Term Paper on

Unrelated Acquisitions
& Corporate
Governance

Submitted by:
Rakesh K : 9136
Ranjith P : 9137
Aravind T : 9206
Ramya K : 9238
Sravanthi M : 9246
 Contents
Introduction.................................................................................................................................................3
Conglomerate Acquisitions..........................................................................................................................4
Advantages..................................................................................................................................................5
Disadvantages.............................................................................................................................................5
Economic Perspective on Unrelated Acquisitions........................................................................................6
Corporate Governance Defined...................................................................................................................7
Implications for Conglomerate acquisitions................................................................................................7
Managerial Perspective of Conglomerate Diversification........................................................................8
1. Private Control Benefits...............................................................................................................8
2. Exploiting Managers’ Firm Specific Skills.....................................................................................8
3. Risk diversification.......................................................................................................................9
4. Conglomerate Performance under the Financial and Managerial Perspectives..........................9
Corporate Governance Case Study............................................................................................................10
Conclusion.................................................................................................................................................16
References.................................................................................................................................................16

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Introduction

Since its development during the period of industrial revolution, large scale businesses continue
to bring significant changes in financing, ownership and management patterns. New technologies
are continually innovated requiring huge investment in the industrial unit. To supply this fund,
people from different sections of the society are coming up with their savings. As a result, once a
sole proprietorship business is turned into joint stock type of organization. In such a widely-held
corporation, the risk bearing function of ownership and the managerial function of control were
separated to give the organizations a wider scope of development. This phenomenon called the
agency theory can be put in simple terms as

“A theory concerning the relationship between a principal (shareholder) and an agent of the
principal (company's managers)”

Thus there came into existence two sets of people viz., the Owners and the managers.

According to Prowse, shareholders’ preferences are to maximize the value of the firm’s
equity, without regard for the value of its debt. Creditors, on the other hand, prefer to
maximize the probability that they will be repaid, which often means the firm taking on
less risky projects than the shareholders would prefer to have. Managers prefer to
engage in activities that maximize their own return rather than that of outside financiers:
this can vary from policies that justify paying them a higher salary (for example, by
increasing the size of the firm), to the diversion of resources for their personal benefit, to
simply refusing to give up their jobs in the face of poor performance. Even different
shareholders may have different objectives. In particular, large shareholders that have a
controlling interest in the firm (“insiders”) would prefer, if they could, to increase their
returns at the expense of smaller, minority shareholders (“outsiders”).

This conflict of interests has given rise to the agency problems between owners and managers
where given the decision making discretion, managers could engage in non-value maximizing

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behavior. This agency problem inherent in the separation of ownership and control of assets was
recognized as far back as in the 18th century by Adam Smith in his Wealth of Nations, and show
the extent to which this separation has become manifest in firms throughout the world.

The conflict of interest can be observed as follows. Managers, one hand are interested in growing
the business to increase their power. On the other hand, a share holder is always interested in
wealth maximization. Most managers find acquisitions as a means to build the business empire
and thereby take more control of the firm. In doing so, they may ignore the rights and interests of
their owners, the shareholders. Sometimes managers may be willing to adopt less risky strategies
in order to keep their position safe in the company, which is against the wish of shareholders.
One way of doing this is diversifying into completely new business, which may need not
necessarily maximize the value of firm. Hence considering all these factors a need to develop
rules, procedures, and practices that govern the managers to effectively function has become
inevitable.

Thus corporate governance theory evolved as a means to guide the businesses in aligning to the
best interest of the two parties. “Corporate governance is concerned with holding the balance
between economic and social goals between individuals and communal goals. The governance
framework is there to encourage the efficient use of resource and equally to require
accountability for the stewardship of those resources. The aim is to align as nearly as possible the
interests of individuals, corporations, and society.”

Conglomerate Acquisitions

A conglomerate is a combination of two or more corporations engaged in entirely different

businesses together into one corporate structure, usually involving a parent company and several
(or many) subsidiaries. Conglomerate acquisitions involve firms engaged in unrelated types of
business.

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Advantages

 Diversification results in a reduction of investment risk. A downturn suffered by one

subsidiary, for instance, can be counterbalanced by stability, or even expansion, in another
division. In other words, if Berkshire Hathaway's construction materials business has a bad
year, the loss might be offset by a good year in its insurance business. This advantage is
enhanced by the fact that the business cycle affects industries in different ways. Financial
Conglomerates have very different compliance requirements from insurance or reinsurance
solo entities or groups. There are very important opportunities that can be exploited, to
increase shareholder value.
 A conglomerate creates an internal capital market if the external one is not developed
enough. Through the internal market, different parts of conglomerate allocate capital more
effectively.
 A conglomerate can show earnings growth, by acquiring companies whose shares are
more discounted than its own.

