Monday, August 10, 2015

Unincorporating Corporations: The Problem with Large Public Corporate Governance

Large public corporations and their managers have come under increased scrutiny since the great recession. They have taken the easy steps of reducing costs and returning cash to shareholders. Unfortunately, they still face revenue growth problems, excess capacity, changing technology and regulation, and lagging performance. These problems have depressed relative share prices and attracted the interest of third parties. Hostile takeovers bids from strategic acquirers have increased to pre crisis 2007 levels of 20%+ of M&A. Activists like Daniel Loeb’s Third Point have raised record amounts to fund new campaigns to instigate strategic change. Understandably, managers are concerned about this increasingly active market for corporate control. They are reluctant to change formerly successful business models even though conditions have changed due to organizational inertia.

These managers are seeking political support to protect their positions. They allege hostiles and activists with their alleged short term focus harm the long-term value of their firms and ultimately the country. Thus, they evoke stakeholder and long-term holding requirements arguments to slow the process; they just need more time to prove that everything will alright. As Ralph highlighted, allowing alternative stakeholders control over capital supplied by shareholders allows one group to risk the capital supplied by someone else-never a good idea.

Equally unwise is to discriminate against investors based on their holding period. Examples include granting long-term shareholder enhanced voting rights as in France or taxing short term investors at higher rates as proposed by Hillary. When it comes to bearing risk the length of ownership is not a factor. There is no grace period during which new shareholders are shielded from management miscues. The real problem with so-called “short-termism” is poor governance and weak board oversight regarding short term orientated incentive compensation plans. Many public boards have been “captured” by management.

The agency cost problem with large slow growth public firms was pointed out over 25 years ago by Michael Jensen in his seminal article. The eclipse is a work in process. Attempts to inhibit the market for corporate control will retard reform efforts. It is puzzling that we do not see more going private transactions for large public low growth firms (like Buffett-3G Heinz and Kraft acquisitions) if markets are so short term. This is especially compelling since they no longer need public capital market access to fund their limited growth opportunities

An interesting legal development is taking place which may offer some new solutions to the agency cost-governance breakdown. The development is outlined in a recent book. Business form matters because it impacts governance and agency costs. The statutory based corporate form may be inefficient for mature public firms. Contract based limited life alternatives like limited liability companies (LLC), REITS and limited partnership do away with permanent capital and encourage the disgorgement of cash. They require investors to “re-up” in new vehicles if they believe in management.

The problem of failed attempts to adjust to a volatile business environment (Schumpeter's Ghosts) is highlighted in a provocative new BCG report. The life expectancy of domestic public firms has declined by almost 50% over the past 30 years due to bankruptcy, liquidation, M&A, LBO, or other causes.  The 5 year morality rate or exit risk for for U.S. public firms is now over 30% compared to just 5% on the 1960s.

There is no escaping change. Not everyone can or will adjust. The agency problem in public firms complicates the problem. The market for corporate control and evolving legal structures are some market solutions addressing the problem. They are preferred over political “solutions”, which merely try to hold back change.


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