Corporate head office – creator or destroyer of value in a conglomerate

The corporate centre of a conglomerate can be value accretive or value destructive to the conglomerate

The best parent companies are those which create more value than any other rival if they owned the same business. Such businesses are deemed to have parenting advantage. In the same way that business strategy gives rise to competitive advantage, it is the corporate level strategy of a conglomerate which gives life to the parenting advantage of a constituent subsidiary. A business will enjoy a parenting advantage only if a parenting opportunity exists. When a corporate parent identifies such opportunities and addresses them with actions which give a positive net present value it will improve the value of the business and, subject to the idiosyncrasies of the market, improve the market value of the parent’s share too

Conglomerates which were the darlings of the sixties and seventies lost their shine in the eighties. The fact that investors wishing to diversify their portfolio could do so by directly buying into the subject companies, particularly if listed, without having a conglomerate do the diversification took deeper root and the infatuation with, and the demand for, shares of conglomerated petered. Against this background, it is imperative that a conglomerate, as the owner of multiple businesses, justifies to its stakeholders the economic reasons for its existence. 

As a corporate parent, it must demonstrate that the influences which it brings to bear on the separate entities make them perform better as a part of a corporate portfolio than if they were operating as independent stand-alone units. This is possible only if the parent possesses skills, abilities, resources – physical, financial, and human and other tangible or intangible features which the component subsidiaries do not have, do not have in sufficient quantities, cannot afford as a single unit or not be able to effectively employ on their own. The conglomerate corporate level strategy cannot be a mere agglomeration of the strategies of the component subsidiaries. If such is the case, there is a near certainty of value erosion than value accretion. 

Markets usually assign a conglomerate discount to diversified or multi-unit business, this being the variance between the ‘sum of the parts’ market value of its business units and assets and market value of the conglomerate. As a rule of thumb, the aggregated market value of the companies in a conglomerate is estimated to be higher than the stock value of the conglomerate by approximately 13 to 15%. 

The factors which contribute to such a discount include, * Negative Market Perceptions of conglomerates because of past failures, * Opaqueness of Purpose and Diluted Focus because of too many irons in the fire which give rise to unclear strategic paths, poor performance and blurred prospects, * Complex Governance Structures, * Capital Allocations based on individual ‘gut’ of influential movers and shakers rather than on data, * Confusing Capital Structures, *Unclear Accounting, and * Over-Engineered Risk Diversification which, at times, dilute the upside of high-performing individual businesses.

Value creating parenting

Notwithstanding the aforesaid, there is ample evidence to confirm that a conglomerate discount can be transformed into a premium through value creating parenting. For example, General Electric (GE) under Jack Welch confounded the conventional wisdom re conglomerates by recording exceptional growth in shareholder value in the eighties and nineties. Since then, the GE shares have had a rocky ride. 

In the same way that business strategy guides business level decisions through a mixture of the knowledge of industry competitiveness and customer needs, the use of information technology in enhancing customer service and the ongoing development of human resources et cetera, the corporate level strategy of a conglomerate is guide-railed by two basic questions, these being, * In what businesses should the company invest its resources? – the portfolio decisions, and * How can the parent company add value to, and influence, the businesses under its control?- being how the ‘centre’ influences and relates to the businesses. 

I have been fortunate to work at top management levels at Anglo American Corporation (Central Africa) Ltd., Zambia, the Lusaka based branch of Anglo- American PLC, UK, (Anglo) and John Keells Holdings Plc, Sri Lanka (JKH), both large conglomerates and powerhouses in their geographies and fields of involvement. The comments/observations which follow are based on my experience with them. Anglo’s corporate level strategy was greatly influenced by the thoughts of Andrew Campbell, Michael Goold and Marcus Alexander, the authors of, “The Quest for Parenting Advantage’. My intense experience at JKH was influenced by the thoughts, practices and methodologies of the Boston Consulting Group and the governance model of GE.

Conglomerates usually operate in multiple industries bringing together a diverse range of businesses under one corporate umbrella with the aim of enhancing productivity and enabling differentiated forms of competitive advantage in them. Creating synergies among disparate businesses, crafting an ‘efficient portfolio’ via diversification, extracting benefits of economies of scale, providing internal capital, and enabling the exchange of expertise, cross-selling, and continuous learning are oft touted as the advantages of a conglomerate. 

