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

LIST OF ABBREVIATIONS

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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 decentral- ized structures are gaining importance and the complexity of the company’s environ- ment 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 re- trieved 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 infor- mation gathering and processing in a complex environment. Hence the following re- search questions arise:

- How can a holding control its listed subsidiaries through data from capital mar- kets?
- 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 pa- per 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 insti- tutions 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 con- troller 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 ex- amine 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 capi- tal market data in group control. Before concluding, the paper takes a look at the em- pirical 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 man- agement 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 institu- tions of rationality assurances. Competing definitions concentrate on an internal view and do not cover external markets and market participants. They limit management con- trol 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 institu- tions.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 partici- pants 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 ration- ality 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 informa- tion. Intentional deficits arise if the management has motivations that contradict the goals of the company. Management control is a supporting function that helps the man- agement 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 manage- ment 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 inten- tional deficits on all three levels.

2.2 Holding structures

There are three types of holdings: traditional headquarters, financial holding and man- agement 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 competen- cies. 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 op- erative decisions. The functions of the headquarters are limited to financing and top management filling. The subsidiaries largely act like independent companies. A finan- cial 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. Cash- flows to the parent company often have a higher priority than the market value. Never- theless, the financial holding is not necessarily more actively involved in the manage- ment 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 rea- sons, 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 manage- ment 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

The capital market works as an institution for rationality assurance and as a source of data that can be used in the internal management control as instrument for rationality assurance. In the following different markets as institutions as well as the data which these markets generate will be presented.

2.3.1 Sources of capital market data

In literature the capital market is described as a central rationality assurance institution which incorporates the estimations and rationales of all market participants.¹² As such institution it provides an unmet objectivity based on the aggregation of different subjec- tive opinions. The capital market can be distinguished between the market for corporate control and the market for corporate finance.¹³ The latter one is divided into the market for equity finance and the market for debt finance. Furthermore, rationality assurance differs between the market itself and the market participants. The participants including banks, financial analysts and large investors may have other goals and functions in their behavior which cause in consequence other implications on the effectiveness of external rationality assurance.¹⁴

Equity market

Generally, the equity market or stock market fulfills two functions: firstly, the financing function and secondly the resource allocation function.¹⁵ In other words it is a market that brings potential investors and companies that need financing together. The stock price functions as indicator and core steering measure for these functions. It assures that the financial capital is always allocated in its most efficient purpose. Because stock prices are quoted nearly daily and constantly, new information and new estimations result directly and nearly instantaneously in new stock prices. It represents a current company valuation.

Financial analysts try to investigate the respective company in its whole in order to sell recommendations to the market participants especially investors. They also incorporate sector and macroeconomic analyses in their work. Hence, analyst reports summarize the state of the company and present a full company valuation including its prospects and future cash-flows.¹⁶ This can move stock prices and lead to a better information processing of the market. All in all, the market provides beside stock prices and other ratios derived from stock prices financial analysts’ reports which can be used like the other ones to assure rationality in the management.

Debt market

The debt market focuses more on the risk - return details of the respective company as debt holders are mostly interested in the default risk of the borrower. However, future potential cash-flows are as relevant as in the stock market because the borrower has to bear interest plus installments in the future.¹⁷ Central measures of risk are the interest rate and the bond price.

Equal to financial analysts act rating agencies in the debt market. The only difference is the target group because rating agencies normally address creditors while financial ana- lysts address equity investors. Agencies improve the information level through their rating and provide risk indicators. However, generally, debt market investors are only interested in ratings if recent decrease in liquidity and performance would increase the default risk significantly.¹⁸ This is increasingly true with higher leverage. In conclusion, the debt market offers the calculated interest rate as control indicator for risk and man- agement decisions.

Market for corporate control

The main aim of the market for corporate control is the identification of company inef- ficiencies in order to achieve value enhancing effects through a takeover of the respec- tive company. It follows two basic functions: firstly, the market function and secondly the control function.¹⁹ While the market function implies an efficient evaluation of the rights to manage corporate resources is guaranteed by the forces of supply and demand, the control function addresses the disciplining effect of the market. The threat of becom- ing a takeover target incentives managers to minimize value gaps themselves, increase company value and act in the interest of shareholders.²⁰ This disciplining effect works as a form of rationality assurance of the management as in case of failure the manage- ment team is likely to be fired.

