A critical View on the Usage of Data from
Capital Markets for Group Control

by: Martin Renze-Westendorf and Christian Schürmann

WS 2005/2006
 

LIST OF ABBREVIATIONS

BSC = Balanced Scorecard
CAPM = Capital Asset Pricing Model
CEO = Chief Executive Officer
DCF = Discounted Cash Flow
EVA = Economic Value Added
MVA = Market Value Added
NOA = Net Operating Assets
NOPAT = Net Operating Profit after Taxes
ROI = Return of Investment
WACC = Weighted Cost of Capital

1 Introduction

1.1 Problem definition and objectives

Questions in the field of group control are increasingly important in today’s economic environment. This development is especially driven by the fact that almost 90% of the German public companies and around 50% of the German limited liabilities companies are organized as groups.¹ These structures imply information asymmetries and higher coordination requirements because commonly the parent company is responsible for strategic decisions while the subsidiary is responsible for the operations. As decentralized structures are gaining importance and the complexity of the company’s environment is growing, the group control faces new challenges and increasing importance for the management. In its aim to supply rationality assurance to the management it needs to work effective and efficient using a set of control tools. The basic data can be retrieved internally or externally. Especially, in the case of listed subsidiaries the data provided by capital markets seem to be a very simple solution for the problem of information gathering and processing in a complex environment. Hence the following research questions arise:

• How can a holding control its listed subsidiaries through data from capital markets?
• What could be rationality deficits and limitation in the application of data from capital markets?

1.2 Outline

Beginning with basic definitions the paper defines management control to lay the basis of the examination and to determine the point of view. The holding is the entity that group control is located in. Capital market data in group control is the theme of this paper and those two terms need to be defined properly. Group control is defined in respect to rationality assurance, so it must be distinguished between external and internal institutions of rationality assurance. The internal institution includes a description of the functions and tasks of the controller. Control instruments are the tools used by the controller to process capital market data in group control. The main part is assessing the theory of the utilization of capital market data in group control. The first step is to examine the aims of the application of capital market data, which are effectiveness and efficiency. In the second step different forms of application of capital market data in group control are assessed by looking at selected control instruments. They are grouped by their employment in the tasks of the controller, which are information, planning and control, and coordination. The final step is a critical view on rationality deficits of capital market data in group control. Before concluding, the paper takes a look at the empirical evidence of the utilization of capital market data in group control.

2 Basic Definitions

2.1 Management control defined as rationality assurance

There is a disagreement in the literature how management control should be defined and what its functions are. Most authors put coordination in the middle of their definition. These approaches differ in the degree of coordination done by the management control. Horváth, for example, understands management control as the coordination between the planning and control system, and the information supply system.² Küpper defines management control as the coordination of the entire management system.³ Weber and Schäffer choose a different approach. They define management control as rationality assurance of the management.⁴ This is the widest definition and includes coordination as one function of the controller.

Management control understood as rationality assurance of the management fits the purpose of this paper best. This definition includes internal as well as external institutions of rationality assurances. Competing definitions concentrate on an internal view and do not cover external markets and market participants. They limit management control to internal institutions like the management control department and the management itself. External markets and market participants are only seen as producers of capital market data as additional information that needs to be processed by internal institutions. ⁵ By way of contrast, in the context of rationality assurance external markets and market participants have two functions. They act as independent institutions of rational- ity assurance irrespective of internal institutions. So they have a direct impact on the management and its decisions. On the other hand, external markets and market participants also provide additional data that can be used by the internal management control in order to assure rationality. Therefore, the definition of management control as rationality assurance provides a broader framework to analyze the use of capital market data for group control.

Rationality assurance is a wide concept and needs to be specified. Rationality is defined as “the dominating opinion of experts concerning a specific purpose-means-situation”⁶. As said before, the purpose of management control is the rationality assurance of the management. That means to prevent two managerial deficits: knowledge deficits and intentional deficits.⁷ Knowledge deficits are due to limited abilities and lack of information. Intentional deficits arise if the management has motivations that contradict the goals of the company. Management control is a supporting function that helps the management to avoid these deficits when making a decision. It has to assure rationality on three levels: input rationality, process rationality, and output rationality.⁸ So management control supports the whole decision making process of the management instead of just looking at the results. The goal is to heal or prevent knowledge deficits and intentional deficits on all three levels.

2.2 Holding structures

There are three types of holdings: traditional headquarters, financial holding and management holding. They are distinguished by the degree of management centralization.⁹ A traditional headquarter is actively involved in the management of its subsidiaries. They are well integrated in the strategic and operative planning. The subsidiary has only little entrepreneurial freedom, while central departments have far reaching competencies. The group is often not very diversified but concentrates its activities in their core business. There is a great need for coordination between the parent company and its subsidiaries.

In a financial holding the subsidiaries have the responsibility for their strategic and operative decisions. The functions of the headquarters are limited to financing and top management filling. The subsidiaries largely act like independent companies. A financial holding is regularly more diversified in the businesses of its subsidiaries. Financial investors are differentiated from financial holdings by the time horizon and the dominating goal of the investment.¹⁰ Financial investors invest for a short period to achieve an optimal return on invested capital. The market value of the company has a high priority, because they plan to exit the investment after a certain period. In contrast, a financial holding is a strategic investor with a long-term investment horizon. Cashflows to the parent company often have a higher priority than the market value. Nevertheless, the financial holding is not necessarily more actively involved in the management of its subsidiary. Financial investors often need to restructure a company in order to generate the target return of investment and are therefore very actively influencing strategic and operative decisions.

The management holding lies between the two extremes. The proprietary company is actively involved in the strategic orientation of its investments. The central leadership is less developed and the subsidiaries are responsible for their business strategy.¹¹ This paper analyzes the special case of holdings with one or more listed subsidiaries. The subsidiary is a public company and therefore legally fully independent. The parent company is just a regular stockholder. The subsidiary might be listed for different reasons, with access to equity capital being the most important. The real influence on the subsidiary varies widely. The parent company might have great influence on management decisions, even if it does not hold the majority of shares. Hence, it is not possible to make general assumptions about the type of holding that owns listed subsidiaries. We have to consider traditional headquarters, financial holdings, management holdings, as well as financial investors.

2.3 Capital market data

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1 See Emmerich/Sonnenschein/Habersack (2001), p. 4.

2 Horváth (2003), pp. 152-156.

3 Küpper (2001), pp. 43-61.

4 See Weber (2002), p. 57.

5 See Langenbach (2001b), pp. 196f.

6 See Weber (2002), p. 53.

7 See Schäffer (2001), pp. 84-107.

8 See Weber (2002), pp. 55-62.

9 See Weber (1997), p. 70; Hüllmann (2003), pp. 24-34; Keller (1993), pp. 31-63.

10 See Werdich (1993), p. 312; Keller (1993), pp. 65-79.

11 See Borchers (2000), pp. 32-36.