Disadvantages

 Synergies are illusory.
 The extra layers of management increase costs.
 Accounting disclosure is less useful information; many numbers are disclosed grouped,
rather than separately for each business. The complexity of a conglomerate's accounts make
them harder for managers, investors and regulators to analyze, and makes it easier for
management to hide things.
 Conglomerates can trade at a discount to the overall individual value of their businesses
because investors can achieve diversification on their own simply by purchasing multiple
stocks. The whole is often worth less than the sum of its parts.
 Culture clashes can destroy value.
 Inertia prevents development of innovation.
 Lack of focus, and inability to manage unrelated businesses equally well.

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Economic Perspective on Unrelated Acquisitions

Conglomerate or unrelated diversification may create value as a result of

 Increased market power or

 Operating an efficient internal capital market

Market power is the ability of a firm in a market to pursue anti-competitive behaviour against its
current rivals or potential entrants. This power does not derive form the monopoly in the market
but by virtue of a range of activities and the size of the firm.

A conglomerate firm, by definition, allocates investment funds to a number of individuals

businesses. If these businesses were independent, they would be receiving such funds directly
from the capital markets – banks or equity markets. The conglomerate firm thus performs capital
market function. Where it performs this function more efficiently than the external capital
market, it can create value. Below are the condition under which this internal capital market
functions efficiently.

Conglomerate’s and Market Power

Economists have identified 3 ways in which conglomerates may yield power in an anti-
competitive manner.

 Cross-subsidizing
 Mutual forbearance; and
 Reciprocal buying

A conglomerate firm can follow a predatory, initially loss-making, pricing policy in a product
market in which one of its division is competing and finance this strategy with the profits it
generates in its other markets. This type of cross-subsidy, of course, requires ‘deep pockets’
which may be provided by the size and range of activities of a conglomerate. A single business
firm competing in only that market will then be at a disadvantage. Once the firm sees off such a
competitor and consolidates its market power, it can shift to more monopolistic pricing, recover
the initial losses and replenish its reserves before trying this strategy elsewhere.

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Where competitors meet in several markets and their relative competitive positions in some
markets are minor images of their positions in others, they may recognise their mutual
dependence and adopt a policy of live and let live. A single-business competitor will not enjoy
such forbearance and may be driven out. The remaining competitors bound by the live and let
live code will then compete less vigorously among themselves. From mutual forbearance
conglomerates may move to mutual support through reciprocal buying and selling among
themselves in different markets. One conglomerate buys from another through one division but
sells to the other through another division. In both markets other suppliers will be kept out.
Greater diversification into a number of markets increases the market for reciprocity. This
essential code is transformed from live and let live to let us live together and bash the smaller
guys.

Corporate Governance Defined

Corporate governance includes the structures, process, cultures and systems that engender the
successfull operation of organisations and mechanisms to cope with these elements. A much
broader functional definition is provided by the Organization for Economic Cooperation and
Development (OECD) describing corporate governance as:
“… a set of relationships between a company’s management, its board, its shareholders and
other stakeholders. Corporate governance also provides the structure through which the
objectives of the company are set, and the means of attaining those objectives and monitoring
performance are determined.”

Implications for Conglomerate acquisitions

There are several implications of conglomerate acquisitions. It has often been seen that
companies are going for conglomerate acquisitions in order to increase their sizes. However, this
also, at times, has adverse effects on the functioning of the new company. It has normally been
observed that these companies are not able to perform like they used to before the acquisition
took place.

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This was evident in the 1960’s when the conglomerate acquisitions were the general trend. The
term conglomerate acquisitions also implies that the two companies that are merging do not even
have the same customer base as they are in totally different businesses.

It has normally been seen that a lot of companies that go for conglomerate acquisitions are able
to manage a wide variety of activities in a particular market. For example, these companies can
carry out research activities and applied engineering processes. They are also able to add to their
production as well as strengthen the marketing area that ensures better profitability. It has been
seen from case studies that conglomerate acquisitions do not affect the structures of the
industries. However, there might be significant impact if the acquiring company happens to be a
leading company of its market that is not concentrated and has a large number of entry barriers.

