CONGLOMERATES WITHOUT (ALIENABLE) ASSETS: FINANCIAL INTERMEDIATION AND THE EVOLUTION OF THE GLOBAL

ADVERTISING INDUSTRY

Andrew von Nordenflycht Faculty of Business Administration

Simon Fraser University 8888 University Drive

Burnaby, British Columbia Canada V0N3Z2

vonetc@sfu.ca

April 2005

CONGLOMERATES WITHOUT (ALIENABLE) ASSETS: FINANCIAL INTERMEDIATION AND THE EVOLUTION OF THE GLOBAL

ADVERTISING INDUSTRY

Abstract

I analyze the evolution of the advertising industry, whose consolidation into public holding

companies contrasts with stylized views of professional service firms as small and private.

Based on interviews and historical research, I propose that the holding companies provide

financial intermediation, rather than product market advantages. This hypothesis challenges

common assumptions about the value of capital and the partnership model in professional

services. It also suggests industry evolution can be driven by access to capital, independent

of technological change.

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INTRODUCTION

For insights into how the rising value of human capital will affect the organization

and governance of firms, scholars are increasingly looking to professional service firms

(PSFs). A common stylized view about PSFs is that they are hard to keep together because

they own few alienable assets and their employees are highly mobile. For example, to

illustrate how an absence of non-human assets poses difficulties for traditional models of

governance, both Hart (1995) and Rajan and Zingales (2000; 1998) tell the story of the ad

agency Saatchi & Saatchi, where outside shareholders ousted founder and chairman Maurice

Saatchi in a dispute over his compensation, only to have him found a new firm and then

poach key personnel and clients months later. The apparent lesson from the Saatchi &

Saatchi story is that firms based primarily on inalienable human capital will be "flimsy and

unstable, constantly subject to the possibility of break-up” (Hart, 1995).

In contrast to the stylized view, however, several professional service industries not

only feature large, long-lived firms, but also have experienced significant globalization and

consolidation (Lorsch & Tierney, 2002; Powell, Brock, & Hinings, 1999). In fact, the very

setting for the Saatchi & Saatchi story, the advertising industry, provides a particularly

pronounced example: the industry’s global C4 ratio (the market share of the largest four

firms) has risen from 6% in 1961 to 45% in 2002, and its largest firms have billions in

revenues and tens of thousands of employees worldwide. Furthermore, its largest firms are

now publicly-traded holding companies, each owning several global agencies.

So why do these large advertising firms not break apart as employees leave to form

their own firms, as illustrated by the Saatchi & Saatchi example? What explains the

consolidation of the industry into a few publicly-traded holding companies? To address these

questions, this paper draws on three sources of evidence: a database of the world’s top 100

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advertising agencies and holding companies over the last forty years; interviews with a range

of industry participants (see Table 1); and an extensive review of trade press and other

secondary sources.

Based on this evidence, I propose that the rationale for the holding companies lies in

financial intermediation, as opposed to the provision of any product market advantage. Their

size, financial expertise, and mitigation of the industry’s client conflict norm provide

advantages in accessing capital. This in turn allows them to pursue profitable acquisitions by

arbitraging high transaction costs between investors and advertising agencies. In other

words, the holding companies might be analogized to business groups in emerging markets

(Khanna & Palepu, 2000; Khanna & Rivkin, 2001) or 1960s conglomerates (Baker, 1992;

Hubbard & Palia, 1999; Klein, 2001; Martin & Sayrak, 2003) in that they intermediate where

factor markets are poorly developed or rife with transaction costs.

I then argue that the financial intermediation hypothesis is consistent with the

historical timing of the holding company phenomenon. Specifically, the emergence of the

holding companies was linked to the evolution of the industry’s access to outside equity.

Access to equity is essential to the intermediation role and was only possible after the

erosion of several barriers to outside ownership of ad agencies. A major increase in access

to equity markets in the early 1980s, pioneered by the UK agency, Saatchi & Saatchi, fueled a

merger wave and the creation of the holding companies. Since then the holding companies

have continued to acquire profitably by providing agency owners with liquidity and

diversification.

This analysis contributes to three strands of research. First, the financial

intermediation hypothesis suggests a correction to the stylized view of PSFs. It argues that

access to external capital can be quite valuable, even in the absence of tangible assets or

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sources of sunk investment—i.e., even in arenas of low capital intensity—because it provides

not just investment funds but also liquidity and diversification of intangible assets. This

contrasts with common assumptions that external capital is of low value to PSFs (Dow &

Putterman, 2000; Hansmann, 1996; Jensen & Meckling, 1979).

Second, this analysis contributes to the literature on industry evolution. It indicates

that industry consolidation or “shakeouts” can be driven by changes in an industry’s

relationship to the capital markets, rather than primarily by technological change and R&D

investment (Jovanovic & MacDonald, 1994; Klepper, 1996; Klepper & Simons, 2000;

Malerba et al., 2001; Sutton, 1998).

Third, this analysis uncovers some interesting behavioral aspects in the evolution of

an industry’s access to equity markets. The history of the advertising industry suggests that

increasing access to external equity resulted less from objective improvements in investor

protections and more from the erosion of cognitive biases against outside equity (biases

among advertising insiders as well as investors) by waves of investor exuberance and

“deviant” industry entrants.

The paper proceeds as follows. Section 2 details the nature of production and the

structure of the industry. In doing so, it reviews a small literature on economies of scale and

scope in ad agencies, it provides new evidence on the structure of the industry over time,

and it points out flaws in product market-based explanations of the holding companies.

Section 3 proposes the financial intermediation hypothesis for the advertising holding

companies. Section 4 describes the industry’s financial evolution to show how the financial

intermediation hypothesis is consistent with the historical timing of the holding company

phenomenon. Section 5 concludes by summarizing the basic argument, identifying

limitations, and discussing implications for existing theory and future research.

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[insert Table 1 about here]

ADVERTISING AGENCIES: NATURE OF PRODUCTION AND INDUSTRY STRUCTURE

Production of Advertising Services

Advertising agencies design and implement advertising campaigns for corporate

clients, a service which traditionally combines three functions: Marketing strategy—the agency

suggests which customers to target with what message, and how best to allocate the client’s

advertising budget across various media (TV, magazines, direct mail, etc.); Creative—the

agency creates the advertisements; and Media Buying—on behalf of the client, the agency

negotiates rates and buys media space and time for the dissemination of the advertisements.1

The production of these functions rests on human capital: marketing expertise,

creative talent, relationship management skills—i.e., assets that “walk out the door each

night.” There are few opportunities for capital investment in non-human assets, such as

equipment, advertising, R&D, or even centralized databases and IT systems. Where

producing advertisements involves expensive, specialized equipment (e.g., TV production or

commercial printing), the work is typically outsourced and charged directly to the client.

Economies of scale and scope at the firm level appear to be minimal. Advertising is

custom-designed for each client, so serving more clients entails more labor inputs. A stream

of econometric research by Silk and Berndt (Schmalensee, Silk, & Bojanek, 1983; Silk &

Berndt, 1993; 1995) estimates that agencies reach minimum efficient scale (MES) at only $3

million in revenue. Noting that there are both many agencies smaller than this MES and

many much larger, they conclude that “agencies of widely varying sizes are economically

viable” (Silk & Berndt, 1995). In addition they find minimal economies of scope.

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There may be economies of scale at the client level. Since agencies are traditionally

paid a commission on clients’ media spending (see footnote 1), larger clients may generate

more revenue without any corresponding increase in labor inputs. However, such scale

economies would be hard to exploit because of the industry’s distinctive “conflict” norm. It

is a long-standing norm that agencies cannot work for clients that are direct competitors (e.g.

Coke and Pepsi; GM and Ford).2 The conflict norm poses an obstacle to agency size because

it limits the agency to only one major company in each industry. The problem becomes

more acute the larger the agency, as a broader client base and larger clients create ever more

conflicts with potential new clients.

