Financial architecture

9 Pages·0.24 MB·English

by  Myers S.

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EuropeanFinancial Management, Vol.5,No. 2, 1999, 133–141
Financial architecture(cid:3)
Stewart C. Myers
MITSloanSchool ofManagement, 50Memorial Dr., Cambridge, MA 02142–1347;
e-mail:[email protected]
Keywords: financial structure; high-tech firms; conglomerates; LBOs.
JEL classification: G3, G31.
Youmaybeexpectingatalkonoptimalcapitalstructure.In1984Iwrote‘Thesearch
for optimal capital structure’, summarizing the main lines of research to that point
(Myers, 1984) In 1990 I wrote ‘Still searching for optimal capital structure’ (Myers,
1990). It is time for a sequel.
The next paper will be called ‘Stop searching for optimal capital structure’.
Financial architecture comes first. Once financial architecture is determined, capital
structure, defined asthemix ofdebtandequitysecuritiesusedtofinanceinvestment,
is usually second-order. Capital structure adapts to financial architecture, not the
other way around.
WhatdoImeanbyfinancialarchitecture?Iwilltellyoulater.Itisbesttostartwith
examples rather than definitions. I will cover two. First, why do high-tech firms go
public? Second, why are public conglomerates dying off in the USA but flourishing
nearlyeverywhereelse?Aftertheexamples,Iwillattemptadefinitionandofferafew
broader comments.
Why do high-tech firms go public?
Thereisatraditionallistofreasonsforgoingpublic.First,goingpublicmakesaccess
to subsequent financing easier. Second, it provides liquidity for investors. Third, it
provides a noisy but objective value for the company. (The tradition of research in
market efficiency looks at how investors learn about the firm. Research in corporate
finance overlooks how much the firm learns from the stock market.) Fourth, going
public makes stock a more useful currency for compensating management. For
example, it allows compensation today for creating growth opportunities, that is,
valuable opportunities for future investment.
Thecostsofgoingpublicincludehassle,paperwork,regulationandlossofprivacy.
Managers worry that outside investors may be poorly informed and perhaps short-
(cid:3)Keynote Address at the EFMA European Conference, Lisbon, Portugal, June 1998. The
address was originally called ‘Financial structure’, but that title sounds too much like ‘capital
structure’.‘Financialarchitecture’maynotbeidealeither:itsoundstoostatic.Othercandidates
are ‘financial design’ and ‘financial organization’. ‘Financial engineering’ has been taken for
anotherpurpose.
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134 S. C. Myers
sighted. The most important cost, at least for mature, cash-cow companies, seems to
be the separation of ownership and control. Effective control by dispersed outside
investors is difficult. Costs of information, monitoring and collective action make
agencycosts inevitable.Consequentlymanagersdonotmaximize value.Withprivate
ownership and tighter control, as in leveraged buyouts (LBOs), maybe they would.
My office at MIT looks out across the Charles River at the Prudential Center. Its
market value is many hundreds of millions—probably over a billion—dollars. If the
‘Pru’ wereorganizedasafree-standingcorporation, itcouldgopublic and trade asa
mid-cap stock. Yet it is privately owned.
MIT is also surrounded by biotech companies, many of them public. These
companies went public when they were pure plays on R&D. Most of them remain
small-cap companies. Why do biotechs and other high-tech companies go public so
early, when their products are not yet solidly established and profitable, and
potentially fatal business risks stand unresolved? The information and monitoring
costs appear enormous. Should not agency costs be correspondingly large? Why not
let investors in the stock market hold prime commercial real estate, levering it up if
they want more action and excitement, leaving the high-tech growth companies to
private investors?
The reason is that long-term private ownership is the wrong financial architecture
for high-tech companies. Here is an example. Imagine a potential breakthrough
technology for producing gargle-blasters. It belongs to an entrepreneur-scientist who
iswillingtocommitsweatequityandbeartheriskoffailurebutdoesnothaveenough
money to take or keep a majority stake in the business. The start-up money comes
from a private investor.1
The business plan has five stages:
1. Experiments to prove that the technology and production process can work
2. Pilot production and sales
3. Improve product and scale up manufacturing
4. Full-scale marketing and production of gargle blasters
5. Development and sale of follow-on products
Iassumethattheentrepreneurisessentialatstages1and2,valuableatstage3,helpful
but replaceable at stage 4, and not needed thereafter.
