Corporate governance and merger activity in the U.S. : making sense of the 1980s and 1990s

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CORPORATE

GOVERNANCE AND

MERGER

ACTIVITY

IN

THE

U.S.:

MAKING

SENSE

OF

THE 1980s

AND

1990s

Bengt

Holmstrom

Steven N.

Kaplan

Working

Paper

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February

2001

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CORPORATE

GOVERNANCE

AND

MERGER

ACTIVITY

IN

THE

U.S.:

MAKING

SENSE

OF

THE 1980s

AND

1990s

Bengt

Holmstrom

Steven

N.

Kaplan

Working

Paper

01-1

February

2001

RoomE52-251

50

Memorial

Drive

Cambridge,

MA

02142

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i^ASSACHUSlTITnSSTITDTr

_OFTKHTOLOGY

Corporate

Governance and

Merger

Activity in the U.S.:

Making

sense ofthe

1980s

and

1990s

by

Bengt

Holmstrom

and

Steven N.

Kaplan

First draft: September2000 This draft: Februar>' 19,2001

Abstract

This paperdescribesandconsidersexplanations forchanges incorporategovernance and mergeractivity inthe UnitedStates since 1980. Corporate governanceinthe 1980swas dominatedbyintensemerger

activity distinguishedbythe prevalence ofleveraged buyouts (LBOs)andhostility. Afterabriefdeclinein

the early 1990s,substantialmergeractivityresumed in the secondhalfofthedecade, while

LBOs

and

hostilitydidnot. Instead, internal corporategovernance mechanismsappeartohave playedalarger role in

the 1990s.

We

concludeby considering whetherthesechangesandthe

movement

toward shareholder

valueare likely tobe permanent.

BengtHolmstrom isthe Paul A. Samuelson ProfessorofEconomics, Massachusetts Institute ofTechnology, Cambridge,Massachusetts.

Steven N. KaplanisNeubauerFamilyProfessorofEntrepreneurshipandFinance, Graduate Schoolof Business,

University ofChicago, Chicago,Illinois.Bothauthorsare alsoResearchAssociates.National BureauofEconomic

Corporate

governance

inthe U.S. has

changed

dramatically throughout the 1980s

and

1990s. Before 1980, corporate governance

-

the

mechanisms

by

which

corporations

and

their

managers

are

governed

- was

relatively inactive. Then, the 1980s ushered ina large

wave

of

takeover' and restructuring activity.This activity

was

distinguished by itsuse of leverage

and

hostility.

The

use of leverage

was

so greatthat

from 1984

to

1990

more

than

$500

Billion of

equity

was

retired

on

net, as corporationsrepurchasedtheir

own

shares,

borrowed

to finance

takeovers,

and were

takenprivate in leveragedbuyouts

(LBOs).

Corporateleverage increased

substantially.

Leveraged

buyouts

were

extreme in this respectwith debt levels typically

exceeding

80%

oftotal capital.

The

1980salso

saw

the

emergence

ofthehostiletakeover

and

the

corporate raider. Raiders like Carl Icahn

and

T.

Boone

Pickens

became

household

names.

Mitchell and

Mulherin

[1996] reportthatnearly halfofall

major

US

corporationsreceived a

takeover offerin the 1980s. In addition,

many

firms that

were

nottakenoverrestructuredin

response tohostilepressure to

make

themselvesless attractive targets.

hi the 1990s, the patternofcorporate

governance

activity

changed

again. After asteep,

butbrief, dropin

merger

activity

around

1990,takeovers

rebounded

to thelevelsof thel980s.

Leverage and hostility, however, declined substantially.

At

the

same

time, othercorporate

governance

mechanisms

began

toplay alarger role, particularlyexecutivestock options

and

the

greaterinvolvement of boards ofdirectorsand shareholders.

Inthis article,

we

describethe changesincorporate

governance

inthe 1980s

and

1990s.

We

then present

and

evaluate several potentialexplanations for thesepatterns. In particular,

we

theconcomitantleverage

and

hostility? Second,

why

haveleverage

and

hostility not returned

withthereturn ofsubstantial takeoveractivity inthe 1990s,

and

what governance mechanisms,

if

any,

have

replaced

them?

Finally, doesthecurrent

dominance

of shareholdervalue asa

corporate objective reflecttemporary

changes

inthe

economic

envirormientor

permanent

improvements

in corporate

governance?

We

willargue thatthepreponderance ofthe evidence isconsistent withan overall

explanationas follows.

The

realdrivers

behind

theincreased

dominance

ofcapital marketsand

the attendantrise of shareholdervaluecan

be

tracedtoderegulation, nationally

and

internationally,

and

to

new

information

and

communication

technologies.

For

many

companies

thesechanges,

which began

before 1980, created a

wedge

between

actual

and

potential

performance.

Managers

were

slow torespond, partlybecause of misalignedincentives,butlikely

alsobecause they

were

confused

and

couldn't figure out the appropriateresponse (anddidn't

believethatthecapitalmarkets

knew

any

better.)

The

fact thatfamily firmsdidn't

seem

to

respond verydifferently

from

thelarge, publicly

owned

companies, suggeststhatit

was

difficult

to

know

what

shouldbe done.

At

the

same

time, capital markets

grew

more

powerful withincreasedinstitutional

investments.

The

potential for

improved

corporate

performance

pairedwith

empowered

investors

gave

birth totakeovers,

junk bonds and

LBOs.

In

some

cases, thecapital markets

reversedill-adviseddiversification; in others, thecapital markets helpedtoeliminateexcess

capacity; in others,the capitalmarketsdisciplined

managers

who

had

ignoredshareholders to

benefitother stakeholders.

The

incentive

and governance

features of

LBOs

areparticularly

Managers

initiallyfought takeovers with legal

maneuvers and

by enlisting political and

popularsupport.

They

were

successful in that hostiletakeovers

became more

costlyinthe 1990s.

But by

that time, managers, boards

and

institutional shareholders had seen

what

LBOs

and

other

market

driven restructuringscoulddo.

Thanks

tolucrative stock option plans,

managers

could

share inthe marketreturns

from

restructuredcompanies. Shareholdervalue

became

an allyrather

than an

enemy.

This explains

why

restructurings continuedat ahighrate inthe 1990s, but for the

most

parton amicable terms.

There

was

less ofa

need

forhigh leverage asdeals could be paid

for with stock with less

worry

that

managers

would

abuse thisprivilege.

Will the capital market'sinfluencecontinue?

We

do

nothave a firm opinion. But

we

will

arguethatshareholdervalue

became

dominant

in the 1980s

and

1990sinpart at leastbecause

capital markets have a comparative advantagein undertaking the kindofstructural reforms that

deregulation

and

technological

change

necessitated. It is possible, therefore, that shareholder

value

and

market

dominance

will subside as the

need

forcorporate restructurings declines.

1.

Corporate

Governance

in the 1980s:

The

Rise of

Leveraged

Takeovers

1.1

The

Managerial

Climate

of the

Early 1980s

Many

authors

have

pointed out thatthecorporate

governance

structures inplace before

the 1980s,

gave

the

managers

ofthelargepublic corporations littlereasonto focus

on

shareholder concerns.

