Private Equity,Corporate Governance,and the Reinvention of the Market for Corporate Control

In the early 1980s, during the first U.S. wave of debt‐financed hostile takeovers and leveraged buyouts, finance professors Michael Jensen and Richard Ruback introduced the concept of the “market for corporate control” and defined it as “the market in which alternative management teams compete for the right to manage corporate resources.” Since then, the dramatic expansion of the private equity market, and the resulting competition between corporate (or “strategic”) and “financial” buyers for deals, have both reinforced and revealed the limitations of this old definition. This article explains how, over the past 25 years, the private equity market has helped reinvent the market for corporate control, particularly in the U.S. What's more, the author argues that the effects of private equity on the behavior of companies both public and private have been important enough to warrant a new definition of the market for corporate control—one that, as presented in this article, emphasizes corporate governance and the benefits of the competition for deals between private equity firms and public acquirers. Along with their more effective governance systems, top private equity firms have developed a distinctive approach to reorganizing companies for efficiency and value. The author's research on private equity, comprising over 20 years of interviews and case studies as well as large‐sample analysis, has led her to identify four principles of reorganization that help explain the success of these buyout firms. Besides providing a source of competitive advantage to private equity firms, the management practices that derive from these four principles are now being adopted by many public companies. And, in the author's words, “private equity's most important and lasting contribution to the global economy may well be its effect on the world's public corporations—those companies that will continue to carry out the lion's share of the world's growth opportunities.”     

BEHIND THE CORPORATE HEDGE: INFORMATION AND THE LIMITS OF "SHAREHOLDER WEALTH MAXIMIZATION"

The article begins by setting out three alternative conceptions of the corporate objective function. Relying on this framework, it shows that legal analyses tend to neglect conflicts between the interests of the corporate entity and the interests of shareholders over the amount of corporate risk-taking. Financial analyses tend to ignore both constraints on managerial discretion imposed by law and a fundamental ambiguity the author identifies in the “shareholder wealth maximization” assumption that underlies such analyses. This ambiguity arises in part from market “frictions”–particularly, the investor uncertainty and heightened price volatility that stem from informational “asymmetry.” Such an information gap between management and outside investors (along with market “irrationality”) can cause material disparities between the actual trading price and the intrinsic value (or what the author calls the “blissful price”) of a company's shares. As a consequence, corporate hedging that maximizes actual share values may not maximize intrinsic values (and vice versa), thus giving rise to a managerial dilemma. Previous analyses have also failed to give adequate consideration to the expectations of shareholders. If, for example, the shareholders of a natural resource company are seeking a relatively “pure play” on that resource–in part because they believe the company's management has no comparative advantage in managing price risks–corporate hedging that increases shareholder wealth may re-duceshareholder welfare. In this sense, the usual “shareholder wealth maximization” directive is not only ambiguous, but also incomplete. These problems stem not only from informational asymmetry, but from other institutional realities (such as the “political” taint associated with reported derivative losses of any kind) that raise the information costs of using derivatives. The article concludes with some suggestions for improving disclosure of corporate risk management “philosophy.” Better disclosure may not only help reduce such information costs, but could also encourage corporations to find–and stick to–their derivatives niche.     

BANK OF AMERICA ROUNDTABLE ON THE LINK BETWEEN CAPITAL STRUCTURE AND SHAREHOLDER VALUE

A number of popular business magazines have recently run cover stories describing the “return of leverage.” Although full of interesting details about individual leveraged deals and the investment bankers who put them together, they are largely silent on several issues of economic importance: Why is this happening now? What are the most important benefits as well as costs of debt financing? Is there such a thing as a value-maximizing, or “optimal,” capital structure for public corporations? No financial economist has thought and written as much about corporate capital structure and its relationship to shareholder value and corporate governance as Harvard professor Michael Jensen. The first economist to see the value-adding potential of LBOs in the 1980s, he was also the first to identify the source of the problems with the late-'80s deals. In this roundtable discussion, Professor Jensen explores the “real” effects of corporate financial policies on managerial decision-making and shareholder value with a distinguished group of corporate executives and financial advisors.     

