Corporate Restructuring and Industrial Research and Development (1990)

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Morning Session October 12, 1989 DR WHITE: Good morning, everybody. I am Bob White. I am the President of the National Academy of Engineering, and it falls to me this morning to welcome you here to our symposium on corporate restructuring and industrial research and development. The symposium addresses an issue that has been of nagging concern in the scientific and technical community. There is undefined anxiety that the recent turmoil in financial markets is or may be disturbing many corporations' ability to pursue traditional long-term research. The Academy of Sciences, the Academy of Engineering and the Institute of Medicine worry a great deal about the health of the R&D enterprise In this country, whether in government or universities or in industry and, of course, that is the reason why through the Academy Industry Program, we have decided to organize this program. We approach the issue with an open mind. We do not believe the case is either proven or disproven. Our purpose here today is to hear differing views on the issue. Last night, we heard from Joseph Grundfest of the SEC that in his opinion, restructuring via takeovers, mergers, buyouts, is really not affecting the amount of R&D in the nation. He believes the real problems for the R&D enterprise, as you heard last evening, are perhaps elsewhere: cost of capital, things of that nature, which affect the investment in research and development in industry. That is one view, but the state of play that we do face and that has given rise to the concerns that we have is that the past decade has witnessed intense restructurings, with record annual numbers of bankruptcies in the 21

22 CORPORATE RESTRUCTURING early 1980s, feverish activity in starting up new companies—for example, 200 biotech companies established between 1978 and 1982; peak numbers of mergers and acquisitions; in 1985 and 1986, the emergence of the leveraged buyout; the growth in foreign ownership of U.S. companies. Some states have begun to adopt legislation restricting takeover activities and the Congress is also considering issues and policies in this area and, in particular, changes in the tax code. Today's symposium will, I am certain, refer to many of these devel- opments, including some of the legislative proposals that are now being considered. As you know, the impact of corporate restructuring on R&D is an open question. Ken Flamm pointed out in his background paper for this symposium that we really do not have enough definitive data to know what determines the level of industrial R&D spending and economists who have studied this issue disagree. The symposium today is intended to bring together three separate but interdependent communities, whose collective decisions combine to determine much about the state of U.S. industry; Wall Street, corporate headquarters and public policymakers. An effort has been made to have balanced views on each panel. The moderator for today's symposium has had much experience analyzing trends and sorting out policy options. As most of you know, Stuart Eizenstat headed President Carter's domestic policy staff in the White House. He is now a partner at Powell, Goldstein, Frazier and Murphy and he is also an adjunct professor and lecturer at the Kennedy School of Government at Harvard. He holds degrees from Harvard Law School and the University of North Carolina and is the author of frequent articles in many of our prominent newspapers and magazines. On behalf of the National Research Council, I would like to thank him for agreeing to moderate today's symposium. Stu Eizenstat. MR. EIZENSTAT: Thank you very much, Bob, and welcome to all of you. With you, Frank Press, my friend Roger Altman and me here today, it proves that there is life after the Carter Administration. I am also pleased that we have members of the Bush Administration who will be joining us. Jay French Hill, Deputy Assistant Secretary for Corporate Finance at Treasury; Rich Endres, Deputy Assistant Secretary for Technology Policy at Commerce and Bob Gray, the Associate Director of the Office of Management and Budget (OMB). In the audience, too, during the day will be staff from Capitol Hill, as we had last night, as well as members of the press. But the most important part of the audience is its largest component and that is the men and women engaged in corporate R&D. When all of our talk about public policy options, strategies and global economics is over today, you will still be the ones who hold the key to the future competitiveness of U.S. industry.

MORNING SESSION, OCTOBER 12, 1989 23 The promotion of American research and development is an obviously crucial ingredient in our ability as a country to compete in a fiercely competitive global market. Fully 70 percent of our products must compete abroad or domestically against imports. We no longer have a monopoly on quality in this country and we can only stay ahead by being at the cutting edge of change through increased research and development. There is a chronic systematic underinvestment in R&D by American industry. In part this is because of the recent uncertainties involved: For example, it has been estimated that 80 percent of all R&D projects fail to produce an economic profit. In part it is because firms can't fully capture the rewards of their own successful innovations: It is estimated that the rate of return to the public is twice that which accrues to the company actually doing the research, even when it produces an economic profit. As Joe Grundfest reminded us in his keynote address last night, if one takes non-defense corporate spending on R&D in our country, we are spending only about 1.9 percent of our GNP, compared with Japan at 2.7 percent and West Germany at 2.6 percent. The general prosperity that the United States has enjoyed since the end of World War II is clearly based on many factors, but chief among them has been our ability to develop, create, manufacture and sell new products that to this day dazzle the imagination. Two of them come to mind, chosen, I must say, not quite at random: instant photography, Polaroid; and l~gamet, SmithKline. These products and others like them have quite literally revolutionized American life in the postwar world and have been the sustaining force that has propelled our economy. I recently completed a book, Dan Boorstein's The Democratic Experience, in which he describes very graphically the way in which our innovation and inventiveness have created a more egalitarian democratic society. And, indeed, experimentation and innovation have been at the heart of domestic American history from the start. Products like Polaroid's and SmithKline's and others like them have quite literally, therefore, been the sustaining force that has propelled our economy, but as everyone in this audience knows, we are in a new and much more challenging era. The world economy has changed dramatically since the halcyon days after World War II in which our country dominated the world economy. The signs are evident all around us. Our share of world exports has continued to decline as first Europe and Japan and the newly-developed industrialized countries develop products in an export orientation. We have become so fixated on our own huge domestic market, that we have failed to produce products for a world market in which other nations have shown an increasing ability to match our quality at lower costs. Our rate of productivity growth has declined each successive decade

24 CORPORATE RESTRUCTURING after the war. Our unit labor costs are among the highest in the world and we find that U.S. companies are moving production and R&D facilities abroad and sourcing out an ever-increasing percentage of components, even in so-called American products. Two of the four largest exporters, for example, to this country from Taiwan are not ~iwanese companies, but rather U.S. corporations, and the largest exporter of computers from Japan to the U.S. is an American, not a Japanese company. The value of imported auto parts bought by our big three automakers more than doubled between 1982 and 1986, accounting for more than 5 percent of our 1986 trade deficit. Our triple digit budget deficits and the current accounts and trade deficits, which those deficits in turn have spawned, are, in a way, testimony to our own unwillingness to pay for our societal demands, to match our resources to what we require from government. This will affect our foreign policy and our influence abroad- for example, last year for the first time, Japan spent more money on foreign aid than we did. And it will also erode our capacity as a country to invest in education, training and health care, so~important to a productive work force. As a consequence of these changes, since the oil shock of 1973, real average household incomes have not increased at all over a 16-year period, even though we have far more two-earner families. For the first time, the younger generation's standard of living, when they become adults, may not be better than that of the older generation. Hourly pay for production workers in this country was twice that of Japan as recently as 1985 and far above that of any other European country. Now. in U.S. dollars. it is lower than Japan's, West Germany's, France's and even Italy's. Only through accelerated industrial research and development can we remain competitive and be at the cutting edge of change, staying ahead in the development of new products and production methods. The more R&D we can encourage, the more new and innovative products we can develop and the more productivity we can achieve. We may disagree, as we will see today, about the causes of our concern and, indeed, about the solutions to what we have come to call America's competitiveness problem, but there is a shared belief that we have to do something about the future course and direction of high technology in this country. Indeed, even in this crucial high-tech industrial sector, so central to determining our standard of living, we now run a trade deficit with the rest of the world. Our semiconductor industry is on its way to dependency for its basic infrastructure on foreign suppliers, from silicon to etching equipment and quartz plates to wafer steppers. A lot is at stake in the topic chosen for this conference, as we will be exploring the impact of corporate restructuring on industrial R&D. Does

MORNING SESSION, OCTOBER 17 1989 25 it further deter American research and development or is it a spur to it or, indeed, is its impact basically neutral? We know less about the answers to these questions than we should and it is my hope that we will generate enough heat as a result of your questions, the points raised by our speakers and future studies this symposium will spawn, that we will in the future be able to shed more light on this issue. For the purposes of today's symposium, we should define restructuring quite broadly. It is, of course, at the very least, leveraged buyouts, but it also refers to mergers and acquisitions, takeovers, both hostile and friendly, as well as internal restructurings, which most large corporations have gone through in recent years. Just to ate five it&D-based American companies, all members or former members of the Academy Industry Program, which is our sponsor today, which have experienced dramatic, if different, restructurings during the past five years: AT&T, which was effectively broken up; General Elec- tric, which acquired RCA; Eastman Kodak which acquired Sterling Drug; Hughes Aircraft, acquired by GM; and DuPont, which acquired Conoco. Any daily edition of a major newspaper dramatizes how tumultuous the corporate landscape has become. Just a random example in the September 29th New York Times had headlines proclaiming, "DuPont, Merck Set Drug Pact; Kyocera and AVX Agree to Merge in a Stock Swap; Borden to Cut 7,000 Jobs in 65 Plants." The competitive pressures of our new global economy are affecting every major corporation in this country, not only the ones, in Wall Street's terminology, that have been put in play, bought out or acquired. All are restructuring to one degree or another or they know they can't survive. The question then remains: What is the impact of all this activity on long-term growth? Has this concern for performance in the next quarter caused myopic managers to cut expensive and risly research, which may not pay off for years to come? Or alternatively, does our new competitive environment lead to better management and more intelligent investment decisions? These are among the questions that we will be exploring today. Aggregate R&D in this country is about $131 billion, half of which comes from the federal government, a figure including military research. I think we have all read the President's lips sufficiently to Mow that we are not likelier to have a great plethora of federal money in the intense competition for federal dollars. While NSF budgets are going up modestly, we can't expect explosive growth in this fiscal environment in research dollars coming out of Washington. So, the question is: Will the private sector make up the slack? As Busuless Week editorialized, with the U.S. under escalating pressure from competitors, an R&D slowdown could not come at a worse time. A poll of this county's 476 largest industrial corporations revealed that

26 CORPORATE RESTRUCTURING most of the firms' R&D budgets would not be growing as fast in the next three years as they had in the previous three. And the latest Industrial Research Institute survey of 161 R&D directors found that R&D funding as a percentage of sales was expected to continue to drop. This symposium will be divided into four parts. First, we will hear two views from Wall Street, from Roger Altman of The Blackstone Group and Michael Ankara of KKR, who will tell us how money managers, who are very often the catalysts for change in our economy, view the current situation. We will then turn to two senior corporate executives: Mac Booth, Pres- ident and Chief Executive Officer of Polaroid and Henry Wendt, Chairman of SmithKline, who will describe their respective companies' restructuring experiences and their likely impact on R&D. After lunch, the Majority Leader of the House of Representatives, Dick Gephardt, will outline how Congress might try to deal with this changing corporate landscape. And finally, three economists will outline their views on what is going on in general. Before introducing the first panel, I would like to take this opportunity to thank the Academy Industry Program staff for their work in putting this program together; in particular, Ed Abrahams, who has been extraordinarily creative, helpful and indefatigable in helping to put these panels together and working with me. I would like to personally thank Frank Press and Bob White, the Presidents of the National Academies of Science and Engineering, for encouraging a full balanced examination of this critically important topic. With no further ado, I would like to start by introducing a long-time friend and former colleague, who will be our first speaker, Roger Altman. Roger is Vice Chairman of The Blackstone Group, a private merchant banking firm, which advises major corporations on financial and corporate development matters and also employs a large pool of capital for buyouts and other principal investments. Prior to joining Blackstone, Roger was a managing director of Shearson Lehman and from 1977 to 1981, worked with us as Assistant Secretary of the Treasury for Domestic Finance with responsibility for federal, municipal and corporate finance. While at Treasury, among the many issues Roger dealt with were the Department's own borrowing program, a particular challenge during our era; the Chrysler bailout; and the rescue of New York City. It seems like ancient history, but, Roger, you were very much a part of making history, which is, in fact, very topical. Roger was educated at Georgetown University and the University of Chicago, from which he received a master's in business administration.

MORNING SESSION OCTOBER 12' 1989 27 Roger, if you will start, I will introduce Michael afterward, and thanks so much for coming, all of you for coming. MR. ALTMAN: Thank you, Stu, and good morning, everyone. Let me say when Stu originally asked me if I would address this Academy Industry Program of the National Research Council, I first thought that he had dialed the wrong number, that he intended to call someone with an affinity for science and somehow mistakenly got me, be- cause if you knew my true ignorance on science, engineering and medicine, you would appreciate my own confusion about the invitation. But when Stu assured me that it was not his speed dial run amuck, I set about thinking what I could possibly contribute this morning. Now, I still don't have a completely clear answer to that, but I hope that when I am finished, it will be a positive rather than a negative contribution. I also should say at the beginning that I am perfectly willing to take a polygraph test to certify that I did not attend last evening's event and did not hear Joe Grundfest's comments. And I say that because I just looked over his speech this morning and you will see in a minute why I assure you that I didn't have a chance to see his comments in advance of my own. Let me start off then by suggesting that we look at this question of the impact of corporate restructuring on industrial research in a little bit broader context. I am sure most of you or all of you have read Mr. Flamm's excellent paper, which concludes, in my view, correctly, that there is no conclusive evidence of a negative impact of restructurings on industrial research. Now, while many of us believe intuitively that restructurings and their attendant leverage are bad for sustaining, indeed, for expanding, as Stu has correctly observed that we must, necessary levels of R&D, the direct evidence is not there. There are a number of logical reasons why that is the case and I will address those toward the conclusion of my comments, but I would like to start by suggesting, as I said, a broader context for the question itself. It seems to me that restructurings are one part, and they are not the main part, of a larger financial trend in the United States, an economic trend, and a very negative one, which is the savings and investment crisis, the dearth of savings and investment, and its impact on the cost of capital. We have seen over the 1980s such sharp declines in private savings and in net private investments and such a widening divergence in the cost of capital for American industry, compared with that of our key trading partners, that restructurings, in my view, have been an inevitable consequence of those trends. But they are not a cause of it. The reason they are a consequence is that as the cost of capital differentials have widened and you have seen Joe Grundfest's rather startling statistics from the New York Fed

28 CORPORAL RESTRUCTURING as to how wide they really are—obviously, only investments with faster paybacks and higher returns can be rationalized. That has given rise to this near frenzy in corporate restructurings, which, as Stu correctly points out, really encompass a rather wide variety of corporate situations, extending far beyond leveraged buyouts. So, I would like, at the beginning, to just spend a few minutes, and I will try to avoid repeating too closely what Commissioner Grundfest said, looking at this larger context. It seems to me that whatever you conclude today on this question of restructurings and industrial research, we are not going to be in a position to expand the contribution of research and development to gross national product (GNP) in this country, or to any other measure of R&D's contribution, without a very fundamental change in both public policies and private behavior, as they relate to savings and investment. Now, you probably all know about various trends in terms of savings and investment, but maybe you don't know quite how serious or how bad these trends have been. Let me say that I had an interesting experience a few months ago, which put this in vivid context, at least for me. I read an editorial in The Wall Street Journal, which, obviously, is the most widely read business publication in the world, to the effect that we were experiencing a savings and investment boom in this country. For those of you who read The Wall Street Journal editorial page, and most people I know don't admit it if they do, you know that has been their long-standing view for the last couple of years. I have a friend who is on the editorial staff and I called him and I said, you know, I really think that that is wrong, that, in fact, we are experiencing sharp declines in savings and investment. And after several weeks of debating and I am not in the business of research myself, even financial research I managed to get my hands on a variety of Federal Reserve of New York-type analyses. They agreed, at least, to run an article which I wrote, to the effect that the truth was really the opposite. My point Is not that I am right and they are wrong. My point is that there is a widespread view in many sectors of America, including very influential sectors, that there is no problem. Let me illustrate why there is not only a problem, but a grave and a worsening problem. For the 30 years ending 1980, private savings in the U.S. averaged about 7.2 percent of all income. This decade, through 1988, the figure has been about 2.8 percent. Net private investment now, there are a lot of different ways of measuring net private investment, as Me Wall Street Journal almost endlessly pointed out to me. But net private investment, excluding housing, according to the Commerce Department figures, averaged 3 1/2 percent of GNP during this earlier 30-year period and it was quite steady in the fifties, the sixties, the seventies.