Industry Structure at the Agency Level

Consistent with conventional expectations for a business based largely on inalienable

assets, the advertising industry overall is highly fragmented, with thousands of individual

firms. The Census Bureau reported 12,607 advertising firms in the U.S. in 1997 (King, Silk,

& Ketelhohn, 2003). The vast majority of these agencies are very small: the mean agency in

1997 consisted of 11.6 employees and $1.3 million in revenue. There are also large agencies:

in 2001, the world’s largest agency (McCann-Erickson) had about $3.0 billion in revenue and

about 24,000 employees.

Now while large agencies do not appear to enjoy scale economies per se, they do seem

to have an advantage in serving large clients, through a greater ability to coordinate large,

complex advertising campaigns. Larger campaigns involve more personnel and typically span

multiple geographic markets and multiple media channels (e.g., print, broadcast, direct mail).

So larger agencies are assumed to have an advantage, relative to smaller agencies, in

providing coordination across geographic markets and functional disciplines. On the other

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hand, smaller clients with simpler campaigns do not need the coordination capabilities that

large agencies offer and may seek smaller agencies who charge lower prices or offer more

responsiveness. In other words, the advertising industry is vertically differentiated (Shaked &

Sutton, 1982; Sutton, 1991), where a key dimension of quality is the ability to coordinate

large projects—and that ability is correlated with agency size. Broadly speaking, large

agencies serve large clients while small agencies serve small clients.

To analyze the structure of the industry, Census statistics are insufficient because

they do not accurately measure firm boundaries in the industry, and do not distinguish

between agencies and holding companies. For a more accurate picture of the evolution of

the industry’s structure, I compiled a database of the largest 100 agencies and holding

companies at the beginning of each decade from 1961 to 2001 from the industry’s leading

periodical, Advertising Age, as well as market size data from Coen (2002). Details of this

database and its potential limitations are included in Appendix I.

With this database, we can see that the structure of the advertising industry at the

agency level seems linked to the structure of the client base. Figures 1 and 2 show the

concentration ratios for U.S. agencies and U.S. advertisers (clients) at the beginning of each

decade from 1961 to 2001. Rather than show the standard concentration ratios (C4, C8,

C20), these figures create mutually exclusive groupings of the top 20 firms, splitting them

into the top four, the next four (i.e., rank five through eight), and rank nine through twenty

(#9-20). Figure 1 shows that the C4 ratio for agencies was relatively stable from 1961

through 1991, then increased between 1991 and 2001. The market shares of agencies 5

through 20 increased slowly but steadily over the forty years. Figure 2 shows that the

concentration of clients appears fairly similar, with the exception that there is no

corresponding increase in C4 between 1991 and 2001.

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[insert Figures 1 and 2 about here]

The geographic and functional scope of large agencies, too, seems connected with

that of their client base. Large agencies have become increasingly multinational, largely to

service increasingly multinational clients (see Caves, 1996, pp 11-13). Agencies have also

diversified from traditional media advertising into related marketing communications

services (direct mail, public relations, internet, etc.), as client marketing spending has shifted

increasingly towards these alternative media (Silk & Berndt, 2003).

Thus, the rationale for large agencies of broad scope appears readily explained by the

need to coordinate large, diverse ad campaigns. However, this theory seems insufficient to

explain the industry’s major recent development, the holding companies.

Advertising Holding Companies

While advertising agencies are relatively “integrated” production entities with a single

identity in the product market, the holding companies do not serve clients directly, but

instead own multiple agencies with independent identities. Most notably, the holding

companies own “duplicate” large agencies, which each have broad geographic and functional

scope in their own right, and which compete with each other for the same clients.

For example, the largest holding company in 2001 was WPP, which had revenue of

about $5.8 billion and 65,000 employees. WPP owned three large global agencies: J. Walter

Thompson, Ogilvy & Mather, and Young & Rubicam (in addition to hundreds of smaller

subsidiaries). Each of these subsidiary agencies possessed global scope, with offices in 90, 77,

and 80 countries respectively, and each provided not only traditional advertising services, but

also additional marketing services like direct mail, sales promotion, and public relations.

They also competed with each other over the same large clients.

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At the holding company level, the industry has undergone tremendous consolidation.

Figure 3 shows the concentration levels calculated at the holding company level, revealing

the enormous increase in C4—from 6% in 1961 to 45% in 2001—noted in the Introduction,

as well as a substantial increase for Firms 5-8, in marked contrast to the relatively mild

increase in agency-level concentration (in Figure 1). While thousands of agencies remain

independent, almost no large ones do. In other words, at the ownership level (if not at the

organizational level), there has been a “shake out” of large firms, leaving the industry with a

few giant holding companies and then a fringe of much smaller independent firms. Figure 3

also indicates that the holding company consolidation occurred almost entirely after 1981. So

the outstanding question about the industry’s evolution is “what explains the rise of the

holding companies after 1981?”

[insert Figure 3 about here]

Clearly the holding companies are connected to the industry’s conflict norm. The

holding company concept is an attempt to mitigate the conflict constraint by serving

competing clients with “independent” subsidiaries of a single organization—this is the

rationale offered by industry executives for the non-integrated nature of the holding

companies. 3 Subsidiary agencies cannot be organizationally integrated or share substantial

assets, since this would violate the perceived independence demanded by large clients.

However, the conflict norm by itself seems insufficient to explain the persistence of the

holding companies or the historical timing of their emergence. Conceptually, while it is easy

to see that a firm would like to compete for more large clients, that does not mean that joint

ownership of autonomous agencies necessarily adds any economic value, relative to two

independent agencies. Without adding any value, it is then unclear how the holding

companies are able to acquire agencies profitably: i.e., why would they be able to buy agencies

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at a price that does not bid away any potential returns? And if no assets are shared among

the subsidiaries, why do the subsidiaries not eventually spin off to improve incentives and

extract more surplus directly (ala Maurice Saatchi)? Furthermore, conflict has been an issue

throughout the history of the industry, whereas the holding companies are only a recent

phenomenon. If the holding company adds value, why did it not appear and/or flourish

earlier?

An economic theory of the holding companies should identify how the holding

companies add value and also explain the historical timing of their ascendance. However,

several standard product-market-based advantages do not seem to meet this challenge.

Certainly if ad agencies do not exhibit significant scale and scope economies, it is hard to

imagine such advantages accruing to the holding companies. Unsurprisingly, Silk and Berndt

(2003) find this to be the case econometrically, reporting “very slight economies of scale”

and “small scope economies … of one to two percent” for holding companies.

Silk and Berndt (2003) implicitly invoke the “coordination” argument (that agency size

and diversification matches client size and diversification in order to provide coordination),

suggesting that holding companies have emerged to serve ever larger clients with more

geographically and functionally diverse ad campaigns. But this theory has conceptual and

empirical problems. Conceptually, there are two problems with explaining holding

companies through coordination advantages. First, the bulk of holding company scale comes

from owning duplicate large agencies, with redundant geographic and functional scope. Thus,

the holding companies do not have considerably broader scope than any one of their major

subsidiaries. Second, the autonomy of the subsidiaries, which is the essence of the holding

company concept, severely reduces any coordination across subsidiaries. Thus, even if some

of the subsidiaries offered complementary scope, their “independence” would hamper

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coordination. And empirically, Figure 2 indicates that there has been no corresponding

consolidation among clients since 1981 that might have driven the holding company

consolidation.

This lack of an apparent advantage for holding companies is consistent with

interviews with industry participants. Agency executives, consultants, and client managers all

indicated that when clients evaluate an agency’s capabilities (i.e., ability to coordinate), they

focus on the agency, not the size and scope of the agency’s holding company. Instead, these

interviews and the history of the holding companies’ emergence suggest focusing on the

capital market, rather than the product market.

