| Krishna G Palepu first raised the temperature and the tempo of management debate in the summer of 1997, when he co-authored an article, "Why focused strategies may be wrong for emerging markets". It was the first voice of dissent against the powerful theory of core competence -- and the first vote of support for diversified business groups in liberalising countries like India. |
| A teacher at the Harvard Business School since 1983, Palepu is the Ross Graham Walker Professor of Business Administration, and teaches finance, control, and strategy. His research has followed two paths. In the US, he has focused on corporate governance and the way capital markets interface with companies. In emerging markets, he has tracked the absence of institutions and its impact on companies operating in such an environment. "In the last few years, both seem to have come together. In fact, I believe that the strength of institutions has to be matched to the complexities of the economies in which a company operates," says Palepu. |
| Palepu is exploring these ideas in two books that are scheduled to be published in early 2003. One of the tomes, which he is co-authoring with HBS' Tarun Khanna, focuses on market-sensitive strategies for corporate leaders. The other book, which he is co-authoring with Paul M Healy, focuses on the crisis of confidence developing in the US in the aftermath of the collapse of companies such as Enron and Global Crossing because of accounting irregularities. "The bashing is at surface level, and everyone is looking for culprits. But the book digs deeper. It asks fundamental questions about why people behaved the way they did, and why institutions failed." Palepu is, therefore, tracking the root causes that conspired to create those disasters. For instance, he believes that the fundamental reason why money managers made wrong investment decisions was because they are evaluated on the relative performance of their funds--not absolute performance. In a conversation with Manjari Raman, Palepu talked about issues ranging from corporate governance and CEO compensation to the limitations of venture capitalism and core competence. |
| The Enron debacle has set off a domino effect in terms of shattering our confidence in corporate governance. What led to the failure of the checks and balances which were supposed to have been built into the system? |
| In the information market, companies supply information, investors demand it. You have to think about where the supply-demand equilibrium did not work. What we are doing is to look at people in the middle, intermediaries like Wall Street analysts, and bashing them. My feeling is you have to go back and look at the two ends of the chain. The real failure has occurred with audit committees, on one hand, and money managers and institutional investors, on the other. |
| If money managers demand good information, the market tends to supply it. For example, if analysts write puff pieces, money managers could tell analysts that we will buy your research only if it is objective. |
| They bought the information, but they didn't impose any discipline. |
| Why? Similarly, audit committees could have disciplined auditors if they found that auditors were not doing their job. That is the audit committee's job--but it was not doing it. What is going wrong with both? And how do we fix it? If we fix it, all the incentives in the system will get lined up properly. In fact, you might not need huge regulatory reform at all. |
| Given the magnitude of the accounting scandals that are surfacing, it's hard to believe that no one in the stockmarket saw the crisis coming... |
| Take institutional investors first. In the last 40 years, some developments took place in the money management industry in the US. You had modern portfolio theory suggesting that diversification was a really good thing for investors. Therefore, they started putting money in mutual funds rather than buying individual stocks so that risks were lower. |
| Mutual funds take commissions to manage the money of investors. What value are they adding in the process? |
| Over time, mutual funds have become one of two kinds. Some are index funds, which means they buy the entire stockmarket - and hold. They are passive investors. If you are buying the whole stockmarket, you have no interest in knowing about individual companies. So you spend no time doing individual company research. That makes up 15-20 per cent of the total market. |
| Then you have mutual funds like Fidelity and Putnam. They are supposed to be active managers, picking stocks and investing in them. But, by and large, they have all turned into quasi-index investors. Because of the size of these funds, they cannot invest in a few stocks. So they pretty much invest in the whole market anyway. |
| Each of them is evaluated relative to how a similar fund managed elsewhere is performing. For example, if I manage a high-tech growth fund, I am compared with all the high-tech growth funds in the marketplace. And my compensation is driven by whether I am beating all those funds or not. It seems like a sensible thing, but what it does is to reduce your incentive to create original insights about individual companies and act upon them. |
| If you act upon them, and other guys don't , you might be penalised. For example, if you think that Enron is an overvalued stock and do not want to invest in it, but everyone else is investing in it, you would be penalised. Even if you know that Enron is a bad stock, you invest in it anyway because you are not interested in long-term value, but only want the stock to go up in the next quarter. |