Advantages to some business units in the conglomerate may be disadvantageous to others

It should be noted that advantages to some business units in the conglomerate may prove to be disadvantageous to others. For example, the overarching group policies, procedures, and processes which improve the governance of some business units may impair the agility of others where speed is a critical success factor. The typical conglomerate will have businesses which operate independently and a corporate head-office, or corporate centre as it is sometimes referred to, consisting of a hierarchy of line and functional experts and support staff, operating as a separate entity outside the businesses. 

It is this ‘corporate centre’ which symbolises the corporate parent. It formulates corporate strategy, makes corporate decisions ranging from composition of portfolio, acquisitions to divestments, designs group governance and operating models, decides on capital structure, defines budgeting and capital expenditure processes, and establishes group-wide corporate values and codes of conduct, amongst many others. 

As stated before, the corporate centre of a conglomerate can be value accretive or value destructive to the conglomerate. JKH followed a very clear principle, this being that the operating costs of the businesses will not be burdened nor their net worths impaired by non-value adding centre costs. On the contrary, the operating principle was that it is the needs of businesses which will drive corporate centre configuration and related costs. It was a case of the tail wagging the dog! The Chief Executive Officers (CEOs) of the businesses were in full charge of the operational aspects with high-level functional support from the centre. The business leaders and their teams were monitored, recognised, and rewarded per a world-class integrated performance management system.

The JKH corporate centre was obsessive in ensuring that the value-add of the parent to the business far exceeded the cost of its existence. Every element of cost in the corporate office had a clear business purpose. I am reminded of a statement made by the visiting head of a large fund which invested in JKH. He said that the fund was motivated to invest in JKH by the pragmatism and austerity he perceived in the design and operations of the JKH head-office and the utilitarian business approach of the JKH top-team. He noted – no grandiose corporate offices, no flashy cars, no ‘for the show’ hobnobbing with the powerful and the elites and no abnormal hours spent in prestigious clubs, social events et cetera. Pre-investment sleuthing!

Best parent companies

The best parent companies are those which create more value than any other rival if they owned the same business. Such businesses are deemed to have parenting advantage. In the same way that business strategy gives rise to competitive advantage, it is the corporate level strategy of a conglomerate which gives life to the parenting advantage of a constituent subsidiary. A business will enjoy a parenting advantage only if a parenting opportunity exists. When a corporate parent identifies such opportunities and addresses them with actions which give a positive net present value it will improve the value of the business and, subject to the idiosyncrasies of the market, improve the market value of the parent’s share too.

A few examples of parenting opportunities are:

(1) Where the subject business needs special expertise which is too costly for it as an individual business but is affordable to a corporate centre which has the means to host the capital expenditure and charge out to the individual businesses on a usage-based ‘pay as you drink’ and/or on a retainer basis or a combination of them. A medium to large sized parent usually has corporate centre resident, cutting edge excellence in New Business Development, Finance and Accounting, Taxation, Informational Technology, Human Resource Management, Sustainability Development, Risk Management, internal Control, Legal and Secretarial and Corporate Communications. Without doubt the fixed cost and the performance based variable costs of these resources are well above market average. But the effective outcome, in terms of value, timeliness and efficacy, per unit of cost are also well above the market norms. Astute corporate parents achieve this with ease. It is a key aspect of their raison d’etre and is embedded in their DNA.

(2) Instances of large businesses who once were at top of their game but have, over time, lost their edge by being reluctant to change. Often, they are steeped in traditional thinking. Traditions which they find hard to discard. The overheads associated with such bureaucracies are unsuited for the present dynamic world and are difficult to eliminate from the inside because of long-serving executives who bask in their past glory, are in a comfort zone, and are oblivious to other alternatives. These are businesses which require a fresh set of eyes. A corporate parent can provide them quickly and effectively.

(3) In businesses where executives, young and smart but immature and relatively unexposed, are reluctant to pursue the ‘Big Hairy Audacious Goals’ (BHAG) because they lack the mega-level experience and/or the businesses do not have the requisite capital to buffer potential risks which usually emerge when pursuing above average rewards. BHAG, pronounced ‘bee-hag’ is a term, coined by Jim Collins and Jerry Porras in their bestselling book “Built to Last”. It metaphorises that successful businesses are those who dare to win by setting audacious goals, goals which are a paradigm shift from the cautious incremental growth targets which CEOs set in annual budgets with a view to making themselves look good at year-end evaluations. A dynamic corporate parent can change this mind-set with its residential expertise and access to less expensive capital because of its size and stature. It is worth noting that not all corporate parents are sensible. Cowboyish corporate parents also exist!

