ask anyone—be it a company executive or a ‘sell side’ analyst
on Wall Street— whether Company X was going to ‘make the quarter’.
Whereas
stock price used to rise and fall on the strength of the profits per se, now it
rose and fell on the strength of profits vis-a-vis analysts’ forecasts.
For many computer and
Internet firms, after all, the bottom line was printed in red every quarter.
Fortune magazine speculates that the emergence of firms making available
consensus forecast data, based on the averages of these profit projections, has
furthered managerial attention to analysts and to their forecasts:
Executives of public
companies have always strived to live up to investors’ expectations, and
keeping earnings rising smoothly and predictably has long been seen as the
surest way to do that. But it’s only in the past decade, with the rise to
prominence of the consensus earnings estimates compiled first in the early
1970s by I/B/E/S (it stands for Institutional Brokers Estimate System) and now
also by competitors Zacks, First Call, and Nelson’s, that those expectations
have become so explicit. Possibly as a result, companies are doing a better job
of hitting their targets: For an unprecedented sixteen consecutive quarters,
more S&P 500 companies have beat the consensus earnings estimates than
missed them. (Fox 1997: 76)
It was
not only that analysts and institutional investors developed preferences for
corporate strategy, but also that executives paid more attention to their
preferences. Firms were, by their own accounts, relatively insulated from
investor preferences in the 1960s and 1970s. Individual investors rarely had
time to scrutinize firms, but with the proliferation of institutional investors
and stock analysts, large firms now had many scrupulous overseers (cf. Davis
and Robbins, Chapter 14, this volume).
With this increase in
attention came more volatility in stock price. Stock price began to move more
frequently in tandem with quarterly earnings reports and with analysts’ buy and
sell recommendations. At the same time, executive compensation had become more
closely tied to stock price. Meeting the profit targets of stock analysts thus
became a preoccupation among corporate executives, for their capacity to
benefit from stock option grants depended on their capacity to drive up stock
price. As Justin Fox wrote in Fortune in 1997:
This is what chief
executives and chief financial officers dream of: quarter after quarter after
blessed quarter of not disappointing Wall Street. Sure, they dream about other
things too—megamergers, blockbuster new products, global domination. But the
simplest, most visible, most merciless measure of corporate success in the
1990s has become this one: Did you make your earnings last quarter? (Fox 1997:
76)
Next, we turn to the
implications the new corporate ideal carried for the structure and strategy of
the large firm. We first explore the structure of the top management team and
then take a look at acquisition strategy.
When the
conglomerate ruled the world, managers from finance backgrounds were defined as
the optimal CEOs, because a key job of the top management team was to manage
the acquisition strategy of the firm. Training in finance, at the MBA level,
meant training in diversification strategy and in strategies for funding
acquisitions. After that approach to management had been well
institutionalized, the idea of naming a COO to take over day-to-day operations
and freeing the CEO to focus on acquisitions became popular. Thus the ideal
conglomerate had a CEO focused on the big picture, and a COO handling the
mundane business of making the widgets.
Institutional investors and
securities analysts helped to frame a new, investor-oriented theory in which
the firm should focus on lines of business where executives held expertise,
leaving the job of diversification to investors. The COO now became a
liability—a signal to markets that the firm had not let go of the old
conglomerate model. Now that the CEO was supposed to oversee the making of
widgets, he needed a sidekick to handle financial markets. The head finance
person c.1950 had been an accountant. The head finance person c.1970 had the
added tasks of planning financing for diversifying acquisitions. The new
finance chief, the CFO, was to manage stock price and market expectations.
When the
conglomerate was king, the typical CEO was trained in finance and it mattered
little whether he knew much about the main line of business (Fligstein 1987,
1990). For a sample of Fortune 500 firms in the early 1970s, Michel and
Hambrick (1992) find that broad conglomerates are most likely to have top
managers with finance backgrounds and without operational expertise in any of
the business units. The early finance model of management suggested clear
prescriptions for who should run the firm and for how it should be run.