THE REVOLUTION IN CORPORATE RISK MANAGEMENT: A DECADE OF INNOVATIONS IN PROCESS AND PRODUCTS

The explosion of corporate risk management programs in the early 1990s was a hasty and ill‐conceived reaction by U.S. corporations to the great “derivatives disasters” of that period. Anxious to avoid the fate of Barings and Procter & Gamble, most top executives were more concerned about crisis management than risk management. Many companies quickly installed (often outrageously priced) value‐at‐risk (VaR) systems without paying much attention to how such systems fit their specific business requirements. Focused myopically on loss avoidance and technical risk measurement issues, the corporate risk management revolution of the '90s thus got underway in a disorganized, ad hoc fashion, producing a curious amalgam of policies and procedures with no clear link to the corporate mission of maximizing value. But as the risk management revolution unfolded over the last decade, the result has been the “convergence” of different risk management perspectives, processes, and products. The most visible sign of such convergence is a fairly recent development called “alternative risk transfer,” or ART. ART forms consist of the large and growing collection of new risk transfer and financing products now being offered by insurance and reinsurance companies. As just one example, a new class of security known as “contingent capital” gives a company the option over a specified period—say, the next five years—to issue new equity or debt at a pre‐negotiated price. And to hold down their cost, such “pre‐loss” financing options are typically designed to be “triggered” only when the firm is most likely to need an infusion of new capital to avoid underinvestment or financial distress. But underlying—and to a large extent driving—this convergence of insurance and capital markets is a more fundamental kind of convergence: the integration of risk management with corporate financing decisions. As first corporate finance theorists and now practitioners have come to realize, decisions about a company's optimal capital structure and the design of its securities cannot be made without first taking account of the firm's risks and its opportunities for managing them. Indeed, this article argues that a comprehensive, value‐maximizing approach to corporate finance must begin with a risk management strategy that incorporates the full range of available risk management products, including the new risk finance products as well as established risk transfer instruments like interest rate and currency derivatives. The challenge confronting today's CFO is to maximize firm value by choosing the mixture of securities and risk management products and solutions that gives the company access to capital at the lowest possible cost.     

Financial Management Association Roundtable on Stock Market Pricing and Value‐Based Management

A group of academics and practitioners addresses a number of questions about the workings of the stock market and its implications for corporate decision‐making. The discussion begins by asking what the market wants from companies: Is it mainly just steady increases in earnings per share, which are then “capitalized” by the market at the current industry P/E multiple to produce a higher stock price? Or does the market pay attention to the “quality,” or sustainability, of earnings? And are there more revealing measures of annual corporate performance than GAAP earnings—measures that would provide investors with a better sense of companies' future cash‐generating capacity and returns on capital? The consensus was that although many investors respond uncritically to earnings numbers, the most sophisticated and influential investors consider far more than current earnings when pricing stocks. And although the stock market is far from omniscient, the heightened scrutiny of companies resulting from the growth of hedge funds, private equity, and investor activism of all kinds appears to be making the market “more efficient” in building information into stock prices. The second part of the discussion explored the implications of this view of the market pricing process for corporate strategy and the evaluation of major investment opportunities. For example, do acquisitions have to be “EPS‐accretive” to be value‐adding, or is there a more reliable means of assessing an investment's value added than pro forma EPS effects? Does the DCF valuation method always offer a better guide to value than the method of comparables used by many Wall Street dealmakers? And under what circumstances are the relatively new real options valuation approaches likely to provide a significant advantage over conventional methods? The main message offered to corporate practitioners is to avoid letting cosmetic accounting effects get in the way of value‐adding investment and operating decisions. As the corporate record on acquisitions makes painfully clear, there is no guarantee that an accretive deal will turn out to be value‐increasing (in fact, the odds are that it will not). As for choosing a valuation method, there appears to be a time and place for each of the major methods—comparables, DCF, and real options—and the key to success is understanding which method is best suited to the circumstances.     

