Recent events surrounding Harry Markopolos’ accusations regarding possible accounting fraud at General Electric Co. (NYSE:GE) highlight another issue captured in several of the comments in my recent article.
These concerns also underscore, I believe, certain differences between the conglomerate form of business organization of the past and the “new” modern corporation now ushering in the future.
Both forms of economic structure place great importance on financial engineering, but the need for financial engineering in the two different forms of organization arises for different reasons.
These reasons are very important and should be considered in every company reviewed in order to understand the benefits… and the costs… that are present.
Regarding the “legacy” image of General Electric, I presented it in a previous article.
The conglomerate form of the corporate structure represented an attempt to build a portfolio of companies, most having little or no synergies with others in the portfolio. Yet additional value is sought by bringing all businesses together under one umbrella.
Earlier I wrote that:
in a conglomerate where there are few or no synergies to create… added value, one wonders where the added value comes from.
What we seem to learn from General Electric is that there are little or no physical synergies in conglomerates and that the excess value comes from the financial engineering that can be achieved in the combination – through the creation of a “financial black box”.
the last part of the 20and century was the era of financialization… It was a time when the focus shifted from valuing the cash flows obtained for production and production to the value of financial assets and instruments.
It was a time when a conglomerate like GE could diversify as, for many years, the management of its financial subsidiaries generated well over 50% of GE’s total profits.
It was a time when a company could become very opaque about its internal financial dealings, while continuing to produce nearly constant increases in profits and a consistent return on equity.
As GE began to separate under Jeff Immelt and John Flannery, the revelations revealed:
how General Electric used its “conglomerate format” to move money within and between companies to get a good overall picture of the company’s situation.
In fact, one could say, earlier, that General Electric became a “poster child of what financial engineering could achieve”.
But it created an environment in which senior management focused primarily on financial results rather than “industrial” results, which had serious implications for the US economy and economic growth.
Financial engineering, as I have written, is very important for the “new” modern society, but for a different reason. The problem with the “new” modern society is that these organizations are built around intellectual capital and not physical capital, and intellectual capital has the enormous attribute of being able to scale at zero or near zero marginal cost.
Simply put, scale can be achieved by generating massive cash flow without major cost increases.
Cash accumulates and must be used in the most productive way possible.
In the conglomerate, like General Electric, cash has been generated in certain areas and distributed around the “portfolio” of companies to produce the desired management financial results.
The legacy conglomerate could generate exceptional results, but it was done in an opaque atmosphere. The aggregated result could be “praised” even if the composition of the aggregate was unknown.
General Electric, under Jack Welch…and Jeff Immelt…produced some very impressive results, but they weren’t always well understood by the investing community.
When things started to go downhill for the company, many questions were raised as to why such a stellar company could experience such uncomfortable results.
Explaining has become very difficult.
Explaining was very difficult not only for Mr. Immelt as he tried to maneuver through the post-Welch period and reorganize the components of the company’s portfolio, but became all the more difficult for those who followed. … Mr. Flannery… and Mr. Larry Culp.
I even wrote in the previous article quoted above:
Perhaps that is why Mr. Flannery (had) difficulty in creating a vision for the future. If Mr. Flannery (destroyed) the company’s ability to “deal with financial engineering” by dismantling the company, one could seriously argue that this was not a very good picture to present as the vision of the future.
Mr. Flannery really struggled and was replaced after a very short time.
Mr. Culp then took the reins, but from the first day of his reign, I criticized him for his failure to present a “new” vision for the future of General Electric. He experienced some of the same difficulties faced by his predecessor.
Now we have Mr. Markopolos and his attack on the company.
Mr. Culp and his team are trying to fight Mr. Markopolos’ charges of accounting fraud, but given the framework provided above, the General Electric team may struggle.
Financial engineering is not going away.
On the contrary, Mr. Welch and General Electric have set fairly high standards for the use of financial engineering. But, since this earlier era, some problems inherited from the past still need to be resolved. Going forward, financial engineering will continue to play a prominent role in business results.
However, the investment community needs to differentiate modern “new” companies from the “legacy” conglomerate form of corporate structure.