Leiden Law Blog

Myths of Mismanagement

Myths of Mismanagement

Usually the failure of a firm is attributed to mismanagement. The implicit argument being that firms (should) normally survive, grow and be profitable. This impression is based on successful business stories, but these stories are very rare and due to serendipity and luck. “Our current knowledge of survivors dominates our impression of the typical experience, and their triumphs are lionized, while the history of the failures is forgotten or considered untypical.” (Hannah, 1999). Failure is one of the great unmentionables in the world of business. This process of business turnover is the essence of capitalism, failure at the individual level is the key to success of the system as a whole.

The collapse of a firm is an emotional event. Somebody is to blame of course. However the causes of failure are not always clear; is it due to internal (mismanagement) or (non-controllable) external  circumstances. In the business failure literature these views are called voluntarism and determinism (or population ecology). I sympathise with the population ecology view, but for different reasons.

Alchian (1950) already pointed towards the impossibility of identifying the causes of success (and failure): “the survivors, may appear to be those having adapted themselves to the environment, whereas the truth may well be that the environment has adopted them.” Ormerod (2005) illustrates this problem with different examples: Suppose business is like a tossing game. Does winning a game mean that a fully rational, maximizing strategy has been chosen? Suppose there are numerous players and the game is played a 100 times. There will still be winners: of course it is misleading to conclude that they have found the optimal strategy and that they behaved as if they were full-information maximizers. In fact we are not able to identify good and bad strategies. However we could reason - as most economists do - that managers behaved “as if” they fully maximized. A more realistic case is the stock market. Are investors able to outperform this market due to their superior strategy? The answer is no: this famous principle is known as the efficient market hypothesis. All information is embodied in the share prices. Share prices only react to new information, but it is not possible to predict new information, because the future is unknown. In this context the most simple hypothesis is to assume that the outcomes we observe are purely random. Are (managers of) firms different than investors, can they beat the market?

Hypotheses to qualify organizational behaviour range from unbounded rationality to a total lack of cognitive ability. According to Ormerod there is strong empirical support for this last hypothesis in the context of firm extinctions. The pattern of firm extinctions appears to be exactly the same as the extinctions of species. It makes no difference that firms/managers are rational conscious beings. It is like firms acted at random. Intent is not the same as outcome. These irregular but patterned extinction waves can be modelled and simulated using different models. These models break down when it is assumed that firms have only slight knowledge about the impact of their strategies. “The implication is that firms have very limited capacities to acquire knowledge about the true impact of their strategies.”(Ormerod, 2004). “Long term survival might be better regarded as a purely random result of complex interaction among competing organizations.” (Stubbart and Knight, 2006). Adam Smith - the first complexity theorist - already pointed towards the unintended consequences of human actions. Why has economics not incorporated and embraced this famous insight? If the cognitive capacities of managers are severely limited, how can we assert that the cause of failure is mismanagement?

Firms are not able to continuously outperform the market and competitors. In the end markets win because evolution is “cleverer” than firms. From the population ecology view it is assumed that firms resist change, are inert. But of course firms do change and reinvent themselves, but the problem is the fact that a business never contains the diversity of business plans as contained in the market as a whole. Taking account of all the future possibilities and opportunities in the economy, market, segment or industry, would paralyse the firm. True strategic decisions require investments that are irreversible. Firms need to specialise and focus and stick to their business, which means that they will certainly not recognise all (relevant) developments. They need to balance exploitation and exploration; this is called ambidexterity. There are no simple rules – no holy grail - for these decisions. In spite of this, most micro economics and management textbooks give the impression that running a business is easy and that maximizing and success are simple. Business failure textbooks contain simple “frameworks” for classifying failure and curing firms in decline. There is a difference however; micro-economic textbooks contain one universal rule: equate price with marginal costs. Curing and classifying business failure textbooks contain (too) many rather simple different frameworks and step-by-step procedures.

