financing long-term investments - princeton university

Chapter 3.

Financing Long-Term Investments

CONTENTSPage

INTERNATIONAL CAPITAL COSTS ...... +... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94The Japanese Financial Market: Sharing the Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

THE AMERICAN FINANCIAL MARKET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105The Decline in Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , ...+........,+,, . . . . . 106Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . .. . . . . . ...,...+. ., . .. . .. +.,,+,... . . 107

FiguresFigure Page3-1. Capital Input Prices, United States and Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 953-2. Comparative Capital Costs: Equipment and Machinery, 20-Year Life . . . . . . . . . . . . . 953-3. Comparative Capital Costs: R&D, 10-Year Payoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 953-4. Comparative Capital Costs: Factory, 40-Year Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 953-5. Net Savings, Percentage of Gross Domestic Product ........, .. .. .. .... +., . . . . . . . 973-6. Capital Formation in the United States, Japan, and OECD Europe . ........,..+,., 97

Chapter 3

Financing Long-Term Investments

Developing improved technology requires long-term investment. This is true of all the activitiesinvolved in technological advance-research, de-velopment, commercialization, and acquisition ofnew capital equipment. All these undertakings havea better chance of success when there is a steadycommitment of money, often for several yearsbefore the investment begins to pay off.

Much has been said about the short planninghorizons of American business managers comparedwith the longer term view taken by foreign competi-tors, especially the Japanese. Because Japan’s eco-nomic success shows most clearly what long-terminvestment can accomplish, this section concen-trates mostly on Japan, although examples fromother countries (e.g., Germany and South Korea)would be equally appropriate.

Several explanations have been offered for theJapanese propensity to take the long-term view, andfor the American focus on shorter term returns. Oneis, simply, national culture and, by extension,business culture. But this is less an explanation thanan observation. A factor with more explanatorypower is the remarkable growth of the Japaneseeconomy since World War II, and the comparativelysluggish growth, on average, of the post-1960sAmerican economy. American firms, doing most oftheir business domestically, faced potential growthrates whose mean was close to overall economicgrowth-3 percent per year or so, in real terms.Japanese manufacturers, however, were also lookingoutward, and had not only their own rapidly growingmarket to expand into, but the U.S. market as well.When markets are expanding at a rapid clip,investment for greater market share over the longterm can reap more rewards than playing forshort-term gains. Conversely, economic stagnation,recession, or even sluggish growth can work to thedetriment of long-term investors and make winnersout of short-term profit takers.

Japan’s rapid economic growth in the postwarperiod and its government’s effectiveness in promot-ing swift recovery from the oil shocks and recessionsof the 1970s and 1980s partially explain the pench-ant of Japanese managers to focus on the long term.Likewise, sluggish growth explains some, but notall, of America’s managerial myopia. Another deter-

mining factor is the financial environment. If a focuson short-term returns and profits is hurting Americanfirms in competition with Japanese and Germanfins-and this is widely accepted as true-then itfollows either that U.S. managers persist in ill-judged strategies in the face of evidence to thecontrary, or that there is something about suchstrategies that is rational, viewed from the perspec-tive of the managers. To achieve any long-lastingchanges in the strategic behavior of American fins,it is necessary to understand how the Americanfinancial environment fosters short-term strategies,and how the Japanese financial environment resistssuch pressures.

A major part of the answer lies in the terms onwhich capital is provided, which includes, but is notlimited to, its cost. By common consent, Japanesefirms have deep pockets and patient capital. Patientcapital is, almost by definition, low-cost capital, orit behaves like low-cost capital. And there issubstantial evidence that Japanese businesses haveenjoyed lower cost capital than American firms overmost of the postwar period. Moreover, the financialclimate has encouraged relatively heavy investmentin things like R&D and fixed capital to an evengreater extent than differences in simple cost ofcapital suggest. The question is why.

Today, when Japanese national income per capitais among the world’s highest and Japanese corpora-tions are swimming in profits, it may be hard toremember that, not so long ago, capital was rela-tively scarce in Japan. The Japanese personalsavings rate has been extraordinarily high through-out the postwar period. But initially, incomes werelow, so the total amount saved was not very great.On the other side of the ledger, demands for capitalwere high, mainly to feed the appetite for investmentcapital of a rapidly industrializing economy but alsoto finance frequent deficits in the national govern-ment budget. The workings of free capital marketsdo not explain the low cost of capital to Japanesefirms during those years. The wide gap betweenAmerican and Japanese capital costs, through themid-1970s at least, was a result of governmentregulation of the Japanese financial market.

Today, after years of deregulation, Japanesefinancial markets have become more open, and real

-93-

94 . Making Things Better: Competing in Manufacturing

interest rates, many suggest, have converged some-what with American ones. Yet even if interest rateswere the same, the risks to business in makinglong-term investments might still be lower in Japan.That is, in large part, because both debt and equityfinancing are provided on a less risky, more long-term basis in Japan (and Germany) than in the UnitedStates, in effect lowering the cost of capital toJapanese firms even if the cost of funds (interest ratepaid on debt capital, for example) were the same asAmerica’s.

INTERNATIONAL CAPITAL COSTSAn often-repeated argument holds that if money

flows freely between nations there should be nodifference in the cost of capital based on the nationalidentity of fins. Investment capital, regardless of itsorigin, will seek investments that are expected toyield the highest return, and investors will seek thebest terms from creditors. If there are enough of both(that is, if no investor or creditor has inordinatemarket power), capital flows should be sensitiveonly to risk. This argument presumes, logically, thatthere is no difference in risk based on nationality.And indeed, one study concludes that there is nopersistent difference in real short-term interest ratesbetween the United States and Japan (the nationmost often alleged to enjoy favorable terms oncapital provision).1

There are many flaws in this kind of argument.Short-term interest rates are not a very relevant basisfor comparison, and comparisons of other real ratesdo show a difference between Japan and the UnitedStates. For instance, the real lending rate in theUnited States in the 1980s was higher than that ofJapan by 1.1 to 4.8 percentage points, averaging 2.6

percentage points.2 But a more fundamental flaw isthe failure to take into account the differencebetween cost of funds—interest rates or the cost ofequity-and the cost of capital, which is influencedby corporate tax rates, the economic depreciation ofthe investment and its tax treatment, and other fiscalincentives for investment.3 Numerous studies havedocumented the gap-sometimes several percentagepoints—between Japanese and American capitalcosts over the past two or more decades.4 Jorgensonand Kuroda, for example, estimate that Japan’slower capital costs have been a very importantcontributor to the increasing international competi-tiveness of Japanese firms over the postwar period,excepting the years 1973, 1978, and 1989 (figure3-1).5

The most thorough study, comparing capital costsof the United States, Japan, West Germany, and theUnited Kingdom, calculated capital costs for varioustypes of investment, including research and develop-ment, new plants, and machinery and equipment.The study concluded that American and Britishcapital costs for all types of investment weresubstantially higher than those of Japan and WestGermany over the period 1977 to 1988 (figures 3-2to 3-4). Specifically, each year from 1977 to 1988,the cost of capital in America averaged 3.4 percent-age points higher than the cost of capital in Japan forinvestments in machinery and equipment with aphysical life of 20 years; 4.9 percentage pointshigher for a factory with a physical life of 40 years;and 8 percentage points higher for a research anddevelopment project with a 10-year payoff lag.6

The impact of differences this great is profound.Even small disparities can be important and havelong-lasting effects. A 1-percentage-point difference

IN~on~ Science Fo~dation, The semico~uc~r[~~, Report of a Federal Interagency Staff Working Group (Washington, DC: NOV. 16. 1987).p. 36. This point is quite debatable, even on short-term rates. The NSF study does not mention which short-term rates were compared, and other studieshave concluded that there are substantial differences in short-term interest rates.

z~e p~e lending ra~ in tie United States, and tie lending rate in Japan, according to International Financial St~iSticS. The rates were deflat~using GDP deflators, from the Organization for Economic Cooperation and Development.

3Rc)befl N. McCauley and Steven A Zimmer, “Explaining International Differences in the Cost of Capital,’ Federal Reserve Bank of New YorkQuarterly Review, summer 1989, pp. 7-28.

qFor example, w ‘‘U.S. and Japanese Semiconductor Industries: A Financial Comparison, ’ Chase Financial Policy for the Semiconductor IndustryAssociation, June 9, 1980; George N. Ha~sopoulos and Stephen H. Brooks, ‘The Gap in the Cost of Capital: Causes, Effects, and Remedies,’ TechnologyundEconomic Policy, Ralph Landau and Dale Jorgenson (eds,) (Cambridge, MA: Ballinger Publishing Co., 1986); Albert Ando and Alan J, Auerbach,‘‘The Cost of Capital in the U.S. and Japan: A Comparison,’ Working Paper No. 2286, National Bureau of Economic Research, Inc., June 1987; andDale W. Jorgenson and Masahiro Kuroda, ‘Productivity and International Competitiveness in Japan and the United States, 1960- 1985,’ paper presentedat the Social Science Research Council Conference on International Roductivity and Competitiveness, Stanford, CA, Oct. 28-30, 1988.

SD~e W. Jorgenson and Masahiro Kuroda, “Productivity and International Competitiveness in Japan and the United States, 1960-1985,” paperpresented at the Social Science Research Council Conference on International Productivity and Competitiveness, Stanford, CA, Oct. 28-30, 1988.

GMcCa~ey and Zimmer, op. cit., p. 16.

Chapter 3--Financing Long-Term Investments ● 95

Figure 3-1--Capital Input Prices, United States and Japan

Prlce index

3~~

1 -+

0.6 -

Ot 1 1 t 1 I 1 1 I 1 I 1 1 1 1 1 # , 1 1 I 1 1 i 1 I11960 1962 1964 1966 1966 1970 1972 1974 1976 1978 198019821984

— J a p a n 1 + Japan 2 -++ Us.

SOURCE: Dale W. Jorgenson and Masahlro Kuroda, “Productivity andInternational Competitiveness in Japan and the United States,1960 -85,” paper presented at the Social Science ResearchCouncil Conference on International Productivity, Stanford, CA,CM. 28-30, 1988.

