Notes Opening the Black Box - Managerial Power and Internal Capital Markets

Opening the Black Box: Internal Capital Markets and Managerial Power

• What do we analyze? The internal capital markets of a multinational conglomerate.
• What questions do we want to answer? 

• How do firms allocate resources across business units?
• Do units with better investment opportunities receive larger capital allocations and invest more?
• Do units run by more powerful and better connected managers receive larger capital allocations?

• We use as direct evidence: unique panel data set of planned and actual allocations to business units from the internal accounting system of the conglomerate + a survey of unit CEOs.
• Findings: Following cash windfalls → more powerful managers obtain larger allocations and increase investment substantially more than their less connected peers → More powerful managers overinvest and their units exhibit lower ex post performance and productivity (identify cash windfalls as a source of misallocation of capital)
• What do these findings contribute? Contribute to our understanding of frictions in resource allocation within firms and point to an important channel through which power may lead to inefficiencies.

• Bright-side view of internal capital markets: Value added as a firm distributes funds optimally to units by making larger allocations to units with greater investment opportunities.

• Dark-side view of internal capital markets: Power within a hierarchy may impact internal policies. Business units run by more powerful or better connected managers may get allocations larger than what is justified by the investment opportunities they provide. In these bargaining-power models, unit CEOs prefer larger capital allocations (for rent-seeking or empire-building reasons) and wield influence in an attempt to obtain more funds for their units. Influence activities are costly → resources are spent to affect allocations + resulting investments may be inefficient.

• We look inside the firm by collecting new data for a multinational conglomerate and analyzing both its capital allocation process and the means through which more powerful and better connected business-unit managers use this process to receive larger allocations following cash windfalls.

• The main contribution of our paper is to empirically document that managerial power and connections affect internal capital allocations, and under what circumstances. Moreover, we show that the effects of power on internal capital allocation reflect inefficient resource allocations.

• Our analysis relies on two new databases

• Five years of quarterly data on planned (i.e., budgeted) and actual (i.e., realized) capital allocations for each of the firm’s 20 business units. Quarterly data on planned and actual R&D and marketing expenditures, as well as on assets, sales, EBIT, and personnel.
• An important advantage of our data is that they allow us to analyze individual business units.
• Second database of formal and informal measures of managerial power and connections for the 40 different business-unit CEOs working at the conglomerate over the sample period.

• An initial set of measures is based on management profile data to proxy for manager’s careers at the firm, their social network at the workplace, and the similarity o their personal profiles to that of the CEO.
• Conduct a survey of business-unit CEOs to collect a second set of measures. The survey makes it possible to construct proxies that capture more informal factors such as a unit manager’s networking activities and his or her connections to executive management.

• Our access to internal firm documents helps us open up the “black box” of internal capital markets and provides a detailed picture of the allocation process and the role played by unit managers.

• When we compare approved planned and actual capital allocations, we find that managers across the firm use the standardized budgeting process to build buffers into their budgets.
• Although all unit managers try to use their excessive capital budgets to justify additional spending, units run by more powerful and better connected managers obtain higher actual capital allocations at times of financial slack in the firm. During our sample period, the conglomerate experiences 8 substantial cash windfalls.

• Planned capital expenditures are not related to the cash windfalls, suggesting that they are not anticipated in the budgets. Although the business units did not consider the windfalls in their previously submitted and approved planned capital budgets, some of the additional cash is available for their investments ex post.
• In quarters in which there are cash windfalls, actual investment rates increase across all units and a large share of the variation in this increase is accounted for by the power and connections of the business units’ CEOs. For all indices of power and connections, we find that on average more powerful unit managers increase their actual investments by 74% more than their less powerful peers. An explanation consistent with our findings is that approval of investments is easier to come by when the conglomerate is awash in cash and planned budgets are not yet fully spent. Such approval is more likely for units run by more powerful and better connected managers. 
• Our methodology focuses on how power and connections affect the allocation of abnormal cash windfalls. An additional advantage of our method is that it uses the difference between actual and planned investment as the dependent variable, thereby controlling for the investment opportunities of the units, which should be reflected in the planned capital budgets.
• We provide evidence on the key question of whether the investments following the cash-windfall allocations are good (efficient) or bad (inefficient).

• Differences in managerial power may prevent cash windfalls from being channeled to the units in which the additional resources would be most valuable, ultimately leading to overinvestment by powerful managers.
• Our evidence seems consistent with the view that the larger allocations of cash windfalls to more powerful managers are not efficient and do not lead to improved unit performance. This evidence supports the dark-side view of internal capital markets and suggests that cash windfalls may be an important source of misallocation of capital.

• We have access to data on planned capital expenditures and data at the level of the business unit, both of which help us develop better proxies for investment opportunities inside the firm.
• Our methodology helps us identify cash windfalls as an important source of capital misallocation, thereby providing direct evidence of a specific channel of inefficiency in internal capital markets.

1. The Conglomerate and Its Capital Allocation

The organizational structure of the firm takes the multidivisional M-form and the conglomerate operates with a headquarters, five product divisions, and 20 business units (Figure 1). The headquarters takes charge of internal capital allocation. The board of directors, chaired by the CEO, has ultimate responsibility for the firm. The five product divisions have no separate operating activities and assets themselves; they are just there to coordinate the activities of their respective business units. Business units hold all the assets of the divisions and business-unit CEOs are responsible for investment, production, and sales.