Using Organizational Architecture to Lead Change*

Effective leadership involves more than developing and communicating the right strategic vision for the company. To encourage employees to carry out the corporate vision, companies must ensure consistency among the following three main components of their “organizational architecture:”

• ? the allocation of decision‐making authority (that is, who in the organization gets to make what decisions);
• ? performance measurement systems (for evaluating the performance of individuals as well as business units); and
• ? reward systems (the rewards for success, both financial and otherwise, and the consequences of failure).

The authors illustrate the application of this framework with the case of Xerox's (eventually) successful attempt to create a customer‐oriented workforce in the 1980s. But a more effective demonstration of the importance of these principles, as the authors go on to suggest, might well be the same company's well‐known failure to realize the commercial promise of the many inventions by its research group in Palo Alto. This organizational framework is especially useful for evaluating the likely effects of major corporate initiatives such as “Six Sigma” or the “Balanced Scorecard.” For example, it could be used to help top management determine whether, and under what circumstances, decentralization is likely to improve decision‐making and performance, as well as the changes in the firm's performance management and incentive systems that would be required to make decentralization work. Finally, the authors apply the framework to another important leadership issue: corporate ethics. In response to the scandals of the past decade and the passage of Sarbanes‐Oxley, many U.S. companies have issued formal codes of conduct, appointed ethics officers, and instituted training programs in ethics. But a key question for top management is whether the incentives established by the firm's organizational architecture reinforce or undermine the code of conduct. In this sense, ensuring consistency in organizational design is an important leadership function—one that is critical to encouraging ethical behavior as well as the pursuit of shareholder value.     

How Corporate Diversity and Size Influence Spinoffs and Other Breakups

In recent months, the list of large diversified companies that have decided they would be worth more as several smaller, focused companies has grown sharply. In many of these cases, it has been outside pressure from activist investors that has motivated these actions by management—and with some pretty favorable results. But what is driving these strategic actions and what is most important in determining whether breakups create value? To answer this fundamental questions, it is critical to decide whether large, diversified companies have a value recognition problem or a value creation problem. In this article, the authors present and try to integrate the findings of two separate but related research studies on business diversity and size with the aim of identifying their implications for corporate strategy and helping company executives create more value for their investors. The specific reasons for underperformance by large diverse companies vary greatly, but there are a number of potential problems discussed in this article, including organizational “distance,” capital allocation, human capital allocation, cross subsidies, and ineffective governance. Instead of waiting for activist investors to demand a breakup, executives of large diverse companies should be proactive in addressing the potential weaknesses of their organizations. Private equity firms understand how to make diversification work and many of today's executives could learn some valuable lessons from these firms. Large diverse businesses should embrace “Internal Capitalism,” a corporate culture and set of practices that emphasizes the importance of strategic decision‐making that is linked through continuous performance assessment to the corporate goals of boosting efficiency and sustainable growth.     

ESG Investing in Graham & Doddsville

The author describes how and why the world's best “business value investors” have long incorporated environmental, social, and governance (ESG) considerations into their investment decision‐making. As the main source of value in companies has increasingly shifted from tangible to intangible assets, many followers of Graham & Dodd have delivered exceptional investment results by taking an “earnings‐power” approach to identifying high‐quality businesses—businesses with enduring competitive advantages that are sustained through significant ongoing investment in their core capabilities and, increasingly, their important non‐investor “stakeholders.” While the ESG framework may be relatively new, it can be thought of as providing a lens through which to view the age‐old issue of “quality.” Graham & Dodd's 1934 classic guide to investing, Security Analysis, and Phil Fisher's 1958 bestseller, Common Stocks and Uncommon Profits, both identify a number of areas of analysis that would today be characterized as ESG. Regardless of whether they use the labels “E,” “S,” and “G,” investors who make judgments about earnings power and sustainable competitive advantage are routinely incorporating ESG considerations into their decision‐making. The challenge of assessing a company's sustainable competitive advantage requires analysis based on concepts such as customer franchise value, as well as intangibles like brands and intellectual property. For corporate managers communicating ESG priorities, and for investors analyzing ESG issues, the key is to focus on their relevance to the business. In this sense, corporate reporting on sustainability issues should be viewed as analogous to and an integral part of financial reporting, with a management focus on materiality and relevance (while avoiding a “promotional” approach) that is critical to credibility.     

