Organizations and Markets

| Peter Klein |

To paraphrase Groucho Marx, would you want to take over a firm that wants you to take it over? Most corporate bidders don’t. From Derek Oler and Kevin Smith:

We investigate 401 firms that publicly advertise a desire to be acquired (”take-me-over” or TMO firms) from 1990 to 2006. Over this period the TMO “wave” lags about one year behind the acquisition wave. Most TMO firms show evidence of high debt levels as well as fundamental underperformance relative to industry peers. Although most TMO firms enjoy positive announcement period returns, they significantly underperform in the year following their TMO announcement, and most do not receive a takeover offer. Greater proportionate ownership of the firm by dedicated institutional investors is associated with greater likelihood of the firm avoiding bankruptcy, but not with greater likelihood of the firm being acquired. These results suggest that the TMO announcement is a significant signal of bad news that is not fully anticipated by the market. However, the TMO announcement does increase the odds of the firm actually receiving a takeover offer.

The paper is titled “The Characteristics and Fate of ‘Take Me Over’ Firms.”

I tell you, I’ve been looking for an opportunity to reference Henny Youngman and Groucho Marx in the same post for years!

| Peter Klein |

A special report from Knowledge@Wharton:

While the credit crunch has put a damper on headline-grabbing large buyouts, private equity firms have found other ways to discover value in the current market. In this special report, produced in cooperation with the Wharton Private Equity Club, Knowledge@Wharton looks at how funds are adapting to changes in the credit environment, what opportunities exist in the developed markets of Europe and Japan, and the ways that proposed changes in taxation may affect the industry. Also included is a roundtable discussion on setting up a first-time fund in the current market, as well as an interview with David Rubenstein, co-founder and managing director of The Carlyle Group.

Get the report here. For more on private equity see the proceedings from last fall’s AEI conference.

Incidentally, I used Jensen’s “Eclipse of the Public Corporation” in my strategy class this semester amd continue to be impressed with Jensen’s insight and prescience in that piece, now nearly twenty years old. Still an excellent introduction to the organizational economics of private equity.

| Peter Klein |

Gordon Smith shared an interesting report on a recent Georgetown conference, “The Future of the Global Law Firm.” Apparently there is a healthy literature in legal scholarship examining the boundaries and internal organization of law firms. Writes Gordon:

The participants seem to have reached a few points of consensus. First, the legal profession has changed dramatically in the past two decades and it remains under significant stress, meaning that more change is on the way. Second, the rules that constrain change (e.g., prohibition of non-lawyer ownership, rules relating to conflicts, non-competition rules) should be changed sooner rather than later. Third, the traditional legal form (partnership) is largely irrelevant to the current practice of law, even if law firms want to create an organizational structure that encourages the collegiality of a traditional partnership. Fourth, the law firms that will succeed in the future are those that get the organizational structure right.

In a follow-up email, Gordon explains that the organizational features being challenged include the partnership model, the up-or-out  ”Cravath system,” and the outsourcing of routine services (e.g., electronic discovery) to places like India. Gordon recommends Laura Empson’s Managing the Modern Law Firm for an overview of the issues. I said I thought there was some work by economists and management scholars on the economic organization of the law firm (and professional services firms more generally), but couldn’t come up with much, aside from a series of interesting papers by Luis Garicano and Thomas Hubbard (here, here, and here). Any suggestions from our readers? Is the persistence of the partnership form, for example, mainly the result of arcane professional-ethics rules or is there an underlying efficiency rationale? If consulting firms can have IPOs, why not law firms?

| Peter Klein |

One advantage of the public corporation over the family-owned firm is longevity: few family firms last beyond two or three generations. Saturday’s WSJ profiled an interesting exception: Marchesi Antinori Srl, a wine business founded by Giovanni di Pietro Antinori in 1385 and run today by Piero Antinori, 26 generations later. Some of the Antinoris’ unusual business practices:

The Antinoris have flourished in part because of their willingness to flout conventional wisdom over how a family company should be run. Instead of creating clear lines that separate the family’s interests from the company’s, the Antinoris blur the two beyond recognition. The Marquis, his wife and their youngest daughter still live on the top two floors of the 15th-century Palazzo Antinori, a few steps from the Florence cathedral, where the family has resided for the past five centuries.

