Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 34 ppt

Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
CHAPTER THIRTY-FOUR
962
CONTROL,
GOVERNANCE, AND
FINANCIAL
ARCHITECTURE
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
FIRST, SOME DEFINITIONS. Corporate control means the power to make investment and financing de-
cisions. A hostile takeover bid is an attempt to force a change in corporate control. In popular usage,
corporate governance refers to the role of the board of directors, shareholder voting, proxy fights,
and to other actions taken by shareholders to influence corporate decisions. In the last chapter we
saw a striking example: Pressure from institutional shareholders helped force AMP Corporation to
abandon its legal defenses and accept a takeover.
Economists use the term governance more generally to cover all the mechanisms by which man-

agers are led to act in the interests of the corporation’s owners. A perfect system of corporate gov-
ernance would give managers all the right incentives to make value-maximizing investment and fi-
nancing decisions. It would assure that cash is paid out to investors when the company runs out of
positive-NPV investment opportunities. It would give managers and employees fair compensation
but prevent excessive perks and other private benefits.
This chapter considers control and governance in the United States and other industrialized
countries. It picks up where the last chapter left off—mergers and acquisitions are, after all,
changes in corporate control. We will cover other mechanisms for changing or exercising control,
including leveraged buyouts (LBOs), spin-offs and carve-outs, and conglomerates versus private
equity partnerships.
The first section starts with yet another famous takeover battle, the leveraged buyout of RJR
Nabisco. Then we move to a general evaluation of LBOs, leveraged restructurings, privatizations,
and spin-offs. The main point of these transactions is not just to change control, although existing
management is often booted out, but also to change incentives for managers and improve finan-
cial performance.
Section 34.3 looks at conglomerates. “Conglomerate” usually means a large, public company with
operations in several unrelated businesses or markets. We ask why conglomerates in the United
States are a declining species, while in some other countries, for example Korea and India, they seem
to be the dominant corporate form. Even in the United States, there are many successful temporary
conglomerates, although they are not public companies.
1
Section 34.4 shows how ownership and control vary internationally. We use Germany and Japan
as the main examples.
There is a common theme to these three sections. You can’t think about control and governance
without thinking still more broadly about financial architecture, that is, about the financial organiza-
tion of the business. Financial architecture is partly corporate control (who runs the business?) and
partly governance (making sure managers act in shareholders’ interests). But it also includes the le-
gal form of organization (e.g., corporation vs. partnership), sources of financing (e.g., public vs. pri-
vate equity), and relationships with financial institutions. The financial architectures of LBOs and most
public corporations are fundamentally different. The financial architecture of a Korean conglomerate

(a chaebol) is fundamentally different from a conglomerate in the United States. Where financial ar-
chitecture differs, governance and control are different too.
Much of corporate finance (and much of this book) assumes a particular financial architecture—
that of a public corporation with actively traded shares, dispersed ownership, and relatively easy ac-
cess to financial markets. But there are other ways to organize and finance a business. Arrangements
for ownership and control vary greatly country by country. Even in the United States many success-
ful businesses are not corporations, many corporations are not public, and many public corporations
have concentrated, not dispersed, ownership.
963
1
What’s a temporary conglomerate? Sorry, you’ll have to wait for the punch line.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
Leveraged buyouts differ from ordinary acquisitions in two immediately obvious
ways. First, a large fraction of the purchase price is debt-financed. Some, often all,
of this debt is junk, that is, below investment-grade. Second, the LBO goes private,
and its shares no longer trade on the open market.
2
The LBO’s stock is held by a
partnership of (usually institutional) investors. When this group is led by the com-
pany’s management, the acquisition is called a management buyout (MBO).
In the 1970s and 1980s many management buyouts were arranged for un-
wanted divisions of large, diversified companies. Smaller divisions outside the

companies’ main lines of business sometimes lacked top management’s interest
and commitment, and divisional management chafed under corporate bureau-
cracy. Many such divisions flowered when spun off as MBOs. Their managers,
pushed by the need to generate cash for debt service and encouraged by a sub-
stantial personal stake in the business, found ways to cut costs and compete more
effectively.
In the 1980s MBO/LBO activity shifted to buyouts of entire businesses, including
large, mature public corporations. Table 34.1 lists the largest LBOs of the 1980s plus
examples of transactions from 1997 to 2001. More recent LBOs are generally smaller
and not leveraged as aggressively as the deals of the 1980s. But LBO activity is still im-
pressive in aggregate: Buyout firms raised over $60 billion in new capital in 2000.
3
964 PART X Mergers, Corporate Control, and Governance
34.1 LEVERAGED BUYOUTS, SPIN-OFFS, AND
RESTRUCTURINGS
2
Sometimes a small stub of stock is not acquired and continues to trade.
3
LBO Signposts, Mergers & Acquisitions, March 2001, p. 24.
Acquirer Target Industry Year Price
KKR RJR Nabisco Food, tobacco 1989 $24,720
KKR Beatrice Food 1986 6,250
KKR Safeway Supermarkets 1986 4,240
Thompson Co. Southland (7-11) Convenience stores 1987 4,000
Wings Holdings NWA, Inc. Airlines 1989 3,690
KKR Owens-Illinois Glass 1987 3,690
TF Investments Hospital Corp of America Hospitals 1989 3,690
Macy Acquisitions Corp. R. H. Macy & Co. Department stores 1986 3,500
Bain Capital Sealy Corp. Mattresses 1997 811
Cyprus Group, with WESCO Distribution, Inc. Data communications 1998 1,100

management*
Clayton, Dubilier, & Rice North American Van Lines Trucking 1998 200
Berkshire Partners William Carter Co. Children’s clothing 2001 450
Heartland Industrial Springs Industries Household textiles 2001 846
Partners
TABLE 34.1
The 10 largest LBOs of the 1980s, plus examples of more recent deals. Price in $ millions.
*Management participated in the buyout—a partial MBO.
Source: A. Kaufman and E. J. Englander, “Kohlberg Kravis Roberts & Co. and the Restructuring of American Capitalism,” Business History
Review 67 (Spring 1993), p. 78; Mergers and Acquisitions 33 (November/December 1998), p. 43, and various later issues.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
Table 34.1 starts with the largest, most dramatic, and best-documented LBO of all
time: the $25 billion takeover of RJR Nabisco by Kohlberg, Kravis, Roberts (KKR). The
players, tactics, and controversies of LBOs are writ large in this case.
RJR Nabisco
On October 28, 1988, the board of directors of RJR Nabisco revealed that Ross John-
son, the company’s chief executive officer, had formed a group of investors that
was prepared to buy all RJR’s stock for $75 per share in cash and take the company
private. Johnson’s group was backed up and advised by Shearson Lehman Hutton,
the investment banking subsidiary of American Express. RJR’s share price imme-
diately moved to about $75, handing shareholders a 36 percent gain over the pre-
vious day’s price of $56. At the same time RJR’s bonds fell, since it was clear that

existing bondholders would soon have a lot more company.
4
Johnson’s offer lifted RJR onto the auction block. Once the company was in play,
its board of directors was obliged to consider other offers, which were not long in
coming. Four days later KKR bid $90 per share, $79 in cash plus PIK preferred val-
ued at $11. (PIK means “pay in kind.” The preferred dividends would be paid not
in cash but in more preferred shares.)
5
The resulting bidding contest had as many turns and surprises as a Dickens
novel. In the end it was Johnson’s group against KKR. KKR offered $109 per share,
after adding $1 per share (roughly $230 million) in the last hour.
6
The KKR bid was
$81 in cash, convertible subordinated debentures valued at about $10, and PIK pre-
ferred shares valued at about $18. Johnson’s group bid $112 in cash and securities.
But the RJR board chose KKR. Although Johnson’s group had offered $3 per share
more, its security valuations were viewed as “softer” and perhaps overstated. The
Johnson group’s proposal also contained a management compensation package that
seemed extremely generous and had generated an avalanche of bad press.
But where did the merger benefits come from? What could justify offering $109
per share, about $25 billion in all, for a company that only 33 days previously was
selling for $56 per share? KKR and the other bidders were betting on two things.
First, they expected to generate billions in additional cash from interest tax shields,
reduced capital expenditures, and sales of assets not strictly necessary to RJR’s core
businesses. Asset sales alone were projected to generate $5 billion. Second, they ex-
pected to make the core businesses significantly more profitable, mainly by cutting
back on expenses and bureaucracy. Apparently there was plenty to cut, including
the RJR “Air Force,” which at one point included 10 corporate jets.
In the year after KKR took over, new management was installed that sold assets
and cut back operating expenses and capital spending. There were also layoffs. As