Does Board Independence Matter in Companies with a Controlling Shareholder?

A number of studies have reported value discounts for listed companies in countries that provide weak legal protection to minority shareholders. Such studies typically attribute these discounts to the ability, and the well‐documented tendency, of controlling shareholders to extract a disproportionate share of corporate resources for “private benefits.” This tendency and the resulting discounts create a dilemma for those controlling shareholders intent on maximizing value for not just themselves, but all shareholders: How can such controlling shareholders assure their minority shareholders that they will not exploit their power to expropriate resources and so eliminate the discount from their companies' shares? This article investigates the possibility that such discounts can be reduced by appointing boards of directors made up of individuals who are independent of the controlling shareholders. Based on the systematic analysis of some 800 companies representing 22 countries, the authors' recent study reports that corporate values are consistently higher when boards are more independent of controlling shareholders—and that this relationship is especially strong in those countries that afford fewer rights to minority shareholders. What is likely to cause controlling shareholders to appoint more independent directors—a change that, after all, effectively limits the controlling shareholders' power and “degrees of freedom”? The answer provided by the authors is that board independence is most likely to be pursued by companies with controlling shareholders that also have major growth opportunities that must be funded mainly with outside equity.     

Materiality in Corporate Governance: The Statement of Significant Audiences and Materiality

Materiality is an elusive, but fundamentally important concept in corporate reporting of all kinds—not only in traditional financial reporting, but in sustainability and integrated reporting as well. In the end, materiality is entity‐specific and based on judgment. Moreover, it is a judgment that should ultimately be made by a company's board of directors, which makes materiality as much a governance as a reporting issue. Whether a given ESG issue is material is in large part a function of the corporate stakeholders, or “audiences,” that the company's board of directors deems to be “significant”—that is, important to the company's ability to create value over the short, medium, and long term. The identification of such audiences—together with the time frames the board uses to evaluate the impact of the company's decisions on these audiences—provides the basis for determining the sustainability issues that corporate management must focus on for performance and reporting purposes. To help ensure that decisions about materiality receive the attention they deserve, the authors propose that corporate boards articulate their views in an annual “Statement of Significant Audiences and Materiality.” Contrary to the prevailing belief that the fiduciary duty of the board is to place shareholders’ interests first, nothing precludes corporate boards from issuing such a statement. Recent research, including the compilation of legal memos on fiduciary duty and nonfinancial reporting for all G20 countries, makes it clear that the board's fiduciary duty is to “the corporation itself.” In exercising this duty, directors have full discretion, under the business judgment rule and other authorities, to decide which audiences, along with the company's shareholders, should be deemed significant.     

The Corporate Social Responsibility (CSR) Trend

Corporate Social Responsibility, or “CSR,” has recently become a subject of study by financial economists. While there is no shortage of anecdotal evidence to support all variety of positions, broad‐based statistical evidence about the CSR movement is in short supply. This article presents some new empirical evidence that aims to answer three related questions about CSR: First, are corporations increasing their “investment” in what is considered socially responsible behavior? Second, does corporate investment in social responsibility affect a company's financial performance and shareholder value? Third, why do companies invest in CSR: to increase shareholder value, or to uphold a “moral” commitment to non‐investor stakeholders and “society”? Using a social responsibility metric that measures the net CSR strengths (i.e., strengths less concerns) of each S&P 500 and Domini 400 company, the authors report that the average net CSR for both indexes decreased during the 15‐year period (1991‐2005) of the study—though the Domini 400, as might be expected, experienced a smaller decline. The authors also report that corporate strengths have increased, on average, but at a slower rate than the “concerns,” which suggests that corporate CSR efforts may be aimed at a moving target with steadily rising expectations and requirements. Second, the authors report that companies with more CSR strengths or fewer CSR weaknesses produced higher ROA over the same 15‐year period. The authors' findings here suggest a “circular” causality in which profitable companies are more likely to invest in CSR initiatives to begin with, but then find their performance further improved by such investment. Third, the authors' findings suggest that most companies devote resources to CSR initiatives as a means of maximizing long‐run value rather than out of a prior commitment to stakeholders. More specifically, the study shows that companies appear to invest more heavily to build CSR strengths than to eliminate CSR concerns. And as the authors conclude, this behavior is consistent with a strategy of using CSR as a form of “risk management” that promotes corporate strengths in order to limit the potential negative effects of—perhaps by diverting attention from—their weaknesses.     

