Corporate Restructuring and Industrial Research and Development (1990)

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Afternoon Session October 12, 1989 MR. EIZENSTAT: Let me introduce Ken Flamme Ken, as many of you know, is Senior Fellow in Foreign Polic y Studies at Brookings. He received his NB. in economics from Stanford and his Ph.D. from MIT. His most recent research has been concerned with the determinants of international trade and investment patterns in high-tech products. He has written several books in this area: The Global Factory, Targeting the Computer, and Creating the Computer. Most recently he contributed a comparative study of the rate and determinants of technological change in the computer and communica- tions industries to a Brookings publication entitled Charge the Rules, a conference volume co-edited with Robert Crandall. It examines the im- pacts of technological change, internationalization, and deregulation on the structure of the computer and communications industries. Ken is a recognized expert on technology policy in the United States and is also the author of the background paper that was distributed prior to the symposium, which gave us a very good context for our discussion. MR. FLAMM: Thank you veIy much. I basically want to tank about four things today, all of which relate to the subject of our discussions this morning. First of all, I prepared the background paper you received, and that was an attempt to summarize the existing studies on the subject that has brought us here today. I would like to talk about some evidence on a subject that was not talked about in that paper- a very brief, crude pass at some evidence. Secondly, I would like to mention briefly the overlooked factor in all 80

A[-l SWOON SESSION, OCTOBER 14 19~ 81 of our discussions here today, and that is the Federal Government itself, which has an impact on research and development in this country through its policies. It is not just Wall Street that shapes and alters the allocation of resources to research and development in this country, and I would like to tank very briefly about that. Thirdly, I would like to point out some of the major issues that came out of venous studies on the impact of takeover activity on research and development, pointing particularly to a couple of subtleties that are not always evident to the naked eye. Finally, I would like to make some brief remarks on capital costs, a subject that has come up over and over again, as linked to this entire discussion. Although I am no expert on capital costs, as a hobby I try to collect studies comparing capital costs in the U.S. and Japan. Let me just sort of dump on you my casual perspective on those, because I think some of that discussion is relevant to issues that have come up today. Without further ado, let me start in on the "new evidence" aspects. In discussions of research and development expenditure, those who argue that takeover activity has had some effect on research and development activity in general—that is, a shift toward shorter-term investment projects also almost inevitably tale about a shift within the category of research and development. The shift, they say, is away from longer-term projects, in particular, basic and applied research, toward projects with shorter-term pay-offs, that is, development expenditure. There is very little evidence on this particular point; in fact, I am unfamiliar with any. What I would like to do with you today is to briefly share with you a graphic I made up that reflects some quasi-National Science Foundation data. What I have done here is, through I hope artful calculation, filled some empty cells in the NSF data to put together a time series. [Editor's note: Mr. Flamm's graphics were rough sketches prepared dunag his talk They were not repeated for this publication because Mr. Flamm's explanations of the data are clear without them.] This graphic basically looks at company-funded research and develop- ment in various U.S. industries and attempts to calculate what percentage of that is going to research as opposed to development. If there indeed has been a shift in focus away from longer-term projects and/or shorter-term projects, the share of research declines. Unfortunately, and this is the first of a long string of "unfortunatelies," the National Science Foundation data really only go up to a relatively distant period. It is about 1985, before much of the activity we are talking about hit its peak. Nonetheless, I think it is worthwhile to point out a few salient facts. The bold line is the average for all industries. These data are also broken out by industry, in terms of research share—that is, companies'

82 CORPORATE RESTRUCTURING funds for research as a share of all funds for research and development. What I would like to point out is that overall, for all industry, the trend has actually been pretty flat but for particular industries there has, In fact, been some evidence of slight decline. However, it seems to have preceded the really dramatic increase in takeover activity in 1984, 1985 and 1986. Overall declines in the machinery industry, in the chemical and refining industry, pharmaceuticals, and instruments were offset by increases in the share of research in company R&D funds in the aircraft and missiles industry aerospace- and In electrical equipment other than communications equipment. I would point out in passing that those are both sectors that enjoy heavy government procurement. There has been a big increase In defense spend- ing, so one interesting hypothesis that perhaps goes with the observation that government procurement can be a driver for company research as Frank Lichtenberg in particular has pointed out in his work is that the rise of defense spending around this period may have played some role in the increase in research in those industries. But to make a long story short, there is not a great deal of evidence to suggest a steep decline associated with the rise in takeover activity, although obviously these data are very limited. The second thing I wanted to point out is that when we are tattling about how the Federal Government can influence research and develop- ment activity in this country, clearly one avenue is policy aimed at regulating or restricting takeover activity. That is certainly the focus of much discus- sion today, but I would just like to point out that the Federal Government funds a substantial amount of research and development activity in indus- try. In the process of going through some recent figures, I was struck by the relatively large percentage of research and development resources in industry that are absorbed in government-related work. That, of course, immediately raises the issue, is there some way to make this substantial federal investment in research and development more relevant to the competitiveness concerns we have been talking about? I would just like to note that overall, something like 18 percent of basic research carried out within industry is funded by the Federal Government. Of course, there is a substantial variation across industries with aircraft and missiles and electrical equipment showing relatively high percentages. Non-manufacturing, somewhat surprisingly to me, is extremely high. I am not sure what is in there exactly, but this is a pattern that emerges in many of these statistics. Just for the record, here is applied research: similarly relatively high percentages, particularly in the machine industry, and the computer in- dustry obviously accounts for much of machinery. And, finally, even in development you find a substantial amount of resources being absorbed in

AFTERNOON SESSION, OCTOBER 19 19~ 83 work for the Federal Government. The overall average is about 36 percent, ranging from about 3 percent to 78 percent. Again, federal funds in the chemical and pharmaceutical industries are not as notable; the Federal Government plays a relatively small role, as opposed to aerospace, electri- cal machinery and other industries. "A lot of variation across industry" is a message that perhaps ought to be stressed more in today's discussion. That is it for the viewgraphs except one. The third thing I wanted to do today is to point out some of the subtleties in the empirical evidence on the impact of takeovers on research and development activity, which may have been glossed over to some extent in some of the discussion we have heard thus far. Without having to actually do this research, it is easy to read and criticize other people's studies and point out shortcomings. But if you look at the arguments about takeovers, it is not clear that all merger and acquisition activity is created equal. Certainly, some of the arguments by opponents of leveraged takeover activity, in particular, hinge on the impact within a company of the increase in leverage on research and development activity. By and large, the empirical studies that exist do not attempt to dis- tinguish between firms that greatly increase their leverage as a result of takeover activity and those that do not. Yet this, it seems to me, is a variable you would want to look at if you were interested in that particular proposition. So I would argue there is a considerable amount of research that remains to be done if these things are to be nailed down quite firmly. A similar comment applies to some of the work associated with the views of Michael Jensen and his colleagues, who argue that hostile takeovers in particular are a vehicle for reorienting management to the stockholder interest. Obviously, friendly takeovers in particular, management buy- outs—ought to be regarded as a somewhat different animal than a hostile takeover, if the intent of the activity is not to reorient or replace existing management. If one wanted to look at the impact of hostile takeover activity on research and development, one would want to distinguish between hostile takeovers and non-hostile takeovers. Again, it is not clear that all merger and acquisition activity is equal if you are looking at the arguments which lie behind the assertion that takeovers are either good or bad. The second point that I think is subtle, but well worth making, is that by and large the data show that there is no strong evidence that research and development intensity declines as a result of takeover activity that is, that the ratio of research and development expenditure to sales declines. In fact, there is even some evidence that it may increase. However, it is not at all clear that this is the same as saying that takeovers have no effect on research and development. Why? Because it is entirely possible that you could have stable or even rising research and development intensity, yet have an aggregate volume of research and

84 CORPORATE RESTRUCTURING development that declines, in particular if the size of the firm declines. Now, since much of the literature on takeover activities suggests downsizing of the firm in the wake of a takeover, it therefore seems clear that it is not quite right to equate research intensity with the aggregate size of research and development activity. Some of the confusion, I think, about empirical evidence on the subject comes from making statements about research based on one variable or the other when really they can behave quite differently. In particular, I would argue that it is quite likely that some of the apparent discrepancies between the studies produced by the National Science Foundation and the studies produced by academic researchers hinge on this distinction between research intensity and the aggregate level of R&D. This point is particularly important because both the schools of thought on the subject essentially argue that some decline in research and devel- opment activity is likely. Those who believe that takeovers are a positive development argue that unprofitable projects are being eliminated and that some of those projects undoubtedly are research projects, and that therefore you would expect research to decline. Those who believe that increased leverage causes declines in research and development activity and who view this as a negative development for the United States, also argue that takeovers cause declines in the total volume of research and de- velopment. Both sides seemingly concur on the proposition that takeovers should cause declines in the overall level of research Well, that, of course, raises an interesting question. If this is true, why is it that most of the empirical studies seem to show no such relationship. The answer, as I pointed out a moment ago, is that most existing empirical studies look at research intensity, not the overall level of research and de- velopment. These two seemingly intractable and contradictory propositions can in fact be reconciled. A third subtlety which is important, very difficult to grapple with, and in some sense the crux of the matter, is that those who argue that takeover activity has basically served a positive function, argue that much of the positive function has been exercised through what you might call demonstration effects. That is, even if you are not subject to an actual takeover attempt, you will look at your colleague at the company next door who was, and you get to thinking, maybe I ought to be thinking a little bit harder about what I am up to. In all of the empirical studies which I reviewed in the background paper prepared for you, the methodology basically boils down to comparing firms that are merged or taken over with firms that are not merged, not taken over, with different definitions of merger and takeover. But in comparing those two groups, you get no handle on whether demonstration effects may have been important That is, both groups may have declined and there