Beginning in the early 1970s, that prescription included a finance-trained CEO,
to make long-term decisions about acquisitions, and a COO to manage daily
operations. In the popular press, the COO was often described as the person who
minds the store. Thus when David Rockefeller created the position at the Chase
Manhattan Bank in 1975, Business Week (1975: 74) reported: ‘a great deal more of
the day-to-day job of checking the slide in Chase’s return on assets, reducing
its soaring loan losses, and fattening its capital base has fallen onto (the
COOs) shoulders’. In a study of the rise of the COO (Dobbin, Dierkes, and Zorn
2003), we find that in the 1970s, firms that pursued conglomeration were most
likely to install COOs. Profitable firms also created COO positions to allow
their executives to focus on strategic decisions, evidently because they had
the luxury of doing so. Hugh Hefner appointed a COO at Playboy Enterprises.
From the end of the 1970s, however, COOs became associated with success because
most high- growth firms had them. The single-industry firm now installed a COO
as well, as an amulet to bring success.
From the
early 1980s, the idea of having a COO became tarnished because it was
associated with the broad conglomerate. The CEO-COO structure implied a top
executive focused on diversification with a sidekick who was supposed to run
the business. CEOs became more likely to name CFOs than to name COOs, for the
CEO-CFO structure seemed to send the right signal to financial markets—that the
CEO was minding the store.
Jack
Welch at General Electric was among the first to eliminate the position of
COO, in 1983, with the argument that he, as CEO, should be running the
business. Welch went on to implement a new approach to managing the large
conglomerate, by whittling down General Electric to a few broad domains. He
spun off unrelated businesses and bought aggressively in the main lines of
endeavor, pursuing both horizontal acquisitions of direct competitors and
vertical acquisitions of suppliers. As General Electric’s star rose, Welch
became the poster boy for hands-on management.
We saw
above that the number of securities analysts more than doubled in the first
half of the 1980s, and that analysts successfully established their importance
by making profit projections that investors took quite seriously. Firms paid
closer attention to analysts and tried harder to meet their projections. To
this end, firms implemented investor relations programs and promoted the
corporate finance function to the level of chief. With the change in name came
a profound change in the job of the top finance manager. For most of the
twentieth century, the corporate finance function had been confined to
bookkeeping, monitoring of debt and capital structures, and creating the
budget—after strategic decisions had been made (Gerstner and Anderson 1976;
Harlan 1986: xv-xvi; Whitley 1986: 181; Walther 1997: 3).
When the
conglomerate came to prominence in the early 1960s, it paved the way for a more
prominent role for financial tools that could relieve executives from the need
for detailed operational knowledge in each of the firm’s business segments. Now
a small head office could monitor the financial performance of different units,
and direct the flow of investment based on relative yields. Conglomerates were
first to embrace the CFO title in the late 1960s. In 1970, Olin Corporation,
with a product range that included books, chemicals, aluminum, and mobile
homes, named James F. Towey vice president and CFO (Wall Street Journal 1970: 19). Sperry Rand
Corporation, a large multiproduct firm, named Alfred J. Moccia CFO in September
1972 (Sperry Rand Corporation 1973), and Rockwell International Corp., a
diversified aerospace and industrial manufacturer, recruited Robert M. Rice
from CBS Inc. as its new CFO in 1974 (Wall Street Journal 1974: 19).
In those
early firms, the CFO was to manage data flows for the top executives. But
between 1980 and 1990, investor relations became a core
function of the CFO (Useem
1993: 132). The New York Times reflected on the change in 2002:
Once upon a time,
window-dressing was not in the job description. ‘The CFO back 20, 30 years ago
generally came out of the accounting profession’, said Karl M. von der Heyden,
former chief financial officer of both PepsiCo and RJR Nabisco. ‘They were
glorified controllers’, he said, ‘and strictly operated in the background’.