Donaldson and

Lorsch (1983),

Donaldson

(1994), and Jensen(1988,

1993) all arguethatbefore 1980,

management was

loyal tothecorporation, notto the

shareholder.

The

external

governance

mechanisms

that

were

formallyavailableto shareholders

were

rare

and

didn't

have

much

chancetosucceed.

Boards

tendedtobe

cozy

with

management,

making

boardoversight weak. Internalincentives

from

management

ownership

ofstock

and

options

were

alsomodest; in 1980, only

20

percent ofthe

compensation

ofchiefexecutive

officers

was

tied to stock

market performance

(Hall

and Liebman,

1998). Lx)ng-term

performance

plans

were

widelyused, but they

were

based

on

accounting

measures

that tied

managerial incentives

much

less direcdytoshareholder value.

1.2

The

Takeover

Boom

ofthe

1980s

Takeover

activity

began

toacceleratein the early 1980s

and

boomed

throughout

much

of

the decade.

Although

the

main

focus ofthis sectionisthe 1980s, the discussion alsocarries into

the 1990s, establishing the basis forlatercomparisons.

(The

figures

and

the analysis

below

are

generally consistent withtheresults in

Andrade,

Mitchell

and

Stafford in this

symposium.)

Figures 1

and

2illustratethe extentofthe

merger

boom

by

presenting

measures

of

merger

activity inrecentdecades. Figure 1 reportstakeover activityas apercentage ofU.S.

GDP

from

1968

to 1999.

For

alongerhistoricalperspective,

Golbe and White

(1988)presenttime series

evidence of U.S. takeoveractivity

from

the late

1800s

tothemid-1980s. Theirfindings suggest

that takeoveractivity

above

2 to3percentof

GDP

isunusual.

The

greatest level of

merger

activityoccurred

around

1900

withactivity atroughly 10 percent of

GNP

for acouple ofyears.

By

thosemeasures, takeoveractivity inthe 1980sishistoricallyhigh

and

the activityinthelate

1990sisextraordinary. Figure 2offers anotherperspective

by measuring

acquisition

volume

asa

fraction ofstock

market

capitalization.

By

thismeasure, takeoveractivity

was

substantialinthe

yearsin eachdecade.

Takeovers

in the 1980s

were

characterized

by heavy

useofleverage.

Firms

purchased

other firms in leveraged takeovers

by borrowing

rather than

by

issuing

new

stock orusing solely

cash

on

hand. Otherfirms restructuredthemselves,

borrowing

torepurchase their

own

shares.

Finally,

some

firms

were

taken private in leveraged buyoutsor

LBO"s.

In an

LBO,

an investor

group, often alliedwith

incumbent

management, borrows

money

to repurchase all of a

company's

publicly

owned

shares

and

takes the

company

private. Kohlberg, Kravis

&

Roberts

(KKR)

was

one ofthe earliest

and

most prominent

LBO

investors.

This patternof additional debt isclearly illustrated inFigure 3.

which

reports the net

issuance or retirementofequity

by

U.S. non-financialcorporations as apercentage oftotal stock

market

capitalization

from

1973 to 1999.

From

1984

to 1990, U.S. non-financial corporations

were

netretirers ofequitywith annual netretirementsrunningatroughly3 percent ofthetotal

stock

market

value($

532

Billion in totalover the six years).

From

1991 to 1994. those

same

corporations

became

netissuers ofequity. Since 1994.U.S. non-financial corporations

have

againretiredequity

on

net, butata lowerrate than inthe 1980s (roughly 1 percentperyear).

Figure

4

shows

the

volume

of "goingprivate" transactions.

Most

ofthese transactions

were

leveragedbuyouts.

These

transactionsincreased sharplyin the 1980s, but virtually

disappearedin the 1990s.

Finally, Figure5 reports the rateofissuance fornon-investment grade or "junk"bonds,

expressed asapercentage oftotal stock

market

capitalization.

Junk bonds

are

bonds

thatare

rated

below

investment grade

by

the top

bond

rating agencies.

As

such, they

have

higher yields

throughoutthe 1980stogether with

LBOs.

In the

mid-

tolate 1980s,

more

than

50%

ofthe

issues

were

takeoverrelated.Drexel

Bumham

and Michael

Milken,

who

originated thisnovel use

of non-investmentgrade debt, underwroteor sold a largefraction ofthe

junk

bond

issues inthe

1980s.

The

useof

junk

bonds

declinedin theearly 1990s withthecredit crunch,

and

returned to

1980slevelsin the late 1990s.

The

fraction usedfor takeovers, however,

dropped

to

below

30%.

Almost

halfofall

major

U.S.

companies

received "hostile" takeoverbids inthe 1980s,

where

hostilityis defined asbidspursued withoutthe acquiescence oftarget

management

(Mitchell

and

Mulherin, 1996).

Even

those firmsthat

were

notactuallytaken overoften decided

torestructureinresponse tohostilepressure, particularly

when

corporate raiders

had

purchased

large blocks ofshares.

Figure

6

provides evidence ofthe highlevel ofhostility inthe 1980s, especially as

compared

tothe 1990s. In the 1980s,

between

20

percent

and

40

percentoftender offers

were

contested

by incumbent management."

Inthe 1990s, 15 percentorfewer

have

been

contested. In

this

symposium, Andrade,

Mitchell

and

Stafford reporta similar decline ofhostility in the 1990s

formergers overall. Again,this understates the difference

between

the 1980s

and

1990s because

itdoesnot includehostilepressure

from

investorswithlarge blocks ofshares.

1.3

Do

LBOs

and

Leveraged

Takeovers

Provide

Productivity

Gains?

When

large-scalehostiletakeovers appearedinthe 1980s,

many

voicedthe opinionthat

they

were

driven

by

investorgreed; the robberbarons of

Wall

Street

had

returnedtoraidinnocent

corporations.

Today,

itiswidely acceptedthatthetakeoversofthe 1980s

had

a beneficial effect

shareholders,explain

why

they appeared.

The

overall effectof takeovers

on

the

economy

ishardto pin

down,

because so

many

factors are involved.For example, the mild resurgencein productivitylevelsin the 1980s

and

greaterboost inthe secondhalfofthe 1990sis consistentwithcorporate governance boosting

productivity

-

but itis consistentwith otherexplanations as well.

One

can try to assess

whether

the combination oftakeovers, debt,

and

hostility islikely to

have improved

efficiency, by looking at the evidence

on

leveragedbuyouts.

With

the use of high

leverage

and

strong incentive

mechanisms

(describedbelow),

LBOs

can be

viewed

asan

extreme

manifestation ofthe

changes

reshaping the corporate sectorin the 1980s. If

LBOs

increased

value, it

seems

likely thatthe shift in corporate

governance

increased value in other areasofthe

economy,

too.