expected, high interest charges meant a net loss of $976 million for 1989, but pre-
tax operating income actually increased, despite extensive asset sales, including
the sale of RJR’s European food operations.
Inside the firm, things were going well. But outside there was confusion, and
prices in the junk bond market were rapidly declining, implying much higher future
CHAPTER 34
Control, Governance, and Financial Architecture 965
4
N. Mohan and C. R. Chen track the abnormal returns of RJR securities in “A Review of the RJR Nabisco
Buyout,” Journal of Applied Corporate Finance 3 (Summer 1990), pp. 102–108.
5
See Section 25.8.
6
The whole story is reconstructed by B. Burrough and J. Helyar in Barbarians at the Gate: The Fall of RJR
Nabisco, Harper & Row, New York, 1990—see especially Ch. 18—and in a movie with the same title.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
interest charges for RJR and stricter terms on any refinancing. In mid-1990 KKR
made an additional equity investment, and in December 1990 it announced an offer
of cash and new shares in exchange for $753 million of junk bonds. RJR’s chief fi-
nancial officer described the exchange offer as “one further step in the deleveraging
of the company.”
7

For RJR, the world’s largest LBO, it seemed that high debt was a
temporary, not permanent, virtue.
RJR, like many other firms that were taken private through LBOs, enjoyed only
a short period as a private company. In 1991 RJR went public again with the sale of
$1.1 billion of stock.
8
KKR progressively sold off its investment, and its remaining
stake in the company was sold in 1995 at roughly the original purchase price.
Barbarians at the Gate?
The RJR Nabisco LBO crystallized views on LBOs, the junk bond market, and the
takeover business. For many it exemplified all that was wrong with finance in the
1980s, especially the willingness of “raiders” to carve up established companies,
leaving them with enormous debt burdens, basically in order to get rich quick.
There was plenty of confusion, stupidity, and greed in the LBO business. Not all
the people involved were nice. On the other hand, LBOs generated enormous in-
creases in market value, and most of the gains went to the selling stockholders, not
to the raiders. For example, the biggest winners in the RJR Nabisco LBO were the
company’s stockholders.
The most important sources of added value came from making RJR Nabisco
leaner and meaner. The company’s new management was obliged to pay out mas-
sive amounts of cash to service the LBO debt. It also had an equity stake in the busi-
ness and therefore had strong incentives to sell off nonessential assets, cut costs,
and improve operating profits.
LBOs are almost by definition diet deals. But there were other motives. Here are
some of them.
The Junk Bond Markets LBOs and debt-financed takeovers may have been
driven by artificially cheap funding from the junk bond markets. With hindsight,
it seems that investors in junk bonds underestimated the risks of default in junk
bonds. Default rates climbed painfully from 1988 through 1991, when 10 percent
of outstanding junk bonds with a face value of $18.9 billion defaulted.

9
The junk
bond market also became much less liquid after the demise in 1990 of Drexel Burn-
ham, the chief market maker, although the market recovered in the mid-1990s.
Leverage and Taxes Borrowing money saves taxes, as we explained in Chapter
18. But taxes were not the main driving force behind LBOs. The value of interest
tax shields was just not big enough to explain the observed gains in market value.
10
966 PART X Mergers, Corporate Control, and Governance
7
G. Andress, “RJR Swallows Hard, Offers $5-a-Share Stock,” The Wall Street Journal, December 18, 1990,
pp. C1–C2.
8
Northwest Airlines, Safeway Stores, Kaiser Aluminum, and Burlington Industries are other examples
of LBOs that reverted to being public companies.
9
See R. A. Waldman, E. I. Altman, and A. R. Ginsberg, “Defaults and Returns on High Yield Bonds:
Analysis through 1997,” Salomon Smith Barney, New York, January 30, 1998. See also Section 24.5.
10
Moreover, there are some tax costs to LBOs. For example, selling shareholders realize capital gains and
pay taxes that otherwise could be deferred. See L. Stiglin, S. N. Kaplan, and M. C. Jensen, “Effects of
LBOs on Tax Revenues of the U.S. Treasury,” Tax Notes 42 (February 6, 1989), pp. 727–733.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill

Companies, 2003
For example, Richard Ruback estimated the present value of additional interest tax
shields generated by the RJR LBO at $1.8 billion.
11
But the gain in market value to
RJR stockholders was about $8 billion.
Of course, if interest tax shields were the main motive for LBOs’ high debt, then
LBO managers would not be so concerned to pay off debt. We saw that this was
one of the first tasks facing RJR Nabisco’s new management.
Other Stakeholders We should look at the total gain to all investors in an LBO,
not just to the selling stockholders. It’s possible that the latter’s gain is just some-
one else’s loss and that no value is generated overall.
Bondholders are the obvious losers. The debt they thought was well secured
may turn into junk when the borrower goes through an LBO. We noted how mar-
ket prices of RJR Nabisco debt fell sharply when Ross Johnson’s first LBO offer was
announced. But again, the value losses suffered by bondholders in LBOs are not
nearly large enough to explain stockholder gains. For example, Mohan and Chen’s
estimate
12
of losses to RJR bondholders was at most $575 million—painful to the
bondholders, but far below the stockholders’ gain.
Leverage and Incentives Managers and employees of LBOs work harder and of-
ten smarter. They have to generate cash for debt service. Moreover, managers’ per-
sonal fortunes are riding on the LBO’s success. They become owners rather than
organization men and women.
It’s hard to measure the payoff from better incentives, but there is some prelim-
inary evidence of improved operating efficiency in LBOs. Kaplan, who studied 48
MBOs between 1980 and 1986, found average increases in operating income of 24
percent three years after the LBO. Ratios of operating income and net cash flow to
assets and sales increased dramatically. He observed cutbacks in capital expendi-

tures but not in employment. Kaplan suggests that these “operating changes are
due to improved incentives rather than layoffs or managerial exploitation of share-
holders through inside information.”
13
We have reviewed several motives for LBOs. We do not say that all LBOs are
good. On the contrary, there have been many mistakes, and even soundly moti-
vated LBOs are dangerous, at least for the buyers, as the bankruptcies of Campeau,
Revco, National Gypsum, and other highly leveraged transactions (HLTs) proved.
Yet, we do quarrel with those who portray LBOs solely as undertaken by Wall
Street barbarians breaking up the traditional strengths of corporate America.
Leveraged Restructurings
The essence of a leveraged buyout is of course leverage. Why not take on the lever-
age and dispense with the buyout?
We reviewed one prominent example in the last chapter. Phillips Petroleum was
attacked by Boone Pickens and Mesa Petroleum. Phillips dodged the takeover with
a leveraged restructuring. It borrowed $4.5 billion and repurchased one-half of its
outstanding shares. To service this debt, it sold assets for $2 billion and cut back
CHAPTER 34
Control, Governance, and Financial Architecture 967
11
R. S. Ruback, “RJR Nabisco,” case study, Harvard Business School, Cambridge, MA, 1989.
12
Mohan and Chen, op. cit.
13
S. Kaplan, “The Effects of Management Buyouts on Operating Performance and Value,” Journal of Fi-
nancial Economics 24 (October 1989), pp. 217–254.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate

Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
capital expenditure and operating costs. It put itself on a cash diet. The demands
of servicing $4.5 billion of extra debt made sure it stayed on the diet.
Let’s look at another diet deal.
Sealed Air’s Leveraged Restructuring
14
In 1989 Sealed Air Corporation under-
took a leveraged restructuring. It borrowed the money to pay a $328 million special
cash dividend. In one stroke the company’s debt increased 10 times. Its book eq-
uity (accounting net worth) went from $162 million to minus $161 million. Debt
went from 13 percent of total book assets to 136 percent.
Sealed Air was a profitable company. The problem was that its profits were com-
ing too easily because its main products were protected by patents. When the
patents expired, strong competition was inevitable, and the company was not
ready for it. In the meantime, there was too much financial slack:
We didn’t need to manufacture efficiently; we didn’t need to worry about cash. At
Sealed Air, capital tended to have limited value attached to it—cash was perceived
as being free and abundant.
So the leveraged recap was used to “disrupt the status quo, promote internal
change,” and simulate “the pressures of Sealed Air’s more competitive future.”
This shakeup was reinforced by new performance measures and incentives, in-
cluding increases in stock ownership by employees.
It worked. Sales and operating profits increased steadily without major new
capital investments, and net working capital fell by half, releasing cash to help serv-
ice the company’s debt. The company’s stock price quadrupled in the five years af-
ter the restructuring.