Managerial Perspective of Conglomerate Diversification

1. Private Control Benefits

Managers may take conglomerate acquisitions to increase firm size for compensation and
non compensation reasons. If managerial compensation increases as the firm becomes larger,
managers have the incentive to make the firm grow through acquisitions. Empire building or
megalomania may drive acquisitions. It is not unknown that, for some CEO’s acquisitions are
ego trips. Size may also confer the private benefit, such as power, status and high public profile,
and the ability to indulge their personal passions paid for by their company. Consumption of
benefits outside formal compensation packages may also increase with firm size.

2. Exploiting Managers’ Firm Specific Skills

Managers invest in developing their skills while working for a firm. As their association with the
firm lengthens, the more firm specific the skills become. These skills may be valued less outside
than in their current employer. Thus managers have an incentive to entrench themselves and
increase the demand for those skills within the firm. In order to entrench themselves managers
invest beyond the value maximizing level. Such investment often takes the form of conglomerate

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diversification. As firm grows and mature, profitable opportunities to invest in the same business
or in related businesses become scarce and managers tend to pursue increasingly far flung
opportunities.

3. Risk diversification

The risk reduction view of conglomerate diversification even has a managerial dimension.
Unlike stockholders, managers hold undiversified portfolios with overwhelming concentration in
their employer firm. In addition to their human capital, much of their financial capital in the form
of stock options or shares held in Employee stock owner ship plans is also invested in the
managers’ own firm. This skewed distribution of their investments increases the risk exposure to
the volatility of their firm’s earnings and their bankruptcy risk. They have an incentive to reduce
this exposure through risk-reducing conglomerate acquisitions and weak agency monitoring by
dispersed shareholders permits this behavior. Thus although, stock options and stock ownership
plans are motivated by the need to align stockholder and managerial interests, they may also
provide the incentives to managers to pursue risk reduction strategies, possibly leading to value
reduction rather than value addition.

4. Conglomerate Performance under the Financial and Managerial Perspectives

While agency and pure managerial considerations lead to the prediction that conglomerate
acquisitions will fail to create, and many even destroy, value, the pure financial rationale of
providing an alternative to stock portfolio diversification may add value under certain conditions.
Bankruptcy risk reduction may be a source of added value.

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Corporate Governance Case Study

The world's biggest, most successful companies, advised by highly educated Wall Street
investment bankers, are leaders of today's failed acquisitions, acquisitions and downsizings. A
recent example is the acquisition of Sterling Drugs by Eastman Kodak. This deal was done
because some analysts at Kodak headquarters figured, “We use chemicals in processing film, and
they use chemicals in making drugs–hey, that's synergy!” (Marks, 2003, p. 57). There proved to
be no synergy between the firms, and Kodak eventually divested its interest in Sterling, resulting
in a financial loss. In light of such dismal performance by the “experts”, can the success rate be
improved? Is this process an opportunity for those in leadership to challenge their current
thought process? Faulty strategy and economic forces are regularly blamed for the dismal
performance, but if you trace the causes back to their roots, people issues often figure
prominently in the failure of reorganization (Donahue, 2001, p. 3). The need for senior managers
to challenge their own ways of thinking about these transactions is at the center of Mitchell
Marks' book.

This case study shows how informed and involved shareholders may add value to their target
companies.

Eastman Kodak Company

Eastman Kodak Company (NYSE: EK) is a multinational US corporation which produces

imaging and photographic materials and equipment. Long known for its wide range of
photographic film products, Kodak is re-focusing on two major markets: digital photography and
digital printing.

Sterling Drug

Sterling Drug was a global pharmaceutical company based in the United States, known as
Sterling-Winthrop, Inc. after the acquisition with Winthrop-Stearns Inc. (which itself resulted
from the acquisition of Winthrop Chemical Company Inc. and Frederick Stearns & Company)
and then as Sterling Winthrop Pharmaceuticals, whose primary product lines included diagnostic
imaging agents, hormonal products, cardiovascular products, analgesics, antihistamines and
muscle relaxants.

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In 1988, Sterling was acquired by Eastman Kodak for $5.1 billion. The after consequences are
as follows

July 1992. (Stock Price, 7/1/92 – $40.50)

Eastman Kodak first selected as a LENS “focus” company. Kodak was unnecessarily diversified
into non value-adding businesses, with a record of long-term under-performance. Kodak’s
problems included:

Debt: Kodak’s balance sheet has deteriorated seriously over the last ten years. As of late 1992,
Kodak’s total debt stood at $10.3 billion, having doubled since 1988. The ratio of debt to total
capital was nearly 60 percent.