Corporate Portfolio Management Roundtable

The dean of a top ten business school, the chair of a large investment management firm, two corporate M&A leaders, a CFO, a leading M&A investment banker, and a corporate finance advisor discuss the following questions:

• ? What are today's best practices in corporate portfolio management? What roles should be played by boards, senior managers, and business unit leaders?
• ? What are the typical barriers to successful implementation and how can they be overcome?
• ? Should portfolio management be linked to financial policies such as decisions on capital structure, dividends, and share repurchase?
• ? How should all of the above be disclosed to the investor community?

After acknowledging the considerable challenges to optimal portfolio management in public companies, the panelists offer suggestions that include:

• ? Companies should establish an independent group that functions like a “SWAT team” to support portfolio management. Such groups would be given access to (or produce themselves) business‐unit level data on economic returns and capital employed, and develop an “outside‐in” view of each business's standalone valuation.
• ? Boards should consider using their annual strategy “off‐sites” to explore all possible alternatives for driving share‐holder value, including organic growth, divestitures and acquisitions, as well as changes in dividends, share repurchases, and capital structure.
• ? Performance measurement and compensation frameworks need to be revamped to encourage line managers to think more like investors, not only seeking value‐creating growth but also making divestitures at the right time. CEOs and CFOs should take the lead in developing a shared value creation model that clearly articulates how capital will be allocated.

     

The Pragmatic Theory of the Firm

Four key ideas provide the foundation for the pragmatic theory of the firm, which is expecially useful for managements and boards in developing an understanding of how companies create long‐term value for the benefit of all stakeholders. First, and a necessary point of departure, is clarity about the purpose of the firm. Maximizing shareholder value is viewed not as the social purpose of the firm, but as a consequence of a company's effectiveness in carrying out a purpose that recognizes the benefits of success to all key corporate stakeholders. Second, a company's knowledge‐building proficiency, in relation to that of its competitors, is viewed as the primary determinant of its long‐term performance. Nurturing and sustaining a knowledge‐building culture facilitates the discovery of obsolete assumptions and early adaptation to a changing environment. Third, the theory avoids “compartmentalizing” a company's activities into silos by treating the firm as a holistic system. A key component of the theory that quantifies corporate performance is the life‐cycle framework in which economic returns exhibit “competitive fade” over the long term. This holistic way of thinking provides insights about intangible assets and other sources of excess shareholder returns. Fourth, managing corporate risk should focus on identifying and removing all major obstacles to achieving the firm's purpose. Such obstacles can lead to value destruction through, for example, unethical behavior and all forms of shortsighted failure to recognize and make the most of opportunities to increase long‐run productivity and value. This theory of the firm is pragmatic in the sense that it aims to produce insights about a company's (or business unit's) performance that can improve management's decisions, especially in allocating capital and other corporate resources. The author uses John Deere's life‐cycle track record over the past 60 years to illustrate a successful application of the theory.     

Morgan Stanley Roundtable on Enterprise Risk Management and Corporate Strategy

In a roundtable hosted by Morgan Stanley, a group of corporate risk officers, consultants, and bankers discuss the state of corporate risk management. The discussion focused on a number of questions: What is the primary goal of risk management, and how does it add value for shareholders? What risks do companies “get paid” to bear (for example, should oil companies hedge oil price risk or banks hedge interest rates)? And, given the accounting obstacles that FAS 133 has put in the way of would be hedgers, should companies continue to hedge exposures—and, to the extent their hedges produce “artificial” earnings volatility, how should they communicate the aims and accomplishments of their risk management program to rating agencies and investors?     

