Having their Cake... How the City and Big Bosses are Consuming UK
Don Young and Pat Scott
Kogan Page, £17.99
MT price £14.99 (see panel, p28)
Don Young and Pat Scott, formerly senior executives (most recently at Redland), have written a provocative book. Its central thesis is that British companies have become too close to financial markets and that this distorts their operational effectiveness.
Young and Scott identify several problems. A love-hate relationship develops between corporate executives and investment analysts. Managers are encouraged - and incentivised - to pursue shareholder value. But the share price reflects not the value of the company, but market perceptions of that value. What matters is not the quality of management, but judgments of the quality of management; not the effectiveness of a corporate strategy - that will take a long time to be revealed - but its consistency with views held in the City about the future development of the industry.
The result is a symbiotic process of managing market expectations and beliefs. Everyone is sucked into the business of guidance towards quarterly earnings forecasts, although quarterly earnings reports provide negligible information about the underlying value of the company.
None of this has anything to do with the activities that develop the business and are the only sustainable basis of shareholder value - winning the loyalty of customers, the commitment of employees, and getting value for money from suppliers. The authors describe one chief executive who receives reports on the company's share price three times a day. He is far from unique. Is he running the business or is the stock market running him?
The most disturbing result of the relations between corporations and their financial advisers is the obsession with merger and acquisitions. In the past decade, corporate strategy and corporate activity have been almost synonymous. Yet most acquisitions destroy value. Young and Scott provide an intimate description of the dysfunctional network that produces this result.
Many people who have not been on the inside of these processes - and many who have - will take particular interest in the table of fees illustrating the costs of Redland's defence against Lafarge. It shows not only the amounts received, but the extent to which each adviser's fee was linked to the price at which management would eventually give in. The remuneration of the public relations consultants was the most heavily geared of all to the price achieved.
The size of the modern corporation means that amounts that are very small relative to the value of the deal are very large in absolute terms.
That effect sucks many talented resources into the frenzied promotion of corporate deals.
But chief executives are not drawn reluctantly to the water. M&A is the mechanism by which they can demonstrate that their decisions have changed the shape of the business. We have learned how US executives were personally rewarded for placing corporate business with investment banks by receiving favoured allocations in new issues. But the greater conflicts of interest are those in the financial sector itself, between research and transactions. So it may be costly to refuse to play the market's game; senior executives upset the financial community at their peril. Young and Scott provide numerous illustrations.
The authors develop their case well. But the issues are less one-sided than their presentation allows. The analysis of Redland - which they develop in an interesting way - does not entirely support their case. Redland was a moderately successful building materials company, which grew rapidly through acquisition. Many of these transactions were probably value-enhancing: the company had better management than many of its rivals in a dull sector.
But what ultimately brought the company to its knees - and led to its acquisition by Lafarge - was not a failed merger; it was the absence of effective financial control in Redland's German subsidiary. That division's pursuit of growth at the expense of profit is precisely what central systems of financial control, focused on return on capital employed, should prevent. The demise of Redland is as much a criticism of the German model of corporate governance as the British one.
The case against Young and Scott's thesis is that much of the rise in share prices over the past 20 years has been driven by genuine improvements in productivity. Managers, oriented towards shareholder value, have attacked costs vigorously. Most of the people they criticise believe this to be true, and in many cases it is true. The authors fail to respond to that argument and don't really acknowledge its existence.
Many more case studies, and more comprehensive statistical analyses, are required to confirm the suggestive and disturbing arguments that Young and Scott put forward. But I believe they would.
John Kay is an author and economist. His latest book is The Truth about Markets (Penguin).