MORNING SESSION, OCTOBER 1~ 1989 29 This decade, it has averaged approximately 2.2 percent, which, by the way, is the lowest level since the Second World War. So, it should be no surprise to any of us that productivity growth has fallen below 1 percent, or that, as Stu alluded, real per capita income for the bulk of Americans is stagnant and for a very high percentage of wage earners actually declining, or that long-term investment, of course, just like industrial research, is weaker. Now, to put that into today's context on restructurings, let me turn to this question of cost of capital and how the cost of capital disparities spring really quite clearly from these savings and investment declines. Three years ago, I had the opportunity to teach a course at Yale for a year, on issues that included very much the question of finance and finance comparisons, comparing the financial systems of, and the related impacts on, the U.S., Germany, and Japan. We had a chance to look at this in great depth. The disparities since that time have only widened. One way to look at it, which Joe Grundfest did not mention, is to examine returns on investment and returns on equity. If you use the U.S.- Japanese comparison and it is the most vivid and, of course, the most relevant in a lot of ways you see that industrial returns on investment here are considerably higher, have been considerably higher for most of the 1980s. I have seen some studies, including a very good one that Professor Ellsworth at Harvard did a couple of years ago, that equity returns in a variety of major U.S. industries have been more than 50 percent higher than the Japanese counterparts, and particularly using industries where most of the relevant assets are in the home countries. There are a few Japanese industries that are still extraordinarily lever- aged and where equity returns are therefore somewhat distorted. But generally returns on equity are much, much higher in the United States than they are in Japan and, for that matter, in many other nations against whom we compete. Now, if you add to that equity point the fact that, as we all know, U.S. interest rates have been consistently higher during the eighties than those in, for instance, Japan and Germany dramatically higher you understand then that the cost of capital here is as much as 100 percent higher than in Japan and perhaps 50 percent higher than in Germany. Now, any of you who are directly familiar with the discount rates, which Japanese acquirers use—or Japanese investors, I should say in evaluating investments, you know what I am referring to. Let me just tell you a quick anecdote, which perhaps illustrates it well. Two years ago, our firm was representing a major Swiss company in its efforts to acquire certain Canadian assets, which had been acquired a bit earlier by a Japanese buyer. The Japanese buyer wanted to keep most of the assets but was interested, we understood, in divesting some of them.

30 CORPORATE RESTRUCTURING Well, we all know that the Swiss enjoy relatively low borrowing costs and, of course, are in a position to evaluate investments with that advantage. In this particular case, we had made quite an aggressive offer. I think we had calculated the discounted cash flow valuation in this case, using about an 8 percent discount rate, which I think any of you in the corporate sector would say is a lot lower than you would use here in the United States. After a few hours of negotiating we had gotten essentially nowhere, having been told time after time that our offer was way too low and that the business was worth much more than that. It was a sufficiently amiable context that I finally asked if they could explain to us how they got their valuation, because we just couldn't understand it. They were quite open, unlike some of the Japanese negotiations I have been in, and actually handed over their work papers and showed us how they made their calculations. There were these smudged worksheets and we hovered over them, kind of peering at them and, sure enough, right there was the discount rate they had used. It was 4 percent. So one of us asked how can you use a 4 percent discount rate, and they said very simple: That is our true cost of capital. Well, needless to say that meeting ended promptly thereafter. The point is, of course, that if you are looking at the world through the perspective of capital costs in that range, then obviously you are able to undertake investments with longer breakeven periods or payback periods and fundamentally lower rates of return. Needless to say, it is a dramatic competitive disadvantage over the long term. There are a lot of reasons why the cost of capital has risen so much in the United States. I won't dwell on them in great depth because that is not our focus today, but I would like to just tick them off as I see them. One is the legacy of inflation and economic volatility of the seventies and early eighties, because it changed expectations on risk. As risk is perceived to rise, of course, returns must be higher to compensate. Another reason, as I mentioned, is that the pool of private savings in America has dwindled during the eighties. Obviously, the competition for those remaining funds has driven up their cost and, of course, our persistent high budget deficits and the corollary current account deficits have been a key cause for that decline in private savings. A third reason is that the U.S. equity markets today are really totally dominated by performance-driven institutional investors of all kinds. The individual investor, for all practical purposes, is a bystander. As real invest- ment rates have stayed high, and with investment managers compensated in line with performance, the drive for higher equity returns is insatiable. One manifestation of that is the almost endless stream of exotic financial products that we see produced as a way to try to capture higher returns.

MORNING SESSION, OCTOBER 12, 1989 31 Maybe the greatest source of creativity in this country, or certainly one of them, is the financial sector, in terms of that exotica. Last, the U.S. banking system has been profoundly changed over the last two decades. Larger U.S. corporations now bypass banks. They borrow directly from a variety of different public credit markets at home and abroad, from commercial paper all the way to long-term markets. Corporations no longer have close relationships with banks or other lenders and the term "committed lender" has almost become an oxymoron in the U.S. Contrast that to the universal banking systems in Europe and Japan, where, among other things, banks are permitted to be major shareholders in corporations, which, of course, breeds long-term lending relationships, the type of thick or thin relationships that you used to see in the United States 25 years ago. But such shareholding relationships, such interlocking ownerships, are prohibited in the U.S. And so, for that and other reasons, we have evolved a very different banking system in this country than our major competitors have. And I think we have gone from the point where it was a matter of pride and correct, too to say that the U.S. capital markets were the broadest and deepest in the world and a major competitive advantage for the United States in industrial development, to the point where the opposite is relatively true. The U.S. financial system today is not a competitive advantage for this country as it relates to industrial development. Now, as to the implications of this world in which savings are low, investment is low, cost of capital Is high. I think some of them are directly relevant to the question that is the direct topic for today—restructurings. I mentioned that investment horizons have shortened and shortened in America. That applies to capital budgeting decisions, as I said; it applies to venture capital decisions; it applies to institutional shareholders of public stocks; and it applies to restructuring decisions taken by corporate managements and boards of directors. Let me say a few words then on restructurings, why they are happening, what they mean and what the future will bring. As I said at the outset, the term "restructuring" really should be ap- plied quite broadly. It applies essentially to corporate transactions aimed at delivering higher values to shareholders. Now, there are also restruc- turings which relate to financial difficulty. Some people call them financial restructurings, of course. Some people call them reorganizations. They are, to some extent, in a different category because they relate to financial difficulties, but, if you will, you can include them in this topic as well. But the main types of restructurings I am referring to have boomed in the last few years because, of course, shareholders are no longer patient as they search for higher and higher equity returns over major value gaps: the differential between private market value or what Wall Street calls M&A

32 CORPORATE RESTRUCTURING value, and public market value. Now, those value gaps have become in the last few years, during the eighties particularly, quite wide in many cases. Time after time, major company shares have traded as low as half of private market value. Faced with that, outsiders have pressured such companies to close those gaps and deliver much of that value, the hidden value, if you will, to shareholders. Basically, those gaps exist because investors are prepared to pay high premiums to truly control the cash flow. Instead of the dividend income, which an owner of a hundred shares looks forward to—either actually paid or anticipated eventual dividend income, and, of course, the capital gains potential—the owner of all shares controls the free cash flow and can apply it in any way he chooses. Those value gaps also exist, as Professor Michael Jensen at Harvard has effectively pointed out, because managements often are motivated to manage the assets of the corporation in a way that is inconsistent with maximizing the present value of the cash flow or the present value of the shareholders' investment. Another important development in this context has been the more and more sophisticated use of leverage. I think this is a particularly misunderstood part of the corporate restructuring trend. Let me try to point it out in a somewhat different way. A couple of years ago, Goldman Sachs simulated the investment returns for the first seven years of the eighties, which would have been achieved had an investor selected a random portfolio of New York Stock Exchange stocks and then applied to that portfolio the type of leverage that is today achievable in private market transactions. For simplicity purposes, you can say that is about 10 to 1, debt to equity. The result, because of the sharply declining interest rates that we had from 1982 forward and because of the rising stock market over that same period, would have been about 70 percent average annual return on equity. The point is that leverage, together with the rising stock market, has permitted leveraged buyouts and many other types of corporate restruc- turings to work as well as they have. And it has been in some respects so easy, that no one really should be surprised at the billions which have flowed into LIED pools including, for that matter, our own firms—and at the interest that these transactions have attracted from investors. I think a central point to your topic today is and I will get to this in more detail in one minute—it isn't necessary in so many restructurings, I would argue in most of them, to squeeze every last dime of cash flow out of a corporation as if you were liquidating it. In most cases and I think the results that Kohlberg, Kravis has achieved illustrate this in most cases, the practice that investors apply is really quite the opposite. It relates to growing the core assets and capitalizing on that magic of leverage, rather

MORNING SESSION, OCTOBER 14 1989 33 than stripping the core assets or, as I say, squeezing them as if trying to get blood from a stone, to get the last dollar over the first year. As for the future of restructurings, the restructuring movement contin- ues to grow. I only see one obstacle that might present itself to that move- ment, and that is a possible recession. The last six years of the restructuring boom, of course, have not seen a recession. There are many arguments as to the impact of a recession on restructurings; most expectations are that it would dampen the restructuring movement quite substantially, but until that occurs, the corporations will increasingly adopt methods of unlocking values and delivering them to shareholders. Many corporations, in my view, are increasingly going to do that on a preemptive, proactive basis of their own volition, rather than being forced to by outsiders. There will be more cases, for instance, like Quantum Chemical, a major producer of basic chemicals it used to be called National Distillers which several months ago voluntarily chose to recapitalize itself, pay a special cash dividend to its shareholders, to close the gap between its private market value or its leveraged value, and its then desultory stock price. I think you will see a lot more of that. Finally, let me come back to the beginning. Mr. Flamm's paper concludes that there is no evidence that the research intensity of companies which have been restructured is lower than that of other comparable companies which have not been restructured. I think that is logical for three reasons. First, truly high-technology companies rarely get leveraged up through restructurings. In so many cases, technology is too volatile and the pre- dictability of operating performance is too low. Putting it very crudely, they don't make good LBOs. Second, investors in restructuring are primarily looking to what Wall Street calls the exit; in other words, that they will liquify their investments over, say, a three- to five-year period by selling or refinancing the core assets, the central assets. That requires, of course, those assets be performing well at that time. So these investors do not have an incentive to cut R&D. It might increase cash flow a bit over the very short term, but it will hurt the exit pnce, which is what really counts in terms of achieving the returns that those investors seek. As I said, most restructurings work through the economics of leverage, not by squeezing the cash Dow in a liquidation style. Remember, if you buy an asset for 100 dollars and you borrow 90 and you put up 10 of your own and two years later you sell it for 120, you have doubled your investment. The value of the total business may only have increased 20 percent, but your equity has doubled. So, cutting back R&D is not usually a consequence of restructurings unless we are talking about a company which is really facing a reorganization.

34 CORPORATE RESTRUCTURING Let me conclude then by making a prediction. It may not be a happy one, and unlike my World Series bets, I hope I am wrong on it, but I don't think so. The dearth of private savings and of net investment is going to continue in this country and the unusually high cost of capital for industry is going to continue and the restructuring trend, which it has caused, is going to continue. Both public policy and private consumption trends and other types of private behavior in America, are harmful today to investment and they are harmful, it seems to me, to R&D. Without adopting a prosavings and a proinvestment set of policies, particularly tax and budget policies, this neg- ative climate is destined to continue. Perhaps there is some consolation in the extent to which other industrialized nations also are seeing slowdowns, as they are, in their rates of capital formation, but ours, unfortunately, is much more pronounced. Now, the hopeful side of it is, if I can say so, Stu, that with the talent assembled here and your obvious concern over these trends and that of others like you, perhaps these attitudes can begin to change and the pressure on R&D spending can be alleviated. All of us must hope so. Thank you very much. MR. EIZENSTAT: Roper. thank vou for getting us off to a very rood and provocative start. ~ , ~ ~ ~ Our next speaker will be Michael ~karz, who is an associate at KKR & Company, which I think everyone would agree has truly revolutionized corporate finance in America during this decade. Since 1976 KKR has grown from a company with just $3 million of its own to invest, to a company that controls an empire of 35 companies at a cost of more than $65 billion. Together, these companies would make up the largest industrial conglomerate in America. They include not only giants like RJR Nabisco, Stop & Shop and Safeway, but also it&D-based corporations, like Duracell. Michael joined KKR in 1985 and since then has participated in nu- merous leveraged buyouts, financings, restructurings and dispositions. He currently senses on the board of directors of Beatrice, Walter Industries, Safeway, IDEX and K3 Holdings. Prior to joining KKR, he was a vice president at Continental Illinois Bank He was educated at the University of Illinois, where he studied both economics and business administration. We look forward to hearing from you and appreciate you coming, Michael. Thanks. MR. TOKARZ: Good morning. In anticipation of being here, I was thinking of your perceptions of what we do. Generally, leveraged buyouts and how you might feel about them pervaded my thoughts. I decided it wasn't really fashionable for any of you to say "I think leveraged buyouts are great." After all, who do you know who is highly leveraged that is really in great shape. Even the

MORNING SESSION, OCTOBER 1~ 1989 35 word "leverage" has an awkward, negative connotation. Certainly, relative to words you are familiar with, such as research and development, which connotate building and growth, the words "leveraged buyout" stand in a stark negative contrast; a building process versus a leveraged buyout, which connotes a consumptive or a consuming process. Yet, I think, strange as it may seem, on a macroeconomic basis, leveraged buyouts and restructurings may actually be an agent for increased research and development. And why? What is happening? Why is our productivity decreasing? Why are our labor costs higher? What is happening? Where is America in this competitive front with the Japanese and other competitive nations? Why are we behind? Why are our television sets made elsewhere? What is happening? Well, it is easy to blame the leveraged buyout because we all were raised with the notion that leverage is bad. It is easy to blame the things we don't understand, as I am sure you can appreciate. After all, if 25 percent of our college seniors don't even know in what century Columbus found America, imagine how their lack of understanding, and the general lack of understanding in our society, breeds fear of change, fear of the research you do, fear of the change we are in the process of stimulating ourselves. Interaction between our communities" research and development and financial communities is quite infrequent. Therefore, our understanding of each other is limited and quite possibly we fear each other. The financial markets are in a rapid revolution, rapid change. Alloca- tion of capital is coming under increasing demands for change, rationaliza- tion, redeployment. ~day, you will be given or you can pick up on the way out an article written in this month's Harvard Business Review by Professor Jensen of Harvard, which deals with something that I think many of you are going to find hard to understand. That is, that the American corporation, the American financial system, the renowned engine of world and global growth, is actually fat and inefficient, poorly structured and badly in need of change. I sit there and I say what is it that you do? What is it that I am afraid of, why I look at you and cast a wary eye on all of you research and development people, people in the sciences. I wonder about your gene splicing, your cloning, your bioengineering, and, most of all, I find it hard to be able to eat the strawberries you sprinkle that beneficial bacteria on. What are we going to do together as a society? What part do I play? What part do restnlcturings play and what part do leveraged buyouts play? Well, I am afraid I don't have the answers to that and as Joe Grundfest and Mr. Altman have briefly explained already through their comments, we are not sure what to do. No one really knows what is happening. But I can assure you of one thing, that what is happening in the finance industry is an

