Strategic managers must not only compose valuable corporate theories; they must also finance them.1 The challenge in finding funds is that investors may have their own beliefs and theories about the optimal path to value creation with the assets and activities an organization controls. They may even question the firm’s judgment and motives. Conflicting ideas about the path to value creation and investors’ suspicion of managerial motives create a tension that pervades corporate boardrooms and executive suites, not to mention the halls of academe, and presents a real challenge to a company’s efforts to compose and pursue a valuable corporate theory.
A fundamental question underlies this tension: Who should ideally set strategic direction—expert managers with deep knowledge of their industries and resources, or an independent “crowd” of investors and their advisers? The answer is not obvious. On the one hand, managers as experts have access to information often unavailable to the market, including extensive knowledge of the resources available and opportunities present in their own organizations. On the other hand, the capital markets aggregate a vast array of disparate opinions of investors (and potential investors) about a firm’s proposed actions. Moreover, if an organization’s task is to maximize enterprise value, there is clear wisdom in taking strategic actions consistent with investors’ beliefs and theories. After all, investors establish the value of the enterprise. Why not give them what they want?
Essentially, the issue that underlies these divergent paths is a problem of agency. Managers are hired to act in investors’ interests because they possess information and skills that investors lack—information vital to composing a valuable corporate theory. But managers also have personal interests in selecting the corporate theory that may diverge from the simple value-maximizing motives of investors. So the choice for owner-investors is either to allow managers—with their self-serving incentives, but presumably better information—to choose the theory, or to maximize their own control by shaping managers’ incentives to simply attend to investor signals and feedback, in some sense crowdsourcing the selection of strategic action from the beliefs of investors.
To see what’s at stake, let’s consider Kraft’s unsolicited offer for Cadbury in September 2009. The offer met substantial resistance from Cadbury’s board. The UK public voiced its own tremendous resistance—the idea that a US firm would buy this iconic British brand seemed unthinkable. In the face of this resistance, Kraft quickly launched a hostile takeover effort, claiming a host of synergies with Cadbury. The investment community, however, was not convinced that the deal would create value, especially when Warren Buffet, a large shareholder in Kraft, opposed the deal. Kraft’s share price dropped in response. Nonetheless, in January 2010, the Cadbury board agreed to terms with Kraft and the deal was consummated. This agreement only amplified the market’s negative response. Though Kraft’s stock rose 5 percent from the time of its initial proposal to the final agreement, Kraft’s shares generally responded negatively, given that the S&P 500 rose 15 percent over this same period.2
The acquisition did little to dissuade the more active of Kraft’s investors from pushing for a strategy revision. The hedge fund Pershing Square Capital accumulated significant shares and began pressuring Kraft to rethink its bundle of businesses. Then, just eighteen months after its acquisition of Cadbury, Kraft announced that it was splitting its more stable, slower-growth grocery products like Oscar Meyer, Jell-O, Maxwell House, and Kraft Macaroni & Cheese into a separate business from the faster-growing snack brands. In doing so, Kraft pushed to “unlock value.”3 The capital market’s response was predictably positive.
Who was in charge of Kraft’s strategy? Was it managers using their superior knowledge to create a corporate theory and execute strategy? Or were investors in charge, pushing managers to forgo what investors perceived as empire-building, value-destroying moves? The question reveals the existence of two very different philosophies about the motivation and roles of managers in the value-creation process. Understanding their difference is vital to understanding your role as a manager in sustaining value creation.