Al-1~-~OON SESSION, OCTOBER 14 19~ 85 may be no obvious difference between the two groups that is evident after the decline. Yet it still somehow may be a product of buyout and takeover activity. This is another subtle point that I think is very difficult to deal with; as I understand it, Bronwyn Hall is in the process of working on a study that will deal with it. I look forward very much to hearing the results of her investigations on the whole issue of demonstration effects. The anal point I would like to make today relates to capital costs. I would like to reiterate the kinds of connections that Margaret Blair was making earlier in her questions today. Along with her colleague and mine, Bob Litan, at Brookings, she has been making what I regard as quite a plausible argument. I would like to briefly sketch out that argument in a way that perhaps is a little differently stated than you have seen thus far. I think it can be best visualized in a diagram. The diagram looks something like this. Let us imagine for a moment that real capital costs have risen quite sharply in this decade. Of course, it is not going to take a lot of imagination to assume that; real capital costs have gone up. I am not really doing justice to the first part of this argument. I urge you all to consult a very interesting paper done by my colleagues Blair and Litan at Brookings, which spells it out in much greater and much more persuasive detail than I possibly could. The bottom line is this. As real capital costs go up, what should the impact be on a rational businessman? The answer is, longer-term projects like research would suffer, presumably because the hurdle rate would go up and they would be much more affected than shorter-term projects. Therefore, in general we expect long-term projects of various sorts, and in businesses that were being developed with long-term expectations in mind, to decline. Presumably research would be especially impacted particularly more basic kinds of research because of the long-term nature of that kind of activity. According to this scenario—and here is where it ties in with Michael Jensen's arguments on the salutary effects of takeover activity if we are coming from a world of relatively low capital costs, into a world of relatively high capital costs, one would expect pressures on companies to adjust, that is, to cut back on the longer-term projects and to divert more of their attention to shorter-term projects. In this world of higher capital costs, some companies perhaps would take longer than others to adjust. As a result, you would then expect pressure on the part of the stockholders to speed this adjustment to reflect their interests in earning a higher return on their investment, in this world of higher real capital costs. As a result you would begin to have hostile takeover activity, conducted with the objective of liberating cash flow from those firms, to be invested by stockholders in more profitable activities than perhaps are available in the industry—or perhaps just buying Treasury

86 CORPORATE RESTRUCTURING bonds (federal borrowing may be one reason why capital costs have gone up). So hostile takeovers in turn would have a demonstration effect. The example of firms actually subject to hostile takeover activity would in turn have impacts on other not yet threatened firms, and again lead to a process, through demonstration, of cutting back long-term projects elsewhere in the industry. So if we are going to ask the question, what is causing the decline in research in this scenario, there are a couple of different ways you can answer the question, all of which would be correct. You can say hostile takeovers are causing a decline in research; strictly speaking, you would be correct, because they were the vehicle by which demonstration effects influenced everyone else in industry and got them to cut back on research and development. Or you can say that real capital cost, the macroeconomic environment, was the culprit, because it was causing this diversion away from long-term projects toward shorter end projects, and you would also be right. It is just a question of the chain of causality and where you choose to break into it. Also, let me just reiterate that discovering that research and devel- opment intensity does not decline is completely consistent with aggregate research falling. So this story could indeed be true even if nothing at all has happened to R&D intensity. The final point which I think merits at least some brief discussion, because it is very much central to many things that have been said today, is the discussion of capital costs and their impact on research and devel- opment. In particular, the differential in capital costs between the United States and Japan, which is often pointed to as one of the major structural factors behind our relative decline vis-~-vis Japan, in industrial success. I guess the major point I would like to make is that there are many, many studies that have been done thus far on the cost differentials for capital between the United States and Japan, and most but not all, I should add—of these studies conclude that capital costs, the real costs of funds and the real cost of capital, in Japan are substantially lower than they are in the United States. The evidence on the margin of that difference is actually quite mixed. In fact, last night you heard Joe Grundfest refer to a 100 percent differential. ALL is cheap in Washington, and I have attended various meetings where I hear people mentioning 300 percent, 400 percent differentials in the cost of the capital between the U.S. and Japan. I would add that there are other studies that point to substantially smaller differentials, on the order perhaps of 20 to 25 percent. The reason you get such widely varying numbers is that there are such difficult methodological issues involved in comparing the costs of capital in the U.S. and Japan. Many of the reasons were brought

AFTERNOON SESSION, OCTOBER 12 19~ 87 up earlier, having to do with the different structure of shareholding in the United States and Japan, imperfections in the Japanese stock market in particular: extensive cross holdings, segmentation of the market, and various other things. Most studies that I know of conclude that the cost of debt is roughly similar. There is some difference but it is relatively minor between the U.S. and Japan. Intuitively we know this has to be true because, according to my colleague Ed Lincoln's figures he is our Japan expert at Brookings something like half of all the bonds issued by Japanese corporations were floated in international capital markets. It really does not make much sense to borrow abroad if capital, or at least debt issue, is that much cheaper in Japan. So if we assume that the cost of debt is at least in the same ballpark, that means that any differences in the cost of capital are going to boil down to differences in the cost of equity. There we have very difficult issues, particularly if you think about the problems of measuring the cost of equity when you have highly imperfect or segmented markets for equity. If we assume for a moment that there are enormous differences in the cost of equity in Japan, then it seems clear that the rational response would be for Western companies to issue stock in Japan and tap into those very cheap equity markets in Japan. Obviously for this not to happen, there must be structural barriers or imperfections of some kind. These very large differentials in the cost of capital simply are inconsistent with perfect financial markets. So one way or another you have to end up saying something about imperfections in the Japanese capital market; that greatly confuses the issue and creates a cloud of uncertainty over estimates of the relative costs of capital in the United States and Japan. That basically wraps up what I had to say. If you took the trouble to read through my rather circuitous review of the empirical evidence that has been adduced about the issues we are examining today, you can see that I spent some time puzzling over the various inconsistencies and trying to square different pieces of evidence that seem inconsistent. I have argued today that the empirical record is far less certain than some would have you believe, in part due to subtle effects that are not really measured in these studies, and more important, because of the distinction between research intensity and the aggregate level of research. MR. EIZENSTAT: Thank you. I must say that in hearing the economic viewpoint, it takes me back to my White House days where we wanted to have answers and we often got questions on both sides, because the data are difficult to get and that is the nature of what we are dealing with. It really is an enormous personal pleasure and privilege for me to introduce Dick Gephardt to you. I have known him since his first term in Congress, and his truly meteoric rise is nothing short of spectacular. I

8% CORPORATE RESTRUCTURING think one would have to go back an awful long way in American political history, to the very beginning to find anyone who, in his seventh term, had been elected to the second most powerful position in the House of Representatives. He was first elected in 1976 and because of the respect of his colleagues, quickly rose in House ranks. He was Chairman of the House Democratic Caucus, which was a particularly challenging position during the Reagan Administration, and it really put him at the forefront of shaping the Democratic Party's platform. Dick found time in the midst of pulling all of those policies together to put his stamp on what is perhaps the most important tax bill of the last 20 or 30 years, the 1986 Fix Reform Act, which is properly called the Gephardt-Bradley Tax Bill. What happens in the next few weeks will determine, in a sense, the longevity of that effort, and, of course, that is one of the reasons I think that Dick has been so much up front in talking about some of the tax issues, capital gains and the like, that are in front of the Congress now. When Dick ran for President in 1988, to me it was the best example of the respect of his colleagues because at least a score of them took almost unbelievable amounts of their personal time away from their own campaigns to campaign around the country for him. This was more, I can assure you, than just a token gesture to someone who might be elected President. It was a genuine show of affection and respect and I still believe that a few votes here or there on Super Tuesday would have propelled Dick, after his showing in Iowa, to the nomination. The Almanac of American Politics has said, and I think rightly so, that his major assets are his rare ability to come up with original and defensible solutions to complex and seemingly insoluble problems, his openness and his intellectual honesty. That is why we are particularly pleased that the Majority Leader has agreed to join us today to tell us how his colleagues view the wave of corporate restructuring that we have been talking about, and what we need to do in a broader sense to ensure U.S. competitiveness and particularly our commitment to R&D. We have here a leader in this country, and a person who will be a leader for decades to come. Dick, thank you for gracing us. CONGRESSMAN GEPHARDT: Thank you very much. I am vely happy to have this opportunity to be with you this afternoon to tank about this very important subject. However, I do not want to begin without paying my respects to Stu Eizenstat. He said that I came in 1976. You will all remember that he did as well, and the fondest memories that I have of the Carter presidency were the times that I had to talk with him, to work with him, to think with him, even though we did not often get much time to do that, about what the policies would be and what we would try to do, and

AFTERNOON SESSION, OCTOBER 17 19~ 89 my admiration and respect for him have only grown through the years as I have continued to work with him on many different subjects. I also want you to know, as I start this talk today, that when you have run for President of the United States and failed, you have a difficult time thereafter with so many people in the country knowing who you are, or thinking they know who you are, but not being quite sure. I will just tell two quick anecdotes that I think sum it up for you. A fellow in an airport the other day, I think it was Atlanta, was walking along very quickly beside me, and I was late for a plane and walking fast and he kept staring at me and then looking ahead and staring and I knew it was one of these deals where he kind of knew but did not know, and finally he just blurted it out, he said, you are Jack Kemp, aren't you? The best of all was the other day in Florida. I was down there for our congressional candidate for Claude Pepper's seat, and I was coming down in an elevator in the Doral Hotel. Some tourists got on. They had bathing suits on, and they kept looking at me and I knew we were into one of these deals again. We got off the elevator, they took one of my aides to the side and were talking to him, and he came over to me afterwards and he was laughing wildly and I said, what did they say? He said, they said, you know, Dice President Quayle looks in person just like he does on TV. So I am not sure that the run for the presidency was worth the time. President Kennedy used to love to tell the story of the man who was seen crawling around on his hands and knees under a lightpost in a parking lot. When a passerby came by and asked him what he was doing, he said, I am trying to find my car keys and it is dark. The passerby asked the man if he could recall where he had lost them or where he had had them last. He said, oh, that is easy, I dropped them just as I was getting them out to open my car door, as he pointed to his car which was on the other side of the parking lot. So the passerby said, why are you looking over here? The man said, because the light is better over here. Many of us have become convinced that America has lost something very important, its economic preeminence in the world economy. And yet, for all of the 198Os, we have insisted on looking not where the answers truly lie, in my view, but where the light is better. I salute all of you for having the courage to look where we need to look, not where it is politically convenient to look. For the last several years, I have been fighting to elevate our trade and economic problems to the top of our policy agenda. During this battle, I have come to realize that one of the principal problems is our unwillingness or our inability to think about our economic problems in more than one dimension. Everyone seems to want to find the silver bullet, the magic solution, the one answer that will restore our economic strength by itself and overnight.