The assertion that mismanagement causes business failure has to take into account that most firms fail, that markets have an advantage concerning future developments and that there are serious limits when it comes to knowledge. In judging  (mis)management we should recognise that the world of entrepreneurs and managers of enterprises is not as simple as in the dogmas of micro-economic scholars and management gurus. It is not easy to determine the causes of failure and how to restructure an insolvent firm (and to assess the viability of a firm). The rhetorical question is why most people who are involved in creating simple successful business formulas have not become rich from running an enterprise themselves?

6 Comments

Tim Verdoes
Posted by Tim Verdoes on July 3, 2015 at 13:47

I have to admit that I (as a Dutchman) even dislike (raw) herring! But maybe you would qualify this as a red herring strategy again.

I have said I’m not impressed by Altman’s z-score…, but I added the reasons for this assertion, not my authority. Accounting figures represent (past) economic performance and position. Often a decline does not show up immediately in the performance. When the problems become more severe, accounting figures deteriorate. Of course a company that is in decline, has a higher chance of becoming insolvent.  Why is the liquidity of a company low?, because payments are higher than receipts. Why is the leverage of a firm high?, because a firm suffers losses. Both occur because a firm does not create value. But more fundamental, these ratios tell us nothing about the underlying causes of failure and thus cannot provide the answer to the central question: who is to blame when a company fails? More sophisticated methods of failure prediction view the firm as an option; this option can be in the money and out of the money (or should I say in the business and out of the business?). In the last case, the option of equity holders to continue the business is not executed and the firm fails. These methods are much more sophisticated indeed, they implicitly use an aggregated opinion of the chance of failure, but again the parameters contain accounting as well as market figures. The methods assume that all these data are available. Market values (and volatility) are only available when companies are listed. In Holland about 150 companies are listed out of a population of 1.5 million businesses. As said these concepts embody an aggregated opinion of the chance of failure, but they say nothing about the underlying causes of failure.

In my (not authoritative intended) opinion the most extreme variant of the population ecology perspective “explains” the survival; it is the outcome of a random process. The real underlying problem - I think - is that you do not qualify this as an explanation. I have to admit (again); it’s a rather disappointing conclusion. Business survival is embodied in the complex interactions in our economic cosmos; uncertainties and complexities make decision making very difficult. That is the reason that managers are only slightly more capable than investors for which the efficient market hypothesis applies. This implies that our scientific contributions can only be very marginal. Besides if science discovers the holy grail everybody can use it, which undermines it. This rather skeptical conclusion is based on the fact that firms that survive and outperform the market are very rare (Foster and Kaplan), sustainable competitive advantage is the extreme case (Ruefli and Wiggins), and reinvented competitive advantage is the extreme case of the extreme case, “long term survival might be better regarded as a purely random result of competing interactions among competing organizations” (Stubbart and Knight) and the fact that failure is pervasive (Ormerod). The firm is better represented as a temporary interactor that experiments and tinkers (through executing its options). Our scientific contribution can only be marginal. Success is abnormal, failure is normal.
Although I’m skeptical on a micro scale, I’m an optimist on a macro scale. Progress needs failure.

JDM
Posted by JDM on July 1, 2015 at 23:34

I feel honoured that you took time in posting a comment. However, you failed to address the issue in question (red herring alert!). The argument you posed, that you are not impressed by the results of ALtman’s z-score, is really irrelevant. Furthermore it shows that one might be fooled that you somehow have the authority to determine what is impressive or not. Let me correct you once more: you have not! In addition, and as you know, there are more methods (even better ones) available. How about Merton’s structured approach? Or the Black-Scholes formula? Or maybe venue Boness’s formula.

Just like law, running a business is a living growth. One must adept to the ever changing jungle landscape that is the market. There’s nothing wrong with that. Same goes for failure. However, as I once stated before, the ecology perspective cannot explain why some firms fail and others do not fail.

In conclusion, and instead of using a red herring strategy, try to answer the posed questions instead.