Controllers generally report numbers and balance budgets, without arranging
financing or offering strategic advice. Chief financial officers also served
as treasurers, banking revenues, paying bills and investing reserves in new
projects while ensuring that the company had enough cash to finance day-to-day
operations. Yet in the 1980s, with the rise of junk bonds and more exotic ways
to raise money cheaply, finance chiefs began to get involved in their
companies’ operations, deciding whether mergers were affordable and helping
chief executives pick which parts of the business would deliver the best
returns on investment. The role kept expanding in the next decade. ‘In the
90’s, the CFO more and more became the partner of the CEO in many good
companies’, Mr. von der Heyden said. ‘At that point, the CFO became more
visible in the public arena, because next to the CEO, he was the person that
generally had the best grasp of the business as a whole’. As partners of chief
executives, chief financial officers took on the task of growth, helping
rapidly expanding companies capitalize on high stock prices with aggressive
financing and by acquiring rivals. (Altman 2002: 10)
To track the effect of the
corporate ideal on executive structures, we collect annual information on top
management teams from Standard and Poor’s Register of Corporations, Directors
and Executives. Figure 13.5 shows the prevalence of each of the titles of CEO,
COO, and CFO separately. Figure 13.6 shows changing combinations of these three
titles. The rise and fall of the CEO-COO dyad and the steep rise of the CEO-CFO
dyad are striking, while the CEO-COO-CFO triad is a model being phased out.
Year
Figure 13.5. Firms
with CEO, CFO, and COO Positions Source: Standard and Poor’s Register of Corporations, Directors and
Executives.
|
Year
Figure 13.6. CEO, COO, CFO Combinations Over Time Source: Standard and
Poor’s Register of Corporations, Directors and Executives.
|
Taken together, these two
graphs show the rise of the COO toward the end of the conglomerate ideal of the
firm, and then the stagnation of that position (in Figure 13.5) and its decline
as one of the top two positions in the corporation (in Figure 13.6). Later in
the period, few firms added new COOs, and firms were increasingly likely to
eliminate the position when its incumbent moved on. We see clearly that the COO
is no longer the preferred partner of the CEO. As we suggested, firms became
reluctant to signal that the CEO was not minding the store. We also see that
the CFO surpasses the COO quickly in prevalence (in Figure 13.5) and that the
CEO-CFO duo becomes the dynamic duo of the 1990s.
With
increased scrutiny from institutional investors and securities analysts, firms
began to try to manage and manipulate analysts’ projections. CFOs held
conference calls to update sales and cost information. They introduced ‘earnings
preannouncements’, in the hope of bringing analysts’ predictions into line with
their own projections. These changes can be seen in Figure 13.7, which charts
the practice of earnings preannouncements in our sample. The first firms issued
preannouncements in the early 1990s, and by 2000 some 50% of firms were doing
so. Figure 13.7 also shows that firms became increasingly successful at meeting
analysts’ forecasts. The share of firms that meet expectations rose from about
half in the 1980s to nearly two-thirds by the late 1990s.
80 70
60 50
s
£ 40 o
30
20 10 0
Year
Figure 13.7. Firms Meeting or Beating
Analysts’ Consensus Forecast and Issuing Earnings Preannouncements
Source:
I/B/E/S and FirstCall.
This
change was the result of two processes, for CFOs both learned to manage
analysts’ projections and to manipulate earnings statements through accounting
sleight-of-hand. The accounting specialist gave way to the spin doctor. As
Daniel Altman wrote in the New York Times in April of 2002:
In the 1990’s, men like Mr.
Fastow (CFO at Enron) and Mr. Swartz (CFO at Tyco) were paragons of corporate
ingenuity for meeting and beating ever-higher revenue forecasts, but those
values have backfired. That model made it hard for investors to figure out how
much companies are really worth. Now, even many scrupulous companies see
earnings statements parsed for accounting gimmicks. In the last decade, as Wall
Street demanded more frequent reports of results and more guidance about
companies’ prospects, chief financial officers became spokesmen and even
salesmen, conducting conference calls with analysts and often delegating to
others the mundane task of watching the numbers. Companies began recruiting
lawyers, investment bankers, and consultants as chief financial officers, more
for their deal-making talents than for technical expertise or fiduciary
integrity. (Altman 2002: 10)
By 1980,
the conglomerate had come to dominate the Fortune 500. By one common
definition, the two-digit Standard Industrial Classification code, only 25%
operated in a single industry. Half operated in three or more
industries (Davis, Diekmann, and Tinsley 1994: 553). The level of diversification had increased dramatically since the Second World War, spurred in part by the Celler-Kefauver Act of 1950 which made vertical integration suspect under antitrust law and which thereby popularized diversifying acquisitions as an alternative growth strategy (Fligstein 1990).
industries (Davis, Diekmann, and Tinsley 1994: 553). The level of diversification had increased dramatically since the Second World War, spurred in part by the Celler-Kefauver Act of 1950 which made vertical integration suspect under antitrust law and which thereby popularized diversifying acquisitions as an alternative growth strategy (Fligstein 1990).