Sealed Air’s restructuring was not typical. It is an exemplar chosen with hind-
sight. It was also undertaken by a successful firm under no outside pressure. But it
clearly shows the motive for most leveraged restructurings. They are designed to
force mature, successful, but overweight companies to disgorge cash, reduce op-
erating costs, and use assets more efficiently.
Financial Architecture of LBOs and Leveraged Restructurings
The financial structures of LBOs and leveraged restructurings are similar. The three
main characteristics of LBOs are
1. High debt. The debt is not intended to be permanent. It is designed to be
paid down. The requirement to generate cash for debt service is designed to
curb wasteful investment and force improvements in operating efficiency.
2. Incentives. Managers are given a greater stake in the business via stock
options or direct ownership of shares.
3. Private ownership. The LBO goes private. It is owned by a partnership of
private investors who monitor performance and can act right away if
something goes awry. But private ownership is not intended to be
permanent. The most successful LBOs go public again as soon as debt has
been paid down sufficiently and improvements in operating performance
have been demonstrated.
Leveraged restructurings share the first two characteristics but continue as pub-
lic companies.
968 PART X
Mergers, Corporate Control, and Governance
14
See K. H. Wruck, “Financial Policy as a Catalyst for Organizational Change: Sealed Air’s Leveraged
Special Dividend,” Journal of Applied Corporate Finance 7 (Winter 1995), pp. 20–37.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate

Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
Figure 34.1 shows some of AT&T’s acquisitions and divestitures. Prior to 1984,
AT&T controlled most of the local, and virtually all of the long-distance tele-
phone service in the United States. (Customers used to speak of the ubiquitous
“Ma [Mother] Bell.”) In 1984 the company accepted an antitrust settlement re-
quiring local telephone service to be spun off to seven new, independent compa-
nies.
15
AT&T was left with its long-distance business plus Bell Laboratories,
Western Electric (telecommunications manufacturing), and various other assets.
As the communications industry became increasingly competitive, AT&T ac-
quired several other businesses, notably in computers, cellular telephone service,
and cable television. Some of these acquisitions are shown as the burgundy in-
coming arrows in Figure 34.1.
AT&T was an unusually active acquirer. It was a giant company trying to re-
spond to rapidly changing technologies and markets. But AT&T was simultane-
ously divesting dozens of other businesses. For example, its credit card operations
(the AT&T Universal Card) were sold to Citicorp. In 1996, AT&T created two new
companies by spinning off Lucent (incorporating Bell Laboratories and Western
Electric) and its computer business (NCR). AT&T had paid $7.5 billion to acquire
NCR in 1990. These and several other important divestitures are shown as the bur-
gundy outgoing arrows in Figure 34.1.
In the market for corporate control, fusion—mergers and acquisitions—gets the
most publicity. But fission—the separation of assets and operations from the
whole—can be just as important. We will now see how these separations are car-
ried out by spin-offs, carve-outs, asset sales, and privatizations.

Spin-offs
A spin-off is a new, independent company created by detaching part of a parent
company’s assets and operations. Shares in the new company are distributed to the
parent company’s stockholders. Here are some recent examples.
• Sears Roebuck spun off Allstate, its insurance subsidiary, in 1995.
• In 1998 the Brazilian government completed privatization of Telebras, the
Brazilian national telecommunications company. Before the final auction, the
company was split into 12 separate pieces—one long-distance, three local, and
eight wireless communications companies. In other words, 12 companies were
spun out of the one original.
• In 2001 Thermo Electron spun off its healthcare and paper machinery and
systems divisions as two new companies, Viasys and Kadant, respectively.
• In 2001 Canadian Pacific Ltd. spun off its oil and gas, shipping, coal mining,
and hotel businesses as four new companies traded on the Toronto stock
exchange.
Spin-offs are not taxed so long as shareholders in the parent are given at least 80
percent of the shares in the new company.
16
CHAPTER 34 Control, Governance, and Financial Architecture 969
34.2 FUSION AND FISSION IN CORPORATE FINANCE
15
Subsequent mergers reduced these seven companies to four: Bell South, SBC Communications,
Qwest, and Verizon.
16
If less than 80 percent of the shares are distributed, the value of the distribution is taxed as a dividend
to the investor.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate

Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
970
Unix
System
Labs,
1991,1995
NCR,
1991
Teradata,
1991
AT&T
Capital,
1993, 1996
AT&T
Submarine
Systems,
1997
AT&T
Universal
Card,
1998
AT&T
Broadband,
2001
Lucent,
1996

NCR,
1996
McCaw
Cellular,
1994
LIN
Broadcasting,
1995
Global
Network
(from IBM),
1998, 1999
Media One,
2000
Vanguard
Cellular,
1999
TCI,
1999
At Home Corp.
(Excite@Home),
2000
Divestitures
Mergers and
Acquisitions
1984
Antitrust
Settlement
Ameritech
Bell Atlantic

Bell South
AT&T
NYNEX
Pacific
Telesis
Southwestern
Bell
U.S. West
AT&T
FIGURE 34.1
The effects of AT&T’s antitrust settlement in 1984, and a few of AT&T’s acquisitions and divestitures from 1991 to 2001. Divestitures are shown by the
outgoing burgundy arrows. When two years are given, the transaction was completed in two steps.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
Spin-offs widen investors’ choice by allowing them to invest in just one part of
the business. More important, spin-offs can improve incentives for managers.
Companies sometimes refer to divisions or lines of business as “poor fits.” By spin-
ning these businesses off, management of the parent company can concentrate on
its main activity.
17
If the businesses are independent, it is easier to see the value and
performance of each and reward managers accordingly. Managers can be given
stock or stock options in the spun-off company. Also, spin-offs relieve investors of

the worry that funds will be siphoned from one business to support unprofitable
capital investments in another.
Announcement of a spin-off is generally greeted as good news by investors.
18
Investors in U.S. companies seem to reward focus and penalize diversification.
Consider the dissolution of John D. Rockefeller’s Standard Oil trust in 1911. The
company he founded, Standard Oil of New Jersey, was split up into seven sep-
arate corporations. Within a year of the breakup, the combined value of the suc-
cessor companies’ shares had more than doubled, increasing Rockefeller’s per-
sonal fortune to about $900 million (about $15 billion in 2002 dollars). Theodore
Roosevelt, who as president had led the trustbusters, ran again for president
in 1912:
19
“The price of stock has gone up over 100 percent, so that Mr. Rockefeller and his as-
sociates have actually seen their fortunes doubled,” he thundered during the cam-
paign. “No wonder that Wall Street’s prayer now is: ‘Oh Merciful Providence, give
us another dissolution.’ ”
Why is the value of the parts so often greater than the value of the whole? The
best place to look for an answer to that question is in the financial architecture of
conglomerates. But first, we take a brief look at carve-outs, asset sales, and priva-
tizations.
Carve-outs
Carve-outs are similar to spin-offs, except that shares in the new company are not
given to existing shareholders but are sold in a public offering. Recent carve-outs
include Pharmacia’s sale of part of its Monsanto subsidiary, and Philip Morris’s
sale of part of its Kraft Foods subsidiary. The latter sale raised $8.7 billion.
Most carve-outs leave the parent with majority control of the subsidiary, usually
about 80 percent ownership.
20
This may not reassure investors who worry about