Thecompanystartsupwithhumancapital.Asandifitsucceeds,anintangiblereal
assetiscreated:thetechnologyisembodiedinproductdesign,theproductionprocess
used, and in the product’s reputation with consumers. This real asset separates from
thepeoplewhocreateditandcaninduecoursebeappropriatedbyfinancialinvestors.
The venture could not raise outside money otherwise. But once the asset exists
separately, the people who created it lose much or all of their bargaining power.
Ofcoursetheentrepreneurcanbegivensharesinthenewcompany.Butwhatisthe
valueofaminoritystake2inacloselyheld,privatecompany?Notzero,butmuchless
than if the company were public and widely held.
1I assume that the venture can not go public at startup. At startup the information costs and
potential for adverseselection maybesolarge thatonly concentrated ownershipworks.
2Amajoritystakefortheentrepreneurwouldhelpresolvetheincentiveproblemsstressedinthis
paper.Ontheotherhand,itwouldmakeitmuchmoredifficulttoraisefirst-stagemoneyfrom
private investors.
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Financial Architecture 135
Thereisaseriousincentiveproblemhere.Theentrepreneuriscommittingatstartup
toinvestsweatequityandacceptlargepersonalrisks.Thereisnopointindoingsoifa
sufficient share of ex post value cannot be extracted.
Incentives are stronger if the entrepreneur knows that the startup will go public.
Dispersed ownershipreducesthe ex postbargaining power of outside equity investors.
But how can the entrepreneur be sure that the initial private investor will take the
companypublic?Apromisetodosowouldnotbecredibleorenforceable.ButIhave
shown,Ibelieveunderreasonableassumptions,thattheprivateinvestorwillgopublic
voluntarily. The private investor’s stake is worth more sold than kept. If sold, the
entrepreneur’s incentives are preserved. If kept, the incentives are damaged and the
value of the venture to the private investor is reduced. Therefore the private investor
sells out to public shareholders.3
Notice the importance of going public at the right time, after potential is
demonstrated but before the entrepreneur’s human contribution is substantially
complete. Going public too early places nearly impossible informational burdens on
dispersedoutsideshareholders.Butiftheprivateinvestorwaitstoolong,theincentive
to go public may disappear. The private investor can not sit tight through stage 2 of
thebusinessplanwithapromisetogopubliclater,sayatstage5.Thepromisewould
not be credible, and the entrepreneur’s incentives would not be preserved.
Letmesummarize.High-techgrowthfirmsgopublicearlyinordertoreducetheex
post power of outsideinvestors. Whenvalue dependson human achievement and the
risk of failure is high, the insiders—the entrepreneurs, scientists and others
responsibleforturning ideas into profitable products or services—haveto beoffered
acredibleupside.Theinsidersandtheoutsidefinancialinvestorsarecoinvesting.Yet
thefinancialinvestorsmaybeabletocapturemostoftheexpostprofits.Withoutthe
prospect of going public, insiders would not commit their sweat equity and agree to
bear the risk of failure.4
Of course it is also necessary that financial investors be protected after the IPO. I
am assuming at least basic legal and institutional backup for dispersed shareholders.
Also there must eventually be assets that are reachable by those shareholders.
Think again of biotechs. The sufficient conditions for them to go public early are:
(cid:42) Outside investors are patient and can diversify. (Public biotech companies are a
dispositive counterexample to claims that investors in the US stock market are
generally myopic or short-sighted.)
(cid:42) Insiders’ payoffs depend on share price, and there is sufficient upside if R&D
succeeds. Insiders’ and financial investors’ interests are thereby aligned.
(cid:42) Outsideinvestorsdo nothavetoworryaboutinsiders’capture ormisallocationof
free cash flow. (For fledgling biotech companies, not much cash is coming in.)
(cid:42) IfR&Dsucceeds,theproduct’svalueisreachablebyoutsideinvestors.Theproduct
isapatented,FDA-approveddrugortherapy.Outsideinvestorsareprotectedfrom
theft, transfer or expropriation.
3Myers (1998). Burkart et al. (1997) have also stressed the value of dispersed ownership for
preservingmanagers’and entrepreneurs’ incentives.
4The financial architecture of venture capital partnerships reassures the entrepreneur that the
startupwillbetakenpublicearlyifitissufficientlysuccessful.Goingpublicallowsprivateinvestors
tocashout,andthegeneralpartnerstogetwhatevercarriedinterestisduethem.Thepartnerships’
livesarelimited,soprivateinvestorscannotholdontothestartupcompanyindefinitely.