LBOs

were

associatedwiththree largechanges incorporate governance. First,

LBOs

changed

the incentives of

managers by

providing

them

withsubstantial equity stakes in the

buyout

company. Because

of high leverage, it

was

cheapertogive

managers

ahigh

ownership

stake.

The

purpose

was

togive

managers

the incentivetoundertake the buyout, to

work

hardto

pay

off thedebt,

and

to increaseshareholdervalue. Ifsuccessful,

buyout

company

managers

could expect to

make

a great deal of

money.

Kaplan

(1989) reportsthat the chiefexecutive

officersofthe leveragedbuyouts increasedtheir

ownership

stake

by

more

than a factoroffour,

from

1.4percentpre-leveragedbuyoutto 6.4percentpost-leveragedbuyout.

Management

teams,

overall, experienceda similar increase. Inthe early 1980s, thisapproach to

management

compensation

was

fundamentallydifferent

from

the prevailing practice.

strong financialdiscipline

on

company

management.

It

was

no

longer possible for

managers

to

treatcapital as costless.

On

thecontrary,failure to generate asufficientreturn

on

capital

meant

default. Thiscontrastssharply with theperceivedcost ofcapital infirms with a conservative

capital structure.

Because

dividends are discretionary,

and

oftendetermined

by

management,

the

priceofequity is

much

lesstangible than the priceofdebt.

Third, leveraged

buyout

sponsorsor investors closely

monitored and governed

the

companies

theypurchased.

The

boards ofthe

LBO

companies were

small

and

dominated

by

investorswith substantial equitystakes.

The

empiricalevidence supports the

view

thatleveraged buyouts

improved

efficiency. In

thefirsthalfofthe 1980s,

buyout

companies

experienced

improved

operatingprofits(both

absolutely

and

relative to theirindustry)

and

few

defaults(Kaplan, 1989;

Kaplan

and

Stein, 1993;

see alsoSmith, 1990).

However,

theleveraged

buyout

experience

was

different inthe latterhalf

ofthe 1980s.

Roughly

one-thirdoftheleveragedbuyouts

completed

after

1985

subsequently

defaulted

on

theirdebt,

some

spectacularly

(Kaplan

and

Stein, 1993).

These

defaultsled

many

to

question the existenceofefficiency gains.

But even

forthelate 1980s, theevidenceis supportiveoftheefficiency story.

The

reason

for thedefaults

was

notthatprofits didn'timprove, butthattheydidn't

improve

by enough

to

pay

off the

enormous

quantitiesof debtthat

had been

takenon.

For

example,

Kaplan

and

Stein

(1993) findthat, overall,the largerleveragedbuyouts ofthe later 1980salsogenerated

improvements

inoperatingprofitsdespite therelatively large

number

ofdefaults.

Even

fordeals

thatdefaulted,

Andrade and Kaplan

(1998)find thatthe leveraged

buyout companies

retained

neteffectofthe leveragedbuyout

and

default

on

capital value

was

slightly positive.

The

case ofFederated

Department

Storesillustrates thiseffect (Kaplan. 1994a).

The

leveragedbuyout firm

Campeau

acquiredFederated in 1988. in

what

is

sometimes

consideredin

thepopularpresstobe the nadirof leveraged buyouts

and

the 1980s (Loomis. 1990; Rothchild,

1991).

On

January 1, 1988. Federated's debt

and

equity traded at$4.25 billion.

From

thatpoint

untilit

emerged from

bankruptcyin February 1992,Federatedreturned roughly$5.85 billion in

value (adjusted forchanges in the

S&P

500). Inotherwords. Federated

was

worth $1.6billion

more

afterbeingpurchased

by

Campeau

than it

would

have been

ifit

had

matched

the

S&P

500.

But

unfortunately forhim,

Campeau

paid $7.67billion forFederated,

and

so

went

bust.

The

logical question is, if

LBOs

increased value,

why

didso

many

companies

default?

The

likely

answer

is that the successofthe

LBOs

ofthe early 1980sattractedentrants

and

capital.

Those

entrants understood the basic

LBO

insights.

The

entrantsbid

up

thepricesofthe

leveragedbuyouts.

As

aresult,

much

ofthe benefit ofthe

improved

discipline, incentives,

and

governance

accruedto thesellingshareholdersratherthan tothepost-buyout leveragedbuyout

investors.

The

combined

gains

remained

positive, but the distribution changed.

1.4

Why

Did

Financial

Markets

Become

More

Active in the

1980s?

The

evidence in theprevioussection pointsto efficiencygainsasthe drivingforcebehind

the 1980s takeoverwave.

What

was

the underlying sourceofthese efficiencies

and

why

did

corporate

governance

capitalize

on

them

inthe 1980s

and

notearlier?

Jensen (1986, 1988, 1989, 1993) takes the

view

thatthe 1980s takeovers

were

ultimately

were

longin

coming.

Ever

since the 1930s,

management

incentives

had

become

weaker

as

corporations

had

become

larger,

management

ownership

had

shrunk

and

shareholders

had

become more

widelydispersed.

No

one watched

management

the

way

J.P.

Morgan

and

other

large investorsdidin the early partofthe 20' century.Boards,

which were supposed

tobethe

guardiansofshareholderrights, mostlysided with

management

and

were

ineffectiveincarrying

outtheirduties.

One

ofthebig

drawbacks

ofthecorporation, according toJensen,

was

thatit

could

and

did subsidizepoorlyperformingdivisionsusingthecash generated

from

successful

onesinsteadofreturning the "free cashflow"totheinvestors.

According

toJensen (1993), corporate

mismanagement

inthe 1970sfinallycausedcapital

marketsto react.

The

large windfall gains

from

theoil crisis that

were

spent

on

excessiveoil

exploration

and

diversification

were

aconcrete trigger.

But

changes intechnology

and

regulation

more

broadly

had

ledto a large

amount

of excesscapacity in

many

U.S. industries.

Managers

were

unwilling topair

down

theiroperations orsimplyexitaslong asthey

had

the financial

resourcestocontinue. In the early

and

mid

1980s, the capital marketsfinally

found

the

instrumentstoreduce excesscapacity.

Leveraged

acquisitions, leveraged buyouts,hostile

takeovers,

and

stock

buybacks were

successful ineliminating freecashflow,because thedebt

servicerequirementsthatusually

accompanied

them

prodded

managers

tofind

ways

to generate

cashto

make

interestpayments.

Impressed

by

the

performance

ofthe

LBOs

intheearly 1980s,Jensen (1989)

went

so far

astoforecastthat in

most

cases these

new

organizational

forms

would

soon

eclipsethe

corporation.

Among

the

main

benefits of

LBO

associationsrun

by buyout

firms likeKravis,

There

is littledoubt that the eliminationof excesscapacityplayed an importantrole in

the takeoversofthe 1980s, particularly in industries likeoil. Itis less clear, however, thatexcess

capacity

was

the primary driverofthe takeover

wave

in the

way

Jensen suggests.

The

excess

capacityexplanation

makes

some

strong predictions aboutinvestment. Specifically,iffirms

involvedin takeovers

and

buyouts

were

spending too

much money

on

capital expenditures, then

afterthe corporate control transaction, these

companies

should

spend

less.

