Sunday, April 16, 2017

Have Business Schools Ruined Capitalism?

By Roy C. Smith

Ross Sorkin’s review of The Golden Passport by Duff MacDonald raises again the question of whether Harvard Business School (and all other business schools) should be blamed for the ethical hollowing out of modern capitalism. 

Apparently MacDonald thinks so, according to the review, because in 1985 HBS hired Michael Jensen, a Chicago-trained, free-market economist from the University of Rochester, who then refocused the school’s notion of the purpose of capitalism from efficient manufacturing to maximizing shareholder value.

Michael Jensen, now an Emeritus Professor at HBS, was undoubtedly one of the more influential business school professors of his day. His seminal work on agency conflicts helped illuminate a lot of the darker niches of corporate governance in the 1970s and early 1980s when, after a decade of underperformance, American corporations attracted a tidal wave of takeovers (25% hostile) that brought the shareholder value movement to light.

It began with the “rogues” of corporate finance (hostile activists, “asset-strippers,” “greenmailers,” leveraged buyout firms, and financial entrepreneurs generally) threatening large, long established corporations with takeover offers made directly to their shareholders, bypassing management.

At first these aggressive outsiders were seen to be disruptive influences, driven only by greed to make trouble for “great American corporations,” whose management, it was assumed of course, had the best interests of shareholders at heart.

The rogues, however, explained their actions by saying that management had destroyed shareholder value through a series of mistaken actions authorized by Boards of Directors that were unchallenged by shareholders. Whenever a challenge did arise, they added, CEOs and their captive boards of directors, were able to squash it with impunity.

It didn’t take long for institutional investors that cumulatively owned controlling positions in the targeted companies to work out that the rogues had a point. In too many cases, so-called great American corporations had fallen into economic disrepair by failing to remain competitive and adapting to changes in their markets. The market capitalization of US corporations slumped in the 1970s (to less than that of Japanese corporations). It became clear that US corporations needed to be revitalized and restructured, but so did the mechanism of corporate governance of public companies with widely distributed shareholdings.

HBS in the 1980s was closely tied to many great American corporations through its case method of teaching (requiring cases to be written with the cooperation of the corporations), executive training, job-placement and fund raising.  But it was also expanding its notion of business education to include financial services and investing institutions, and Jensen’s arrival helped to create a platform for scholarly examination of some of the issues that emerged with the takeover boom.

One of these issues, in which Jensen specialized, was agency conflict, i.e., the conflicts of interest that are inherently present in relations between shareholders (owners) and managers (agents). Owners, of course want to see the maximization of value of their investment over time and after taking business risks and obligations into account. Owners are represented by Boards of Directors, but boards could be dominated by CEOs. CEOs, however, are not owners but agents hired to run the company on behalf of owners. Some agents see their role as maximizing the stock price over relatively short periods of time, regardless of risks and obligations, so as to profit from incentive compensation arrangements. 

Throughout the 1980s (and ever since), agency conflicts involving takeovers and control issues have been litigated extensively in the Delaware Chancery Court, resulting in a well illuminated but continuously updated pathway of what is permissible and what was not in launching and defending against unwanted takeover efforts.

At the same time, a different form of corporate organization was emerging to improve operational efficiency and to maximize returns to investors. This was the leveraged buyout in which an investor group would acquire control of a corporation, leverage its balance sheet to increase shareholder returns and then manage the enterprise to maximize value and minimize risks. There was very little agency conflict in these organizations – the ownership was concentrated into a powerful, knowledgeable group that hired managers but watched them very closely and made all the important decisions. 

Jensen was certainly important in bringing attention to these issues in corporate governance, and bringing HBS into the field.  But he was by no means alone.  At Stern, a number of finance professors, including Yakov Amihud, Edward Altman, William Allen, David Yermack, Aswath Damodaran, Ingo Walter and myself, authored books and papers on various aspects of these issues, contributing to a wider national effort to better understand and balance-out the roles of Boards and managers.  

The Golden Passport, aims to persuade readers that despite its great success in recruiting great students and faculty, and in maintaining important working relationships with corporations, it has lost its soul to corporate greed and recklessness epitomized by an overwhelming emphasis on maximizing shareholder value above all else. This is absurd - neither Harvard not any other business school has done that.

On the contrary, business schools such as HBS and Stern have contributed knowledge and insight into how corporations maintain their competitiveness, the pros and cons of takeovers, how leveraged buyouts should be structured to work best, and how corporate boards and their critics can agree on practical ways to minimize agency conflicts going forward.

These are important contributions and we should be proud on them.

Note: The author is a graduate of HBS.

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