Figure 3-2-Comparative Capital Costs: Equipmentand Machinery, 20-Year Life

1s1

12 -

10 -[ 1

F

0’ 1 1 1 1 1 1 1 1 1 I I

1 9 7 7 1 9 7 6 1 9 7 9 1 9 8 0 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 6 7 1 9 8 8

— Uni ted S ta tes + J a p a n + Germany -% United Kingdom

SOURCE: Robert N. McCauley and Steven A. Zimmer, “ExplainingInternational Differences in the Cost of Capital,” FederalReserve Bank of New Yotk Quarter/y Review, summer 1989,table 2.

in the after-tax cost of capital can result in differ-ences in capital stock of 7 to 13 percent in the longrun. 7 Even if American and Japanese capital costswere the same today —which they are not—markedly lower costs in previous decades in Japanwould still favor the Japanese firms.

Figure 3-3-Comparative Capital Costs:R&D, 10-Year Payoff

30 -

25 -

15 -

10 -

5 ‘

L I 1 1 , I 1 1 1 I I I1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

‘– United States + J a p a n 4 Germany * United Kingdom

SOURCE: Robert N. fvfeCauley and Steven A. Zimmer, “ExplainingInternational Differences in the Cost of Capital,” FederalReserve Bank of New York Quarterly Review, summer 1989,table 2.

Figure 3-4-Comparative Capital Costs: Factory,40-Year Life

1 4

I ,’ I12 -

10[

8 -

6 -

\

0 1 1 1 1 1 I 1 I 1 , I1 9 7 7 1 9 7 8 1 9 7 9 1 9 8 0 1 9 8 1 1 9 8 2 1 9 8 3 1 9 8 4 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8

— Uni ted S ta tes + J a p a n ‘+ Germany * United Kingdom

SOURCE: Robert N. McCauley and Steven A. Zimmer, “ExplainingInternational Differences in the Cost of Capital,” FederalReserve Bank of ~w York Quarter/y Review, summer 1989,table 2.

Sustained differences in capital costs of themagnitudes shown by McCauley and Zimmer arenot likely under free market conditions in interna-tional finance.8 Based on evidence of capital-costdifferences alone, we would conclude that thefinancial market of either the United States or Japan

TM. Fukao ~d M. Hmaz~, “Internation~izati~ of Fin~ci~ Markets: Some Implications for Macroeconomic Policy and fOr the Allocation ofCapital,” OECD Working Paper, No. 3, November 1986.

81t is q~~ ~sible, however, mat sm~ler differences could be sustained simply by different cdcdat.ions of ~vestment ri* b~ on c~ncYfluctuations, even if capital moves across national borders without restriction. A Japanese investor, for example, might insist on a higher return on aforeign investment than on a comparable domestic one simply to cover the risk of losses induced solely by changes in currency value.

96 ● Making Things Better: Competing in Manufacturing

is not free to seek its own equilibrium. Since theAmerican financial market is known to be relativelyopen internationally, and interest rates are higherhere, the hypothesis is that the Japanese financialmarket has been controlled. That is in fact the case.

Moreover, regulated financial markets are not theonly influence on capital investment or formation.Tax incentives and exemptions are widely used topromote capital investment in Japan, often for quitespecific purposes. The Japanese main-bank systemhas also played a crucial part in lowering capitalcosts and reducing the risk of investment in Japan.9

So, too, has the Japanese network of stable share-holding, designed to help managers resist pressurefrom equity owners to concentrate on short-termprofits and dividends at the expense of market share.

The American financial environment is markedlydissimilar. Not only are there fewer provisions,public and private, to promote investment, but thegovernment gives less effort to maintaining overallmacroeconomic stability, shareholders demand muchgreater accountability, and relationships betweenbanks and companies they lend to are more distant.Moreover, the pressure exerted by the financialenvironment to focus on short-term payoff, orsimply to invest less compared with Japan, isgrowing.

The Japanese Financial Market:Sharing the Risk

Capital costs are based on risk. Riskier invest-ments must promise higher returns to induce inves-tors to provide capital. There is evidence based onthe likely future earnings potential of American andJapanese firms in 1989 that the international Japa-nese manufacturing firms could now be better betsthan the American ones. While they were oftensatisfied with lower profits in the past, many

international Japanese firms are earning handsomeprofits now; their reputations are sounder, and theircapital spending plans are lavish. A 26.3 percent realincrease is anticipated in Japanese capital spendingin manufacturing in fiscal year 1989, and 11.8percent overall,10 compared with a 12.1 percentincrease planned expenditures on new plant andequipment on the part of U.S. manufacturers.11 Astable prosperous future for Japanese manufacturersis a recent development, at least in the eyes ofinternational investors. In the 1960s and even in the1970s, large, long-term investments by Japanesecompanies in markets dominated by European andAmerican corporate giants must have been viewedwith much more skepticism than comparable largeinvestments in Japan now. Yet this higher degree ofrisk was not perceived in the same way in Japan, norwas it reflected in the costs of capital for largeJapanese manufacturing concerns.

The regulation of many facets of the financialsystem of Japan made it possible for these compa-nies to get low-cost capital. According to Abegglenand Stalk, "[t]he policy of the Japanese governmentis, and long has been, to hold interest rates toindustry at as low a level as prudent monetary policymanagement allows. ’ ’12 Until the 1980s, Japan’sfinancial market was effectively closed to outsiders,and Japanese investors had few options for invest-ment outside Japan.13 Moreover, Japan’s financialsystem spread the risks of long-term investments inindustrial development widely among banks, savers,consumers, and corporations. This was done throughcontrolled interest rates; tax policies that limitedconsumer spending, encouraged saving and trans-ferred household savings to businesses on veryfavorable terms; and a variety of tax incentives thatreduced the cost of investment. In America, muchmore of the risk of long-term investment is borne by

9y. KUOWIW~ op. cit.l~e Jqm ~vclqment B~nk, ‘ ‘me Japan ~velopment Bank Reports on capi~ Spending: Survey for Fiscal yew 1988 -90,’ mimeo, September

1989, pp. 2-3. Mr. Nobuyuki Arai, Deputy Manager and Economist of the Economic and Industrial Research Department of JDB expects these plannedtargets to be met. Personal communication with Mr. Arai, November 1988.

1 Iu.s. ~partment of Commerce, Bureau of fionomic Analysis, “Plant and Equipment Expenditures, the Four Quarters of 1988, ’ Survey ofCurrentBwines.s, September 1988, p. 19.

12J~~s c. A@@ and George Stw, Jr., Kais~, the ~~anese co~or~ion (New York, NY: Basic BOOkS, hlc,, 1985), p. 178.13The following dlsc~sion ~aws heavily from tie fol]ow~g ~Uces: M. ‘f’hemse Flaherty and H.iro~ Ita,mi, ‘ ‘Finance,’ Competitive Edge: The

Serniconductor[ndustry in the U.S. and Japan, Okimoto, Sugano and Weinstein (eds.) (Stanford, CA: Stanford University Press, 1984), pp. 135-76.Philip A. Wellons, “competitiveness in the World Economy: The Role of the U.S. Financial System,” U.S. Competitiveness in the World Economy,Bruce R. Scott and George C, In@ (eds.) (Boston, MA: Harvard Business School Ress, 1985), pp. 357-394.


the corporation itself.14 In addition, Japan’s high rateof savings and rapidly rising income levels haveprovided an increasingly generous pool of capital forinvestment. Since World War II, net savings as apercent of GNP averaged well above 20 percent inJapan through the late 1970s, and have declined onlymodestly since. Net savings as a percent of GNPhave rarely approached as much as 15 percent inother advanced industrial democracies. 15 America isthe worst performer among the most advancedOECD nations; net saving hovered at just below 10percent of GNP through the end of the 1970s, andthen plummeted, reaching a low of 2.4 percent in1987, and then recovered slightly (figure 3-5).Capital formation, as a percent of GDP, has alsobeen higher in Japan than in the United States orOECD Europe (figure 3-6). Finally, Japanese lend-ers—stockholders and large city banks-tend tohave much closer and more influential relationshipswith their corporate debtors than is the case in theUnited States.l6

Although some of the conditions described aboveare slowly changing as the Japanese financial systemis deregulated, their combined influence over thepostwar period was to give Japanese firms substan-tially more freedom to make riskier, long-terminvestments at lower cost than American (or proba-bly European) firms enjoyed. From this perspective,Japan’s much-touted long-term vision—and corre-spondingly, the much remarked myopia of Ameri-can managers—becomes understandable. Rationalmanagers, operating under the rules and conditionsof financing in both countries, could be expected tobehave quite differently. This view is persuasiveeven if the numerical difference in interest rates—aslow as 1 to 3 percentage points, according to someanalyses--is modest.

The sharing of risk in Japan is not the result of anysingle action or actor, but rather of a variety ofinstitutions and laws. Moreover, the risk-sharingthat lowers the cost of capital to corporations doesnot apply to consumers. The factors that spread therisk of business investment include closed or con-trolled financial markets, channeling of funds to

Figure 3-5-Net Savings, Percentage of GrossDomestic Product

15

t I)

10 -[

5 -

I 1 I , I 1 1 1 1 1 I1977 1978 1979 1980 1981 1982 1983 1984 1986 1988 1987

— Uni ted S ta tes + J a p a n +7 Germany ~ Great Britain

SOURCE: Organization for Economic Cooperation and Development,Historical Statistics 1960-87 (Paris, France: 1989), table 6.16.

Figure 3-6--CapitaI Formation in the United States,Japan, and OECD Europe

Percent of GDP40% [ I

1‘+\ + -+~+—./ —+--+30% -+%+—+—

I3 G . . . *

-...*. .- .*. - . . + - - - * - - - . * - - -*-. -.

20% - 6

10%

I0% ‘ I I 1 1 1 1 1 1 , , 1

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

— Us. + Japan - *- OECD Europe

SOURCE: Organization for Economic Cooperation and Development,National AccourIts 1960-1964 (Paris, France: 1986).

businesses and away from consumer loans, a largepool of savings for investment, and close relation-ships between companies and capital providers(banks, affiliated financial institutions, governmentinstitutions, and stockholders). For targeted indus-tries-those viewed as having most promise fordevelopment —there are other mechanisms as well,

lq~e @@p~ ~onomies of western Europe, except West Germany, more closely approximate the American model than the Japanese, at 1east interms of capital costs, according to available evidence. See, for example, Y. Suzuki, Money and Banking in Contemporary Japan (New Haven, CT: YaleUniversity Press, 1980).