CHAPTER 34
Control, Governance, and Financial Architecture 971
17
The other way of getting rid of “poor fits” is to sell them to another company. One study found that
over 30 percent of assets acquired in a sample of hostile takeovers from 1984 to 1986 were subsequently
sold. See S. Bhagat, A. Shleifer, and R. Vishny, “Hostile Takeovers in the 1980s: The Return to Corporate
Specialization,” Brookings Papers on Economic Activity: Microeconomics (1990), pp. 1–12.
18
Research on spin-offs includes K. Schipper and A. Smith, “Effects of Recontracting on Shareholder
Wealth: The Case of Voluntary Spin-offs,” Journal of Financial Economics 12 (December 1983), pp. 409–436;
G. Hite and J. Owers, “Security Price Reactions around Corporate Spin-off Announcements,” Journal of
Financial Economics 12 (December 1983), pp. 437–467; and J. Miles and J. Rosenfeld, “An Empirical Analy-
sis of the Effects of Spin-off Announcements on Shareholder Wealth,” Journal of Finance 38 (December
1983), pp. 1597–1615. P. Cusatis, J. Miles, and J. R. Woolridge report improvements of operating per-
formance in spun-off companies. See “Some New Evidence that Spin-offs Create Value,” Journal of
Applied Corporate Finance 7 (Summer 1994), pp. 100–107.
19
D. Yergin: The Prize, Simon & Schuster, New York, 1991, p. 113.
20
The parent must retain an 80 percent interest to consolidate the subsidiary with the parent’s tax ac-
counts. Otherwise the subsidiary is taxed as a freestanding corporation.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
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lack of focus or a poor fit, but it does allow the parent to set managers’ compensa-
tion based on the performance of the subsidiary’s stock price.
Some companies carve out a minority interest in a subsidiary and later sell or
spin off the remaining shares. For example, Sara Lee, the food company, carved
out a 19.5 percent stake in the luxury leather goods retailer Coach in 2000. The
remaining 80.5 percent of the Coach shares were sold to Sara Lee stockholders
in 2001.
21
Perhaps the most enthusiastic carver-outer of the 1980s and 1990s was Thermo
Electron, with operations in healthcare, power generation equipment, instrumen-
tation, environmental monitoring and cleanup, and various other areas. At year-
end 1997, it had seven publicly traded subsidiaries, which in turn had carved out
15 further public companies. The 15 were grandchildren of the ultimate parent,
Thermo Electron.
22
Some companies have distributed tracking stock tied to the performance of par-
ticular divisions. This does not require a spin-off or carve-out, only the creation of
a new class of common stock. For example, in 1997 Georgia Pacific distributed a
special class of shares tied to the performance of its Timber Group. The company
noted that having two classes of shares “provides the opportunity to structure in-
centives for employees of each Group that are tied directly to the share price per-
formance of that Group.”
23
Asset Sales
The simplest way to divest an asset is to sell it. Asset sale refers to the acquisition
of part of one firm by another. The record asset sale is Comcast’s acquisition of
AT&T Broadband, AT&T’s cable television division, for $42 billion in 2001.
We have mentioned the sale of AT&T’s credit card division to Citibank. Asset
sales are common in the credit card business. The largest credit card issuers, in-
cluding Citibank, MBNA, and First USA, grew during the 1980s and 1990s by ac-

quiring the credit card operations of hundreds of smaller banks.
Asset sales are also common in manufacturing. Maksimovic and Phillips exam-
ined a sample of about 50,000 U.S. manufacturing plants each year from 1974 to
1992. About 35,000 plants in the sample changed hands during that period. About
one-half of the ownership changes were the result of mergers or acquisitions of en-
tire firms. The other half of the ownership changes came about by asset sales, that
is, sale of part or all of a division. On average, about 4 percent of the plants in the
sample changed hands each year, about 2 percent by merger or acquisition, and
about 2 percent by asset sales.
24
972 PART X Mergers, Corporate Control, and Governance
21
Sara Lee stockholders were allowed to exchange Sara Lee shares for Coach shares. The terms of the
exchange gave Sara Lee’s stockholders the opportunity to get Coach shares at a discount, so all of the
Coach shares were issued in short order.
22
In 1998 Thermo Electron announced a plan to consolidate several of its children and grandchildren in
order to move to a less complicated structure. In 2001, it began to spin off some of its peripheral oper-
ations as separate companies.
23
Georgia Pacific Corporation, Proxy Statement and Prospectus, November 11, 1997, p. 35. The Timber
Group was sold to Plum Creek Timber Company in 2001. Timber Group tracking stock was exchanged
for Plum Creek shares.
24
V. Maksimovic and G. Phillips, “The Market for Corporate Assets: Who Engages in Mergers and As-
set Sales and Are There Efficiency Gains?” Journal of Finance 56 (December 2001), Table I, p. 2030.
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Announcements of asset sales are good news for investors in the selling firm,
and productivity of the assets sold increases, on average, after the sale.
25
It appears
that asset sales transfer business units to the companies that can manage them
most effectively.
Privatization
A privatization is a sale of a government-owned company to private investors. For
example, the government of Germany originally owned Volkswagen but sold it in
1961. Britain sold British Telecom in 1984. The United States sold Conrail in 1987.
Most privatizations are more like carve-outs than spin-offs, because shares are
sold for cash, not distributed to the ultimate “shareholders,” that is, to the people
of the selling country. But several former Communist countries, including Russia,
Poland, and the Czech Republic, privatized by means of vouchers distributed to
citizens. The vouchers could be used to bid for shares in newly privatized compa-
nies. Thus the companies were not sold for cash, but for vouchers.
26
Privatizations raised enormous sums for selling governments. France raised
$17.6 billion in two share issues for France Telecom in 1997 and 1998. Japan raised
over $80 billion in the privatization of NTT (Nippon Telephone and Telegraph) in
1987 and 1988. Privatizations have also been common in airlines (e.g., Japan Air-
lines and Air New Zealand) and banking (e.g., the French bank Paribas).
The motives for privatization seem to boil down to the following three points:
1. Increased efficiency. Through privatization, the enterprise is exposed to the
discipline of competition and insulated from political influence on

investment and operating decisions. Managers and employees can be given
stronger incentives to cut costs and add economic value.
2. Share ownership. Privatizations encourage share ownership. Many
privatizations give special terms or allotments to employees or small
investors.
3. Revenue for the government. Last but not least!
There were fears that privatizations would lead to massive layoffs and unem-
ployment, but that does not appear to be the case. While it is true that privatized
companies operate more efficiently and thus reduce employment, they also grow
faster as privatized companies, which increases employment. In many cases the
net effect on employment is positive.
On other dimensions, the impact of privatization is almost always positive. A re-
view of research on privatization concludes that privatized firms “almost always
become more efficient, more profitable, . . . financially healthier and increase their
capital investment spending.”
27
It seems clear that changing from state to private
ownership is in general a valuable change in financial architecture.
CHAPTER 34
Control, Governance, and Financial Architecture 973
25
See Maksimovic and Phillips, op. cit.
26
There is extensive research on voucher privatizations. See, for example, M. Boyco, A. Shleifer, and R.
Vishny, “Voucher Privatizations,” Journal of Financial Economics 35 (April 1994), pp. 249–266; and R. Ag-
garwal and J. T. Harper, “Equity Valuation in the Czech Voucher Privatization Auctions,” Financial Man-
agement 29 (Winter 2000), pp. 77–100.
27
W. L. Megginson and J. M. Netter, “From State to Market: A Survey of Empirical Studies on Privati-
zation,” Journal of Economic Literature 39 (June 2001), p. 381.

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We now examine a different form of financial architecture, the conglomerate. Con-
glomerates are firms investing in several unrelated industries. Large public con-
glomerates are now rare in the United States, though common elsewhere. We will
try to figure out why. We will also examine the financial architecture of the private
conglomerates that invest in venture capital and LBOs.
Pros and (Mostly) Cons of U.S. Conglomerates
Conglomerates were the corporate celebrities of the 1960s. They grew by leaps and
bounds through aggressive programs of acquisitions in unrelated industries. By
the 1970s, the largest conglomerates had achieved amazing scopes and spans.
Table 34.2 shows that by 1979 ITT was operating in 38 different industries and
ranked eighth in total sales among U.S. corporations.
In 1995 ITT, which had already sold or spun off several lines of business, split its
remaining operations into three separate firms. One acquired ITT’s interests in ho-
tels and gambling; a second took over ITT’s automotive parts, defense, and elec-
tronics businesses; and a third specialized in insurance and financial services (ITT
Hartford). Most of the conglomerates created in the 1960s were broken up in the
1980s and early 1990s; however, a few successful new conglomerates have sprung
up. Tyco International, AMP’s white knight, is one of these.
28
What advantages were claimed for conglomerates? First, diversification across
industries was supposed to stabilize earnings and reduce risk. That’s hardly com-

pelling, because shareholders can diversify much more efficiently and flexibly on
their own.
29
Second, and more important, was the idea that good managers were
fungible; in other words, that modern management would work as well in the
manufacture of auto parts as in running a hotel chain. Neil Jacoby, writing in 1969,
argued that computers and new methods of quantitative, scientific management
had “created opportunities for profits through mergers that remove assets from the
974 PART X
Mergers, Corporate Control, and Governance
34.3 CONGLOMERATES
Sales Rank Company Number of Industries
8 International Telephone & 38
Telegraph (ITT)
15 Tenneco 28
42 Gulf & Western Industries 41
51 Litton Industries 19
66 LTV 18
73 Illinois Central Industries 26
103 Textron 16
104 Greyhound 19
128 Martin Marietta 14
TABLE 34.2
The largest U.S. conglomerates in
1979, ranked by sales compared to
all U.S. industrial corporations.
Most of these companies have
been broken up.
Source: A. Chandler and R. S. Tetlow,
eds., The Coming of Managerial