U.S. Corporate Governance: Accomplishments and Failings A Discussion with Michael Jensen and Robert Monks

Two of America's most prominent shareholder activists discuss three major issues surrounding the U.S. corporate governance system: (1) the case for increasing shareholder “democracy” by expanding investor access to the corporate proxy; (2) lessons for public companies in the success of private equity; and (3) the current level and design of CEO pay. On the first of the three subjects, Robert Monks suggests that the U.S. should adopt the British convention of the “extraordinary general meeting,” or “EGM,” which gives a majority of shareholders who attend the meeting the right to remove any or all of a company's directors “with or without cause.” Such shareholder meetings are permitted in virtually all developed economies outside the U.S. because, as Monks goes on to say, they represent “a far more efficient and effective solution than the idea of having shareholders nominate people for the simple reason that even very involved, financially sophisticated fiduciaries are not the best people to nominate directors.” Moreover, according to both Jensen and Monks, corporate boards in the U.K. do a better job than their U.S. counterparts of monitoring top management on behalf of shareholders. In contrast to the U.S., where the majority of companies continue to be run by CEO/Chairmen, over 90% of English companies are now chaired by outside directors, contributing to “a culture of independent‐minded chairmen capable of providing a high level of oversight.” In the U.S., by contrast, most corporate directors continue to view themselves as “employees of the CEO.” And, as a result, U.S. boards generally fail to exercise effective oversight and control until outside forces—often in the form of activist investors such as hedge funds and private equity—bring about a “crisis.” In companies owned and run by private equity firms, by contrast, top management is vigorously monitored and controlled by a board made up of the firm's largest investors. And the fact that the rewards to the operating heads of successful private equity‐controlled firms are typically multiples of those received by comparably effective public company CEOs suggests that the problem with U.S. CEO pay is not its level, but its lack of correlation with performance.     

VALUE MAXIMIZATION AND STAKEHOLDER THEORY: COMPATIBLE OR NOT?

Complicating the current corporate governance controversy is a major disagreement about the fundamental purpose of the corporation. There are two main views on what should constitute the principal goal of the firm. Most economists tend to endorse value maximization—that is, maximization of the value of the firm's debt plus equity—or a version of value maximization known as “value‐based management” (VBM) that aims to maximize shareholder value. The main challenger is “stakeholder theory,” which argues that the corporation exists to benefit not just investors but all its major constituencies—employees, customers, suppliers, the local community, and the federal government, as well as shareholders. Thus, whereas the success of a corporation under VBM could be assessed simply by its long‐run return to shareholders, under stakeholder theory a company's success would be judged by taking account of its contributions to all its stakeholders. Using statistical analysis of various measures of corporate success in satisfying non‐investor stakeholders, the author investigates whether a broader focus on multiple stakeholders is necessarily inconsistent with the pursuit of long‐term shareholder value. His main findings in fact suggest just the opposite—namely, that long‐term value creation appears to be a necessary condition for maintaining corporate investment in stakeholder relationships. More specifically, the author's study shows that companies with higher levels of value creation tend to have stronger reputations for treating stakeholders well while companies that create little value end up shortchanging not just their shareholders but all their constituencies. For profitable companies that have previously failed to devote the optimal level of resources to their non‐investor stakeholders, the message of this article is that investing in stakeholders can add value—and, in fact, it pays for companies to spend an additional dollar on stakeholder relationships as long as the present value of the expected (long‐run) return is at least a dollar.     

