December 5, 2018 / 4:14 PM / 12 days ago

Breakingviews - Hadas: Conglomerates will never die

LONDON (Reuters Breakingviews) - Markets can be a costly business. Ronald Coase won a Nobel prize in economics in 1991 for pointing that out. He said that companies are created to save on transaction costs, and according to one interpretation, the savings are often large enough to justify pulling together quite diverse businesses. Problems at General Electric and the break-up of United Technologies show why that analysis is only partly right.

The ticker and logo for General Electric Co. is displayed on a screen at the post where it's traded on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., June 30, 2016. REUTERS/Brendan McDermid

If the best deal were always the one available in the market right now, the world would look rather different. Companies would rent labour and working space every day. In reality, the cost of constantly negotiating contracts often exceeds the gains from getting the best price on demand. Businesses scale up because they can spread their research, legal and management skills more widely. Bigger firms also save by bulk borrowing and by better tax management.

Coase, like most economists, purposely oversimplified human nature. Normal people could simply say that bigger teams which do many things often work better than smaller, specialised ones. They might call it a cooperation benefit or, being a little more technical, economies of multiple scales.

The gains are often subtle. It is hard to measure the value added by the cross-fertilisation of ideas, the deepening of a long-term employee’s professional skills, the ready availability of loyal experts and the flexibility on opening and closing businesses. It is even harder to count up the losses sidestepped by having to deal with fewer untrustworthy outsiders and of not being deprived of credit in tough times.

Still, those gains are big enough that many have pursued them successfully. The different enterprises of the Japanese zaibatsu, the Korean chaebol and Turkish and Indian groups such as Koc and Tata, have profited by working together both formally and informally. The gains of staying close are often especially large in developing economies, where credit, trust, expertise and good government relations are all very costly, if they can be purchased at all.

It can work in developed economies too. Warren Buffett’s Berkshire Hathaway and many private equity groupings claim that excellence is spreadable across many product lines. Consumer goods giants like Unilever and Procter & Gamble are essentially built on Coase’s premise. Paper towels and toothpaste, two product lines at P&G, may seem to have little in common, but there can be synergies in marketing, distribution and all-round competence.

Then there are times when Coase-advantages go stale. American conglomerate United Technologies said on Nov. 26 that it was breaking into three parts after considerable pressure from activist investors, and would spin off its dismembered elevator and building parts divisions to shareholders.

General Electric provides another salutatory example. In the company’s early decades, it gained greatly from spreading its electric expertise over everything from light bulbs and radios to power plants and locomotives. Managers also kept finding synergies in building up related businesses, eventually including health care, plastics and financing.

However, by the 1980s, the product synergies were fading. Jack Welch, then the chief executive, decided that GE’s main Coase-advantage was management expertise. He thought that brilliant buying and selling of companies, regular culls of weak executives and a shared focus on perfection in design and execution would allow the company to expand simultaneously in many businesses, including finance.

Welch was greatly lauded at the time, but he was deeply wrong, especially about finance. The failures of GE Capital have deeply wounded the enterprise. GE’s market capitalization was well over $500 billion in 2000 – now, after multiple losses, writedowns and divestments, it is less than $70 billion.

At least Welch has company. Efforts to profit from lower frictional financial costs – whether of raising money, managing risks or pleasing investors – have poisoned many companies, including a collection of conglomerates. For example, back in the 1970s the quest for savings from buying companies with expensive stock and cheap debt first fuelled and then felled such enterprises as ITT and Gulf & Western. More recently, Enron and Tyco suffered because aggressive financing multiplied the damage from vastly overestimating the gains from low-friction management.

Stories of conglomerate failure can give the wrong impression. While dreams of financial riches seem to deprive many managers of their common sense, the Coase-effect is crucial to the success of modern economies. Without the ability to bring disparate businesses and skills together, costs in most firms would be higher, revenues lower and many new and improved products would never have been created.

All big companies have something of the conglomerate about them, because they do many things. Corporate fashions come and go, and managers of companies like GE may fall prey to stultifying complexity and financial overreach. But Coase was right enough about costs that diversified enterprises, by one name or another, will play a big role in the business world for a long time.

Breakingviews

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