ISFlahe~ and Itsmi, op. cit., p. 137.16For Cxmple, cor~tt m~es he Point hat Japane= ba~S probably monitor the companies they lend heavily to more actively than is the Case in

other countries. See Jemy Corbett, “International Perspectives on Financing: Evidence from Japan, ” O#ord Review of Economic Policy, vol. 3, No.4, 1987, p. 45.


some of them explicit (subsidies for R&D andcapital investment, for example) and some implicitor consensual, such as protection from the threat ofhostile takeovers.17

Controlled Financial Markets—The history ofthe Japanese financial system is a study in controland fragmentation. Although recent market-openingmoves have gained widespread attention. it is onlyin the 1980s, under intense internal and externalpressure, that real liberalization has occurred, andeven so, Japan’s financial market remains one of theworld’s more controlled.18 Between World War IIand the early 1980s, a dominant purpose of theJapanese financial system was to revive and strengthenJapanese industry, often at the expense of consum-ers. Guidance of the financial system had two aims,subsumed under the single purpose of promotingJapan’s reconstruction and economic development.First, the system was designed to favor businessinvestment instead of current consumption, or, in thewords of an official of the Ministry of Finance, ‘‘toprepare the ground for industry to walk on.”19

Second, the government selectively promoted heav-ier investment in certain sectors as a part of Japan’sindustrial policy, and also helped non-targetedindustries cope with the costs of adjustment.

Preparing the Ground-Japan was a poor coun-try after World War II. Its needs for capital wereenormous. Much of its industry had been devastatedby or dismantled after the war, and the zaibatsu,family-controlled bank-holding companies that weremajor providers of capital pre-war, were dismantledduring the occupation.

20 To rebuild industrial pro-duction--and then, beginning in the 1950s and1960s, to accelerate development of targeted indus-

tries like machinery, motor vehicles, and electronics--required what capital there was in Japan to bepreferentially provided to utilities and manufactur-ing. Several things made this transfusion possible.

Japan’s financial institutions were compartmen-talized and fragmented, each with its own rathernarrow purpose and with many proscriptions on itsbehavior. Briefly, the institutions worked together toincrease savings rates (generating capital for invest-ment) and pass them on to industrial users withouthigh costs. They also worked to reduce the riskassociated with financial downturns and the costs offinancial distress to the firms.2] The institutions thatpromoted high savings rates in Japan included alump-sum payment at retirement (rather than alifetime annuity) and a marginal system of socialsecurity (though this is changing to become moregenerous); large required downpayments on houses;the absence of scholarships at universities; a systemof postal savings banks authorized to pay interestrates higher than rates available elsewhere ondeposits, and tax exemptions on interest on postalsavings up to a certain level (14 million yen in theearly 1980s); a bonus-pay system of compensationin Japanese corporations; and very high interest rates(with no tax deductibility of interest paid) onconsumer loans .22

Together, these measures discouraged consump-tion and encouraged saving. In addition to providinga large pool of capital, the system also controlled thecost of raising it. Households were paid low rates ofinterest on the savings they put into banks,23 butrewarded by the tax benefits, or ‘‘maruyu,’ fordoing so. Securities markets were tightly controlledso as to concentrate household savings in postal

ITpC~~ ~O=miC~tim ~i~ROn~d ~re, ~wri~ college, University of London; and Edward J. Lincoln, The Brookings ktitution, ~ch 1989.lg~on V&r, Jqanese Financial Markets (Homewood, IL: DOW Jones-Win, 1988).l~erW~ ~m~c~on, OTA st~f witi W. Kit~~a, Financial Bureau, h4inistry of Finance, Tokyo, Japan. Mm. 13>1989.

~efollowingdiscussionof Japan’s financial system depends heavily on the following sources: Viner,op. cit.; Andreas R. Prindl, JqpaneseFinance:A Guide to Banking in Japan (New York, NY: John Wiley & Sons, 1981); Philip A. Wellons, ‘‘Competitiveness in the World Economy: The Role ofthe U.S. Financial System,’ in Bruce R. Scott and George C. Imdge, U.S. Competitiveness in the World Economy (Boston, MA: Harvard Business SchoolPress, 1984).

21 Wellms, op. cit., p. S(jl. ~o~er ~t of ~stltutlons, ~u~ly impfiant, gave J~anese fiis preferenti~ access to the domestic market, helping toassure a demand for the products of Japanese industry without ruinouscompetition from (at that time) abler foreign competitors. Japan’s trade policiesand their relation to industry policy will be discussed in the final report of this assessment of Technology, Innovation, and U.S. Trade.

22Tobe specific, a change in the rules governing consumer finance companies-known as sarakin—in 1985 reduced the maximum rateon consumerloans from 109.5 percent per annum to 73 percent, and set a maximum of 10 percent of amual salary of 500,000 yen to the amount one customer couldborrow. Source: Viner, op. cit., p. 339. For an explanation of how the bonus-pay system promotes savings, see Abegglen and StaJk, op. cit., p. 1%.

mB~s did not pay ~ hi@ intere~ rates ~ ~st~ ~vings, but tie upper limit on be ~o~t of any one ps~ savings account, the trouble of keepingseveral accounts, and the fact that company employees are often encouraged to use the company’s main bank or an affiliate, kept some household savingsaccounts in banks.


savings and in banks, so that banks, with theircontrolled interest rates, did not have to compete forsavings by paying high rates of interest to deposi-tors, and thus narrow their profit margins. Interbanktransfers of funds were also handled so as tominimize the eventual interest rate that industrypaid. The result of all this control was that moneywas channeled from households through severalbanks to corporations, at rates that greatly favoredindustrial investment and expansion at the expenseof consumption. The extent of the transfer was huge.According to one estimate, if these measures low-ered the interest rate to business by 2 percentagepoints in 1971,800 billion yen was transferred fromhouseholds to businesses in that year-money that,under free market conditions, would not have goneto the corporate sector.24

Both commercial and governmental banks lendmoney to Japanese corporations, but the distinctionbetween them is rather more blurred than is the caseinmost other industrialized nations. The commercialbanks include the large city banks, which specializedin lending to large, blue chip corporations during thehigh growth period;25 regional banks, which tend tolend to small and medium-sized companies; theBank of Tokyo, technically a city bank, but the onlyone that could make foreign exchange transactionsuntil World War II, and is still a specialist in foreigntrade financing and foreign exchange; trust banks,which specialize in managing pension funds; spe-cialized banks; the postal savings system; andlong-term credit banks created in the 1950s and1960s by government to make long-term fundsavailable for industrialization. These last (whichinclude the Industrial Bank of Japan and the LongTerm Credit Bank) were able to provide funding tocompanies even when there were severe liquidityshortages, thus reducing the vulnerability of Japa-

nese firms to ordinary fluctuations in economicconditions.

The government exercises control over andthrough the banks in many ways. First, interest rateshave been tightly regulated since 1947, when theTemporary Interest Rate Adjustment Law waspassed. 26 By 1986, after 2 years of steps towardderegulation, about 80 percent of deposits in Japanstill came under fixed interest rate regulations.27

Interest rates have historically been negotiated bythe Ministry of Finance, the Bank of Japan, andlong-term credit banks, the financial institutionsmost concerned with the competitiveness of Japan’sindustry. Equity-to-asset ratios have also been ex-tremely low by international standards; they aver-aged 2.19 percent for the city banks as of March1986, compared with 5 to 6 percent for U.S. banks.28

This allows Japanese banks to make low-interestloans both domestically and (lately) abroad.

There are informal controls as well. The Ministryof Finance exercises enormous (though waning)control over all aspects of Japanese finance. Much ofthis is through so-called administrative guidance,which takes a variety of forms, and can affectbehavior at the level of the individual firm or bank.MoF’s instructions and desires are not often ignored,even when they are not backed by force of law. Itsstaff are “the most gifted graduates of the bestuniversities. 29 Like many other powerful Japaneseinstitutions, MoF operates through frequent contactand consensus building; it holds regular meetingswith the management of main Japanese banks,influencing the actions of Japanese branch banks inforeign nations as well as at home. When its seniorstaff retire,30 many of them accept positions at thelong-term credit banks, which were privatized dec-ades ago. According to Viner, “. . . it is neitheraccurate nor meaningful to describe the threelong-term credit banks as private institutions. Their

24y+ K~o~wa, q). Cit., p. 13.

2SBo~ km~auon and tie fmaci~ SWcess of tie lwge corporations of Japan have encouraged the city btis to look for new kinds of b@ne~-Now, with many large businesses financed mainly by bonds, depreciation, and retained earnings, the city banks are turning increasingly to medium-simdbusinesses for customers. Personal communication with Mr. Tatsuo Takahashi, Manager, Public Relations Division, Japan Development Bank, March1989.-e word “temporary” is misleading; the law is still in effect.zTViner, op. cit., pp. X16-3W.Zgviner, OP. cit., p. 20*. ~s low ~uity.to.~wt ratio is typic~, despite the fact that the 1954 Banking Act required a ratio of 10 percent. wording

to Viner, “this level was considered absurdly high by banks and was ignored. ”2~~, op. cit., p. 9.

q~e tem for this is um@duri, or ‘descent from heaven’—which by itself connotes a status of civil servants that is very different from Americanexperience.


ties with the government are so close that in manyrespects they resemble auxiliary components of theMinistry of Finance. ”

Industrial Policy--Formal and informal controlscan be used both systemwide—to advance capitalrelatively cheaply to firms and away from personalconsumption, for example-and in pursuit of moreindustry-specific goals. The government acts both asa direct lender and as a bellwether for other privatesector lenders. Its direct role is small-in 1980, only5.6 percent of all funds placed in financial institu-tions in Japan reached business directly from gov-ernmental institutions,31 and long-term credit banksprovided another 5.2 percent. But this governmentalrole is more powerful than its modest funding wouldsuggest. According to Wellons, “few dispute thatprivate lenders in Japan treat this lending as a signthat the firm or project has government support,which would reduce the risk of the credit. ” ManyJapanese sources agree. According to Kurosawa,

The government also helped to reduce risk; MITIestablished specific goals and initiated investmentfor companies, and when necessary, adjusted theorder [of] which group of companies should investfirst and which next (Rinban Toshi).32

