Special report | Driving forces

Why giants thrive

The power of technology, globalisation and regulation

ACROSS NORTHERN CALIFORNIA the world’s best-known tech companies are engaged in a construction contest. Facebook got off to an early start with a building of 430,000 square feet (40,000 square metres) that looks like a giant warehouse. It is said to be the largest open-plan office building in the world. Google is hard at work on a new headquarters to replace its Googleplex: a collection of movable glass buildings that can expand or contract as business requires. Samsung and Uber, too, are in construction mode. But the most ambitious builder is Apple, which is spending $5 billion on something that looks like a giant spaceship.

Silicon Valley is a very different place from what it was in the 1990s. Back then it was seen as the breeding ground of a new kind of capitalism—open-ended and freewheeling—and a new kind of business organisation—small, nimble and fluid. Companies popped up to solve specific problems and then disappeared. Nomadic professionals hopped from one company to another, knowing that their value lay in their skills rather than their willingness to wear the company collar. Today the valley has been thoroughly corporatised: a handful of winner-takes-most companies have taken over the world’s most vibrant innovation centre, while the region’s (admittedly numerous) startups compete to provide the big league with services or, if they are lucky, with their next acquisition.

Most of the new tech firms are “platforms” that connect different groups of people

Tech aristocracy

The most successful tech companies have achieved massive scale in just a couple of decades. Google processes 4 billion searches a day. The number of people who go on Facebook every month is much larger than the population of China. These companies have translated vast scale into market dominance and soaring revenues. The infrastructure of the information economy is increasingly controlled by a handful of companies: Amazon has almost one-third of the market for cloud computing, and its cloud-services division has grown by more than half over the past year. The world’s three most valuable companies at present are all tech companies, and Amazon and Facebook come in at number six and seven (see chart).

In the industrial era companies used economies of scale to become giants: the more a steel company could produce, the more it could cut its unit costs, driving its smaller competitors to the wall, and the more money it had to invest in research, marketing and distribution. The same applied to any other physical product. Tech companies have reinvented this principle for the virtual age by shifting their attention from the supply side (production efficiencies) to the demand side (network effects). Just as the old industrial giants used technological innovations to reduce their costs, the new tech giants use technological innovations to expand their networks.

Powerful connections

Network effects have always been powerful engines of growth: not only is success self-reinforcing but it follows the law of increasing returns. Some network companies even pay people to become customers in order to achieve scale. And those effects become even more powerful if networks connect with each other to produce multi-sided versions. Most of the new tech firms are “platforms” that connect different groups of people and allow them to engage in mutually beneficial exchanges. Older tech companies too are putting increasing emphasis on the platform side of their business. Everyone wants to sit at the heart of a web of connected users and devices that are constantly opening up further opportunities for growth.

In some ways these tech giants look not so much like overgrown startups but more like traditional corporations. The open-plan offices and informal dress codes are still there, but their spirit is changing. They are investing more in traditional corporate functions such as sales and branding. This corporatisation is one reason for the companies’ success. Startups are increasingly willing to sell themselves to established companies, which can provide everything from legal services to quality control. Whereas most startups are happy to get things right 90% of the time, customers demand perfect products.

The most powerful force behind the rise of the new giants is technology. But two other forces are pushing in the same direction: globalisation and regulation.

The biggest beneficiaries from the liberalisation of the global economy from 1980 onwards have been large multinational companies. An annual list of the world’s top multinationals produced by the United Nations Conference on Trade and Development (UNCTAD) shows that, judged by measures such as sales and employment, such companies have all become substantially bigger since the mid-1990s. They have also become more and more complex. UNCTAD points out that the top 100 multinationals have an average of 20 holding companies each, often domiciled in low-tax jurisdictions, and more than 500 affiliates, operating in more than 50 countries.

Big companies have reaped enormous efficiencies by creating supply chains that stretch around the world and involve hundreds of partners, ranging from wholly owned subsidiaries to outside contractors. Companies are chopping their businesses into ever smaller chunks and placing those chunks in the most cost-effective locations. They are also forming ever more complicated alliances. Pankaj Ghemawat, of the Stern School of Business at New York University and the IESE Business School at Navarra, Spain, calculates that America’s top 1,000 public companies now derive 40% of their revenue from alliances, compared with just 1% in 1980.

Multinationals are increasingly focusing on building up knowledge networks as well as production networks. Strategy&, the consulting arm of PwC, an accountancy giant, produces an annual survey of the world’s 1,000 most innovative companies. It found that last year those that deployed 60% or more of their R&D spending abroad enjoyed significantly higher operating margins and return on assets, as well as faster growth in operating income, than their more domestically oriented competitors. Global companies can buy more innovation for their money by doing their R&D in cheaper places. They can also tap into local innovation resources. General Electric develops more than a quarter of its new health-care products in India to take advantage of the country’s frugal innovation. Its revenues outside America have risen from $4.8 billion in 1980 to $65 billion in 2015.