Moral Hazard: Managers as Villains
The philosophy that pervades Wall Street and dominates the academic finance literature emphasizes the remarkable and well-documented efficiency of prices in capital markets as a guide to strategic choice. Friedrich Hayek long ago argued that the “marvel of the market” is its capacity to assemble the collective wisdom of dispersed actors in markets and to essentially send powerful signals to managers about the merits of their strategic choices.4
This genius is well illustrated by capital markets’ rapid and accurate response following the Challenger disaster. While NASA launched an extensive five-month investigation pinpointing the proximate cause as supplier Morton-Thiokol’s defective O-rings, the capital markets fingered Thiokol on the very day of the disaster. Within twenty-four hours, Thiokol’s share price plummeted 12 percent, while the other large contractors on the project saw much more modest reductions in value. Capital markets may be equally skilled in evaluating strategic choices, or even the merits of a corporate theory. So why not defer to the wisdom of capital markets in selecting strategy?5
From the capital markets perspective, the manager’s task is reduced to deciphering market signals and responding strategically. This position would argue that Kraft’s managers destroyed value when they ignored the market’s negative signals and pushed forward with the purchase of Cadbury. They generated value when they responded to investors’ signals and separated out the slow-growing grocery business from the remaining assets. Thus, managers create value when they pursue strategies consistent with the wisdom of the crowd and destroy value when they ignore it.
The core challenge in this worldview is ensuring that managers follow market signals. Investors therefore seek to shape managers’ incentives so that they attend to investors’ interests and beliefs about the path to value rather than their personal interests or beliefs. This approach was most explicitly articulated by Michael Jensen and William Meckling, who in a pathbreaking 1976 article delineated the fundamental agency problem, often called moral hazard, in which managers pursue personal interests rather than the interests of principals.6
Many experts credited the rapid growth of large conglomerates in the 1960s to this phenomenon. With their salaries strongly linked to the size of the enterprise they managed, managers favored weak corporate theories that privileged organizational size over value creation. A lack of incentives to focus on shareholder value caused managers to craft flawed theories aimed at building empires that yielded private benefits but compromised value.
To sum up, in the capital markets perspective, investors are assumed to be highly efficient in their capacity to gather information, evaluate strategies, and allocate resources. Managers, by contrast, are seen as lazy and/or self-interested. Firm value is therefore increased when managers’ pursuit of personal agendas is corrected by imposing equity-based compensation systems that tie managers’ incentives to the beliefs and interests of shareholders. Motivated by such incentives, managers choose actions consistent with investors’ collective beliefs about value creation.
Managers’ self-interested actions may also be corrected by increasing the flow of information to investors about a firm’s corporate theory and by creating organizations that use simple, pure plays, operating within a single business—where capital markets can send direct signals to management about the value of actions free from the tangle of multiple strategies and businesses. Empirical evidence suggests that capital markets respond favorably as firms unbundle their strategic combinations and become focused pure plays. From this perspective, the market’s favorable response to Kraft’s decision to unbundle reflects a belief that the increased incentives and market discipline will somehow elevate performance. Better incentives will in essence “unlock” value previously lost.
The Lemons Problem: When Markets Fail
Powerful as the capital markets perspective is, it is arguably not the primary path to sustained value creation. Instead, I would argue that the primary path to value creation results from the creative, theory-building capacities of managers—those hired to see things investors often cannot. This strategic perspective (as opposed to the capital markets perspective) also recognizes that the separation of ownership from managerial control creates an agency problem, but unlike the moral hazard problem, here the problem is that well-intentioned and well-informed managers are constantly searching to build value but are frustrated by their inability to convince investors of their superior knowledge and vision. The strategic perspective sees the primary governance challenge as one of curing capital markets of their inability to correctly value firms, rather than curing firms of their lazy or empire-building managers.
Consider again the Kraft example. From the strategic perspective, the CEO’s job is to craft a far-seeing, insightful theory that forecasts the evolution of the industry and specifies the complementarity between the assets owned or available for purchase. Here, the CEO’s task is to make strategic choices that will maximize the firm’s long-run profitability, even if capital markets fail to see this value in the short run. After all, the CEO is hired to be smarter than investors. The challenge is convincing investors this is true—a task made all the more challenging because frequently it simply isn’t; sometimes managers’ theories are bad, aimed at building empires and not value.