One way the Japanese Government primes theprivate lending pump is through the Japan Develop-ment Bank (JDB). When motor vehicles werechosen for rapid development in the 1950s, andelectronics in the 1960s and 1970s, the Japanesecompanies were generally far behind American andEuropean companies in technology, and financialreturns from heavy investments in those industrieswere therefore quite uncertain. City banks, with

much of the lendable capital, might have been waryof making heavy investments in such industries, butwere reassured by JDB’s lending. Throughout thepostwar period, JDB loans have been among themost important sources of funds for new equipmentacquisition in manufacturing. In fact, even in the1980s, long after the end of any real capital scarcityin Japan, about one-fourth of JDB’s funds still go tomanufacturing. 33 Where JDB lends is, in turn,decided by a variety of government departments,with strong participation from MITI, and its lendingis meant to help major strategic industries directly.%

Financial support for both industry as a whole andstrategic industries in particular has been a crucialelement of Japanese industrial policy, but it is by nomeans the only one. Government support takes avariety of forms, including preferential access to theJapanese market,35 support for research and devel-opment, market segmentation among domestic firms,and control of foreign investment. With such apanoply of tools at hand, and the demonstratedwillingness to use them to support development ofindustries, government can pack a powerful punchwith a relatively modest direct financial role.36 Also,the variety of available tools helps to make up forweaknesses in the use of any one. For example,pump priming alone would not have induced Japa-nese banks to invest in certain sectors where theexpected returns were especially low; it was deci-sive, however, where both expected returns and riskswere high.37

The government’s control over the financialmarkets is lessening. Many Japanese financial insti-tutions see narrowing opportunities for growth

31’’fh= fi~tutionS ~c]u~e the J~p~~ Development Ba~, the Japan Export.~pofl B*, and agencies to finance smd and MdkM-Skd business.Source: Wellons, op. cit., p. 380.

32y- K~=wa, op. Cit., p. 16.XIR~fi J. B~lon @ ~wao ~mita, The Fi~n~~l Behavior of Japanese corpor~~~ (Tokyo: Kodm~ International, 1988), p. 37.

sdperm~ cornm~c~on with W. Kitamura, Ministry of Finance, op. cit., and Ballon and Tomita. op. cit.35This is ~t ~t~ Mwket pro~tion, ~ is ~met~e~ cl~m~; however, access to Japan’s markets in Wgeted tid~tries is c~fully controlled and

limited, as are opportunities for direct foreign investment and direct investment abroad. Preferential access allows Japanese producers to sell goods inJapan at higher prices or of lower quality than they could if foreign products were allowed unlimited access. Barriers to foreign competition are usuallyphased out once the Japanese indusrnes have grown to be formidable competitors. However, we are now beginning to see Japan resorting to voluntaryrestraint agreements in industries that are under pressure with the rise of the yen and the growing competence of other Asian competitors. A more completediscussion of these mechanisms will appear in the next and f-real, report in this OTA assessment.

36Althou@ ~e~ nu~r is ~lin~g, there we expe~s who @pute the dqy~ to w~ch Japan’s indu~d policies have been responsible for thepostwar success of her industries. Clearly, other nations have used tools similar to Japan’s without the same results, and Japan herself has demonstratedremarkable ability to develop industries in eadier periods when policies were quite different, as in the decades following the Meiji Restoration in thelate 19th century. Thus, more than industrial policy is responsible for Japan’s reeent performance. However, industrial policy has been and remains acritical factor in Japan’s development, as will be explained more fully in the next and fuial report in this OTA assessment.

3TS~ibWaEi~e, Ro&t Feldmm, ad Yum H~~a, The Japanese Fina~~ System in Compar@”ve perspective, study Pmpa for the U= Ofthe Joint Economic Committee (Washington, DC: U.S. Government Printing Office, 1982).

Chapter 3-Financing Long-Term Investments ● 101

domestically, as prosperous Japanese firms areincreasingly able to finance themselves, or havemore freedom to choose among domestic andforeign financing options. International pressure hasalso been a factor forcing liberalization of Japanesefinancial markets. However, it would be a mistake toregard Japan’s financial market as open—the dereg-ulation is proceeding deliberately, so as to avoidmajor shocks--or to discount the advantage thattight controls gave to Japanese industry during thepostwar period through the early 1980s. Without thedeliberate channeling of capital away from personalconsumption and towards industry-particularlythose that were targeted-it is unlikely that so manyJapanese industries would be so prominent on theinternational scene as they are now. It is also prudentto assume that, if Japanese manufacturing comesunder increasing international pressure, the financialsystem is capable of mobilizing quickly in response.

Corporate Finance-It is well established thatJapanese firms rely more heavily on externalfinancing-both debt and equity—than Americanfirms, and that the reliance was greater in the pastthan it is now. Debt financing in particular hasplayed a greater part in corporate finance in Japanthan in the United States (until very recently) andother western industrialized nations, and it still doesso today, even though the percentage of equityfinancing is growing in Japan.

Precise figures are somewhat deceptive, as manycritics have pointed out. The gearing ratios38 re-ported are based on the book value of companies’assets, which are reported at historic cost. Inflation,especially the run-up in the value of property andland in Japan, tends to understate asset value andthus overstate gearing ratios. However, even whenthe figures are corrected to reflect more realisticmeasures of Japanese (and American) fins’ assetvalues, gearing ratios in Japan were still roughlytwice as high as those in the United States only a fewyears ago. In 1981, for example, Japanese gearingratios were estimated at 0.56 to 0.62; American at0.28 to 0.30.39 Japanese dependence on bank financ-ing is also high compared with that of European

nations. American companies have depended muchmore heavily on retained earnings (internal financ-ing) and equity. This remains true even with modestmoves away from debt as a source of new funds inJapan and increases in debt in America,40 the latterresulting mostly from takeovers and leveragedbuyouts to defend against the possibility of take-overs.

Japanese reliance on bank financing, particularlywhen capital was much less available there than it isnow, underlines the importance of low interest ratesin Japan. It also means that fins’ relationships withbanks are more important than their relationshipswith shareholders, compared with the United States(and much of Europe). As long as Japanese banks_ aresympathetic to the need to make long-term invest-ments with little immediate return, firms are morelikely to make such investments. This would be trueeven if Japanese fins’ relationships with theirshareholders were the same as those of Americanfins; however, Japanese shareholders are also moresympathetic to the long-term interests and perform-ance of Japanese firms than in short-term financialgains, compared with American shareholders.41 Inshort, while the structure and regulation of Japanesefinance would alone lead to the conclusion thatJapanese firms are better able to make long-term,relatively heavy investments than American firms,the nature of the relationships between capitalproviders and firms supports this conclusion as well.

Japanese banks-including both commercial bankslike city and regional banks, and governmentinstitutions like the Japan Development Bank-aremore involved with their clients than are Americanbanks. This is true at every step of the process, fromscreening to monitoring of firm performance.42 Tobegin with, Japanese firms usually have a specialrelationship with one bank, a system known as themain-bank system, and this relationship is animportant part of the risk-sharing that allows Japa-nese firms to enjoy or act like they have lower capitalcosts. Kurosawa characterizes the main bank systemthis way:

s~e~ng r~o is defined as the sum of short- and long-term liabilities divided by total assets.s~lWes ~P~ in Jenny ~~~, ‘‘l,n~rnation~ Perspectives on Financing; Evidence from Japan,’ O#Ord Revi6’w of Ecown”c po/icY~ vol~ 3!

No. 4., p. 34.

Wen Bemanke, “Testimony on corporate debt,” mimeo, May 25, 1989.AIThis is l~gely due to tie institution of stable shareholding, as is explained later in this chapter.4~s coWlwim, ad much of tie following disc~sion about banks’ relationships with firms, depends heavily on CorbeV oP. cit., Passim.


The main bank almost always has the largest sharein such business relationships as lending, sharehold-ing, trusteeship of bonds, deposits, and so on. It givesspecial priority to the client firms in credit rationing,and in the case of a severe slump or bankruptcycrisis, coordinates the responses of other lendingfinancial institutions and acts as a mediator andsupporter for the clients’ survival. Consequently, itis essential for the main bank to monitor the firm, andfor the other banks the actions of the main bank actas a signal. If the actions of the main bank remainunchanged, there are no problems in the fire-t. Themain bank’s additional loans in effect guarantee thesecurity of the other banks’ loans.43

Differences begin with the way they screenpotential borrowers. For example, city banks are lessconcerned about debt/equity ratios and are moresensitive to the firm as a going concern (rather thanas a default risk) than are non-Japanese banks. Thescreening is extensive, so when a city bank takes ona client it is generally considered a good credit riskby others. Part of the screening is done by the citybanks, but they are also able to rely on extensivescreening by the Japan Development Bank and theIndustrial Bank of Japan (IBJ).44 There is somegenial disagreement between these two institutionsas to which developed the screening procedures bothemploy—both lay claim to it—but in any case, it isthorough. According to IBJ, the screen consists ofincreasingly smaller sieves. First, the IndustrialResearch Department (IRD) develops informationon specific industries, examining in detail possibili-ties for growth and international competition. TheIRD also examines new sectors and technologies,such as biotechnology and superconductivity, fortheir eventual commercial possibilities. Once indus-try prospects are understood, the Credit Departmentscreens individual companies. If IBJ accepts acompany, that is a powerful signal to other financialinstitutions of the company’s creditworthiness, anda pattern of heavy lending to any particular industryor sector is also a bellwether.

There are several reasons why the close tiesbetween main banks and their corporate customerscould lead to a longer term outlook on the part ofbusinesses, and possibly even to better decisionmak-

ing than in countries like the United States orEngland, where ties between banks and the compa-nies they lend to are more frequently arm’s-length.As noted above, the close relationships between citybanks and their customers are based on massiveamounts of information, always a good basis forsound advice and decisionmaking. The city banks,along with other major Japanese financial institu-tions like JDB, have become powerful informationbrokers, and their ability to gather and processinformation about businesses and business condi-tions in a variety of industries around the globeprobably exceeds that of all but the very largestcorporations. Banks can therefore serve as importantsources of information for strategic and operatingdecisions for their closest customers. This assistanceon the part of banks is influential in encouragingcompanies to focus on longer term goals in Japanand Germany.