Such companies are starting to be challenged by non-Western competitors. Fortune magazine’s annual list of the world’s 500 biggest companies now features 156 emerging-market firms, compared with 18 in 1995. McKinsey predicts that by 2025 some 45% of the Fortune Global 500 will be based in emerging economies, which are now producing world-class companies with huge domestic markets and a determination to invest in innovation. China’s Tencent rolled out its mobile text and messaging service, WeChat, to 700m customers in just a few years. At China’s Huawei, which makes networking and telecommunications equipment, half the staff of 150,000 works in the research department. If Western companies are to survive against such competition, they have to become even bigger and more innovative.

The growth in regulation has also played into the hands of powerful incumbents. The collapse of Enron in 2001 arguably marked the end of the age of deregulation, which began in the late 1970s, and the beginning of re-regulation. The financial crisis of 2008 served to reinforce that trend. The 2002 Sarbanes-Oxley legislation that followed Enron’s demise the previous year reshaped general corporate governance; the 2010 Affordable Care act re-engineered the health-care industry, which accounts for nearly a fifth of the American economy; and in the same year the Dodd-Frank act rejigged the financial-services industry.

Regulatory bodies have got bigger. Between 1995 and 2016 the budget of America’s Securities and Exchange Commission increased from $300m to $1.6 billion. They have also become much more active. America’s Department of Justice has used the Foreign Corrupt Practices act of 1977 to challenge companies that have engaged in questionable behaviour abroad. The average cost of a resolution under this act rose from $7.2m in 2005 to $157m in 2014.

Regulation inevitably imposes a disproportionate burden on smaller companies because compliance has a high fixed cost. Nicole and Mark Crain, of Lafayette College, calculate that the cost per employee of federal regulatory compliance is $10,585 for businesses with 19 or fewer employees but only $7,755 for companies with 500 or more. Younger companies also suffer more from regulation because they have less experience of dealing with it. Sarbanes-Oxley imposed a particularly heavy burden on smaller public companies. The share of non-executive directors’ pay at smaller firms increased from $5.91 out of every $1,000 in sales before the legislation to $9.76 afterwards. The JOBS act of 2012 exempted small businesses from some of the more onerous requirements of the legislation, but the number of startups and IPOs in America remains at disappointingly low levels.

Too much to read

The complexity of the American system also serves to penalise small firms. The country’s tax code runs to more than 3.4m words. The Dodd-Frank bill was 2,319 pages long. Big organisations can afford to employ experts who can work their way through these mountains of legislation; indeed, Dodd-Frank was quickly dubbed the “Lawyers’ and Consultants’ Full-Employment act”. General Electric has 900 people working in its tax division. In 2010 it paid hardly any tax. Smaller companies have to spend money on outside lawyers and constantly worry about falling foul of one of the Inland Revenue Service’s often contradictory rules.

Both Sarbanes-Oxley and Dodd-Frank set the tone for legislation in Britain and mainland Europe. China has also become more zealous about regulation, partly in order to pursue nationalist and political goals and partly because of worries about conflicts of interest. But different regions have adopted different approaches to regulation, exacerbating the problem of complexity. As a result, in many markets all but the most sophisticated companies can find it impossible to do business.

An additional problem that companies have to face today is disappointing economic growth, particularly in the West, at a time of widespread technological disruption. This paradox is easier for big companies to deal with. Martin Reeves, of BCG, a consultancy, argues that such companies are good at “buffering”. They have enough spare resources to absorb external shocks or ride out temporary downturns, and they can move operations from one part of the world to another if the political climate turns against them. Mr Reeves points out that the mortality rate for all American listed companies over a five-year period is as high as 36%, but for companies worth more than $1 billion it is only half that.

Slow growth also plays into the hands of incumbents. Joseph Gruber and Steven Kamin, two economists at the Federal Reserve, find that big companies are increasingly saving more than they spend. Apple, for instance, holds about a quarter of its market capitalisation in cash. These huge cash piles allow leading companies to consolidate their position by buying startups and hoovering up the most talented employees.

The superstar companies, then, seem to have all the advantages. But two arguments are being advanced to suggest that their success may not last. One is that the forces speeding up creation, which currently work in their favour, could also speed up destruction. The other, more fundamental one is that these companies are merely holdouts against a general trend towards a more fluid economy. The next article will consider these objections.

This article appeared in the Special report section of the print edition under the headline "Why giants thrive"

In the shadow of giants

From the September 17th 2016 edition

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