36 CORPOR~I1E RESTRUC1TJRING agent of change that is producing results that I think you are going to find interesting. What are buyouts doing? Where have buyouts been done? Well, they are typically done on stable, generally unleveraged com- panies that are not R&D intensive at all. The evidence produced by Joe Grundfest and Marty Altman, with which I won't bore you by going over it again, shows that we don't buy R&D intensive companies at all. As a matter of fact, we generally avoid them. So, where are restructurings happening? Well they are happening in inefficient or large corporations that have limited opportunity to deploy their capital and their businesses in high-return or marginally beneficial projects. High-return projects are used up, in essence, in areas such as food, retailing, banking and tobacco. As a result, these mature corporations have accumulated massive amounts of capital and, as Jensen points out in his study and Kaplan, from the University of Chicago, points out in another study, 40 percent of the production of American corporations between 1940 and 1980 was wasted. Forty percent of the productive capacity, the assets generated that could be redeployed into R&D or elsewhere, were wasted. They were wasted because managements were paid on growth, size and the volume of assets they had under their control. Companies hus- banded capital rather than disseminating it to shareholders and the financial markets, limiting redeployment into projects with higher returns. How is it that a leveraged buyout or a management restructuring opportunity can pay on average a 50 percent premium over the public trading value of a company? How can we attract the capital? Who will give us the money to go and pay 50 percent more than what the so-called sophisticated and perfect knowledge markets are paying for a business? Well, again, Roger pointed out that it is corporate control. It is the ability as an entrepreneur, as an owner, to take a set of assets and manage them more efficiently. In short, drive the race car faster and more efficiently than the next guy; same asset, different management, different result. Cost of capital- macroeconomic statistics, more than we can possibly digest. But isn't it supply and demand? Isn't it true that capital is, in part, allocated through a system, and isn't the system today in America a function of the public corporation? The public corporation: RJR Nabisco, trading at $50.00 a share, public market value about $15 billion. Management decides that they can buy that company and productively manage it under private enterprise. So, they bid approximateh,r $20 billion. The financial markets take over and we end up buying it for a total capitalization in excess of $30 billion. Many of you look at your R&D budget and say just give me a little, just to have a chance to deploy that; we can show you how productive we can be. Well, in essence, in a macroeconomic sense, that is just what we did.

MORNING SESSION, OCTOBER 14 1989 37 The capital locked up in a tobacco company and in a food company—tens of billions of dollars- was returned to shareholders, those people who had equity investments, those people who will take that money, pay their taxes and then, again, reinvest it, seeking out yet another new opportunity. I can assure you from the work we have done in organizations such as Beatrice, Safeway, RJR, that the internal utilization of cash, prior to our purchase, the internal utilization of the capital was, as Jensen puts it, inefficient. I would like to draw a quick parallel as to why. They key is manage- ment, if you take a look at the capital accumulation in our country, the great growth, the industrial capacities built up in the late 1800s and early 1900s, they were done by owner/manager entrepreneurs. The Rockefellers, the Carnegies and many of those names you read in the history books built up our country into the capital and industrial giant it was. But they passed- their generation passed and they passed control and ownership through financial markets to the multitudes, to the institutions, to the individual investors and they passed the management of their corporations to the pro- fessional manager. The professional manager the professional manager of the corporate asset, the professional manager of the institutional dollar, the savings dollar that we all talk about. Well, what we have come to realize is a very simple tenet and this is the predicate upon which we build our purchase and our belief that we can pay more for a company, 50 percent on average more than someone else is willing to pay, and do better with it. Again, I would like you to read Professor Jensen's article because it focuses on it: in our buyouts, ownership of the corporation is rendered back in part a substantial part to the management. They own it. They run it for the long term. Quarter- to-quarter earnings do not pervade the mentality. Careers, month-to-month, quarter-to-quarter, year-to-year perfor- mance bonuses are not predicated upon short-term results. They don't ask: did I do better than last month, did I do better than the last quarter? They don't think: Oh, my God, if I make this long-term investment in an R&D expense, which is a current expense, charged currently to the quarter, if I make that investment, my earnings go down; I look bad. I won't do as well and my career may be impaired because the return may be five, seven, ten years off. Yet, when we do a leveraged buyout, management is building value for the long term. I can assure you Duracell's R&D budget is dramatically higher under private ownership than it was under public ownership. Our capitalization is much more leveraged than Kraft, the prior owner of Duracell. But why? Because management runs the company and we are the owner and we want long-term value appreciation. In the process of reallocation of capital

38 CORPORATE RESTRING to change the public corporation, the agent of change is the people- the Boone Pickens, the Sir James Goldsmiths, and some of these nasty characters—who attack these corporations that waste 40 percent of their assets. They are able to attract capital as we are $5.6 billion in our case— to invest in these companies because of the simple difference between a renter and an owner. I characterize management of many companies today as mere renters of those corporate assets; that psychological difference be- tween ownership and renting, we think, drives the long-term considerations . ~ . In many OI our compames. Rather than cover many of the macroeconomic statistics that were covered by the speakers you have already heard from, I am going to alter my tale So you can have a little understanding of what we do, I am going to tale a little bit about buyouts, how they are structured and some of the results we have obtained in examining our own records in areas such as research and development, capital spending. I will spend a few minutes on that. The definition of a leveraged buyout, similar to restructuring, is that a leveraged buyout is nothing more than a financing technique. Its name is driven by the fact that the acquirer usually borrows a large percentage of the purchase price, typically from a variety of sources, such as commercial banks, insurance companies and other sophisticated financial institutions or public purchasers of a high-yield financial instrument often called junk debt. Occasionally, a portion of the purchase price is paid in the form of securities, which are distributed to the public, who originally owned the company. Generally, in a leveraged buyout, a company goes from being a public company to one that is privately held by a small group of owner- investors; such are the investors in KKR Funds. What is the capital structure of the buyout? Well, you hear about these wildly leveraged schemes. For most major corporations that we structure, we find that 40 percent of the debt for that company is in the form of bank loans; 25 percent in long-term subordinated, often called high-yield securities; 15 percent in the form of a preferred stock instrument, many times sold to investors; and then 10 percent in common equity that we may put in. The critical element, again, is that ownership, the management of the corporation, puts up its own money and has a risk/reward profile approximately 200 times more effective than it would have if it were in a publicly-held company. For every 1,000 dollars of value increase in the company in a leveraged buyout, a manager has 200 times the return to him personally that he would if he were in a publicly-held company. The criteria for our buyouts are fairly simple. The financial character- istics include such things as a demonstrated stable profitability history and

MORNING SESSION, OCTOBER 12, 1989 39 the ability to obtain above-average profit margins over a longer period of time. ~rned-around situations are not attractive. Strong, predictable cash flows to service the financing costs related to the acquisition are critical. Readily separable assets or businesses which could be available for sale to provide flexibility are often necessary. The business characteristics: a strong management team. We don't provide management and as you will see in Jensen's article, most LBO firms or restructuring firms have very low component. At Kim, we have $63 billion of corporate purchases under our belt and only 16 professionals. The companies we buy usually have well-known brand names and strong market positions. Typically, they are low-cost producers within industry and thereby competitive and competitively advantaged. We look for circumstances where there is potential for real growth over the long term and we hope our companies are not subject to prolonged cyclical swings in profitability or in their business segments. And, most important for this group, products which are not subject to rapid technological changes. So, what do we buy? We buy a Safeway food store chain, $20 billion in revenues. Upon simple examination I am sure you would agree that if one-third of those revenues produced a loss then approximately one-third of those revenues are, in fact, inefficient. By dealing with the one-third of revenues that produced the loss, within two years we are able to double the profitability of the company. A short while thereafter, we are able to triple the investment in new stores, new concepts, in new delivery mechanisms. In Beatrice, when we examined its budget, we found that a company called Tropicana many of you may drink their orange juice was denied the capital to complete a project and packaging, which would extend the shelf life, extend the quality and the Vitamin C retention of the juice for an additional four weeks. They were denied the capital to put into their organization a computerized system for manufacturing, a computerized system for corporate control and distribution of fresh juice from Florida to New York and the East Coast. This was an A-rated company and its subsidiary was denied a meager $40 million to complete these projects. With a net worth of over $1.5 billion, with cash flow over $1.1 billion, they were denied the $40 million, not for one year, not for two years, but for three years in a row. When we took over the company, we found that that $40 million had been allocated to a Mario Andretti race car program. As a matter of fact, it was a $75 million commitment over a three-year period to put the Beatrice name on the bonnet of a race car. The company had spent in its capital program over $80 million on corporate aircraft in the previous three years; it had spent $200 million developing a plan to advertise the name Beatrice

40 CORPORALS RESTRUC1IJRING and relabel all of its products so that the red label "Beatrice" was on the package. When you look at the Mario Andretti program, you look at the Beatrice labeling program, the stunning fact was there wasn't a single product that was sold under the label "Beatrice," not one. Yet, $40 million was denied for the research and development of packaging and the computerized systems for manufacturing and distribution for one of its subsidiaries. Well, if you look at the statistics for the capital spending of Beatrice, you will see that after we took over, it went down. Yes, we did not spend money on the Mario Andretti program. We cancelled it. Yes, we did cancel the Beatrice labeling program and we sold the planes, but we redeployed the money, $40 million of it anyway, into the packaging program, into the management information systems program for Tropicana. It has been alleged that buyouts reduce tax are based on tax benefits. I would like to cover that for a second. Do buyouts result in lost tax revenues for the government? We did a study and the University of Chicago did a study. On all of our acquisitions, prior to R]R, we have calculated that a net tax benefit to the government, present value, was $3.2 billion, positive. The Kaplan study, looking at the RJR transaction alone, shows a net present value to the government in tax revenues of $3.8 billion, for a total of that present value benefit to the government treasury of $7.0 billion as a result of leveraged buyouts that we did. What is the effect of buyouts on employment? We have found that, and you will see in the Kaplan studies and in the Jensen study, that employment actually grows after a leveraged buyout because the companies are so much more efficient. In our own analysis, based upon budgeted numbers in part for the last year, we found that our annual rate of growth of employment went from Z3 percent three years prior to the buyout, to 4.2 percent after. We were criticized for this study, by the way" some of you may have seen The Wall Street Journal because we included a budgeted number. So, we recast the numbers only for actual results, three years prior, three years after. The employment growth for the companies only three years prior was 3.4 percent; after, there was 8.0 percent growth in employment. Can buyouts and restructuring stand negative events and downturns and recessions? It amazes me. I read the paper. I see all of the press saying, well, wait until these buyouts hit the next recession, boy, are you going to see a mass of problems. Well, we arranged 13 leveraged buyouts in the period from May 1, 1976 to December 31, 1982. All of these buyouts were owned through the recession of the early 1980s, which was one of the deepest recessions we have had since the Great Depression. Prime interest rates soared to over 20 percent. Despite the recession, each and every one of these buyouts retired all of their debt on time or early and collectively provided the equity investors with an annual compounded

MORNING SESSION, OCTOBER 1g 1989 41 rate of return of 35 percent. At the same time, I am unaware of any buyouts or leveraged restructurings in the television, steel, machine tool, auto, tire manufacturing, banking or electronics industries, all of which suffered dramatic declines in market shares and profitability during this period and many of which were notably bankruptcies or troubled situations. What about capital spending? Well, I have told you already, we do cut out wasteful spending, but we have found out that in our companies, where management is in control and again an owner, that the rate of investment in capital projects increases over the years prior to the buyout. What about research and development? In our companies, on average, research and development had a declining trend in the three years prior to our purchase. On average, after the period of purchase for the next three years, it had an increasing trend. Capital R&D spending was up 15 percent in the threeyear-period postbuyout, relative to the period prior to the buyout. The Kaplan study of LBOs showed, however and this is important to know that of all our companies and all the companies that do R&D that are leveraged or restructured, that only 1 percent of the revenues is really dedicated to R&D. Therefore, although the percentages may seem impressive, I have to submit to you, again, we do not buy R&D intensive companies. With $131 billion of R&D in the United States, I am afraid that KKR companies are responsible for only $250 million. Is corporate leverage excessive in the economy today? Well, relative to our trading partners, we are the least leveraged. As a matter of fact, on a market value basis, debt to equity, we are at a 57 percent ratio today, the lowest ratio of debt to market value of equity in the last 20 years. Finally, I would like to talk a little bit about whether companies are more efficient after a buyout or not. Well, we tend to make money, as you know, on average, but are they more efficient? Are we milking them? I think fundamentally all of you would agree with this example. If you bought a house and paid for it with leverage, and you wake up in the morning and realize that you own only 10 cents of every dollar in that house personally—the rest was borrowed when you look out at the lawn, you are not going to neglect it. And if the roof begins to leak, you are not likely to let it go. You are not going to sell the garden to the neighbor and you are not going to rent your garage to the kennel Clearly, you are not going to take a bunch of strangers into your house and let them run rampant. You are going to take care of it because you know from the record that you can sell the home for more than you paid for it. Certain~, none of you would be able to sell your house, nor could I, if we let it go into a gross state of disrepair. Jensen says that the pay/performance ratio of the ownership profile

42 CORPORATE RESTRUCTURING that I am talking about in these companies is very significant, very strong. The CEO of a public company owns less than 0.25 percent, less than a quarter of 1 percent of the economic value appreciation of his enterprise, versus a leveraged buyout manager, who owns 6.4 percent on average, a ratio of over 200 percent stronger. He cares about this house. That manager cares about how he spends on it. As for performance over the long run, Kaplan of the University of Chicago did a study of over 96 buyouts In leveraged restructuring that shows that operating income increased 42 percent within two years of the buyout and cash flow increased 96 percent. The free cash how doubled within two years of the buyout. And, yet, R&D expenditures increased. Finally, I would like to comment on our financial institutions and I am just going to quote the statement of the Controller of the Currency, Robert Clarke, about the impact of debt on financial institutions in America. "Our inquiries do not lead us to conclude that national bank participation in leveraged financing posed undue safety and soundness concerns. Instead, we found that when well-managed, well-conceived, such transactions offered banks a business opportunity that was important because of the decline in their traditional commercial financing activities. "In general, the banks had established and were following well-thought- out policies and philosophies for the leveraged portfolio. Because leveraged financing is a type of financing, not an industry, not all leveraged transac- tions will be affected in the same way by changes in the economy. The risk of default on such transactions varies from company to company and from industry to industry, but is generally dispersed." In closing, I would like to comment on one thing and that is that we are going through a period of change in the financial markets, that the inefficient public corporations are under pressure to change, and are being forced to do so. Heretofore, inefficient companies had little impetus, few outside factors to affect them. It is only because these 'mild men" now attack them and challenge them, challenge the boards, that people are reexamining the efficiency of what has become an inefficient American public corporation. MR. EIZENSTAT: We have now gotten the Wall Street view. ~ get the most out of our day today, it is important to hear your questions and comments to Roger and Michael, so we will throw the floor open for those comments and views. If you have comments, keep them brief because we really want to elicit responses from our panel. We do want to record your questions and comments for the record. So, please identify yourself. However, if you wish to ask a question incognito, we will allow that, too. MR. FLAX: I am Al Flax and I am with the National Academy of Engineering.