A THEORY OF ADVERTISING HOLDING COMPANIES: FINANCIAL INTERMEDIATION

I propose that the holding companies add value not in the product market but

primarily (though not necessarily exclusively) through financial intermediation. Their size,

their diversification across clients, and their financial expertise—when combined with

advertising industry expertise—mitigate the high transaction costs between outside investors

and ad agency owners. With this advantageous access to capital, they are able to acquire an

agency at a price that is lower than the NPV of the agency’s earnings stream, yet greater than

what the agency would be able to obtain independently. In this theory, the holding

companies play a role similar to that posited for business groups in emerging economies

(Khanna & Palepu, 2000; Khanna & Rivkin, 2001) and for acquisitive conglomerates in the

1960s (Baker, 1992; Hubbard & Palia, 1999; Klein, 2001; Martin & Sayrak, 2003):

intermediary institutions where input markets are highly imperfect. In this sub-section, I first

outline the intermediation opportunity: why agencies need capital yet face significant

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constraints in obtaining it. Then I suggest how the holding company might mitigate those

constraints.

The intermediation opportunity

In Section 2, it was argued that the production of advertising services was not capital

intensive, involving no major capital investments in plant, R&D, or advertising. However, at

some point, agencies still need infusions of capital to provide liquidity and diversification—i.e.,

to “cash out” the agency’s owners, particularly as they seek to retire. Yet private agencies

face serious capital constraints from both internal and external sources, forcing owners to

“leave money on the table.”

The traditional source of capital is internal: employees buy out departing owners. But

internal transfers of ownership often undervalue the shares for two reasons. The difficulty of

valuing private shares has led to the common practice of establishing fixed valuation

benchmarks, often using book value.4 But book value doesn’t capture the significant

intangible sources of agency value. Second, even at book value, internal transfers can be

difficult because employees are typically wealth-constrained and may be highly risk-averse,

since they would be reducing their overall diversification by putting both their human and

financial capital into the firm (Dow & Putterman, 2000).

Outside investors, although well-diversified and not wealth-constrained, would also

undervalue the shares because of serious moral hazard problems. Investors would be

concerned that the value of their investment could be expropriated by the employees who

control the inalienable means of production: i.e., investors cannot own the productive

assets.5 And the main use for the capital, cashing out, is especially problematic since

investors may be paying for the very human capital that is leaving the firm.

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A third source of capital is a larger agency. Another agency has two (potential)

valuation advantages vis-à-vis outside investors. First, it can mitigate the moral hazard costs

because its industry-specific expertise improves monitoring of the acquired operations and

provides a source of “replacement assets,” i.e., the acquiring agency has relatively low search

costs in finding people to replace departing employees.6 Second, another agency may possess

complementary scope, such as a different geographic location or different expertise. Thus,

mergers have been a common feature of the advertising industry throughout the century, as

a mechanism for buyers to expand their service scope and for sellers to cash out. Yet while

an agency may be able to finance relatively small acquisitions with internal funds or debt, the

size and pace of its acquisitions are limited by the acquiror’s own constraints on external

finance.

Thus, while ad agencies, like PSFs generally, are not capital intensive businesses, their

owners still have needs for liquidity and diversification. Yet these needs have traditionally

been underserved, because of constraints on internal and external financing, resulting in

agency owners failing to realize the full value of their ownership stakes. In fact, this under-

served need is particularly great in the professional service context, where most of the firm’s

value stems from intangible assets and hence is severely understated if book value is the

chosen valuation method.

How holding companies intermediate

I hypothesize that the holding companies are able to mitigate the transaction costs of

external finance by providing two things: diversification and financial expertise. First, their sheer

size in itself offers some risk reduction, relative to smaller firms (including large agencies).

Perhaps more importantly, by mitigating client conflict issues the holding companies offer

some diversification across large clients. Even for very large agencies, a few large clients

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often represent a significant share of an agency’s revenue and profits.7 However, if a holding

company can serve several competing large clients or there is a chance that an unsatisfied

large client could still be won by a sibling agency, the risk of losing a significant percentage

of revenue all at once is reduced. A trade association executive suggested that holding

company value came from the ability to “keep clients in the fold, even if they are disaffected

with one agency.” 8

A second source of holding company value seems to come from financial (and

managerial) expertise. Much of this expertise lies in the installation of financial systems and

management practices, which are often absent or very simplistic in many private agencies.

Many observers indicate that private ad agencies are often run in unprofessional or

unsophisticated ways (Bower, 1997; Fendley, 1996; personal interviews; Millman, 1988). Two

case studies of advertising holding companies note that a key intervention at acquired

agencies was the installation of more extensive and sophisticated control systems (Bower,

1997; Collis, 1995). In addition to financial control systems, holding companies are also said

to implement more systematic practices in other functions as well, such as human resources.

These practices may improve the new subsidiary’s earnings stream, making the

acquisition more profitable. This is similar to the argument made regarding conglomerates

(e.g., Baker, 1992). But these practices may also help reduce capital market discounts by

making the operations more secure. Earnings are made more consistent and less volatile.

Managerial systems create more organizational (or firm-specific) capital, making the agency

less dependent on specific individuals.

More professional management may also buy credibility or legitimacy with outside

investors (DiMaggio & Powell, 1991). In addition to management systems, the holding

companies’ financial expertise also includes knowledge of the norms for interacting with the

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capital markets. An industry consultant suggested that “holding companies are about

presenting a face to the financial community” and a case study indicated that “the concept of

WPP was primarily that of a ‘financial brand,’ a bland holding company name to which Wall

Street and the City of London could relate” (Bower, 1997).

The holding companies’ brokerage role between the capital markets on the one hand

and advertising personnel and clients on the other seems to be captured in the difference

between the holding company names and the names of their subsidiary agencies. The

subsidiary agencies retain “people-based” names: e.g., Young & Rubicam, J. Walter

Thompson, Ogilvy & Mather. Clearly this is to preserve the value of the agencies’ brand

names, but also conveys to clients that they are dealing with specific professionals: human

agents who deliver personalized service. By contrast, the holding companies have

institutional names: Interpublic, Omnicom, WPP, Cordiant. These are the names used to

face the capital markets, and connote supra-individual permanence: a machine rather than a

partnership.

This financial intermediation argument is well-illustrated by interviews with the

senior managers of a large, global agency that was recently acquired by a holding company.

This agency had the broad geographic and functional scope needed to serve the largest

multinationals, with offices in some eighty countries and subsidiaries that specialized in a

wide range of marketing communications disciplines. It also was publicly-traded, which

should have provided shareholders with easy opportunities for liquidity and diversification.

In other words, there was seemingly little room for a holding company to add value.

Nonetheless, senior managers indicated that the primary rationale for selling the firm

was to provide shareholders—and in particular the senior managers with large holdings—

with liquidity and diversification. One VP admitted that one of the deal’s primary rationales

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was that it allowed many senior managers to cash out their restricted shares (i.e., providing

liquidity). The CEO repeatedly mentioned “risk reduction” (i.e., providing diversification):

“Why is it an advantage to you to be part of a larger holding company? It’s partly risk reduction. … If you look at [subsidiary 1] and [subsidiary 2] and [subsidiary 3] and all the other parts of [the holding company], one part can be down, but then the other parts can be up, and I think, as an investor, as a shareholder, you’ve diversified your risk.”

In particular, the CEO was concerned about losing their largest client to a holding company

whose subsidiaries also had significant business with the same client. In other words, he was

seeking diversification across large clients, hoping to mitigate the potential loss of that

client.

Interestingly, the CEO also cited benefits in recruiting senior personnel:

“This is a talent business and what it gives you is more access to more talent and the ability to [share executives searches across the company] ... because it is a talent business, it’s a big issue... if i were rating the values of being part of the holding company, that would be very much near the top of it.”

This further links the holding companies to the literatures on business groups (Khanna &

Palepu, 2000; Khanna & Rivkin, 2001) and conglomerates (Baker, 1992), where the entity

substitutes not only for thinly developed capital markets but also for professional labor

markets rife with high transaction costs.