In 2001, George Akerlof received the Nobel Prize in economics for groundbreaking work illuminating our understanding of a more general form of this precise problem.7 Akerlof labeled it the “lemons” problem, comparing it to the used-car market, where it is difficult for buyers to know whether the car they are purchasing is of high or low quality.8 The essence of the general problem is this: in markets where the quality of goods and services cannot be readily observed or measured, sellers, who uniquely know their quality, have incentives to exploit this information advantage to their benefit. They do this by selling indiscernibly low-quality goods in markets that expect and are correspondingly priced for higher-quality goods. While a growing flood of low-quality goods eventually drags down the market price, the interim benefits from offering them may be substantial. Because those who wish to sell high-quality goods have no means to credibly signal their high quality, high quality is simply withheld from the market. As a consequence, the market evolves to the point where it consists only of low-quality “lemons,” and all goods sold are heavily discounted.
Managers face an analogous problem in attempting to sell their theories to investors in capital markets. The quality of a corporate theory is massively difficult to assess—the product is a mere cognitive vision of a path to sustained value creation. A more difficult-to-evaluate product is hard to imagine; the true value is unknown even to the manager and is revealed only as “experiments” or strategic actions are pursued over a period of years. Accordingly, managers can all too easily disguise poor-quality theories as high-quality ones.
To overcome this information problem, managers often devote substantial time and resources to convince capital markets of the inherent value of their theories. CEOs of public firms often spend as much as 25 to 30 percent of their time meeting with investors and analysts, in an effort to minimize the information gulf between senior managers and investors. These efforts do not create real value themselves, but instead seek to alter investor perceptions of value, or investor patience as discussed below.
The dot-com boom (and bust) of the late 1990s highlights the potentially troubling consequences of this information gulf. From 1995 to 2000, scores of internet firms emerged with different business models for value creation and capture. Entrepreneur after entrepreneur developed online businesses, articulated strategic messages connecting their models to future value creation, sent out IPO prospectuses, and then solicited investors through public equity offerings. Many of these companies had no revenues. Few, if any, had profits. Nearly all had very vague theories about their path to cash-flow growth. Historical accounting numbers provided no real basis for evaluating the quality of these theoretical businesses. Value in the market was therefore merely a reflection of the subjective assessments of completely untested theories.
What emerged quite predictably was a classic market for lemons. Because the real value of these business models was impossible to assess, market valuations were based on observable “performance” measures. For instance, a 2000 study of dot-com valuations concluded that market valuations were negatively related to net income, but strongly and positively related to hits to the company website and to simple measures of R&D and marketing dollars spent.9 Far too little attention was focused on the likely future revenue or profit that a hit to the website might garner.
Unsurprisingly, the strategic actions developed by dot-com management teams focused on generating web traffic, to the detriment of strategic thought focused on real value creation. Equally unsurprisingly, the majority of these dot-com theories were revealed to be lemons, grossly deficient in strategic logic and pandering to the web-hit metric that so powerfully shaped valuation. As this reality set in, the market crashed. The difficulty of separating those firms with truly valuable strategies from the lemons became apparent, and even those with compelling strategies and positions, such as Amazon, were sharply discounted.
The lemons problem is not limited to the dot-com model. Managers crafting corporate theories of growth face a very similar information problem as they attempt to sell these theories to investors. These managers are paid to know more than capital markets about the quality and future value of their theories, but they are often incapable of persuasively articulating that inherent future value. As a consequence, high-quality theories paradoxically may be discounted in capital markets, especially when they are difficult to evaluate.
The big problem with such discounting is that managers rely on capital markets for resources to pursue their corporate theories. Perceptions of low quality elevate financing costs. Moreover, managers’ compensation and continued employment typically depend on their capacity to generate market value in the present. Thus, this lemons problem leads to a strategic dilemma of massive significance. Managers may be tempted to pander to the beliefs and preferences of the capital markets rather than pursue the corporate theories that would maximize value for the firm.
The Strategy Paradox
Many managers are certainly aware of this dilemma. Over the years, I heard many complaints from CEOs of publicly traded firms such as Boeing, AT&T, Cardinal Health, Aetna, and Tyco that their strategies were being incorrectly valued. Their frustration was often directed at young securities analysts who were either unable or unwilling to dig in and evaluate their complex or unique strategies.