Another difference between Japanese and Ameri-can bank lending is that loans from city banks aremuch more likely to be long term. According to theBank of Japan, about 40 percent of Japanesecorporate borrowing had a maturity of more than ayear, compared with only 19 percent in the UnitedStates, as of 1985. However, the longer maturities ofmany Japanese loans are not exceptional comparedwith France and the United Kingdom (where about40 percent of loans are classified as being long ormedium term) or Germany (where about 60 percentof corporate loans are long term) .45

Finally, it is well established that the conditions ofloans are changed when economic conditionschange in Japan. Although this practice is alsocommon in western industrialized nations, the kindsof changes made are different. Corbett points outthat a shortening of the term of a loan would beexpected if a firm gets into trouble; yet in Japan loanmaturities have lengthened at the same time thatbankruptcies increased. With heavy investments ofboth capital and prestige in the successor failure oftheir clients, Japanese (and also German) banks arefar more likely, in a crisis, to extend additionalfinancing and assistance before pulling the plug than

43Y. K~~Wa, op. cit., p. 18.

44~e ~~~ B~of Japmis me of J~an’s~ ~ong.~~ c~it ba~, ~d it is~s~ly descri~ u tie most prestigious of d Japanese @Vatebanks. Its purpose is to provide long-term capital to private corporations, witb priority given to industries that are part of the government’s industrialpolicy.

d5Bti of JqM& ECO?WW St@stics Att?u@ VtiOUS ye~; ~d COrb@t, Op. cit.. P. 42.

Chapter 3-Financing Long-Term Investments ● 103

an American or a British bank.46 Japanese banksoften forgive payments on debt principal duringtough economic times, or restructure debt in order toallow firms additional options to overcome theirproblems. 47 While some firms do eventually gobankrupt or are forced to restructure severely, banksexplore many other options with their clients (oftenat great cost to themselves) before declaring loans indefault. Prindl tells the story of Ataka, the fourthlargest Japanese trading company in the early1970s. 48 It got into trouble over excessive creditextended to a refinery in Canada, and eventually hadto merge with another firm, C. Itoh. However, $370million in uncollectable receivables were absorbedby its house banks, Sumitomo and Kyowa. This waspossible, in part, because of the widespread beliefthat no large bank would be allowed to fail. Indeed,in 1986, Japan had its first bank failure since WorldWar H, and that was a result of ‘massive, long-termcorruption. This situation is changing, like somuch of Japanese business. According to Viner,“banks have been informed that they can no longerexpect central bank rescue in the event of a liquiditycrisis.”49 So far, this new policy has not been tested.

Even the promise of government support does notseem adequate to explain why Japanese banks aremore willing to go the distance with their clients, aslong as there is some chance of maintaining thecompany in business. In part, it is because the mainbank’s relationship with a client company goes farbeyond a loan. Companies generally encourage theiremployees to deposit their savings in their mainbank, and deal with the main bank or its affiliates forlife insurance and managing the pension fund. Inaddition, the main banks, in return for bearing someof the risk of the company’s long-term investment,are privy to a great deal of information about thecompany, and are allowed to take part in itsmanagement should it get into trouble. Main banksoften accept deferment of payment on principal and

interest if a client gets into trouble,50 and willcoordinate rescue funds from other banks. In addi-tion, however, they investigate whether the com-pany can be restructured to get it out of trouble, andoften draw up the restructuring plan.51 Corbettpoints out that exchanges of personnel at both seniorand junior levels between banks and large firms (andgovernment ministries) are common.52 Banks some-time suggest changes in strategy when evaluating acustomer’s request for a loan, and make moreforceful suggestions of strategic changes when afirm gets into trouble.

The kind of involvement that large banks main-tain with their customers resembles that of preferredstockholders more than creditors, according toKurosawa. Preferred stock may have a fixed divi-dend, but if profits are insufficient to support it, therate will be reduced and carried over.53

But what about actual equity holders? Here, too,there are different relationships in Japan. Most largeJapanese firms belong to groups known as keiretsu,which translates as “group arranged in order. ”These are companies that have primarily beenassociated with one city bank, and hold relativelylarge amounts of each other’s stock—1 to 3 percent,typically, of the stock of each other member of thegroup. The result is that a majority of shares of allmembers are held by other members of the samekeiretsu.54 Japanese city banks also typically holdstock in the companies they provide credit to, withthe maximum amount now limited to 5 percent.Finally, although intra-keiretsu shareholding is de-creasing, a majority of stock in Japanese corpora-tions is still typically held by corporate and otherinstitutional investors, rather than by individualshareholders. As of 1988, 69 percent of all shareslisted on the Tokyo exchange were held by domesticinstitutional investors—19 percent by banks, 13percent by life insurance companies, and 26 percentby other corporations—while 25 percent was held by

‘WOrbett, op. cit.a~erW~ com~c~on wi~ David HI,@ Whittier, 1988; Flaherty and Itami, op. cit., p. 144; Corktt, pp. 46-51 Passim.4~~, op. cit., p. 64.49Viner, op. cit., p. 196.

5TM5 should not be reg~d as a distant possibility, Ballon and ~rnita point out th~, “more often than not, [the] bank at some point in time hashad to stage a rescue operation for its mqjor clients with the cooperation of other parties concerned,” Ballon and ‘fbmita, op. cit., p, 60,

51Y. Kuosaw~ op. cit., pp. 19-20.5~a~ti, op. cit., p. 45.

53Y. Kwsawa, op. Cit., p, 20.54Viner, op. cit., p. 2.


individual Japanese stockholders and 6 percent bynonresidents. 55 In contrast, 57 percent of U.S.equities were held by individuals as of mid- 1989.56

More important than the pattern itself is thecharacter of equityholding in Japan. Until the early1970s, it was virtually impossible for more than atiny trickle of foreign capital to find away into Japanwithout the express permission-indeed, sponsor-ship--of government. In 1971, the door was openeda crack through revision of the Securities ExchangeLaw, and along with the liberalization came mount-ing concern that foreign companies would take overJapanese corporations. To prevent that, Japanesecompanies—at the urging of government—resortedto a system known as stable shareholding.

Stable shareholders are Japanese nationals whocan be counted on to keep their shares, no matterwhat happens to their price. It is a primary duty offinancial officers of corporations to find stableshareholders. According to Ballon and Tomita,

When a capital increase is planned, financialexecutives usually visit the major shareholders whomight be willing to subscribe to new shares andrequest their cooperation in purchasing the newshares at par while retaining both old and new shares.However, a request for further subscription of sharesfrequently implies a favor in return. . . the firm mayat this time confirm its friendly relationship with thebank by promising (albeit unwillingly) to buy morebank shares.57

Stable shareholding has had the direct result ofpermitting companies to keep a longer term view intheir capital investment. Stable shareholders preferretaining earnings to receiving high dividends,permitting the company that issued the stock toreinvest its earnings, This reinvestment, in turn, isviewed as directly contributing to higher shareprices. Since stocks are carried on their owners’books at purchase price, rather than market value,the rapid increase in share value has allowedJapanese banks and corporations to carry substantialhidden reserves. These hidden reserves are the utility

infielders of Japanese accounting: they can be usedto manipulate the reported levels of profit, andthereby, taxes and dividends. For example, if thecompany has a loss and needs to show a small profit,it can sell a portion of its investment securities,whose book value is usually significantly underre-ported. Often, it sells these to an affiliate or anotherstable shareholder, and expects in its turn to pay thesame consideration to its affiliates when needed.58

The amount of hidden reserves is staggering: at theend of March 1988, the hidden reserves of securitiesof the 13 city banks alone totaled $229 billion.59

Stable shareholding has served the needs of theJapanese economy admirably. It permitted long-term investment at a time when Japan’s companieswere much more vulnerable to foreign competitionthan they are now. It has helped Japanese companiesto continue expansion and market share-buildingduring the various economic upheavals that para-lyzed their competitors—through energy shocks ofthe 1970s, the recessions of 1974 and 1982, andthrough endaka in 1985-86. Most observers expectstable shareholding to continue for the foreseeablefuture, although it will face increasing challenges inthe years ahead. Financial liberalization in Japan andthe expansion of Japan’s business and financial tiesaround the world have made it more vulnerable tooutside economic uncertainties. While its recoveryduring the postwar period has been robust, this newinternational exposure could well reduce its powerin the future. The high yen, too, has put the wholeeconomy on a more precarious footing. Some of theadvantages Japanese firms receive have narrowed ordisappeared, and strong competition from a new setof industrializing nations has left Japanese manufac-turers with less ability to ride out a prolongeddownturn. In a downturn, stable shareholding mightstart to unravel, as companies in trouble draw downtheir hidden reserves. The demise of this institutionis unlikely without a major recession, and not certaineven with one; however, if it does happen, thesystem is likely to come apart rapidly.60 That,according to Ballon and Tomita, “would have

55H1dW Ishihwa, “Jap~’s Compliant Shareholders, “ The Asian Wall Street Journul Weekly, June 13, 1988, p. 17.56sW~tia ~dwq ASWciation ~ta, ~mpi]~ from Fl~ of F~ A~~ou~s, F~er~ Re~~e Bo~d. Thi.s total is down from 65 percent in 1985

and 85 percent in 1%5.sTB~lon and Tbmita, op. cit., p. 52.ssB~lon and Tomita, op. cit., p. 202.59y. K~o~wa, Op. Cit., p. 20.

@Personal communication, OTA staff with Kimihide Takano, Senior Analyst, Corporate Division, The Nikko Research Center, Ltd., Tbkyo, Mar,22, 1989.

Chapter 3---Financing Long-Term Investments . 105

profound repercussions on the stock market and theJapanese economy as a whole.”6l It would tend toshorten the perspectives of Japanese managers andfirms, making them more like American fins.However, given the pervasive effect of administra-tive guidance from the Ministry of Finance, it seemsunlikely that the Japanese financial market willbehave a great deal like that of the United Statesanytime soon.