Capitalism, Richard D. Irwin, Inc.,
Homewood, IL, 1985, p. 772; see also J.
Baskin and P. J. Miranti, Jr., A History of
Corporate Finance, Cambridge
University Press, Cambridge, UK: 1997,
chap. 7.
28
See Section 33.5.
29
See the Appendix to Chapter 33.
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inefficient control of old-fashioned managers and place them under men schooled
in the new management science.”
30
There was some truth in this. The most successful early conglomerates did force
dramatic improvements in some mature and slackly managed businesses. The
problem is, of course, that a company doesn’t need to be diversified to take over
and improve a lagging business.
Third, conglomerates’ wide diversification meant that their top managements
could operate an internal capital market. Free cash flow generated by divisions in
mature industries could be funneled within the company to other divisions with
profitable growth opportunities. There was no need for fast-growing divisions to

raise financing from outside investors.
There are some good arguments for internal capital markets. The company’s own
managers probably know more about its investment opportunities than do outside
investors, and transaction costs of issuing securities are avoided. Nevertheless, it ap-
pears that attempts by conglomerates to allocate capital investment across many un-
related industries are more likely to subtract value than add it. Trouble is, internal
capital markets are not really markets but combinations of central planning (by the
conglomerates’ top management and financial staff) and intracompany bargaining.
Divisional capital budgets depend on politics as well as pure economics. Large, prof-
itable divisions with plenty of free cash flow may have more bargaining power than
growth opportunities; they may get generous capital budgets while smaller divi-
sions with good prospects but less bargaining power are reined in.
Berger and Ofek estimate the average conglomerate discount at 12 to 15 per-
cent.
31
Conglomerate discount means that the market value of the whole conglomer-
ate is less than the sum of the values of its parts. The chief cause of this discount,
at least in Berger and Ofek’s sample, seemed to be overinvestment and misalloca-
tion of investment. In other words, investors were marking down the value of the
conglomerates’ shares from worry that their managements would make negative-
NPV investments in mature divisions and forego positive-NPV opportunities else-
where.
Conglomerates face further problems. Their divisions’ market values can’t be
observed independently, and it is difficult to set incentives for division managers.
This is particularly serious when managers are asked to commit to risky ventures.
For example, how would a biotech startup fare as a division of a traditional con-
glomerate? Would the conglomerate be as patient and risk-tolerant as investors in
the stock market? How are the scientists and clinicians doing the biotech R&D re-
warded if they succeed? We don’t mean to say that high-tech innovation and risk-
taking is impossible in public conglomerates, but the difficulties are evident.

Internal Capital Markets in the Oil Business Misallocations in internal capital
markets are not restricted to pure conglomerates. For example, Lamont found that,
when oil prices fell by half in 1986, diversified oil companies cut back capital in-
vestment in their non-oil divisions.
32
The non-oil divisions were forced to “share
CHAPTER 34
Control, Governance, and Financial Architecture 975
30
Quoted in A. Chandler and R. S. Tetlow, eds., The Coming of Managerial Capitalism, Richard D. Irwin,
Inc., Homewood, IL: 1985, p. 746.
31
P. Berger and E. Ofek, “Diversification’s Effect on Firm Value,” Journal of Financial Economics 37 (Jan-
uary 1995), pp. 39–65.
32
O. Lamont, “Cash Flow and Investment: Evidence from Internal Capital Markets,” Journal of Finance
52 (March 1997), pp. 83–109.
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the pain,” even though the drop in oil prices did not diminish their investment op-
portunities. The Wall Street Journal reported one example:
33
Chevron Corp. cut its planned 1986 capital and exploratory budget by about 30 per-

cent because of the plunge in oil prices . . . A Chevron spokesman said that spending
cuts would be across the board and that no particular operations will bear the brunt.
About 65 percent of the $3.5 billion budget will be spent on oil and gas explo-
ration and production—about the same proportion as before the budget revision.
Chevron also will cut spending for refining and marketing, oil and natural gas
pipelines, minerals, chemicals, and shipping operations.
Why cut back on capital outlays for minerals, say, or chemicals? Low oil prices are
generally good news, not bad, for chemical manufacturing, because oil distillates
are an important raw material.
By the way, most of the oil companies in Lamont’s sample were large, blue-chip
companies. They could have raised additional capital from investors to maintain
spending in their non-oil divisions. They chose not to. We do not understand why.
All large companies must allocate capital among divisions or lines of business.
Therefore they all have internal capital markets and must worry about mistakes
and misallocations. But this danger probably increases as a company moves from
a focus on one, or a few related industries, to unrelated conglomerate diversifica-
tion. Look again at Table 34.2: How could the top management of ITT keep accu-
rate track of investment opportunities in 38 different industries?
Fifteen Years after Reading this Chapter
You have just seized control of Establishment Industries, the blue-chip conglomer-
ate, after a high-stakes, high-profile takeover battle. You are a financial celebrity,
hounded by business reporters every time you step out of your stretch limo. You’re
contemplating a Ferrari and a trophy spouse. Fundraisers from your college or uni-
versity are suddenly very attentive. But first you’ve got to deliver on promises to
add shareholder value to your renamed New Establishment Corporation.
Fortunately you remember Principles of Corporate Finance. First you identify New
Establishment’s neglected divisions—the poor fits that have not received their
share of capital or top management attention. These you spin off; no more internal
capital market. As independent companies, these divisions can set their own capi-
tal budgets, but to obtain financing, they have to convince outside investors that

their growth opportunities are truly positive-NPV. The managers of these spun-off
companies can buy stock or be given stock options as part of their compensation
packages. Therefore incentives to maximize value are stronger. Investors under-
stand this, so New Establishment’s stock price jumps as soon as the spin-offs are
announced.
Establishment Industries also has some large, mature, cash-cow businesses. You
add still more value by selling some of these divisions to LBO partnerships. You
bargain hard and get a good price, so the stock price jumps again.
The remaining divisions will be the core of New Establishment. You consider
pushing through a leveraged restructuring of these core activities to make sure that
free cash flow is paid out to investors rather than invested in negative-NPV ven-
tures. But you decide instead to implement a performance measurement and com-
976 PART X
Mergers, Corporate Control, and Governance
33
Cited in Lamont, op. cit., pp. 89–90.
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pensation system based on residual income.
34
You also make sure managers and
key employees have significant equity stakes. You take over as CEO, and New Es-
tablishment survives and prospers. Your celebrity status fades away, except that

once a year you are listed in Forbes magazine’s annual compilation of the 400
wealthiest executives and investors. It could happen.
Financial Architecture of Traditional U.S. Conglomerates
This fanciful tale sums up the argument for focus and against conglomerate diver-
sification. We must be careful not to push the argument too far, however. GE, an
exceptionally successful company, operates in a wide range of unrelated indus-
tries, including jet engines, equipment leasing, broadcasting, home appliances,
and medical equipment.
But we can confidently identify the challenges set by the financial architecture
of conglomerates.
To add value in the long run, the conglomerate structure sets two tasks for top
management: (1) Make sure divisional management and operating performance
are better than could be achieved if the divisions were independent and (2) oper-
ate an internal capital market that beats the external capital market. In other words,
conglomerate management has to make better capital investment decisions than
could be achieved by independent companies responsible for their own financing.
Task (1) is difficult because divisions’ market values can’t be observed sepa-
rately, and it is difficult to set incentives for divisional managers. Task (2) is diffi-
cult because the conglomerate’s central planners have to fully understand invest-
ment opportunities in many different industries and because internal capital
markets are prone to allocations by bargaining and politics.
Now we turn to a class of conglomerates that does seem to add value. We will
find, however, that they have a different financial architecture.
Temporary Conglomerates
Table 34.3 lists the businesses in which a Kohlberg, Kravis, Roberts (KKR) LBO
fund operated in 1998. Looks like a conglomerate, right? But this fund is not a pub-
lic company. It is a private partnership.
CHAPTER 34
Control, Governance, and Financial Architecture 977
34

