WEB–APPENDIX I

CONGLOMERATES AS A MEANS OF OVERCOMING CAPITAL MARKET IMPERFECTIONS

Conglomerates are assemblies of firms whose products are unrelated to each other. Hence, the perfect capital market argument applies in the sense that conglomerates ought not to be able to create economic value in a such a market because they only create portfolios that investors could create on their own (see the homemade diversification argument in the discussion of mergers in Web-Appendix H). Moreover, the arguments of possible monopoly power cannot be applied because by definition a combination of unrelated firms does not create market power. Nonetheless, the imperfect information and managerial incentive arguments discussed in this book can still be used to rationalize conglomerate activity. But what are the other arguments supporting conglomerates based on market imperfections?

Managerial efficiency of the conglomerate form is sometimes cited as a reason conglomerates might create economic value. Perhaps this argument takes its most telling form in asserting the superiority of internal financial management relative to that of the capital markets, for certain kinds of transactions. Management of conglomerates may better be able to allocate investment capital to their divisions than can financial markets to separate companies, for the reasons that management might have better operating information and supervisory capability than do investors. Hence, conglomerate management might be in a better position to appraise and to manage the risks involved in some kinds of financial transactions. Conglomerates may therefore help to overcome some capital market imperfections associated with risky lending and thus create economic value.¹

Another widely believed argument contends that conglomerate activity is sometimes attributable to the rewards associated with defrauding the investing public. The precipitous decline in conglomerate prices, the near collapse of some conglomerates, and the voluntary spin-off of many conglomerate divisions in the early 1970s lend some support to this claim. According to the fraud theory, conglomerate management convinced the public that (contrary to our earlier analysis) they could increase the value of acquired assets by adding financial leverage. Additionally, in effecting acquisitions, the argument holds that management of conglomerates used complex securities, the implications of which eluded investors. In particular, it is sometimes argued that investors have not fully understood the convertibility features of some such securities, especially since the conversion possibility was not required to be reflected in earnings per share. However, today that argument is difficult to accept given the change in the accounting treatment for earnings per share that takes into account the potential dilution that may result from a convertible security a corporation has issued.

A third strand to the argument holds that certain accounting techniques (pooling rather than purchase accounting) were used by acquiring firms to understate the values of assets acquired and hence to report overstated rates of return on those assets. These overstated rates of return were then sometimes interpreted as evidence of managerial efficiency that may have had the result of increasing the market price of the conglomerate's shares. Again, changes in the accounting treatment minimize the risk that this accounting gimmickry can be used.

Another argument that the public can easily be misled turns on a consideration of price-earnings ratios. To see this argument in its simplest form, let us reconsider an example developed in Chapter 4. Suppose the shares of two firms, A and B, respectively, are growing in perpetuity and valued by risk-neutral investors under uncertainty according to the formula:

where P is price, E expected earnings per share, k the earnings retention rate, r the interest rate, and g the growth rate of a firm's earnings. The firms are supposed to be financed entirely by equity. Assume the following data:

It then follows that the price-earnings ratios for firms A and B are, respectively, 10 and 20, and the share prices $100 and $200. Let us now suppose that firm A has 6,000 shares outstanding and firm B 1,000, so that the total earnings for the two firms are $60,000 and $10,000, respectively, while their market values are $600,000 and $200,000.

Suppose that an acquisition is effected with firm A being the acquiring company and providing the following exchange: two shares of firm A for each share of firm B. Then subsequent to the acquisition, the acquiring company should have a total market value of $800,000, and since 8,000 shares will be outstanding, the market value of each will be $100. Since for the combined firm earnings are $70,000 and there are 8,000 shares outstanding, the price-earnings ratio will be $70/8. It follows from the previous equation that:

which when solved for g gives a growth rate of . Note that the P/E ratio is now approximately 11.43 in comparison to the previous 10 for the acquiring company. The growth rate of total conglomerate earnings may also be determined by weighting the original firms' growth rates by their relative values in the marketplace; that is,

as before.

However, in imperfect markets with unequally distributed information, prospective investors in the acquiring company might well be tempted to overestimate the growth rate of the combined firms, reasoning in the absence of other information that earnings growth for the entire firm might exceed the weighted average just calculated. If, for instance, the market wrongly guessed that the acquiring company would exhibit earnings growth of 0.175, the acquiring company's share price would rise according to:

so that P is equal to $137. Alternatively, some investors might incorrectly reason that a multiple higher than 11.43 might apply to existing earnings. If, for example, they used a multiple of 15, their estimate of the share price would rise to or approximately $131.25.

In the real world, the kinds of mistakes just discussed might be made at least some of the time, because there can be considerable uncertainty about the acquiring company's earnings, and this uncertainty may well be colored by optimism on the part of investors. To the extent these situations occur, the stockholders of acquiring companies stand to make relatively large capital gains and hence have powerful incentives to pursue acquisition strategies. But this should not blind the sophisticated investor to the fact that these initially occurring capital gains may vanish with the passage of time as the economic realities governing the combined companies' operations gradually emerge. In any event, some amount of acquisition activity may well be based on profiting from exactly the combinations of uncertainty and optimism just explored.

To recapitulate, some of the serious, nonfraudulent reasons for forming conglomerates derive from the same information imperfections that we have discussed in this book. That is, it may be difficult to raise funds in the market because of divergent opinions. Forming a conglomerate is one way of circumventing this difficulty through internal transfer of funds from cash-generating to cash-using companies.

REFERENCE

Williamson, Oliver E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications. New York: Free Press.