In sum, a network of policies, practices, andrelationships acts to support heavy investment inlong-term performance in Japanese industry byspreading risk. In contrast, American firms mustcarry more of the risk of such investments bythemselves. While changes are occurring in theJapanese financial market, the backlog of more thanthree decades of such advantages has been highlyeffective in putting Japanese firms in the securepositions they now hold, relative to American andEuropean competitor. Even if the changes weredramatic and rapid (which they are not) theseadvantages would not disappear quickly. It may wellbe that alterations in the way American managers aretaught to think about business could foster a morepositive attitude toward long-term investment, par-ticularly in improved technology. But it is the rulesunder which they must operate rather than theireducation that is the principal influence on how U.S.managers view long-term investment.

Even with changes in the rules, however, therewill be outliers. High capital costs have hobbled butnot crippled American firms in international compe-tition; some firms are able to make substantialinvestments in technology development for manyyears. If a firm exploits its R&D effectively, suchinvestments are rewarded, not penalized, by equityholders. But now, with increasing competition, morefirms are forced to choose between supporting profitmargins or stock prices and postponable expendi-tures like R&D.

Some long-term investments pay off, and somedon’t. We should not expect that risk-sharing willnecessarily result in longer term investment acrossthe board in America, or that every long-terminvestment will be successful. However, withoutsome changes in the financial rules of the game,

American companies will continue to focus mostlyon short-term profit, to their detriment in interna-tional competition.

THE AMERICAN FINANCIALMARKET

The problem for America is not only that Japan’scapital costs are lower than those of the UnitedStates, or that Japan’s providers of debt and equitycapital are content to take more of their rewards ascapital gains rather than as cash payments. Amongthe developed nations, Japan goes unusually fardown these paths. America is, for the most part, atthe other end of the scale. Our capital costs are highnot only relative to Japan’s, but relative to those ofmany European countries as well, and they are highin real terms, compared to what they were in the1960s and 1970s. Institutional investors are, ifanything, more insistent on receiving short-termfinancial gains than they have been, and they havepowerful tools to use if their interests are notaddressed. Rather than mobilizing its resources tosupport American manufacturing during its difficul-ties, the United States often seems indifferent to orcontemptuous of the nation’s manufacturers. Theproblems of manufacturers, we often say, are self-generated; manufacturing is badly managed, andbadly managed firms ought to fail, or change hands.The contrasts with Japan, and with Europe as well,are great.

Some—not all--of what we attribute to badmanagement is simply a matter of intelligent peopleplaying by the rules. If our interest rates are such thatAmerican managers can prudently invest $0.37 inreturn for $1.00 in 6 years, while a Japanese managercould invest $0.66 for the same return,62 we wouldexpect to see about half as much long-term invest-ment in America as in Japan. If stockholdersevaluate a company’s performance on the basis ofquarterly or half-yearly reports of profit, we wouldexpect managers to emphasize short-term profits,even when it raises possible conflicts with longerterm investment. And if showing a profit forshareholders is one of the most important factors inthe survival of a business, we should expect to seefinancial specialists wielding more power in compa-

61B~lon and lbtnita, op. Cit., p. 53.6~e= fiWes reflWt tie actu~ co5taf<api~ difference of Japan and Americ& according to one calculation. See J~es M. po~rbas ‘me cow of

Capital Consequences of Curbing Corporate Borrowing, ’ Testimony before the committee on Ways and Means, U.S. House of Representatives, May16, 1989.


nies than in nations where share price is a lesspressing daily concern to company managers. Thepreoccupation with finance and short-term shareprice performance was reinforced by the wave ofmergers and acquisitions American business experi-enced in the 1980s. Rather than moving toward anenvironment more conducive to long-term invest-ment in the development and use of outstandingtechnology, the U.S. system raised the hurdles.

Another complicating factor is instability in thefinancial environment. Federal decisions affectingthe value of the dollar and interest rates take businesscompetitiveness into account only tangentially, if atall; yet such changes can have profound effects onthe ability of businesses to make prudent long-terminvestments. Again, Japanese policies contrast sharply.U.S. Government support for long-term research,development and investment has also been some-what shaky, leaving businesses that invest in suchprojects vulnerable. For example, the Administra-tion sent confusing signals about its support fortechnology development in semiconductors andhigh definition television in 1989. Even if themodest support for R&D in these areas is continued,the unreliability of Federal commitment to suchprograms could make industry wary of such ven-tures. 63 Another example of the inconstancy ofFederal efforts to promote technology developmentand diffusion is the impermanence of tax measuresthat favor capital spending or R&D.

In short, America’s financial environment isgenerally unfavorable to long-term investments intechnology development and diffusion, and govern-ment actions that mitigate the effects of this unfavor-able environment have lacked commitment.

The Decline in Savings

Nations must continuously invest in productiveassets-plant and equipment, people, and technol-ogy development—to sustain investment and livingstandards. Investment funds come from saving,domestic and foreign. In the 1980s, an increasingproportion of U.S. investment has come from

foreign saving, because U.S. savings rates havefallen.

In the 1970s, net national saving (the percent ofnational income saved by business, government, andhouseholds) averaged 7.9 percent. Of this, 96percent was invested domestically, and 4 percentwas invested abroad. In the 1980s, savings ratesdropped, and by the middle of the decade-1985 to1987—net national saving dipped to 2.1 percentbefore rising to just above 5 percent in 1989. Netdomestic investment (the percent of national incomeinvested) dropped to 5.7 percent, lower than in the1970s but greater than the amount of investablecapital provided domestically. The United Statesmade up the difference by becoming a net importerof investment funds, borrowing $417 billion fromabroad over the 1985-87 period.64 To attract savingsfrom abroad, the United States has had to raiseinterest rates, or the return to investors. Importingcapital allowed the United States to invest more thanits own savings would permit, but it also raised theprice of domestic investment. This means thatimproving and replacing productive assets andtechnology for U.S. firms became more expensive inthe 1980s. A nation trying to keep pace withwell-financed and technologically sophisticated com-petition can ill afford this.

The decline in savings occurred across the board.The sharpest change in the 1980s was a decline ingovernment saving, manifested by budget deficits atthe federal level. Falling household and businesssavings contributed to the decline as well. TheFederal budget deficit resulted from a tax cut, whichslowed the growth of revenue, and from increasedoutlays, principally for defense.

The reasons behind falling household savings areless obvious. Many explanations have been ad-vanced for this drop-and conversely, the rise inconsumption as a percent of national income—butthere is little consensus on which are most signifi-cant. Some analyses attribute part of the decline tohigh interest rates, which made it possible forcorporations to decrease contributions to pension

631n ]~e 1989, -Or$ of an A&ninis~ationpropos~ t. kill f~ding for Sematwh in tie fisc~ ye~ 1991 budget s~fac~. The nunor woseconcurrentlywith Administration proposals to shut down the Defense Manufacturing Board, and an OMB proposal to reduce DARPA funding for HDTV, While theAdministration eventually denied any plan to kill funding, the rumor was widely believed and taken seriously by much of the electronics industry. See‘‘Administration Charged With Seeking Funding Cuts for Sematech, Other Projects,’ lnternatwnal Trade Reporter, Nov. 15,1989, pp. 1481-1482; andLucy Reilly, “Death Knell for Sematech?” New Technology Week, Nov. 6, 1989, p. 1.

@George N. Hatsopoulos, Paul R. Krugman, and James M. Poterba, Overconsutnptwn: The Challenge to U.S. Econom”c Policy (New York, NY andWashington, DC: American Business Conference and Thermo Electron Corp., 1989), pp. 6-7.

Chapter 3---Financing Long-Term Investments ● 107

funds (these are included in household savings). Thejury is out on the effect of demographics. Some thinkthe baby boom was a major factor in increasingconsumption rates: since young people typicallysave less than the middle-aged, they expect personalsavings rates to rise as the baby boomers mature.Others dismiss demographics as having little ex-planatory power. Another often-cited argument isthat gains in wealth in the 1980s--capital gains oncorporate equities and homes----encouraged con-sumption. If people feel richer because their assetsare increasing, goes the argument, they feel less needto save. On the other hand, since real wages andsalaries dropped during the 1980s, falling savingsmay reflect attempts to keep up consumption pat-terns in the face of (for most families) decliningincomes.65 Another theory is that the propensity toconsume may have been fueled by the easy availabil-ity of consumer credit.66

The enormous increase in Federal Governmentdebt and the fall in household savings rates wereenough by themselves to force a curtailment ofcapital formation, or a switch to capital imports, orboth. The decline in business saving has been lessremarked, but is important for two reasons. Betweenthe mid-1960s and the late 1970s, business saving—measured in national accounts by the retainedearnings of corporations-fell from 4.5 percent ofGNP to 2.75 percent. By the mid-1980s, businesssaving fell still further, to 1 percent of GNP.67 Unlikethe ballooning Federal deficit and falling householdsavings, the decline of business savings is long-standing, and cannot be fully understood in terms ofthe events of the 1980s alone. Nonetheless, thedepression of business savings to the lows of the1980s is part of another change in the financialenvironment-that is, mergers and acquisitions—that limits the willingness of American companies tomake long-term investments.

Mergers and Acquisitions

Mergers and acquisitions are a normal feature ofthe U.S. financial landscape, and ordinarily not acontroversial one. Occasionally, though, merger andacquisition (M&A) activity heats up, as it did in the1980s, provoking debate and examination. M&Aactivity has raised many questions including those ofbasic efficacy (are mergers and acquisitions really aneffective managerial disciplinary force, for example)and effect (do mergers and acquisitions generallyimprove long-term productivity, or produce out-comes as desirable from society standpoint as fromtarget shareholders’?). None of the questions areresolved. Even questions that are somewhat periph-eral to the whole debate—such as the effect onmanagers’ willingness to undertake longer terminvestments in technology development and diffu-sion—are hotly debated. While there is a growingbody of research and empirical evidence on thecauses and consequences of M&A, there are fewpoints of consensus in the argument. But it is clearthat the takeover wave of the 1980s is a specialfeature of the American financial environment,much more prominent here than in any other nation.The length of the following discussion is not meantto imply that M&A is the only, or even the major,factor that causes American managers to focusstrongly on short-term profit, but M&A does inten-sify the pressures of the American financial environ-ment, characterized by high interest rates and capitalcosts and macroeconomic instability.68

Briefly, the argument goes as follows. One pointof view-often articulated by businessmen—is thatcorporate raiders have forced a preoccupation withshort run performance that has disrupted businessplanning. With access to new capital instruments(junk bonds), acquirers can afford to pay inflatedprices to get controlling interest in their targets. Thefirst defense against potential raiders, therefore, is tokeep the stock price high enough to fend them off.Since stock prices can fall significantly on disap-pointing quarterly profit performance, business man-

GsKatherine Gillrnan and Joy -erley, “Is the Middle Class Shrinking?” Furures, April 1988.~he following sources discuss reasons for falling savings rates: Barry P. Bosworth, ‘ ‘There’s No Simple Explanation for the Collapse in Saving,’

Challenge, July-August 1989, pp. 27-32; George N, Hatsopoulos, Paul R. Krugman, and James M. Poterba, Overconsumption: The Challenge to U.S.Economic Policy (Washington, DC: American Business Conference, 1989); David E. Bloom and Todd P. Steen, “Living on Credit,” AmericanDemographics, October 1987, pp. 22-29; and William D. Nordhaus, ‘‘What Wrong With a Declirting National Saving Rate?’ Chullenge, July-August1989, pp. 22-26.