Finally, the CEO dismissed any scale or scope economies as a justification for the

merger, saying: “the cost benefits are uninteresting. ... everyone sells cost synergies when

they do deals. But [in] this industry ... they’re really not that interesting.”

The hypothesis, then, is that the holding companies can continue to make profitable

acquisitions because they realize lower costs of capital (and perhaps larger earnings streams)

than agencies could achieve on their own. Their provision of diversification and financial

expertise generates a lower cost of capital by reducing the extent to which investors discount

their shares for both market risks and moral hazard. In the end, then, the mitigation of client

conflict may be essential to explaining the persistence of holding companies, but not because

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it facilitates growth (which is the reason for their initial formation), rather because it reduces

discounting of share values.

However, as noted earlier, the conflict norm has operated throughout the industry’s

history without spawning holding companies. How might this financial intermediation

hypothesis help explain the historical question of why holding companies did not become

dominant until after 1980?

THE FINANCIAL EVOLUTION OF THE ADVERTISING INDUSTRY

This section argues that the historical timing of the rise of the holding companies is

linked to the evolution of the industry’s access to equity markets, because access to public

equity was critical to the ability to supply the intermediation function. Before 1980, there

were regulatory barriers and perceived transaction costs that limited the presence of outside

equity in the advertising industry. Not until after 1980 could a firm combine financial

expertise and advertising expertise with fully-valued public equity in order to pursue an

acquisition-based strategy. This section recounts the history of these financial and

organizational developments in four stages. First, I recount the experience of the first

holding company, Interpublic, for clues to why the phenomenon did not spread in the early

1960s. Second, I describe the emergence of public ownership in the industry in general, for

clues to why holding companies did not spread in the early 1970s. Third and fourth, I

describe the role played by the U.K. agency Saatchi & Saatchi in attracting public equity and

then catalyzing a merger boom in the late-1980s that resulted in the sudden emergence of

several holding companies.

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Interpublic: a holding company before its time?

Interpublic was formed in 1961 by McCann-Erickson, a large U.S. advertising

agency, as a holding company for the agency and several subsidiaries.9 It was formed to

circumvent the conflict norm to facilitate high growth (Anon, 1963a; Millman, 1988). Upon

its founding, Interpublic began an acquisition spree, buying agencies and marketing firms in

the U.S. and overseas.

However, Interpublic had two weaknesses in the pursuit of its strategy. First, it was

privately-held, as were all agencies until the early 1960s (as is described shortly). This

constrained its ability to finance acquisitions in two ways. Its share price did not incorporate

intangible value and was relatively illiquid, so it was not a highly valued currency.

Accordingly, its largest early acquisitions were purchased in cash and financed by debt. Also,

the firm had to provide liquidity to its shareholders, buying out the shares of retiring or

departing executives—which was also financed with debt. The second weakness was its own

lax management systems. Its CEO was “a consummate ad man but a financial neophyte”

(Millman, 1988) and paid little attention to cost controls.

The combination of high debt and spendthift management prevented Interpublic

from becoming an early adopter of public ownership (Anon, 1964a, 1964c). Worse, the

combination led to a financial crisis in the mid 1960s. When the agency violated its debt

covenants, banks forced the ouster of the CEO in 1967. Its acquisition strategy was curtailed

until it restructured its finances and finally went public in 1971.

The Interpublic experience highlights the importance of access to equity markets as

well as financial expertise in the ability to play the intermediary role. Without being able to

arbitrage the differential between public and private valuations, the holding company was

hard-pressed to pursue large-scale acquisitions profitably.

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The rise and fall of public agencies (1962-1981)

For the first century of the advertising industry’s history, all its firms were privately

held.10 Agencies were not publicly held for two key reasons. The first reason was regulatory:

the industry trade association—the American Association of Advertising Agencies (4As)—

imposed certain ownership restrictions on its members, including a prohibition against

having owners who were not involved in managing the agency, i.e., no outside investors.11

The restrictions existed, in theory, to prevent conflicts of interest that might compromise an

agency’s ability to serve clients fairly, hence were manifestations of classic professional codes

of ethics (Nanda, 2002a, 2002b).12

The second reason was the perceived transaction costs of external finance. As noted

in Section 3.1, advertising was perceived by investors as an unacceptably risky business, with

the lack of alienable assets compounded by a reputation for high levels of turnover among

personnel and clients (King et al., 2003)—as one industry historian writes: “The volatility of

the ad agency business—in which a company fortune’s could quickly sink if it was deserted

by a major account—led analysts and investors to believe that the agencies were not a sound

bet.” (Millman, 1988).

Nonetheless, twenty-one U.S. advertising agencies went public from 1962 to 1973.13

The wave was initiated by a two-year old agency that had not joined the industry association

and was thereby unaffected by the 4A’s ownership restrictions. Soon thereafter, leading

members of the 4As worked to repeal the restrictions and all agencies were free to go public

by 1963 (Anon, 1963b, 1964b). On the investors’ side, the willingness to buy agency equity

despite the perceived risk seems to have been driven simply by speculation in the midst of a

buoyant stock market. As Figure 4 indicates, the industry was not experiencing particularly

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high growth or high profitability in the early 1960s. Figure 5, which shows the number of

advertising IPOs (columns) and total IPOs (line) in the U.S. from 1960 to 2000, shows that

agency IPOs began at the end of one “hot” IPO market (Ritter, 1998) and peaked during an

even hotter IPO market between 1968-1972. The contemporary trade press indicates that

agencies were being solicited to go public by investment bankers eager for untapped growth

industries,14 and that the investment came mostly from speculative investors, with few

institutional holdings (Anon, 1964d).

[insert Figures 4 and 5 about here]

The emergence of publicly-traded agencies in the mid-1960s poses two challenges to

the financial intermediation hypothesis. First, if some agencies gained access to equity

markets in the 1960s and were thus able to play the intermediary role, why did holding

companies (excepting Interpublic) not emerge until the 1980s? Second, if agencies could go

public, why would there be any need for a financial intermediary in the first place? Agency

owners could achieve liquidity on their own, leaving no room for holding companies to add

value.

The answer to both of these questions is that agency stock prices collapsed as the

industry’s IPO wave was ending, following a larger slump in the stock market and national

economy in the early 1970s. As shown in Figure 6, which shows the median price-to-book

and price-to-earnings ratios of large U.S. ad agencies from 1965 to 1990, most agency stocks

traded below their book value by 1974, meaning they were worth less than they would have

been if the agencies were privately-held (hence valued at book value). This eliminated any

potential financing advantage the public agencies might, in theory, enjoy.15 Also, during this

time, six of the public agencies (almost one-third) re-privatized, which contributed to the

- 20 -

industry’s “image problem” among investors (Curran, 1980), whose skepticism about the

industry was renewed.

[insert Figure 6 about here]

As the industry’s growth rates improved greatly in the second half of the 1970s (see

Figure 4), fueled by economic recovery and significant inflation in media prices,16 agency

stock values went back up (see Figure 6). But the real change came in the early 1980s when a

brash UK agency combined advertising expertise, financial expertise, and access to equity

markets to restructure the industry.

Saatchi & Saatchi (1970-1986)

Saatchi & Saatchi (hereafter “S&S”) was founded in London in 1970 by brothers

Charles and Maurice Saatchi. From its birth, S&S was innovative and “deviant”—in the way

it solicited clients, in the creative advertising it produced (Fendley, 1996; Millman, 1988),

and, of most lasting relevance to the industry, in its financial sophistication and

aggressiveness. In 1974, S&S acquired a public listing through a reverse takeover of a

crematorium. By 1979—at only nine years old—it had become the largest agency in the UK,

largely through acquisitions. In 1983, the agency acquired a listing on the NYSE, only the

third British company to do so. And in 1987 it became the first company to be traded on the

London, New York, and Tokyo stock markets (Collis, 1995; Fendley, 1996; Millman, 1988).