(4) In businesses which have unique technical competencies but do not have the traits and skills of discipline, routine and order which can bestow positive incremental effects on their returns on capital employed and returns on equity. Proven, well-oiled policies, procedures and processes take time to develop. They can be costly if bought off the shelf in the form of a platform or application. Battle hardened corporate parents possess time-tested systems and processes which are immediately available to a business on a ‘plug and play’ mode. 

(5) Businesses which lack the skills of dealing and negotiating at a strategic level with key external parties such as politicians, public servants and other relevant officials in government ministries, important regulatory and monitoring bodies, multilateral and bilateral funding institutions, business associations, big local and multinational suppliers of products and services, trade unions and activists et cetera. When dealing with such individuals, an element of brinksmanship is essential. A corporate parent’s ‘mental maps’ provide this aplenty to the businesses in its group. Campbell, Goold and Alexander define ‘mental maps’ as, (quote), “the values, aspirations, rules of thumb, biases, and success formulas that guide parent managers as they deal with the businesses. Mental maps shape the parent’s perception of opportunities to improve business performance. They embody its understanding of different types of businesses. They underlie the knee-jerk reactions and intuitive assumptions of the parent. Usually, they reflect deeply held attitudes and beliefs and are based on managers’ personal experiences.” (unquote).

(6) Businesses which can benefit through linkages, cross-selling, knowledge dissemination, sharing of common capabilities and the use of centralised services. Corporate parents centralise services to optimise costs and improve efficiency. Nevertheless, there are instances where the mandated use of such services, even when they are ineffective, can be frustrating to business units who are able to secure superior services from external parties on competitive terms. When shared finance and accounting services were introduced by JKH as a part of SAP implementation, the parent mandated that business units must use the services of InfoMate, the finance and accounting shared services company of JKH, for a period of five years. This was a dictatorial decree with a strategic end goal. At the end of five years the businesses were given the freedom to look for third parties. Despite the initial ‘moans’ and ‘groans’ of demanding internal customers, not a single business unit ditched InfoMate. Also, there are opportunities for businesses to derive economies of scale benefits in procurement by the parent consolidating the common products and service requirements of all the group companies in bargaining best prices and terms with major local and global suppliers. Anglo had globally negotiated purchase agreements with key suppliers of mining vehicles and equipment, fuel, computers, banking services et cetera. So has JKH. 

(7) Businesses which can benefit immensely from the structured, disciplined and vision/mission driven human resources management practices which a multi-business conglomerate can operationalise more cost effectively at the centre. Studies indicate that these centre level practices transcend the ‘transactional’ practices which most businesses adopt without heed to strategic needs such as leadership/competency development, career progression, recognition and reward, integrated performance management including goal setting, performance evaluation and feedback, talent management, succession planning, job evaluation, internal remuneration equity, internal job posting and continuous learning. 

Key skill in a corporate centre

Portfolio analysis and crafting of an efficient portfolio, defined in corporate finance jargon as the one which gives the highest return at a manageable, and acceptable, level of risk, is a key skill which must be resident in a corporate centre. In deciding on the ‘efficient’ portfolio, Financial Filters and Importance Filters must be applied at the business level and Balance Filters and Strategic Filters must be applied at the portfolio level. These filters coupled with Gross Margins, Returns on Capital Employed (ROCE), Economic Value Added (EVA) et cetera, and most importantly the extent of ‘fit’ between the business and centre, are the factors which must be deliberated in crafting an efficient portfolio. Typical considerations are – Where to invest? What to harvest? What to divest? What to retain and turnaround? 

Structures, systems, and processes are the mechanisms through which the parent creates value. These are its intangible assets. Notwithstanding their existence, it is the emotional buy-in of employees to the modes of interaction within the structure which is critical. The ‘magna carta’ of the working relationship between the centre and business is animated by an operating model which delineates, inter-alia, the decisions which fall under the purview of the parent and those which fall under the purview of the business managers and their teams. Statements of due process, decision rights, accountabilities, authority limits et cetera are established and clearly communicated. They eventually become the culture of the group. Experience confirms that, over time, the operating arrangements become second nature to all participants with the centre knowing instinctually where its contribution is required and where its excessive interference is damaging. 

The bottom line is that the corporate centre cannot add value to the conglomerate through ostensible effectiveness. Its effectiveness must be real. It is the corporate centre which creates or destroys in a conglomerate.

(The writer is currently, a Leadership Coach, Mentor and Consultant and boasts over 50+ years of experience in very senior positions in the corporate world – local and overseas. www.ronniepeiris.com.