67Nordhaus, Op. Cit., p. 23.

6s The u~t~ States is not ~W~le compm~ t. most Comtnes, but the American financial environment for business is less stable than that of eitherJapan and West Germany, our premier international competitors.


agers must focus on keeping short term profits atacceptable levels. This, in turn, exaggerates thealready short-term planning horizons of Americanbusiness. 69

In some cases, more drastic steps maybe taken tofend off a potential takeover, such as taking thecompany private by means of a leveraged buyout(LBO), or implementing some kind of “poison pill”defense. While these strategies can keep the com-pany from changing hands, the effects on planninghorizons can, ironically, be no friendlier to long-term investment and planning. In the case of adefensive LBO, the company exchanges equity fordebt, making it safer from raiders but harder pressedto maintain cash flows. Debt payments must bemade, while dividends can be postponed during thintimes. Cash flows that could have been invested inresearch and development, plant and equipment, orother long-term projects must be at least partlydedicated to paying interest and debt retirement; socompanies may defer long-term projects in favor ofmeeting their short-run obligations.70

Current concern is spurred by the fact that theavailability of high-risk, high-return bonds hassubjected many more companies to the threat of atakeover than in the past. Junk bond financing canturn even relatively small operators into potentialraiders, and even large companies are not immunefrom the possibility of a takeover. Any company thatappears undervalued may be fair game.71 Moreover,a company’s value to a raider can seem inordinatelyhigh to many business managers;72 company manag-ers feel pressed to keep their stock price above eveninflated asset value.

The foregoing argument raises two questions.First, it is difficult to accept at face value thecontention that a price can be too high if a willingbuyer agrees to pay it. The difference between

managers’ estimation of the real value of theircompanies and that of potential acquirers maytherefore be that outsiders can see higher yieldingopportunities for managing companies’ assets thanmanagers do. Experts hold divided opinions onwhether acquisition prices are too high.

The concern implicit in the arguments of manybusinessmen is that equity markets consistentlyundervalue long-term investments. If the resultingstock prices do not fully reflect the companies’investments in future output, then perhaps acquisi-tion prices are not too high, but represent a morerealistic appraisal of long-term company value.Here, too, there is no consensus of expert opinion,but it should be pointed out that there is no necessaryinconsistency here: while ordinary stock prices maybe too low, acquisition prices may be too high.73

The opponents in the debate view debt verydifferently. Those who see takeovers and mergers asa necessary disciplinary force on management seethe higher debt levels that result from much of thecurrent takeover activity as keeping managers fromsquandering corporate assets on less productiveventures. 74 Others regard the high debt that oftenresults from a hostile takeover, or a defense againstone, as a ball and chain hampering companies’abilities to invest, particularly in long-term ventureslike R&D. The pressure of high debt load is expectedcause many defaults or bankruptcies in a recession.Even without a recession, however, the junk bondmarket is troubled; in 1989, corporate bond defaultswere up 136 percent over 1987, largely due todefaults on junk bonds.75

Most of the evidence indicates that the directeffect of all kinds of M&A activity on R&Dexpenditures or intensity (R&D as a percent of sales)is small or negligible. Bronwyn Hall, examiningapproximately 250 manufacturing acquisitions be-

@John C. Coffw, Jr., ~uis ~we~~in, and Susan Rose-Ackerman, Knighrs, Rai&rs and Targets (New York, NY: Oxford University ~ess. 1988),pp. 34.

7Wor a briefsummary of the arguments on both sides of the controversy, see Robert R. Miller, ‘‘The Impact of Merger and Acquisition Activity onResearch and Development in U.S.-Based Companies,’ contractor report to OTA, November 1989. The report is a summary of interviews with R&Ddirectors of 19 fms with a variety of M&A experiences. Some had undergone friendly mergers, some hostile takeovers, some leveraged buyouts, anda couple had no resent experience with M&A.

71 Miller, op. Cit., p. 3.

TzW~en E. Buffett, Mich~l D. Dingman, and Harry J. Gray, with Louis Lowenstein, Moderator, ‘‘Hostile Takeovers and Junk Bond Financing: APanel Discussion,” in Coffee, et al., op. cit., pp. 10-27.

T3Coff=, et al., op. cit., P. 4.TqMiller, op. cit., p. 6.75Richmd D. Hylton, “Corporate Bond Defaults Up Sharply in ‘89, ” The New York Times, Jan. 11, 1990.

Chapter 3--Financing Long-Term Investments . 109

tween 1977 and 1986, concludes that the post-acquisition R&D intensity of the firms was about thesame as pre-acquisition; moreover, the R&D inten-sity of the post-acquisition firms was not differentfrom the R&D intensity of all manufacturing firmsduring the same period.76 In addition, there is abroadconsensus that R&D-intensive firms are unlikely tobe attractive takeover targets, and that the majorityof M&A happens in firms that do relatively littleresearch and development.77

Some use this kind of evidence to dismiss thepossibility that M&A is having corrosive effects onR&D in particular or long-term investment inparticular.78 Yet there is reason for skepticism. First,while much of the evidence supports the contentionthat the effect of M&A on R&D is small, it is notunanimous. The National Science Foundation exam-ined the R&D spending and intensity of the 200largest industrial R&D performing companies in1984-86. 79 These companies account for almost 90percent of all U.S. industrial research and develop-ment. Among the 200 firms were 24 firms that hadeither merged or undergone an LBO during theperiod; these 24 accounted for nearly 20 percent ofthe R&D spending of the entire group of 200 in1987. The firms that did not undergo restructuringincreased real spending on R&D by 5.4 percent,while the 24 firms that were restructured throughM&A reduced their R&D spending by 8.3 percent inreal (deflated) terms from 1986 to 1987. Theseoverall findings were consistent with comparisonsof restructured and unrestructured firms at theindustry level as well.80 The NSF data should beinterpreted cautiously-the study spans only 3years, and some of the reductions in R&D might beelimination of redundant programs in newly merged

companies—but they indicate a need for equalcaution towards studies that show negligible impactsof restructuring.

One possible reason for inconsistencies betweenthe studies cited above is that not all restructuringsare alike. One of the few points of consensus in thedebate is that M&A in the 1980s is unlike earlierwaves of M&A activity, and is certainly differentfrom the background level of restructuring. Differentkinds of restructuring-friendly mergers, hostiletakeovers, defensive LBOs, and other managementbuyouts, for example-would be expected to havedifferent effects on managers’ abilities and incen-tives to invest in R&D and other activities consid-ered discretionary in the short run.

The last wave of M&A activity, which occurred inthe 1960s, was characterized by diversification andagglomeration. The 1980s, in contrast, are character-ized by so-called bustup takeovers of diversifiedcompanies with subsequent selloffs of the compo-nents.81 Hall’s study includes many mergers fromwhat could be considered another era--the late1970s--which may blur the effects observed by theNSF study which focused on the mid-1980s. Highdebt is closely associated with the bustup takeover.Friendly mergers often have little or no effect onoverall corporate debt levels, while hostile takeoversand defensive LBOs, in particular, often leave veryhighly leveraged companies in their wake. One ofthe striking effects of the 1980s wave of M&A is thesubstantial increase in corporate debt attributed to it.According to one estimate, the corporate debtburden was 20 percent higher in 1988 than it wouldhave been without the effects of corporate restructur-ing. 82

7~ew ~eS~tS ~ Sm~~ ~ c ‘TeStimony of Bronwyn H~l in He~ngs on corporate Res~c~g and its EffWts on R&D Before the Science,Research, and Technology Subcommittee of the House Committee on Science, Space and Technology, July 13, 1989;” and Bronwyn Hall, “Effwt ofTakeover Activity on Corporate Research and Development,’ Alan J. Auerbach (cd.), Corporate Tdeovers: Causes and Consequences (Chicago, IL:University of Chicago Press, 1988), pp. 69-96.

77sW, for exmple, Lawrence SummerS> “LBO Debt and Taxes,” Across the Board, April 1989; Hall, op. cit.; and Abbie Smith, “CorporateOwnership Structure and Performance: The Case of Management Buyouts,’ Leveraged Buyouts and Corporare Debt, Hearing Before the Committeeon Finance, United States Senate, Jan. 24, 1989.

TWW exmple, w Jo=ph A. Grundfest~ ‘‘M&A and R&D: In Corporate Restructuring Stifling Research and Development?” Address to NationalAcademies of Sciences and Engineering, Academy Industry Program of the National Research Council, Oct. 11, 1989.

79The tem “~dm~~” refers to companies in mining, cons~ction, and manufacturing. The vmt majority are in mmUfaCtUring.8~est~ony of ~. Willim L. Stewm, Nation~ Science Foundation, ~fom tie Committee on Science SpaCe and TtxhnoIogy, Subcommiu* on

Science+ Research and Technology, House of Representatives, July 13, 1989.81Lym E. Browne and Eric S. Rosengren, “The Merger Boom: An Overview, “NW Enghd Economic Review, March/April 1988. P. 23.s~ol~an Sachs, Fi~ncia/MarketF’ersPectives, December 1988, quot~ in Lawrence SummerS~ ‘‘Taxation and Corporate Debt,’ in U.S. Congress,

House of Representatives, tiveraged Buyouts and Cmporate Debt, Hearing Before the Committee on Finance, U.S. Senate, Jan. 25, 1989. TheGoldman-Sachs analysis shows the outstanding debt of nonfhancial corporations as a percent of the gross domestic product of those corporations at 66percent in 1988, compared with an estimated 55 percent without restructuring.