Portfolio
theory in economics reinforced the idea that the modern firm should be run as
an internal capital market, investing in promising sectors and spreading risk
across different sorts of industries. Oliver Williamson (1975) also reinforced
this idea, arguing that conglomerates could acquire poorly performing firms and
improve their profitability by managing them under financial accounting
methods. Meanwhile, the major consulting firms—McKinsey, Arthur D. Little, The
Boston Consulting Group— had developed technologies that simplified the
management of diversified conglomerates. By the end of the 1970s, 45% of the
Fortune 500 had adopted these portfolio planning techniques (Davis, Diekmann,
and Tinsley 1994: 554).
This
business model came crashing down in just a decade. It never made sense to
financial and organizational economists, because it turned the firm into a
diversified stockholder that could not easily sell off stocks that had turned
into bad bets. Managers would have to turn around poorly performing units,
which were often in industries they knew nothing about. Moreover, the Reagan
administration helped to make a new model of the large firm possible. Reagan’s
antitrust officials relaxed restrictions against mergers among competitors and
the courts relaxed controls of hostile takeovers, in the first place permitting
firms to expand by moving toward monopoly and in the second allowing groups to
acquire and break up conglomerates (Davis, Diekmann, and Tinsley 1994: 554).
As we
saw in Figure 13.1, the hostile takeover became a popular solution to a new
management problem, the relative undervaluation of conglomerates. Diversified
conglomerates sometimes served the interest of their CEOs, who wanted to run
huge firms, better than the interests of their investors, in whose interest
stock price was paramount. Agency theorists cited this mismatch of interests as
the reason for tying executive compensation to stock performance. The firm of
Kohlberg, Kravis, and Roberts (KKR) showed how successful the strategy of
buying up large conglomerates and selling off tangential businesses to raise
the stock price could be. Beginning in 1976, they bought up over forty
companies and restructured them, including such behemoths as Beatrice Companies
and RJR Nabisco. They often played ‘white knight’, helping executives to fend
off external suitors by taking firms private themselves, but the results were
much the same: the diversified conglomerate was broken up and a streamlined
firm emerged (Baker and Smith 1998).
The new theory of how the
large firm should be managed was reinforced by four different theories of the
firm, from different camps. The ‘corecompetence’ movement among management
consultants built on the classical theory of managerialism, which suggested
that managers should stick to what they know best. Financial economics had long
favored allowing investors to diversify their portfolios. ‘Business process
reengineering’, a.k.a. downsizing, suggested that firms should eliminate the
need that conglomerates produced for extra management layers. ‘Shareholder
value’ theory defined the firm’s first goal as pleasing shareholders by driving
up stock price. ‘Agency theory’ in economics encouraged firms to tie executive
compensation to stock price.
Davis,
Diekmann, and Tinsley (1994) show two effects of the decline of the
conglomerate ideal. First, in the 1980s, firms that were diversified were significantly
more likely to be acquired (and presumably broken up) than firms that were not
diversified but were otherwise similar. Second, the lion’s share of the
acquisitions in the late 1980s were horizontal and vertical acquisitions. We
look at two related indicators. We examine acquisitions over a long period of
time, to show the decline of diversifying acquisitions and the rise of horizontal
and vertical acquisitions. We use the mergers and acquisition database
(provided by SDC Platinum) to retrieve information on domestic acquisitions
patterns among firms in our sample. We follow extant research in the field of
mergers and acquisitions and distinguish between horizontal, vertical, and
deals that are unrelated to a focal firm’s major business lines (e.g. Blair,
Lane, and Schary 1991; Haunschild 1993). To assign a particular acquisition or
divestiture to any of these three groups, we follow Davis, Diekmann, and
Tinsley (1994: 560).
Figure
13.8 charts the change in acquisition pattern from 1983 to 1998 among 328 of
the 429 large firms in our sample. This figure shows the relative numbers of
unrelated (diversifying) acquisitions, horizontal acquisitions (those in an
industry the firm currently operates in), and vertical acquisitions (those in
an industry that supplies, or buys from, an industry the firm currently
operates in) over time. The number of diversifying acquisitions rises until the
mid-1980s, but then it declines and remains low. Meanwhile, the number of horizontal
acquisitions—acquisitions of firms that are in one of the businesses that the
corporation already covers—rises sixfold, and the number of vertical
acquisitions—typically of supplier firms—rises fourfold. The investor-centered
finance model is clearly reflected in these changes, for firms become less
likely to try to diversify and more likely to buy other firms that are in the
existing areas of strength.
