Corporate apocalypse

Since the 1980s, dealmakers earned fees pushing firms into dodgy takeovers and spurious share buybacks. Self-interested managers abandoned long-term goals to collect rewards as share prices rose. Now that the bomb has gone off, business leaders must find a new way. Simon Caulkin points to beacons of hope in the ruined commercial landscape. Firms that looked old-fashioned in the PE era now seem bastions of long-term values. The tortoise and the hare come to mind...

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Last Updated: 09 Oct 2013

The bomb that has blown up the heart of the world's financial system was not primarily financial. It's true that finance provided the high explosive in the shape of the structured vehicles, collateralised debt obligations (CDOs) and derivatives devised by the rocket scientists of Wall Street and the City. But it needed a detonator to set them off: the unfit-for-purpose management model that has governed the way our companies work for the last 40 years.

'This is not an act of God like a tsunami or a landslide - people's actions made the crisis happen, all the way from the chairman to the dealing desk,' says Bob Bischof, an anglophile German industrialist who has advised UK governments on manufacturing.

'The crash is an astounding market failure,' notes Julian Birkinshaw, co-founder of the London Business School's Management Labs (an incubator for fresh management ideas) and LBS professor. 'But the interesting thing is that the visible hand of management failed, too. Most big companies just failed to do what big companies are supposed to do.'

They incentivised people wrongly, miscalculated risk and misallocated resources. They disastrously neglected the role of trust. They got every basic task wrong. Financial services, which should have been the most scrupulous, got them wrongest, resulting in the greatest episode of value destruction the world has ever known outside two world wars.

In the 1960s, when the new business schools were being set up, management, technocratic and neutral, was the social technology that was going to conquer the world's great problems. Hadn't Peter Drucker declared it was management's ability to amplify and aggregate human effort that had made the 20th century possible? How then has management suddenly morphed from the answer into the problem? Management guru Gary Hamel, co-founder of MLabs, says it's a kind of feudal system, whose dead hand is a giant brake on the economy's progress.

The short answer is that management was hijacked by ideology. The origins of today's events can be traced back to the 1970s and the backlash against the cosy corporatism of the 1960s, which would become 'Reagonomics'. The concern then was that after two decades of post-war easy pickings, the Western economies had gone soft. Faced with formidable competition from Japan and newly emerging Asian economies, bloated Anglo-American conglomerates needed cutting down to size, with managers obliged to focus on shareholders' rather than their own concerns.

There was some truth in the stereotype. So how could managers be forced to shape up? Reagonomics - the supply-side agenda of downsizing government, tax-cutting and deregulation - provided a powerful framework. At the height of the Cold War, this approach was strongly influenced by Milton Friedman and the free-market Chicago school.

To make Reagonomics (and Thatcherism) work, its managerial complement was equally clear-cut. The company's job was to make money for shareholders; the individual's job was to pursue self-interest, allowing the invisible hand to work its magic; and the job of governance was to align 'agents' (managers) with 'principals' (shareholders) by incentives and sanctions. The carrot was pay linked to stock price, often in the form of stock options. The stick: high levels of debt and a vigorous market for corporate control, which ensured that underperforming assets could readily pass into the hands of sharper managers at hungrier companies.

The apotheosis of this credo was private equity, whose great boast was that, under its stringent regime, managers and owners were so closely aligned that there wasn't a cigarette paper between them. And, initially, some sleepy companies were undoubtedly jerked awake as newly incentivised managers threw themselves into the agenda with gusto.

But as theories hardened into dogma and self-interest became ever more powerfully vested, two things happened. The first, says Birkinshaw, was that companies that had previously paid too little attention to market disciplines now paid too much. They forgot that companies weren't markets and had different imperatives. Instead of nurturing purpose, organisation and human capital, companies brought the market inside, buying and selling companies at the drop of a hat, hiring stars at exorbitant salaries, outsourcing and downsizing whatever they could.

A barometer of how management was changing was the emphasis on mergers and acquisitions. In 1980, M&A activity was 2% of US GDP. By 2000, it had grown tenfold to 21%. Equity-based pay for self-interested execs increased in tandem. Standard & Poor's said stock options granted to US executives in 2002 amounted to 20% of all corporate profits.

