Duke, Richard M.

Kuhlman, John M.

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A Concept of the Conglomerate Firm

St. John's University School of Law

St. John's Law Review Volume 44 Number 5 Volume 44, Spring 1970, Special Edition Article 11 December 2012 A Concept of the Conglomerate Firm John M. Kuhlman Richard M. Duke Follow this and additional works at: https://scholarship.law.stjohns.edu/lawreview Recommended Citation Kuhlman, John M. and Duke, Richard M. (1970) "A Concept of the Conglomerate Firm," St. John's Law Review: Vol. 44 : No. 5 , Article 11. Available at: https://scholarship.law.stjohns.edu/lawreview/vol44/iss5/11 This Symposium is brought to you for free and open access by the Journals at St. John's Law Scholarship Repository. It has been accepted for inclusion in St. John's Law Review by an authorized editor of St. John's Law Scholarship Repository. For more information, please contact selbyc@stjohns.edu. A CONCEPT OF THE CONGLOMERATE FIRMJOHN M. KUHLMAN*RICHARD M. DUKE**An apparent lack of relationship among the product lines of conglom-erate firms creates a conceptual problem for those who wish to analyze theirbehavior. Generally, the growth of the conglomerate firm over a period oftime produces a record of seemingly unrelated acquisitions and examinationof the order in which they were made often fails to provide any sense of acorporate objective or rationale in terms of product lines.It is the purpose of this paper to present a concept of the conglomeratefirm that explains the apparent illogical nature of its product diversity andits acquisition record. This concept focuses upon the objectives of the con-glomerate firm, and not upon the price-cost relationships of its specificproducts. The intent of this paper is to develop this concept; the formulationof hypotheses and the results of testing them with data are not includedhere.The central theme of this paper is that in the development phase theconglomerate firm is financially oriented, rather than product oriented, andthat its primary objective is rapid growth of earnings. If successful, theconglomerate later enters into a mature stage in which its top managementdevotes less attention to acquisitions and more to existing product lines.The following discussion places more emphasis upon the developmentphase because it is in this phase that the behavior of conglomerates makesthem appear different from other firms and creates the problem of an ap-parent lack of rational economic behavior.THE DEVELOPMENT PHASESeveral behavioral aspects of the creation and development of conglom-erates follow from the propositions that conglomerate management is finan-cially oriented and that its primary objective is very rapid growth of earn-ings. As long as the primary objective is very rapid growth of earnings,conglomerate management must make acquisitions, for they do not allowthemselves the time to build new capital facilities, produce new products,and then establish a place for them through promotional campaigns. Fur-thermore, in order to realize their primary objective, conglomerate manage-ment must make acquisitions at a rate that increases its earnings rapidlyenough for the firm to become acknowledged as a "growth" company. This* Professor of Ecooomics, University of Missouri School of Business and Public Admin-istration. B.A., Washington State University, 1948; M.S., University of Wisconsin, 1949;Ph.D., University of Wisconsin, 1953.** Staff Economist, Federal Trade Commission. B.A., The College of Wooster, 1953;M.A., Yale University, 1954; Staff Economist, Antitrust Division, U.S. Department ofJustice, 1962-1965. The views expressed in this article are those of the authors and donot necessarily represent the views of the Federal Trade Commission.ST. JOHN'S LAW REVIEWmeans that the developing conglomerate will make many more acquisitionsin a few years than a more traditional firm.In order to achieve its desired rate of acquisitions, the conglomeratedoes not limit itself to acquisitions that can be financed by retained earn-ings; instead, the growth of a conglomerate is a financial pyramiding oper-ation. The original assets are used as a base for acquiring additional assets,and the enlarged asset base is used, in turn, to make more acquisitions.'Thus, the conglome-ate firm. builds a financial structure upon its asset basewhich will maximize its capacity to acquire other firms and thereby max-imize its rate of short-term growth.2As a result of the emphasis upon the utilization of the firm's asset basefor financial leverage, the management of the conglomerate values potentialacquisitions in terms of financial criteria rather than operational criteria.The value of an acquisition is in its capacity to contribute to the conglom-erate's financial base rather than in its product lines and