Beginning in 1982, S&S entered the U.S. market with several headline-grabbing

acquisitions of unprecedented scale. It debuted with the acquisition of Compton, a top 20

agency more than four times larger than S&S itself. After several more U.S. acquisitions in

the mid-1980s, S&S’s coup de grace came in April 1986, when they acquired the 2nd largest U.S.

- 21 -

agency (and 3rd largest in the world), Ted Bates. Bates was over three times larger than any

previously acquired agency and the price paid was over seven times higher than the previous

high. The Bates acquisition not only vaulted S&S into the position of the world’s largest

advertising organization (only 16 years after its founding!), but has come to be seen as the

watershed transaction in the industry’s transformation.17

These acquisitions also introduced U.S. agencies to S&S’s innovative acquisition

financing practices, two of which are often noted. First, S&S typically struck deals in which

half of the acquisition price was paid over several years and contingent on the target’s

performance over that period (a practice known as an earn-out). Second, while S&S’s

acquisitions were typically in cash, they were not financed with large amounts of debt.

Rather, they issued new equity in the form of “rights issues” (Fendley, 1996; Millman,

1988).18 As well, the agency developed sophisticated internal systems which it imposed

quickly on acquirees (often referred to as being “Saatchified”) (Collis, 1995; Millman, 1988)

and actively courted the investment community (Fendley, 1996; Magnet, 1986; Millman,

1988).

In sum, S&S was using its public listing and financial expertise to acquire other

agencies like never before in the advertising industry. Industry observers generally credit S&S

with playing a key role in increasing capital market interest in the industry (Fendley, 1996;

McEwan, 1986). As Figure 6 shows, agency stock valuations in the U.S. shot up in 1982,

simultaneous with S&S’s first U.S. acquisitions. At the height of S&S’s rise, a Fortune article

profiled the disruptive effect the firm was having on the industry, through its relationship to

the capital markets and its role as a financial intermediary:

“…like all revolutionaries they are in fact helping history. Changing conditions made the worldwide agency possible; admen with financial genius and grandiose corporate ambitions were needed to make it reality. The Saatchis’ success transformed the competitive situation, forcing other multinational agencies to hurry to catch up, completing the revolution. … Though the Saatchis are famous for creative ads, they soared to dominance fueled by a trait for which

- 22 -

they are less well known: financial savvy. … [F]or the acquirees…Saatchi & Saatchi’s ability to raise capital in the stock market goes to the heart of the matter. [One acquiree said] ‘We were looking for a benevolent banker.’” (Magnet, 1986).

The rise of global holding companies (1986-2000)

In making its large acquisitions, S&S faced increasingly difficult client conflict issues

and so ultimately adopted the holding company structure, keeping large subsidiaries relatively

independent. Thus, S&S became the industry’s second global holding company (after

Interpublic). But where Interpublic had little effect on the industry’s structure, the pace of

S&S’s growth and its tapping of equity markets with innovative financial techniques

catalyzed the creation of two other global holding companies.

Simultaneous with Saatchi’s acquisition of Bates, three large U.S. agencies (BBDO,

Doyle Dane Bernbach, and Needham Harper Steers), each hoping to avoid being

marginalized by the unfolding merger wave (Bacon, 1987), combined themselves under a

single holding company christened Omnicom.

Another holding company emerged from the efforts of Martin Sorrell, who was the

finance director at S&S when they launched their international expansion and who is often

credited with much of S&S’s financial expertise (Bower, 1997; Collis, 1995; Fendley, 1996;

Millman, 1988). Sorrell left S&S in 1985 and acquired an existing U.K. company, WPP (a

maker of shopping carts), to use its public listing as an acquisition vehicle. He introduced yet

another “financial innovation” to the industry by launching its first hostile takeovers

(Morgan, 1991), through which he acquired two of the top U.S. agencies, J. Walter

Thompson (1987) and Ogilvy & Mather (1989).

But were these holding companies simply the product of a capital market bubble—a

pyramid scheme or “bootstrap game” (Brealey & Myers, 2003) that added no value, as

- 23 -

suggested by many observers? In fact, S&S fell into a deep financial crisis by 1990 from

which it never really recovered 19—so what makes it any different than the case of

Interpublic in the 1960s? Actually, S&S’s downfall may further illustrate the financial

intermediation hypothesis, as its troubles arguably began when Sorrell left and the brothers

strayed from the financial and organizational practices that took them to the top. They paid

over twice what Sorrell recommend for Bates and paid most of it upfront (rather than in

earn-outs). They increasingly relied on debt instead of equity. And they diversified beyond

their advertising expertise, making a major investment into management consulting and

flirting with the idea of buying a commercial bank. This reiterates the key elements of a

holding company’s feasibility—advertising expertise, financial expertise (and discipline), and

public equity.

Furthermore, S&S’s rivals survived the stock market collapse and industry downturn

of 1990-91 and renewed their aggressive acquisition activity when the product and capital

markets revitalized. In the late 1990s, two French advertising firms also made a number of

large acquisitions to join the remaining three as the leading global holding companies. The

success of these acquisition-driven holding companies fifteen years after the capital market

bubble that spawned them strongly challenges the notion that they are only a pyramid

scheme.

Summary

This section argued that the historical timing of the rise of the advertising holding

companies is consistent with the theory of their role as financial intermediaries. The non-

integrated structure of the holding companies—i.e., the reason that acquired agencies are

kept independent rather than being merged into a single operating company—stems from

the conflict norm. But acquisition-based growth via such a holding company was financially

- 24 -

infeasible in the absence of access to external equity and financial expertise, as illustrated by

the case of Interpublic. The value-added role of financial intermediation was not available

until agencies could access equity markets—at high valuations—after 1981. Saatchi & Saatchi

blazed the trail, combining advertising expertise, financial expertise, and a richly valued stock

to catalyze the industry’s consolidation—and then lost its position when it strayed from

those fundamentals. The creation of the holding companies is linked to a merger wave fueled

by an influx of equity capital in the late 1980s. But their persistence since then comes back to

the intermediation function hypothesized in the previous section, driven by diversification

across large clients and the combination of financial and advertising expertise.

On deviance and cognitive biases

Before concluding, it is interesting to note some behavioral or social aspects of the

industry’s financial evolution. First is the role of “deviants” or “outsiders” in the

introduction of key financial innovations. As noted above, the first agency to go public, for

instance, was a two-year old “creative maverick” (Anon, 1962) that opted not to join the

industry association. Furthermore, many of the early adopters of public ownership stood

apart in some way from the industry’s economic and social norms: they were start-ups,

heavily Jewish, headed by women, or based outside of New York. “Mainstream” agencies—

large, old, New York, WASP-dominated agencies—were slower to go public, even though

they may have been better suited for going public, in terms of both connections to Wall

Street and the need for liquidity.

Similarly, Saatchi & Saatchi, the industry’s main financial innovator, had an

“outsider” reputation along numerous dimensions, starting with the Iraqi Jewish background

of the Saatchi brothers. In addition to their financial “deviance,” they violated norms against

attacking competitors’ products in their clients’ ads and against soliciting other agencies’

- 25 -

existing clients (Fendley, 1996; Millman, 1988). This aspect of the financial evolution of the

industry is akin to Palmer and Barber’s (2001) “social class theory” of conglomerate

acquisitions.

The second interesting element is the role of investor biases. The industry was long

viewed as “unsuitable” for outside investment because of the lack of alienable assets.

However, neither the wave of agency IPOs in the 1960s nor the capital inflows of the 1980s

were associated with any obvious increase in investor protections. Investment into the

industry seems to have been fueled by speculation and investor “exuberance” and by the

growth records of particular agencies. In other words, the revision of investors’ biases

against the industry resulted not from contractual protections that reduced expropriation

risks, but from making speculative bets and experiencing strong returns—from reputational

mechanisms, rather than contractual protections.

