VIEWPOINTS : A Case for Restructuring of Corporate America : When Examined, Criticisms Lack Real Substance

Is the restructuring of corporate America good for the vitality of the United States or not?

Unfortunately, public debate over corporate takeovers, leveraged buyouts and restructurings often focuses on the process: hostile raids, poison pills, shark repellents, junk bonds, white knights, store closings and employee layoffs.

Perhaps the most important question, however, is whether this seemingly frenetic activity will help the long-term competitiveness of the U.S. economy and thus benefit our country’s companies, employees, consumers and shareholders.

The public should take a good, hard look at some of the criticisms of takeovers and corporate restructurings.

Criticism No. 1: Takeover mania wastes investment capital.

In fact, takeover money goes to shareholders and either returns to the savings-investment pool or is spent on consumption, which in turn stimulates the economy and leads to further investment. Most economists agree with Michael Jensen’s study published in the Harvard Business Review stating that “scientific evidence indicates that activities in the market for corporate control almost uniformly increase efficiency and shareholders’ wealth.”

Criticism No. 2: Takeovers result largely from undervalued stock prices, and since institutions holding most of this equity are so intensely competitive and short-term oriented, managements are forced to maximize short-term earnings at the expense of long-term projects, research and development investments, etc.

Interestingly, a Securities and Exchange Commission study shows that the stock market in fact does not favor short-term earnings. It shows that institutions invest more in companies with the highest research and development expenditures and that most takeover targets have the lowest R&D; expenditures within their industries.

Criticism No. 3: The breakup of companies is bad for the economy.

As President Reagan’s Council of Economic Advisers notes, breaking up a company does not destroy its assets. It simply moves assets to managers who think they can use them more productively and therefore are willing to pay a higher price for them.

Disciples of Joseph Schumpeter call this process “creative destruction” and view it as an inevitable response to new economic fundamentals, particularly increased international competition. Many of the conglomerates formed in the 1960s and 1970s had become unwieldy and needed to contract and focus on their core business before they could produce the lowest-cost, best-quality products.

Lawrence Franko of Tufts University found that companies diversifying out of their core areas did worse internationally in market share and profitability. His conclusion was clear: Focused firms do better.

Criticism No. 4: Takeovers and restructurings eliminate jobs and hurt the U.S. economy.

Clearly, restructurings are likely to result in an overall loss of jobs in the short term. But the pressures to cut layers of management, to streamline what Deputy Treasury Secretary Richard Darman called the bloated corpocracy of big business to increase productivity and to become more competitive with international exports, will be the pressures that ensure jobs in the long term.

As economist Edward Yardeni, who also has deep misgivings about the effect of restructurings on employment, has stated: “Global competitive pressures and gluts are the roots of restructuring. If the (Carl C.) Icahns and (T. Boone) Pickenses don’t do it, the Japanese will do it for us by putting our companies out of business and taking what’s left in their markets.”

Criticism No. 5: The restructuring of corporate America is resulting in an overleveraged America.

The prudent amount of leverage for a company can be determined only on a case-by-case basis. Nonetheless, Richard Ellsworth of the Claremont Graduate School in a recent column expressed precisely the opposite concern about leverage. His question: “Given the increasing concern over America’s competitive decline in world markets, can U.S. companies afford to have so little leverage?”

The percentage of debt in the capital structure of Japanese and West German manufacturers averages 66% and 64%, respectively, more than twice the 30% level of U.S. manufacturers.

The highly leveraged capital structures of foreign competitors give them two key advantages: They lower the after-tax cost of capital by substituting debt, with tax-deductible interest, for higher-cost equity; and they increase the growth rate a firm can finance at a given level of profitability.

This lower cost of capital lets foreign managers undertake investments that U.S. companies would find unacceptable. Consequently, since the 1960s our net fixed investment as a percentage of gross domestic product, and our growth rate in manufacturing output per hour, have significantly trailed those of West Germany and Japan. As our investment level has declined, so has our competitive vitality.

Jensen concurs with Ellsworth by emphatically stating that the “leveraging of America has been highly beneficial on balance and that it discourages managers from throwing away resources on misguided acquisitions or sitting on cash as they have in the past.”

Criticism No. 6: Takeovers and restructuring threaten many “fine old companies.”

While it is probably too early to definitely respond to this claim, it is interesting to reflect on the testimonials of numerous restructured managements, including Disney, Macy’s, Martin Marietta and Union Carbide. They have all publicly stated that it was the very discipline of restructuring that spurred management to strengthen its performance, to concentrate its business focus, to cut back its bureaucracy, to increase its returns to shareholders and to improve its long-term competitive position.

Time will tell whether the restructuring of the oil industry will yield results. We do know that no pressure was brought to bear on managers in the steel industry 15 years ago. They did not restructure their companies, and the nation is faced today with the results of their failure to act. Perhaps it is time to try another approach.

There is no question that billions and billions of dollars of value have been created for stockholders in both successful and unsuccessful takeover attempts. The Dow Jones industrial average recently topped 2,100. After taking 20 years to break 1,000, the market made it to 2,100 in only four years. Restructurings, which have helped to drive financial values closer to replacement costs, have played a significant role in this surge.