The Asian financial crisis serves as a timely reminder of a fact too often overlooked: Merchant banking is the leading edge of shareholder activism. Indeed, one of the chief traits shared by hard- hit Pacific Rim economies is a decided lack of such activism. As a result, their companies are less prepared than they might be for global competition. To one degree or another, much the same holds true in other markets abroad.
U.S. companies, in contrast, have seen their competitive ability markedly strengthened by shareholder activism. And much credit goes to merchant banking–that is, private investors managing their own capital. True investor activism as practiced by such financial buyers has created a new model for American enterprise. That model is based on highly leveraged capital structures, on compensation and equity ownership that align the interests of managers with owners, and on effective corporate governance mechanisms to monitor and control the use of free cash flow. All have the objective of maximizing value.
Contrary to popular perception, the strategies of merchant banks involve not just financial engineering, but also growth, which would not be achievable without risk capital. In the buyout world, we have seen a fundamental shift from the 1980s mantra of “unlocking value”–capitalizing on arbitrage opportunities and market inefficiencies. Today, the emphasis is on creating value by molding strategic direction, giving incentives to and empowering managers, and rationalizing operations.
Increasingly, merchant banks are the key agents of change. In the 1980s, parts of the manufacturing and retailing sectors were entirely reconfigured by leveraged-buyout activity. In the 1990s, financial buyers have changed the landscape of such industries as media, broadcasting, business services, printing and publishing, and food and health services. America’s technological reemergence, captured in part by the Silicon Valley phenomenon, has been fueled by venture capital. And for more mature industries, LBOs have triggered corporate renewal.
Countless academic studies and real-world examples have highlighted the perils of the corporate governance status quo sans LBO: the central conflict between owners and managers over the control and use of corporate resources, the unenlightened use of free cash flow, and the scrutiny of and pressure on quarter-to-quarter earnings growth versus long-term growth and value creation.
By severely constraining and imposing restrictions on the use of free cash flow, LBOs force only positive net present value capital decisions. Studies have shown that operating cash flow increased on average by about 40 percent in a one-to-four-year time frame following the transaction.
With LBOs driving many companies to become more focused and better at what they do, the impact on the U.S. economy and American competitiveness has clearly been positive. Michael Jensen, of the Harvard Business School, has argued that the highly leveraged transactions of the 1980s triggered increased levels of productivity and export growth for manufacturers by eliminating excess capacity in mature industries.
What academics call the Anglo-American model functions in sharp contrast to the Japanese and German relationship-based systems, which are dominated by networks of banks and corporations and, until very recently, were marked by the absence of an active market for corporate control. Remember the Japanese economic miracle? It turns out that phenomenal growth concealed the deep-seated problems of that system. Accordingly, excess capital was not being returned to investors but instead was employed in building overcapacity and many a misguided diversification initiative. Similarly, capital allocation in the German economy has been driven by the big banks, well known to have low return expectations.
Yes, the results of the U.S. model for corporate control and ownership can be quite harsh–such is true capitalism. But merchant banking helps keep U.S. business focused and can be a key driver in the system. In the final analysis, merchant banking is a boon for the competitiveness of U.S. industry as we approach the next millennium.
Steven J. Berger is a managing director of Lehman Bros. and is head of its merchant banking business. This article is drawn from a speech he gave to the Metropolitan Club of New York on September 25, 1997.