Unrelated diversification: The $5.1 billion acquisition of Sterling Drug in 1988 has never
produced the anticipated returns. Analysts speculated that the money-losing copier division could
also be sold.

Long-term under-performance in its core businesses: According to Business Week, “The

Company angered Wall Street by assuming that the slowdown in its core photographic market in
the 1980s was only temporary. Its cost structure was predicated on a return to growth that never
materialized.” Contrary to analysts’ predictions, Kodak assumed growth in its core photo
business of 6–8 percent. Actual growth was nearer 2–4 percent.

Poor long-term strategy: Since 1982 Eastman Kodak has undertaken four separate restructurings,
including billions of dollars in write-offs. Yet (according a PaineWebber market analyst) the
company has under-performed the S&P 500 Index by 200 percent since 1982. During the last
decade sales growth has been at an annual rate of 6.7 percent, but earnings, which in former
times were running around $3.00 per share, had dropped to virtually break even in 1991. Over
the last four years Kodak has spent $5.2 billion on R&D, and has made $8.2 billion of capital
expenditures. Long-term debt increased $5.2 billion, total debt $6.1 billion, and shareholders’
equity rose by less than $100 million. Management has not been able to convert massive
expenditures into additional value for shareholders, despite the several restructurings.

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August 1992 (Stock Price, 8/3/92 – $43.37)

LENS Principal, Robert A.G. Monks wrote to Kodak’s CEO, Kay R. Whitmore, identifying
Kodak as a company where the involvement of credible shareholders could add value. Monks
wrote:

In Eastman Kodak’s 1991 Annual Report you [Mr. Whitmore] describe the company’s
underlying precepts: “We will not participate in a market or enter into a business simply because
we possess the technical competence to do so. Our goal is the number one or number two
positions in markets where rates of return consistently exceed the cost of capital.” It is not
apparent that Eastman Kodak’s position in chemicals, drugs, or copying is at the top of their
respective industries; nor is there indication of progress towards that goal in the performance of
recent years; it is clear however that the rates of return achieved are not among the leaders. . . .
Kodak still has the dominant position in photographic markets throughout the world, but
competition is growing. Is it better able to confront its formidable competitors in that field as a
diversified conglomerate or through the focused creation of a competitive corporate culture?

November 1992: (Stock Price, 11/2/92 – $41.37)

Three LENS Principals met with CEO Kay Whitmore and other senior managers to discuss
Kodak’s competitive position. Both sides agreed that the meeting was frank and constructive. In
a letter following the meeting, LENS outlined its specific concerns with the company’s strategic
direction:

The financial results of Eastman Kodak in recent years could objectively indicate to an outsider
that management has:

 Followed a policy of building an empire measured only by gross size;

 Thrown larger and larger amounts of money at Kodak’s core problem – competition for
market share – seemingly without a strategy;
 Invested heavily in diversification in an attempt to sustain corporate growth and restore
shrinking margins; and,
 Allowed the development of a vast bureaucracy;

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Kodak’s diversification efforts have been generally unsuccessful to date. Cost of acquisitions,
and of the huge research programs and capital budgets, have been financed by a nearly five-fold
increase in debt, while shareholders’ equity has remained flat. Growth has remained slow, and
margins have fallen drastically, Management has taken six special write-offs, totaling $4.7
billion, in less than eight years, with little or no improvement in margins.

The letter was accompanied by a detailed financial plan (available on request) outlining a six-
point plan for improved shareholder value:

 Increasing the realization on assets and sales

 Resuming earnings growth
 Shifting the usage of cash flow to reduce debt and allow dividend increases as soon as
prudently possible
 Restoring the company’s financial strength by reducing debt,
 Focusing the attention and energies of the board and the management on Kodak’s core
business, and distributing unrelated assets to Kodak shareholders.

The plan also recommended some “governance reforms” to create a constructive relationship
between the managers and owners of Eastman Kodak. The recommendations were to:

 Introduce confidential voting

 End the system of staggered board elections to provide for the annual election of all
directors;
 Improve the ratio of insiders to outsiders to provide for a genuinely independent board;
and separate the positions of chairman and CEO.

Finally, the letter said that LENS would be filing a shareholder resolution at the Eastman Kodak
1993 Annual Meeting. The resolution proposed a by-law amendment to create an advisory
committee of the company’s largest, long-term shareholders.