P.S. 1) Since you’re so much into Popper: How about the problem of demarcation?
P.S. 2 (instead of using Popper) Solon once answered, I respectfully quote: “the observation of numerous misfortunes that attend al conditions forbids us to grow insolent upon our present enjoyments, or to admire a man’s happiness that may yet, in course of time, suffer change. For the uncertain future has yet to come, with all variety of future; and him only to whom the divinity has [guaranteed] continued happiness until he end we may call happy”.

Tim Verdoes
Posted by Tim Verdoes on July 1, 2015 at 11:11

The explanation is simple: if success is random, some companies will survive while others (the most) will not. Theoretically, philosophically, statistically and empirically it can be argued that firms in general have a strong disadvantage compared to the market and that failure is and should be more common than survival. In theory a business never contains the diversity of business plans as contained in the market as a whole (Beinhocker), philosophically the future cannot be predicted at least as one adheres to Popper’s “Poverty of Historicism”, statistically the permutations of possibilities/opportunities of combinations is almost unlimited (Paul Romer calls this “post scarcity”) and empirically it is shown by Ormerod that failure is one of the great unmentionables in economics and that knowledge creation is severely limited. Of course managers are free to choose and to formulate their strategies, but the (future) consequences of their actions are largely unknown. According to Foster and Kaplan General Electric (GE) is the only company that survived and outperformed the market for decades because GE reinvented itself. This is a fascinating company because they do not focus, as Porter demands, but are a conglomerate.

Quantitative methods (Altman’s Z-scores) are used to predict future failure. I’m not impressed by the empirical results of these methods because they extrapolate trends from the past. Poor liquidity and gearing ratios are connected with the risk of failure but, usually the decline started much earlier. Accounting figures only neutrally resemble economic reality of a company – at least we hope that they do. So these scores tell us nothing about the causes of failure, and the question who is to blame.

There is nothing wrong with failure. Failure or falsification is more general than survival, Popper taught us.

JDM
Posted by JDM on June 30, 2015 at 02:50

Interesting remarks of Tim Verdoes. Yet, to challenge the critic(s), how come that the perspectives mentioned cannot explain why some firms in the same industry fail and others survive? (See: Mellahi & Wilkinson, 2004, p. 22). In addition, and if success and failure are purely random processes, how come there are several plausible (quantitative) methods available to predict failure? Again, even if the influence is very marginal, should ‘we’ aim for appeasement?

Tim Verdoes
Posted by Tim Verdoes on June 24, 2015 at 14:39

Of course we (business scientists) would like to create knowledge that contributes to the solution of the needs and problems of society e.g. to assist businesses in creating value. Otherwise business science seems rather useless. But the macro or aggregated perspective shows that business failure is pervasive and the cognitive abilities of firms and their managers are severely limited due to the complex interactions in business life. It is disturbing and may be disappointing to conclude that on an aggregate scale the influence of (scientific) knowledge is only very marginal. We assume that we can contribute a lot (a positive bias again!) to the wealth creation of businesses, but do we?

Bernard Santen
Posted by Bernard Santen on June 23, 2015 at 09:22

This is a nice but somewhat abstract analysis. Although it gives food for thinking indeed, one should not conclude that managers are in no position to steer the fate of their company. By taking appropriate and timely actions, they surely can contribute positevely to the survival of the company. One such a measure I studied in my book ‘On the role of monitoring near financial distress’ (Rotterdam, 2011) wherein I empirically asserted that the creation of independent, knowledgeable monitoring mechanisms in a company, declines the chance of financial distress. The creation of these critical working monitoring mechanisms such as a works council, a supervisory board, a whistleblower arrangement, a customer and/or a suppliers panel and so on, is management’s primary responsibility.

Add a Comment

Name (required)

E-mail (required)

Please enter the word you see in the image below (required)

Your own avatar? Go to www.gravatar.com

Remember me
Notify me by e-mail about comments