The business is still run on the palazzo’s bottom two floors, and the three daughters are top executives. . . .

Though the company has a six-person board of directors — including two non-family members — the Marquis says it only meets “for formalities.” The real board meeting, he says, “happens every Sunday, when we sit down to lunch.” That often takes place in one of the family’s nearby vineyards, either in the hills of Chianti, or along the Tuscan coast.

Instead of focusing on quarterly results, the Antinoris plan far into the future, laying the foundations for a company their grandchildren can run. They have been wary of following popular business trends. The family is suspicious of growing too much, which they say can compromise quality and run a company into debt.

One should be wary of drawing strong inferences from a sample of one. Of course, as Herbert Simon once noted, a sample of one is infinitely more informative than a sample of none.

Here is the Antinori wikipedia page. are some older posts on family firms.

| Peter Klein |

Steve Bainbridge reviews the history of insider-trading litigation and characterizes Henry Manne’s classic contribution.

Here are Manne’s own reflections (in 2005) on the influence of his work from the 1960s. The new paper, “Insider Trading: Hayek, Virtual Markets, and the Dog that Did Not Bark,” suggests that the activities of insider traders, in so far as they help move stock prices toward their “true” (full-information) values, provides valuable information to corporate decision-makers facing the Hayekian knowledge problem.

| Peter Klein |

Back in grad school I was regularly hectored by a fellow student about joining the Association of Graduate Student Employees (AGSE), our local collective-bargaining association. Despite his attempt to stigmatize me as a free rider, I never joined. I didn’t think I agreed with the organizations goals, and I was sure I didn’t want to be associated with AGSE’s parent organization, the United Auto Workers (go figure). One year there was even a strike, which I found silly (I scabbed).

This semester I’m getting repeated invitations to join the American Association of University Professors (AAUP). Again, I hesitate. Of course, as an American university professor, I’m happy to see more power, prestige, and perquisites go to American university professors (OK, specifically, to me). But the AAUP has a strange agenda. Its mission includes not only protecting academic freedom and defending the role of the university in public life, but also preserving shared governance. Having spent many years in university settings, I’m convinced that shared governance is grossly inefficient, at least most of the time. There can be benefits, of course, to offset these costs, as is the case with worker-owned cooperatives and other non-standard forms of organization. But one searches the AAUP’s website in vain for any analysis or evidence on shared governance. What are the benefits and costs, relative to other feasible organizational forms? Why should professors defend this peculiar institution? (more…)

| Peter Klein |

There is a large literature on the performance effects of organizational form. Obviously, for the strategist, getting organizational form right is important only if it leads to superior performance. Of course, the empirical literature recognizes that organizational form, governance, strategy, and other key decision variables are at least partly endogenous. Still, the causal arrows are usually thought to run from strategy to performance.

Ben Hermalin was at Missouri this week to present his paper, “Firm Value and Corporate Governance: Does the Former Determine the Latter?”, which argues that good governance can be the result, not the cause, of good performance. He constructs a model in which the benefits of getting governance right are, on the margin, increasing in the value of the firm’s investment opportunities. Better-performing firms have better opportunities and hence more to gain from designing governance structures that align managers’ incentives with owners. The model is based on an agency framework and applies specifically to managerial governance, but the general problem would seem to apply to a variety of organizational problems and contexts. (more…)

| Peter Klein |

LBOs do not reduce patent activity, and the quality of patents may actually increase following a “going-private” transaction, according to a new paper by Morten Sorensen, Per Strömberg, and Josh Lerner.