Figure
13.9 represents changes in the level of diversification in a different way.
Here we show the level of diversification in over time, plotting the number of
four-digit industries firms operate by quartiles from 1963 to 2000. The firm at
the seventy-fifth percentile rises in the number of four-digit industries it
covers from five to nine, and then decreases to six over the period.
Year
Figure
13.8. Horizontal, Vertical, and Unrelated Acquisitions Source: SDC Platinum
and Compustat.
|
Year
Figure
13.9. Distribution of Firm Diversification Levels (Twenty-Fifth, Median, and
Seventy-Fifth, Percentile)
|
Diversification in the
median firm rises from three to five and then declines to three.
Diversification in the firm at the twenty-fifth percentile rises from one to
two, and declines to one. The overall pattern suggests that the average firm in
2000 is no more diversified than the average firm was in 1963—despite the fact
that the average firm is much larger in terms of sales and workforce. The
conglomerate model is clearly on the wane. The data on diversification, then,
show a pattern consistent with that found by Davis et al. The rise of the new
corporate ideals of shareholder value and core competence, as promoted by
institutional investors, securities analysts, and takeover firms, led to
changes in core corporate strategy. These huge corporations shed unrelated
industries, and when they went shopping, they bought competitors and suppliers
rather than branching out.
In the
last quarter of the twentieth century, key groups in financial markets came to
play increasingly important roles in shaping structure and strategy among
America’s largest corporations. As investors evaluated firms in terms of how
financial markets would value them in the future, firms became acutely aware of
the norms for corporate governance that key players in financial markets were
developing.
The
diffusion of new models of how to manage the firm is anticipated by
institutional theory in organizational sociology, but the mechanisms of
diffusion we identified are not entirely anticipated. Institutionalists argue
that new business models are developed and promoted in organizational fields,
consisting of industry members and of people in important related industries.
For the most part, the community of investors was exogenous in these models.
The initial formulation, by Meyer and Rowan (1977), suggested that government
agencies might promote new models of management, or that organizations and
consultants might develop new models among themselves. In DiMaggio and Powell’s
(1983) version, executives could copy peer organizations, states could coerce
firms to adopt new management techniques, or professional groups that spanned
organizational boundaries could promote new management techniques. Many of the
empirical studies (Edelman 1990; Dobbin and Sutton 1998) showed how these last
two factors worked together—how professional groups actively interpreted public
policy edicts and constructed compliance mechanisms that diffused among
organizations.
The
story of the rise of the shareholder value ideal of the firm does not quite conform
to this theoretical model. Here the preferences of exogenous groups—emergent
networks of hostile takeover firms, analysts, and institutional
investors—became increasingly important to corporate executives. These groups
expressed a new ideal of corporate structure and strategy, voting for this new
ideal with their market power. They lowered the price of firms that did not
abide by this new ideal (in the case of institutional investors), recommending
against buying stock in them (in the case of stock analysts), or took them over
and did the restructuring themselves (in the case of hostile takeover/white
knight firms).
The result of
these events was, to be sure, a new myth of the efficient firm. The myth of the
ideal modern firm as an internal capital market, based in portfolio theory,
gave way to the myth of the ideal firm as a focused single-industry
oligopolist. Institutional theory describes the rise of successive myths of
rationality in the modern firm, and to that extent we have provided evidence for
the theory. But the agents of change in most institutional models are managers,
not outsiders. And the mechanisms they use to change organizations are largely
rhetorical. Our findings suggest that the agents of change can be professional
groups in financial markets who have relatively little direct contact with the
corporation, but who express their preferences for firm structure and strategy
through their roles in markets. And the mechanism of change can be market
power, which became salient to executives largely through agency theory’s
effect on compensation—from size-related-salaries to stock options. Our
findings suggest that institutionalists should pay greater attention to the
role of outside forces in constructing corporate strategies, and to the role of
power in promoting new strategies.
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