The Finance Conception of Control

The Finance Conception of Control is a term coined by Neil Fligstein to describe the way in which high-level executives in multidivisional conglomerate firms managed the operations of their companies. The finance conception of control emphasizes the use of financial tools to allocate capital across industries and product lines in order to maximize short-term profits. This form of control emerged in the mid-1950s as a result of regulatory changes in the American economy brought about by the Celler-Kefauver Act. Prior to the adoption of the finance conception of control, firms evolved through three other conceptions of control: direct, manufacturing, and sales and marketing .
History
Through structural changes in the economy such as the Celler-Kafauver Act, tax incentives, and international competitions, the financial conception of control emerged as the main form of control in the 1950s. Finance conception of control emphasizes the importance of diversifying product mixes, evaluating new products for continual growth and increasing the influence of financial considerations in the structure of large corporations . For example, AMF originally a cigarette and a packaging equipment manufacturer expanded into product lines such as bicycles, fasteners, and guided missiles in the 1950s. Even though these product lines did not relate to their main product lines, they had good earnings, so AMF invested in them .
The Celler-Kefauver Act of 1950 had strengthened the Clayton Antitrust act and led large firms to stop merging for market share. As a result, the Celler-Kefauver Act prevented horizontal and vertical mergers. Fligstein states that this act was written to prevent two problems: 1) increases in market concentration and 2) the centralization of economic activity through mergers by a few large corporations . In order for businesses to diversify without legal implications, firms took advantage of unrelated product mergers . Although this act helped to address the first concern, a significant increase in mergers occurred between 1954-1969 . Andrei Shleifer and Robert Vishny argue that the regulatory environment caused this peak because, in order to expand, a company had to purchase companies outside their industries . However, others argue that, since an increase in merger activity also occurred outside the U.S., it was the economic environment driving the increase. Businesses were searching for new ways to grow in order to increase their company value and reduce the volatility of earnings . Both these theories point to the use of finance as a conception of control from 1954 to 1969: firms were more focused on product line expansion to maximize short-term profits rather than overall strategic plans to optimize a firm’s existing product lines’ long-term earning potential.
Moreover, the re-investment tax structure provided incentives for firms to take advantage of merging unrelated companies. As firms reinvested their profits through acquisitions, acquired firms often worked as tax shelters as their losses could be applied against future profits. Neil Fligstein also states the benefits of the tax structure on merging: “The acquired firms’ assets could be depreciated immediately, which provide instantaneous profit for the purchasing firm” .
However, when the stock market crashed in 1969, the environment for mergers, which created many conglomerates through the use of inexpensive floating debt, began to decline. Availability of cash for mergers became tighter and the Nixon administration enforced stricter rules on mergers of large corporation. The poor market performance of the 1970s led to a divestiture movement . Neil Fligstein argues that this reflects finance conception of control as firms divested product lines when they did not perform well .
Greta Krippner takes Fligstein’s theory one step further by looking at the financialization beyond the governance structure of large corporations . Her analysis of the portfolio income to corporate cash flow of non-financial firms provides support for Fligstein’s argument. She argues that starting in the 1970s, non-financial firms were receiving an increasing amount of revenue from financial sources because of the falling returns on investment in productive activities caused by growing labor militancy in the US and increasing international competition abroad . Her argument helps to confirm Fligstein’s argument because she shows that firms were no longer looking for traditional products that fit in with their core business line, but were instead looking at ways to increase short-term profit.
Differences from Previous Conceptions of Control
Prior to the adoption of the finance conception of control, firms evolved sequentially through three other conceptions of control: direct, manufacturing, and sales and marketing. Each of these systems represented an alternative strategy to improve growth and profitability for large firms in the context of their regulatory and economic environments . Under the direct conception of control, firms aimed to reduce competition by either attacking or uniting with their competitors . To establish price stability for their own firms, managers employed predatory practices such as price gouging and sales disruption, formed cartels to assign production quotas and set prices, and created monopolies to exert greater control over the market. The manufacturing conception of control, on the other hand, focused on mitigating the risk of interference from competitors in a firm’s production processes. Firms aimed to control input and output costs through the vertical integration of production processes. They also engaged in horizontal integration under the belief that size would serve as a buffer against price wars. In contrast with direct control and manufacturing control, the sales and marketing conception of control focused on growth and increasing sales, rather than eliminating competition . As firms diversified their product lines, sought out new markets, and launched new advertising campaigns, direct competition lessened so that “managers in firms fought over market share, not the right to exist” . However, because the sales and marketing conception did not have a way to direct diversification in the newly formed multidivisional firms, it was eventually replaced by the finance conception of control, which still dominates corporations today .
The finance conception of control differed from its predecessors primarily in its interpretation of the best way for firms to achieve growth and maximize profits. While direct control focused on reducing competition, manufacturing control focused on managing the supply chain, and sales and marketing control focused on expanding sales, “the finance conception pursued growth by evaluating the contribution of each product line to the overall profit and goals of the firm” . The finance conception of control also differed from previous conceptions of control in its influence on the firm’s relationship with competitors and the “organizational field” . Under the finance conception, because managers viewed their firms as collections of assets rather than producers of industry-specific goods, they began to measure and manage their position in the hierarchy of large corporations such that “the reference group for the largest firms became the other large firms,” instead of firms in the same industry .
