Image source: thestreet.com
By Julian Gary
Jack Welch is widely considered one of the most successful CEOs of all time. Leader of General Electric from 1981 to 2001, Welch’s aggressive acquisition-based strategy drove GE to become one the most valuable companies in the period. However, the company’s remarkable success in the eyes of Wall Street ended at the turn of the century. Partially due to the stock’s lackluster performance in the last 20 years, GE announced on November 4th that it would break up into three separate companies: GE Aviation, GE Healthcare, and GE Energy. As one of the many former sprawling conglomerates that recently announced divestitures, GE’s breakup is a testament to the failures of the conglomerate model in the modern economy. Other examples include Johnson & Johnson, which split into a consumer healthcare segment and a drug development segment, and Organon, which spun off from Merck in 2021. While an overarching reason for the trend toward pure-play company models remains elusive, certain factors have contributed towards divestitures like GE’s.
The recent divestitures are a signal of changing investor appetites as much as they are representative of the structural inefficiencies of the business model. Proponents of conglomeration have argued that a conglomerate such as GE can allocate capital to business ventures better than outside investors can, making it more productive for investors to invest in the conglomerate rather than choose stocks individually. The underperformance of GE’s stock price and the company’s failure to generate growth in the last 20 years seem to counter this claim. GE’s current market cap is about 1/5th of its peak in 2000, and, in general, conglomerates’ stock tends to trade at a 10-12% discount to the rest of the market. Investors want the option to choose their risk profile rather than invest in a company that is a combination of a mature business and high growth segment. This trend has been accelerated by the democratization of finance through online brokerage platforms. Brokerage platforms such as Robinhood have made it incredibly easy for casual investors to develop a portfolio tailored to their risk preferences, decreasing the demand for the stock of diversified companies.
Along with shifting investor appetites, economic factors have also contributed to the movement toward more pure-play company models in the last 40 years. The conglomerate boom occurred between the end of WWII and the 1970s. At the peak of the boom, 84% of large mergers were conglomerates. While academics haven’t reached a consensus on a primary factor prompting the boom, several developments could have played a role. One of these factors was the increased regulation of mergers and acquisitions (M&A) activity, which hampered horizontal and vertical mergers due to antitrust concerns. In search of M&A-induced growth, companies turned to conglomerate mergers. However, by the 1980s, the strict regulation began to taper off which may have contributed to divestitures in the following decade.
While government regulation may have played a role in the decline of conglomerates in general, regulation is unlikely to have affected GE’s fall given that GE’s peak was in the 1980s and 1990s. In an article for Bloomberg, Joe Nocera postulated that GE’s success in the 1980s was a function of luck more than the company’s management. Nocera pointed out that this period was during a two-decade-long bull run without major financial distress. The success of GE’s portfolio companies during that time were the result of general economic growth rather than superior management. The first cracks in GE’s model appeared in the 2000 dot-com bubble, when GE’s market cap declined by 24 percent. Eight years later, GE’s dominance came to a grinding halt during the 2008 financial crisis after GE famously received an emergency bail-out from Warren Buffet. The failure of GE Capital during 2008 speaks to GE’s overstretched management, which failed to properly identify risk within the division. The lack of management focus on portfolio companies is a major downside to the conglomerate model.
While GE’s worst days occurred in the economic downturns of the 2000s, according to an analysis by Marakon, diversified companies’ stock generally performed better than the stock of pure-play companies during the 2008 financial crisis. As the 2008 financial crisis recedes more and more from investors’ memories, the added cyclical benefit of diversification may be forgotten, further contributing to the break-up of conglomerates.
Another factor that could influence the decline of conglomerates is the growing private equity industry. Despite the industry’s near nonexistence in 1980, private equity buyout deal volume hit $513B in the first half of 2021. In an interview with Financial Times, Jeffrey Immelt, Jack Welch’s successor, stated, “Private-equity funds are the conglomerates of this era.” The private equity industry has created a liquid market for corporate spin-offs, allowing conglomerates to unlock shareholder value through divestitures and reduce the diversification discount. Furthermore, the private equity model allows for more autonomy of division management. Rather than replacing target company executives like in a conglomerate merger, private equity buyouts generally retain existing managers while simply providing additional advisory services to the company. Thus, private equity buyouts have a less risky ownership transition period.
Private equity has also fueled the explosive growth in acquisition multiples in recent years, which poses a problem to strategic buyers such as conglomerates. According to Jack Welch, the biggest benefit of GE’s model was its ability to spend $500M on a promising investment without risking the whole company. Given the growing number of private equity buyouts, strategic buyers compete with mega fund private equity firms for promising investments. In the past, strategic buyers were able to afford higher multiples because of their abilities to realize synergies with the target company. However, that has been changing. From 2004 to 2020, average private equity purchase multiples have increased from 8x to 13.2x EV/EBITDA. These expanding multiples have improved PE firms’ returns. However, given that strategic buyers generally don’t intend to sell the company, strategic buyers aren’t able to profit through multiple expansion in the way that PE firms are. Because of the elevated multiples, strategic buyers must pay higher prices for attractive target companies, counteracting the cost-saving benefits they would have received from synergies. This phenomenon can be illustrated through the decreasing proportion of sales to strategic buyers in private equity exits. In 1996, private equity portfolio companies were almost exclusively sold to strategic buyers, whereas in 2018, strategic buyers made up about 60% of sales.
While the exact cause of the decline of conglomerates remains a topic of academic debate, the trend is unlikely to reverse soon. As for General Electric, the move toward a break up was a long-time in the making. In the future, investors will be watching the three segments to see if a more focused business model can serve as a catalyst for internal growth and stock price appreciation. □