MORNING SESSION, OCTOBER 12, 1989 43 I have two questions that could be addressed to either of the two speakers and, perhaps, the speaker last night. Number one is that if this change, as represented by the complex picture of the leveraged buyout, is so critical to the performance of the economy, how does the Japanese economy get along without it? Paren- thetically, Financial Week says they have a different political and social system, which is not really the answer because we could change ours, too. Something like the Glass-Stegall Act that prevents banks from getting in bed with companies can be changed as easily as it was instituted in the first place. And I was there when it was instituted in the first place. Now, the second question. I am quite impressed by the argument that takeovers are only of non-A&D companies because there is one capital market and if we bid up that capital market with activities that are lucrative but unproductive in a long-term sense- a pejorative implication here—it is going to keep us out of investments in R&D, and incidentally not just in R&D, but what is more important, commercialization, that improves much more than R&D. It improves capital investment and launches new products. MR. ALTMAN: Well, Mike lUkarz and I may have different views on this, and I hope so because that will make it more interesting. But I did not intend to say, because I don't believe it, that restructurings are vital to the health and future vitality of American industry; quite the opposite. I jUSt said that restructurings are a consequence of broader savings, investment and cost of capital trends, which are really quite negative for American industry and for the competitiveness of this country and ultimately for the most important goal all of us have, which is rising standards of living for our citizens. So I guess I take issue with the premise of your question as far as my remarks are concerned. As to the part of your question on Japan, I am not actually sure that the Japanese will not eventually find restructurings more and more widespread in Japan, as their financial system increasingly is reformed and liberalized. You are in some respects beginning to see some of that, as the merger and acquisition trend in Japan is rising, both internally and externally. I would point out that restructurings are growing quite rapidly in Europe, particularly in the U.K The Europe 1992 phenomenon, it seems to me, is going to open up more of Europe at least internally within the boundaries of the EC to restructurings, which originate from the wider market that is going to be an opportunity for investors. So, I agree with the premise of your first question, rather than disagree with it. MR. EIZENSTAT: Roger, it seems to me that the question about why the Japanese get along without it underscores your point, which is if your

44 CORPORATE RESTRUCTURING point is that these restructurings are a consequence of our capital cost problem, the Japanese don't have the same capital cost problem; therefore, they don't have the same pressures on restructuring. I mean, it is another way of looking at it. MR. TOKARZ: Well, I, too, think that it would be a misunderstanding of my thoughts on whether or not they are vital. In aggregate, KKR for 14 years has done only 35 total transactions, a small number relative to the entire number of corporations in America. What I find unique, however, in comparing our economic system and our governmental interplay in it with Japan's, is that the capital flows in Japan include no significant syphoning off of such flows for purposes of defense. Clearly, our budget here has a large component of defense. As a matter of fact, in many respects, we are a world guardian. In terms of how they manage their society, I think we are just at different stages. After World War II, they rebuilt basically from scratch. You can argue about cultural differences, but that culture, that society, had to have long-term views. They were not able to get short-term consumption, period, and the political, governmental and economic systems there, I think, were brilliantly coordinated to gain international world competitiveness over a longer horizon. Our society at that stage was in a totally different phase and I think they interrelate in ways that are difficult to understand; the science of economics is still quite imperfect. So, I don't think restructurings or buyouts per se are going to solve any problem at all or are going to be vital to American competitiveness. I think, like Roger, that they are by-products of some gross inefficiencies, particularly in the capital markets and particularly in our entire economic integration between government and the private sector. MR. NOLFI: I am Frank Nolfi, with the Alcan Aluminum Corporation. My question is mainly directed to Mr. I6karz. If I take you at your word that you, in fact, correctly describe the case that buyouts tend to increase the efficiency of corporations, would you also say though that you have dismissed in aggregate manufacturing in the so-called high-tech industries? And if I take you at your word then, I guess I would like to comment, what about the manufacturing industnes? You say they have not been successful. If not, why? Do you have any feelings about these industries in aggregate? You really did draw the distinction and in all the cases that you cited as successful examples of buyouts, they were not manufacturing industries. Is the implication that we are to dismiss these or say that the prudent investment of capital should be away from these industries? I am not sure I completely understand the implications of your remarks. MR. TOKARZ: My remarks did highlight ones that were not man- ufacturing; although we do have very successful manufacturing leveraged

MORNING SESSION, OCTOBER 1g 1989 45 buyouts in our portfolio, including some that have had to compete vigor- ously against foreign competition. I will give you an example of one. As a matter of fact, the first large buyout done with a publicly-held company was Houdaille Industries. Houdaille Industries was formed back in the twenties and it made auto- motive parts. It grew to be one of the top 500 companies in America. It was very, very stable and 40 percent of its profitability was generated from machine tools; another 40 percent from chrome-plated steel automotive bumpers and the remainder from industrial products. We had the unfortunate mistiming of purchasing that company in 1979, which was nearly after the peak of industrial activity in the United States. By 1980, the 40 percent of their profitability that was generated through the manufacture of chrome-plated steel bumpers was gone. There were no more chrome-plated steel bumpers, period, bought in the United States. So, we lost 40 percent of our income within two years of buying the company. Additionally, in this same period of time from 1979 to 1985, our friendly Japanese competitors targeted the machine tool industry another 40 percent of our profitability as an area for penetration and market share gain in the United States. Between 1979 and 1985 their share of the U.S. machine tool market grew from 3.6 to 84.5 percent. Of course, that was another 40 percent of this company's profitability. At the same time, as you may remember, in the early eighties interest rates soared to over 20 percent for the prime rate. It was one of the most adverse interest rate environments that we've had. Despite the gross adversities vis-a-vis foreign competition, vis-a-vis change in domestic markets, the management, who had a significant own- ership in that company, was able to aggressively manage their balance sheet. They took what would be considered write-offs on an accounting basis, that had cash-positive impacts on the corporation, so they could redeploy their assets aggressively and effectively. Not only did they survive what would be catastrophic for most companies in terms of the four-year period, but they came out and flourished, acquiring another company 50 percent of their size and now are actually public on the New York Stock Exchange. So, to answer your question in a straight-on manner, manufacturing companies are actually very good potential buyout candidates for us, or for restructurings of any type. Typically, the whole purpose of the restructuring is to get ownership in the hands of the managers, who then view it as though it is their house and get that marginal benefit, the marginal productivity that Kaplan from the University of Chicago and others have identified as efficiency gains. Quite honestly, our studies don't show quite as strong results as theirs

46 CORPORATE RESTRUCTURING do, but, generally speaking, manufacturing companies are attractive buyout candidates. MR. EIZENSTAT: Michael, you mentioned something to me that you didn't mention. I think it is an interesting figure for everybody to have, that 6 percent figure for ownership shares of buyout by your managers. MR. TOKARZ: We feel, as I should mention to you, that ownership in the hands of management improves productivity. In our companies, on average, 15 percent of the ownership is turned over to management. They buy 15 percent, relative to a public ownership where management owns less than 1 percent on average. In terms of CEOs, in our companies on average the CEO owns 6 percent versus a public corporation where the CEO owns less than a quarter of 1 percent. MR. HOLLAND: My name is Max Holland. [Editor's Note: Mr. Holland is Contributing Editor of The Nation.] I would like to ask Mr. Tokarz some questions about the Houdaille buyout as a success story. The fact is Houdaille doesn't exist anymore as a public corporation. What Mr. Ankara described as going back on the stock exchange is sort of a lump of Houdaille, Ivex Corporation- - 20 percent of what Houdaille used to be. He spoke earlier about not selling the garden to neighbors. The fact is the best part of Houdaille, a company called John Kramer, was sold to a British conglomerate in order to retire the debt that Houdaille had acquired. I would like to ask him how his assertion on capital expenditures applies to the experience of Houdaille. Prior to the buyout, in constant '82 dollars, capital expenditures were on the level of 20, 27, 28 million dollars. That is 4.9, 3.3, and 5.4 as a percentage of sales in constant dollars. After the buyout, of course, figures aren't available, but the most recent ones that have to be supplied to the SEC showed that capital expenditures were 1.4, 1.7, and 2.1 percent of sales. I would like to ask him to address that question. MR. TOKARZ: Mr. Holland, I heard more than one question. I am not sure I got them all. MR. HOLLAND: Does the best part of a company have to be sold to a foreign corporation in order to pay down the debt? Is that success? MR. TOKARZ: When you say the best part of the corporation was sold to a foreign corporation, the entire Houdaille Industries was sold to that foreign corporation in 1987. That is correct. MR. HOLLAND: As Mr. Colberg points out in his complaint against KKR, it was obviously a sweetheart deal to sell the rest back to KKR. MR. TOKARZ: Well, Mr. Colberg does allege that, and Mr. Colberg is going to receive an affidavit from that foreign company shortly, which will indicate that his understanding of that circumstance is actually inaccurate,

MORNING SESSION, OCTOBER 12, 1989 47 according to that company's deal. We sold the entire corporation to TI Group of U.K in 1987. The TI Group, subsequent to the crash, for purposes in and of itself, determined that it wanted to sell what is a group of six companies. They had it on the public markets for sale. As a matter of fact, Morgan Stanley, I understand, had an arrangement with them to buy those companies. We became aware of that and offered to buy those companies from them and did so and since have taken those companies public. MR. ALTMAN: Could I just add one thing, which maybe puts this in a bit of perspective? I am no expert on Houdaille, but it is important to understand that leveraged buyouts, by their very essence, at least most of them, are designed to eventually be liquified, as I mentioned in my comments, by the organizer, by the equity investor. So, the notion of selling all of the company, as happened in Houdaille, is exactly the point of ordinally organizing the buyout. Now, we could debate as a separate matter whether that is good or bad, but if you look at buyouts that have been organized over fairly long periods of time or rather early on as Houdaille was, you are going to find that most of them which worked were sold or refinanced substantially. That is the point. MR. HOLLAND: That is true, but, Mr. Altman, if you were familiar with the Houdaille case, you would realize that the sale came about because Houdaille precisely didn't reach the pot of gold, at which point they could go back to the stock exchange— MR. ALTMAN: Well, as I said, I am not trying to address the specifics with Houdaille. I am wholly unfamiliar with them. I am just- MR. HOLLAND: I think we ought to talk about specifics sometime in order to understand the issue. MR. ALTMAN: I am just trying to point out that it is correct that the core assets are eventually sold but the way to think of that is that it is the basic goal at the beginning, from the point of view of those who organize them. MR. HOLLAND: That is absolutely true. That is the basic goal, and the financial investors have absolutely no interest in running it for the long term. It is simply that three- to five-year period, after which they go back and reach the pot of gold. But I would still like Mr. Karl to address the issue of capital expen- ditures at Houdaille as a percentage of sales. MR. TOKARZ: Well, two things. One is that Houdaille was owned by us far in excess of the three- to five-year period. So, I mean, I would quarrel- MR. HOLLAND: Why was that? MR. TOKARZ: Well, for numerous reasons associated with that com- pany's life cycle, growth, redistribution of its assets and reorganization

48 CORPOR41~ RESTRUCTURING under duress. As I mentioned to you earlier, 40 percent of its business was in steel chrome-plated bumpers, 40 percent was in machine tools. One was totally wiped; the other, obviously, was under some pressure. That company had to redeploy its assets and it took a longer period of time for it to do well than it might in some other cases. In the case of Houdaille, all of the debt was retired ahead of schedule and the investors had a very fine return, I think around 33 percent, but it took a long period of time. That is 33 percent compounded per annum. As far as capital expenditures as a percent of sales, I think part and parcel to it is the time frames you use. Because if you take a look at the period 1982 to 1985, industrial sales declined dramatically in the U.S. and as a result, the profitability of those companies declined as well. Therefore, capital spending was curtailed because companies were husbanding their cash in an adverse environment Consequently, when things improved and sales were more robust and opportunities for investment of capital generated by the business were more attractive, companies like Houdaille had increased capital investment in their plant and equipment. MR. HOLLAND: So, you are saying it had nothing to do with the debt? MR. TOKARZ: No, I think quite honestly, Mr. Holland, the way we structure our debt is critical to the understanding of how monies are spent. Because if you take for the moment the premise that our objective is to increase value over the long term, otherwise you wouldn't get a return, it would be incongruent to take and starve our companies, directly or indirectly, for the capital that they need to become more robust or more valuable. So, in the case of Houdaille, I think it very well could have been less than it was in other periods of time. At any point in time where capital is constrained or declines are relative to any measure, sales or otherwise, it is because management is determining when it is best to make that investment and under what conditions, to maximize the value in the long run. The whole premise is value appreciation long run. So, at any— MR. HOLLAND: Long run being three to five years. MR. TOKARZ: Well, like I said, in the case of Houdaille, it was something like nine years or eight years that we owned that company. And, by the way, the change of corporate control from us to the TI Group had in no way a negative impact on the employees of that corporation, its health or its future. It was a simple change of ownership, which occurs daily on the stock market: The shares of many of these companies out there change significantly every day; General Motors shares, IBM shares trade all over the place, and it does not affect the basic company.

MORNING SESSION, OCTOBER 1~ 1989 49 As a matter of fact, some of the divisions sold from that company and others actually get into more productive hands. I will switch gears for a minute to Beatrice, where we sold the Playtex unit, which makes bras and tampons and owned Max Factor. We did a leveraged buyout and we sold that company to the management.~ I was shocked when I saw management's budget for operating profit of that company a year after we sold it to them. When I had the company, Beatrice had $120 million of operating profit, of which $40 million was really Max Factor. They sold Max Factor to Revlon, another company in its business—imagine Beatrice, by the way, owning Max Factor they sold that business, which had $40 million of operating profit, in other words, one-third of the $120 million, and their budget for that very year after they sold it was $120 million of operating profit. So, they improved the productivity of the remaining businesses 50 percent. Now, even we, who feel that we have some impact on improved productivity, didn't do as well in that case as the management that we sold it to. So, sometimes these redistnbutions actually improve productivity even further. MR. EIZENSTAT: Last comment. MR. HOLLAND: I would just like to say that I think Mr. Ankara is offering a disingenuous version of what happened inside Houdaille and inside Houdaille's divisions after the leveraged buyout. I talked to people who worked at different divisions and I don't think that it became a more efficient corporation after the buyout. MR. TOKARZ: I think then for the audience's benefit that people should know that Mr. Holland wrote a book called, When the Machine Stopped. I believe that Mr. Holland's dad worked at one of the divisions of Houdaille. It was the machine tool division and you are welcome to read his book. I think, in part, that is why he is so concerned about Houdaille. Quite honestly I would clearly argue the "disingenuous." On the other hand, I can only submit to you the record that was submitted to the SEC on Houdaille, which, by the way, shows that the company improved its value, retired its debt and met all its obligations over the period of time in question. MR. EIZENSTAT: I now feel like a judge instead of a moderator. MS. BLAIR: I am Margaret Blair from the Brookings Institution. I address my question to both speakers. Mr. I6karz spoke of the magic of leverage and the efficiency that can be had in an organization when the organization is very closely held, as though this was some sort of universal truth about organizational behavior. Yet Mr. Altman said it is the intention from the beginning to go public in three to five years. How do you reconcile those two facts?

so CORPORATE RESTRUCTURING MR. ALIMAN: I think that they are related to each other In the big picture, but they are not directly related, those two points you make. First of all, just for clarification, I said the goal usually is to liquify the equity investment over a three- to five-year period, or something like that, which, as Mike points out, differs from company to company because of cycles and so on. That doesn't mean to go public with it. A lot of these are refinanced and remain in private hands and there are other ways of doing that. But the point about management incentives is really about as basic as any, in terms of human behavior. Mike pointed out the very, very basic difference between the public corporation format and the private corporation format, and Professor Jensen has published a piece, which is really very provocative and I commend to all of you, arguing that for a lot of underlying long-term reasons, the day for many corporations where public ownership was the most efficient form of ownership is over. That has to do with access to financing that private companies now have that they didn't used to have, and with the way the capital markets have evolved; it is no longer necessary to be publicly owned, for instance, to finance a business efficiently. I would say there is quite a bit to that argument that Professor Jensen makes. It seems to me that there has been for many years in the United States and in other industrialized countries, an orientation to reported profit; in other words, earnings per share for financial accounting purposes having been the primary measure of corporate performance. That increasingly has been a very short-term measure, as there has been a focus on quarterly earnings per share and even often on very small differences among quarterly earnings per share, one quarter versus the next, one year's quarter versus a comparable year earlier period, and so forth. You are all familiar with the arguments over that, as to whether it is healthy or unhealthy. The point is that is not the case in a private ownership format. Usually, the orientation is somewhat longer term. Often, it is a lot longer term and it is often to cash flow return on investment rather than reported earnings. So many accounting factors determine what reported earnings are, which can be, not always, but can be irrelevant in a private format. So, my answer to you would be the set of incentives that revolve around ownership, but also revolve around just measures of performance, are, in fact, very different in a private format than they are in a public format. They do produce different motivations and have produced in a lot of cases, which have been carefully studied by many people more capable than I, different results. MR. TOKARZ: I accept that answer. MR. KLIEM: Peter Kliem, Polaroid Corporation.