their relation tothe products of the acquiring firm. The conglomerate management is pri-marily interested in the effect of the present acquisition on its ability tomake future acquisitions.Several consequences follow from this emphasis:(1) Conglomerates tend to make acquisitions on a more opportunisticbasis than do production-oriented firms or firms engaged in an orderly pro-gram of diversification. Consequently, conglomerate management will beless concerned with such subjects as distribution systems and the need toreconcile those systems. It will have little or no reason to relate the productsof the acquired and acquiring firms.Conglomerates, instead, generally seek firms that are profitable3 orundervalued, or possessing a low price-earnings ratio, large cash reserves, orunutilized tax credits of one type or another. What is sought, in effect, is afirm with a financial position which will permit the conglomerate to en-large its financial base in greater proportion than the increase in the assetbase. It is this increase in the financial base which pernits further ac-quisitions. Thus the criteria for profitable acquisitions is to be found in theeffect of the merger on the financial base of the conglomerate. This criteriais in contrast to the mergers of the production-oriented firm, which measuresthe profitability of a merger in terms of its effect on the long-term oper-ational profit of the firm.1 The concept of the financial base used here is slightly different than that in E.ROBINSON, THE STRUCTURE OF COMPETITIVE INDUSTRY (1958). His optimal financial unit isrelated to the cost of production and is defined in terms of average cost and output. Inthe present instance, the financial base is related to the growth of the firm.2 Over a succession of time periods, the conglomerate may be borrowing in both thelong- and short-term financial markets, selling equity securities, buying property andleasing it to others, selling property and leasing it back, and so on. Some of the strategies,such as the sale of property and lease-back contracts, may be costly in the long run, butin the short run they provide an immediate expansion in the firm's financial base.3 BuREAu OF ECONOMICS, FTC, ECONOMIC REPORT ON CORPORATE MERGERS 97 (1969).CONCEPT OF THE CONGLOMERATE FIRM(2) The management of the conglomerate firm is financially oriented.In many instances the personnel of the acquired firms continue to providethe operational management. This is particularly true of the conglomeratefirm in the initial phases of its acquisition program. In such an instance, thewould-be conglomerate may have little in the way of operational manage-ment skills. Thus its first acquisitions will, of necessity, have to be managedby the management personnel associated with the acquired firm, while thetop management of the conglomerate devotes most of its attention to con-sidering possible acquisitions and to negotiations.(3) In order to maximize its short-term growth, the conglomerate makesthe maximum use of its financial capacity. In other words, it operates towardthe margin of its financial base. Unused financial capacity is regarded as awasted resource. In contrast to the traditional firm, capacity in the case of theconglomerate is a financial concept. The crucial financial issue is, given anexisting stock of assets and a projected flow of income, how large a financialstructure can be supported? Further, given the assets and projected income,what structure of financial instruments will yield the optimal financial base?THE DEVELOPMENT OF A COMPLEX CAPITAL STRucTuREThe emphasis on rapid rate of growth through acquisitions requiresthat the company sustain a financial performance that will be favorably as-sessed by the financial community. The failure to do so jeopardizes thecontinued success of the merger program, and ultimately, management con-tinuity.Since the earnings-per-share of common stock is frequently used asa measure of company performance, conglomerates characteristically issuesecurities that cannot reduce this figure. These issues include debt instru-ments and equity securities other than common stock. Extensive use ofdebt as a means of financing acquisitions is indicative of the conglomerate'sgreater willingness to assume risk. But further, the use of debt lessens thethreat to the management by dissident stockholders.The percentage debt of the total capital structure of the conglomeratealso indicates what might be thought of as the maturity of the conglomeratefirm. First, a firm obviously cannot continue to increase its debt as a per-centage of its total capital structure without limit. But more significantly, itappears that at some stage in the development of a conglomerate this ratiowill decline.THE MATURE CONGLOMERATEConglomerate firms cannot continue to develop indefinitely