9o CORPORATE RESTRUCTURING Rather, I think what we need is a comprehensive approach that looks at the long-term needs of our economy and our country. A recent poll indicates that 60 percent of the American people see our competition - problem being caused by too much focus on short-term profits, and more than 50 percent rate an excess of corporate takeovers as a major factor. Last year's trade bill that we passed, which has gotten so much notice for Super 301 and a lot of other very, very emotional topics, addressed many of the concerns facing our nation. Your symposium addresses others, especially the troubling decline in industry research and development, the increase in corporate debt through mergers, acquisitions, leveraged buyouts. It is these and other long-term problems that must be addressed if we are to restore America's economic strength. Of late, there has been concern that the wave of corporate restructuring has reduced the rate of growth of corporate research and development. I know the studies on this issue are inconclusive in the narrow scientific sense, and I am certainly no expert on this subject, but I know one thing. I know what I would do if I were a chief executive of a company under severe financial market constraints to show improved financial results on a quarter-to-quarter basis. I would be under pressure, extremely high pressure, perhaps unbearable pressure, to reduce all expenses as well as research which were not tightly focused on quickly developing profitable products. Thus, at the very least, I expect the character of research coming out of industry to shift away from free-wheeling basic research to highly focused research. A climate like this might have made it impossible for Bell Labs, for instance, to discover the transistor. So the question is, what can we do about it or what should we do about it? We cannot and should not construct barriers to all takeovers in corporations, but we should examine whether we can remove those tax subsidies that exist that artificially encourage takeover activity. Second, the trend toward takeovers and leveraged buyouts and reduced emphasis on basic research supported by industry puts an even higher importance on increasing the level of federal support for basic research. The Congress has been flying to do this and will continue to try. For example, I believe that substantial increases in the National Science Foundation budget are desirable, and even necessary, even in the world of tight budgets. However, because of the budget problems we face, we have been unable to do what needs to be done, in my view, and will continue to fall short of our goals as long as those budget problems remain. You also know that the deficit not only makes it difficult to increase federal support for research, but by keeping interest rates and the costs of capital high, the deficit makes it almost impossible for companies to afford

AFTERNOON SESSION,OCTOBER1419~ 91 the longer view that we all know is necessary. In my view, we will not solve our budget problem until we get presidential leadership on making the tough budget choices. Congress has a role, that is clear, an important one, but we only have one leader in America, and that leader must lead in order to get the budget to be changed. Many are aware of President Bush's black box budget earlier this year [1989], where he specified a set of increases to the Reagan budget and let Congress do a multiple choice test on where to make the cuts needed to make it all add up. He said, read my lips, no new taxes, and while that clearly is the platform that he ran on and what he obviously believes, that also constrains our ability to put together the kind of commitments to investment in research that we need. Third, I would like to spend some time telling you about the trade and technology initiative that I recently announced with Senator John Glenn, Congressman Mel Levine and Congressman Sandy Levin of Michigan, which I think will help American companies make better use of U.S. re- search resources by reshaping our trade and economic priorities. America's national security must be viewed not only in terms of defense capabilities, but also in terms of our economic prowess. The stark reality, we must realize, is that true strength today is measured in megabytes as well as megatons. Made and technology will be as important to America's na- tional security in the twenty-first century as air power or armor were in the twentieth. Already we are seeing the proof. At a time when the Polish people are calling for our help to foster economic freedom and democracy, the President finds the U.S. simply does not have all the resources needed to lend a helping hand. Clearly, here and in many other areas we could tank about, economic and military security are inextricably intertwined. The trade and technology initiative will place our top economic officers on the National Security Council, ensuring that our economic security has an equal voice when generals and diplomats discuss national security with the President. The bill establishes a permanent statutory position for the Assistant to the President for Science and Technology. Our bill restructures trade- related federal agencies, including reforming the Commerce Department into a streamlined Department of Industry and Technology, beefing up the foreign commercial service and creating an export strike force. But what I want to discuss with you this afternoon is the part of our bill that deals directly with research and development, the part that I think is the most promising aspect of this new bill. As you know, the fundamental philosophy of federal involvement in R&D has not really changed much since the 1945 report issued by the Office of Scientific Research and Development which, in the heat of war, focused our priorities on basic

92 CORPORATE RES12UCl7JRlNG scientific research and concluded that commercial applications were an area in which government should keep a strict hands-off policy. Forty-four years later, I think that report is still right or to be more precise, about half right. Yes, the Federal Government must take the lead on basic research. No other entity has the resources and the long view needed to invest in it properly. But the other conclusion of 1945, that government should never fund or support anything with commercial applications, sounds to me as outdated as a 1945 fighter plane going up against an F-14, F-15 or F-16. The good news is that throughout the 198Os, the federal involvement in R&D has changed. The bad news is it has changed for the worse. In 1980, the division between federal dollars for military research versus civilian research was about dollar for dollar, about where it had been for the previous 20 years. But by 1988, we were spending two dollars on military research for every dollar we spent on civilian research. Military R&D rose an astonishing 83 percent in real dollars during this decade and about 90 percent of the overall increase in federal R&D went to developing weapons systems. Non-defense R&D, on the other hand, declined in that period by 12 percent in real terms. If we could return to the previous, albeit imperfect, ratio, if we could just have an even split between military and civilian R&D, it would free up an extra $15 billion. That is not spending more. That is just spending smarter. There are things we can learn from the military research program. One of the most interesting lessons we can take from it is structural. The Defense Advanced Research Projects Agency, DARPA, has done a wonderful job with a relatively small budget, which they use to perform high-risk, long-term R&D for the Pentagon. Based on the DARPA model, we are recommending in our new bill the creation of an advanced civilian technology agency a new way to promote the public-private partnership we need to compete on cutting- edge technologies such as biotechnology, advanced materials science and robotics. ACTA, which will be its name, will have two aims. First, to assist and promote the development of advanced civilian technological capabilities and second, to assist in the application and commercialization process. That is, to help industries where they need it in getting new ideas from basic research to the marketplace. ACIA's focus will be generic research projects areas of research, development and application that are not already being adequately addressed by the private sector alone and that are common to an industry or industries. These projects will be funded on a cost-sharing basis with industry. If the project makes money, each partner, government as well as industry, will get a share of it. ACIA will be a lean organization, probably not more than about 35

AFTERNOON SESSION, OCTOBER 17 19~ 93 professionals to begin with. They will assist in funding generic research projects where industry thinks there may be a potential for profit and a need for federal investment. It will not be directing or second guessing the market any more than the National Science Foundation does today. ACTA will be working with experts in the private sector on projects they consider to be promising. All market-based decisions will be left to those who can make them best, the private sector. In ACTA, as in all good partnerships, each partner will do what it does best. The government will put up the money, assistance, support, and leave the market decisions to the private sector. ACIA could fund and support the technology transfers in joint ventures now being advanced by the machine tool, biotechnology, superconductivity and advanced television industries. It will encourage public-private part- nerships through various levels of government, business, and academia, and significantly, ACLA will eliminate the sort of ad hoc, special interest funding on an industry-by-indust~y basis which characterized the birth of SEMATECH. The key to ACEA's success will be to keep it as lean and as flexible as possible. I foresee people like yourselves taking an active role in places such as the Board of Directors and on various ACTA projects. You know where the action is, or where it should be in the next 20 years, but for various reasons, a given company or companies together cannot or will not go it alone. That is where ACTA will have to come in to help. But this new idea is only a small part of the puzzle. We have a lot of do. We need to boost our national savings rate, improve our educational system, return a long-term perspective to both business and government, make it easier for industry to cooperate on R&D projects where desirable, and much more. We need to do all of these things yesterday. They are not simple, but neither are they impossible. Our parents were able to defeat depression at home and dictatorships abroad at the same time, and while the fight is less dramatic today, the stakes are just as high. We have got to rise to meet the challenges of a changing world in order to give our children and their children the jobs, the hope and the opportunity they deserve. Einstein once said that splitting the atom changed everything except the way we think. So, too, does the new economic competition change everything. But too often, it does not change the way we think. Last week, on Thursday I went to Europe, to Geneva, and then to Vienna and then to Brussels to be brought up to date, with the Arms Control Observer Group in the House of Representatives, on the status of arms control right now. I knew a lot about it, or I thought I did before I went there, but I came back with a much deeper understanding of what is happening in that important part of the world. It has been the scene of the

94 CORPORATE RESTRUCTURING two major world wars of this century, and I came to understand in a much more impressive way what the possibilities were. For instance, I had not understood maybe I had heard it but I do not think I understood it that the Soviets were actually making an offer in Vienna in conventional talks that would reduce their tanks from 60,000 to 20,000 in one fell swoop; that they were offering to cut the number of troops they have in Europe and to demobilize them from 600,000 to 300,000. Also, to get rid of lots and lots and lots of other weapons. One of our NATO ambassadors, during one of the dinners, came over to me and he said, "Do you people in the United States really understand what is happening? It is a watershed. It is the end of an era and the beginning of a new era." The Soviets, I think quite clearly, at least under this leadership, are willing to make an almost irrevocable decision that the Cold War is over, the military conflict as we have known it has ended, and that we are now on to a new competition that will be economic and not military. I then visited our people at the European Community and we talked trade. As you all know, the European Community is now coming together in a way that no one believed possible even five years ago because they, too, understand that the Cold War is over. Perhaps their amalgamation had something to do with convincing the Soviets and the others in Eastern Europe that they had to change. To put it in its simplest terms, the world is changing dramatically and radically before our very eyes. Ibo often we are so caught up in what we are doing here that we do not understand the nature and the immensity of the change. I am convinced that the competition of the future will be more economic than it is military. If it is to be, and if we are to continue to be in the position where we are a leader in that competition, we have to change the way our economy is structured, and the way we relate to economic growth. Your discussion here today is a very important part of that because you must help us move toward that change. I believe the bill that I have described is a small part of that. Much more must be done, and the work that you do, the interest that you have, the responsibility that you have, Frill be critical in bringing about change so that we can continue to be a leader in the kind of world that we are in today. Thank you very much. MR. EIZENSTAT: We have time for one or two questions. Please take the opportunity and use the microphone. PARTICIPANT: What does the acronym stand for in your bill? CONGRESSMAN GEPHARDT: The Advanced Civilian Technology Agency. MR. ZAININGER: Sir, what was it that made you all of a sudden understand the change in Europe so much better than before? I did not quite get that.