The

evidence forthis

ismixed.

Kaplan

(1989) and

Kaplan and

Stein (1993) findthat

management

buyoutfirms

do

make

largecuts incapital expenditures.

However,

Servaes (1994) finds

no

evidence thattargets

ofall takeovers, ofhosdle takeovers,

and

ofgoingprivate transactions

were

overinvesting in

capital expenditures before the takeover. Furthermore, there

do

notappeartobe significant

changes in the ratio ofcapital expenditures to sales forfirmsthat

went

through takeovers in the

1980s(Healy, Palepu

and Ruback,

1992; Bhagat, Shleifer,

and

Vishny, 1990).

Also, itis not obviousthat self-interest alone

was

thereason

why

managers

didn'texit

industries with excesscapacity or didn't returnfreecash flow. Free cash flow is notan

accounting

number

and

how much

cash should bereturned to investors

depends on

theestimated

returns

from

internalinvestments. Itis plausiblethat

some management

and

boarddecisions

stemmed

from

uncertaintyabout returns and competitiveposition in a

changed market

environment.

Moreover,

returningcash to investors

was

notpartofthe prevailing

management

culture atthe beginning ofthe 1980s.

Managers were supposed

to haveasurplus, not ashortage

of investmentideas. (Witness the difficultiesthattoday's

fund

managers have

withthis

same

issue.)

Vishny

(1990), isthat "thetakeover

wave

ofthe

1980s

was

toa large extent aresponse tothe

disappointment with conglomerates" that

had been assembled

in theprevious

merger and

acquisition

wave

inthe 1960s. In theirview, corporate

America

in the 1980s "returnedto

specialization."

Companies

soldunrelatedbusinesses

and

expanded

intorelatedbusinesses.

"To

asignificantextent the 1980sreflectthedeconglomeration of

American

business. Hostile

takeovers

and

leveragedbuyouts ... facilitated thisprocess." In otherwords,the 1960s

conglomeration

wave was

amistake, atleastinhindsight,

something

managers were

slow or

unwillingtorecognize untilcapitalmarkets

began

toexertpressure

on

them.

Again, this

argument

has strong implications. Ifmergers

were

about deconglomeration,

thenitshould betrue thatcorporate diversification

was

value decreasing

and

deconglomeration

value increasinginthe 1980s,

and

thatU.S. business

became

substantiallylessdiversified inthe

1980s afterthe

wave

of deconglomeration.

The

evidence

on

these implicationsismixed.

In influentialpieces,

Lang

and

Stulz(1994)

and

Berger

and

Ofek

(1995)find that

diversifiedfirmsinthe U.S.trade atadiscountto single-segmentfirmsin the 1980s

and

early

1990s.

These

pieces suggestthatdiversificationdestroys value. Berger

and

Ofek

(1996)find

thatfor diversifiedfirms the likelihoodofatakeoverincreaseswiththesizeofthe diversification

discount.

More

recentevidence,

however,

suggeststhatatleasthalfofthe diversification discount

(andpotentiallya

good

deal

more

ofit) can be attributed tothefact that diversifying firms are

different.

Many

of the targets

were

discounted beforethey

were

acquired

and

became

partofa

diversifiedfirm

(Graham,

Lemmon

and

Wolf, 2000). Similarly, acquirers apparently trade ata

discount before

making

diversifying acquisitions

(Campa

and

Kedia, 1999)."*

difficultfindingto explain isthatthe

combined

gain to bidder

and

target shareholders atan

acquisition

announcement even

indiversifying acquisitionsisalwayspositive

on

average in

every study

we

have seen.

While

U.S. businesses did

become

less diversifiedduringthe 1980s, the extentofthe

decrease remainsunclear.

Montgomery

(1994) points out that, in 1991, the typicalfirm inthe

S&P

500 had

the

same number

of industry

segments

as the typical firm in the

S&P

500

in 1981

.

Comment

and

Jarrell (1995),

on

theotherhand, reportbigger declines in diversificationover the

1980s.

Among

firms covered by Compustat, thepercentage offirms with a singlebusiness

segment went up

from

36.2 percent in

1978

to 63.9 percentin 1989. Finally, Mitchell

and

Mulherin

(1996)findthat takeoveractivity in the 1980sclustered inparticular industriesat

particularpointsin time. In contrast, takeoveractivity in the 1960s

and

1970sexhibited

no

such

clustering.

To

them, the 1980s

seem

lessabout breaking

up

conglomeratesthan about

restructuringcertain industries.

Stein (2001)

summarizes

the large

and

conflicting

body

ofevidence

on

diversification

and

its value implications.

One

ofthe

main

observationsis thatit

was

primarily the poorly

performingconglomerates that

were

takenover

and

restructured(Berger

and

Ofek, 1996). In that

respect, conglomerates

may

not

be

any different

from

otherfirmsthat

perform

poorly (Morck,

Shleifer,

and

Vishny, 1989). Overall, these empiricalresults suggest thatdeconglomeration

played arole in the 1980stakeovers, but

was

probably not theprimarydriver.

Donaldson

(1994) providesyetanotherperspective

on

the 1980s takeover

wave.

He

arguesthat inthe 1980sthebalance of

power

shifted

from

corporate stakeholdersto

large institutional investors nearly

doubled

theirshareof

ownership

of U.S.corporations

from

under

30%

toover

50%

(Gompers

and

Metrick, 2000),while individual

ownership

declined

from

70%

in 1970, to

60%

in 1980, to

48%

in

1994

(Poterba

and

Samwick,

1996).

The

shifttowards

institutional

ownership and

the resulting shiftin

power

arekeys forunderstanding

why

the

takeoversappeared inthe 1980s.

Donaldson

calls the 1980s the "decade ofconfrontation."

One

oftheimportanteffectsofgreaterinstitutional

ownership

was

on

takeovers.

Fund

managers were

more

interestedin squeezingouthigherreturns

and

less loyal to

incumbent

management

than individualinvestors. Institutionalinvestors

were

often the

key

sellersoflarger

blocks ofsharesintakeovers. This

made

takeoverseasier. Institutionalinvestors alsosupported

takeovers

by

beinglarge investors inthe

buyout

funds

and

inthe

market

for high-yieldbonds.

In

summary,

we

believe the 1980s takeover

wave was

caused

by

a

complex

combination

ofthefactors

mentioned

above.

Without

a large increase inpensionassets,

which

concentrated

financial power, itisless likelythatthere

would

have been

a willingness

and

abilitytosupport

large multi-billion dollartakeovers.

The

scale

and

scope ofthe

1980s

takeover

wave was

a

product oftheincreased sizeofthe financial markets.

On

the otherhand,there

must

also

have

been

significantinefficiencies inthe

way

corporations

were

run.

Without

inefficiencies,the

purpose oftakeovers

would

have

been

missing.

The

sourceofthe inefficienciesremains

open

todebate. Jensen(1986, 1988)thinks the

problem

is apoorlydesigned

governance

system, buthis

endorsement

ofthe

LBO

associationhas

not

had

material following. In the 1990s, the largest

pubHc

corporations

have

become

even

larger

and

many

of

them

have been

exceptionally successful.