throughacquisitions. At sone point several factors begin to take effect, each of whichserves to limit the external growth of the conglomerate. The first of thesefactors is the size of the successful conglomerate, i.e., as it grows, larger ac-quisitions are required to maintain the same relative growth rate in earnings.ST. JOHN'S LAW REVIEWA second factor is the diminished supply of companies suitable for con-glomerate acquisition. This is a result of the acquisitions made by severalconglomerates over a period of years; after a time, few desirable firms remainindependent. A third factor is the higher prices which the stockholders andmanagers of such firms will demand. Finally, the fact remains that at somepoint capital allocation decisions must be made concerning existing productlines. A time must come when the conglomerate management must decidebetween using available financial resources for acquisitions or for themodernization, replacement or expansion of capital facilites. 4 Thus, as thesefactors make it more difficult to maintain an increasing rate of short-termgrowth, the attention of conglomerate management will shift from thegrowth objective to operational objectives.Adversity is one force that has caused some conglomerates to enter intothe mature phase earlier than the factors just described. Conglomerates thathave encountered a decline in earnings have often sold assets in order torecover as quickly as possible. They have done this because their emphasisupon a rapid short-term growth rate during the development phase pre-cluded the initiation of cost-reduction programs to improve earnings. Fur-thermore, since conglomerate management operates near the margin of thefirm's financial base, it may be impossible to borrow funds to carry the firmthrough a crisis. Thus, the reaction to adversity by some conglomerates hasbeen not only to become less diversified, but also to change their primaryobjective toward more concern with the firm's existing product lines.CONCLUSIONSWhat we have described is a concept of a life cycle for the conglomeratefirm. It differs fron that of the more traditional firm in several respects.The most important difference is in the use of acquisitions to achieve rapidshort-term growth in the developing phase. This accounts for the apparenthaphazard nature of the product lines acquired by conglomerates. Therationale for the conglomerate is not revealed by its products but, instead,by its use of its financial base as it pursues its objective of rapid short-termgrowth of earnings. Conglomerates become highly leveraged in the process,and consequently, their capital structures often become complex. Duringthe development phase a characteristic reaction of conglomerates to a de-cline in earnings is to sell assets. This is consistent with the primary objectiveof rapid short-term growth of earnings and with their manner of realizingthis objective: an emphasis upon the financial value of assets rather thanupon their productive uses.4 Reid, Conglomerate Growth: Consistency with Economic Theory of Growth, inECONOMICS OF CONGLOMERATE GROWTH (L. Garoian ed. 1969). A similar observation wasmade by Harold S. Geneen, President of International Telephone and Telegraph, beforethe Antitrust Subcommittee of the House of Representatives. Wall Street Journal, Nov.21, 1969, at 8, col. 2.CONCEPT OF THE CONGLOMERATE FIRMAfter a time, conglomerates that survive the development phase enterinto a mature phase. For some conglomerates adversity hastened entry intothis phase, causing them to become less diversified and, more importantly,less concerned with making future acquisitions and more concerned withmanaging their existing product lines. And even if a conglomerate escapesadversity, at some point in time its management must pay more attentionto operating affairs and less to new acquisitions.It is noteworthy that this concept does not cite attempts to innovate orto achieve economies as factors important to the development of conglom-erate firms. Although these factors are not ruled out for conglomerates inthe mature phase, the development of conglomerates is viewed essentially asa process of utilizing the financial positions of existing firms in order to de-velop a larger firm through leverage. This concept allows one to regardthe development of conglomerates as, in part, a process of taking advantageof imperfections in the market for firms and in financial markets. Thisthought raises the question of whether conglomerates are more than a tem-porary phenomenon, for the imperfections in these markets may be over-come or reduced. And it raises the question of whether conglomerates con-tribute real benefits to the economy.

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A Concept of the Conglomerate Firm

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