AFTERNOON SESSION, OCTOBER 18 19~ 95 CONGRESSMAN GEPHARDT: Well, you know, we all read the newspaper and have an intellectual understanding of it. It helps, I think, to go and talk to Europeans who are in the middle of it and get their sense of importance, urgency, about what is in front of us and what can be done about it. You know, in our country we probably talk more about, think more about, care more about, for instance, the START talks because that has to do with missiles aimed at us and our missiles aimed at the Soviets, and we have, for a long time, been caught up in arms control that had to do with missiles rather than troops or tanks. The Vienna negotiation is, of course, about Europe and it is a mul- tilateral negotiation. It is not just the United States and Russia. It is everybody else. And so it helps, you do not read much about it here, frankly, you do not hear much about it. We hear about START, we do not talk about Vienna but when you go there and see it in process, you talk to the Europeans and they let you know how important and earth-shaking this is to them, and how the map is being redrawn. When they say it is the most important thing that has happened since World War II, you begin to get into their mindset and understand how vastly important it is. In the last month since the Gorbachev changes that got the Vienna talks started, most of the talk in the United States is, yes, that is great but can you trust them? Will Gorbachev last? What I learned there in the last few days is, it does not matter if he lasts. Sure, we would like him to last, we hope he does, but if they destroy 40,000 tanks and lots of airplanes and lots of guns and lots of personnel carriers, even if Stalin returned, they would have a heck of a time building that armament back. We are literally asked in the treaty to do nothing, we get rid of virtually nothing. It is asymmetrical. The Russians and the Warsaw Pact countries are doing all the reduction. As the Russian negotiator said to me, "Do you people really understand what this means?" They are kind of perplexed that we are not moving a little faster. MR. EIZENSTAT: Dick, I will make this the last point. You may be interested to know that in some of the earlier panels, particularly our corporate panel, there was a rather, I would say, cruel view of the capital gains cut. I think you might have been surprised by that. Do you have any sense of how that fits into this whole picture and where it is going to come out? CONGRESSMAN GEPHARDT: Sure. Well, without giving a long tale on tax reform, let me just say that starting when I came to the Congress and through 13 years of service on the Ways and Means Committee, which ended Friday when I resigned because of my new position, I came to the conclusion that we had confounded our economic policy and outcomes by too great a reliance on the tax code to try to drive economic behavior. We had put so many gizmos in the code to try to get this to happen or that to

96 CORPORATE RESTRUCTURING happen or the other thing to happen, that we were causing people to lose interest in economics and to be interested only in tax breaks. That was the genesis of the Bradley-Gephardt Bill, and we were fortunate to have a President at the time who agreed with it, in principle, and we went ahead and I think wrote very good although not perfect tax reform legislation in 1986. Just a side anecdote, in Europe last week, talking to business people, a lot of them were saying, yes, Europe 1992 is great and so on, but one of the things we have got to do in Europe is get these tax rates down. Even though you are being told that it is cheaper to get capital in Europe than it is in the United States, the Europeans say, that is really wrong, because we have got tax rates of 70, 80, 90 percent. The only way we got our tax rate on high income down from 90, which is where it was when Kennedy was president, to 28 percent—or 33 if you understand that crazy bubble that I have decided never to tale about again- is by restoring the base. That means you take out some of the gizmos, the loopholes, the incentives, however you like to characterize them, which we littered the code with for over 40 years. Now, when we got down to the final act, as is always the case in a democracy, you have a giant compromise. The compromise was that we would put up with this anomaly of letting the wealthiest have a lower rate than the people just below them, which is crazy. We would put up with getting rid of industrial development bonds and the investment tax credit and lots of other things that a lot of us really thought were pretty keen ideas, in order to get capital gains at the same rate as ordinary income, and to get the whole rate down to about 30 percent, which we thought was real progress. Now people could invest, people could make decisions based on how they thought they could make money, not by some attractive gimmick in the tax code. The problem, and the great reaction that I and others have had to the President's suggestion, is that before the ink on the bill is dry, we are now back to trying to get a lower rate for capital gains. 1b make it worse, this particular proposal in the House was a two-year deal. It only gave it to gains for things that you had already decided to do, which makes no sense whatsoever. It is not even an incentive to have you invest. It is a windfall, entirely. Again, it broke the symmetry, and, believe me, if it goes in the code and I suspect that it will, we will wind up a year from now with the investment tax credit people coming back. We will wind up two years from now with others coming back and you will be back to a 50 percent rate and a corporate rate to match. That, to me, is not progress and is not moving us in the right direction. So that is all the fire over the capital gains, and you know, again, none

AFTERNOON SESSION, OCTOBER 17 19~ 97 of this alone is going to make that much difference. We have got about 12 or 15 things we have got to do at the same time, and we have got to do them well. Not any of these battles or skirmishes are going to win or lose the war, but we are in a war, an economic competition war. It is a heck of a lot better war to be In than the ones that we have been in in the past, but we have to win our share of this war. We have to win some battles, and we have to be strong, not only for our kids and their material comfort, but because we are a leader in this world and other countries look to us. If we are borrowing 30 percent of our capital from somebody else, and we are unable to help the Polands when they come along, then that is a sorry situation and it does not need to be that way. We are better than that and we can get this done. Thank you very much. MR. EIZENSTAT: Dick, thank you. You really added immeasurably to our discussion and Mike Wessel, we appreciate your help as well. Thank you again. Gregg Jarrell will be our next speaker. He is a Professor of Economics and Finance and Director of Managerial Economics for the Research Center at the Un~versibr of Rochester. He is also Senior Vice President at the ALCAR group, a Chicago-based software and management education firm where he sensed full time as Director of Research until 19~. He was the chief economist, as he mentioned during his question, at the SEC from 1984 to 1987. He has published several articles on the economics of tender offer regulation, and was a member of the SEC Advisory Committee on tender offer policy. He graduated from the University of Delaware and the University of Chicago from which he received an MBA and Ph.D. Gregg will now give you a second bite of the apple, from his side this time. DR JARRELL: It is a pleasure to be here. I would lye to thank Ed Abrahams for the invitation. I would like to thank Stu Eizenstat for the introduction, and I would like to thank my old friend, Commissioner Joe Grundlest, for essentially giving my speech last night at dinner. I would like to start off by telling you a story which has a very strong moral to it. I work with a lot of lawyers. I get involved in a lot of these takeover battles, and the CEOs we've heard from, especially Mr. Booth, are a different crowd of people from corporate takeover lawyers and their advisers and investment bankers. A thing you have to remember about investment bankers is that they are just lye people. You have to keep that model in mind when you try to understand how they operate. I have a lawyer friend in Rochester and he told me this story which I hope you will find interesting. He said that he ran into a very unusual situation a few months ago. This elderly couple came into his office, and they were very elderly, mid-9Os. They sat on separate sides of the room, and

98 CORPORATE RESTRUCTURING they had obviously been having quite a tiff. They announced to him tersely that they wanted his help in getting a divorce and he kept a straight face but he asked well, what is the problem, and they both agreed immediately that the problem was irreconcilable differences. They never really did like each other and they continued to make it impossible to get along with each other. So he thought about this, and finally he said, well, you folks must be what, and the man said, I am 94 and she is 92. My friend said, well, you have obviously hung in there for a long time. Tell me, why now? Without missing a blink, they looked at him and they said, well, we thought we ought to wait for the children to die. I like that story because of this discussion about short term and long term. Some people are willing to wait a very long period of time to get certain results that they view to be desirable, and other folks, in the modern age, if you don't get along that first week you get divorced and you go searching around. I do not know who is right and who is wrong, but there do seem to be tremendous differences. I come from the University of Rochester where the business school is called the William Simon Business School, named after Bill Simon who was our former Secretary of the Treasury. He is a big-time businessman, a won- derful guy, and that is for the record. Bill Simon got a very small fraction of the millions of dollars that he gave to the University of Rochester to help us build a better business school, with an international reputation from a deal involving the Gibson Greeting Card Company. It was one of the original firms that went LBO, and then within a few short years went public again at some phenomenal rate of return. It staggers the imagination. I do not even like to say it because I like Bill Simon and when you start talking about those kinds of riches, it is hard not to dislike someone. He did quite well with that, and he has continued to do quite well after that. I think it is only appropriate. I am also good friends with Michael Jensen. In fact, I have his old job. Michael Jensen is now at Harvard. I am sure he would have been delighted to be here. He would have had a lot to add to the conversation. I talked to him the other day and he agreed that I should be his official spokesman. So anything that you wanted to ask Michael Jensen, you can ask me and he will have to live with the answer. He started an outfit which I now am the director of, called the Managerial Economic Research Center. We have been doing some work that I wanted to share with you. It is very, very, very preliminary work but I think it has something to do with the topic today. One of the things we have done is to collect a sample of 160 big-time firms that have been restructured in the last four or five years, probably an exhaustive sample of all firms on the American and New York Stock Exchange that have

AFTERNOON SESSION, OCTOBER 18 19~ 99 announced in a fairly important way that they have restructured themselves or that they have embarked upon a restructuring program. As many of you know, there are restructurings and then there are restructurings. There are some things that are restructuring in name only and you do it for one reason or another. There are other types of re- structurings that are major, that involve both sides of the balance sheet, levering up, paring down operations, making basic strategic decisions that are dramatically different from the path that you have been on. We tried a very simple way to distinguish between these two types of things. We developed a measure of the focus of the business. Those of you in antitrust economics know there is a thing called a Herfindol index, which is one quantitative measure that in and of itself gives you a pretty good feel for what the industry is, how the industry is composed, whether it is made up of a lot of small competing firms or whether it is dominated by a small number of large firms. This Herfindol index concept we took to the firm itself in order to measure how far-flung were the firm's operations across the different businesses that they might operate in. A conglomerate would have a very low number, a firm that had all of their operations in one business would have a very high number. We were able to develop this measure for each one of these firms on an annual basis. So by looking at this measure and this measure alone, we were trying to see whehter the firm restructured in a way that dramatically refocused its efforts, or whether it really just restructured in name only and did not change its basic strategic measure—at least, as reflected in this particular number. Then what we did was rank the 160 firms from those that had the biggest increase in this focus measure to those that had the smallest increase or the largest loss in this particular focus number. We grouped them into portfolios. We said, okay, now, take the top 25 percent and put that in a portfolio. Like the bottom 25 percent and put that in a portfolio and measure the shareholder rate of return—capital gains plus dividends—over a long period of time, from the mid to late 1980s. The answer we got was that the firms that had refocused to sharpen their operations and the asset side of the balance sheet~ompletely ignoring the degree of leverage that they undertook just focusing on business strategy those firms had a rate of return that was, on average, 10 percentage points higher than the firms at the bottom of the list. All of these restructured firms that refocused, on average, had a higher rate of return for their shareholders than others. I do not know what you make from this. I mean, if you do not believe in stock markets, you probably do not make much out of it, but it does indicate that there is something more than just debt that is going on here. The debt is not the entire story; leverage is not the entire story. You have to understand that

100 CORPORATE RESTRUClURlNG some firms, when they restructure, must get in on that asset side and do something dramatically different. We heard some talk earlier about Jensen's free cash flow theory and I wanted to say a few words about that because I think that it is a very simple theory and it is very controversial and it is very unproven. It is a very ingenious idea that strikes a lot of people as being intuitively obvious and helpful, yet it remains very much an untested proposition. If I could summarize it, I would start off by saying that Finance 101 is a simple subject. We tell MBA students and future business people in Finance 101 that your basic rule of operation is to look at projects and measure the rate of return that they are going to throw off. It sounds easy, right? You measure their internal rate of return. You estimate it. If that internal rate of return for a project is greater than your cost of capital, then you do it. That is a go. If the internal rate of return is less than the cost of capital, then you do not do it. That is a no-go. Okay? That is what we teach them. It is a short course. The bright students say, well, how do you measure the internal rate of return of the project, and we say, that is a matter for statistics or quantitative analysis. What happens in many, many business firms is that the analysts try to figure out what projects the CEO is going to like, and for those projects they go ahead and say, well, that has got a good internal rate of return. Or there is some kind of mysterious process that goes on. I do not mean to make fun of it. It is a very difficult thing to implement, and when you get all done measuring what you think the rate of return of the project will be, then you turn around and you measure the cost of capital. Well, good luck there, too. When I advise people on the cost of capital, I use a very simple rule. I say, look, rather than spend a lot of money and time and effort estimating your cost of capital, which you know you are going to get wrong anyway, just use the simple Jarrell Rule. The Jarrell Rule is this: if it is in a business that you have been in before and you have done well and you kind of think you know what you are doing, the cost of capital is 10 percent. If it is in a business that you have never been in before but you think you might be able to do okay, it is 20 percent. And if you are going into a business that you have never done before and you are not sure whether you are going to do well in, then it is 30 percent. It is that simple. I have still not done my talk What is free cash flow? Free cash flow is a result of having past successes in business. Businesses that have had past successes have investments and projects that are doing well. They are throwing off a lot of cash, and a lot of firms in this American economy are in that enviable position. They are throwing off cash. In the old days, they had to borrow or raise money. Now, they have prospered, they have done well, they are throwing off cash. The free cash flow problem arises when

