U.S Is On It\'s Way

U.S Is On It\'s Way

The Asian financial crisis serves as a
timely reminder of a fact too often overlooked: Merchant banking is the
leading edge of shareholder activism. Indeed, one of the chief traits shared
by hard-hit Pacific Rim economies is a decided lack of such activism. As
a result, their companies are less prepared than they might be for global
competition. To one degree or another, much the same holds true in other
markets abroad.

U.S. companies, in contrast, have seen
their competitive ability markedly strengthened by shareholder activism.

And much credit goes to merchant banking--that is, private investors managing
their own capital. True investor activism as practiced by such financial
buyers has created a new model for American enterprise. That model is based
on highly leveraged capital structures, on compensation and equity ownership
that align the interests of managers with owners, and on effective corporate
governance mechanisms to monitor and control the use of free cash flow.

All have the objective of maximizing value.

Contrary to popular perception, the strategies
of merchant banks involve not just financial engineering, but also growth,
which would not be achievable without risk capital. In the buyout world,
we have seen a fundamental shift from the 1980s mantra of "unlocking value"--capitalizing
on arbitrage opportunities and market inefficiencies. Today, the emphasis
is on creating value by molding strategic direction, giving incentives
to and empowering managers, and rationalizing operations.

Increasingly, merchant banks are the key
agents of change. In the 1980s, parts of the manufacturing and retailing
sectors were entirely reconfigured by leveraged-buyout activity. In the

1990s, financial buyers have changed the landscape of such industries as
media, broadcasting, business services, printing and publishing, and food
and health services. America\'s technological reemergence, captured in part
by the Silicon Valley phenomenon, has been fueled by venture capital. And
for more mature industries, LBOs have triggered corporate renewal.

Countless academic studies and real-world
examples have highlighted the perils of the corporate governance status
quo sans LBO: the central conflict between owners and managers over the
control and use of corporate resources, the unenlightened use of free cash
flow, and the scrutiny of and pressure on quarter-to-quarter earnings growth
versus long-term growth and value creation.

By severely constraining and imposing restrictions
on the use of free cash flow, LBOs force only positive net present value
capital decisions. Studies have shown that operating cash flow increased
on average by about 40 percent in a one-to-four-year time frame following
the transaction.

With LBOs driving many companies to become
more focused and better at what they do, the impact on the U.S. economy
and American competitiveness has clearly been positive. Michael Jensen,
of the Harvard Business School, has argued that the highly leveraged transactions
of the 1980s triggered increased levels of productivity and export growth
for manufacturers by eliminating excess capacity in mature industries.

What academics call the Anglo-American
model functions in sharp contrast to the Japanese and German relationship-based
systems, which are dominated by networks of banks and corporations and,
until very recently, were marked by the absence of an active market for
corporate control. Remember the Japanese economic miracle? It turns out
that phenomenal growth concealed the deep-seated problems of that system.

Accordingly, excess capital was not being returned to investors but instead
was employed in building overcapacity and many a misguided diversification
initiative. Similarly, capital allocation in the German economy has been
driven by the big banks, well known to have low return expectations.

Yes, the results of the U.S. model for
corporate control and ownership can be quite harsh--such is true capitalism.

But merchant banking helps keep U.S. business focused and can be a key
driver in the system. In the final analysis, merchant banking is a boon
for the competitiveness of U.S. industry as we approach the next millennium.