| But hasn't that way of functioning been a market reality for some time now? What made the bubble burst suddenly? |
| It wasn't a market reality; it comes out of a particular feature in these funds. Fund managers are evaluated on a relative basis. If you remove that, you will actually get away from it. For example, Warren Buffet doesn't think this way because he is not evaluated that way. He is evaluated on the absolute returns he can generate -not relative returns - and so he is not looking at other people. |
| Buffet is looking at his own insights. It's the institutional design of funds that has ended up creating this disincentive against looking at individual companies to make your calls. That's why you are not interested in reading a company's annual report and making judgments. |
| Instead, what you are looking at is whether the stock is popular or not. That means that you don't care what's in an annual report. People who prepare those annual reports and people who write analyst reports now know that you don't care. It's like GM knowing that its customers don't actually care about quality. So, there is no incentive for GM to produce high quality cars. |
| To understand why analysts are behaving badly or why auditors are not doing their jobs, you have to understand that the customer of those services is not demanding quality. If you don't fix that, however much you punish these guys, there is no reason for them to do anything other than what they have been doing. The way it is structured, the market is leading money managers to make bad decisions - and provide resources to companies that don't deserve them. Like Enron. |
| At the other end of the spectrum, what was the failure of audit committees? |
| Audit committees got caught up in a similar kind of dynamic. They also thought that if the final clients, the money managers, don't care about the information put out, why should they push managers to clean up the stuff? That's one dynamic. |
| Moreover, the way audit committees are structured, they really have an impossible task. They usually meet an hour or an hour-and-a-half before the board meeting. And they meet four or five times a year. You have about six hours of time to spend. The charter of the audit committee is that, one, you appoint the auditors, and two, you supervise the auditors' work and make sure that the financial statements comply with all the rules and regulations. |
| In six hours a year, what can you do? But that's not quite how it is meant to work. Usually, the materials are sent out earlier, and, as an audit committee member you are supposed to do your homework and raise objections to the audit committee. If you raise enough questions, those six hours can extend to six days. |
| So the weakness in the system is their failure to do their homework? |
| Yes. Moreover, many audit committees are not equipped to do anything in terms of homework because if you are sent the financial statements, you look at them and what do you do? There is a little note there that probably says "our auditors have approved this". |
| If the auditors have already approved it, how can you, spending just a few hours, second-guess them and say this is not actually meeting all the rules? You hired these guys and you trust them, and if they say things are according to GAAP, it must be according to GAAP. Audit committees have essentially become rubber stamps. |
| Does this mean the fault lies more with the acts of commission of the auditors rather than the acts of omission of the audit committee? |
| Actually, I think the fault lies with the way the charter of the audit committee is defined. It's almost a duplication of the work of auditors. And it's not even value-added work in a sense, because, if auditors have already done their work, audit committees have nothing to add. If auditors haven't done their work, audit committees have no way of knowing it. Either way, they really can't do much. |
| What do you recommend for fixing the problem? |
| I think we need to re-label audit committees. I think we should call them transparency committees. Essentially, what they should be doing is not asking technical questions - is it following rule X or Y? - because that's not their expertise. But they should ask 'what' questions. |
| Given my understanding of the company - which a board member should have - are the financial statements reflecting the company's reality in a broad sense? Or are they misleading? Are the discussions we are having in the boardroom leading me to think one way about the company compared to what I read in the annual report? Is the annual report or the quarterly report communicating the basics of the business? |
| The basic performance metrics, the basic key success factors, the key risk factors - are they getting reflected in the financial statements so that an intelligent reader can get a good sense of what it happening inside a company? These are the broad set of questions that audit committees should be asking, which they don't do today. They essentially do a technical review and ask if the rules have been followed. But even if the company has followed the rules, it might not be communicating what is really happening. |
| Ironically, all this happened after a decade of corporate governance reforms. It's almost as if, like the analysts, the board also wants to hear only good news. Is the fact that compensation of the board is often linked to stock prices one of the issues? |
| Yes, that creates a big problem. It is not the price of the stock that is the problem; it is the short-term price of the stock. If you are on a board - I would say this is true even for a CEO - and if you are compensated in stock, you should be required to hold it for five or 10 years. That way, what you are interested in is the long-term value of the company and not the short-term value. |