A long-standing controversy is whether LBOs relieve managers from short-term pressures of dispersed shareholders, or whether LBO funds themselves are driven by short-term profit motives and sacrifice long-term growth to boost short-term performance. We investigate 495 transactions with a focus on one form of long-term activities, namely investments in innovation as measured by patenting activity. We find no evidence that LBOs decrease these activities. Relying on standard measures of patent quality, we find that patents applied for by firms in private equity transactions are more cited (a proxy for economic importance), show no significant shifts in the fundamental nature of the research, and are more concentrated in the most important and prominent areas of companies’ innovative portfolios.

I very much like this kind of work even though I’m a patent skeptic (1, 2, 3, 4).

| Peter Klein |

John Armour, Simon Deakin, Prabirjit Sarkar, Mathias Siems, and Ajit Singh add to the debate with a new dataset and a new interpretation: common-law countries offer better shareholder protection not because of the characteristics of common law per se, but because the emergence of a global common-law standard gave common-law countries a head start, a sort of network effect. Here is the paper. Abstract:

We test the ‘law matters’ and ‘legal origin’ claims using a newly created panel dataset measuring legal change over time in a sample of developed and developing countries. Our dataset improves on previous ones by avoiding country-specific variables in favour of functional and generic descriptors, by taking into account a wider range of legal data, and by considering the effects of weighting variables in different ways, thereby ensuring greater consistency of coding. Our analysis shows that legal origin explains part of the pattern of change in the adoption of shareholder protection measures over the period from the mid-1990s to the present day: in both developed and developing countries, common law systems were more protective of shareholder interests than civil law ones. We explain this result on the basis of the head start common law systems had in adjusting to an emerging ‘global’ standard based mainly on Anglo-American practice. Our analysis also shows, however, that civil law origin was not much of an obstacle to convergence around this model, since civilian systems were catching up with their counterparts in the common law. We then investigate whether there was a link in this period between increased shareholder protection and stock market development, using a number of measures such as stock market capitalisation, the value of stock-trading and the number of listed firms, after controlling for legal origin, the state of economic development of particular countries, and their position on the World Bank rule of law index. We find no evidence of a long-run impact of legal change on stock market development. This finding is incompatible with the claim that legal origin affects the efficiency of legal rules and ultimately economic development. Possible explanations for our result are that laws have been overly protective of shareholders; transplanted laws have not worked as expected; and, more generally, the exogenous legal origin effect is not as strong as widely supposed.

| Peter Klein |

Henry Manne did as much as anyone to create the modern discipline of law and economics. I refer here not only to his scholarly contributions, particularly his work on the market for corporate control and on insider trading, but also his creation of institutions (such as the original Law and Economics Center at the University of Miami) to support the emerging field. So it’s nice to see this essay by Larry Ribstein, “Henry Manne: Intellectual Entrepreneur,” coming out in Pioneers of Law and Economics edited by LLoyd Cohen and Josh Wright. (Via Josh.)

Writing when there was a theory vacuum in legal academia, Manne breathed life into corporate law by using economic principles to formulate a sweeping new theory of the corporation. Then he took his show on the road with seminars, programs and ultimately a law school to create a market for his ideas. The Chapter shows that Manne was an entrepreneur not only in bringing people and ideas together, but also in the Schumpeterian sense Manne discussed in his work on insider trading — an active participant in the creative destruction of the existing paradigm rather than merely a manager of existing ideas. Manne’s career demonstrates that, under the right conditions, a single scholar can leave noticeable ripples in the stream of intellectual history. By demonstrating that corporations, and by inference other important institutions, are best analyzed in market terms, and by creating an intellectual market for these and other economic ideas, Manne changed the way scholars, judges, regulators and others think about the role of law in society.