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136 S. C. Myers
LetusreturntothePrudentialCenter.Isayitisprivatelyheldbecausethevalueof
this asset does not depend much on human capital, effort and personal risk-bearing.5
There is no need to reduce the bargaining power of financial investors through
dispersed ownership. But if it were public, the separation of ownership and control
would lead to agency costs, for example, the free cash flow problems stressed by
Michael Jensen (1986). Therefore private ownership is better.6
Conglomerates
HereisathumbnailsketchofthehistoryofconglomeratesintheUSA.Ispeakwitha
verybroadbrush,andunderstandthatthereareexceptionstoalmosteverypoint.But
I believe the overall story is accurate.
I am old enough to remember the 1960s and early 1970s when conglomerates like
Litton, LTV, Tenneco, Gulf & Western and ITT were the cat’s pajamas. They were
supposed to bring superior centralized management to the sleepy or slackly managed
companies they acquired, and to reinvest cash flow efficiently in internal capital
markets. Diversification was supposed to reduce risk. Growth in earnings per share
was supposed to generate capital gains for stockholders.
Conglomerates were not success stories. Their top managements may have added
valueinsomecases,butcontinuingsynergieswererare.Thewholewasworthlessthan
the sum of the parts. Most of the pure conglomerates were broken up in the 1980s.
Many of their divisions ended up as leveraged buyouts (LBOs).
Nowitseemsallagreethatfocusbeatsdiversification,atleastintheUSA.Wenow
understand that diversification undertaken just to reduce risk does not add value;
shareholders can diversify much more efficiently on their own. One might make a
theoretical case for internalcapital markets,7but inpractice they seem to misallocate
capital.
Internalcapitalmarketsareaformofcentralplanning,inwhichcapitalbudgetsare
determined by company politics as well as economics. Profitable divisions end up
subsidizingweakerones.BergerandOfekfoundthatconglomerateswithdivisions in
industries with poor investment prospects tend to overinvest in these divisions. The
more the investment, the greater the conglomerate discount—that is, the greater the
shortfallofthevalueofthewholefromthevalueoftheparts(BergerandOfek,1995)
This is one example of recent research concluding that diversified companies do not
invest efficiently.8
Conglomerates face further problems. Their divisions’ market values can not be
observedindependently,anditisdifficulttosetincentivesfordivisionmanagers.This
is particularly serious when managers are asked to commit human capital to risky
ventures.Forexample,howwouldabiotechstartupfareasadivisionofatraditional
5Development of the Prudential Center is, as far as I know, substantially complete. If it were
not,humaninputwouldbeessentialtoassetvalue.Theremightbeacaseforpublicownership
of areal estate development company.
6Ofcoursethere are otherreasons for somecommercial real estateto bepublicly owned.For
example,itprovides a distinct‘asset class’to helpinvestors diversify.
7Internal capital markets could avoid information problems which can impede access to
external equity. (SeeMyersand Majluf,1984).
8Twofurtherexamples are Lamont(1997) andScharfstein (1997).
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Financial Architecture 137
conglomerate?Wouldtheconglomeratebeaspatientandrisk-tolerantasinvestorsin
the stock market? Maybe, but I doubt it. How are the internal entrepreneurs
(includingthescientistsandcliniciansdoingthebiotechR&D)toberewardedifthey
succeed?Itisdifficulttopaythemalargelump-sumbonus,becausetheconglomerate
doesnotknowhowmuchsuccessisworth,intermsofmarketvalue,andbecausethe
internal entrepreneurs will have no special bargaining power, relative to other
divisional managers, after the R&D is successfully completed. I do not mean to say
thathigh-techinnovationandrisktakingareimpossibleinpublicconglomerates,but
the difficulties are evident.9
Successful US conglomerates
Yet there is a class of successful US conglomerates. They are private companies and
partnerships investing in venture capital and private equity, including LBOs. They
includeindependentorganizationssuchKohlberg,Kravis,Roberts(KKR),aswellas
merchant banking groups at commercial and investment banks.
IfmaysoundstrangetocallventurecapitalandLBOfirmsconglomerates,butthey
meetthedefinition:theypursueunrelateddiversification.Forexample,in1998oneof
KKR’s LBO funds contained companies in publishing, printing, communications,
food, hospital management, insurance, transportation equipment, and several other
industries.