Al-l~OON SESSION, OCTOBER 18 19~ 101 the stock market loses confidence in the ability of the senior management to "do the right thing" with the free cash flow. What is the right thing? Well, go back to Finance 101. If you have new projects that allow you to get a higher rate of return on that free cash flow than the shareholders could get if you gave the money to them, then keep the money and invest it. If you do not have those sorts of projects, then give the money back to the shareholders somehow. There are dividends or stock buy-backs or that is Finance log, exactly how you do that. So in order to be talking about the free cash flow theory, you must talk about a firm that has free cash flow. If the firm has got a free cash flow discount, you are really talking about a firm where the stock market does not have a lot of faith in management's ability to follow that simple Finance 101 rule. Now, if the firm is subject to this free cash flow disease, it will have what is called a value gap. There will be a difference between the stock price out there in the open market, and the stock price which could prevail if somehow you could solve this free cash flow discount. This is Jensen's theory. What is the role of debt in this theory? Here is the story. If you have a firm that is suffering this free cash flow discount, they are takeover bait. A raider can come in and buy it at the low price and then do whatever has to be done to solve it and make a windfall profit from the increase in value. How does the incumbent management get out of this problem? Simple. This is a theory now. Incumbent management gets out of this problem by restructuring the liability side of the firm. What it does is it takes on a lot of debt, levers the firm up and then retires equity. What does that do? That eliminates the free cash flow. You have got no more free cash flow. All of your free cash flow, which was this excess cash coming from past investments, is now used to pay off the debt. It is like the old story where you are tying yourself to the mast of the ship so you don't do something that later you mill be sorry for. It is essentially what the theory says, that you limit the room for dis- cretion on the part of management because Wall Street has lost confidence in management's ability to take that money and do the right or productive thing with it. Now, we know a lot of managements that may do this. A lot of the conglomerate mergers in the past have perhaps been a result of this. Professor Mueller is an expert in this area. He was one of the people that was screaming about this years and years ago. Perhaps this is one of the reasons for that type of behavior. But one of the things I want to point out is that this free cash flow solution, this role of debt, is perfectly consistent with what people are concerned about in this conference. What people are concerned about is that debt constrains the ability of management to invest in something

102 CORPORATE RESTRUCTURING other than the interest payment on the debt. Here is somebody from the University of Chicago who is telling you that that is perfectly consistent with Jensen's theory. In fact, that is the inherent logic of the theory. They go hand in glove. It is supposed to constrain management. Where does that leave this debate about research and development? It is consistent with the theory because if you have to make these inter- est payments, you are not going to be able to make all kinds of other discretionary expenses. Will research and development necessarily suffer? Sounds like it. It turns out it does not have to super, but if research and development were excessive, then it would be cut back. Presumably these managers would cut back on R&D. They would cut back on any kind of expenditure that they had made that was excessive. That is the logic of the theory. This implies several things that are important. One, it implies that LBOs are not for all firms. They are for firms that suffer from this particular disease. Although at times, when you read The Wall Street Journal, you would think that LBOs and leveraged restructurings were taking over America. We have been dramatically surprised at the number of industries and the types of firms that have gone in for this type of high-leverage financing. But this theory, in and of itself, implies that it is certainly not for all firms. It is only for those that are suffering from this free cash flow disease. Now, let me continue on this theme for a minute. I am going to make a full circle. This sounds like a bad segue but I swear it is not. There is a tremendous amount of competition in the takeover market these days. The last two or three years, the competition has gotten very, very fierce. There are several reasons for this. One is that the defensive tactics that takeover targets can use essentially allow them a lot of resources and time to get an auction going. The regulatory officials, the courts in Delaware, everybody is very much in favor of the auction solution to takeovers. There is some evidence on the horizon that this is changing. The Polaroid defense is the first break in this system whereby once you are in play, you are going to come out of it with high leverage. I do not want to get sidetracked, but the courts in Delaware appear to be trying to carve out some room for an in-between solution, and the Polaroid case is probably the best example of this new policy on the part of the Delaware courts. But suffice it to say that there is a tremendous amount of competition and that means that bidders that win are paying top dollar, absolute top dollar. There are some staggering premiums that are paid. In my back yard, Kodak bought Sterling Drug, and if I recall correctly, on the day the market got the news that Kodak was "the winner," Kodak stock dropped 19 or 20 points. Kodak is bigger than Sterling, and that is a lot of money.

AFTERNOON SESSION, OCTOBER 1, 19~ 103 In fact, the stock market acted like Kodak bought this enormous, valuable drug firm and then on the way home dropped it and broke it. The stock market wrote off most of the value, not the premium. They did not write the premium off. They went way beyond the premium. They wrote off a tremendous amount of value from Kodak and I do not think there is any evidence so far that Kodak has recovered from that. I do not know if that is good or bad. It is just that bidders are paying top dollar, and there is a thing out there called the winner's curse. Again, Professor Mueller knows about this. There Is also a tremendous amount of capital. Some have referred to it as predatory pools of capital we heard that earlier today enormous pools of capital looking for profitable outlets. Managements are bidders on almost all of these cases. They come up with a bid. Unions become bidders, employees become bidders. There are a lot of people bidding for these firms once they get into play, and there are a lot of people who are initiators willing to put them into play. So this is an enormous competition, and what is bothering people, what concerns policymakers, is that when firms get out of this fray, people are paying top dollar, they are financing a lot of it with debt, and they are getting closer and closer and closer to this razor's edge. Combine that with the fact that we have been in a prolonged business expansion. We have not been slapped around lately in economic terms. We have not been disciplined lately. We have been in this long economic expansion. Demand curves just keep moving to the right. Oh, they hit back a little bit but they just keep moving to the right. I should also add that these high-leverage techniques are spreading to greater and greater industries that are more and more cyclical. It used to be that only the mature, low-cyclical industries were the LBOs. Don't worry, we thought, the LBOs are only being done there and they are temporary. Now, they do not look so temporary. Firms like KKR are hanging in there and the high leverage is hanging in there. Also, you have industries that are more cyclical having LBO activity in them. What everybody is concerned about is that one of these days, demand is going to back up. We are going to go into this recession, and even with a fairly soft landing, they are worried about these high-levered firms littering the financial landscape and then having certain kinds of domino effects. That is what is bothering everybody. You do not want to sort of be the person that goes out and kills the golden goose. On the other hand, if you are a policymaker, you are paid to be concerned about those sorts of disasters. You are paid to be on the lookout for tomorrow's whoops. In a junk bond market, what I am here to say is that I, too, share some of these concerns. Even Chicago economists have feelings, it is true. It is also a very cheap word, concern. It does not cost a nickel. Over the next two weeks, for those of you who are in Washington, just count how

104 CORPORATE RESTRUC1UR~G many times you hear the word concern. Count it. It is the most incredibly used word. It is so cheap. I was in Washington a week before I learned that. Whenever you are asked a question and you are tempted to say, oh, that is the most foolish question in the world, have you no faith in markets whatsoever? That is what you are saying inside your head. What comes out of your mouth is, that remains a top concern of the SEC and we continue to look at it with grave interest. MR. EIZENSTAT: Now you took my talk. DR. JARRELL: Anecdotally, there is a tremendous amount of support for this view that LBOs and hostile, high-debt takeovers and restructurings reduce R&D. You could put a line in here of distinguished people who know what they are talking about, been in business all their lives, who will swear to you on a stack of Bibles that that is true. I have anecdotes myself. I have been on the inside of these deals and I have seen on the bidder side, bidders that are budgeting cuts in R&D in order to pay for the financing over the next two years that they used to take the firm over. They will not say it under oath. They will say that is just a scenario—"We ran all kinds of scenarios" but you know that that is what they are going to do. On the defensive side, you see target management that would not have thought of cutting R&D over the last 10 years, but if they have got to do a leveraged restructuring to get out of this takeover pickle, what are they going to do? The first thing they do is, "We can cut R&D $10 million. That will give us a little bit of breathing room. That will finance some debt, right?" One of the things that I was told at the University of Chicago is that the plural of anecdote are data. The data are that the Flamm overview and the Grundfest tank and the work that Bronwyn Hall and others have done indicate that it is very, very tough to find any support at the aggregate data level for the notion that R&D is suffering at the hands of the restructuring community. I was moved when I heard both gentlemen from the corporate community this morning refuse to condemn restructuring activity per se. Obviously they have some misgivings, and they have some concerns, but they refuse to condemn restructuring per se. So I do think that one of the things we ought to come out of here with is there is not a real good basis upon which to go around attacking restructuring per se as a way to save the world in order to boost R&D. How come LBOs do not sacrifice research and development? It seems obvious that they could. Why don't they? I was surprised. I understand mergers in general. They tend to occur in low R&D industries and it is tough to find them, all right, but if you zero in on LBOs and look at 40 LBOs of big firms over the next three years, they have got to have decreases in R&D. But it does not show up; R&D as a fraction of sales does not fall. But if you do not see it, why not? I think the answer must be that