That is, on EVA. See Section 12.4.
Books, cards, other publishing (2 companies)
Communications
Consumer services (Kindercare Learning Centers)
Fiber optics (coupling and connections)
General food products
Golf and healthcare products (1 company)
Hospital and institutional management
Insurance (in Canada)
Other consumer products (1 company)
Printing and binding
Transportation equipment and parts
TABLE 34.3
KKR formed an LBO partnership in 1993. By 1998 this fund
held companies in the following industries. The partnership
was a (temporary) conglomerate.
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This KKR fund is a private investment partnership and a temporary conglomerate. It
buys up companies, generally in unrelated industries, but it does not buy and hold. It
tries to buy, fix, and sell. It buys to restructure, to dispose of incidental assets, and to
improve operations and management. If the program of improvement is a success, it
sells out, either by taking the company public again or by selling it to another firm.

KKR is famous for LBOs. But its financial structure is shared by venture capital
partnerships formed to invest in startup companies and by partnerships formed to
buy up private companies without LBO financing. These are all private equity part-
nerships. Figure 34.2 shows how such a partnership is organized. The general part-
ners organize and manage the venture. The limited partners
35
put up most of the
978 PART X
Mergers, Corporate Control, and Governance
35
Limited partners enjoy limited liability. See Section 14.2.
Partnership
General partners
put up 1% of
capital
Management
fees
Limited
partners
put in
99% of
capital
Investment
in diversified
portfolio
of companies
Sale or IPO
of companies
Limited
partners get

investment
back, then
80% of
profits
Investment Phase
Company 1
Company 2
Company 3
Company
N
•
•
•
Partnership
General partners
get carried interest
in 20% of profits
Payout Phase
FIGURE 34.2
Organization of a typical private equity partnership. The limited partners, having put up almost all of the money,
get first crack at the proceeds from sale or IPO of the portfolio companies. Once their investment is returned, they
get 80 percent of any profits. The general partners, who organize and manage the partnership, get a 20 percent
carried interest in profits.
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money. Limited partners are generally institutional investors, such as pension
funds, endowments, and insurance companies. Wealthy individuals or families
may also participate.
Once the partnership is formed, the general partners seek out companies to in-
vest in. Venture capital partnerships look for high-tech startups, LBO partnerships
for mature businesses with ample free cash flow and a need for new or reinvigo-
rated management. Some partnerships specialize in particular industries, for ex-
ample biotechnology or real estate. But most end up with a portfolio of companies
in different industries.
The partnership agreement has a limited term, 10 years or less. The portfolio
companies must be sold and the proceeds must be distributed. The general part-
ners cannot reinvest the limited partners’ money. Of course, once a fund is proved
successful, the general partners can usually go back to the limited partners, or to
other institutional investors, and form another one.
The general partners get a management fee, typically 1 or 2 percent of capital
committed, plus a carried interest, usually 20 percent of the fund’s profits. In other
words the limited partners get paid off first, but then get only 80 percent of any fur-
ther returns. (The general partners have a call option on 20 percent of the partner-
ship’s value, with an exercise price equal to the limited partners’ investment.)
Table 34.4 summarizes a comparison by Baker and Montgomery of the financial
structures of an LBO fund and a typical public conglomerate. Both are diversified,
but the fund’s limited partners do not have to worry that free cash flow will be
plowed back into unprofitable investments. The fund has no internal capital mar-
ket. Monitoring and compensation of management also differ. In the LBO fund,
each company is run as a separate business. The managers report directly to the
owners, the fund’s partners. Each company’s managers own shares or stock op-
tions in that company, not in the fund. Their compensation depends on their com-
pany’s market value in a sale or IPO.

In a public conglomerate, these businesses would be divisions, not freestanding
companies. Ownership of the conglomerate would be dispersed, not concentrated.
The divisions would not be valued by investors in the stock market, but by the con-
glomerate’s corporate staff, the very people who run the internal capital market.
CHAPTER 34
Control, Governance, and Financial Architecture 979
LBO Partnerships Public Conglomerates
Widely diversified, Widely diversified,
investment in unrelated investment in unrelated
industries industries
Limited-life partnership Public corporations designed
forces sale of portfolio to operate divisions for the long run
companies.
No financial links or transfers Internal capital market
between portfolio
companies
General partners “do the Hierarchy of corporate staff evaluates
deal,” then monitor; lenders divisions’ plans and performance.
also monitor.
Managers’ compensation Divisional managers’ compensation
depends on exit value of depends mostly on earnings—“smaller
company. upside, softer downside.”
TABLE 34.4
LBO funds vs. public
conglomerates. Both diversify,
investing in a portfolio of
unrelated businesses, but their
financial structures are
otherwise fundamentally
different.

Source: Adapted from G. Baker and
C. Montgomery, “Conglomerates
and LBO Associations: A
Comparison of Organizational
Forms,” working paper, Harvard
Business School, Cambridge, MA,
July 1996.
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Managers’ compensation wouldn’t depend on divisions’ market values because no
shares in the divisions would be traded and plans for sale or spin-off would not be
part of the conglomerate’s financial architecture.
The advantages of LBO partnerships are obvious: strong incentives to man-
agers, concentrated ownership (no separation of ownership and control), and lim-
ited life, which reassures limited partners that cash flow will not be reinvested
wastefully.
These advantages carry over to other types of private equity partnerships, in-
cluding venture capital funds. We do not say that this financial structure is appro-
priate for most businesses. It is designed for change, not for the long run. But tra-
ditional conglomerates don’t seem to work well for the long run, either.
Conglomerates around the World
Nevertheless, conglomerates are common outside the United States. In some
emerging economies, they are the dominant financial structure. In Korea, for ex-

ample, the 10 largest conglomerates control roughly two-thirds of the corporate
economy. These chaebols are also strong exporters so that names like Samsung and
Hyundai are recognized worldwide.
Conglomerates are common in Latin America. One of the more successful, the
holding company
36
Quinenco, is in a dizzying variety of businesses, including ho-
tels and brewing in Chile, pasta making in Peru, and the manufacture of copper
and fiber optic cable in Brazil.
Why are conglomerates so common in such countries? There are several possi-
ble reasons.
Size You can’t be big and focused in a small, closed economy: The scale of one-
industry companies is limited by the local market. Scale may require diversifica-
tion. There are various reasons why size can be an advantage. For example, larger
companies have easier access to international financial markets. This is important
if local financial markets are inefficient.
Size means political power; this is especially important in managed economies
or in countries where the government economic policy is unpredictable. In Korea,
for example, the government has controlled access to bank loans. Bank lending has
been directed to government-approved uses. The Korean conglomerate chaebols
have usually been first in line.
Undeveloped Financial Markets If a country’s financial markets are substandard,
an internal capital market may not be so bad after all.
“Substandard” does not just mean lack of scale or trading activity. It may mean
government regulations limiting access to bank financing or requiring govern-
ment approval before bonds or shares are issued.
37
It may mean information in-
efficiency: If accounting standards are loose and companies are secretive, moni-
toring by outside investors becomes especially costly and difficult, and agency

costs proliferate.
980 PART X
Mergers, Corporate Control, and Governance
36
A holding company owns controlling blocks of shares in two or more subsidiary companies. The hold-
ing company and its subsidiaries operate as a group under common top management.
37
In the United States, the SEC does not have the power to deny share issues. Its mandate is only to as-
sure that investors are given adequate information.
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In many countries, including some advanced economies, minority investors are
not well protected by law and securities regulation. Sometimes there are blatant
transfers of wealth from outside shareholders to insiders’ pockets. It’s no surprise
that financial markets in such countries are relatively small.
Recent research by Rafael LaPorta and his colleagues finds a strong associa-
tion between legal systems and the development of financial markets and the
volume of external finance.
38
Minority shareholders seem to be best protected in
common-law systems such as those in the United States, Great Britain, and other
English-speaking countries. Civil-law systems, such as those in France and
Spanish-speaking countries, offer less effective protection; consequently, finan-