The

privatization

movement

has

intervention

and

shareholdervalue

may

partly reflect atemporary comparative advantageof

these

forms

ofgovernance.

2.

Why

Did

Corporate

Governance and Mergers

in the

1990s

Look

So

Different?

At

the

end

ofthe 1980s, the takeover

wave

ended.

As

theprevious figures show,

takeover volume, goingprivate

volume, and

the use of leveragedeclined substantiallyin 1990.

At

the time, anti-takeoverlegislation

and

jurisprudence, overtpolitical pressure against leverage^,

the collapse ofthe highyield

bond

market,

and

acreditcrunch

were

among

theexplanations

profferedforthe decline (Jensen. 1991;

Comment

and

Schwert, 1995). Since then, both the

political pressure againstleverage

and

the creditcrunch

have

abated

and

thenon-investment

grade

bond

markethas recovered(see figure 6). Yet, neitherthe use of

extreme

leverage nor

hostility

have

come

closeto their 1980slevels, suggesting thatanti-takeover legislation has

had

an effect.

In thissection,

we

document

thatcorporations in the 1990s

began

to emulate

many

ofthe

beneficial attributesof

LBOs.

This could explain

why

hostilitydeclined: hostile takeovers

were

no

longerneeded, as

companies

voluntarily restructured

and

adopteda shareholder value

perspective withthe prodding

from

time totime ofinstitutional shareholders.

The

fearof the

1980shostile takeoverslikely playedapart in thisdevelopment.

Also

important (andperhaps

more

so), is that

managers

became

aware

ofthe potential benefits ofpursuing shareholder value

by

observing thesuccess of

LBOs

and

takeoversin the 1980s.

Helped

alongby generousstock

optionprograms,

management

came

toendorse shareholder valuein the 1990s and pursue it with

2.1

The

Rise of Incentive-based

Compensation

Hall

and

Liebman

(1998)find aremarkableincreaseinequity-based

compensation

for

U.S.

CEOs.

From

1980

to 1994, theaverage annual

CEO

option grant (valuedatissuance)

increasedalmost seven-fold.

As

aresult, equity-based

compensation

made

up

almost

50%

of

total

CEO

compensation

in 1994,

compared

to lessthan

20%

in 1980.

The

effectofthe increase

inequity-based

compensation

has

been

toincrease

CEO

pay-to-performancesensitivities

by

a

factoroftentimes

from 1980

to

1998

(Hall

and Liebman,

2000).*^

The

increasein

pay-for-performance

sensitivityoverthis periodis ofthe

same

orderof

magnitude

asthe increase for

CEOs

in

LBOs

found

in

Kaplan

(1989).

The

results inHall

and

Liebman combined

withthosein

Holdemess, Kroszner

and

Sheehan

(1999) suggestthatmanagerialequity

ownership

is veryhigh todayrelative to

most

of

thelastcentury(andperhapsall ofit).

Holdemess

etal.

compare

equity

ownership

by

officers

and

directorsin

1935 and 1995 and

findthatequity

ownership

was

substantiallygreaterin

1995

thanin 1935.

Itisarguablythecasethatthe largepayoffsearned

by

LBO

sponsorsand,

more

importantly,

by

thetopexecutives of

LBO

companies

made

it

more

acceptable for topexecutives

ofpublic

companies

to

become

wealthy through equity-based compensation.

2.2

Forcing

a

Recognition

ofthe

Cost

ofCapital

The

second

distinguishingcharacteristic of

LBOs

istoincur

enough

leverage toforce

repaythe interest

and

principal

on

the debt. Corporations (andconsulting firms)

now

increasinglytryto create aparalleleffectthrough

new

performance

measurement and

compensation

programs. Forexample.

Stem

Stewart markets

Economic

Value

Added

(EVA)

and

the

Boston

Consulting

Group

marketsTotal Business Return

(TBR).

These programs

compare

a

measure

of returnon capital

-

usually the after-tax profitearnedby a

company

or

division

-

to a

measure

ofthe costofcapital

-

the after-tax profitrequired

by

the capitalinvested,

i.e., the product ofcapital

employed and

the weighted averagecost ofcapital.

Managers

are

then

monitored

and

compensated on

theextentto

which

the return

on

capital

exceeds

the costof

capital. This allows boards and

CEOs

to

make

sure that

managers view

capital ascostly.

While

it isreasonable to arguethatthese

programs do

not

impose

as

much

discipline as

thedebtin an

LBO

would, thereis evidence thatthese

programs

have

LBO-like

effects.^ Biddle,

Bowen

and Wallace

(1999)findthat firms that

implement

EVA,

improve

operatingefficiency,

dispose ofassets, reduce investment,

and

repurchase stockto a greaterextentthan a control

sample

of non-implementers.

There

is alsoanecdotal evidence that

companies

increasinglyapproachdecisions withthe

goal of

maximizing

shareholdervalue. For example,consulting firms like

McKinsey

&

Co.

routinely

measure

the effectsoftheirconsultingassignments

on

shareholder value

(Copeland

et

al., 1994).

2.3

Monitoring

The

thirddistinguishing characteristicof

LBOs

is closermonitoring

by

shareholders

and

management more

closelyin the

1990s

thanin the 1980s. First,as

mentioned

earlier, the

shareholdingsofprofessional, institutional investorsincreasedsubstantially.

From

1980

to 1996,

large institutionalinvestorsnearly

doubled

the shareofthe stock

market

they

owned

from

under

30%

toover

50%

(Gompers

and

Metrick, 2000). This

means

thatprofessional investors

- who

have

strong incentivestogenerate greater stock returns

-

own

an increasingly largefractionof

U.S. corporations.

Second,in 1992, the

SEC

substantially

reduced

the coststo shareholders of

mounting

proxy

conteststhatchallenged

management

teams.

Under

the oldrules, ashareholder

had

tofile

a detailed

proxy

statementwiththe

SEC

beforetalkingto

more

than ten other shareholders.

Under

the

new

rules, shareholderscanessentially

communicate

at

any

timeinany

way

aslongas

theysenda

copy

ofthe substanceofthe

communication

to the

SEC

afterward.

The

rule

change

has

lowered

thecostof coordinating shareholderactions

and

toblock

management

proposals.

Not

surprisingly,the Business

Roundtable -

a

group

of

200

CEOs

oftheverylargestU.S.

companies

-

and

other

management

organizations

were

extremely hostile tothisrule

change

when

it

was

proposed.

Shareholder activismhas increasedintheU.S. since the late 1980s with

CALPERS,

the

Council ofInstitutional Investors, the

LENS

Fund,

and Michael

Price's

Mutual

Shares

among

the

more

prominent

activists.

Changes

in the

proxy

rules

have

made

this possible.

The

evidence

on

the impact of shareholderactivism,

however,

is mixed.