MORNING SESSION, OCTOBER 1~ 1989 51 Gentlemen, I do have a question for you but before I ask it, let me join you on two premises. The first one is that I join you on the premise that productivity is the central issue that we are dealing with. And I also personally happen to believe that ownership is a powerful motivator in the dilemma that we have. My question to the panel, particularly you, Mr. Ankara, is the following: Do you emphasize the value of ownership within management in a corpo- ration? It is my belief that it is the intellectual capital of a corporation that really in the end will change productivity, but by that I do not just mean the intellectual community of R&D, but of all employees and all members. One vehicle to bring that ownership about, not just within the man- agement ranks, but within all of those who can change that equation of productivity, is employee ownership in a publicly-held corporation. It is my impression that Wall Street in general is not very supportive of that concept. I would be interested in your personalized view of this. MR. TOKARZ: There is no question in my mind that if the corpo- ration's management and the board of directors deliver to the employees ownership of that company, by whatever means, whether it be through distribution of shares or any other mechanism, those employees will be much more attuned to productivity gains because they have an ownership interest. In Houdaille, if I might, when we took it public, we gave to each and every employee shares of that company. The reason is just what we have tried to emphasize: When we deliver this 10 to 15 to 20 percent of the company to the management of the enterprise, when we take it public or when we buy it -- take it private, I should say it is distributed down to various ranks in the company. I think in Beatrice it was down to approximately 250 or 300 people. In some instances we stimulate ownership through delivery of the unit that literally mimics or mirrors the stock ownership that the individual investors have at the higher levels. So, from a Wall Street standpoint, there are so many companies that would be totally inappropriate for a buyout; probably the vast percentage of companies are grossly inappropriate for what we do. I would submit to you that mechanism should be improved, to deliver ownership to the employees, and I favor that totally. MR. EIZENSTAT: Both of our speakers have to leave at 10:30 a.m. and I want to take this time to ask the last question of the panel. It is admittedly an untutored question and just based on intuition and I would like both panelists to respond. It seems to me intuitively that if you have a corporation which is more heavily debt laden as a result of a buyout, that in order to service that debt, it has to divert assets that might have been used for research and development and other things to servicing the debt. Why is that intuitive

52 CORPORATE RESTRUCTURING feeling incorrect and why do some of the studies, which Joe Grundfest made, not seem to back that up? MR. ALTMAN: Well, first of all, Stu, I agree with you on what seems to be intuitive and I am not persuaded that the entire set of factors that I tried to talk about, of which, I think, restructurings are a consequence or a by-product, aren't really quite negative for research and development. We all know that basically the R&D trends are negative in the United States, in terms of private R&D share of GNP. It is a declining percentage and it is well below that of most of our industrialized competitors, not just Japan and Germany, and there are a lot of reasons for that. But it seems to me more important than any others are these points about negative savings and investment trends and productivity trends. So I look upon the points that Mr. Framm made in his paper as correct, but only in a very narrow sense. First of all, it is a rather small sample and I think it is just one small slice of the whole restructuring trend (and an even smaller slice of the whole pie) that I think is the most relevant part of it. Now, on a much different level, asset sales are not central to every buyout in terms of making it work. There are actually a lot of buyouts. Mike could probably quote the statistics much better. There are a lot of buyouts where leverage is applied and improvements are made in the basic operations of the company. Assets, or at least major assets, are not sold; research and development continues either at the prior pace or, as Mike talked about, in some cases is expanded. The improved operating profit of the business, together with the fact that previously it was unleveraged, permit the enterprise to move forward and the equity investors ultimately to prosper without asset sales. So, it just isn't the case that it is a requirement of every transaction. Also, if you think about Mr. Flamm's measurement techniques, you do have to ask yourself: if assets are sold, what is the ongoing research and development trend within those assets in the hands of the new owner? From the point of view of our society as a whole or our economy as a whole, that is really the germane question. For instance, one thing that might have been mentioned here this morning, the biggest restructuring going on in the world right now is British American Tobacco, BAT, a huge conglomerate. It has been attacked by a very colorful group of characters, led by Sir James Goldsmith, and has now announced its own restructuring, which essentially is a deconglomeratization of BAT. I don't know a lot about BAT. I am not involved in it. I am not an expert, but it is not difficult to conclude from afar that BAT is in tobacco, insurance, retailing, to pick three main businesses, for no particular reason, other than it was nice to get bigger. So, it is hard for me to look at that and I am in a certain sense a

MORNING SESSION, OCTOBER 1g 1989 53 practitioner, not involved in that one—it is hard for me to look at that and say isn't it bad that BAT is being restructured. At least there is a good chance that those assets are going to be more productively used in separate hands retailing if they are sold to other retailers; insurance, in the hands of insurance owners; and tobacco elsewhere than at present. MR. EIZENSTAT: Michael, could you explain to me why my intuition about this may be incorrect? MR. TOKARZ: I think it is natural to assume that if you are leveraged and you must husband your individual dollars and cents, that you are going to deprive other areas where if you had excess cash flow, you would deploy it. I think that is a natural and a logical deduction. Why then does the evidence suggest that it doesn't occur? Well, what we and Kaplan and others find is that the actual enterprise is 46 percent more profitable within two years and 96 percent more productive in generating cash. By the way, when we design them, we design them based upon very, very modest expectations. We don't plan for a 46 percent increase in operating profit, I can assure you. And again, it is a very small number of companies. I wouldn't want to suggest to you that this is the panacea for American or any other societal change. But what happens in these companies is that because of the ownership change to the employees and the management, they become more pro- ductive and, therefore, they are not short of cash and can continue those programs and, often times, because they are value oriented, look to the longer run. So, I think it is a result of the result that permits that fear in most instances not to be realized. MR. EIZENSTAT: I think everyone would agree we have had a provocative panel and an interesting panel We appreciate both of you coming. We will break until 10:45 a.m. and we will start right on time at 10:45. (Brief recess.) MR. EIZENSTAT: We are really particularly fortunate and, indeed, if I may say so to both Mac and Henry, privileged to have two exceptional CEOs who have taken time out from their very busy schedules to participate in our panel on the corporate view, and we do appreciate both of you coming vely deeply. Mac Booth is Chief Executive Officer and President of the Polaroid Corporation, positions he has held since 1986. He has worked for Polaroid since 1962, after his Air Force service, in a variety of positions. Among his many accomplishments was to help develop Polaroid's first color film, the SX-70 Land Film. He knows every aspect of Polaroid, from its research labs to its management headquarters. Mr. Booth has also made corporate history during the last two years

54 CORPORATE RESTRUCTURING by being among the first CEOs to maintain his company's independence in the face of a hostile takeover, without paying greenmail and without radically changing the structure of the company. I am sure he will be telling us more about that experience, as well as its significance to our central topic of restructuring and research and development. Mr. Booth holds a B.S. in mechanical engineering from Cornell and also an MBA from Cornell. Mac, we appreciate you coming. MR. BOOTH: Good morning, everyone. I am very pleased to be here this morning, to be a part of a debate, which I know we have already seen part of and I am sure we will see more of as we go along, that is an extremely important issue in my sense of what is facing American life today. I think that either one of the benefits or one of the problems of coming on after some other people have had an opportunity to say their thing is that you want to rebuts immediately what you have heard. But before I do start my formal talk, let me just try to say a few things that I have heard last night and had some opportunity to think about, obviously, over the evening and here this morning. I personally don't think the question here is good guys and bad guys and I think if we polarize it in that way, we are doing the wrong thing. The question that we should be discussing today is the impact, and what I consider a significant impact, of high leverage on R&D, no matter who is running the company, no matter who is controlling it. I think that is the question that is facing us. As Peter Kliem said, you won't find any person in the Polaroid man- agement questioning ownership. We believe in it. We have gone through a very serious ownership activity in the company, where 20 percent of our company's ownership is held by the employees, which they have paid for out of their wages. It has been deducted from my wage and from Peter's wage and from all of our wages. We are paying for that stock ownership. We believe in it. We believe it is important. We believe this country would be much better off if we had more ownership by the employees. So, I don't think that is a question that we should be arguing. I think the question that you might ask is, is going private the only way to get ownership? I obviously believe it is not and I don't believe that private ownership is the long-term benefit for this country. I believe public scrutiny is important and I believe there should continue to be public scrutiny for public corporations. I believe it keeps you healthy and it keeps you on your toes and it keeps forcing you to really justify why you are doing things. So, as I say, I think that the question of high leverage is the issue. Whether it is restructuring, LBOs, however it is done, what is its effect on R&D? So, I believe that this broad issue that we are facing is how

MORNING SESSION, OCTOBER 12, 1989 55 do we make sure that U.S. industry keeps or, better yet, improves its worldwide competitive position and, thus, provides a handsome return for all its shareholders and a growing standard of living for all Americans. There are many factors that contribute to our relative worldwide competitive position. Education of our youth, we have heard discussions of that. Education of our continuing work force, I don't believe there is enough emphasis on that. National fiscal policy, such as tax and savings incentives; antitrust policies; uses of national financial funding for research and development; and of course what we are here today to discuss is corporate research and development. I believe everyone here would agree that corporate research and development is vitally important to the long- term success of our corporations. The three issues that we need to be discussing are: One, are we getting our money's worth from our corporate research and development expenses? Two, what is the effect on research of high debt and the large cash flow requirements to pay off that debt? And, three, what is the danger that the desire for unusually high annual rates of return on investment, of 30 percent or more, will negatively impact our corporate research and development programs? It is my belief that such demands will slowly destroy U.S. firms, by making them uncompetitive in an increasingly competitive worldwide mar- ket. "Slowly destroy U.S. firms" is a strong statement. Unfortunately, it may be an understatement. The destruction may come more quickly than slowly. There is no question in my mind that without invention and innova- tion, we will become a second-class economy. And, therefore, we must adequately fund and adequately manage corporate research and develop- ment activities or we will eventually become a nation of followers rather than leaders. There is no mystery in what we are talking about today. Research and development expenditures are not intended to increase sales or profits in the years in which those expenditures are incurred. In fact, they reduce profits and they reduce cash flow in those years. Heavily leveraged companies require large cash flows to meet the huge interest payments on their increased debts, and in situations where a public corporation is taken private, not only is there usually a large debt payment, there is also a need to make the company appear profitable. So, when it is again taken public, usually in three to five years, the financial reward for the private owner is huge, which is the principal motivator. Under such circumstances, research and development expenditures sit on the profit and loss sheet like a fat plum ready to be picked. R&D becomes a predictable target for reduced spending. Of course, neither the corporate raider nor the leveraged buyout team will announce plans to

56 CORPORATE RESTRUCTURING drastically cut or even eliminate research and development expenditures in order to dramatically increase the cash flow of the company. You won't hear any of them say, "I don't need to spend much money - on research and development because I won't be around in three to five years to reap the benefits of that research." Rather, the words that are used are more like this: Look at the money that is being spent on research. Are the shareholders really getting their money's worth? Are they getting the kind of efficient return they deserve? Where is research leading this company? These are all good questions; in fact, the same questions that all good companies ask themselves on a regular basis, but from a different perspective. The questions we ask sound like this: How can we use our research capabilities more productively? How can we get twice as much from our existing resources? How important is the role of research in our vision of the future and what is the potential return for our shareholders now and in the future? Research becomes one of the three or four focal points of attention by all parties in a hostile takeover or leveraged buyout situation. Everyone takes a long, hard look at research. That look focuses discussion about long- and short-term strategies, product development, focusing of resources, et cetera. And this dialogue is often public in nature. I would like to offer Polaroid's recent experience to illustrate the nature of this dialogue, but before I do, I think some historical perspective might be helpful. From the time of Polaroid's founding in 1937, Edwin Land set out to build a great enterprise, based on a vision of what a research-driven company could accomplish for its customers, employees, communities and society. It was a grand vision that outlined very specifically the significant role of research in the company's organization and in its culture, and it served as the catalyst for our growth. Dr. Land built a new field from the basic research conducted by himself and his fellow associates. He relied on his tremendous faith that the cumulative benefits of research would eventually produce products and processes of great appeal and value. He believed quite clearly that his company should be as much a research organization as it is a manufacturing company; fiercely creative in its pure science, its contributions comparable with those of university laboratories. Dr. Land's innate belief in the value of research reflected the times as well, especially as postwar America prepared to change from a defense- oriented economy to a domestic business boom. It was a wonderful and optimistic strategy that was instrumental to American business development from 1945 to the mid to late seventies. In 1945, Vannevar Bush, FDR's science adviser, outlined a vision of

MORNING SESSION OCTOBER 1~ 1989 57 the role of research in postwar America. I would like to quote from him. "Basic research leads to new knowledge. It provides scientific capital. It creates the fund from which the practical applications of knowledge must be drawn. New products and new processes do not appear full grown. They are founded on new principles and new conceptions, which, in turn, are painstakingly developed by research in the purest realms of science." He continued, "today, it is truer than ever that basic research is the pacemaker of technological progress. In the nineteenth century, Yankee mechanical ingenuity, building largely upon the basic discoveries of Euro- pean scientists, could greatly advance the technical arts. Now, the situation is different. A nation which depends upon others for its new basic scientific knowledge will be slow in its industrial progress and weak in its competitive position in world trade, regardless of mechanical skill." This view was echoed by leaders at M.I.T., Cal Tech, and the Carnegie Institution, the National Science Foundation and other members of the business and science establishment. Science and technology had in a major way won the war and science would now pave the way for a great American business resurgence in peacetime. Vannevar Bush and Edwin Land had never heard of a leveraged buyout. In fact, they had only one real mission in life and that was to build our economy through invention and innovation. Polaroid's early success proved to a model for other postwar start-ups to emulate. Yet, as Polaroid grew from a small enterprise to a $2 billion business, the role of research evolved, changing and modifying its place in the conduct of our business. World-class marketing, engineering and manufacturing capabilities grew and developed the kind of balanced weight one would expect in a large corporation. Still, at each stage of our development, new products led the way to growth, and each new product could find its roots somewhere in the basic building blocks developed by our scientists and engineers in our laboratories. The world marketplace also evolved, as did the development of com- plex imaging-related technologies. By the late seventies, we realized that to compete we could not solely grow our own, that to invest and become proficient in every complex technology needed for Polaroid's future would be too expensive and too time-consuming. We realized that we had to bring our marketing intelligence and skills earlier into the product development cycle and that our engineering had to be more closely coordinated with our photochemical research. We had to find new and different ways to accomplish our task, new and different ways to approach product development and research in general. We were well on our way to implementing these changes in the way that we approach our jobs within Polaroid, when in July 1988, Shamrock Holdings