It is quite possible that high-debt restructuring hasa greater impact than friendly mergers on R&D. Thisproved to be the case in OTA’s interviews with 19manufacturing companies representing a variety ofdifferent restructuring experiences. Although thesample was not a statistically valid sample of M&Aas a whole, the firms that had increased debt as theresult of a takeover or as a defense against a takeoverconsistently reduced R&D following the event. Thereductions may not prove permanent-companiesmay rebuild R&D as they pay down their debt—butmost of the R&D managers of the firms that had cutback also believed their firms’ future ability tocompete was compromised as a result.83 Halldownplays the overall importance of R&D cutbacksfollowing LBOs (which invariably results in muchhigher leverage), citing evidence that most firms thatundergo LBOs do no R&D. Also, Hall points outthat in her sample of 200 manufacturing acquisi-tions, 30 were LBOs. Those 30 had very low R&Dintensity-on average, 0.4 percent of sales-andaccounted for only 1 percent of the R&D done in theprivate sector in the years 1984-86.84

What all this seemingly conflicting evidence maymean is that LBOs as a whole have not directlyaffected R&D overall by a measurable amount, butthat LBOs in large manufacturing firms have re-sulted in reduced R&D, at least in the short run,because of the pressures of high debt. Indirectsupport for this conclusion comes from anotherstudy. Abbie Smith found that R&D intensitydeclined in firms that reported R&D expendituresbefore their LBO, and that sold assets after the LBO.Smith warns against any conclusory interpretationof this result, however, because so few of the firmsin the population of LBOs studied reported anyR&D at all.85

Another complicating factor is firm size. Mostservice firms and small manufacturing firms per-form very little or no R&D. The fact that NSF’s top200 R&D spenders accounted for 90 percent of allindustrial R&D is telling. Summers points out thatmany LBOs occur when the owner-manager of a

small establishment approaches retirement, and thatthese are “almost certainly benign.”86 In anothercommon LBO situation, a company finds that acertain line of business no longer fits into its overallstrategy, and makes amicable arrangements with themanagers of a division for the sale. Again, thesebuyouts could be expected to have little or no effecton R&D, either because many of the firms involveddo little or none, or because amicable transfer ofownership of a division to its current managers canoften be accomplished without the high acquisitionprices often associated with LBOs.

Analysts have concentrated more on the effects ofM&A on research and development than on itseffects on other discretionary expenditures. ButR&D isn’t the only kind of discretionary expendi-ture that affects a fro’s technology; the other iscapital expenditure. There are no clear and consis-tent answers to questions about the effects ofcorporate restructuring. Capital expenditure is nec-essary if firms are to keep up with and advancetechnology, but like R&D, capital expenditure maybe postponed for a short time without long-termmaterial damage to a fro’s technological base. Theduration and depth of sustainable cuts varies byindustry and by firm, but even so, available evidencegives some cause for concern. Smith reports asubstantial and significant reduction in capital ex-penditures as a percentage of sales that occurred in58 management buyouts between 1977 and 1986.87

This finding is consistent with anecdotal evidence.For example, consider Houdaille, a machine-toolmaker that underwent an LBO in 1979. Pressured byforeign competition and (later) the effects of the1982 recession as well as its high debt burden,Houdaille cut capital spending as a percent ofrevenues in half following its post-buyout restruc-turing. 88 One owner of a machine-tool makingbusiness states, “When we hear LBO, we knowthey’re not going to be buying anything.”89

Most analyses of the consequences of M&A havebeen confined to measurable direct effects—spending on various activities or overall perform-

83Milkr, op. cit., p. 14.

‘Hall, op. cit., p. 3.8SSmj@ Qp, Cit. PI 71o

%hunmers, op. cit., p. 187.S7S~~, op. Cit., p. 47-

88M= Holl~d, “HOW to Kill a Company, “ The Wmhington Post, Apr. 23, 1989.8gHowad G~is, ~sident, Kinefac, personal communication, NOV. 16, 1989.


ance of companies that have undergone restructur-ing. Two others should also be considered. First,there are qualitative effects, not readily measurable,on R&D or firm activities. Again, we would expect(and find, according to the limited evidence) thatdifferent kinds of restructuring have different quali-tative effects. In OTA’s interviews, firms thatmounted successful defenses against hostile take-overs (leaving the companies with high debt)long-term R&D had invariably been significantlycut back in favor of projects with promise of quickerpayoff. 90 Some analysts interpret this kind of cut-back as making R&D more efficient, and this isindeed possible in the short run. R&D is by its naturea long-term process, and firms can cut back on newlong-term projects without impairing their ability toexploit the results of projects undertaken in the past.So a shift in emphasis toward shorter term projectswould be unlikely to show up as detrimental for atleast a year or two. But in the long run, it seemsunlikely that increasing the focus on short-termprojects on the part of American firms will permitthem to maintain even their current level of compet-itiveness.

Friendly mergers, on the other hand, had eitherlittle impact on R&D, or effects that would begenerally accepted as positive. One example is thepurchase of Celanese Corp. by the West Germanchemical firm Hoechst. Hoechst was interested inexpanding its U.S. operations through the purchaseof an American firm with strong R&D, and after theacquisition increased Celanese’s R&D expendituresby 10 percent annually. Significantly, the newGerman managers were also more willing to commitsubstantial resources to long-term projects with lesscertain payoffs.91 A similar story was told by thepresident of Materials Research Corp., a semicon-ductor equipment and materials company recentlyacquired by Sony. After the deal was completed, thepresident was told by Akio Morita, the president ofSony, that he had “essentially unlimited capital,”and was no longer obliged to concern himself withquarterly profits. “I can think of projects that taketwo years, ” said Dr. Sheldon Weinig, the president.“It’s a wonderful way to live.”92

It is difficult to make a few cases add up to astrong finding, but the anecdotes about the qualita-tive effects on manufacturing R&D of differentkinds of M&A activity are consistent with quantita-tive evidence, if the focus is adjusted correctly. Inother words, both the qualitative and quantitativeevidence suggest the following: in manufacturingfirms that have appreciable amounts of R&D,restructurings that result in high debt levels depressR&D spending or intensity, or both, and oftenshorten the allowable time for completion of R&Dprojects. Because such restructurings are not common—most happen in firms that do little R&D, and manyof them are in service fins-the overall directeffects of M&A on overall national R&D are not yetlarge, and may never be, particularly as hostiletakeover/LBO activity seems to be winding downfor now. This does not justify complacency aboutM&A. NSF’s data are disturbing, and will be moreso if the highly leveraged companies continue to lagin R&D spending or long-term planning. Additionaldepression of discretionary expenditures on capitalequipment or R&D could well occur in the event ofa recession, or perhaps even when growth is less thanrobust. Such cutbacks, normal in recessions, aremore likely when companies are highly leveraged.

Finally, the indirect effects of M&A must beconsidered. The 1980s added a new wrinkle to thetakeover enterprise: the expansion of the pool ofpotential raiders. In the past, in most takeovers, largefirms acquired smaller ones. In the 1980s, junkbonds made it possible for “individuals, smallerentities, and investment banking fins” to takepart. 93 In another contrast to past takeover waves(and ordinary M&A activity), these new playersoften intended to dismantle the acquired companyrather than to assimilate it. Both factors-theincrease in number of raiders, and the consequencesof a successful takeover-have apparently increasedmanagers’ fears of takeovers markedly, and mayalso have depressed discretionary expenditures.Managers, feeling that an unwelcome takeover bidmight come at any time, might take steps thatapproximate what they would do to defend againsta real hostile takeover bid, with the same effects onspending for R&D and capital equipment. In mid-

~iller, op. cit., p. 18.glMiller, op. cit., p. 31.WAII*W Pollack, ‘Cne Challenge of Keeping U.S. Technology At Home, ” Z% New York Times, k. 10, 1989.

93John C. Coffee, Jr,, “Shareholders Versus Managers: The Strain in the Corporate Web,” in Coffee, et al,, op. cit., p. 77.


1989, for example, Honeywell acted to discouragepotential raiders by cutting out certain lines ofbusiness (reducing the breakup value of its assets),eliminating 4,000 jobs, repurchasing up to 10million shares of its own stock, and increasing itsannual dividend to shareholders by 31 percent.94

There had been speculation that Honeywell might bea takeover target, but no actual bid.

Few companies make moves as dramatic asHoneywell’s, but many members of corporateboards and senior managers report that hostiletakeovers came to dominate corporate board meet-ings and decisionmaking to an unprecedented extentin the 1980s. The effect on overall business plan-ning, almost certainly, was to increase the emphasison distributing profits to shareholders in preferenceto reinvesting in the company.

Hostile takeover activity seems to be windingdown, although not crashing; the number of dealscompleted in the first 9 months of 1989 was smaller,according to a preliminary estimate, than the number

in the first 9 months of any of the preceding 3 years.The first three quarters of 1989 saw 2,298 completedacquisitions, compared to 2,790 in 1988, 2,851 in1987, and 2,707 in 1986. However, the value of thesedeals in 1989 was $144 billion, just below the peakof $144.7 billion in 1988. The story is different forLBOs: there were slightly fewer completed in thefirst 9 months of 1989 (214) than in a similar periodof 1988 (221), but the total value of those LBOs in1989—$47 billion—was quite a bit higher than theprevious high of $29.1 billion in 1988.95 T h enumbers aren’t the only story. There is a widespreadperception that the market has grown pickier aboutthe kind of deals that can be approved, and there hasbeen a flight from junk bonds.96 Acquisitionscontinue, but many believe that the wave of highlyleveraged, bustup takeovers is on the wane. If this istrue, it could provide time to examine how much ofthe negative effects of M&A is associated with thisparticular type of financial activity, and time forpolicymakers to evaluate how to tailor possibleregulation to the real problems.

%Tony Kennedy, “Honeywe]l ACE Agtist PotentiaJ Raiders,” The Washington poM j~Y 2571989,95jUdi~ H. Dchyzinslci, “Deals, Yes. Maniac Deals, No,” Business Week, Ox. 30, 1989.~hristopher Farrell, with I-ah J. Nathans, “The Bills Are Coming Due, ” Business Week, (M. 30, 1989.

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