“If you have made a mistake, cut your losses as quickly as possible” — Bernard Baruch
Earlier this week, the Wall Street Journal reported Time Warner‘s likely decision to sell AOL‘s Internet service provider dial-up business. Pundits brim with schadenfreude at the outcome of this unhappy merger. The announcement of the merger in 2000 pitched it as a deal from heaven, converging old and new media, content and distribution. But it turned out otherwise. While AOL’s shareholders did very well in the deal, Time Warner’s did not. ((Two books offer a detailed history of the deal: Swisher, Kara There Must Be A Pony In Here Somewhere: The AOL Time Warner Debacle and the Quest for a Digital Future New York: Crown Business Books, 2003. And Klein, Alec, Stealing Time: Steve Case, Jerry Levin, and the Collapse of AOL Time Warner, New York: Simon and Schuster 2003.)) With news of negotiations to sell the business, I’m relieved that Time Warner is moving on. It has some good businesses in its portfolio. Warner Brothers seems to know how to make movies: the recent release of Dark Knight just broke all-time box-office records. HBO and Turner Broadcasting are very successful. And the company owns very strong magazine brands. The sale might enable the company to devote more time and money to the most promising businesses.
The pundits’ chief criticism has to do with the slow speed of Time Warner’s exit when the decline of the dial-up business must have become obvious four or five years ago: AOL’s number of subscribers fell from about 27 million in 2002 to under 10 million at the end of 2007. One blogger said, “What the hell took so long? I think Time Warner missed its chance to sell AOL at a high price.” We’ll probably never know the full story. Perhaps Time Warner found a way to squeeze cash out of the business, and therefore tarried. Or perhaps there were important uncertainties about the future of AOL that impeded a hasty exit. Hindsight is always 20-20: it assumes we had all the information then that we have now. But in contrast to Bernard Baruch’s advice, corporations generally seem slow to cut their losses quickly.
When Baruch gave advice, people tended to listen. He was an extraordinarily shrewd investor, noted especially for selling his large holdings of stocks shortly before the Crash of 1929. During the Great Depression, Baruch turned to public service and philanthropy. (For more information, see James Grant’s excellent biography of Baruch.) Why can’t corporations do what Baruch suggested and just cut their losses?
The illiquidity of a company’s assets is an obvious reason; under the best of circumstances, selling a business can take months. But there is more to the story. In a recent published panel discussion, I outlined several classic reasons for the slow speed of exit from unsuccessful acquisitions:
- Measurement and information problems. It is tough to identify the point of inflection where the acquired business begins to turn sour. Five years ago, newspaper publishers had little clue that classified advertisers would begin to flock to Craigslist and other Internet marketplaces. Those publishers today are taking a pounding from the Internet that would have been very hard to foresee in 2003. Similarly, the demise of the dial-up Internet connectivity (in favor of wired broadband and WIFI) has been faster than many forecasters expected in 2000. Monitoring the trends within the portfolio of a firm’s businesses is difficult to do and fraught with error.
- Biased thinking. This is what psychologists call “behavioral factors.” An example would be “sunk cost” thinking: “I can’t just sell a $100 billion investment for $50 billion”—even though it might be rational to do so if $50 billion is a fair value today. Sunk cost thinking regards the business the way it used to be, not the way it is or will be. Behavioral economists have discovered many kinds of biases in thinking that cause decision-makers to depart from rational choices.
- Corporate governance practices and incentives. There is a well-known correlation between firm size and CEO pay. This can prompt management to think that bigger is better and that smaller is not better. Boards of directors may not monitor and challenge the thinking of management as vigorously as they should. And various kinds of takeover defenses or share voting restrictions may prevent shareholders from directly challenging the board and managers to sell ailing businesses.
- Barriers to exit. The Federal Communications Commission took a year to approve the merger of Time Warner and AOL. It might take that long to approve a divesture. A small number of buyers or the existence of unusual liabilities very nearly scratched the sale of Bear Stearns. A price tag in the billions of dollars along with the reluctance of banks to finance a purchase (that, as many private equity firms will tell you, is the situation today) could kill a sale. Uncertain environmental clean-up costs or generous union agreements (think of the auto industry) can drive potential buyers away.
And so on. A firm requires strong will and strength of character to cut its losses in the face of these kinds of problems. Plainly, it takes the same kind of alacrity to sell a business that it does to acquire it. By “alacrity” I mean bias for action, regard for opportunities, careful due diligence, and tough-minded concern for your investors’ return. As I said in the roundtable discussion, “we want firms to exploit the flexibility to enter and exit from businesses because it promotes dynamism and growth in the global economy. But the devil is in the details. Economic discipline, timeliness of response, and focus on action are all vital.”