At-1~OON SESSION, OCTOBER 1; 19~ 105 there is more to LBOs than just R&D and meeting debt payments. There is a lot more to them. There must be some sort of productivity increases in the cases that we are looking at that allow them to make the interest payments, to increase profits, to give that 30 percent to those avaricious, well-heeled investors that have put the money into this in the first place. And another answer is that R&D is not sacrificed. A, it does not have to be in the LBOs that we seek because they are doing well, and B. the R&D can be justified. There is probably not an LBO on record where they did not change dramatically the composition of R&D. R.J. Reynolds, I think we have seen evidence of that in The Wall Steel Journal. Didn't they cut out the smokeless cigarette? The first thing they did, right? Is that to say they cut R&D? They probably did in that firm, but who knows? Maybe it is the composition of R&D; I think that that is where the debate should go. It is the composition: what are we investing in? The aggregate data are fairly uninteresting. We have got an R&D crisis. What are we investing in and why are we investing in it? It is a very complicated question. I want to close with one more story. This is a story I am going to tell on my good friend, T. Boone Pickens, Jr., who is the famous would-be takeover specialist. He was a villain when he was taking over American oil companies or attempting to take over American oil companies and now he is a hero because he aimed his guns at a Japanese firm. He is a clever man. I am telling this story just because I love to do his accent. When I was at the SEC, you know, you take a job like that not for the money. You take a job like that because you want some kind of recognition or press or to meet some people and have some fun in Washington. I did it for that reason as welt and one of the big, exciting things happened in the middle of the Unical-T. Boone Pickens-Mesa Petroleum takeover battle. I had written an article, or actually Ken Lane, who is now the chief economist at SEC, wrote an article and I was helping take the credit for it. He wrote an article on this subject of long-term investment and myopia, is it true or is it not. I think that we were among the first people to look at this. Bronwyn, you were involved in it at the time. Pickens called me up in my office; this is when I first met him. I wrote an editorial for 17ze Wall Steer Journal and he read that and he got excited because he was in the middle of this battle. He did not have one friend in Washington at the time, so he called me up and congratulated me for the article and all this sort of stuff and he said he was going to be on TV that night on one of those tank shows. It was the Ted Koppel show and it was one of these debating things where they had T. Boone Pickens in one booth with the TV camera and they had Fred Hartley, the chairman of Unical, in another room. They were not actually with each other. They would have pounded each other to death. They were very much antagonists at the time. Separate rooms,

106 CORPORATE RESTRUCTURING and I thought, this is going to be wonderful. Pickens is going to mention my name and my research project. So they had this debate and they are going back and forth and they cut for a commercial and Ted Koppel says, when we come back after a commercial, we are going to get to this issue about the myopic stock market, short-term, long-term. I thought, this is it. Of course, I had all my friends and relatives watching TV for my name, it was very exciting. They came back from the commercial break and they went to Fred Hartley, and Fred Hartley said some things. Then they went to Mr. Pickens and they said, Mr. Pickens, you heard Mr. Hartley. He said that you are out for the short term, that you are only in this for a quick profit, that you are greedy and avaricious and that you are not in it for the long term. Did you hear all that? And Mr. Pickens looked at Ted Koppel and he said, "Fred Hartley said all that, didn't he?" Ted Koppel says, "Yes, you heard it, didn't you?" He says, "Yes, I heard all that. Was he on TV when he said that?" Koppel says, "Yes sir, we just had him, he was just saying it." "And American viewers saw him, on the TV?" He was really confusing Ted. He says, "Yes, Mr. Pickens, they saw him." "Well, then, they got a good, close-up view of Mr. Hartley, didn't they?" "Yes, Mr. Pickens, they did get a good close-up view of Mr. Hartley. Could you please respond to this question?" Mr. Pickens says, "Well, then you saw Mr. Hartley is not in very good shape. He is all puffy-faced and he has got a red nose and he is overweight and he does not take very good care of himself. Look at me. I stay in shape. I eat fresh fruits, cereal, I play racquetball every day. I am lean, I am mean. Look at Mr. Hartley there." He says, "Hell, if I was Fred Hartley, he said that about me? I am in it for the short term and he is in it for the long term? Hell, if I was Fred Hartley, I wouldn't buy green bananas." That was the level of the debate at the time, and I am happy to say that the debate has elevated itself dramatically. Thank you very much. MR. EIZENSTAT: Gregg, we appreciated both your wisdom and at this late hour, your humor as well. I must say that in listening to your description of the free cash flow theory and the limits that it puts on management, it reminds me on the public policy side of a policy some allege the Reagan Administration participated in, in which taxes were cut so deeply it created a deficit so large that it constrained members of Congress from spending anything that they wanted to spend. Whether that is actually a public policy analog I do not know, but it sounds at this hour about as close as I can come. We will conclude, except for my very brief summary, with Dennis

AFTERNOON SESSION, OCTOBER 19 19~ 107 Mueller who is a Professor of Economics at the nearby University of Maryland, in College Park, where he has taught since 1977. He received his Ph.D. from Princeton and a B.S. in math from Colorado College. His honors, like his publications, are too many to cite and still leave time for him to speak but I will mention just a very few. He has been the President of both the Public Choice Society and the Industrial Organization Society, which are separate fields in the economics profession. He received a Fulbright in 1987. He has written numerous books with titles that show his wide-ranging interests: Public Choice; The Detem~inants and Effects of Mergers: An Intemanonal Companson; and many others. I am literally omitting six pages of articles on his resume. We appreciate you coming. You have the opportunity to either look at yourself as the last speaker or the clean-up batter. I will call you the clean-up hitter. Thanks. DR. MUELLER: Thank you. The one advantage I can think of going last is you do have the benefit of everyone else's comments and discussions so you can try and relate your talk to them rather briefly. The disadvantage, as Gregg so amply illustrates, is that most of what you wanted to say has already been said, and the greatest disadvantage, of course, is that it is so late In the day nobody really cares what you are going to say anyway. What I am going to do first of all, so as not to prolong debate, is to agree with both Gregg Jarrell and Ken Flame on what in some sense is the question of the day. That is, can we say anything about the relationship between leveraged buyouts and R&D expenditures in 1987, or maybe 1986 and 1987, or whatever the period is? I am going to agree and say I do not think we can say anything that is very definite, and I am not going to really talk about that very much. Instead I want to talk about what I think ought to be our concern at a conference like this, namely more broadly based questions about corporate restructuring, again broadly defined to include mergers and acquisitions, hostile takeovers as well as LBOs and innovative activity. Let me begin with the latter and ask some questions about what we do know about innovative activity. Where do innovations come from? What are the most innovative firms? First of all, we know that innovation is a very information-intensive activity. Information-intensive activities demand rather flat, decentralized organizational structures, with considerable exper- tise on the part of the top decision makers with regard to the technology of the firm. Innovative activity also entails greater risks than other forms of corporate decisions and thus requires more entrepreneurial leadership and an organizational environment in which lisle taking is encouraged and rewarded. All of this suggests that innovative firms will be relatively small and undiversified. (As an aside, I also suggest that proposals for large consortia, in general, are not going to be a solution to our problems.) Now, this image

108 CORPORATE RESTRUCTURING of relatively small, undiversified firms as being innovative, is an image that fits what we know about the sources of invention and innovation in this country. A disproportionate share of important inventions and innovations in this century has come from independent inventors and small firms Polaroid is a classic example. Even among the very large firms, the ones one can think of that have good, innovative records, the ones one can think of that have not lost their domestic markets to foreign competition and have even gotten good export performance, are typically companies like Boeing and IBM, some of the pharmaceutical firms and so forth that have stuck to their major lines of activity and have not engaged in a lot of acquisitions and diversification. Mr. Wendt of SmithKline Beecham I think would put SmithKline Beecham in that category also; the one large diversification effort they made when they acquired Beckman Instruments does not seem to have been a big success. I am reminded in all of this of one of the characteristics of best- managed companies that Peters and Waterman uncovered in their study of 10 years ago or so. They termed it "they stick to their knitting"—they do not engage in much merger activity, and certainly very little that is unrelated to their major lines of business. I do not think that this is just a coincidence. Rather, growth by internal means and external growth through acquisitions are substitutes. Let us look again where I began getting my spurs. If you go back to the first page of my vitae, you will see that some of my spurs were earned looking at conglomerate mergers back in the 1960s. Had I been precocious enough, I would have even named what I was doing a free cash flow theory of mergers and gotten some of the accolades that Mike Jensen is now getting for that. We know that most of the active acquiring firms in the mid-1960s were based on mature, slow-growing industries: tobacco, textiles, paper, et cetera. These companies had basically three choices. They could continue to grow slowly and indeed decline relative to other firms in the economy, paying out their cash flow to stockholders to be reinvested elsewhere in the economy. They themselves could invest in R&D and invent and develop new products, or they could buy up other firms. They chose the latter route. The same choices faced the oil companies in the mid-197Os when the OPEC oil price increase swelled their profits, and many of them also opted for the acquisition alternative. Now, how did these acquisitions turn out? The answer to this, it seems to me, depends on whom it is that you asL I am not exactly sure who these people are any more, because the cast of characters seems to be changing. The last tune I was at a conference like this, a mixture of academicians and business, and Wall Street type people, where Michael Jensen was present,

AFTERNOON SESSION OCTOBER 17 19~ 109 I went there assuming we would be on opposite sides of the fence, and disagreeing about all this, and Michael Jensen got up and seemed to be saying things that had a sort of deja vu ring to them. At that time, I thought Gregg Jarrell and I were disagreeing on these issues. ~day, I thought I heard him saying that acquisitions by Kodak and so on were not wealth increasing. But it used to be that there were people from finance departments, and indeed a very famous (and very often cited) survey by Jensen and Ruback, that basically said that the mergers of the 1960s, conglomerate and otherwise, were a success, as were the mergers of the 1970s and 1980s. If you go back to the Jensen and Ruback paper which was, I think, part of this empirical consensus that Kenneth Flamm tastes about as to mergers and takeovers having been on average a success, you will see that most of the studies use databases heavily weighted toward the 1960s. Why were they a success? Because on average the premium paid for the acquired firms was greater than the losses, if there were losses, to the acquiring firms at the times the mergers were announced. Now, some of you may be surprised to learn that the empirical consen- sus is that the mergers of the 1960s were a success. Indeed, a consensus of writers for such publications as Business Week Fortune, Forbes, Wall Street Journal, et cetera, would probably run the other way. Indeed, since many of the so-called bust-up takeovers of the l970s and l980s were motivated to undo earlier mergers, one might even assume that at least one set of mergers must have been characterized as mistakes. But such is the beauty of the market for corporate control, at least in the eyes of some of its ardent champions. I guess at least the two people from Wall Street this morning would still be in that camp, maintaining that wealth is created when companies are put together and wealth is created when companies are broken apart. Is it any wonder, therefore, that the criticisms of takeover activity heard from its champions, let us say, on Wall Street, are only that we have too little takeover activity, that the Williams Act slows up takeovers and thus stops this wealth-creating process and that, for example, section seven in the Clayton Act, when we used to enforce it, prevented too many synergy-enhancing, horizontal, and vertical acquisitions? Now, this chorus of enthusiasm is not unanimous and the reason Business Week and Harvard Business Review, et cetera, often seem to come to alternative conclusions is that they do not judge mergers' success entirely on the basis of stock market reactions at the time the mergers are announced. Instead they look at how the merging companies perform in the months and years following mergers. Similarly, economists who have studied the real performance of corporations, namely, their profits and market share over time—and I am thinking here of Professors Scherer and