The transactions were part of the second development - the apparently alchemical discovery, as Hamel puts it, that making money no longer required boring things like plant, machines and patient organisation: it just needed money itself. This underpinned the vertiginous rise of the financial services industry, one of the wonders of the age. In 30 years, the banking, broking and insuring businesses grew from around 10% to 35% of the economies of the US and the UK, heartland of financial capitalism. Fuelled by outsized incentives and massive computing power, and unchecked by internal restraints, the creativity of bankers in inventing new instruments to expand the secondary market knew no bounds. In September 2008, behind the $40trn of outstanding global equities stood more than $1,000trn of derivatives based on them. It is these that are now blowing up under the system like depth charges.

It's worth reflecting on the enormity of what has happened here. In the 1960s, financial services were just that. 'They existed to serve the real economy', says Bischof. 'Now it's the other way round.' In a Copernican inversion, instead of bankers jumping when a large corporate wants to invest in a new plant or product, companies jump when banks or fund managers decree that it's time for a deal, a break-up or a share buyback. Companies dance to the tune not only of the dealmakers but also of hedge-fund managers, who borrow shares to vote them not in the interests of the company, but to make their bets pay off in the short term.

In many cases, of course, managers do want to dance - for the same reason bankers and fund managers do: the effect on their pay packets. In this sense, the new financial management has worked only too well. The short-term interests of shareholders and managers are perfectly aligned - but at the expense of all else, including the company itself.

A stunning testimony to the collusion of managers and shareholders to plunder the company is the spectacular growth of stock buybacks. According to one calculation, between 2003 and 2007, US companies bought back $1.7trn worth of their own shares, nearly $600bn of it in 2007 alone. And the champion buyback sector? That's right, financial services. Between them, Fannie Mae, Freddie Mac, Bear Stearns, Citigroup, Merrill Lynch and Lehman Brothers - the very same companies that are now bankrupt, bailed out or going cap-in-hand for cash from almost any source - spent some $43bn on nothing more productive than buying back their own stock. General Motors, another basket-case, has spent billions the same way.

There's no other way of saying it: today's doctrines of shareholder primacy and managerial self-interest have brought many companies to the brink of self-destruction. Alan Greenspan admitted as much when he told the US House of Representatives' Oversight Committee in October that he had erred 'in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms'.

Questioning self-interest is like a Catholic questioning Papal infallibility. But in truth, Greenspan should have seen it coming. With each crisis - Long Term Capital Management, the technology bubble and Enron in the last decade alone - it has become harder to argue that the debacle was an anomaly and clearer that it was part of the pathology of management itself. Indeed, after Enron, LBS's late Sumantra Ghoshal made the connection explicit. In a much quoted article, 'Beyond self-interest revisited (Journal of Management Studies, May 2006), Ghoshal declared that to prevent future Enrons, the business schools didn't need to put on new courses; they just needed to cancel some old ones. 'It is our theories and practices,' he charged, 'that have done much to strengthen the management practices we are all now so loudly condemning.'

No-one would claim that business schools bear all the blame. But wherever culpability lies, it is clear that the credit crunch has delivered a devastating blow to the tottering vestiges of the old managerial edifice. Already, powerful secular forces of globalisation and the internet were reshaping the basis of competition. The world recession unleashed by financial excess now threatens an entire genus of Management 1.0 corporations with extinction. Some of the banks have already gone. Plenty of hedge funds and over-leveraged private equity houses will follow.

In the real economy, the prime example is General Motors - a monument to the techniques of mass-production, hierarchy, economies of scale and marketing push that in their day were radical management innovations benefiting the consumer. But, as academic Shoshana Zuboff has eloquently described in her 2004 book, The Support Economy: Why corporations are failing individuals (Penguin), consumers no longer accept mass production and marketing push. Real-economy companies such as GM are experiencing in slow motion the same consequences of the seizing up of trust that has brought the financial world to a juddering halt. The only thing that might save them is the kind of innovation that does for cars what Apple did for recorded music, reconfiguring existing assets 'in a new way... under new leadership, with a new business model', to meet the demand of consumers for a model that puts them in charge. Unfortunately, the technologies of compliance that brought them to where they are are utterly unsuited to this task.

This is the challenge for Management 2.0: reorienting management from compliance to creativity, from flogging efficiencies out of existing resources to generating new ones, from zero-sum to positive-sum by recognising, as Hamel says, the commonsense proposition that in the long term the corporation can only prosper if employees, suppliers, the community and indeed the planet do too.