Thus, the advertising industry’s structure prior to 1980 may have been supported by

various biases against outside equity. The violation or revision of those norms facilitated a

significant restructuring of the distribution of ownership in the industry. This example

suggests the potential importance of cognitive norms in the organizational structure of an

industry, independent of “objective” or “economic” characteristics.

CONCLUSIONS AND IMPLICATIONS

The evolution of the advertising industry poses interesting puzzles about the nature

of large firms where alienable assets are supposedly few and far between. Property rights

theorists, using a Saatchi & Saatchi anecdote to illustrate their points, predict that firms in

such environments will be “flimsy” and will not be amenable to traditional forms of

corporate governance (Hart, 1995; Rajan & Zingales, 2000). Yet a few publicly-traded

- 26 -

holding companies have emerged to acquire almost half of the global advertising industry,

thereby shifting ownership of ad firms from the professionals who own the inalienable assets

to dispersed investors. What’s more, any attempt to explain these holding companies

through economies of scale and scope must confront the extensive econometric work that

indicates that such economies are limited at best (Silk & Berndt, 1993, 1995, 2003).

This paper analyzes the evolution of the advertising industry in two steps. It

documents the industry’s structure and evolution with data on the 100 largest ad agencies

and holding companies in the world, thereby locating the industry’s consolidation after 1981

and largely in the form of holding companies. Second, drawing on field interviews and

historical research, it proposes that the holding company phenomenon is a financial

intermediation story, rather than a story about product market competitiveness. With their

size, diversification across large clients, and financial expertise, the holding companies may

enjoy advantaged access to external capital. This advantage then facilitates the profitable

acquisition of independent agencies, which face severe discounts from any other financing

source when seeking to provide their owners with liquidity and diversification. This

hypothesis appears consistent with the historical evolution of the holding companies, in that

their emergence was linked to the increase in the industry’s access to external equity markets.

Prior to 1980, the industry’s high cost of capital made the intermediation function infeasible.

Limitations

One of the key limitations of this study is that the phenomenon may be idiosyncratic

to the advertising industry. The conflict norm, for example, may be a relatively unique

constraint that has had a large impact on the industry’s structure. Extending this research to

comparing the evolution of other professional service industries would be a valuable next

- 27 -

step, to assess which aspects of the advertising experience are idiosyncratic and which can be

generalized.

Furthermore, this hypothesis rests on qualitative reasoning and should be tested with

quantitative analyses. For example, the hypothesis implies that holding company stocks

should enjoy higher valuations than stocks of independent agencies, and that stock

valuations should be affected by firm size and by the diversification of the firm’s client base.

Implications

Limitations aside, this analysis has implications for several different literatures. First

and foremost, if the financial intermediation hypothesis is correct, it challenges one of the

key stylized facts about PSFs: that capital is of low value because there are few sources of

sunk investment. This hypothesis suggests that outside equity is potentially important even

in arenas of low capital-intensity, because it functions to intermediate differential risk

preferences and time horizons, not just to provide investment. If the idiosyncratic conflict

norm makes holding companies unique to the advertising industry, we still must ask what

alternative mechanisms have arisen (or will arise) to intermediate in other professional

service contexts, since their high levels of intangible assets create similar liquidity issues.

Second, many theorists have suggested that the professional partnership model

functions to provide optimal employee incentives where human capital the sole source of

value (Dow & Putterman, 2000; Fama & Jensen, 1983; Greenwood & Empson, 2003; Jensen

& Meckling, 1979; Roberts & Van den Steen, 2000). However, this study suggests that one

of the primary features of the professional partnership model—the exclusion of outside

ownership—may have resulted from regulatory barriers and transaction costs (real and

perceived) of external finance, rather than from any employee incentives. Where these

regulations and transaction costs decrease, we are likely to see the emergence of more

- 28 -

publicly-traded professional service firms. Thus, while some scholars suggest that as the

value of human capital increases, corporations will look increasingly like professional service

firms, (Blair & Kochan, 2000; Lowendahl, 1997; Scott, 1998; Teece, 2003), it may be instead

that professional service firms will look increasingly like traditional corporations, because

capital markets have also been evolving to facilitate investment in the face of inalienable

human capital.

Third, this research contributes to the literature on the evolution of industry

structure by highlighting the potential impact of an industry’s relationship to the capital

markets. As is the case in this paper, the economic literature on industry evolution focuses

on explaining industry consolidations or “shakeouts” (Jovanovic & MacDonald, 1994;

Klepper, 1996; Klepper & Simons, 2000; Malerba et al., 2001; Sutton, 1998). However, this

literature also focuses almost exclusively on technological change and R&D investment as

the forces driving industry consolidation. In contrast, this analysis of the advertising industry

suggests that increased access to capital, rather than any product market development, was

the key factor in the transformation of industry structure. In this way, this research connects

to a (largely theoretical) literature at the intersection of finance and industrial organization

that explores the relationship between an industry’s access to capital and its structure (e.g.,

Brander & Lewis, 1986; Jean-Baptiste & Riordan, 2003; Rajan & Zingales, 2003).

Within the industry evolution literature, this research links most interestingly to

Sutton’s recent work. In describing an industry’s transformation from fragmented to

concentrated (Sutton, 1998), Sutton suggests that the industry initially does not support

investment in endogenous sunk costs (such as R&D or advertising). After an exogenous

change to demand or technology makes the industry more amenable to such sunk

investments, however, the industry may remain fragmented until a “high-spending deviant”

- 29 -

violates the existing low investment equilibrium, realizes major share gains, and thus

catalyzes industry consolidation. This seems somewhat analogous to the cases of Interpublic

and Saatchi & Saatchi. Interpublic tried a high investment strategy but without success

because the enabling capital market conditions were not in place. Saatchi & Saatchi’s high-

spending deviation, however, followed (or was coincident with) a favorable shift in the

industry’s access to capital and ended up catalyzing the industry’s massive consolidation in

the mid-1980s. However, as with the rest of the industry evolution literature, Sutton’s

argument rests on the product market impact of sunk investments, while the advertising

industry example seems to be driven largely by mitigation of the perceived agency costs of

external finance.

Fourth, this analysis of the emergence of outside equity in the advertising industry is

related to the literatures on venture capital and private equity (Lerner, 1995) and on business

groups in emerging markets (Khanna & Palepu, 2000; Khanna & Rivkin, 2001), in that they

all analyze organizational arrangements that facilitate the financing of economic activity that

is subject to severe risks of investor expropriation. However, much of this literature focuses

on mechanisms that provide greater investor protection (such as ex-ante contracts or high

levels of monitoring), hence facilitate greater outside investment. By contrast, the evolution

of the ad industry’s access to equity markets, as noted in the previous section, seems to have

been driven more by changes in cognitive biases than by real increases in investor

protections. In this regard, this analysis contributes to an empirical literature that seeks to

assess the relative importance of reputational mechanisms vs. investor protections in

accessing outside investment (Siegel, 2005).

Overall, the counter-intuitive evolution of the advertising industry indicates that

traditional assumptions about professional service firms may not provide a solid basis for

- 30 -

theorizing about organization in a more human capital intensive economy. Clearly more

extensive empirical research on professional service firms is warranted to test the veracity

and representativeness of the Saatchi & Saatchi fable and other such stylized facts about

PSFs.

- 31 -

APPENDIX I: Largest 100 Databases

The lists of the largest 100 advertising firms in the world and in the U.S. were

constructed from the annual “Agency Report” in Advertising Age. A number of adjustments

to the Advertising Age data were required to generate appropriate figures at both the holding

company and agency levels of organization.

First, I describe the basic size measure used. Worldwide revenue figures are used

except when U.S. shares are stipulated. Prior to the mid-1970s, for many agencies the only

size metric reported is agency “billings.” Billings represent the total media expenditures by

an agency’s clients. This translates fairly directly into agency revenue, since agencies were

traditionally compensated through a commission rate of 15% on client billings. However,

the more accurate measure of agency revenue (for purposes of market share calculations and

for purposes of longitudinal comparability) is “gross income,” which is the sum of an

agency’s commissions and additional fees. Billings were converted to gross income figures in

the 1961 and 1971 reports by multiplying by 0.1515, which was the average ratio of billings

to gross income for those agencies for which both billings and gross income were reported

in these periods.