Risk Management,Corporate Governance,and the Search for Long-Term Investors

This discussion explores a number of ways that more effective risk management, corporate governance, and communication with investors can help companies increase their effciency and long-run value. According to one of the panelists, recent surveys of corporate directors suggest that companies should devote more time and attention to three issues—strategy, risk management, and succession planning—and that strategy and risk are the “flipsides of the same coin.” As the panelist argues, “You can't talk about strategy without talking about what risks you're going to take—and what risks you decide to take has to depend on the core competencies that drive the corporate strategy.” In addition to making risk management a critical part of corporate strategy, another notable recommendation is to communicate a company's strategy and business plan as clearly as possible to investors, with the aim of attracting more sophisticated, long-term shareholders. Contrary to popular belief, such a group may well include some hedge funds and other activist shareholders. According to a newly released report on shareholder activism (produced and cited by another panelist), corporate boards should work harder to identify and engage the “largest 10 shareholders in the organization,” with the ultimate goal of cultivating a shareholder base that buys into the company's strategy.     

Using Organizational Architecture to Lead Change

Effective leadership involves more than developing and communicating the right strategic vision for the company. To encourage employees to carry out the corporate vision, companies must ensure consistency among the following three main components of their organizational architecture: (1) the allocation of decision‐making authority; (2) performance measurement systems; and (3) reward systems. The authors illustrate the application of this framework with the case of Xerox's (eventually) successful attempt to create a customer‐oriented workforce in the 1980s. But a more effective demonstration of the importance of these principles, as the authors go on to suggest, might well be the same company's well‐known failure to harvest the commercial promise of the many inventions by its research group in Palo Alto, one of which became the basis for Steve Jobs' success at Apple. This organizational framework is especially useful for evaluating the likely effects of major corporate initiatives such as “Six Sigma” or the “Balanced Scorecard.” For example, it could be used to help top management determine whether, and under what circumstances, decentralization is likely to improve decision‐making and performance, as well as the changes in the firm's performance management and incentive systems that would be required to make decentralization work. Finally, the authors apply the framework to another important leadership issue: corporate ethics. Since the scandals of the early 2000s and the passage of Sarbanes‐Oxley, many, if not most, U.S. companies have issued formal codes of conduct, appointed ethics officers, and instituted training programs in ethics. But a key question for top management is whether the incentives established by the company's organizational architecture reinforce or undermine the code of conduct. Ensuring consistency in organizational design is an important leadership function—one that is critical to encouraging ethical behavior as well as the pursuit of shareholder value.     

Realizing the Potential of Real Options: Does Theory Meet Practice?

The idea of viewing corporate investment opportunities as “real options” has been around for over 25 years. Real options concepts and techniques now routinely appear in academic research in finance and economics, and have begun to influence scholarly work in virtually every business discipline, including strategy, organizations, management science, operations management, information systems, accounting, and marketing. Real options concepts have also made considerable headway in practice. Corporate managers are more likely to recognize options in their strategic planning process, and have become more proactive in designing flexibility into projects and contracts, frequently using real options vocabulary in their discussions. Thanks in part to the spread of real options thinking, today's strategic planners are more likely than their predecessors to recognize the “option” value of actions like the following: ? dividing up large projects into a number of stages; ? investing in the acquisition or production of information; ? introducing “modularity” in manufacturing and design; ? developing competing prototypes for new products; and ? investing in overseas markets. But if real options has clearly succeeded as a way of thinking, the application of real options valuation methods has been limited to companies in relatively few industries and has thus failed to live up to expectations created in the mid‐ to late‐1990s. Increased corporate acceptance and implementations of real options valuation techniques will require several changes coming together. On the theory side, we need more realistic models that better reflect differences between financial and real options, simple heuristic methods that can be more easily implemented (but that have been carefully benchmarked against more precise models), and better guidance on implementation issues such as the estimation of discount rates for the “optionless” underlying projects. On the practitioner side, we need user‐friendly real options software, more senior‐level buy‐in, more deliberate diffusion of real options knowledge throughout organizations, better alignment of managerial incentives with long‐term shareholder value, and better‐designed contracts to correct the misalignment of incentives across the value chain. If these challenges can be met, there will continue to be a steady if gradual diffusion of real options analysis throughout organizations over the next few decades, with real options eventually becoming not only a standard part of corporate strategic planning, but also the primary valuation tool for assessing the expected shareholder effect of large capital investment projects.