Karpoff

(1998)

summarizes

theresultsof

20

empirical studies

on

theeffectsofformal shareholder proposals

and

private negotiationswith

firms,

and

finds evidenceof, atbest, onlysmalleffects

on

shareholdervalue.

because

much

ofitis

communicated

verbally

and

not reported (Russell

Reynolds

Associates,

1995). Interestingly,

Gompers

and

Metrick (2000)findthatreturns are higherin

companies

with

greaterinstitutional ownership. This isconsistent with a monitoringrole forlarge institutions

-greaterinstitutional

ownership

implies

more

effective monitoring,

which

is associatedwith

higherstockprices. Furthermore, ina survey ofinstitutional investors, Felton etal. (1997) find

that

many

institutional investorswill

pay

a

premium

ofapproximately

10%

for

companies

with

good

corporate governance.

There

also isevidence thatboards ofpublic

companies have changed

in the 1990s

and

become more

active monitorsthan in the past. Like top

management,

directors receivean

increasing

amount

of equity-based compensation. Perry(1999)estimates thatthe fraction of

compensation

for directors thatis incentive-based increased

from

25%

in

1992

to

39%

in 1995.

Russell

Reynolds

Associates (1998) reportthatthe useof incentive-based

compensation

for

directors alsoincreased

from 1995

to 1997.

Boards

ofpublic

companies have

become somewhat

smallerover time (Hermalin

and

Wesibach,

2000;

Wu,

2000). This is interestingbecause boards of

LBO

firms are smaller than

otherwise similarfirms (Gartner

and

Kaplan, 1996);

and

smallerboardsare associatedwith

higher valuations

(Yermack,

1996).

The

CEO

turnover processalso appears to

have

changed.

Huson,

Parrino,

and

Starks

(1999)

compare

CEO

turnoverforlarge

companies from

1971 to 1994.

They

finda

marked

increase inforcedturnovers

and

hiring of

new

CEOs

from

outside the

company.

The

incidence

offorced turnovers

and

outside successionis highest

from 1989

to 1994.

Parrino,

and

Starks (1999)findthat

CEO

turnoveris

more

sensitive to

changes

inoperating

income from 1989

to

1994

thanin earlier years.

On

theotherhand.

Murphy

(1999)finds that

CEO

turnoveris less sensitive toindustry-adjustedstocic

performance

from 1990

to 1995 thanin

earlieryears.

2.4

Changes

in

Regulation

and

Taxation

Two

other corporate

governance

changesin the 1990s

- one

inregulation

and one

in

taxation

-

are

worth

mentioning.

In 1992, the

SEC

required public

companies

toprovide

more

detaileddisclosureoftop

executive

compensation

and

itsrelation tofirmperformance,particularlystockperformance.

Thisrequirement arguably

had

two

effects. First,itfocusedboards ofdirectors

on

stock

performance.

Companies

now

routinely reportfirm, industry,

and market

stock

performance

in

their

proxy

statements. Thisrepresents a substantial shift

from

thepre-1980s

when

companies

were

more

likely tofocus

on

earningspershare, growth,

and

other

measures

that

might

or

might

not affect

company

stockperformance. Second, therequirement

makes

equity-based

compensation packages

easiertodefend.

Boards

ofdirectors are lesslikely to

be

criticized

by

shareholders or the

media

if

managers

are

compensated based

on

stockperformance.

In 1993,

Congress

passedlegislation that

capped

the tax deductibilityoftopexecutive

compensation

at$1 million unless the

compensation

was

performance-based. Hall

and

Liebman

(2000),Perry

and Zenner

(2000),

and

Rose

and

Wolfram

(2000)find that this legislation

had

at

2.5

Summing

up

the

Change

in

Corporate Governance

in the

1990s

Taken

as a whole, theevidence strongly suggests that U.S. corporations

have

increasingly

pursued shareholdervalue friendly policies

on

their

own

in the 1990s. This alsoprovidesthe

most

plausibleexplanation of

why

hostile takeovers

and

LBOs

largelydisappearedinthe 1990s

-they

were no

longerneeded.

A

telling piece ofanecdotalevidence

on

the

change

inthe corporate

mindset

comes

from

a

1997

statementon corporate

governance by

the Business

Roundtable(1997).

Up

until 1995, the Business

Roundtable

consistently

opposed

hostile

takeovers

and

raiders as well as substantial

changes

in corporate

governance

practices. In 1997

the Business

Roundtable

changed

itsposition toread "the

paramount

dutyof

management

and

theboardis tothe shareholder

and

not to ... other stakeholders."

Commenting

on

this, Nell

Minow,

a

prominent

shareholderactivistnoted:

"I'm

not on the fringe

anymore"

(Byrne, 1997).

We

believe

management's

acceptance ofthe shareholders' perspective

was

greatlyaided

by lucrative stock option plans,

which

allowed executives toreap bigfinancial benefits

from

increased shareprices.

As

aresult, the restructuring ofcorporate

America

continuedin the 1990s

on

much

more

amicable termsthan in the 1980s.

Another

reason

why

the 1990s

merger

wave

differed

from

the 1980s

wave

likelyhasto

do

with differentstages oftherestructuringprocess. In the 1980s, restructuring

was

justbeginning.

The

focus

was

on

forcing corporate assetsoutofthe

hands

of

managers

who

couldnot or did not

want

to use

them

efficiently.

The

results included takeovers

and

restructurings of

companies

with excesscapacityas well asbust-up takeoversofinefficientconglomerates. Hostility

and

leverage

were

important

accompaniments.

The

1990s appearto have

been

more

ofabuild-up

markets. This logic alsofitswith the evidence ofincreaseduseofequityin place ofdebt.

The

move

towards shareholder

and market preeminence

alsoisapparent inthe

way

corporations

have

reorganized themselves.

There

has

been

abroadtrendtowards

decentralization. Large

companies

are tryinghard to

become more

nimble

and

tofind

ways

to

offer

employees

higher-poweredincentives.

At

the

same

time, external capitalmarkets

have

taken

on

a larger shareofthereallocationofcapital.

The

large

volume

of

mergers

is evidencein

point.

Venture

capital funding

commitments

also

have

increased

by

an orderof

magnitude

over

the

1990s

(asdiscussedin this

symposium

by

Gompers

and Lemer).

While

corporate

managers

stillreallocate vast

amounts

of resourcesinthe

economy

throughinternal capital

and

labor

markets, the

boundary

between

markets

and

managers

appears to

have

shifted.

As

managers

have ceded

authoritytothemarkets, the scope

and

independence oftheirdecision-making have

narrowed.

3.

An

Alternative

View

on

Changes

in

Corporate

Governance

There

are

two

interpretationsofthe increased influenceof

markets

on

corporate

decision-making.

One

view

is that, afteraperiod ofcorporate

mismanagement,

including

misguided

experiments with conglomeratesinthe 1960s

and

waste offree cash

flow

inthe late 1970s

and

early 1980s,

we

have

finallyseena returntohealthy

market

capitalism. Shareholder valueis

back,becauseitis the

most

efficient

form

ofcorporate governance.

While

such aconclusionis consistentwith

much

oftheevidence

we

have

presented, the

efficiencyhypothesishasits

weak

spots.