Havingsaidthis,thereisanobviousdifferencebetweentheseprivateconglomerates
and their public counterparts. Private investment companies and partnerships are
temporaryconglomerates.Theirstrategyistobuy,fix,improveandthensellout.They
do not buy and manage for the long run.
Baker and Montgomery provide a detailed discussion of the differences between
LBO organizations and traditional conglomerates.10 The most important differences
include:
(cid:42) LBO organizations invest through limited-life funds organized as partnerships.
Each fund is forced to sell, take public, or otherwise dispose of its portfolio of
companies, usually within 10 years. Conglomerates are public corporations
designed to buy and hold for the long run.
(cid:42) There is no internal capital market in LBO funds. Profits from one portfolio
company can not be siphoned off to another. The funds’ partnership agreements
prohibit reinvestment.
(cid:42) LBOfundshavenohierarchyofcorporatestaffevaluatingplansandperformance.
(cid:42) Managers of LBOs are given big equity stakes in their companies, not in the
portfolio of companies held by the LBO fund. Compensation depends on the
companies’ exit values, in other words, on their market values. In a conglomerate,
compensation depends mostly on earnings. There is a smaller upside and a softer
downside.
9The difficulties threaten high-risk innovation in any large, public company, not just in pure
conglomerates.
10Baker and Montgomery (1996). Their title is ‘Conglomerates and LBO associations: a
comparison of organizational forms’, I would have said ‘A comparison of financial
architectures’.
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138 S. C. Myers
The comparison of private equity organizations, such as LBO funds, with
traditional public conglomerates shows how financial architecture adapts to the task
at hand. The private equity organizations are designed to create, build or reform
companies, not to hold and manage them indefinitely. I suspect that part of the
original motivation for conglomerates like Litton and Textron was similar—to build
and reform—but that the wrong financial architecture was chosen. Litton and
Textron should have been temporary conglomerates; they should have bought,
improved, and then sold their portfolio companies. We have learned that focus beats
unrelated diversification when the task is managing for the long run in public
companies.
Outside the USA, and especially in less-developed economies, it seems to be the
other way around.Conglomeratesareeverywhere. In some countries, such asKorea,
conglomerates are the dominant financial architecture. It must be that the economic
and financial environment is different, or that the task is different.
There is a standard laundry list of reasons why conglomerates can make sense in
emergingeconomies.First,sizemaybeanadvantageingainingaccesstointernational
financialmarketsandattractingprofessionalmanagement.Insmallereconomies,size
may require unrelated diversification. Size also begets political power, especially
important in ‘managed’ economies. Kharma and Palepu (1998) suggest that large
conglomerates may ‘protect [entrepreneurs’] property rights in countries where
enforcement is...inefficient or capricious’. In the USA, growth firms go public to
protectentrepreneursagainstprivateinvestors;elsewhereconglomeratesmayformto
protect entrepreneurs against the government.
Ithink thatthemost efficient andsuccessfulconglomeratesinemergingeconomies
willbetemporary.(Idefinesuccessasmarketvalueadded,notjustsizeandsurvival.)
Conglomerates in some countries, Argentina and Chile, for example, seem to have
formed for opportunistic, not strategic reasons: an opportunity to bid in a
privatization, to buy up and modernize a sleepy but well-established family business,
or to take advantage of deregulation to do something that was not allowed before.
Theseareopportunitiestocreate,buildorreformbusinesses.Successdoesnotrequire
holdingforthelongrun.Thedanger,ofcourse,liesinfinancialarchitectureswhichdo
not rule out holding and managing for the long run.
Financial Architecture
Financial architecture is broader than corporate control or corporate governance.
Governancefocusesonhowinvestors’interestsareexpressedandprotected,butwith
financial architecture held constant. Corporate control has looked mostly at mergers
and acquisitions of public companies in the USA. But the new research which
compares control and governance in different countries is really delving into
differences in financial architecture.
Financialarchitecturemeanstheentirefinancialdesignofthebusiness,including
ownership (e.g. concentrated vs. dispersed), the legal form of organization (e.g.
corporation vs. limited-life partnership), incentives, financing and allocation of
risk.
Mostofthetheoryandstandardpracticeofcorporatefinancehasdevelopedwitha
particularfinancialarchitectureinmind:thatofapubliccorporationinacountrylike
the USA or UK with well-developed security markets. But even in these countries
there are other distinct and successful architectures. I have mentioned high-tech
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Financial Architecture 139
startups, venture capital and LBO funds, and private investment in commercial real
estate. There are others, for example,law and consulting firms, which remain private
becausemostofthevaluestayspermanentlyfixedinhumancapital.Theassetsgoout
to the parking lot every night, and there is little value reachable by outside financial
investors. 11
Trading and investment banking firms are another interesting case because they
requiresuchlargeco-investmentsofhumanandfinancialcapital.Thesefirmshaveto
reconcile two residual claims, the return to common stockholders and the annual
bonus pool.