The market for corporate control incorporates besides the information of the equity market the knowledge of sector specialists and strategic investors. Hence, it can elimi- nate possible shortcomings and inefficiencies of the equity market. Nevertheless, the market for corporate control is not free from opportunistic behavior of some managers who gain private advantages when acquiring another company by an unrealistic high price.²¹ Summarizing, the market for corporate control disciplines managers and improves transparency by eliminating inefficiencies.

Market Participants

Institutional investors like pension funds, insurances and - especially in Germany - banks can influence the decision making in companies. As large provider of equity or debt they are interested in the rationality assurance of the management. In cases they intervene and influence the decision making process knowing that they can control the management by their stake of the company.²² However, it cannot be stated a general positive behavior of these participants because often different internal strategies lead to different implications for the respective company. Hence, in respect to group control these will have a minor impact on the rationality assurance.

Having presented the different sources of capital market data, several instruments and institutions of external data can be determined. Stock prices, interest rates reflect the market in a quantitative perspective whereas ratings and analyst reports provide qualita- tive data. Corporate raiders as well as large investors do complement the rationality as- surance by their insights. Group control can select the institutions and instruments that meet its requirements best.

2.3.2 Implications of the imperfect capital market on its data

Using the provided data from sources as equity market, debt market or analyst reports demands caution because in reality the capital market is an imperfect market.²³ Imper- fect data will in consequence lead to an imperfect rationality assurance. The market im- perfections on capital markets mainly result from incomplete and asymmetric informa- tion.

In contrast to perfect markets, prices in imperfect markets are not reflecting all relevant information. Either the information is not available to the market as it is only internally communicated or the information is unequally distributed among market participants. There are insiders who possess private knowledge or fragmented private knowledge which is not available to the public. According to the completeness of information available to the public one can distinguish weak, semi-strong, and information efficient capital markets.²⁴ As a result of incomplete information but also because of the human limited capabilities, investors often react irrationally when new information becomes public. As several studies prove markets temporarily show an overshooting effect.²⁵ The stronger this irrational reaction the weaker is the efficiency of the respective market leading to systematic errors and arbitrage possibilities.²⁶

Information asymmetries in general refer to the observed imbalance between two parties in terms of available information. In this context, it can be regarded from different per- spectives. On the one hand, the external market has not access to all internal available information. The external reporting or investor relations department can decide to what extent internal information is given to the market including its shareholders, creditors and financial analysts. In regard to the equity holder and management relation this is described as principal-agent relationship.²⁷ On the other hand, the information asymme- try can be regarded vice versa. Analysts and market participants possess more detailed information about the overall economic situation and the sector situation. As external parties receive data from competitors and peer companies they are able to analyze the sector by benchmarking the data more accurately. As a result, sometimes analysts know more about an industry than the CEO of one firm within this industry.²⁸

Information asymmetries are inherent in the capital market because of information costs. Both analysts and company employees have to spend money and time to retrieve information they need to overcome their knowledge deficits. While the analysts joins press meetings, analyst conference and conducts personal interviews, the company employee uses market research agencies, consultants or business intelligence to gather information of competitors and the market.

2.4 Group control in respect to rationality assurance

Group control is defined as rationality assurance of the management in respect of managing an investment or subsidiary. This definition includes external as well as internal institutions of rationality assurance. Consequently, the capital market can be defined as an external rationality assurance institution or as a basis for an internal rationality assurance institution. In the following the two opposing concepts are presented in order to choose one concept for this paper from now on.