110 CORPORATE RESTRUCTURING Caves at Harvard as well as myself we have found that when you look at the performance of merging firms and particularly acquired companies in the years following acquisition, that the performance tends to be, on average, negative in terms of profit declines and market share declines and the like. One of the studies I did was of acquisitions in the 1950s and 1960s. I tracked the acquired firms for an average of 11 years after they were acquired. I found a significant destruction of wealth following the firm's acquisition. A typical acquired firm was, in fact, projected to basically disappear after 20 years. It is worth noting that these were not simply firms that were on their way out anyway. Included in this group of firms were companies like Harley Davidson in motorcycles, Talon in zippers, companies that, in fact, were the industry leaders prior to acquisition and then subsequently were displaced by Japanese firms. Other firms included small and very up-and-coming firms like Hamms Brewery and Vapor Valve and Pump and a bunch of others whose growth trajectories were basically turned around following their acquisition. On face value, it is hard to envisage why hostile takeovers would improve the innovative records of the companies involved. Certainly, the immediate effects of hostile takeovers and the restructurings that follow— and of leveraged buyouts, for that matter—and the pressure to increase immediate earnings, are unlikely to create a corporate environment that enhances the long-run commitment to R&D and investment and risk taking that the innovative activity requires. In thinking about these issues, it is perhaps useful to look at a concrete example, namely, the machine tool industry in the United States. In 1975, the U.S. was the world's largest producer of machine tools, was the second largest exporter, and it had the lowest dependency on imports. In 1987, 12 years later, we were fourth in production behind Japan, West Germany and the USSR, sixth in exports behind countries Lee East Germany, and more than 50 percent of our purchases were in the form of imports. What is perhaps worst about this example is that we lost market share because we lagged in introducing innovations in a market in which we were the technological leader, at least back in the 1970s. Here I might comment on Mr. ~karz's assertion it is easy to attack people now that they have gone on the Pan Am shuttle back to New York- that Japan had targeted machine tools as a market to attack back in the 1970s and that helps explain why we lost market share. I am very skeptical of that kind of "Japan bashing." My suspicion is that if Polaroid were a Japanese firm and had come out with the instant development camera in the last five years, there would be at least one congressman and two senators from New York coming down to Washington and saying that Japan

AFTERNOON SESSION, OCTOBER 17 19~ 111 had targeted our amateur camera market for attack and that in particular Kodak was being singled out for a ruthless attack. If it was targeted, it was probably because it was a market ripe to be taken because of the lag of innovative activity by the firms in that industry. It is interesting when you look at that industry that among the leading machine tool firms were several growth-through-merger conglomerates: Litton Industries, Houdaille, White Consolidated, Textron, Bendix, Colt. And yet they fared no better and probably worse than the undiversified companies in that industry. I had planned to talk about two firms as concrete examples in this talk, and as it would be, these have been heavily discussed already today. But let me perhaps give a little different light on these two companies. I think it is particularly interesting in this regard to look at the history of Houdaille, a firm which for basically a half century produced auto parts in this country. In the 1960s they went the "typical conglomerate" route; they started to lose their auto parts market and so they began conglomerate diversification. They moved heavily into machine tools and by the mid-197Os they were one of the leading machine tool manufacturers in the country. In 1979, as everybody now knows who was here this morning, they went through a leveraged buyout and in the next six years, their constant dollars sales dropped by over 70 percent. Shortly after those six years were up, the entire division was liquidated. Now, it is true that undiversified firms also suffered badly in this period. My point is not that mergers in some sense caused the particular problems of the firms in the machine tool industry. But certainly the mergers and the other kinds of restructuring that went on do not seem to have led to those firms outperforming the other companies in that industry. Indeed, it is inconceivable that Houdaille could have had a worse trajectory in machine tools than it had following the leveraged buyout. Beatrice is another good example which was also discussed this morn- ing. Maybe I can give a slightly different perspective on that. Beatrice was, in fact, the only exception in the Peters and Waterman book to the "stick to the knitting" rule. It was one of their best-managed companies, and yet it had engaged in a lot of acquisition activity, basically acquiring small firms that fit into its corporate mix of food-manufacturing companies. No sooner was the ink dry on the millionth copy of In Search of E'cce11ence than Beatrice itself became the target of a takeover movement by S-Mark (which was formerly Swift but which had also recently acquired Norton-Simon). Beatrice was forced, to avoid being taken over, to turn around and take S-Mark over itself. By the mid-1980s, Business Week was calling Beatrice an acquisition junkie and Beatrice was, in fact, spinning off divisions to regain earnings and to improve its performance.

112 CORPORATE RESTRUCTURING Rumors of hostile takeover continued to circulate and eventually Beat- rice went through a management buyout. ~ think if you are going to talk about restructuring, you have got to look at the entire Midyear period, including the mergers that Beatrice undertook, including the management buyout and so on. Certainly all of that period was not one in which I would guess Peters and Waterman, if they were to repeat their study, would have classified Beatrice in the best-managed group. Maybe the manage- ment buyout did improve Beatrice's performance relative to the period just before the management buyout, but there was a lot of restructuring going on both before and afterwards. Well, if one listens to people who champion a free market for corporate control and hears only good news about the effects of these kinds of transactions, then conglomerate mergers of the 1960s increased efficiency and corporate wealth, and the mergers and takeovers of the 197Qs and 1980s are doing so also. Eleven years ago I estimated that merger waves following World War II had resulted in some 25,000 companies being acquired through merger or takeover. In the intervening 11 years, we have probably had another 25,000 companies disappear. Yet, despite all of the bad managements that have been ousted and the synergy that has been created by this merger and acquisition activity, the country continues to decline in productivity. We continue to lose our markets to the Japanese and other foreign firms. As I mentioned this morning, for every 10 mergers and acquisitions in this country, there is one that takes place in Japan. One has to, I think, ask the question how it is the Japanese seem to remain so innovative and efficient without the tight constraints on the market for corporate control, and the discipline on managements which we get through the much heavier and more intense merger and acquisition activity that we have in this country. (Here I might mention, on the point raised this morning, that the Japanese can engage in cooperative R&D but, of course, the diversification mergers that have taken place in this country are supposed to have a similar effect. The synergies that were expected from them were because one division would be able to cooperate in terms of R&D with the other divisions and so on. So partly we were supposed to accomplish some of these things through diversification and the mergers that went with it.) Now, obviously, correlation does not imply causation, and one cannot conclude from this that mergers and acquisitions have caused our poor industrial performance over the last 20 years. But I do think that these facts fit rather uncomfortably together, and I think it is about time that we begin asking some very serious questions—well, people have been asking, maybe it is about time we begin answering some very serious questions. How can it -be that our macroeconomic performance, in terms of productivity and growth and so on, continues to go down—or certainly not go up—and

AFTERNOON SESSION, OCTOBER 18 19~ 113 yet on the micro level, we continue to conclude that mergers, acquisitions, hostile takeovers, and so on, are improving the efficiency of the companies involved? Here, just a final note on demonstration effects. If there are demon- stration effects to these takeovers and so on, then they should appear as an upward trend in efficiency and performance over time. Certainly, now, you would expect that in 1989 the demonstration effects of the market for corporate control and action would be that managers would be much more sensitive in 1989 to the threat of takeover; they should be doing a better job than they were doing in 1969. So we should begin to see an improvement in performance, in efficiency, through demonstration effects at the macro level, and yet I think it is hard to discern and I think we should begin looking for it. I have some speculative suggestions for policy but I think I will close at this point because some of you, and certainly Stu Eizenstat, want to have a chance to talk MR. El7FNSTAT: Thank you. Are there any comments or questions for our panelists? DR LICHTENBERG: I think Dennis and perhaps some of the other speakers may have described slightly inaccurately the macroeconomic record, particularly on productivity growth. My reading of the trends on productivity is we had a dramatic slowdown in U.S. industrial productivity starting in 1973. However, during the 1980s, we have had some resurgence in productivity growth. Certainly, strongly in the manufacturing sector where we can measure productivity best. In fact, the productivity growth rate, starting in about 1980, is higher than it was even in the golden age of 1945 to 1973. Now, in fact, that fits fairly well with the story that yes, perhaps the conglomerate merger takeovers were a mistake, they may have contributed to the productivity slowdown of the 197Qs. In the 1980s we have accelerated the undoing of some of that damage so the time-series evidence does provide some support for the notion that the takeovers of the 197Os and the 198()s and the changes in ownership have, in fact, been consistent with productivity improvement. MR. EIZENSTAT: May I just myself to that? My understanding is that in the manufacturing area there has been an upsurge in productivity. However, if you look at the overall productivity figures for the decade, they still are below 2 percent. They are not really terribly exciting, and the productivity has increased in precisely that area most subject to foreign competition, so you also could make the argument that it may not be the leveraged buyouts and restructuring so much as the downsizing of those industries and the requirement to mechanize and to have to compete with foreign competition and not have the luxury of having as many men and

114 CORPORATE RESTRUCTURING women doing the work as you did before the foreign competition was there. That is just a non-academic response. DR. LICHTENBERG: I agree with you, I do not want to rely too heavily on the macroeconomic data. We need microeconomic studies, and there are some of those around which I think support the view of productivity enhancement. MR. EIZENSTAT: Any comments on that point? DR. MUELLER: This is not my field, I must say, but you can come back with about 14 different references on each side. I guess my reading of Martin Bailey's work of Brookings' work, would suggest that productivity, even in manufacturing, has not bounced back. But apart from this, there is a major problem determining where you are starting these trends and where you are stopping these trends as to whether we have a serious problem in that regard. MR. FLAX: We seem to have a lot of conflicting argument here, even coming from people on the same side. For example, we are told that what counts is that we are really not attacking industries that have substantial RED. We are attacking Beatrices, we are attacking retail trade. Some of those are not successful either. There have been numerous others. These things have changed hands. What is happening, and I think it lies outside the area of this conference, but certainly has been happening, is the redistribution of income. The reason people say that first conglomeration and then deconglom- eration were equally successful is that they put money into people's pockets, and if you look at the statistics, they show that there is ever-greater concen- tration of wealth, something like what happened before the 1929 market crash. In this game of musical chairs in finance, there is always a new gimmick. I read that Mr. MiLken says now that the junk bonds are not really appropriate for the present era. He is ready to go in some other direction if we give him the chance. But let me say one thing more which is in the nature of a question. I have been told by numerous people, including Mr. Grundfest, that all I had to do was read the Jensen paper and I would find all the evidence I need. I do not find any evidence. I find a purely theoretical economic argument of the Chicago school. I recognize it because I used to work with Bill Niskanen, and it is right there. But evidence, no. The business of converting anecdotes into data and data into knowledge, which is another step, it is doctrinaire. So those who told me I would get the answer out of this particular paper have misled me, or I am too stupid to extract the answer. I wonder if any of you have seen the answer here. DR. JARRELL: Who would have thought you would have read it? It is sort of an easy answer to give. You give somebody an academic paper and you say, well, you just read that and you will find the answer and usually