And for many years, I remained firmly convinced of the capital markets perspective and the reliability of collective wisdom in assessing value. I generally dismissed such complaints as scapegoating; placing the blame on analysts seemed to me an excuse for empire building and poor strategic choices. But a question lurked beneath the surface: Was it possible that the CEOs’ view was accurate—that capital markets and the market actors that supported them simply had an aversion to the unique, complex, and unfamiliar? The answer to this question is critical, as it fundamentally shapes the path to value creation. Does value creation primarily mandate solving a moral hazard problem by motivating otherwise lazy, greedy, or overconfident CEOs to act in shareholder interests? Or does value creation mandate solving the lemons problem that prevents CEOs with valuable corporate theories from being able to pursue them?
My thinking on this critical dilemma shifted when in 1999 a student sent me an analyst report about his employer, the Monsanto Corporation. At the time, Monsanto was heavily invested in a portfolio of businesses and assets that leveraged biotechnology and chemical sciences to generate innovative food, agriculture, and pharmaceutical products—as noted in chapter 2, a bundle of businesses that it described as “life sciences.”
The theory was that these businesses could share common R&D investments and benefit from commonly applicable technology. Also fundamental to this theory was a belief that pharma and agricultural biotechnology were better investment prospects than chemicals. However, by 1999, the capital markets had soured on the theory. Public opposition to agricultural biotechnology, particularly overseas, made ag-biotech a dirty word among investors.
At the same time, Monsanto’s pharmaceutical unit generated the anti-arthritis drug Celebrex, which was widely regarded as destined for blockbuster sales. Securities analysts began to press Monsanto management to abandon the strategy of bundling these businesses and investing so heavily in ag-biotech, which they viewed as causing a “valuation drag” on Monsanto’s stock. In fact, analysts valued ag-biotech investments, related R&D, and potential future products as practically worthless.
But the report my student sent to me, drafted by Paine Webber, caused me to rethink the logic of the market:
The life sciences experiment is not working with respect to our analysis or in reality. Proper analysis of Monsanto requires expertise in three industries: pharmaceuticals, agricultural chemicals and agricultural biotechnology. Unfortunately, on Wall Street, particularly on the sell-side, these separate industries are analyzed individually because of the complexity of each. This is also true to a very large extent on the buy-side. At PaineWebber, collaboration among analysts brings together expertise in each area. We can attest to the challenges of making this effort pay off: just coordinating a simple thing like work schedules requires lots of effort. While we are willing to pay the price that will make the process work, it is a process not likely to be adopted by Wall Street on a widespread basis. Therefore, Monsanto will probably have to change its structure to be more properly analyzed and valued.10
Talk about the tail wagging the dog. This analyst was suggesting that Monsanto incur tens of millions of dollars in investment banking and other transactions fees—not to mention the loss of any synergies—to unbundle the corporation not on the basis of in-depth evaluation or toward real value creation, but because analysts with differing expertise could not coordinate work schedules. Moreover, the report strongly suggested that coverage choices by analysts are based in part on the effort required to provide that coverage. Most importantly, the report directly recommended that the firm dismantle its current strategy to reduce these burdensome information costs for analysts, thereby permitting more extensive and precise analysis, and ultimately raising the overall valuation of the assets.
Interestingly, elsewhere in the report, the analyst applauded Monsanto’s history of staying the course despite “heavy resistance from the Street” to change. This was in reference to CEO Dick Mahoney’s unwillingness to sell its pharma unit, Searle, in the 1990s when its pipeline looked empty. Of course, events proved that Mahoney possessed foresight in staying the course and that ignoring the analysts then was a good move.
Now in 1999, Monsanto was again at a crossroads. In this instance, however, the CEO played to Wall Street—divisions such as Nutrasweet were sold or spun off, then the remaining entity was sold to Pharmacia, which was in turn quickly acquired by Pfizer. After holding onto the ag-biotech business for the legally required two years, Pfizer spun it off as Monsanto in 2002. Even then, the business was viewed as having rather limited value. Yet the unit’s phenomenal subsequent performance has completely exploded this negative judgment. What was nearly valueless to analysts in 1999 turned out to be worth $55 billion in 2013.