2.4.1 Rationality assurance by external institutions

Besides internal institutions there are external institutions such as consultants, auditors, suppliers, clients, investors and bankers that can fulfill the task of rationality assurance, too.²⁹ In contrast to internal institutions, rationality assurance is not the main purpose of these external groups. They provide assurance as a “side-effect” of their main function. In this concept, investors and bankers can be grouped together as the capital market which is an external institution of rationality assurance. The capital market directly ad- dresses the rationality deficits of the management without any processing of internal institutions. There is a direct link between the external institution and the management In order to evaluate the capital market as an external rationality assurance institution, basic requirements have to be defined. Based on the definition of rationality assurance as the identification and elimination of rationality deficits management control must meet ability-linked as well as willingness-linked requirements. Besides efficiency, there are four central requirements for its effectiveness: knowledge, motivation, influence and acceptance.³⁰ In the following these criteria are further explained.

Knowledge Requirements

The capital market has to have information processing abilities to disclose rationality deficits of the management. Most important for an assessment of a rationality assurance institution is the amount of knowledge the institution can generate and provide. For ex- ample, an institution like the capital market can combine public and private knowledge including also private insider knowledge. Thus, it works as an aggregation of spread knowledge. Besides that, it is of importance whether the knowledge is publicly accessi- ble or not and to what extent the knowledge is comprehensive.³¹ Finally, the knowledge should be up-to-date providing a timely reflection of all available information. Assuming a perfect capital market these requirements are fulfilled perfectly.

Motivation requirements

Besides the knowledge aspects of the rationality assurance its motivation to work in this function is a basic requirement. Motivation deficits can arise from two origins. Firstly, the assurance can incur costs which decrease the utility of the institution. Secondly, the institution has simply different goals leading to opportunistic behavior. The capital market and namely investors often do not want to influence the respective management using their voting rights, for example. This is described as a free-rider problem which refers to the fact that investors only are interested in stock performance as they lack an incentive to exercise control rights. They rather sell their stocks than influence the man- agement.³² Governance rights only are used by large investors who have material inter- est in controlling the management.

Influence requirements

A rationality assurance institution needs the power to endorse its assurance function onto the management. Generally five different sources of power can be distinguished: formal, economical, political, social or competence-based power.³³ The division of power between management and institution is decisive when one assesses the rationality assurance potential. At least one of the five sources of power is needed to influence the management even against its will. The capital market has only weak formal, social and political power.³⁴ It mainly bases on the economical power in the long run as sourcing of capital through the market is becoming less interesting when stock prices are low. Acquisitions through a share deal are becoming less attractive and managers are often evaluated and measured by the stock price performance, also in regard to their salaries. The competence-based power of the market even can lead to the lay off of the manage- ment as better informed corporate raiders acquire the company to discipline the man- agement.

[...]

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.

¹² See literature on corporate governance, especially Shleifer/Vishny (1997), pp. 737-787.

¹³ See Manne (1965), pp. 110-120.

¹⁴ See Langenbach (2001a), p. 154.

¹⁵ See Schmidt (1984), p. 339.

¹⁶ For a content analysis of analyst reports, see Previts/Bricker/Robinson/Young (1994), pp. 55-70.

¹⁷ See Fisher (1959), pp. 212-237.

¹⁸ See Langenbach (2001a), p. 171.

¹⁹ See Günther (1997), p. 34.

²⁰ See Jensen (1993), pp. 831-880.

²¹ See Jensen (1988), pp. 23-25; Shleifer/Vishny (1988), pp. 7-20.

²² See Maug (1998), p. 67.

²³ See Nelson/Winter (2002), pp. 23-46.

²⁴ See Fama (1970), pp. 383ff.

²⁵ See Daniel/Hirshleifer/Subrahmanyam (1998), pp. 1867-1885.

²⁶ See Camerer (1987), pp. 981ff.

²⁷ For an overview of all aspects of principal-agent relations in management control, see Günther (1997), pp. 41ff.

²⁸ See Marsh (1994), pp. 80-82.

²⁹ See Weber/Schäffer (1999), p. 743.

³⁰ See Langenbach (2001a), p. 109.

³¹ See Dietl (1998), pp. 28f.

³² See Grossman/Hart (1980), pp. 42-64.

³³ See Mintzberg (1983), pp. 24f; Kang/Sorensen (1999), pp. 21f.

³⁴ The formal power is limited through the free-rider-problem, the political power is not applicable and the social power is minimal as there are only few interactions between investors and management.