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The Evolution of U.S. Corporate Governance

We Are All Henry Kravis Now

Research by Steven Neil Kaplan

The 1980s brought a phenomenal dollar volume of corporate takeovers and restructuring activity -- activity distinguished by an unprecedented level of leveraged buyouts (LBOs) and hostile takeovers led by raiders such as Henry Kravis of Kohlberg Kravis & Roberts (KKR) fame. Despite the resurgence of takeovers in the 1990s, LBOs and raiders have not reappeared. Their legacy, however, remains. As finance professor Steven Kaplan of the University of Chicago Graduate School of Business explains, today's shareholders, boards of directors and managers have applied the insights and strengths of the 1980s LBOs to today's corporate governance. “In that sense,” says Kaplan, “we are all Henry Kravis now.”

Before 1980, corporate governance in the United States was very different from today. Executives held modest amounts of stock and options in their companies. Top executives and their incentives were more focused on traditional performance measures such as sales or earnings growth. Boards of directors were not particularly active and shareholders were relatively passive.

In the 1980s, this began to change. The takeover wave of the 1980s appears to have been a capital market response to corporate governance deficiencies. During the years from 1968 to 1996, seven of the nine years with the greatest amount of takeover activity occurred in the 1980s.

In addition to the unusually large volume of activity, the 1980s also saw the emergence of the leveraged buyout and the corporate raider. But today, despite the recent upsurge in acquisition activity, raiders have not reappeared and hostile takeovers are less frequent. Why?

Today, Kaplan argues, shareholders and corporations increasingly obtain the benefits of LBOs and raiders on their own.

The LBO Insights

The LBOs of the early 1980s were driven by three primary insights:

  • First, the high amount of debt incurred in the LBO transaction imposed a strong discipline on buyout company management. With that debt, it was no longer possible for managers to treat capital, particularly equity capital, as costless. On the contrary, failure to generate a sufficient return on capital meant default.

  • Second, LBOs provided managers with substantial equity stakes in the company after the buyout. These stakes gave managers the incentives to undertake the buyout, to work hard to pay off the debt, and to increase shareholder value. If successful, buyout company managers could expect to make a great deal of money. Kaplan's earlier research shows that the Chief Executive Officers of the LBOs increased their ownership stake from 1.4% pre-LBO to 6.4% post-LBO. Management teams, overall, experienced similar increases. “In 1980, this approach to executive compensation was fundamentally different from common practice,” says Kaplan. “Management ownership of stock and options was modest. And management was loyal to the corporation, not to the shareholder.”

  • Third, LBO sponsors or associations closely monitored and governed the companies they leveraged. Unlike public company boards that were large and dominated by distant outsiders with small ownership stakes, LBO company boards were small and dominated by LBO sponsors with substantial equity stakes in the companies (and the companies' successes).

What did these insights lead to? In the first half of the 1980s, the LBO insights led to great, sometimes phenomenal success. But in the latter half of the 1980s, the LBO experience was different. Many LBOs defaulted, some spectacularly. Roughly one-third of the LBOs completed after 1985 subsequently defaulted on their debt. But did this default experience mean that the LBO insights were wrong?

The evidence, even for the late 1980s, indicates that the LBO insights hold. Kaplan finds that, overall, the larger LBOs of the later 1980s also generated improvements in operating profits despite the relatively large number of defaults. Even for deals that defaulted, Kaplan notes that the LBO companies retained approximately the same value they had attained before the LBO.

The Application of LBO Insights

Today, corporations routinely apply the three primary LBO insights without actually doing LBOs. Recall that the first LBO insight is to impose a cost of capital management so that management does not view (equity) capital as costless. Corporations and consulting firms now implement this insight through innovative performance measurement and compensation programs. The best-known of these programs are marketed by consulting firms. For example, Stern Stewart markets economic value added (EVA) and the Boston Consulting Group, and its Holt Value Associates subsidiary, markets cash flow return on investment (CFROI).

Compensation committees and consultants increasingly apply the second LBO insight – providing more high-powered incentives to top executives. It is arguably the case that the large payoffs earned by LBO sponsors and, more importantly, by the top executives of LBO companies, made it more acceptable for top executives of public companies to become wealthy through equity-based compensation. Coca-Cola's $100 million-plus restricted stock grant to Roberto Goizueta, the company's late chairman, is one of the more prominent examples.

Finally, public companies increasingly appear to be applying the third LBO insight – closer and more active monitoring by boards and shareholders. Boards are pressured to become more active and more shareholder-oriented, and shareholders have increased the pressure they place on corporate management. In other words, today's institutional shareholders are the raiders and LBO sponsors of the 1990s.

The Future of Corporate Governance

While it is clear that public companies increasingly apply the insights emphasized by the LBOs of the early 1980s, it is important to understand why all of this is happening now.

First, the shareholdings of institutional investors continue to increase. Research shows that individual ownership of private corporations in the U.S. declined from 70 percent in 1970, to 60 percent in 1980, to 48 percent in 1994. Individual ownership of public companies is even lower.

“This means that sophisticated shareholders – who like higher stock returns – own an increasingly large fraction of U.S. corporations,” says Kaplan.

Second, in 1992, the Securities and Exchange Commission (SEC) substantially reduced the costs to shareholders of coordinating challenges against underperforming management teams by relaxing the proxy rules regarding shareholder communications.

The third reason for the corporate governance changes is the SEC's requirement, also imposed in 1992, that public companies provide more detailed disclosure of top executive compensation and its relation to firm performance, particularly stock performance.

“Given the developments we see today, it seems likely that institutional investors and boards will continue to apply LBO insights and work for shareholder value in the U.S. in the future,” says Kaplan.

And with the clear successes of the U.S. capital markets over the last 15 years, Kaplan believes that other countries, such as Germany and Japan, have begun to move their systems closer in line with the U.S. market and corporate governance system.

“Many people have criticized the 1980s, saying that the takeovers were short-term oriented, that LBOs and takeovers mortgaged the future, that it was all an asset swapping game,” says Kaplan. “While everybody complained about these practices then, everybody is using them today.”

Steven Neil Kaplan is the Leon Carroll Marshall Professor of Finance at the University of Chicago Graduate School of Business.

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