| When there is a gap between the short-term value and the long-term value of the company, and you provide incentives to the board and to the CEO to maximise the short-term stock price, they will pump it up. They can actually collude in the business of not releasing hard-hitting, negative news. |
| CEOs don't have a long horizon, and boards can't seem to understand that an overvalued stock is just as bad as an undervalued stock. Just like Enron, an overvalued stock generates bad behaviour inside the company to keep it at that level. Top management comes to the board, and says: "Hey listen, we can't release this information because it's going to tank the stock." |
| The board should understand that tanking the stock is okay if the stock is overvalued. Ultimately, investors who are seeking long term value will not be hurt; it's only people with short-term interests who will get hurt. That's okay because your responsibility is the organisation's survival. The role of the director is not maximising stock price, but maximising the long-term survival of the company. |
| You have to understand what is driving your stock's price and what the embedded expectations are. And if the embedded expectations are unrealistic, you should tell the CEO to find ways to get the news out so that the stock is talked down from its unrealistic levels. |
| That's if the CEO isn't sacked first. There is so much pressure on CEOs to keep the good news coming just to retain their jobs. What do you do when the whole system is suffering from "affluenza"? |
| There is an interesting feature there, which is also an important problem. Companies have, over time, gravitated more towards a hero CEO like Jack Welch. As a result, they are quick to blame the CEO and fire her if something happens. The board cannot be in the business of appointing God, and then sleeping. It has to do the job of acting in a collegial manner and treat the CEO as a human being. |
| Can you put the current crisis on corporate governance in perspective? Is over-reaction causing a domino effect? Or are there fundamental problems? |
| There is a danger of over-reaction. When there's a bust, there's a popular anger that needs to be vented. That's part of the process; people have to find scapegoats. But there are some real weaknesses in the system that we are seeing. We will have a much better system coming out of the introspection that is going on now. A decentralised marketplace like the United States can only work if information flows are good and people have incentives to use whatever information is provided. |
| And if there is trust in the system... |
| Exactly. What we are discovering is that (a) information is not very good, (b) whoever is in charge of using the information has not done a good job of using that information, and (c) there is cynicism in each of these institutions that have been created to perform the function. |
| I feel we will go through this institution by institution and think this through carefully. And we have not completed this process. We'll go back to money managers and venture capitalists who were extolled in the last five years as real heroes. There will be some examination of their institutions too. |
| The key to whether this will lead to constructive reform or something populist depends (upon many things). If you think that people are behaving in a particular manner because of the way the institutions are designed, and if that is the general consensus that emerges, then a rational process for redesigning these institutions may emerge. On the other hand, if the feeling is that people are misbehaving because they don't have character and they are unethical, then you will have a completely different reaction. |
| I belong to the camp of the institutionalist. A whole society cannot be corrupt, and when you see big scandals like this, you shouldn't be blaming individuals as much - certainly, the individuals can do better - but the dominant issue really is, do we have the right institutions and do we have the right institutional design? Can we change incentives? Can we change the governance of these institutions? |
| A lot of effort is spent on corporate governance, but you also have to worry about the governance of the intermediary. Are venture capitalists governed properly? Are money managers governed properly? Are audit firms governed properly? Are investment banks governed properly? What can we change in those institutions? |
| The more we go down that road, the more the long-term benefit we will derive from a scandal like this. If the reaction is that there are a few scoundrels and we need to get them, chances are, we won't change much. |
| What can a company do to protect itself in such a vitiated environment? |
| First thing, like GE has done, work very hard to increase your transparency. If you have nothing to hide, you should actually try to be increasingly transparent. Second, if I am a good company, I should realise that the current system is not allowing me to separate myself from scoundrels. |
| If the system is not transparent and governance is not very good, there will be a pooling of good guys and bad guys in the eyes of the investors - and you could be penalised. It's in the interest of the good guys to improve the system so that they can separate themselves. |
| Its like draining the river so that you can see the rocks. But this enlightenment has to take place in good companies, which, unfortunately, it hasn't yet. That's the reason why you have great corporate names like AT&T, Xerox, and Lucent all tarnished. |
