In 1952 Harry M. Markowitz published an article entitled "Portfolio Selection." Markowitz had studied under Milton Friedman at the University of Chicago and his work eventually spurred an interest in key relationships between the concepts (diversification, risk and return, volatility) that now form the underpinnings of financial modeling. Additional work from James Tobin, and William Sharpe, who's 1964 article "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk," among others, eventually ended up in the body of theory we call "Modern Portfolio Theory" today. He, along with others in the portfolio theory field, later won the Nobel Prize for their work.
This is important to our little tale here because a host of business school students, then a fast growing population and weaned on one or another early version of portfolio theory, increasingly ended up in general management positions in the largest companies in the United States. Congress managed to fuel the fire early on back in 1950 by passing the Celler-Kefauver Act, which, among other things, made it quite difficult to acquire other firms in an industry you already had a substantial presence in. Consequently, by the mid to late 1960s large corporations began to interpret the need for "diversity" to mean that they should acquire anything and everything they were able to pay for. The less relevant to their own underlying business, the better. This marked the beginning of the "conglomerate wave" where a flurry of mergers and acquisitions activity dominated thinking about how large firms should look and act. Like portfolios, it was argued. Diversified and large enough to enjoy economies of scale, of course.
Depending on how cynical you are, you might join the voices that actually attribute the rise of the Chief Operating Officer ("COO") position to the concept that mergers and acquisitions played such an important part in the success of the large 1960s and 1970s era firms that the CEO should be freed up from the bland and routine day-to-day functions of actually operating the business in order to pursue the mergers and acquisitions strategy of the firm full time. One might imagine the various ways this played into the hands (or egos) of the CEOs.
Neil Fligstein traces the evolving strategy of corporate America in these periods to the evolving networks of "experts" that progressively dominated the management teams of large firms. The rise of business schools during this period is, consequently, no accident. Growth was the key motivator. Acquisitions were the vehicle to get there. Stock price and, to a lesser extent in this period, leverage, was the currency to fund the acquisitions. Fligstein's 1990 work, "The Transformation of Corporate Control," is really required reading for anyone interested in the sociopolitical changes in corporate America at the time. That population should include anyone interested in private equity.
What could be called the "core competency" model came about somewhat differently. Instead of being the result of close cabals of insiders, from the senior executives down to the dozens of Vice Presidents who dominated the halls of public companies, and all of whom were often divided between firms along graduate school alumni lines, the rise of more external forces in finance pushed the next evolution in corporate think.
As the importance of acquisitions as a strategy rose, so too did the importance of the intermediaries who performed the mechanics of such acquisitions. The rise of large corporate law firms with mergers and acquisition specialties as well as the large investment banks, valued primarily for their ability to identify and help fund acquisitions, proved the undoing of the conglomerate wave.
Eventually, institutional investors moved towards a preference for specialization. The stock price of well focused firms was well rewarded in keeping with the new thinking: Firms that confined their acquisition to areas in which they had expertise, "core competencies," were more likely to be able to convert management expertise into success and therefore were rewarded on the exchanges. Large, and what had become unwieldy, conglomerates had failed to produce efficiencies (instead the reverse). Their stock prices sunk as their increased costs (and bloated management corps) sucked away at their profits. With their ready acquisition currency, their own stock, now devalued, they stagnated, and, perhaps worse, became weak and slow moving targets for what became the new paradigm: The Corporate Raider.
Percentage of Firms Receiving Hostile Takeover Bids (1983-1999 3 Year Moving Average)
Source: Zorn, Dobbin, Dierkes, Man-Shan Kwok
"The New New Firm: External Control of Organizations and Corporate Prototypes"
"Core Competency Theory" was formally named with the 1990 Pralahad and Hamel Harvard Business Review article "The Core Competencies of the Firm," but it existed far before that as an informal understanding in the "Market for Corporate Control," where a slipping stock price meant Michael Douglas swooped down in a corporate jet and liquidated your sagging firm. And that's where the bulk of our private equity story begins. In 1985, with Gordon Gekko. With the sudden importance of debt, rather than stock price, as an acquisition tool. No longer did you have to be a publicly held firm with a large market cap and shares to fund your acquisitions. Now you could be a scrappy set of smart guys with a talent for convincing bankers to lend you millions. With the rise of the dedicated takeover firm. With the sudden liquidity in the market for corporate control. Here marked the early height of the buyout firm. For good or for ill this is the birthplace of private equity.
How far we have come.
-ep