This story is only one such anecdote; my experience suggests that managers generally do face a real dilemma as they craft and then sell their corporate theories to capital markets. They can choose simple, familiar strategies that are easy for capital markets to decipher or they can choose complex, unfamiliar, or unique ones based on theories that are difficult to evaluate. In the latter case, valuation is costly, prone to error, and likely leads to a discount in the market.
Figure 3-1 depicts four types of corporate theories that differ along two dimensions: quality and ease of evaluation. Type I theories—theories that are of high quality and easily evaluated—are clearly the preferred choice. However, such theories are unlikely to exist in great abundance since, as discussed, good theories are unique—and unique seldom means easy to evaluate. Type IV theories—theories that are of low quality and relatively opaque—are clearly to be avoided. The majority of options, however, are likely to be type II—theories that are lower in quality and therefore long-term value, but are easily evaluated and therefore may maximize investors’ current value—or type III—theories of high quality that maximize long-term value but are difficult to evaluate and are therefore discounted in the present. The correct choice is by no means obvious. It is precisely in this quandary that Monsanto found itself.
FIGURE 3-1
Four types of theories
Securities Analysts and the Costly-to-Analyze Discount
There are actors in capital markets for publicly traded firms who seek to bridge this information gulf and resolve the dilemma. In used-car markets, mechanics and auto dealers certify quality and even function as brokers. In capital markets, there are securities analysts who specialize in assessing the merits of each firm’s theory. Their task is to assemble information, monitor performance, and evaluate the quality and likely future performance of the theories that managers propose, as these provide information to investors through earnings forecasts and buy and sell recommendations.
Unsurprisingly, managers’ incentives to cultivate analyst coverage are substantial. All else being equal, more coverage positively influences the firm’s valuation.11 It does this by both reducing uncertainty for the investor and by functioning as a “marketing” arm for the security.12 However, as the Monsanto story illustrates, just because these intermediaries shape the valuation of firms clearly does not mean they fully resolve the lemons problem. Indeed, the presence of analysts with such control may simply encourage managers to pander to analysts’ preferences, which brings its own problems. Let’s look at how that happens.
Obviously, sell-side analysts have incentives to dig in and effectively evaluate managers’ strategies. Individual analysts are ranked on the accuracy of their forecasts and thus develop reputations with important financial implications. But there are other incentives in play as well. Brokerage firms, which employ the analysts, seek investment banking business from corporations as well as order flow from investors.
These incentives encourage analysts to be overly optimistic about the prospects of the firms they cover. While recent regulation has sought to eliminate these incentives, it has been less than fully effective, and it is hard to imagine how regulation could completely eliminate them. Suppose you are a respected analyst who attracts significant investment banking business. If your current employer will not reward you for this, a competitor will hire you away in hopes of attracting the investment banking business as well. The obvious result is that analysts are many times more likely to issue buy recommendations than sell recommendations. What’s more, many brokerage firms will simply drop coverage rather than move to a sell recommendation, after which prospects for obtaining investment banking business from that company predictably diminish.
But there’s another, less controversial factor at play. Analysts, like all individuals, seek to allocate their effort in ways that generate the best return on their time invested. Covering more firms expands order flow and reduces the costs spent per firm in analysis. But to economize on the effort expended per firm, and thereby cover more, analysts prefer firms that are easy to analyze—in other words, those pursuing theories that are familiar and simple.
The logical result, therefore, of choosing a more complex or unfamiliar strategy is a lemons discount or a costly-to-analyze discount not unlike that seen in used-car markets. While this all sounds fine in theory, is there any evidence to suggest it is empirically true?