58 CORPORATE RESTRUCTURING began what was to become a nine-month battle for the control of the Polaroid Corporation. Needless to say, I am very pleased to have the opportunity to be here in my present position to tell you some of the facts of that experience. The ensuing battle for Polaroid in the courts and the press, in the hearts and minds of our shareholders, has been well documented. I will save you the blow-by-blow account for another time, unless you want to ask me some of the particulars in the question and answer period. More important, though, I believe, for this forum is the focus on research. That became a major factor in the public debate about the future of Polaroid. Indeed, at the same time that our research activities were being attacked externally by Shamrock Holdings, they were being examined and reexamined in great detail within the corporation itself. In Polaroid, the takeover threat was the ultimate confrontation with the future and the rapidly changing world we live in. The future had landed on our doorstep. The questions that we had to ask ourselves about our research and development activities reflected the urgency of the situation. We asked, what are our expectations really? Are they realistic? Are they worth it? Does the potential market justify the research costs? What can we pare down? What can we streamline? Is there a need to divest some projects that simply cannot be justified? Where in our research and development activities were we not getting our money's worth? How can we get the job done without expanding our resources? How can we conduct our research more passionately in new creative ways, faster and more productively? These are not trivial questions in any business climate. The accelerated pace of the takeover environment made our inquiries all the more intense. Under the takeover threat, our version of the future of Polaroid became a very key factor. That future was greatly dependent on our R&D activity. We knew this more instinctively than we did objectively. We also knew that the world, both inside and outside the company, needed to hear our vision stated in concrete terms. In fact, what started as a need to quickly communicate to the outside world became an internal source of energy. Managements know that investors may believe in the importance of R&D, but if presented with a handsome, all-cash premium to the market price of their stock, they tend to forget about the long-term value. Our job then became a challenge of communicating to the shareholder community the value of what is going on in our laboratories. If the market correctly valued the potential found in the company labs, then the shareholders facing the decision as to what to do with their shares would have a better basis for making that decision. That challenge continues today. In its study, Made in Amenca, the M.I.T. Commission on Industrial Productivity noted that managements may have a market-imposed tendency

MORNING SESSION, OCTOBER 12, 1989 59 to overdiscount R&D in the option values arising out of R&D. Although the Commission and the study it drew from relate this tendency to investment decision analysis, it should also apply to the valuation models used by institutions and analysts in reviewing corporate performance and market value. This would suggest to me the development of a new evaluation system for use in growing, technically-oriented businesses. Idday, America remains a leader in industrial research, but the world has changed. In the past, there wasn't any debate on the depth or breadth of research performed in the United States. Idday, there is constant debate over whether we are falling behind or how fast we are falling behind in commercializing the technology being developed in our laboratories. There is no question in my mind that we are slipping and I strongly believe that very high debt and the consequent need for large cash flows foster a significant short-term emphasis in business and industry, at the expense of important R&D projects, and that this is a strong negative force on our collective future. That doesn't belie the fact that we must be better in our approach to research. I don't think that the raiders and the leveraged buyout kingpins are wrong when they demand that corporations look at their R&D spending. If there are lasting lessons to be learned from the Polaroid experience, they relate to how we conduct our research, as much as what we choose to invest in. Let me suggest what some of these lessons are. Research and de- velopment cannot function productively in splendid isolation. It must be connected to the business environment in very direct ways. Researchers must be part of an integrated team of product developers that includes manufacturing and marketing personnel. They must understand the com- petitive environment in which we live, the realities of the marketplace and how their work relates to the financial and product strategies of the corporation. They must also understand the need to abandon some projects of truly brilliant technical brains that just don't fit into the overall corporate strategy, or for which the potential return would be too long in coming. And research in engineering must become as innovative in how it performs its research as it has been in what it delivers. We must find ways of improving the productivity, the effectiveness of research, just as we have improved the productivity of manufacturing. Research and development will continue to be the driving force for our country's growth, as it has been for the past 40 years, but our owners have a right to expect that we improve the effectiveness of the dollars we are spending. The answer isn't to spend less. The answer must be to spend what we have more effectively, striving for measurements, striving for collaboration and striving for some tough, hard decisions.

60 CORPORATE RESTRUCTURING If we expect our shareholders to think beyond the short term, then we must share with them the vision that undergirds our research efforts, and we must establish a serious dialogue with the investment community. Major shareholders and influential analysts must understand the potential value of the technologies under development in the laboratory. They must have a comprehensible blueprint of how technology re- sponds to and capitalizes on the marketplace. It is not necessary to disclose competitively sensitive information, but investors must have enough infor- mation to understand the critical option value several years old. Only then will the market value more accurately reflect long-term potential. I can tell you from experience that this dialogue can be a productive experience. Hearing outsiders' perspectives on your company can give you new ideas, keeping your outlook fresh and responsive to that outside world. This is not a time for excuse-making and hand-wringing in American business. We don't need to protect R&D by keeping it locked in an ivory tower. We don't need to keep R&D isolated from the sweaty reality of the marketplace. We need to demand higher levels of productivity and effectiveness and we need to expose it to the full glare of public scrutiny and we need to sell it. Thank you very much and I am looking forward to the questions. MR. EIZENSTAT: Thank you, Mac. Henry Wendt is Chairman of the Board of SmithKline Beecham. He joined SmithKline in 1955, shortly after receiving his B.A degree in American diplomatic history from Princeton. He has served in a variety of executive marketing positions in the U.S., Canada and Japan before being elected as president in April of 1976, a position he held until he was selected as chairman in April 1987. He was named Chief Executive Officer of SmithKline in 1982. He is a member of the Board of Directors of ARCO, the Pharmaceutical Manufacturers Association and the Japan Society. He is chairman of the U.S.-Japan Business Council and a member of the Advisory Council of the Department of East Asian Studies at Princeton. He is also a member of the Business Roundtable and serves on the Roundtable's International Trade and Investment Ask Force. Perhaps as a result of his international outlook, last year he led SmithKline into a merger with a British corporation, Beecham. He will be describing that decision and its significance for us. Henry, thanks for coming. MR. WENDT: Thank you, Stu. Good morning, everyone. It is a great pleasure for me to be here. I have been fascinated by the discussion this morning and it is an honor to participate in that with you. It is especially an honor to serge on the same panel as Mac Booth I admire his spirited fight and all that he has done in his leadership of Polaroid.

MORNING SESSION, OCTOBER 1~ 1989 61 I would like to begin this morning with an important confession. I arrived here in Washington early this morning on a company plane. It is a 10-year-old Cessna loin. It is not very comfortable. It charges out on a fully-loaded basis at 100 dollars an hour. So, with two of us on board, it is definitely competitive on a fare basis to Dump, and it is a darn sight more reliable. Of course, our topic is of major importance. That is why we are all here; the effect of restructuring on research and development. Goethe said many years ago that the only way to know anything perfectly is to do it. As the chairman of a newly-merged company deeply involved in restructuring, as Stu pointed out, I suppose I fit Goethe's definition. At SmithKline Beecham, we are definitely doing it. What I have to say then is based on the experience of one company. But in describing that experience perhaps I am also discussing an industry; in our case, the makers of prescription and non-prescription medicines, where research and development is not only a way of life, but the only way of life. Drug companies either innovate or perish. My experiences and observations may not be typical of all industry; yet, of course, I believe, they are relevant to the topic. Although many take a negative view of the effect of restructuring on research and development, I come down on the positive side. But I have no doubt that there is also a negative side. This conference was called, if I judge correctly, because it appears that the ground has shifted in American research and development and, indeed, all the previous speakers have reaffirmed that observation. There are two principal facts pointing in that direction: The growth rate of spending on R&D has been slowing measurably since 1984; and U.S. research managers, some of them anyway, observe that corporate restructuring, particularly those restructuring events that involve a great deal of financial leverage, have caused R&D cutbacks at their own and other companies. I will attempt to make the following points to you this morning. First, I will characterize SmithKline Beecham's status in the world of corporations and describe our recent merger. Then I will discuss the transnational corporation and in doing so, introduce another element into our debate here this morning; that is, of world markets and of national ownership of research. In doing so, I will grapple with the question of whether transnational companies have a good or bad effect upon national economies. Finally, I will give you my own conclusion, that restructuring under proper conditions is not only no threat to R&D, but, in fact, can give it new life, not only through increased investment but also through the stimuli arising from sheer challenge and change. I will also stress the fact that the American short-term investment horizon, more than any amount

62 CORPORATE RESTRUCTURING of restructuring, is the real culprit causing a slowdown in investment in research and development within the corporate sector. First, SmithKline Beecham. What is it and how did it get to be that way? It is, of course, a research-intensive, indeed, a technology-intensive corporation, in contrast to at least some of the companies characterized in this morning's discussion as the ideal targets for leveraged buyouts, which are perhaps the most dramatic form of corporate restructuring. SmithKline Beecham is a direct product of corporate restructuring; in our case, an equity merger, an old-fashioned equity merger, with a strong like-minded partner on a friendly basis, designed to form a more vigorous world competitor. Our prosperity depends entirely on the development of innovative products through technological advances. But there is a new message in the merger of SmithKline and the Beecham group to form SmithKline Beecham. That message is this. We believe we are a member of a new breed. We have joined the ranks of the global or transnational company, which I personally believe will be the major organizational style for many businesses in the next century. Who are we? How are we different and why are we devoting a half billion dollars, and growing each year, to research and development? And although we are not solely an American company, why is our success good for America? SmithKline Beecham, with nearly $7 billion in annual sales, is among the top five global companies in prescription pharmaceuticals, over-the- counter medicines and animal health products. We market some of the most prescribed medicines, such as Tagamet for ulcers, and a full line of hospital antibiotics. We market consumer brands that are familiar names to you and other consumers worldwide; lams, Contac, Sucrets, Sominex, Aquafresh toothpaste, to mention only a few. How are we different? The fundamental nature of our restructuring is different. Ours is a friendly and purposeful merger of an American company and a British company. This fact can pose a conundrum for Americans, who love to keep score. I might say parenthetically, the British do just as much. For example, how do you score us if we succeed against Japanese competitors? Is that a win for the American side? Likewise, if we prosper in Italy, does that strengthen America's balance of trade? In other words, when an American company and, in this case, a European company merge, whose side are they on? The answer is that the question is wrong. The question posits a business outlook that belongs to the past. The future business outlook, I believe, will be quite different. It will perceive a world not so much of national corporations reflecting the aims and ambitions of one country, but a world of true transnational corporations, configured in their nature by the needs of all countries in

MORNING SESSION,OCTOBER12, 1989 63 which they do business. That is a substantial change in market perspective and it does, as I will attempt to show you, have relevance to the future of R&D. So scorekeeping in the traditional sense may no longer be appropriate. The game has changed and government statisticians are going to find more and more companies that do not fit their traditional categories, because more and more companies are going to become and certainly think transnationally. SmithKline Beecham reflects a new reality, the reality that technology flows across borders and oceans and land masses in spite of executive fiat or any kind of protectionist legislation. We have all anticipated and for years talked about one world. Now one world has become more than an abstraction. It is a market reality and it is not yet, of course and perhaps never will be a political reality, but it is certainly an economic reality. The market reality of the next century will definitely be one world. The EEC's Common Market of 1992 is merely one symbol of a step in that direction. But we confront not only a market reality, we must accept a technolog- ical reality. Patent applications and grants show how things are going. Our competitors and, again the Japanese are a notable example patent their discoveries in the United States and in other countries, as well as their homeland. SmithKline Beecham, likewise, patents our discoveries in all the attractive marketplaces, including Japan. Where there is no reasonable patent system, however, we usually don't do much business. It must be said that the reality of the transnational corporation, of open markets and an international trading system, has not always been seen as good. It has, in fact, been feared in the past and in some quarters it is feared today. But it is precisely that international open trading system that has allowed the non-communist nations to grow and prosper for 30 years, to the great and lasting benefit of all of us who participated and to the very severe detriment of those who dealt themselves out of it. This is the system on a global basis in which SmithKline Beecham must compete. We were not entirely breaking new ground when we merged with a British company. In the past, as SmithKline & French Laboratories, we conducted much of our primary pharmaceutical research in Great Britain, as well as in the United States. We did so by choice, not by chance. There is a great tradition of medical discovery in the English-speaking world. Many of the quantum leaps from the understanding of how blood circulates, to polio vaccine, to the double helix and the breaking of the DNA code were the work of U.K scientists, often in collaboration with U.S. scientists. Dr. James Black, for example, was awarded the Nobel Prize this year for his investigations, in the United Kingdom laboratories of SmithKline, that led to Tagamet, our leading product. So, we are not awakening to the

64 CORPORATE RESTRUCTURING elegance of British science. We are simply institutionalizing our faith in British science and American science. The R&D perspective for our company is this. As SmithKline Beecham, we will be a larger, stronger investor in science and in innovation than either company could be alone. And, I may say parenthetically, a more efficient one as well. Moreover, as a global company, we have many scientific and technolo- gy-based alliances, with Boehringer Mannheim in Germany, with Sunto~y in Japan, with Novo-Nordisk with Nova Pharmaceuticals in Baltimore and with Stanford and Oxford universities. In some cases these are collabora- tions with individual scientists, although all of those that I just mentioned are institutionalized as broad-based contractual collaborations. Sometimes we collaborate with a small company with superb technol- ogy that is seeking a partner. In every case, whether following our own avenues of R&D or joining with partners, we are matching our needs to the realities of the global market. That means an expanding R&D budget, not a contracting one. And matching our R&D to the global market is one of the keys to understanding SmithKline Beecham and our approach. The price of admission to the world league of pharmaceutical discovery is an annual R&D investment now of at least a half a billion dollars. We and a handful of other companies are at that level. But if, as I see it, the handful of transnational companies now in existence are prototypes for the future, scientists working in research and development have no reason for concern. Our real concern is whether we will have enough scientists in the next century to do the work that needs to be done. The stakes are very high for research-oriented pharmaceutical compa- nies. World sales of pharmaceuticals last year totalled $154 billion. Europe led with $43 billion, followed by the U.S. at $39 billion, with Japan coming on strong at $31 billion. What about the question of national advantage that I mentioned ear- lier? When SmithKline Beecham plays in the big global league, competing with many U.S. and international companies and cooperating with a few, is that good for America? I believe it is. If we are at the forefront of knowledge, medical advances are made available to U.S. citizens rapidly and efficiently. We employ the best scientific talent and invest in plant and equipment in the United States, as well as in Britain and other countries. That is good for the employment of scientists and for capital investment. We pay at least as much in taxes as we did as separate companies. With the strength and stability of our greater resources, we will probably pay more in the future. We continue our full program of contributions and other aspects of corporate citizenship.