So how were the holding company and agency lists created? The key difference

between the holding company-level and agency-level lists is the treatment of subsidiary

agencies. The holding company-level list includes only organizations that are independently

owned (i.e. own a majority of their own equity), and the revenue numbers for those

organizations include the revenue of their subsidiaries. There is one exception to this rule:

agencies that are owned by non-advertising parents (e.g., by a media company or a non-

advertising conglomerate) are included as independent firms.

The agency-level list adds in distinct agencies that are nonetheless majority-owned by

another advertising organization. Whether a subsidiary is a “distinct agency” to be included

on the top 100 list is merely a function of whether it is listed as a separate organization in the

“Agency Report.” The key adjustment in the creation of the agency-level list is the

subtraction of a subsidiary agency’s revenue from its parent, if the parent is also an operating

agency in its own right.

Of course, these two lists contain many common entries. The holding company-level

list includes, obviously, holding companies that are not on the agency-level list. But since

there are only a handful of holding companies at any given time, most of the firms on this

- 32 -

list are independent agencies, i.e., “integrated” firms without numerous distinct subsidiaries.

The holding company-level list is more accurately labeled the “independent firm” list.

The first step in making these adjustments was to identify the ownership status

(independent/subsidiary) and parent firm of each agency. Because the “Agency Report” did

not always identify the ownership status of agencies and because most advertising directories

and business directories erroneously list many subsidiary agencies as independent firms, this

task ultimately involved Lexis-Nexis-based searches in major newspapers and trade

magazines for articles indicating an acquisition.

The second step entailed calculating the holding company-level and agency-level

revenue figures for those firms which had distinct agency subsidiaries. Because of a change

in the methodology of the “Agency Report” in 1990, the adjustment method was different

before 1990 than after. Before 1990, the “Agency Report” used a “double-dipping” method:

the list of agencies included both parent agencies and subsidiary agencies, and the revenue

figures for the parents included the revenue from the subsidiaries. Hence, the revenue of the

subsidiaries was ultimately listed twice, i.e., it was “double-dipped.” The holding company-

level list simply excludes any subsidiary agencies. For the agency-level list, the revenue of

subsidiary agencies was subtracted from the revenue listed for parent agencies. Also before

1990, holding companies—firms that had no advertising operations of their own but owned

multiple agencies—were not included in the “Agency Report” at all. However, this really

included only one firm, Interpublic. Interpublic was added to the holding company-level list

by adding up the revenue of its subsidiaries.

After 1990, Advertising Age split the annual ranking into three lists: the world’s “top

100” independent advertising organizations (which includes holding companies); the world’s

top 25 “consolidated” agencies (which includes agencies owned by holding companies, but

aggregates those agencies’ own subsidiaries into a total revenue figure); and roughly 500 U.S.

“brands” (which includes both independent and subsidiary agencies, but lists an estimate of

only their U.S. revenue excluding their own distinct subsidiaries). To create the holding

company-level list, the “top 100” list was the obvious starting point. However, this list is

problematic because it includes a significant portion of revenue from firms that engage

exclusively in non-traditional advertising businesses: direct mail, sales promotion, public

relations, marketing consulting, which are collectively referred to as “below the line”

businesses (hereafter “BtL”). These BtL-only firms populate the “top 100” list in two ways:

- 33 -

by the inclusion of independent BtL-only firms on the list; and by the inclusion of subsidiary

BtL-only firms in the revenue figures of the holding companies. While agencies have

engaged in BtL work throughout the 40-year period, BtL-only firms were not included in

previous “Agency Reports.” To make the lists comparable over time, two adjustments were

made. First, independent BtL-only firms were excluded. Second, the revenue figures for the

major holding companies were calculated as only the sum of the revenue figures of their

subsidiary agencies. For example, instead of using Advertising Age’s revenue figure for WPP in

2001, WPP’s revenue was calculated as the sum of the global revenue of its subsidiary

agencies (J. Walter Thompson, Ogilvy & Mather, Young & Rubicam, CommonHealth,

VML, Berlin Cameron, and Mendoza Dillon). The resulting holding company totals are

systematically lower than the total revenue reported by the holding companies. If the top-

line revenue figures were used, though, the concern would be that part of the holding

company-level consolidation estimates would actually stem from the inclusion of market

segments that were not included in earlier concentration calculations. The method used here

is quite conservative and likely understates the increase in concentration over time. Even with

this conservative method, the increase in C4 is still quite stunning.

After excluding the BtL-only firms, the holding company-level list was filled out to

one hundred firms by including the largest organizations from the “brands” list. Since the

“brands” entities include only U.S. revenue, the size of the firms at the bottom of the top

100 list may be understated, to the extent that they have non-U.S. revenue which is excluded

or to the extent that large foreign agencies outside of the “top 100” list are not included.

However, past the 50th ranked firm, international revenue is basically non-existent, so these

omissions are immaterial to the concentration calculations.

The post-1990 agency-level list was easier to create. It, too, began with the “top 100”

list, and excluded both BtL-only companies as well as holding companies. To this list were

added all the “consolidated” agencies. Finally, to the extent needed, the list was filled in with

the largest “brands.” Thus, like the holding company-level list, the size of firms at the

bottom of the list may be slightly understated, but not to any degree that would make a

difference in the overall calculations.

There is one other issue regarding the Advertising Age numbers. Large advertising

firms often have minority equity investments in other agencies. This was particularly true

when agencies began expanding internationally and started with minority investments in

- 34 -

overseas agencies. Advertising Age calculates a firm’s total revenue by including the pro-rated

share of any minority affiliate’s revenue. This is not GAAP procedure, and results in

instances where the Advertising Age figures are larger than those reported in annual reports.

This analysis has not sought to adjust for this method. This likely means that the revenue of

the largest firms is overstated, especially in the middle periods—1971 and 1981—when

minority positions were more prevalent. In terms of results, this would likely dampen any

measured increase in concentration over time, so again this paper’s estimates of

consolidation are conservative. Furthermore, including the revenue of minority affiliates is

consistent with the context of the research question. The basic puzzle is how a single firm

can “own”—i.e. appropriate the returns from—large, broad chunks of advertising business

without any obvious alienable assets. Firm revenue is effectively being used as a proxy for

the scope of returns that the firms is appropriating, so to the extent that the firm is receiving

a fraction of the returns from its minority affiliates, the revenue measure should also reflect

that fraction.

So much for the numerator. The denominator—total global and U.S. advertising

agency revenue—is calculated from Coen’s (2002) estimates of total global and U.S.

advertising spending. Coen’s advertising spending estimates include not only traditional

media (magazines, newspapers, radio, TV) but also direct mail and outdoor advertising, thus

including some (but not all) of the BtL market for all the years. Coen’s numbers represent

advertising dollars spent by clients, so to estimate ad agency revenue, I multiply by 0.1515

(see second paragraph above). This assumes that the bulk of ad agency revenue comes from

a 15% commission on client ad spending.

- 35 -

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Table 1: Industry Participants Interviewed Agency Founders and Executives

Director of Strategy, Holding CompanyEVP, Large Boston AgencyFounder/Art Director, Midsize Boston AgencyFounder/Account Manager, Midsize Boston AgencyFounder, Small Boston AgencyCEO, Large NY AgencyVP Strategy, Large NY AgencyFormer CEO, Large NY AgencyFormer Senior Executive, several NY agenciesFounder/Art Director, several NY agencies

Other Industry ParticipantsDirector, Trade AssociationInvestment BankerConsultant, BostonConsultant, NYMarketing Director, Office Products RetailerMarketing Supervisor, Office Products RetailerIndustry Journalist

- 42 -

Figure 1. U.S. Share of U.S.’s 100 Largest Agencies, 1961-2001

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Firms #1-4 Firms #5-8 Firms #9-20

1961 1971 1981 1991 2001

Notes: Bars show combined market share of firms in size range in given year: e.g., the first bar on the left is the combined market share of the largest four firms in 1961; while the last bar on the right is the combined market share of the firms ranked 9-20 in 2001. Details of calculation of shares are included in Appendix I. Figure 2. Share of Advertising Spending of 100 Largest U.S. Advertisers, 1961-2001.