See also this Manne essay on the emergence of the field. And these papers by my former student Alex Padilla on insider trading. (And these cool gowns worn by the examiners at Alex’s dissertation defense at l’Université d’Aix en Provence.)

| Peter Klein |

Did you catch Henry Manne’s tribute to Louis E. Wolfson, whom Manne calls “the original corporate raider,” in the 18 Jan WSJ?

[T]he obituaries dutifully acknowledged that he was a serious and valued benefactor of children’s health care, and that he devoted himself in later life to the cause of penal reform. . . . They missed the big story. Wolfson’s contribution to human welfare far exceeded the total value of all private philanthropy in history. He invented the modern hostile tender offer. This invention, which activated and energized the market for corporate control, was the primary cause of the revolutionary restructuring of American industry in the 1970s and ’80s, and the ensuing economic boom.

Before Wolfson’s innovation, executing a “hostile” (i.e., against the wishes of incumbent management) takeover required winning a long and potentially costly proxy contest. Now, potential bidders could appeal directly to shareholders, asking them to “tender” their shares at the offered price, bypassing the incumbent management team altogether. Naturally, this outraged the business establishment — the “powerful corporate elite of the 1960s,” as Manne calls them — and pressure mounted for legislation to restrict hostile takeover offers, leading to the 1968 Williams Act, designed to protect incumbent managers by giving them time to prepare counter-offers and otherwise restricting “raiders.” (more…)

| Peter Klein |

Jim Brickley combs through the mess of Enron trial materials to examine the behavior and performance of Missouri’s own Ken Lay. His findings may surprise you:

Internal documents released through the Enron litigation allow for a more detailed examination of the activities of top executives than is typically possible. This clinical study of Enron’s Ken Lay highlights the difference between popular opinion on the role and knowledge of CEOs with that suggested by economic theory and evidence. In contrast to popular opinion, the evidence is consistent with the following three hypotheses: 1) Lay performed a role at Enron that is consistent with existing economic theory and evidence, 2) he performed this role with reasonable diligence, and 3) while he was relatively well informed about Enron at a high level, it is unlikely that he would have had detailed information on many of Enron’s transactions — including deals with Fastow’s partnerships. News analysts assert that a positive feature of Lay’s legacy is that CEOs are now spending more time monitoring the details of financial reports and internal controls. This study suggests that the opportunity costs of this change in CEO behavior are higher than these analysts suggest.

On a related note, here is an interview with Gene Fama (via Don Boudreaux) covering principal-agent issues and CEO compensation, as well as efficient-markets theory.

| Peter Klein |

I meant to blog on the newest LLSV paper (actually LLS, in this case) but never got around to it. LLSV, you’ll recall, inaugurated a stream of empirical research on the financial and economic effects of legal systems (focusing on the differences between common- and civil-law countries). The newest paper clarifies the argument and reflects on ten years of research, discussion, and debate on the role of legal origins.

Fortunately, Daniel Sokol has written some comments on the Conglomerate blog (one of my regular reads, by the way — keep up the good work, guys!). Daniel notes, wisely:

I believe that LLSV makes certain assumptions about history and political economy in legal origins that are not exactly supported by the underlying historical record. A number of scholars have attacked LLSV on these grounds. Nevertheless, I still find myself strangely attracted to LLSV. In many ways, the results are what you would intuitively expect if you were on your own to attempt to rank countries based on investor protection or other similar features. More importantly, a number of the variables that LLSV uses are a bit squishy but we have yet to come up with better cross country measurements. Indeed, as a result of the critiques, LLSV have gotten better as to how they measure shareholder protection. From a policy perspective, the key to change to various bottlenecks requires not merely a top down approach in the change of the legal system but a bottom up approach by the users of these legal systems to overcome various bottlenecks that are regulatory. This makes me believe that over time the common law/civil law distinction will be seen as a rather false one where instead you will find countries lumped into categories based on their ability to respond to local and changing conditions (even the United States, which in recent years may have created increased regulatory bottlenecks such as SOX). This evolutionary approach is what I believe holds the key to understanding how to think about law and institutions.