AFTERNOON SESSION, OCTOBER14 19~ 115 that takes care of them. I would want to tell you that Joe Grundfest's office number is 272-2400, and that you ought to give him a piece of your mind. But less frivolously, it takes a lot more money to write empirical papers than it does to write theoretical papers. Jensen is a clever fellow and he can rip off one of those things and it is a good idea and you get all this press; as Dennis well knows, you can struggle and work for literally years to produce a piece of empirical work and by the time you get finished, nobody cares. You know, three people read it, including your parents. So that is a very difficult area for our profession. MS. HALL: I am Bronwyn Hall from the University of California at Berkeley and Gregg just gave me an excellent introduction. I am an empirical worker with some late-breaking facts. Ken Flamm, when he wrote his overview, did not have the latest version of my work in progress and I thought it would be useful if I gave you a couple of results. The first one is small but it basically confirms his hypothesis. I had mentioned it this summer in the testimony I gave to Congress. It is that the difference between the NSF and my results at least—I cannot speak for Frank Lichtenberg is that I am talking about R&D intensity when I ask does it increase or decline after acquisition, and they are talking about the level of R&D. There is no question about the fact that acquisition in general produces some downsizing in which sales decline and therefore the R&D intensity tends to stay pretty comparable, so that is the first answer. MR. EIZENSTAT: Another theory that the sales dropped. MS. HALL: So the relationship stays the same, which I take to mean that nothing much has changed really drastically at that level. On the other hand, it is true that there is downsizing going on, but that may be a good thing. I mean, you cannot say whether it is bad or good yet. You do not have enough information. The second fact is a little more interesting. I looked at the thing he was asking about, which is, suppose you now ignore leveraged buyouts and look at acquisitions in the manufacturing sector which are public firms and which are leveraged at the time they take place. It turns out, and I do not know what to make of this, that if you ask, what is the R&D intensity of the firms that make these acquisitions, zero, one, two years later, it actually goes up relative to other firms in their industry by a tiny bit. Again, not significant, but it is certainly not the case that those showed declines either. On the other hand, it is also the case that the acquisitions themselves are relatively small fractions of the firms which are doing the acquiring and I do not think you would expect leverage to have an overwhelming effect on that. So if you think there is just a problem caused by leverage, it is not there. It is not there in that sample. I think the next place to look is firms that leverage in order to avoid hostile takeovers or other types of attack, and that I cannot give you the answer on yet.

116 CORPORATE RESTRUC17JRING I also want to comment on the topic that Ken raised, which I raised two years ago or so, that he calls the demonstration effect. If everybody looks around him and sees that maybe he is a target, then the control sample, the firms that did not get acquired, their R&D behavior could be almost the same as those that were acquired, so that our tests are not very good. We cannot tell if the whole economy has reduced its R&D in response to what it sees as a more active churning of the capital market; we are not measuring that. I think that is an important question actually, and I just want to underscore that I agree with Ken, that we may not be doing the right tests yet, we empirical workers. My third comment is for Gregg Jarrell. He alluded to a result on leveraged buyouts which is not really a result. It does not actually exist, although I think the spirit of what he said is correct. In leveraged buyouts, nobody has actually gone out and asked what happens to research and development in the vast total of leveraged buyouts after they take place. The only study that actually did that is the KKR study and they have only their own sample, which is small. I have something like 80 and, of course, I do not see the numbers after the leveraged buyout takes place. Steve Caplan—he is at The University of Chicago—has made some attempt to look at numbers after leveraged buyouts take place in about 50 cases. The truth is it is hard to do. The reason it is hard to do is because there is not a whole lot of R&D in those firms to begin with and that is the important fact. It is not whether the R&D is going up or going down or whatever, it is that in leveraged buyout activity, even in the last three years, even in this most active period, the amount of industrial R&D involved is one-quarter of 1 percent of the total industrial private R&D spending in this country. You could just take it away and it would not have an effect. I mean, it is too small a number, and that is actually the important fact about leveraged buyouts and why many of us, myself included, are looking elsewhere now. MR. EIZENSTAT: Thank you for that update. We will conclude with Dennis and then I will give my very brief summary. DR MUELLER: I just wanted to chime in on one of the points that was made. One was to interpret my results- that market shares of acquired firms decline after they are taken over or merged—as indicating that downsizing is occurring, and indeed if you wait 20 years, the average firm is downsized out of existence. That, in itself, is neither good nor bad. It depends on who takes up the slack, and I think Chicago-~e economists like me tend to assume the market will work, and somebody else will come in and produce a better widget. I think what we have observed is the market does work and it is the Japanese that come in and produce a better widget. That may or may not be something we want to be concerned about,

AFTERNOON SESSION, OCTOBER 14 19~ 117 but I think that is the kind of question we want to be looking at, and whether there would be a better way of changing incentives and controls so we would keep some of these firms not have to downsize them out of existence and maybe get them recycled and on the upward track. Now, again, the market works and we'll find something to do, but there are parts of Europe where it almost looks like their main industry in the future is going to be tourism. I mean, they are good cooks and it is very pleasant to go there and the Japanese will go there for their tourist activities, but they are basically disappearing from productive activity. That is the kind of question- who is taking up the slack as these firms disappear—that certainly I do not have an answer to, and I doubt if any of us in this panel does, but I think it is a key question here. MR. EIZENSTAT: Let me conclude with first some thank you's for all of the panelists for the time and effort and really very rich contributions they made. I want to particularly thank our two CEOs, Mack Booth and Henry Wendt, for their contributions and for staying. It shows a depth of interest in the topic which we really appreciate. I want to thank the Academy Industry Program, and the two National Academies of Sciences and Engineering for hosting this symposium, and I am told that there will be a very prompt publishing of a transcript, sent to all of you and widely distributed and rightly so. This is obviously a difficult topic to summarize but let me make a stab at it. First, it does seem to me that there is a dramatically different Wall Street view from the corporate view. Quite obviously they have different economic interests. Wall Street makes money on it and it is an aggravation to corporate America. The academic data are obviously quite mixed at best. If anything, they certainly do not seem to tilt toward any evidence that there is a significant reduction in R&D from restructuring. The Wall Street view is that the major problem we have in competi- tiveness in R&D spending which everyone admits is a problem relates almost wholly to the cost of capital, that restructuring, if anything, is pos- itive, that privatizing these companies and giving the managers an equity share actually encourages better management. Indeed, it may encourage more R&D, although it is hard to know since acquired companies are sold within three to five years. In any event, that is their view. By their own ad- mission, on the other hand, LBO candidates tend to be rather low-intensity R&D performers, and this may make a real analysis of the impact on R&D very difficult to come to. The corporate view is that the real villain is the short-term horizon, and that the short-term horizon forces corporations to make short-term decisions, to satisfy stockholders who want to know what the next quarter returns are going to be, and therefore take away from the necessary concentration on R&D, which is obviously a long-term interest. In this

118 CORPORATE RESTRUCTURING view, LBOs are, if anything, essentially a negative to R&D because, again, they tend to force a short-term attitude of paying off the debt and then selling the company. Again, the data do not seem to support although anecdotally they might- the intuition one would have that higher debt levels for these LBOs would lead to less R&D. That again may be because we are dealing with firms with low R&D intensity. It may be, in fact, that these LBOs create so much more productivity and growth that companies can, in effect, pay off that debt, pay the rate of return that is required and still keep their R&D up. For me, the most important thing, of course, is the public policy implications of this. It seems to me there are, perhaps, two, and I will conclude with these. Congress, number one, did take a look at takeovers, last year and the year before. There was a great frenzy in the Congress about takeovers. There were hearings in the Ways and Means and Finance Committees; there were hearings in the Energy and Commerce Committee. Basically, although Congress wanted to act because it sensed the public wanted action, it did not. It did not even pass a bill out of committee, and I think the reason it did not is it realized that the data did not support dramatic action to limit takeovers. There were, as you know, efforts to try to eliminate the deduction for debt in takeovers, which was an obvious way to handle the situation, but then somebody said, well, that is great, except when a foreign corporation comes in to do a takeover, and they do it through debt. You cannot stop them from deducting the debt off their country's taxes. So every time Congress looked at getting to first base, it found three other reasons why getting to first base might actually be going backward rather than forward. One of the reasons that we do not see more congres- sional action right now is, I think simply that there has not yet congealed an academic view. I am a great believer in the fact that we have an almost unbelievable open public policy and political system. The guys up there, the Dick Gephardis of the world, look to you to tell them whether or not what they want to do instinctively is the right thing to do. They knew what they wanted to do instinctively, which was to stop these takeovers, but they could not find the academic and business consensus on doing it and certainly on how to do it. I think what this conference today has shown conclusively is that there are no conclusive data. That is an important point. It is sort of like a President not making a decision to fire a missile. That is as much a decision as if he fired it. It may be the right one. Here, not having academic consensus, not having adequate data, it seems to me that we ought to be moving extremely slowly in anything that would limit restructurings, until we have better data. Maybe what we ought

AFTERNOON SESSION, OCTOBER 18 19~ 119 to do is get the Office of Science and Technology Policy, and the Congress with this one trillion dollar budget, to give somebody a million bucks to really do a first rate empirical study so we can know. We have volunteers. But the point is that we do not have that data now, and when you do not have them, you do not act because your actions may be worse than the status quo. The second point and the last point that I would make is that it is not to say there has not been a consensus stated here. There is clearly a consensus that we have competitiveness problems; there is clearly a consensus that R&D spending is declining. Whether it is due to leveraged buyouts or whatever, that it is not—or at least its rate of increase is not what we would like to see. There is clearly a consensus that capital costs are higher than our competitors whether 25 percent, 75 percent, 100 percent or 300 percent, they are still higher, and you have got to figure that when capital costs are higher than your competitors, you are at somewhat of a competitive disadvantage. And there is, in fact, built into our economic system and maybe into our tax system, a sort of tilt toward short-term horizons that forces our CEOs and our best managers to act in ways they wish they did not have to, and would not if they could be given some relief from these pressures. I think we got some extremely provocative and very interesting notions from our corporate panel and from others about possible tax policies to change the short-term horizon problem: taxing pension funds, a graduated capital gains tax, ways to reduce our capital costs. Perhaps until and unless we have the kind of empirical studies that will develop a consensus on restructuring, what we ought to be doing is focusing on those things where we have reached some form of consensus, which are: we need to spend a hell of a lot more on R&D than we are; there are serious reasons for the R&D decline; we do have short-term horizon problems; and we do have capital cost problems. It seems to me that is a very productive eight-hour day that we all put in. I thank you for coming, I thank the Academies for producing it, I thank the audience for tolerating a long day. Thank you.