cial markets are less important in such countries. The volume of external fi-
nancing is low. Financing tends to flow instead through banks, within large, di-
versified companies, or among members of groups of associated companies.
Many of these companies or groups are controlled by families.
The Bottom Line on Conglomerates
Are conglomerates good or bad? Does corporate diversification make sense? It de-
pends on the task at hand and on the business, financial, and legal environments.
If the task is fundamental change, then the required management skills and
knowledge may not be industry-specific. For example, the general partners in LBO
funds are not industry experts. They specialize in identifying potential diet deals,
negotiating financing, buying and selling assets, setting incentives, and choosing
and monitoring management. It’s no surprise that LBO funds end up with diver-
sified portfolios; they invest wherever opportunities crop up. But these same skills
are not best for long-run operation and growth. Thus LBO funds and other private
equity partnerships are designed to force the managers of change to hand over the
reins once change is accomplished.
If the task is managing for the long run, and the company has access to well-
functioning financial markets, then focus usually beats diversification. Conglom-
erates have a hard time setting the right incentives for divisional managers and
avoiding cross-subsidies and overinvestment in the internal capital market.
In less developed countries, conglomerates can be effective. Local history and
practice have led to diversified companies or groups of companies. Also, diversifi-
cation means scale, and size counts when local financial markets are small or un-
developed, when the company needs to attract the best professional managers, and
when assistance or protection from the government is required.
CHAPTER 34
Control, Governance, and Financial Architecture 981
38
R. LaPorta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Law and Finance,” Journal of Political Econ-
omy 106 (December 1998), pp. 1113–1155 and “Legal Determinants of External Finance,” Journal of Fi-

nance 52 (July 1997), pp. 1131–1150.
34.4 GOVERNANCE AND CONTROL IN THE UNITED
STATES, GERMANY, AND JAPAN
For public corporations in the United States, the agency problems created by the
separation of ownership and control are offset by
• Incentives for management, particularly compensation tied to changes in
earnings and stock price.
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Control, and Governance
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Companies, 2003
• The legal duty of managers and directors to act in shareholders’ interest,
backed up by monitoring by auditors, lenders, security analysts, and large
institutional investors.
• The threat of a takeover, either by another public company or a private
investment partnership.
But don’t assume that ownership and control are always separated. A large
block of shares may give effective control even when there is no majority owner.
39
For example, Bill Gates owns over 20 percent of Microsoft. Barring some extreme
catastrophe, that block means that he can run the company as he wants to and as
long as he wants to. Henry Ford’s descendants still hold a class of Ford Motor
Company shares with extra voting rights and thereby retain great power should
they decide to exercise it.
40

Nevertheless, the concentration of ownership of public U.S. corporations is much
less than in some other industrialized countries. The differences are not so apparent
in Canada, Britain, Australia, and other English-speaking countries, but there are
dramatic differences in Japan and continental Europe. We start with Germany.
Ownership and Control in Germany
Figure 34.3 summarizes the ownership in 1990 of Daimler-Benz, one of the largest
German companies. The immediate owners were Deutsche Bank, the largest Ger-
man bank, with 28 percent; Mercedes Automobil Holding, with 25 percent; and the
Kuwait government, with 14 percent. The remaining 32 percent of the shares were
widely held by about 300,000 individual and institutional investors.
But this was only the top layer. Mercedes Automobil Holding was half owned
by two holding companies, “Stella” and “Stern” for short. The rest of its shares
were widely held. Stella’s shares were in turn split four ways: between two banks;
Robert Bosch, an industrial company; and another holding company, “Komet.”
Stern’s ownership was split four ways too, but we ran out of space.
41
The differences between German and U.S. ownership patterns leap out from
Figure 34.3. Note the concentration of ownership of Daimler-Benz shares in large
blocks and the several layers of owners. A similar figure for General Motors would
just say, “General Motors, 100 percent widely held.”
In Germany these blocks are often held by other companies—a cross-holding of
shares—or by holding companies for families. Franks and Mayer, who examined
the ownership of 171 large German companies in 1990, found 47 with blocks of
982 PART X
Mergers, Corporate Control, and Governance
39
A surprising number of public U.S. corporations do have majority owners. A study by Clifford Hold-
erness and Dennis Sheehan identified over 650. See “The Role of Majority Shareholders in Publicly Held
Corporations: An Exploratory Analysis,” Journal of Financial Economics 20 (January/March 1988),
pp. 317–346.

40
You would predict that companies with concentrated ownership would show better financial per-
formance simply because the blockholders face less of a free-rider problem when they represent share-
holders’ interests. This prediction appears to be true. However, investors who accumulate very large
stakes and gain effective control of the firm may act in their own interests and against the interests of
the remaining minority shareholders. See R. Morck, A. Shleifer, and R. Vishny, “Management Owner-
ship and Market Valuation: An Empirical Analysis,” Journal of Financial Economics 20 (January/March
1988), pp. 293–315.
41
A five-layer ownership tree for Daimler-Benz is given in S. Prowse, “Corporate Governance in an In-
ternational Perspective: A Survey of Corporate Control Mechanisms among Large Firms in the U.S.,
U.K., Japan and Germany,” Financial Markets, Institutions, and Instruments 4 (February 1995), Table 16.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
shares held by other companies and 35 with blocks owned by families. Only 26
of the companies did not have a substantial block of stock held by some company
or institution.
42
Note also the bank ownership of Daimler-Benz. This would be impossible in the
United States, where federal law prohibits equity investments by banks in nonfi-
nancial corporations. Germany’s universal banking system allows such invest-
ments. Moreover, German banks customarily hold shares for safekeeping on behalf
of individual and institutional investors and often acquire proxies to vote these

shares on the investors’ behalf. For example, Deutsche Bank held 28 percent of
Daimler-Benz for its own account and had proxies for 14 percent more. Therefore
it voted 42 percent, which approaches a majority.
The ownership structures illustrated in Figure 34.3 are common for large Ger-
man corporations. Control rests mainly with banks and blockholders, not with or-
dinary stockholders. Corporate control is achieved by buying or assembling blocks
of shares. When control changes, selling blockholders receive premiums of 9 to 16
percent over the trading price of the shares. That price increases by 2 or 3 percent
CHAPTER 34
Control, Governance, and Financial Architecture 983
Daimler-Benz AG
Kuwait
Government
Mercedes
Automobil
Holding AG
Deutsche
Bank
Widely
held
Stern Automobil
Beteiligungsges.
mbH
Stella Automobil
Beteiligungsges.
mbH
Widely
held
Widely
held

Robert Bosch
GmbH
Komet Automobil
Beteiligungsges.
mbH
Bayerische
Landesbank
Dresdner
Bank
28.3% 14% 25.23%
25%
25% 25%25%25%
50%
about 300,000
shareholders
25%
32.37%
FIGURE 34.3
Ownership of
Daimler-Benz, 1990.
Source: J. Franks and C.
Mayer, “The Ownership
and Control of German
Corporations,” Review
of Financial Studies 14
(Winter 2001), Figure 1,
p. 949.
42
See J. Franks and C. Mayer, “The Ownership and Control of German Corporations,” Review of Finan-
cial Studies 14 (Winter 2001), Table 1, p. 947. A block was defined as at least 25 percent ownership. In

Germany, a block of this size can veto certain corporate actions, including share issues and changes in
corporate charters.
Brealey−Meyers:
Principles of Corporate
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Control, and Governance
34. Control Governance,
and Financial Architecture
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Companies, 2003
only, so the gains to ordinary stockholders from changes in control are small.
43
In
the United States, by contrast, the big winners in acquisitions are usually the sell-
ing firm’s ordinary stockholders.
Blockholders in Germany do not have unchecked power, however. Large Ger-
man companies have two boards of directors: the supervisory board (Aufsichtsrat)
and management board (Vorstand). Half of the supervisory board’s members are
elected by employees, including management and staff as well as labor unions. The
other half represents stockholders, often including bank executives. (There is also
a chairman who can cast tie-breaking votes if necessary.) The supervisory board
oversees strategy and elects and monitors the management board which operates
the company. Thus control of shares does not mean control of the company—100
percent ownership controls only half of the supervisory board.
This two-tier governance structure reflects a belief, widespread in Europe, that
the firm should act in the interests of all its stakeholders, including its employees
and the public at large, and not just seek to maximize shareholder value. This struc-
ture does not mean poor financial performance or an easy life for management—
poor performance leads to management turnover, just as in the United States,