Despite these fundamental differences, the finance conception of control also shares some features with its predecessors. For example, though the sales and marketing conception led to the development of the multi-product, multidivisional firm, the finance conception of control augmented this structural innovation by establishing profitability as the guiding principle for diversification efforts and espousing diversification through mergers rather than through internal expansion . Additionally, like its predecessors, the finance conception of control emerged as a direct response to antitrust regulation and pressure from the state . By adapting their conceptions of control to conform to new government mandates, firms aimed to maximize growth while still maintaining “institutional legitimacy” . While manufacturing control emerged as a response to the Clayton Act’s efforts to outlaw the strategies of direct control, and sales and marketing control emerged as a response to the enforcement of antitrust laws by the Roosevelt administration and the economic uncertainty of the depression, the finance conception of control emerged in response to the Celler-Kefauver Act, which inadvertently promoted conglomeration and diversification by outlawing mergers intended to increase market share .
Impact of Finance Conception of Control on Multidivisional Conglomerates
The finance conception of control represented a dramatic shift in the way that high-level executives in multidivisional conglomerates managed corporate strategy in the United States. After heightened antitrust legislation discouraged horizontal and vertical integration, multidivisional conglomerates adopted the finance conception of control to expand and diversify primarily through acquisitions in unrelated industries. Under this new system, capital allocation became the corporate office’s primary means of control and finance executives sought to increase growth by using financial metrics to evaluate, buy, and sell company divisions . As the finance conception of control gained traction among American conglomerates, managers increasingly shifted their focus toward manipulating business units to boost short-term profits .
American corporations implemented the finance conception of control to evaluate potential merger candidates and maximize returns on new acquisitions. Most conglomerates during this time replaced sales and marketing experts with finance-oriented managers that “sought profitable and growing industries where their capital would earn higher rates of return and avoided mergers where the threat of antitrust prosecution might exist.” Fligstein posits that the industry of a target firm did not matter; instead, the executive’s primary function was to invest in any opportunities that increased sales, assets, and profits. Financial managers looked for attractively priced companies whose stock traded below book value and developed innovative financial techniques such as LBOs to fund acquisitions that could yield high returns in the short run . Davis and Stout argued that by the late 1970s and early 1980s, this mentality also promoted the use of hostile takeovers, or takeover attempts over a target company whose management is unwilling to agree to the merger or acquisition . By reducing firms to streams of future cash flows, the finance conception thus encouraged conglomerates to make hostile bids for companies that would positively impact the company’s profits.
To manage the various business lines, conglomerates centralized financial control and adopted tools from portfolio theory to allocate capital and make budgeting decisions. Corporations under the finance conception “viewed the central office as a bank and treated the divisions as potential borrowers.”. The central office allocated funds to divisions that were expected to earn the highest rates of return and divested capital from those in slow-growth markets. Budgets were prepared by individual business units and reviewed and approved by the corporate headquarters with little discussion of specific operational plans. In this sense, conglomerates applied portfolio theory by running their business as an internal capital market, “investing in promising sectors and spreading risk across different sorts of industries.”. By the end of the 1970s, 45% of all Fortune 500 companies had adopted these portfolio management techniques.
Once firms embraced the finance conception of control, short-term profits and immediate gains became the primary drivers of corporate strategy. Companies increasingly measured their success each quarter based on financial metrics such as earnings per share Under this system, the “stock market, stock prices, and the relative rates of return of firms in other industries became as important as the behavior of a firm’s competitors.”. Chandler argued that firms that focused more on short-term gains rather than long-term earnings evaluated potential projects on their individual merits and not in relation to an overall strategic plan. Additionally, capital expenditure decisions were primarily assessed based on the attractiveness of short 2-3 year payback schedules. Chandler noted that while this short-term outlook was effective in service industries and other industries with small R&D expenditures, conglomerates that invested in technologically complex, capital-intensive industries that required longer-term planning were less successful and often were forced to pull back and concentrate only on a small number of related products . Although not all American firms at the time adopted the finance conception, the spread of these tactics nevertheless increased the power of finance executives and resulted in the large, financially driven, multidivisional firm that dominates American business today.
Decline of the Finance Conception of Control
By the mid-1980s, the diversified corporate conglomerate, the archetypal model of Fligstein’s finance conception of control, was in steep decline. A combination of voluntary divestitures and hostile ‘bust-up’ takeovers led to the emergence of a new model of organization which defined success through shareholder value. The decline of the conglomerate corporate structure aligns with the broader predictions of Fligstein’s theory of firm organization: a change in regulatory conditions created instabilities within organizational fields, allowing a new model (the ‘shareholder value’ model) to take hold . However, the continued relevance of the finance conception of control after deconglomeration in the 1980s is less clear; the primacy of financial metrics actually deepened during the 1980s, but firms implemented financial strategies to ensure organizational security in ways which differed sharply from the strategies followed by earlier conglomerates.