| What can a director on the board of such a good company do to protect its interests? |
| I would rethink compensation systems very carefully so that CEOs and top management are more slated to think of long-term value than short-term gains coming out of stock price increases. I would think in terms of a sound system in terms of information to the board about what is going on inside a company. Many times, that information flow itself is broken. Boards themselves are not aware of issues and challenges till it is too late. |
| If you get this thick binder three days before the board meeting, you are not really going to be able to figure out what's happening. What you need is an intelligent three-page briefing on what's happening that is strategic. Very few companies have a good board information system. |
| The third thing to do is to really strengthen the audit committee. Make sure the audit committee takes more time and has the strategic perspective on how to make itself more transparent. The fourth is that the board should have an evaluation system for itself. |
| Very few boards actually have a good system of figuring out if each board member is performing the function for which he or she was inducted onto the board. And very few companies make any effort to see whether the board is adding any value or not. |
| You mentioned to me earlier that your second book is on market-sensitive strategies. Is that related to the crisis in corporate governance? |
| The second book deals with what the strategic implications are if the markets are not working well. It builds on the work on business groups that I have done earlier. If you are a CEO, one of the first things you need to do is understand the market you are in and how well it is working. |
| What some of the bottlenecks in that marketplace are, whether various institutions are or are not working, and then, track the strategy inside your company in terms of product market strategy, financial market strategy, and labour market strategy. That helps you exploit opportunities that come out of that insight and also creates a robust enough strategy so that it actually works even though the markets are not working well. |
| But isn't that what the CEO is supposed to do anyway? |
| That is what a CEO is supposed to do. But two things have happened in strategy in the last 20 years. First, many of the ideas came from the thinking about the US economy, and two, an assumption has been made that markets really work well in the US. |
| Therefore, many of the strategy recommendations that CEOs get are based on the assumption that markets really work well, you've got to outsource a lot of stuff, you need to focus, and you need to think about value chains and strategic positioning in a particular way. |
| In some industries and some countries, that works well. But what we have discovered is that markets don't work well in many parts of the world. And if that is the case, a lot of the strategy prescriptions in the last 20 years have to be rethought. |
| Can you give an example of a prescription which needs to be reconsidered? |
| Take the simple prescription that you should compensate CEOs with stock because that is how you motivate them to create value. That's based on the assumption that the stock-price at any point of time is the right representation of value. But if market institutions are not working, the stock price is actually not a good index of value. |
| Rewarding CEOs on the basis of stock might be perverse, and may make them do things that are not right. There are many, many things to be rethought and the second book is about that. It makes much more powerful connections between the health of the markets and the strategic choices that people make. |
| What would be the prescriptions that Indian companies might have got in the last 10 years which would require rethinking? |
| One, which I am quite famous for... |
| Your anti-core competence beliefs? |
| Yes! Whether companies should be focused on one line of business or whether they should be in multiple lines of business. Another relates to venture capital. |
| In the last four years, there has been a lot of hand wringing in countries like India about established companies launching new ventures versus venture capitalists coming in and helping form new ventures. |
| What we have discovered through the dotcom experience, even in the United States, is that venture capital is not perfect. For venture capital to work in a constructive way, it requires a number of other institutions to work in the economy. When you don't have those institutions, venture capital actually has a tough time. |
| Therefore, the notion that individual entrepreneurs can walk in and exploit many opportunities in economies like India without the help of some association with existing businesses, I think, is a flawed notion. |
| If I was advising individual entrepreneurs in India, I would advise them to think in terms of collaborative relationships with existing companies""either multinationals or big business groups""because they act as sources of capital, expertise, business and credibility. |
| Rather than relying on venture capitalists as your saviour, you should be thinking about a cooperative or alliance kind of relationships with existing businesses, and carve out your own niche. People who are likely to be successful entrepreneurs in India are people who can see that rather than those who try to duplicate the US model of coming in from a big company, renouncing everything, going to a venture capitalist, and trying to start your own venture. |
| (This article appeared in the June 2002 issue of Indian Management magazine) |
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