Outside the developed and securitized economies, the financial architectures
multiply: Japanese keiretsus, Korean chaebols, family-controlled Italian companies,
state-owned enterprises, and so on.
Some financial architectures depend on active, patient and risk-tolerant capital
markets.Theseinturndependonadequateinformation(includingfinancialreporting
and security analysis), basic protections for investors, human capital specialized in
finance, enforceability of contracts, and law and regulation generally.
For example, US-style venture capital will not work unless there is a stock market
prepared to accept IPOs by young and unproved growth companies; such companies
go public early in order to cash out the venture capitalists, reduce the ex post
bargaining power of financial investors, and thereby maintain insiders’ incentives.
NewEuropeanexchanges,includingEASDAQ,theNeuerMarktinFrankfurtandLe
NouveauMarche´ inParis,havebeensetupforpreciselythispurpose,apparentlywith
great success.
ThelessonisnotthattraditionalfinancialarchitecturesincontinentalEuropeare
obsolete,butthatdifferentarchitecturesareneededfordifferenttasks.Governments
and financial leaders should not design or promote the most ‘efficient’ or ‘modern’
financial architecture. They should develop laws and regulation and promote
financial markets and institutions so that several financial architectures can coexist
andnewonesdevelop.IfintheUSAallinvestmentandinnovationwereassignedto
widely-held public corporations, the economy would be hobbled. Economies where
only large conglomerates and family-owned businesses work likewise face serious
long-run problems.
Conclusions
Isthereanythingnewaboutfinancialarchitecture?No,itisjustanattempttolook
at corporate finance from a different vantage point, and to break out of some well-
worn, stylized models.
Mostoftheideasinthispaperhavebeenrepackagedfromtheresearchliterature.
But one idea strikes me as new, at least to our somewhat parochial field, and also
important: financial architecture adapts to support the co-investment of human and
financial capital. Corporate finance talks about agency costs preventing managers
from maximizing value; the assumed objective is value for financial investors. This
may make sense for developed commercial real estate, where asset value requires
11Several economic consulting firms, including Hagler-Bailly and Charles River Associates,
haverecentlygonepublic,apparentlyinattempttoprovemewrong.Wewillseehowtheyfare
withtheirnew financial architecture.
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140 S. C. Myers
relatively little further human input. It does not make sense for many going
concerns.Iftotalvaluedependsoninvestmentofhumancapital,onsweatequityor
personal risk-bearing, the objective should be maximizing the total value generated
by human and financial investment. It follows that financial architecture should
providetherightincentivesforbothtypesofinvestmentandtherightdistributionof
returns ex post.
This may sound like soft talk about stakeholders. Finance people scoff at well-
meaning proposals for a ‘fair’ distribution of profits between management, labor,
customers, local communities and the environment as well as stockholders. They are
right to scoff if claims are made for stakeholders who never invested. Chainsaw Al
Dunlap, the former CEO of Sunbeam, put it bluntly:
The most ridiculous term heard in boardrooms today is stakeholders.
Stakeholders! Every time I hear that word I ask, ‘How much did they pay for
their stake?’12
That is the right question. But if managers and employees are led by financial
architecture to absorb opportunity costs, bear personal risks, and develop firm-
specific human capital, they have indeed paid for their stakes.
We in academic finance tend to take financial architecture as given, as a fixed part
of the financial landscape. Worse, we tend to assume that architecture should be
designed to maximize ex post value to outside financial investors. That is often, but
not always, the most efficient arrangement.
Financial architecture is not new, but it deserves a name. Sometimes an important
issue does not get sufficient thought until it has a name.
References
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organizational forms’, WorkingPaper (HarvardBusiness School, July1996).
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firm’, QuarterlyJournal of Economics, Vol.112, August 1997, pp.693–728.
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12Quotedin Kay(1998).
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Financial Architecture 141
Myers,S.C.andMajluf,N.S.,‘Corporatefinancingandinvestmentdecisionswhenfirmshave
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conglomerates’, WorkingPaper (MITSloanSchool of Management, July1997)
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