MORNING SESSION, OCTOBER 1~ 1989 65 All these benefits accrue to the United States, although strictly speak- ing we are not an American company. But what about national goals? Obviously, our goals stand in contrast to the current enthusiasm for na- tional competition technonationalism, as it has been labeled by some of my Japanese friends through government-financed consortia. I realize that some of these efforts have their legitimate origin in the concern over domination of an industrial segment, particularly those deemed vital to defense or national security. That argument is often related to government-backed Japanese or European interests. But the response often seems to me to have an unrealistic, "Fortress America" quality to it; a belief that if we can simply erect the right fence, we will somehow be safe behind our borders. If in doing so we can just outwit the crafty bureaucrats of Japan and Germany, then millions of their consumers will somehow buy our products. The truth is otherwise. America is not going to compete successfully in other home markets abroad, unless we are prepared to invest time and sweat to know the customer and learn from the customer. For example, we made our initial investment in Japan 23 years ago. We formed partnerships. We have successful businesses there today. We contribute, in fact, to the American positive balance of trade with respect to Japan, but in Japan, as elsewhere, we know that we must continue to build, to learn, and, most of all, to adapt. The Economist magazine commented on the issue of national consortia a few months ago in discussing high-definition television. It pointed out that an American-only consortium of computer and telephonic companies, particularly one financed by the military, hardly seems best suited to develop hot-selling consumer goods, like high-definition TV Perhaps such efforts will succeed, but I fear for any national consortium that does not fully appreciate the global marketplace. My conclusion is that the observed dip in R&D funding may be a temporary phenomenon. It is, to be sure, in large part related to the takeover frenzy, but what I believe is this. The long-term tendency for large corporate organizations is to grow into or toward the transnational model Their imperatives are to meet their markets worldwide and to meet their competitors, who increasingly come from abroad. That being the case, we can, for the long term, expect increased R&D activity, not less. But there are some corollaries to those propositions. Corporate restructuring on balance is a good thing, regardless of whether it is driven by takeover or a merger. It is a major instrument of economic regeneration. The corporate model for non-restructuring, if you will, is state-owned enterprises. They soon become dedicated to the status quo and unless heavily subsidized are, by definition, noncompetitive in the

66 CORPORATE RESTRUCTURING world market; hence, the current trend to privatization in Britain, France, and, now, even some communist countries. Secondly, restructuring has not hindered research and development funding nearly as much as the short-term investment horizon, tied perhaps, as has been pointed out by Roger Altman this morning and Joe Grundfest last night, to the disadvantageous cost of capital in the United States. Nevertheless, I am convinced that the short-term investment horizon does demand emphasis on quarter-to-quarter earnings and forces corpora- tions to think short term, while R&D, by its nature, is a very long-term process. The American financial markets are geared to short-term invest- ment. Indeed, on any given day, I think it is fair to say for a publicly-traded New York Stock Exchange corporation, long-term investors are in the minority among the total group of shareholders. At any rate, the corporate managerial response is geared to producing short-term results. The effect on decisions about R&D investments is, therefore, often predictable and in my judgment is the chief cause for the slowdown in private sector R&D funding in recent years. The Administration's suggestion for a cut in capital gains tax relates to this topic. Although blocked by Congress, the proposed tax reduction, in my view, was not likely to promote long-term investment in American corporations. On the contrary, the proposals and, indeed, the debate all seem directed to draw even more speculative funds, looking for a quick kill, all of which is the bane of the American economy at present and an obstacle in the way of long-term funding of our R&D. Finally, an industry, certainly one such as ours, and Mac has already made the point with respect to Polaroid, is as prosperous as its technol- ogy, which means that all industry, and especially transnationals, cannot survive without science and scientists. Research and development will in- evitably thrive under the stimulus of well-funded, large, fiercely competitive transnational companies. Now, I look forward very much to the discussion. I am sure between the two of us, we have provoked a few questions. We look forward to the debate. Thank you. MR. EIZENSTAT: I wanted to personally thank both Henry and Mac not only for interesting talks, but for talking very directly to the topic, and it seems to me that your different experiences In restructuring have very much enriched the discussion. I hope that this will provoke some questions and that you won't feel in any way intimidated because they are CEOs. MR. WENDT: No one else does. MR. EIZENSTAT: Yes again, for those who may not have been here at the beginning, we are trying to use the mikes. If you will identify yourselves, so we can get you recorded.

MORNING SESSION, OCTOBER 12, 1989 67 MR. BURTON: Yes. I am Stan Burton, Council on Competitiveness. I have a question for Mr. Booth. In your comments, you talked about the need to look at the productiv- ity, efficiency, effectiveness of R&D within corporations; get R&D closer to the sweaty realities of the marketplace is the way you put it. Do you think your experience with Shamrock and the attempted takeover may have had a healthy impact on the way that Polaroid looked at the whole R&D process, in that it forced you to look at productivity and effectiveness and efficiency of the R&D process within the corporation? MR. BOOTH: I have been asked that question over not just R&D, but over a number of things that relate to the company. Were we just reacting, if you will, and, therefore, isn't that better, and God love all those guys out there who do that to you. I have had the chance to testify on that subject in the courtrooms. I said in the court in Delaware that there was no question that the Shamrock phone calls and letters were a bit of a cold shower. It surely got our attention and woke us up. I think that while many people have trouble believing this, it is true. I can assure you that we started much of this long before Shamrock showed up, but as I was saying to Stuart Eisenstat last night, one of the things that made me very upset with that phone call and the subsequent activity is not Stan Gold and Shamrock, but myself, that I didn't move more quickly before the call came, because we knew what we should be doing. It did act as a stimulus. There is no question. It did not provoke us into doing anything that we didn't have planned. It accelerated it. Now, it is easy for me to sit here now, as still the public company, and talk about this effect. The question is, what if they had won and we had lost, what would the company be like today? I believe the company would be dramatically different. I believe that was stated in the courtrooms and other places, that research would have been one-third of what it is today in many aspects. We aren't a company which had businesses that could be separated and sold off. We were going to be consolidated and sold in pieces to various activities, in my judgment. That is a personal judgment, not something that necessarily is accurate. So, I ramble a little bit, but let me just say that there is no question that there was a stimulus there. What I would lee to leave for this group and any group I can tank to is, for God's sake, don't wait until the phone call comes. Do it; grab the bull by the horns and look at research. I think it is so important to the future of our country and to our well-being and our standard of living. I do think because of the history of the forties and fifties and sixties of this wonderful research engine, building our economy, that it was sort of left alone and thought of as an ivory tower. I believe today that you can't

68 CORPORATE RESTRUCTURING think of it that way. It has to react to the sweaty reality of the marketplace and it has to be looked at hard and looked at in a productive way, just like we looked at manufacturing or whatever. So, let's get on top of it before you get behind it and someone is knocking at your door. I don't believe the marketplace does value research, as some of our predecessors have said here. So, I think you have to be out there knocking at the door and showing shareholders what you are doing. That is difficult and troublesome, because they aren't all friendly when you are doing that, but I think they need to understand what you are doing and what the value of that is. Then, heavens, if someone offers them more money, I guess that is the name of the game and they can take it, but they need to be informed and they need to understand. And that is really what I was trying to say earlier. MR. WENDT: I might add a comment to that. I don't think the markets value research either. They certainly do not value input or al- location in an investment sense to research. They value research when they see the output on the threshold or already across the threshold of commercialization, after it is all done, in other words. I, too, believe that the general atmosphere of corporate restructuring, takeovers, potential takeovers, brings a true sobriety to the board room, particularly among the external directors. That is all to the good in my view. That is one reason why I think it is very healthy as a general phenomenon. But research is extremely fragile. One can point to takeovers where the intent genuinely has been to maintain research, but the very act of takeover has destroyed it. The change in management, managerial climate, the culture of the company is too unsettling to people who are in high demand; they can easily go elsewhere, and they do. There are lots of examples of that. So, just the managerial challenge on the takeover environment of research is extremely difficult and should never be underestimated, regardless of intent. MR. JARRELL: My name is Gregg Jarrel and I am a professor at the University of Rochester. I used to be the chief economist at the SEC, where we got very much involved in this stuff. I am a speaker this afternoon and I need your help in getting some of my comments prepared. First, Mr. Wendt, you are obviously in an industry that has probably the heaviest research and development expenditures of almost any industry in the world. Do you think currently or recently that your stock has been undervalued by the U.S. stock market as a result of your R&D expenditures? MR. WENDT: Yes. MR. JARRELL: That was easy. I would ask you by approximately how much? MR. WENDT: Are you working for KKR?

MORNING SESSION, OCTOBER 14 1989 69 MR. JARRELL: Mr. Wendt, that was an excellent answer. Here is a tougher question. You say that restructuring is basically a healthy force, but you also strongly believe in myopia in the stock market. In the ivory towers and among the policymakers, there is something inconsistent about those two views. Myopia the problem of a stockmarket that does not appreciate long-term research and development, that discounts it, overdiscounts it is precisely the kind of a condition that will lead to excessive restructuring, will lead to a substitution of debt for equity, will lead to privatization, leveraged buyouts and a sacrificing of research and development. So, I am having a little trouble—did I hear you right or are you comfortable saying that most of the restructuring activity in the U.S. is a healthy sign and is useful, and at the same time you are comfortable believing that the stockmarket has a fundamental problem of myopia? - MR. WENDT: I am very grateful that you asked that question because obviously I did not make myself very clear. So, now, I will give you a longer response, if I may. I believe restructuring is a healthy process of economic regeneration and when I use the word "restructuring," I do so in the very broadest sense, including many voluntary forms of restructuring initiated by companies at various levels and on a continuous basis, but not excluding mergers, takeovers, or LBOs, either. I think they have on balance provided an overall helpful stimulus. If restructurings were somehow outlawed by your former employer, I think that over time that would be an unhealthy event. So, I don't think restructuring is the villain of the piece. I do think a short-term investment horizon, which you referred to as myopia, is, indeed, the villain of the piece. Clearly, we must have, all of us, the opportunity to restructure the economic engines. Change is the universal law of life. Anything that prevents change is counterproductive in my view. I am very, very concerned about the short-term investment horizon in this country and I accept the arguments that we heard this morning relating that to the cost of capital, but there are psychological elements as well and it is not just cost of capital. I relate it directly to the fact that for large, let's say Fortune 200, cor- porations listed on the New York Stock Exchange, we see the phenomenon now of every year a turnover of 55 percent of our shareholders. So, we lose more than half of our shareholders in a 12-month period. I think that, therefore, in a two-year period I can't absolutely prove this, but I think it is quite easy and safe to say that we will have a continuing shareholder base that represents perhaps a quarter to a third of our shares. The rest are not continuing; they are in and out. In fact, I believe the average holding time, coming at it in another direction, is 4 months and 20 days. They are not investors; they are not really shareholders. They are not interested in the quality of R&D or what the long-term future for this

70 CORPORATE RESTRUCTURING company is as we move into the l990s. It is peculiar and special in my view in the United States, and not found to nearly the same degree abroad. That puts enormous pressure on our boards, on the directors, who represent all the shareholders and sit around the board room once a month, viewing the company's strategic plans and operations and investment proposals, and on the management as well. So, you did, indeed, misunderstand me totally. MR. JARRELL: Do you favor the tax that has been bandied about in Washington, the special tax on short-term holdings, a transactions-type tax? MR. WENDT: Yes. I am in favor of what I call a progressive capital gains tax. For example, I believe that holdings for one year or less should be taxed at a higher rate than ordinary income; let's say, just to keep it simple, 50 percent. A few of my friends on Wall Street don't like this, but I really believe this and that if they are held for two years, perhaps it can come down close to the ordinary rate; in three years lower, in four years and maybe in five years zero. That would change this very climate we are discussing. If we add to that, as Nancy Kassebaum has proposed, a tax on pension funds for their transactions, since they are moving all the shares anyway, then we might really change the climate. Another topic, but it does relate to investment in R&D. MR. DINNEEN: I am Gerry Dinneen with the National Academy of Engineering. My question is for Mr. Wendt. It has to do with the growth of transnational corporations and national advantage. Let me define national advantage as an increased standard of living for our people, which says that we should continue to attract manufacturing and also R&D, whether they be from U.S. corporations or transnational. Do you see a role for our government in trying to make the environment better here to attract that kind of investment, whether it comes from U.S. or transnational corporations? MR. WENDT: Well, that is a very good question. I think that the single best thing the government could do is to change and try to affect the investment climate as just discussed. I think that using tax policy to encourage R&D in this country, rather than discouraging it, would be the next best thing. Perhaps more fundamental than anything, as Mac pointed out very early in his remarks, is the quality of education and, therefore, the quality of the scientists and engineers, and it can't be attacked quickly or with tax Dolicv. But I have said on other occasions and I don't mean to pick on Ronald Reagan, but it is easier, I suppose that if education, particularly in the harder sciences, had received the same priority, not necessarily the same allocation of resources, as the 600-ship Navy, now, in 1989, this would

MORNING SESSION OCTOBER 12, 1989 71 be a very different country. This whole discussion would be different. I mean, if that had started out as a priority of the same order, this morning's meeting would be significantly different. So, that is where it begins, I think. MR. EIZENSTAT: Mac, would you like to respond to that in terms of government policy. MR. BOOTH: I think that I would just be echoing what Henry said here. I do think that there needs to be an incentive for research. I really do believe that and I think that maybe one of the better things is, in general, stay out of it and let the natural things happen. I am in favor of letting Japanese firms build plants and do research and come over here and join the fray. I think that is positive. We sure thought it was positive for many years when we did it that way. I don't know why it still isn't positive. MR. HARDIS: I am Steve Hardis, Eaton Corporation. I am not on this afternoon's program, so I am going to indulge myself bv making a comment. This is my only shot. ~ ~ ~ c' I would like to suggest that the speaker last night and the first panel this morning focused on different situations than did these two gentlemen. The data that were commented on last night and this morning draws on the experience of industries that were ripe for liquidation or semi-liquidation, and all the positive statistics that were cited were germane to that group. What we have heard here are two people talking about industries that are vital and need technology renewal, which is really the subject of this symposium. Now, my thesis is that the short-term investment horizon is, in fact, the problem. There is, in fact, a cost of capital differential that is a problem, but I don't view that as the determining issue. It seems to me that the pernicious event is that the returns offered by liquidation and semi-liquidation- and the speakers were liberal in quoting them, minimum 30 percent, maybe 50 percent- are now substituted for what were the traditional 9 to 10 percent equity returns, and those are now being imposed upon companies that have a much more vital mission. A lot of the commentaries by the government people and the academic observers are confusing the two. You can't operate a vital institution on the kind of returns you can get out of liquidation and semi-liquidation. MR. BOOTH: I tried to say the same thing. I think the 30 percent returns are there for private benefit. I think we all should recognize that that is our system. I mean, to ask a person who did an LBO, is it a good idea, is sort of silly to me because they wouldn't have done it if they didn't think it was a good idea. They think they are going to make a lot of personal money out of this thing: that is why they are doing it, and it is a short-term focus. I really do believe that. So, I believe we are talking past each other. I would agree with you.