What would such a management look like? Some clues surfaced at a gathering of practititioners and theorists convened by Hamel and Birkinshaw last May at Half Moon Bay, California, with the ambitious aim of 'inventing the future of management'. A tall order for a two-day meeting, but tentative conclusions emerged - some quite surprising.

First, many of the 'grand challenges' put forward in the discussions - the need for companies to articulate a purpose beyond making money (a conference near-consensus), distributed leadership and strategy- making, the fostering of community and citizenship, building trust - are not new at all. It's more that they have been driven to the periphery of management concerns by the treadmill of Management 1.0.

Given research by Arie de Geus, Jim Collins and others indicating that purpose-driven companies do better for shareholders than profits-driven ones, there are questions on why companies (and advisers and academics) have been so slow to investigate different models. Tools and techniques for harnessing the 'wisdom of crowds' - crowdsourcing, information markets, virtual worlds and games - will emerge from Web 2.0. Getting to the promised land may be as much about stopping doing old things as inventing new ones. As Stanford's Jeff Pfeffer told the meeting: 'We need an implementation as much as an innovation engine.'

Second, when you look for it, there is quite a lot of Management 2.0 about. For instance, the five companies present at Half Moon Bay included an Indian outsourcer (HCL Technologies), a high-tech global manufacturer (WL Gore), the world's fastest-growing retailer (Whole Foods Markets) and a leading design company (IDEO), as well as a manufacturer of green toilet products (Seventh Generation). There are plenty of others. The granddaddy of Management 2.0 firms is Toyota, the exactly reversed image of GM: employing market pull rather than marketing push, economies of scope rather than scale, putting workers rather than computers in control of the work.

In the UK, one would single out John Lewis and other employee co-owned companies, including Eaga, a quoted social enterprise, and consultancies such as Arup. Companies that looked terminally old-fashioned during the private-equity era now seem like bastions of commitment to long-term values. (The fable of the tortoise and the hare comes to mind). For instance, conspicuous risers in our Most Admired Companies list for 2008 are Unilever, Diageo and Stagecoach (see last month's MT).

Even financial insitutions are getting in on the act. Zopa.com, a small online intermediary between savers and borrowers, is Management 2.0 in microcosm - redefining a service, making it easy for customers to pull what they need, almost eliminating intrusive management bureaucracy.

What do such companies have in common? First, incorporation of broader societal concerns. 'Democracy gives companies huge latitude, not least in terms of limits to its liability, and is entitled to expect something in return,' says Hamel. This can take many forms, from direct social enterprise to Whole Foods' view of customers, suppliers, community and company as a system to be optimised as a whole.

Second, they have a determination to make their own rules. Strikingly, none of the Half Moon Bay CEOs had a business education, and all emphasised the paradoxical benefits of having to decide for themselves, seeing strong advantage in not following conventional wisdom.

Third, governance for them is based on strong internal values rather than an external rulebook. 'Do we need more control in financial services? Yes,' says Hamel. 'How do we do that? It has to be internalised.'

Terri Kelly, CEO of Gore, which has little hierarchy, no rulebook and where no-one can tell anyone else what to do, maintains that, especially in difficult times, the best governance is having 8,500 fiercely motivated associates with no fear of challenging leaders, and leaders who know they can't rely on power or status to keep followers in line.

Fourth is trust - an abused word, but without which no lasting relationship is possible. Reinstating requisite trust between investors, consumers, suppliers and company is an essential part of Management 2.0.

Finally, there's a preference for intrinsic reward - the work itself - over extrinsic reward. Gore, for instance, emphasises that pay has to be fair internally before it is benchmarked externally. Whole Foods, otherwise a fiercely competitive (and quoted) company, boasts an egalitarian pay structure in which no-one gets more than 19 times the lowest paid.

This list is not exclusive: finding ways to break the dead hand of conventional budgeting and performance management is high on the Management 2.0 agenda. None of it will be easy - particularly in today's climate, when the kneejerk tendency will be to intensify measures that give the illusion of control but risk making matters worse. Vested interests remain formidable, and getting leaders to unlearn the principles that have got them to the top under the old management rules will be tough.

Yet there is optimism in the air. 'We're at a very, very interesting stage,' says Hamel. 'In the creative economy, ingenuity is the only currency that pays. That means the values of freedom, openness and community have to permeate management. I have no doubt that we're about to witness a management revolution as powerful as that which created the industrial age.'

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