David Stockman, President Reagan’s Budget Director and then an early partner at the private-equity firm Blackstone Group, graciously gave me permission to re-publish the particularly relevant and prescient Chapter 23 of his bestseller, The Great Deformation: The Corruption of Capitalism in America. Here is the fourth installment.
The first Greenspan bubble provided fair warning about the dangers of rampant financial engineering. This unprecedented wave of M&A had not only supplied rocket fuel for the final stock market blow-off, but also had frequently generated the flaming mishaps mentioned above; that is, failures too ludicrous to be chalked up as ordinary business mistakes on the free market.
In fact, the Wall Street coddling monetary régime which became institutionalized during the Greenspan era had deeply transformed M&A. What had traditionally been a limited tool of corporate business strategy became an all-encompassing mechanism for speculative finance. It generated a steady diet of windfalls for takeover speculators and generous exit stipends for the top executives of target companies. On the other side of the table, top executives at acquiring companies obtained a mechanism to build empires, stock options, and an interval of apparent, if unsustainable, earnings growth.
Another attribute of this new-style financialized M&A was also critical; namely, that it put paid to the idea that there existed an honest “market for corporate control.” Irrationally high takeover premiums, giant golden parachutes for target company executives, blatant abuse of merger accounting reserves, and spectacular crash landings of M&A empires like WorldCom and Lucent were evidence of an excess supply of takeover finance, not an abundance of undervalued corporate assets.
By the late 1990s, M&A had more often than not become an instrument of corporate value destruction. Companies were routinely paying such huge takeover premiums as to preclude any reasonable probability that they could be earned back through synergy. Yet the free market failed to arrest this spree of value destruction because its natural checks and balances were disabled.
As in so many other venues, monetary distortion was the culprit. During the final forty-month interval leading up to the April 2000 stock market peak, the Fed fostered a speculative environment on Wall Street that rivaled the late 1920s. The S&P 500 index doubled and NASDAQ quadrupled. At the same time, the Fed’s panicked response to the LTCM crisis in September 1998 left no doubt that downside risk had been sharply neutered by the Greenspan Put.
Given this febrile environment, it is not surprising that deal making quickly became nonsensical and reckless. Empire-building CEOs in the tech, telecom, finance, and diversified sectors, among others, had little reason to fear that their stock prices would be punished owing to dilution from overpaying for acquisitions. Potential hits to earnings per share were being obfuscated by short-term “accounting benefits” from merger reserve kitties and wildly expanding PE multiples.
Owing to Wall Street expectations that the Fed wouldn’t allow the market to falter, the damage from rampant financial engineering remained hidden below the surface. The normal disciplinary forces of the free market were thus disabled, even as the runaway M&A spree was heralded as an expression of free market vigor.
In the late 1990s professor Mark Sower of Columbia University published a startling finding from an extensive study of M&A deals; namely, that 65 percent of large mergers destroyed shareholder value: “Clearly this negative evidence raises serious doubt over the value of the takeover market as a mechanism for disciplining poor-performing or self-dealing managers as proposed by the market for corporate control hypothesis.”
That was a heavy-duty proposition because it stripped corporate takeovers of their beneficent aura. The dislocations visited upon takeover targets were supposed to generate efficiency gains, improved asset utilization, and other economic synergies which would yield higher profits. Yet if shareholders of acquiring companies in the main do not benefit from M&A deals, then takeovers are just a random generator of unearned rents.
This goes to the very heart of bubble finance: it took M&A out of the toolbox of corporate asset management and transformed it into a thundering stampede of Wall Street rent seeking. In fact, the huge “announcement” gains in takeover stock prices are exactly the type of capricious windfalls generated by casinos, not honest capital markets. On the evidence, therefore, Wall Street became a veritable geyser of unearned M&A rents during the bull market top of 1998–2000, a pattern which would repeat itself in 2005–2007.
That most M&A deals fail was taken as a given by the Wall Street cynics who practiced the merger trade. But as that truism became evident in the 1990s M&A takeover spree, it posed an acute challenge to Greenspan’s own doctrine, under which it was axiomatic that the free markets could not be wrong two-thirds of the time.
The monetary central planners in the Eccles Building did not resolve this contradiction, or even acknowledge that the eruption of M&A was destroying value, not expressing free market impulses. Instead, they embraced the merger wave because their prosperity management model required that stock prices be levitated at all hazards. By David Stockman.