72 CORPORA RESTRUCTURING MR. PAXI ON: I am Harty Paxton from Carnegie Mellon University. Most of my career has been spent in research and I like to talk about it to anyone who will listen. So, I am very interested in your remarks, Mr. Booth, that you would like to tell a number of constituencies about research. My experience has been when I go to a cocktail party and someone says what do you do and I say I am in research, their eyes glaze over. Do you have any clever thoughts on how you are going to convince your constituencies? MR. BOOTH: Well, I usually don't see my owners in the cocktail parties, but I didn't find that to be true personally when we went around and visited with our owners. We spent a lot of time with them. I think what Henry talked about is true; sometimes they are the owners of the day. I mean, there is a tremendous change in shareholder ownership when you are in this sort of a play that we were in. We went from 20 percent to 60 or 70 percent of people that were less than a week in their holdings. My sense is that research isn't as important to them as what you are going to do next week and how you are going to recapitalize the company and pay them a dividend, but I do believe that there is a genuine interest in where your company is going and what your research is developing. I didn't find them glazing over. I found them very interested, but we had to spend a lot of time and a lot of effort and a lot of visits to our laboratories and a lot of Peter Kliem's time and a lot of our scientists' time to really take them through it. I found that a product of that was a positive response. So, that is all I can tell you from personal experience. MR. EIZENSTAT: Henry? MR. WENDT: I would only say that the follow-up question usually is, what is coming out of research? And if you describe a product that is going to be introduced in the next quarter, the eyes brighten right up, but if you describe a wonderful breakthrough that might make it onto the market in 1994, they turn on their heel; if they are shareholders, they go right out the door. That is all part of this phenomenon we are tattling about. MR. ZAININGER: I am Karl Zaininger from Siemens. I would like to thank these panel members, first of all, for addressing the topic of this meeting. It was very nice. I didn't think that the first session did that. Secondly, I agree with you on just about everything, but I would like to ask Mr. Wendt a question, which is an extension of his comments on globalization or transnational companies, and that is really the concern about the global management of R&D. You just talked about R&D, but the question is, as you become more global where do you do what research and why? MR. WENDT: Well, that is an excellent question and if I really had the answer to it, I guess, I would have written a book or something, but the thrust is that the output has to match the market but the source of

MORNING SESSION, OCTOBER 1g 1989 73 R&D does not. So, one tends to put one's investment in a place where you expect continuing productivity of the science and technology. Historically, the United States has been a very good place and I believe will remain a good place and I pointed to Britain also as a good place. Frankly, we are probing Japan, to be perfectly honest about it. Japan may be or may become a good place for the new non-traditional sciences, as opposed to the more traditional sciences. So, in biotechnology, for example, or molecular biology, particularly using fermentation technology, Japan is very interesting. They have great expertise in fermentation technology and they are applying it to this new technology. In the more traditional technologies, frankly, I think Japan is a terrible place to do research. The academic hierarchy is very, very restrictive. It is very difficult, particularly for a foreign company, but in the new technologies, we are intrigued. I mentioned a collaboration with Suntory. That is kind of a scientific probe in that direction. So, that Is our view at the moment. The Continent has some appeal, although we can do in Britain much of what we can do on the Continent and probably obtain better value, because we have the investment there and the people there already. But it is a question we ask repeatedly and a large company, I think, tries to push the envelope on that basis. MR. EIZENSTAT: May I ask a related question, Karl, just to follow up on that because this is, I think, a concern of people who are concerned with employment. Is it naturally the case in this new global market to both of you that when you move your R&D facilities or some of your R&D abroad that it will naturally bring manufacturing along with it? Or will you perhaps just do research in the best place possible and the manufacturing may be done in quite a different place? MR. BOOTH: Let me just say we don't do any research outside the United States. We do do manufacturing, and in our case it would follow the other way, that the research would follow the manufacturing more than the other way around. We will be questioning that as time goes on, as to how much research we do want to do outside the States, but in our case it would be the reverse of that. MR. WENDT: Well, it is a very pertinent question for SmithKline Beecham in that as a consequence of the merger of these two very large companies, we are examining everything that we do with an eye to the future rather than to the past. In the past, the practice in the pharmaceutical business has been to put a plant in almost every country, because the regulatory authorities of the country lee it that way. They can regulate it. If the factory is not there, they feel they can't regulate it so well and so they are unhappy and they make life hard for you. I think that is clearly changing in Europe. So, the answer now and for the future is, you do your research in the best place and you do the

74 CORPORATE RESTRUCI~URING manufacturing in the best place. You manufacture in the fewest places pos- sible, in order to gain the greatest efficiencies and the greatest competitive advantage. MR. EIZENSTAT: And they may be two different places? MR. WENDT: And they are almost certainly two different places. Scientists can get on an airplane, just like anybody else and go to the factory and vice-versa. Going back to the other question, one other thought. There is no large biologically-based corporation, health care corpora- tion, pharmaceutical or otherwise, that can afford not to do research in the United States. That should give you all some comfort. Beecham was look- ing at a very major investment in the United States that this merger made unnecessary. It is absolutely competitively vital, at least in the health care business, to do research in this country and I think that most large Japanese competitors—most of them do not do any research in this country if they were in this room and had a little sake, they would agree with that and say so. MR. STERN: I am Bob Stern, an independent consultant. My question is largely addressed to Mr. Wendt, but really to both of you. I was struck by somewhat negative connotations in your views about consortia as a way to do research and, yet, the Europeans have had a fair amount of success at it through things like Esprit and Eureka. The Japanese in their superconductivity consortium have had a fair amount of success. I wonder, in this globalization era, whether that isn't a form that the United States need to experiment with, and whether we need to gain experience before we look at it too negatively? MR. WENDT: Well, I will start in response. My comments were directed to the concept of an American consortium in competition to other countries. We do collaborative research in a variety of ways, as I think I indicated in my talk, and we will certainly continue to do so. While I can't think of a case at the moment, I could imagine that we would also engage in a consortium if it proved desirable. I would definitely prefer to do that, however, with a global view and I would want my partners to be the very best in the world. Now, if the very best in the world are all American, that is great; I am all for it, but if the very best in the world are also from other countries, then that is the way we have to go. We have to do that to be truly competitive. ~ think that we can just sort of erect national boundaries in this day and age, I think is wrong. MR. STERN: It may be that the economies of scale for R&D may drive us in that direction anyway. Something I have noted is that, for example, with regard to the semiconductor area, it is very important to U.S.-based corporations to be members of JESSI, which is the European

MORNING SESSION, OCTOBER 12, 1989 75 counterpart. It seems to start out with a national goal in mind—certainly that was clear in the Japanese case but I think maybe everyone will have to broaden their view and do what you say, which is get the best researchers in and look at the overall impact. Maybe that is the way it will go. MR. WENDT: Whatever is best I think has to rule. I agree with what you said. MR. EIZENSTAT: In fact, I think one of the arguments that has been used against opening Sematech to non-U.S. companies has been the fact that the European consortium has been closed to companies like IBM, which tried to get in. Henry and Mac, there may also be a question about whether govern- ment-led consortia work better in places like Europe and Japan, which have a stronger, longer history of deeper government involvement in the economy; whereas, there is a certain distrust in this country of that. That is an open question that we could debate, I suppose, forever. MR. ALTHUIS: I am Am Althuis from Pfizer, Incorporated, and I would like to address a question to Mr. Wendt. I was particularly fascinated by your thoughts on the transnational cor- poration. However, your company and mine have long been international or multinational corporations and I am not quite clear what you view as the differences between the transnational and multinational corporation- although I think some of that began to come out in the answer in the previous question and what that specific difference is going to have on research. MR. WENDT: Thank you. I am assisted in answering that question by the fact that transnational appears in both Webster and the Oxford English Diction any and the definition is "exceeds national boundaries." Multinational, also, in both of those dictionaries is defined as operating in more than several nations. So, in brief, that is the difference. Now, SmithKline Beecham, more than SmithKline or Beecham prior to the merger—and I dare say, perhaps more even than Pfizer has sales and profits that on a proportional basis match more closely the global market. I mentioned that Europe is the larger market, followed by the United States and Japan. Basically, our sales and profits match the global market and are not dominated by any one country, although the U.S. is the largest country, Europe is the largest market. Our ownership is 50/50 across the Atlantic Ocean; therefore, not dominated by any one country. Our board is 50/50 in terms of national identity; therefore, not dominated by any one country; likewise, the management. Our purpose is to bring onto the board more third-party nationals, to truly reflect at the highest levels of the company this transnational character. Our R&D is split almost 50/50 between the United States and Britain

76 CORPORATE RESTRUCTURING in the new company; therefore, not dominated by any one country. I think that those various factors go pretty far in illustrating the dictionary definition of "exceeding national boundaries." I don't know that I can say that it is a prototype for the future, but it is the way I think the world is going and this company illustrates it. There are a few others that are moving in that direction certainly. MS. BLAIR: I am Margaret Blair with the Brookings Institution. I want to go back to the issue that both of you have spoken to, about the short-term mentality in the financial markets. What I want to get at is, I want to relate that back to something that both Mr. Altman and Mr. Grundfest talked about last night: the high cost of capital. My own research has been looking at the possibility that it is the high cost of capital that is in fact driving the restructuring, because the high cost of capital enforces a short-term mentality on the investor. The question I want to ask is about which way the causality runs, because it makes a big difference in terms of policy implications if you think that you have got a short-term mentality in the stock markets, and that is what is driving up your cost of capital, or if there is some exogenous factor driving up your cost of capital and that is forcing people to think short term. Let me tell a little story to illustrate my point. I recently had an op- portunity to look at some research that was done by a Japanese economist, who is studying at the Brookings Institution. He decided to see if he could come up with some explanation for why the performance of Japanese manufacturing companies had been so far superior to American manufac- turing companies during the last 15 years. His measure of this was that the Japanese have gained market share and the American companies had lost market share. He went through several different explanations for why this might be and concluded that it wasn't that the Japanese companies had a lower materials cost and it wasn't because they had a lower labor cost and it wasn't because they had some sort of exchange rate advantage. It was simply due to the fact that the Japanese firm had a much lower cost of capital. When I looked at his results, I said a Wall Street economist would look at that and say, in fact, American companies perform much better than Japanese companies because their return to capital was higher during the same period. It seems to me that it makes a big difference in what your goals are and what questions you are asking here about what you want out of the company. So, I think either or both of you could address this question of which direction the causality runs. Are we thinking short term and, therefore, demanding that our firms impose a higher hurdle rate on our their investment strategies, or is there some exogenous factor that we could

MORNING SESSION, OCTOBER 14 1989 77 be addressing that is driving up the interest rates and, therefore, forcing us all to think short term? MR. BOOTH: Well, I am not sure which is the chicken and which is the egg. I am not sure which way that goes. I think early this morning there was just a slight mention made of the fact that many of us are invested in pension funds, which demand high returns. They are a huge source of funds in this activity that is going on out there. It is kind of like eating your own tail to a degree here. I mean, if we weren't demanding the 30 to 25 or whatever it is percent return on our investment in our pension funds I think that is where the cycle starts. Now, does it start there because someone can deliver that and, there- fore, it keeps going? I am not sure where that starts, but I do know that it is a huge source of the funds that are in all of these big, highly leveraged situations. I think this idea of making folks pay more dearly for short-term transactions is a very good idea. I think that may change the mentality. I think we are on a roll here that we don't know how to stop. The financial people—I have met with many of them, as I am sure Henry has, and if they don't get us 30 percent, they are out. The pension fund cuts them off and they are off to someone else. So, that creates a very barracuda kind of a thought process. MR. WENDT: I really don't have anything to add to Mac's reply. I don't know which is the causative factor either. I hope you find out, though, and tell the world because the phenomenon is very dangerous. It may, indeed, be caused by us and our pension funds. And there, incidently, total tax exemption is also a factor. They just roll their money as rapidly as they can. MR. HILL: I am Chris Hill with the Congressional Research Service. A question for Mr. Wendt. I am glad you introduced the analysis of the transnational corporation into this morning's discussion. My suspicion is that that phenomenon is a great deal more important in the long run to research and technology development than the LBO phenomenon, per se, is likely to be. And let me say, I agree with the substance of your analysis of where we are and where we are going. But I need your help. I work for Congress. Congress needs your help in the following little conundrum. We are now spending about 20 to 22 billion dollars a year in public money on non-defense-related research and development, about 6 billion of which goes for purposes that lie at the root of your own industry, the biomedical research at NIH and elsewhere. A lot of the argument about why that is a good investment of United States citizen-taxed public funds, or borrowed public funds, is that it will enhance the competitiveness of American firms in the competition with

78 CORPORATE RESTRUCTURING firms abroad, and contribute to the income and standard of living of the working people of America and so on. We need some new arguments to be able to say why that continues to be a good idea in a world of transnational corporations. Or are we, in fact, on the verge of having to reexamine the relationship of the transnational corporation to the independent nation-states? Do we need new parallel structures of governance, so that there continues to be some overlap between the geographic domains of industrial operation and those of taxing, spending, employment and unemployment? MR. WENDT: Well, I definitely endorse the latter view in terms of advice. I think that you would also be well-advised to reexamine the tax policy with respect to the deductibility of R&D against foreign-sourced earnings, as opposed to just U.S.-sourced earnings, which for any globally- minded company tends to drive research right outside the country. It seems to me to be totally counterproductive, and a good place to start. The American pharmaceutical industry is now spending more on re- search and development than you in Congress are spending at the NIH. Those lines have now crossed, with NIH really plateaued—in real terms, I think, down and the industry up. Nevertheless, I think we would all say, and certainly our R&D executives would say, that NIH has served as a wellspring of scientific excellence and training for the country. Like all big institutions maybe NIH, too, should come under the discipline of restructuring; it is fair to say that it hasn't. So, if the thrust is on training and developing first-class scientists and practicing leading edge science, I think it is a good thing. That proposition really has to be examined with respect to our national-funded research centers. That is about all the wisdom I have and it is not very much, I am afraid. DR. MUELLER: Just a brief comment. I am Dennis Mueller at the University of Maryland and also will talk this afternoon, but I will save myself having to make a detour this afternoon. Just following up Margaret Blair's question, because I think it is a very important one. My work and work I have done in collaboration with the Japanese does suggest that both U.S. managers and Japanese managers are pursing growth, perhaps more than would be in the wealth-maximizing interests of stockholders, as has been mentioned earlier this morning. The important difference is, however, that very often U.S. firms have done that via the merger route and via the "take over all other companies" route, far more than the Japanese. Indeed, we have 10 times as many mergers as the Japanese do. They have relied much less on mergers and acquisitions as a growth strategy; rather, they have relied on investment R&D and taking over markets. And of course, they have been very successful at it. Thinking about policies and how we change things around in this country, the thing to be asking ourselves is how can we get managers to

MORNING SESSION OCTOBER 1~ 1989 79 shift emphasis from taking over other firms to taking over markets, and how to get the growth proclivities of management In this country directed in what is more socially beneficial investment in R&D kinds of investments. MR. WENDT: Is that a question? DR. MUELLER: If you have an answer, it is a question. MR. WENDT: I would start the examination with analyzing the dif- ference in the shareholder structure in the two countries and the demands of shareholders on the management. And if anybody thinks that corporate managers are immune from shareholder demands in 1989, they are crazy. I think that is where it starts frankly. Mac should give his perspective, but that is certainly mine. The structure is obviously very different in Japan, the needs and demands of the shareholders are very different, and it is no wonder that there is a difference in managerial behavior. That is who we work for, that is who the directors remind us that we work for, at least once a month; generally, more frequently. MR. BOOTH: I absolutely agree with that, but there was something else that you were saying I would like to comment on. It has to do with the perception of what happens in Japan versus the United States as far as collaborative research. You don't need mergers and acquisitions if you can get collaborative research. I am not an expert on the Japanese marketplace or Japanese industry. I can speak about my own experience and our own corporate experience in electronics and in photography. There is a tremendous amount of collaboration that everybody denies, but it goes on continually in the marketplace, about sharing technology. It is one of the most remarkable things I think I have ever seen, where they kill each other in the marketplace and yet share technology between companies and have common suppliers that both invest in to provide them with components. It is a remarkable arrangement that we haven't done. Our antitrust activity and all seems to squelch it historically, and I don't think it is probably in our culture, but they do it. So, when you say they don't do mergers and acquisitions to do that, I am not so sure I am sure that is correct literally, but if you look behind that, I am not sure that the same things aren't going on. MR. WENDT: Just to tie those two responses together, I think Mac is describing the keiretsu system of collaboration, often apparently informal, but driven essentially by common shareholders. That is what provides that. That is the umbrella for that system and if they are not common shareholders, they tend not to cooperate in quite that fashion. MR. EIZENSTAT: And they are often big banks who don't demand the short-term returns. I really want to thank both of you. This was a terrific contribution to our topic with very rich discussion. We appreciate your coming.