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Clients #1-4 Clients #5-8 Clients #9-20

1961 1971 1981 1991 2001

Notes: Bars show combined market share of firms in each size rank range in given year (1971 figures not available). Data from Advertising Age’s “100 Leading National Advertisers” in specific years. Client expenditures include both measured media spending and unmeasured spending. Denominators (total U.S. advertising expenditures) are “national” level expenditures estimated in Coen (2002).

- 43 -

Figure 3. Global Share of World’s 100 Largest Independent Advertising Firms (Holding Company level), 1961-2001

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Firms #1-4 Firms #5-8 Firms #9-20

1961 1971 1981 1991 2001

Notes: See Figure 1. Shares are calculated at level of independent firms, not at agency level (see Appendix I).

- 44 -

Figure 4. U.S. Advertising Industry Growth and Profitability, 1952-2001

-5

0

5

10

15

20

52 53 54 55 56 57 58 59 60 61 62 63 63 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Percent

Growth in Advertising $ (Coen)

Average Return on Sales (4A's)

Notes: Solid line represents annual growth rate in total U.S. advertising expenditures, from Coen (2002). Dashed line represesnts the average ratio of net income to revenue for approximately 225 agencies, as reported by the Association of American Advertising Agencies (4As) in Advertising Age annually. Figure 5. Number of U.S. Advertising Agency IPOs and all U.S. IPOs, 1960-2000

1 1 1

2

1 1

2

7

3

1 1 1 1

2 2

1 1

0

2

4

6

8

10

12

14

16

18

20

60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00

AgencyIPOs

0

100

200

300

400

500

600

700

800

900

1000

All IPOs

Agency IPOs

Total U.S. IPOs

Notes: Bars (and left y-axis) represent number of IPOs of U.S. firms whose primary business was traditional media advertising (print, radio, television). Foreign firms and firms specializing in non-traditional media (direct mail, outdoor, etc.) are not included. IPOs were identified through a combination of CRSP, Compustat, Thomson Research, SDC Platinum, and the Business Periodicals Index. Dashed line (and right y-axis) plots the number of total IPOs in the U.S., from Ritter (2004).

- 45 -

Figure 6. Median Price-to-Earnings and Price-to-Book Ratios, Seven Large U.S. Agencies, 1965-1990

0.7 0.50.9

0

2

4

6

8

10

12

14

16

18

65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90

Price to Book

Price to Earnings

Notes: Solid line plots median ratio of stock price to book value for the seven large public U.S. advertising agencies. Dashed line plots median ratio of stock price to net income per share. Data from Compustat.

- 46 -

NOTES 1 Brokering between advertisers and media outlets was the industry’s original function at its

birth in the mid-19th century. During the industry’s rapid growth from the 1880s through

the 1920s, which accompanied the rise of mass produced goods and mass circulation

periodicals, agencies switched from being agents of the media to agents of the advertisers

and began to provide advertisement design services (Pope, 1983). The original brokerage

function accounts for the traditional way in which agencies earned revenue: through a

commission (usually 15%) on client media expenditures, rather than via hourly fees for

labor provided. Despite its seeming obsolescence early in the 20th century, only in the last

two decades has the commission system has been largely replaced by fee-based

compensation.

2 The term “conflict” comes from “conflict of interest,” and nominally stems from concerns

that agencies might leak strategic information between competing clients. This norm is

not a formal prohibition instituted by the advertising agencies (e.g., through their industry

association), but rather is enforced by clients themselves, who will end a relationship with

an agency that serves a competitor.

3 To be sure, the holding company concept has not eliminated the conflicts. Early on there

was much uncertainty about whether clients would accept the claim of sibling

independence and holding companies lost key clients that would not accept the idea.

Over time, many clients have acquiesced to the idea, but some large clients still refuse to

allow holding-company-level conflict. One agency executive indicated that the stringency

of the norm varies by industry. Recently, holding companies have been developing

centralized relationships with key clients, contradicting the original rationale. Thus, the

extent to which the holding company can serve competing clients has been evolving over

- 47 -

time. In the end, it is fair to say that the holding company allows servicing of competing

clients to a greater extent than possible at a single agency.

4 The use of a fixed valuation benchmark may be attributed to the desire to avoid costly

haggling between two monopolists (the buyer and the seller of the shares) (Dow, 1998).

5 Debt is easier to justify, as it is not based on ownership of inalienable assets. Not

surprisingly, then, the investment needs of large private agencies were typically debt-

financed. However, even debt financing faces significant limitations, as lenders’ ultimate

recourse is still based on repossessing the minimal alienable assets of the firm.

6 The importance of advertising-specific expertise in monitoring an ad agency is consistent

with the fact that there are very few successful examples of non-advertising firms owning

ad agencies. In each instance (in the US) where a firm from another industry acquired an

ad agency, the agency either withered or was ultimately spun-off again. The specificity of

advertising “capabilities” is also the reason that clients do not produce advertising in-

house (with important exceptions—see Horsky (2002)).

7 For even the largest agencies, the largest client usually represents from 5% to 15% of total

revenue and the largest ten clients represent 30% to 40% of total revenue (Curran, 1980).

8 Interview: Director, Trade Association, December 2001.

9 This section draws primarily on Millman (1988), unless otherwise noted.

10 One agency actually went public as early as 1929 (Albert Frank–Guenther Law), in order

to raise money to pay off the mortgage on its office building, but it re-privatized soon

thereafter.

11 Since the prohibitions were self-imposed by the industry association and the industry

association could not prohibit non-members from practicing advertising, the prohibitions

might better be labeled “quasi-regulatory” as there was no involvement by the state.

- 48 -

12 Similar prohibitions remain in place in the legal and accounting professions and were in

place until 1971 in the brokerage/investment banking industry.

13 U.K. agencies also began going public in the early 1960s. In fact, a U.K. agency was the

first to IPO in 1961. However, this discussion of the early IPOs focuses on the U.S.

industry, only bringing in the U.K. industry as it began to have an impact on the U.S.

industry in the early 1980s.

14 Reports include: “Stock underwriters reportedly have been stepping up their activities in

the agency field, trying to sell the agencies on the advantages of public offerings.” (Anon,

1963c).

15 This also explains why Interpublic, which finally went public in 1971, could still not

pursue a pace of acquisition that led to a diffusion of the holding company concept.

16 Since agencies were compensated as a percentage of their clients’ media expenditures,

rising media prices increased agency unit prices without any associated cost increase.

17 Particularly shocking to the industry was the $100 million netted by the head of Bates,

Bob Jacoby.

18 Issuances of additional equity (seasoned offerings) are relatively rare in the U.S. capital

markets, supposedly because they signal that management believes the shares are over-

valued. Why a similar transaction was more palatable on the U.K. capital markets in the

1980s is not clear.

19 S&S’s psuedo-demise: On the verge of bankrupcty, S&S brought in a new CEO in 1991,

who restructured the company. As the company recovered, the brothers tried to reassert

control, leading to the conflict between Maurice Saatchi and institutional shareholders in

1995 noted in Hart (1995) and Rajan and Zingales (2000). Ultimately, the S&S holding

company was renamed Cordiant, and broken up by spinning off the eponymous agency

- 49 -

(Saatchi & Saatchi) in an IPO in 1997, while retaining the Bates agency. Then Saatchi &

Saatchi, the agency, was acquired by a French holding company in 2000, while Cordiant,

again near bankruptcy, was acquired by WPP in 2003.

- 50 -