Conglomerates in Developing Countries

Jaime Augusto Zobel de Ayala, chief executive of Ayala Corporation, the largest conglomerate in the Philippines, is rare among Asian tycoons for his willingness to ponder the imponderable. Every so often, he discusses with his brother, father and Ayala’s other directors whether they should break their conglomerate up. After all, Ayala owns, among other things, the Philippines’s most profitable property developer, bank and mobile-phone operator. Any of these could easily stand alone, and Mr Zobel knows that global investors usually prefer focused companies. So will he give them focus?

Not yet. Instead, he plans to give shareholders change of a far more interesting sort. There are good and enduring reasons why conglomerates thrive in such inefficient markets as the Philippines. At the same time, globalisation poses challenges that are catching many traditional conglomerates off guard. So Mr Zobel’s vision is to turn Ayala into a new model for conglomerates, one that exploits market inefficiencies as well as globalisation.

The case against conglomerates is compelling. Capital markets, the argument goes, are better than chief executives at allocating resources among industries. Why should a fund manager who likes, say, telecoms also be forced to invest in property? If he wants exposure to both, he can build a portfolio better than any conglomerate boss could. Conglomerates therefore tend to have lower market values than the sum of their operations. Focus brings other benefits too. Managers do not have to divide their time, energy and expertise among industries.

These arguments, however, appear to apply only in a specific historical context. Take America, which probably has the most focused companies in the world: the oft-cited success of General Electric, an outstanding conglomerate, is the exception that proves the rule. Yet a century ago America’s biggest companies were all conglomerates, run by “robber barons” not unlike today’s tycoons in poor countries. Demergers and spin-offs became seriously fashionable only after the 1970s.

The most likely explanation for this evolution is that conglomerates go out of fashion as markets become more efficient. Krishna Palepu and Tarun Khanna, two professors at Harvard Business School, argue that efficiency arises from the presence of “specialised intermediaries”. In the market for capital, these are mutual funds, venture capitalists, equity analysts, auditors, and so forth. In the market for labour, they include executive-search firms, vocational and business schools, and certification agencies. In the markets for products and ideas, they include intellectual-property lawyers and consumer activists. The America of the Rockefellers and Morgans had few such intermediaries, just as poor countries do today.

Hence the appeal of conglomerates. They are their own intermediaries. In a country that lacks a functioning stockmarket, a conglomerate can channel cash from one business to another. If educational levels are low, it picks the brightest, trains them in one subsidiary and transfers them to another. If property, contract and liability laws are confusing and the courts venal, it substitutes the group’s reputation in transactions. Thus arose the family empires of the overseas Chinese in South-East Asia, the chaebol in South Korea, and conglomerates in India and South America.

The Asian financial crisis of 1997 exposed the flaws in this model, with a brutal cull of many once-illustrious conglomerates. Past success was now attributed less to internal talent pools than to cronyism, if not corruption. Internal capital markets were now maligned as cross-subsidisation or empire-building, and were blamed for wasteful investments. Complexity became synonymous with opacity, as minority shareholders realised they had no way of tracing how their investments in a conglomerate were being used.

How Globalisation Hurts

Globalisation is exacerbating these shortcomings in two ways. The first is the entry of multinational giants into industries that used to be protected. In banking, for instance, local conglomerates, in effect, held depositors captive until recently, but they are now confronting the likes of Citibank and HSBC, who have global back offices and lower costs of capital. The second threat is the increasing mobility — ie, flight — of talent. In the past, the career path of a gifted software programmer in a poor country inevitably led to a local conglomerate. Now it might lead to Silicon Valley, or to a multinational company. Mr Zobel says that Ayala’s bank has lost about a quarter of its IT professionals in this way.

Concluding from all this that conglomerates will die out, however, would be naive, says Mr Khanna. In reality, some countries take many generations to acquire efficient markets. Farsighted conglomerates can use this respite to adjust to globalisation. But how?

The winning model may already exist. It is that of a typical venture-capital fund in the West, but with the local connections of the conglomerates — a “VC plus”, as Ken Gibson, a consultant at McKinsey, puts it. Like any good venture capitalists, survivor conglomerates will concentrate on spotting new opportunities and finding the talent, capital and partners to exploit them. They will avoid like the plague transferring funds between ventures, staffing subsidiaries with incompetent family members, conducting dealings that are not transparent to the outside, and other old tricks.

Ayala is pioneering this strategy. It operates a “talent bank” of several dozen executives, sending some to American business schools and drafting others in from the Filipino diaspora before dispatching them to subsidiaries. It keeps its business practices squeaky clean, in order to be first choice for foreign partners and investors. And it issues new equity only to finance new ventures. Ayala’s expansion into mobile telephony in recent years is a case in point. It sold shares to western investors, invited Singapore’s telecoms incumbent to be a partner, seconded executives from the talent bank, and, after years of losses, now runs the most profitable mobile operator in the country. To make the conglomerate’s new culture more explicit, Mr Zobel recently created a new subsidiary, run as a venture-capital fund.

Ayala is not alone. Other reformers include the Tata group, India’s largest conglomerate, and the companies controlled by Li Ka-shing, the biggest entrepreneur in Hong Kong. But most tycoons are finding change hard. Take Lucio Tan, who controls the other large conglomerate in the Philippines. A Chinese immigrant, Mr Tan used his connections during the dictatorship of Ferdinand Marcos, and again during the presidency of Joseph Estrada, to build an empire ranging from tobacco and brewing to banking and aviation. Both leaders left after popular uprisings, and Mr Tan, who is notorious for his secrecy and unloved by former investors, today finds business challenging. He still keeps four helicopter pads on a Manila rooftop. Visiting business leaders, however, are rarely on his choppers these days; they are sitting in Ayala’s headquarters across the street.