The Monsanto report piqued my interest on this question, eventually leading to a large empirical study assessing whether indeed firms pursuing more complex or unfamiliar strategies receive a discount in capital markets.13 Earlier studies had uncovered related empirical findings. MIT’s Ezra Zuckerman, for example, found that firms tend to reshape themselves through divestitures and spinoffs to essentially “match” the “categories” covered by analysts.14 Another study showed that net of other effects, analysts tend to avoid complex businesses with multiple operating divisions.15
My project with Lubomir Litov and Patrick Moreton focused on a topic even more central to the question. We examined the impact of a strategy’s uniqueness on the level of coverage and the premium or discount that it received in capital markets.16 We assumed that the most valuable corporate theories are built around uniqueness: either unique foresight about the value of a strategic bundle of assets, or the possession of unique assets that preclude others from enjoying similar value as they pursue complementary assets. We then examined all publicly traded firms from 1985 to 2007 and developed a measure of how unique a firm’s strategy was relative to other firms in its primary industry.
Our study revealed several intriguing findings. First, we found that covering firms with more complex and unique strategies demands more effort from analysts. Analysts are able to cover fewer other firms when they cover a firm that is unique or complex. As a result, firms pursuing more complex and unusual strategies receive less analyst coverage, all else being equal. Second, we corroborated an abundance of earlier research showing that the amount of coverage matters to valuation (in other words, reduced coverage reduces valuation). Finally, we showed that firms pursuing more novel theories receive a valuation premium in the market consistent with the logic of chapter 1, but this premium is smaller than it might otherwise be because of the higher cost of coverage and lower resulting analyst coverage. The bottom line is that this uniqueness paradox is pervasive even in the market for publicly traded firms. Choosing unique theories, which may maximize long-term value, will likely receive a discount in the present.
How Should Managers Respond to the Lemons Problem?
In light of the lemons discount, firms face a dilemma in how to best pursue value creation. They can choose to pursue a unique corporate theory—one that they feel will ultimately maximize shareholder value, but will be discounted, possibly for a long period, due to the elevated cost of analysis, and that of course may turn out to be wrong. Or they can choose a theory that is inconsistent with their own beliefs about long-term value creation but that panders to the capital markets and is likely to generate a short- and even medium-term increase in market value, and that may even turn out to be right.
In the face of this dilemma, firms can make one of four choices:
COMPROMISE THE STRATEGIC THEORY. First, firms may choose to alter their theory in response to this lemons discount, instead adopting one that imposes a lesser information burden on analysts and enables more accurate analyst coverage. There is clear evidence that this approach works as predicted. One study finds that simplifying a firm’s strategy through focus-increasing transactions increases both the volume and accuracy of analyst coverage.17 Another finds evidence that managers do precisely this. They divest businesses to compose their strategy to better match the existing preferences of analysts.18 However, this path may very well compromise the long-term potential for value creation.
THUMB YOUR NOSE AT THE MARKET. Second, companies may simply ignore what they believe is the market’s shortsighted undervaluation and instead bank on the true value of their corporate theory eventually being revealed in superior operating returns. How feasible this option is depends on the patience of investors (and of course the accuracy of the manager’s beliefs). Clearly, some investors are more willing than others to forgo current value increases for what may be higher future value. Hence, assembling investors who support the theory is a significant managerial task, regardless of whether the enterprise is an angel-funded new venture or a large multinational enterprise. Of course, if the theory proves accurate, investors’ belief in it may provide tremendous value. As noted, capital markets are actually very much like the used-car market. If you, as an investor, find a trusted seller—a company with a valuable corporate theory, then the market affords real bargains.
INCREASE INFORMATION DISCLOSURE. Third, an organization can stay the course, but attempt to increase investors’ access to information regarding its corporate theory. To do this, it may pursue one of several tactics. First, it can push analysts and investment banks to devote greater resources to analyzing the current strategy. For instance, the company may engage in aggressive publicity campaigns to market its theory to capital markets. Alternatively, it may choose to directly pay for analysis, an option that has become more possible in recent years with the emergence of “paid-for” analyst research firms that offer firms analyst coverage for a fee.19 In recent years more than 35 percent of publicly traded firms received no security analyst coverage whatsoever, and as we have seen, the difference between having coverage and not having coverage on the market value of a firm is enormous.