The decline of major conglomerates coincided with the reversal of key regulatory and economic conditions previously identified by Fligstein as the structural lynchpins of the finance conception of control. Free-market economists in the Nixon and Reagan administrations reversed the anti-trust policies of the 1950s and 1960s which had been anchored by an activist interpretation of the Celler-Kefauver Act. . At the same time, new business analyses questioned the organizational efficiency of using financial tools to redistribute capital within a firm, the central innovation of the finance conception of control.. Finally, the 1980s witnessed a crisis of competition, as US firms struggled to keep pace with Japanese and European competitors. The cumulative impact of these changes created instability in organizational fields which allowed a new model of corporate organization, the shareholder-value model, to take root.
More specifically, ‘bust-up’ takeovers proliferated, exploiting new investor preferences to buy conglomerates for purposes of selling sell off component pieces at a profit. A tolerant US regulatory environment and recent financial innovations incentivized these practices, the former by deeming these practices legal and the latter by allowing individual investment groups to buy conglomerates without substantial personal investment.. Other conglomerates, responding to new more lenient merger regulation and changing competition for capital on the metric of shareholder value, voluntarily divested from industries which were not considered their ‘core competences.’ These changes drove the promulgation of a new strategic model in which a firm’s security was driven by its ability to satisfy institutional investors’ profit expectations.
However, the question of whether these sweeping changes in corporate organization signaled the decline of Fligstein’s ‘finance conception is control’ is contested. Fligstein claims, in fact, that the shift to a shareholder value model represents a deepening of the finance conception of control, observing that many of the same practices which defined the finance conception of control found more extreme expression in the shareholder value model. In opposition to Fligstein, however, Davis et al’s analysis of deconglomeration in the 1980s argues convincingly that the shift reflected a deeper change in institutional beliefs. Their study tracks movement in the rhetoric of business leaders towards a new conception of the firm which emphasizes “extreme specialization and contracting for any aspects of production outside a firm’s ‘core competence,’ (ASR 563) . In this view, deconglomeration represents a change in “the totalizing worldview” of business leaders as opposed to a more limited change in corporate strategy.
Criticisms
As stated above, Neil Fligstein's theory of finance conception of control postulates that the rise of conglomerates and other diversified companies in the 1960's was due to an increasing managerial emphasis on financial metrics as a source of control over corporations. Fligstein argues that organizations in the mid-1950's began to operate as "a collection of assets" in which financial-oriented executives acquired and divested companies based on the individual company's rate of return . In this fashion, he attempts to consolidate historical corporate behavior from the 1950's and beyond under one unified theory.
In response to Fligstein's theory, critics have criticized Fligstein's singular, exclusive focus on financial controls and have suggested a broader approach to understanding corporate acquisitions that incorporates factors such as ownership relationships and network ties. In particular, Donald Palmer, Brad Barber, and Xueguang Zhou contend that Fligstein's finance conception of control theory is a historical and institutional approach to organizational analysis that "fails as a single-handed explanation of the likelihood of acquisition in the 1960's" . This argument was made in a direct reply to Fligstein's criticism of Palmer et. al.'s paper on the relationship between social ties and corporate behavior. The two sides published a series of responses against one another in a debate to reconcile the theoretical differences in their respective frameworks.
Palmer et. al. first argued within their 1995 paper, The Friend and Predatory Acquisition of Large U.S. Corporations in the 1960's: The Other Contested Terrain, that the likelihood of acquisition during the 1960's was influenced by "a firm's position in the resource-dependence network of the economy as well as the positions of its managers and directors in the firm's ownership structure and in the social network of the business elite" . The premise of their argument is that network interlocks . influence a firm's chance of being acquired because these interlocks affect the capacities and interests of the corporate elite (managers and directors) and shape the actions they take to command their firms. Palmer et. al.'s framework is in line with other network theorists, such as Mark Granovetter, that believe social relations affect economic exchange. To be clear, Palmer et. al. do not completely dismiss Fligstein's theory of finance conception of control, but rather they suggest alternative measures that complement his theory and create a more comprehensive account of corporate acquisition behavior.
Alternatively, Ravenscraft and Scherer present a different explanation for the conglomerate merger wave in the 1960's in their book, Mergers, Sell-Offs, and Economic Efficiency. Ravenscraft and Scherer performed a large-scale study of manufacturing firms in the 1960's and found that, while the share prices of merging firms did on average rise with the announcement of the proposed restructuring, post-merger profit rates were unimpressive.. As a result, Ravenscraft and Scherer concluded that acquisitions were more a product of managerial "empire building" rather than a purely profit-driven decision.. This is a departure from Fligstein’s claim that financial metrics acted as the sole driver of acquisitions and diversification for corporate executives in the 1960’s. Ravenscraft and Scherer's argument serves to further the argument against Fligstein's finance conception of control in favor of a more expansive explanation of the 1960's merger wave.
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