Chief

among

them

isthe U.S.

economic

performance of

supposedly wasted large

amounts

of

money

on

conglomerates?

How

couldan inefficient

governance

system

produce

so

much

more

wealth?

And

what

aboutall thefamilyfirms that

became

conglomerates inthe 1960s?

Family

firmsare subjectto fewer agency

problems

than

widelyheldcompanies,yet

many

of

them

followedthe general trend.

The

1960s, rightlyor

wrongly,

viewed

conglomerates

more

favorably than

we

do

today. Indeed, stock marketsreacted

positivelyto

most

conglomeratesinthe 60s (Matsusaka, 1993). Ifhindsight can

condemn

this

economically successful periodas

mismanaged,

then

what

guarantees thatshareholdervaluewill

not suffer the

same

fate?

As

an alternative hypothesis, thissection explores thepossibility that capital markets have

come

to play abiggerrolenot becausethey

have

become

betteratallocatingcapital

and

not

because

managers

misbehaved, but ratherbecause the market'scomparative advantage has

been

favored

by economy-wide

trendsinderegulation, globalization,

and

information technology.^If

the shifts incorporate

governance

have

been

driven

by

these factors, then themarket's strong

influence

on

corporate

governance

may

be

more

transitory.

3.1

When

Markets

are

Superior Agents

of

Change

Markets

are

more

effectivethan

managers

when

it

comes

to

moving

capital

from

declining industries to

emerging

industries.

Firms

are experts atparticulartechnologies,products

and

processes. It

would

make

littlesense forshareholders to

become

directlyinvolved in General

Motors's choice ofcarmodels, for instance

—

though theiropinion

may

be reflectedinthe

subsequentshare price. But ifresourcesareto shift

from

carmanufacturingto

computer

computers, an areain

which

the

company

currentlyhas Httleexpertise,

would

make

economic

sense. Instead, the

market

may

have

arole toplayin funnelingcapital

toward

the

new

companies.

Europe

offersa

counterexample

ofwhere, instead ofmarkets

moving

capital

from

sunset

industries tosunrise industries, corporations

have

triedto

do

so.

Mannesmann

and

Preussagare

perhapsthe bestexamples.

Both were

inthemetals businessjustten years ago.Before the recent

takeover

by Vodafone,

Mannesmann

was

well

on

its

way

to

become

apurewireless operator. In

another five years,Preussag willprobably

be

apuretravelbusiness.

While

both ofthese

transitionsappearto

have been

relativelysuccessful,migration ofcorporateidentityas a

mechanism

for

economic

restructuring

seems

difficult to relyupon.

Europe and Japan have

clearly

had

more

difficultiestransformingtheircorporations than the UnitedStates inthelast

two

decades.

A

major

problem

with askingacorporationtomigrate

between

businessesis thatit

exacerbatesinternal conflicts

(Milgrom and

Roberts, 1988;

Meyer,

Milgrom

and

Roberts, 1992).

Employees

know

that theirfirm-specific

knowledge

islikely to

become

less valuable

once

the

firmchanges course

and

startspursuing

new

linesofbusiness.

A

new

firm, withalackof

commitments

and

oldbaggage, canofferadistinctivecompetitiveadvantage inrapidly

growing

industries suchasinformation technology

and

telecommunications.

From

thisperspective,

forcing older

companies

toadhere

more

rigorously to

maximization

of shareholder valuereduces

those activitiesof

employee

influencethatcausecostly delays, distortedinvestmentdecisions,

and misguided

efforts tosavejobs. Ifdecisionsof

where

tocut

and where

to

expand

jobs

were

left toademocratic

body

of workers, theheterogeneityin

employee

preferences

would

make

the

shouldgo, the decision can be

made

swiftly withoutfavoringany particulargroup of workers

(Hansman.

1996; Hart

and

Moore,

1996).

Markets

alsohave adistinctadvantage overcorporations

when

it

comes

toevaluating

and

rewardingfutureperformance. U.S.capital markets have often

been

accusedofshort-termism

(forexample. Porter, 1992), but insofaras these accusations suggestthat investmentsshouldnot

be evaluated

on

an

ongoing

basis inthe lightof current events, the accusations are largely

misplaced. Especially in a time of technological transition, quick reassessments of

where

capital

should be reallocated are arational response togreater uncertainty. Large swings in stock prices

ariseprecisely because the markettakes a long

view

of

growth

expectations. Also, while stock

prices arehighly imperfect, they have one

unmatched

virtue: they have integrity, because

markets are askingpeople to puttheir

money

where

their

mouth

is.

Without

the

measuring

stickofshareprices, thelong-termeffects of

management

actions

would

become

much

harderto assess. IfNetscape,

E-Bay

or

Amazon

had been invented inside a

big

company,

theirpotential value

would

probably

have been

overlooked.

Even

if

some

degree of

value

had been

seen, it

would

have

been

difficult orimpossible togive

management

astrong

incentiveto

maximize

the value inherentin these ideas.

As

independent firms withtheir

own

stockprices,

management

incentives

were

altogetherdifferent. In timesof change,

when

the

futuretakes

on

exceptional significance,the value of

market

information

and

market-based

incentives isparticularly great.

The

hierarchical investment approval process thatischaracteristic ofinternal capital

marketsis another

impediment

toinnovation within firms. Business historyislittered with tales

establishsuccessful

new

businesses

on

their

own.

Tightscreening ofprojects shouldnot

necessarilybe seenas adefectofthe large corporation. Peoplewithin the organization

do

not

carry the responsibilitythat an entrepreneurcarries.

The

freedom

topursue innovation needsto

be curbedto avoid excessive experimentation

and

inattention tothebusiness

end

oftheprocess.

Afterall,the

freedom

topursue innovation with the

company's

money

needs tobe monitored,lest

easy

money

fosterexcessive experimentation

and

inattention to thebusiness

end

ofthe process.

(FairchildTechnologies

and

Xerox

PARC

are

famous examples where

thefruitsof innovation

were

reaped

by

others.)

By

design, the large corporation isnotset

up

for revolutionary inventions

(Holmstrom,

1989; Bhide,2000).

Today,

corporationstryto adjusttothe increased

need

forinnovation

by

outsourcing

some

ofitto start-ups.

Companies

realize that theirin-houseresources are insufficient to

generate the quantity

and

varietyof

new

ideasthey need,

and

so they

must

participate in the

market-oriented innovationprocess,

whether

by

forming

alliances withpromising start-ups,often

by

usingcorporate venturecapital funds,

and sometimes by

purchasingfirmsoutright.

3.2 Will the

market's

influence

continue

toprevail

The

logical nextquestionis

whether

thecapitalmarket's

enhanced

role will

be

sustained.

One

argument

is thatthepace of

economic change

has accelerated

and

that

market

flexibility will

continuetobevaluable, ifnot

more

valuable,overtime. Alternatively,

one might

appeal to

historytoargue that thiscontinuallyfaster

change

isunlikely. Periods ofbig technological

and

organizational

change

are,nearly

by

definition, followed

by

lessexciting periods. If

change

itself

business?