TAKE THE COMPANY PRIVATE. Ultimately, neither assembling desired investors nor escalating information disclosure may prove sufficient. Casual evidence suggests that many managers pursuing more unique or complex strategies simply migrate to some form of private equity. We already know that funding new technology ventures is largely undertaken by expert private investors because evaluating new technology is often too costly for public equity markets. The same logic applies to the high information costs that accompany evaluating the complex or unique theories of established corporations. Extensive empirical literature documents the disappearance of conglomerates from public markets over the past two decades but arguably conglomerates have merely re-emerged as private equity firms, bundles of highly unrelated businesses, which are clearly very costly to analyze in the composite. Going private creates proper incentives for incurring the information costs required for accurate analysis and investment. While some suggest that private equity’s primary benefit is solving the moral hazard problem with high-powered incentives for managers, in my mind an equal, if not greater benefit, is that it addresses the lemons problem.
Another way to go private is to find a large privately owned acquirer. Koch Industries’ recent purchase of pulp and paper product giant Georgia-Pacific created the largest privately owned company in the United States. As reported in the Financial Times:
[Georgia Pacific’s assets] have underperformed the broader S&P500 index partly because it has an awkward mix of assets that are difficult to value together. Some of its consumer products, such as tissues, are in solid, high-margin niches that deserve a relatively high share-price multiple. Other activities, such as selling building products, are in volatile sectors where investors are beginning to worry about the effects of a downturn in the US housing market … The combination means an otherwise strong company has been trading at a significant discount to the sum of its parts at a time when potential buyers have lots of cash and borrowing is cheap.20
The logic is that by taking the company private, Georgia-Pacific acquires patient investors who will allow managers to play out their corporate theory and reveal its value. Moreover, because Georgia-Pacific’s complexity generated a discount, Koch creates value through the deal. Thus, private equity—whether in hedge funds or through privately owned groups—finds underpriced assets not merely because the managers were previously poorly motivated, but rather because the capital markets were poorly informed about value. The clear prediction of this logic, then, is that high-information-cost strategies, including complex or unique strategies, will migrate to private equity.
In the remainder of the book, I will assume that managers are well-intentioned and seek to maximize long-term shareholder value. I will therefore not devote much attention to how to optimize CEO governance in pursuit of the first option by tying a manager’s rewards ever more tightly to the capital market’s current assessment of firm value and investment opportunities.21 Instead, I will turn my attention to providing strategic guidance to managers who seek to apply value-creating corporate theories. The first major implementation question is this: As you acquire complementary assets and capabilities, how do you figure out whether you should purchase and control them or whether you should access them from suppliers through contracts? That is the focus of chapter 4.
LESSONS LEARNED
Managers face a fundamental dilemma in choosing strategic actions. Should they develop and faithfully adhere to their corporate theories of value creation or should they follow the signals of the financial markets? The explanation for the dilemma—and how to work through it, depends on which of two dynamics you believe to be dominant:
• Moral hazard: In this capital market perspective, often favored by investors, managers are hired to apply the knowledge and expertise they have to pursue shareholder interests, but may instead choose to pursue strategic paths that benefit them privately. The route to value-creation is one of making lazy, self-interested managers do what the market wants.
• The lemons problem: In this strategic perspective, often favored by managers, it is very difficult for markets to assess the value of original theories. Too often good theories get priced at the same level as the bad ones. The challenge is for well-intentioned managers to better communicate the value of their theories and thereby obtain the funds and patience required to pursue them.
All too often, the capital markets perspective dominates the strategic perspective, as market participants, including stock analysts, have insufficient incentive to dig in and accurately evaluate more unique and difficult to evaluate strategies. The upshot is that any value created by a good theory may well be discounted by the market. In this situation, managers have the following options:
• Go along with the market: This is often the easiest course and is likely, given incentive structures, to be the most personally remunerative course. But it amounts to giving up on genuine strategy making.
• Communicate better: This is easier said than done (else why would analysts avoid such strategies?), and in some settings disclosing the full details or even the logic of a strategy compromises its value by inviting competitive imitation.
• Find the right shareholders: In an increasing number of cases, management teams keen on applying real theories about how their firms create value have ended up taking companies private in some form rather than rely on the questionable strategic wisdom of the public markets.
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