44
and the German economy has, in general, thrived over the last 50 years. One may
ask, however, whether German companies which undertake extensive interna-
tional operations, and seek financing in international capital markets, are best
served by a financial architecture that skimps on protection for outside minority
investors and discourages attempts to maximize the market value of the firm.
Daimler-Benz, now DaimlerChrysler, is an interesting case study. In the mid-
1990s it reversed an unsuccessful diversification strategy that had led it into sev-
eral other industries, including aerospace and defense. In 1998 it took over
Chrysler. It listed its shares on the New York Stock Exchange and issued financial
statements conforming to U.S. accounting standards. It turned to international cap-
ital markets for financing, including a share issue in the U.S. At the same time
Deutsche Bank was reducing its stake in the company. DaimlerChrysler has for-
mally announced a commitment to increasing shareholder value.
. . . And in Japan
Japan’s system of corporate governance is in some ways in between the systems of
Germany and the United States and in other ways different from both.
The most notable feature of Japanese corporate finance is the keiretsu. A
keiretsu is a network of companies, usually organized around a major bank. There
are long-standing business relationships between the group companies; a manu-
facturing company might buy a substantial part of its raw materials from group
suppliers and in turn sell much of its output to other group companies.
The bank and other financial institutions at the keiretsu’s center own shares in
most of the group companies (though a commercial bank in Japan is limited to 5
percent ownership of each company). Those companies may in turn hold the
bank’s shares or each others’ shares. Here are the cross-holdings at the end of 1991
between Sumitomo Bank; the Sumitomo Corporation, a trading company; and
Sumitomo Trust, which concentrates on investment management:
984 PART X
Mergers, Corporate Control, and Governance

43
Franks and Mayer, op. cit., Table 9, p. 969.
44
See Franks and Mayer, op. cit.; and S. Kaplan, “Top Executives, Turnover and Firm Performance in
Germany,” Journal of Law and Economics 10 (1994), pp. 142–159.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
Thus the bank owns 4.8 percent of Sumitomo Corporation, which owns 1.8 percent
of the bank. Both own shares in Sumitomo Trust . . . and so on. Table 34.5 illustrates
the myriad of cross-holdings in a keiretsu. Because of the cross-holdings, the sup-
ply of shares available for purchase by outside investors is much less than the to-
tal number outstanding.
The keiretsu is tied together in other ways. Most debt financing comes from the
keiretsu’s banks or from elsewhere in the group. (Until the mid-1980s, all but a hand-
ful of Japanese companies were forbidden access to public debt markets. The frac-
tion of debt provided by banks is still much greater than that in the United States.)
Managers may sit on the boards of directors of other group companies, and a “pres-
idents’ council” of the CEOs of the most important group companies meets regularly.
Think of the keiretsu as a system of corporate governance, where power is split be-
tween the main bank, the largest companies, and the group as a whole. This confers
certain financial advantages. First, firms have access to additional “internal” financ-
ing—internal to the group, that is. Thus a company with capital budgets exceeding
CHAPTER 34

Control, Governance, and Financial Architecture 985
Sumitomo
Corporation
Sumitomo
Bank
Sumitomo
Trust
3.4%
5.9%
1.8%
4.8%
2.4%
3.4%
Percentage of Shares Held in:
Sumitomo
Sumitomo Metal Sumitomo Sumitomo Sumitomo
Shareholder Bank Industries Chemical Trust Corporation NEC
S. Bank — 4.1 4.6 3.4 4.8 5.0
S. Metal Industries * — * 2.5 2.8 *
S. Chemical * * — * * *
S. Trust 2.4 5.9 4.4 — 5.9 5.8
S. Corporation 1.8 1.6 * 3.4 — 2.2
NEC * * * 2.9 3.7 —
Other
†
9.7 4.8 9.8 10.4 9.5 11.6
Total
†
13.9 16.4 18.8 22.6 26.7 24.6
TABLE 34.5

Cross-holdings of common stock between six companies in the Sumitomo group in 1991. Read down the columns to see
holdings of each of the companies by the five others. Thus 4.6 percent of Sumitomo Chemical was owned by Sumitomo
Bank, 4.4 percent by Sumitomo Trust, and 9.8 percent by other Sumitomo companies. These figures were compiled by
examining the 10 largest shareholders of each company. Smaller cross-holdings are not reflected.
*
Cross-holding does not appear in the 10 largest shareholdings.
†
Based on the 10 largest shareholdings in 1991.
Source: Compiled from Dodwell Marketing Consultants, Industrial Groupings in Japan, 10th ed., Tokyo, 1992.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
X. Mergers, Corporate
Control, and Governance
34. Control Governance,
and Financial Architecture
© The McGraw−Hill
Companies, 2003
operating cash flows can turn to the main bank or other keiretsu companies for fi-
nancing. This avoids the cost or possible bad-news signal of a public sale of securities.
Second, when a keiretsu firm falls into financial distress, with insufficient cash to pay
bills or fund necessary capital investments, a “workout” can usually be arranged.
New management can be brought in from elsewhere in the group, and financing can
be obtained, again “internally.”
Hoshi, Kashyap, and Scharfstein tracked capital expenditure programs of a large
sample of Japanese firms—many, but not all, members of keiretsus. The keiretsu
companies’ investments were more stable and less exposed to the ups and downs of
operating cash flows or to episodes of financial distress.
45
It seems that the financial

support of the keiretsus enabled their members to invest for the long run.
The Japanese system of corporate control has its disadvantages too, notably for
outside investors, who have very little influence. Japanese managers’ compensa-
tion is rarely tied to shareholder returns. Takeovers are unthinkable. Japanese com-
panies have been particularly stingy with cash dividends; this was hardly a con-
cern when growth was rapid and stock prices were stratospheric but is a serious
issue for the future.
Corporate Ownership around the World
The theory of modern finance is most readily applied to public corporations with
shares traded in active and efficient capital markets. The theory assumes that
stockholders’ interests are protected, so that ownership can be dispersed across
thousands of minority stockholders. The protection comes from managers’ incen-
tives, particularly compensation tied to stock price; from supervision by the board
of directors; and by the threat of hostile takeover of poorly performing companies.
This is a reasonable description of the corporate sector in the U.S., UK, and other
“Anglo-Saxon” countries such as Canada and Australia. But as Germany and
Japan illustrate, it is not an accurate description elsewhere. Corporate ownership
in Germany is typical of continental Europe. The ownership diagram for a large
French company would resemble Figure 34.3.
46
The financial architecture of public companies in “Anglo-Saxon” economies
may be the exception, not the rule. La Porta, Lopez-de-Silanes, and Shleifer sur-
veyed the ownership of the largest companies in 27 developed countries. They
found that “except in economies with very good shareholder protection, relatively
few of these firms are widely held. Rather these firms are typically controlled by
families or the State,” or in some cases by financial institutions.
47
This finding has various possible interpretations. The first is obvious: Protection
for outside minority stockholders is a prerequisite for dispersed ownership and a
broad and active stock market. Second, in countries that lack effective legal pro-

tection for minority stockholders, concentrated ownership may be the only feasi-
ble financial architecture.
986 PART X
Mergers, Corporate Control, and Governance
45
T. Hoshi, A. Kashyap, and D. Scharfstein, “Corporate Structure, Liquidity and Investment: Evidence
from Japanese Industrial Groups,” Quarterly Journal of Economics 106 (February 1991), pp. 33–60, and
“The Role of Banks in Reducing the Costs of Financial Distress in Japan,” Journal of Financial Economics
27 (September 1990), pp. 67–88.
46
See J. Franks and C. Mayer, “Corporate Ownership and Control in the U. K., Germany and France,”
Journal of Applied Corporate Finance 9 (Winter 1997), pp. 30–45.
47
R. La Porta, F. Lopez-de-Silanes, and A. Shleifer, “Corporate Ownership around the World,” Journal of
Finance 59 (April 1999), pp. 471–517.