Conglomerate organization: Competition in the Capital Market

Internal organization has an influence on competition in the capital market in three respects. First, divisionalized firms (of the appropriate kind) more assuredly assign cash flows to high yield uses. The arguments here are already familiar from the preceding chapter. Second, the divisionalized firm is well-suited to serve as a takeover agent. Acquired firms that might otherwise run slack are thereby made to operate more efficiently. Third, when the background threat of takeover exceeds threshold probabilities, prospective target firms are induced to take self-corrective measures.

1. Internal Resource Allocation

The capital market in an environment of U-form firms was earlier regarded as a less than efficacious surveillance and correction mechanism for three reasons: its external relation to the firm places it at a serious information disadvantage; it is restricted to nonmarginal adjustments; it experiences nontrivial displacement costs. The general office of the M-form organization has superior properties in each of these respects. First, it is an internal rather than external control mechanism with the constitutional authority and expertise to make detailed evaluations of the performance of each of its operating parts. Second, it can make fine-tuning as well as discrete adjustments. This permits it both to intervene early in a selective, preventative way (a capability which the capital market lacks altogether), as well as to perform ex post corrective adjustments, in response to evidence of performance failure, with a surgical precision that the capital market lacks (the scalpel versus the ax is an appropriate analogy). Finally, the costs of intervention by the general office are relatively low. Altogether, therefore, a profit-oriented general office in an M-form enterprise might be expected to secure superior performance to that which the unassisted capital market can enforce. The M-form organization might thus be viewed as capitalism’s creative response to the evident limits which the capital market experiences in its relations to the firm, as well as a means for overcoming the organizational problems which develop in the large U-form enterprise when variety becomes great.

2. Takeover 

The argument can be carried a step further by considering the effects of the M-form innovation on capital market displacement efforts. Ceteris paribus, displacement is more likely the greater the unavailed profit oppor- tunities in the target firm and the lower the costs of effecting displacement. In relation to the U-form enterprise, the M-form innovation enhances the attractiveness of making a displacement efforts in both respects.

The realization of operating economies by reconstituting a large U-form enterprise along M-form lines represents a source of potential profit gain which, in the absence of reorganization, is unavailable. The resulting eco- nomies are due to more effective resource allocation (between divisions and in the aggregate), better internal organization (a reduction in technical control loss), and the attenuation of subgoal pursuit. Unitary form organizations for which either (1) divisionalization is difficult (the natural unit is the integrated form)12 or (2) the prevailing attitudes and distribution of power among the incumbent management make self-reorganization difficult are natural takeover candidates.

Existing M-form enterprises are probably the most effective instruments for achieving displacement. For one thing, they are apt to have superior inference capabilities; the elite staff of the M-form structure may even have as one of its principal assignments the discovery of potential takeover candidates. In addition, such firms are already experienced in the organiza- tional advantages that this structure offers.

3. Systems Consequences

Unitary form enterprises that anticipate takeover efforts may attempt to shrink the potential displacement gain by making appropriate internal changes: subgoal pursuit may be reduced or, possibly, self-reorganization along M-form lines may be initiated. Such forestalling efforts are not apt to be common, however, until the probability of a takeover attempt has reached a nontrivial value. Except in U-form enterprises which have been specifically targeted for takeover, this may require that there be a relatively large number of multidivision enterprises actively surveying takeover opportunities. With only a few multidivision firms performing this function, the probability that any one unitary form enterprise will be the object of a takeover attempt is too small to warrant ex ante adaptation. Once the number of multidivision firms becomes sufficiently large, however, the effect on unitary form enterprises that are otherwise shielded from product market pressures is equivalent to an increase in competition in so far as subgoal pursuit is concerned. Selection on profits is thereby enhanced; the effects indeed may be pervasive. The argument thus reduces to the following proposition: internal organization and conventional capital market forces are complements as well as substitutes; the two coexist in a symbiotic relationship to each other.

But adaptive responses of a protective rather than a corrective kind might also appear. Although such protective responses serve the interests of incumbent managements, they are apt to be dysfunctional from the standpoint of the system as a whole. Cary (1969) enumerates the corporate devices used to insulate management from attack as follows: (1) amending the certificate of incorporation, including the abolishment of cumulative voting and the specification of super-majority requirements (for example, an eighty percent rule) to approve a merger; (2) acquiring a firm with products similar to those of the takeover agent, in order to produce anti-trust problems; (3) placing additional stock in friendly hands by making a stock acquisition of another firm; (4) restricting loan agreements by including an unacceptable change of management clause; (5) buying off a raider by using corporate funds to purchase his stock; (6) making a tender offer to its own stockholders, so as to drive up the price of its stock above the existing tender offer value; (7) raising the dividend and splitting the shares for a similar purpose; (8) applying for an injunction by claiming that rival tender offers are misleading; and (9) applying to the securities commission of a state to change requirements for tender offers in such a way as to obtain relief. That these tactics are not merely hypotheticals, but in fact have been devised as defenses to the takeover threat posed by the conglomerate, should be noted.

4. Special Relevance of the Conglomerate 

If the M-form firm is to perform the capital market policing functions described above and if, simultaneously, antimerger policies with respect to horizontal and vertical acquisitions are to remain tough, preserving the conglomerate acquisition option may be essential. Otherwise, the threat of a takeover to firms operated by moribund managements will be rendered effete; bringing every form of market organization—including the conglom- erate — under antitrust attack would have the unfortunate and presumably unintended consequence of impairing what Manne (1965) refers to as the “market for corporate control.”

But why M-form firms or conglomerates? Under conventional assump- tions that more choices are always preferred to fewer, ought not the banking system have superior resource allocation properties? Put differently, why should a miniature capital market ever be preferred to the real thing? Similarly, ought not individual banks, were they so inclined, be able to intervene actively in the internal affairs of firms — even to include the dis- placement of managements should the need arise?

There are three problems with such arguments: bounded rationality considerations are suppressed; crucial differences between internal and external controls are overlooked; and adaptive responses (given the prevailing institutional rules of the game) are neglected. Thus, were it that decision makers could be easily apprised of an ever wider range of alterna- tives and choose intelligently among them, there would be little reason to supplant the traditional market. But it is elementary that, where complex events have to be evaluated, information-processing capacities are quickly reached. As a result, expanding the range of choice may not only be without purpose but can have net detrimental effects. A tradeoff between breadth of information, in which respect the banking system may be presumed to have the advantage, and depth of information, which is the advantage of the specialized firm, is involved. The conglomerate can be regarded as an intermediate form that, ideally, optimizes with respect to the breadth- depth tradeoff.

The failure to distinguish clearly between internal and external control processes is an equally serious defect in the banking argument. The powers of internal organization that are discussed in earlier chapters are, by definition, unavailable to an external control agent — whether he be a purchaser (as in the case of the military services», a supplier (such as a bank», or a regulatory commission. Access to internal information is strictly limited and difficult, without first-hand experience, to evaluate. It is thus unrealistic for the external control agent to attempt to make fine-tuning adjustments in anticipation of prospective market developments; even ex post audits are subject to severe limitations. The control instruments that the external agent commands are likewise limited. Control over the screening-selection- promotion process is mainly denied to outsiders; indeed, extensive inter- ference by outsiders in internal personnel matters is apt to be thoroughly disruptive and have demoralizing effects.

Finally, were the banks to attempt aggressively to reallocate resources among sectors, large corporations could be expected to adapt defensively. Greater reliance on internal financing could be expected. Firms might even develop pools that bypassed the banking system.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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