January 1993 (Stock Price, 12/31/92 – $40.50)

Kodak’s management took a series of steps that demonstrated a new commitment to the
company’s owners. Business Week wrote: “Insiders say Kodak Chairman Kay R. Whitmore has

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concluded that only radical surgery can rescue the company . . . ‘Shareholders have been the
most underserved of our constituents’ he confesses.” The new measures included:

The appointment of a new chief financial officer, Christopher J. Steffen:  Steffen came to Kodak
in January 1993, having helped create successful turnarounds at Chrysler and Honeywell.
Significantly, Kodak broke its traditional rule of promoting insiders, Steffen being the highest
ranking outsider appointed since 1912. His recruitment was greeted enthusiastically – Kodak’s
stock improved 17 percent in a matter of days. Business Week dubbed Steffen the “$2 billion
man” for his contribution to the company’s market value.

An overhaul of the core imaging business: In a letter to Monks, Whitmore described the strategy
as “an aggressive action plan . . . which is quite consistent with much of what we discussed when
you visited with us last November here in Rochester.” The strategy was based on an admission
that growth in Imaging would be a sluggish 2–4 percent, and that cash flow would have to be
increased in other ways. To this end, Kodak announced it was cutting R&D spending, revamping
overseas operations, and paring some 2,000 employees from its Rochester headquarters. These
measures were expected to lower net costs by over $200 million a year. The plan received
widespread approval: “It’s a belated recognition that Kodak is no longer growing its core
business,” said Eugene Glazer of Dean Witter. “This is a business strategy that really fits with
reality,” said PaineWebber’s Kimberly Retrievi.

-A new compensation plan for senior executives: The plan requires 40 top managers to buy stock
in the company equal to one to four times their current salary. Whitmore personally pledged
himself to achieving holdings of four times his current salary, or $3.8 million, within five years.
The plan was applauded by investors across the board. “There’s nothing that gets manage-ment
thinking like a shareholder than being a shareholder,” said LENS Principal Nell Minow.

A new Corporate Directions Committee: The committee will consist solely of outside directors,
and has a straightforward charter: “to assess Kodak’s competitive position and develop plans to
increase shareowner value.”

A new long-term strategy: Two weeks after his appointment as CFO, Steffen said that he
expected to have a business plan ready in about six months. He intends to cut the debt-capital

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ratio from its current 59 percent to around 30–40 percent, and he said he wouldn’t rule out asset
sales to achieve that goal. The stock jumped a further $2.63 on the news.

The response of the investment community to Kodak’s measures was very positive. By the end
of January 1993, the company’s stock had risen to $49.88.

February 1993 (Stock Price, 2/26/93 – $53.62)

As a result of the giant steps Kodak’s management took to gear the company to improved
performance, coupled with the company’s genuine desire to address shareholder concerns, LENS
agreed on February 26 to withdraw its shareholder proposal calling for a shareholder advisory
committee.

Kodak was not long out of the news, however. On April 28, just eleven weeks after his arrival in
Rochester, Chris Steffen resigned as Kodak’s CFO. Mr. Steffen found that his ideas were
perceived as too “revolutionary” when others wanted a more “evolutionary” approach. When
Steffen abruptly resigned (causing Kodak’s stock to lose an over $5 in a single day), Kodak
shareholders questioned the company’s commitment to change.

During the two-week period between Steffen’s departure and the company’s annual meeting,
investors demanded that Kodak explain why Steffen had resigned, and why they should trust
incumbent management to lead the company to success. Ultimately, many institutional holders
recognized that CEO Whitmore had not sought Steffen’s departure, and that his commitment to
change had not weakened. At the annual meeting, Whitmore spoke to shareholders about the
“constructive” and “helpful” role LENS and other investors had played over the previous year.
He said, “It provides us an external point of view that we have to listen to with care.”

Ultimately, the independent directors at Kodak were not convinced that Mr. Whitmore would be
able to fulfill the commitment made to shareholders to improve Kodak’s performance
significantly. On August 6, 1993, the independent directors announced that Mr. Whitmore would
step down upon the naming of a successor, and on October 27, 1993, they announced the
appointment of Motorola CEO George Fisher as Kodak’s new CEO. On the day of the
announcement, Kodak’s stock rose $4.87 to $63.62.

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Conclusion

References

Sudi Sudarsanam, Value creation through Acquisition’s & Acquisitions (Pearson Education)

Alexander N. Kostyuk, Udo C. Braendle, Rodolfo Apreda, “Corporate Governance” (virtual

interpress.org)

John Roberts, “Agency theory, Ethics & Corporate Governance” ( Corporate Governance
&ethics conference, Graduate School of Management, university of Australia)

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