A

reversion tothe olderstyleofcorporate governancein the 1960s

and

1970s

seems

unlikely for

two

reasons. First, the institutional

and

organizational

knowledge and

infrastructure

thathave

been

developedtodeal withcorporate restructuring have

changed

traditional trade-offs.

Forinstance, financial markets have

more

timely

and

betterinformation,

many new

instruments,

and

much new

expertise available to help

managers

reallocate capital. This is also areason

why

merger and

acquisition activityis likely to stay ata higher averagelevel in the future.

The

second

reason

why we

will not see a return to the olddays isthatderegulation

and

information technology have brought structural changes thathave altered the old trade-offs

between

markets

and

hierarchies.

For

instance, deregulation has increased

market

opportunities

and

competition, reducing thecost ofpotential hold-ups ina vertical chain.

Improved

informationtechnology, including the Internet,

have

made

access tofinancial capital easier

and

reducedthe

power

ofphysical assets relative to

human

capital (Rajan

and

Zingales, 2000).

The

industrial

and

organizationalimplicationsofthese

changes have

not

been

easy to

predict. Inthe 1970s, the

common

belief

was

thatpowerful

computers

would

resultin

more

centralization

and

ever-largercorporate structures,since corporations

would become

better

planners

and

information processorsrelative tothe market. This

matches

poorlythe

growth

of

networked, market-intermediated

forms

oforganizationboth in

new

and

traditional industries.

While

thecurrent

number

ofalliances,joint ventures

and

related hybrids islikely todecline as

therushinto

new

marketsdeclines, itis alsoclearthat

companies have

discovered

new

patterns

of cooperationthat will have a

permanent

effect

on

the organizational landscape.

On

the other

the corporation (Jensen, 1989). Evidently, hierarchies as well asmarketsbenefit

from

information technology withtheneteffectsgenerally

ambiguous

(Brynjolfson, 1994).

As

Baker

and

Hubbard

(2000)

have

nicelydemonstrated in thecontext oftrucking, adetailedstructural

studyisrequiredto sortout

competing

effects.

4.

Concluding

Remarks

U.S.corporate

governance

has

changed

substantiallyin the last

20

years.

The

underlying

substanceofthistransformationhas

been

thatU.S.

managers have

become

much

more

focused

on

stockprices.

The

corporate

governance

mechanisms

that

have

driven thisfocus

have

evolved

overtime,

from

theleveragedhostile takeovers

and

buyouts ofthe 1980stothe incentive-based

compensation, activistboards ofdirectors

and

shareholders in the 1990s.

We

have

arguedthatatleast

some

oftheefficiency gains associatedwiththese

changes

can

be

tracedtothecomparative advantage of markets in undertakinglarge-scalechange. Since,

theseeffects aretemporary, itispossiblethatthe current level of

market

influence

on

the

governance

and

organizationoffirms is goingtoabate. Itisnothardtobuildascenarioin

which

thepursuitof shareholder value

becomes

aless importantguidelineto

managers

in thenext

few

years.Stockoptions

were

popular

when

thestock

market

boomed

inthe 1960s,butdisappeared

duringtheflat

market

in the 1970s. Ifthestockmarketsare flator

down

forthenext

few

years,

then the extensive reliance

on

stockoptions

may

again dissipate,leading

managers

to

have

less

focus

on

stockprices.

But even

aftertaking suchreservations intoaccount, it

seems

to us thata

more

/

growth

ofmutual funds

and

institutional investors

seems

certain tocontinueoverthenextcouple

ofdecades.

The

market-based systemof corporate

governance

also

seems

to

have

a potentially

powerfulrole toplay asthe forcesof deregulation, globalization, and information technology

continue to

sweep

across the world

economy.

It will be revealing tosee

how

market-orientedthe

corporate

governance

systems in othercountries will

become.

Historically,U.S. corporategovernance has differed in the use ofequity-based

compensation, in the ability to repurchaseone's

own

shares,

and

in allowinga

number

of

takeovers'^. Inrecentyears, other countries

have

begun

to

move

towardthe U.S. model. In

Europe, accordingto accounts inthe popularpress, the use ofstockoptions forexecutives

and

boardsis increasing.

Japan

has eliminated a substantial tax penalty

on

executive stock options."

Inthe last several years, France,

Germany, and

Japan

have

made

it easier for

companies

to

repurchase their shares. Finally, continental

Europe

hasrecentlyexperienced arise in hostile

takeovers. Escherich

and

Gibbs

(2000)report that

34

hostile bids with atotal value of

$406

billion

were

announced

in

1999

inContinental Europe.

These

included

Vodaphones'

bidfor

Mannesmann.

TotalFina'sbidforElfAquitane,

and

Olivetti'sbid for

Telecom

Italia.This

volume

compares

with

52

bids for

$69

billionovertheentire

1990

to

1998

period.

Inthe 1970s

and

1980s,

many

observers criticizedtheU.S. capital markets

and

governancesystemquitestrongly

and

lookedtoothersystems, particularlythe

German

and

Japanese systems, asbeingsuperior (forexample, Porter, 1992). But since the mid-1980s, the

U.S. style ofcorporate

governance

has reinventeditself,

and

therestof the

world seems

tobe

Acknowledgements

We

thankGeorgeBaker,Bradford Delong,Robert Gibbons, Martin Hellwig,

Raghu

Rajan,JohnRoberts,

Figure 1

All Acquisition

Volume

As

%

of

Average

Giy

1968^1999

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

Figure2

All

Acquisitioii

Volume

As

%

of Average

Total

Stock

Market

Capitalization

1968-1999

1968

1971

1974

1977

1980

1983

1986

1989

Source: IVfer^stat,Authors' Calculations

Figure 3

400%

Net

Eqiity

Issuance

rfUS.

>tofiiBndal

Goporate

Bua^^

As

ftrcot

of

Avaa^

Total

Stodk

Mate

Value

1968-1999

1968

1970

1972

1974

1976

1978

1980

1982

19^

1986

1988

1990

1992

19^

1996

1998 200C

3.00%

0.50%

-0.00%

Figure

4

Gang

Private

Vdume

As

Percent

of

Average

Total

Stock

Market

Value

1979-1999

1976

1979

1982

1985

1988

1991

1994

1997

20C

Figure 5

200%

0.00%

NDn-ImcsdiHt

(iade

Bmd

Vdure

(As

a

%cf

A\o^

Total

Stock

Matet

Gptalization)

1977-1999

1977

1981

1985

1989

1993

Source:

Mnill

Lynch, Aithors'CMculations

45%

40%

35%

30%

Figure 6

Contested

Tender

Offers as

%

of Total

1974-1999

/ \ \

R

_A

J V-X / \ /

\

^

1

a

—

f-25%

I J

^

/

V

'

20%

Q

—

^

ti~-q

15%

D

/ / \ /

10%^

D-'^/

^

^

0%

/

1971 1975 1979 1983 1987 1991 1995 19 Source: Nfo^rstat