Can't stand the carapace: if you thought the concept of the shell company was a thing of the 20th century, think again. Malcolm Howard explains why this destructive phenomenon could be making a comeback.

I remember, as if it were yesterday, a lecture given on shell companies--and I'm going back 30 years to a time when I was grappling with my management accounting exams. The concept was simple enough, but those perpetrating such schemes did seem to be outrageously ruthless. The idea was that unscrupulous people would take over a well-managed firm that wasn't generating much growth. The reason given for the takeover was that a more dynamic management style was required, since the incumbents had no entrepreneurial flair.

Once the firm was acquired, all spending on capital items and R&D would be stopped and marketing and admin costs would be cut to the bone. All staff aged over 50 would be made redundant, thereby reducing the firm's pension liabilities. Assuming the scheme was salary-related, any surplus in the pension fund would be transferred to the company. In the short term, momentum in the system would keep the orders flowing and, with increased profits through cost-cutting, standard accounting measures such as return on capital employed (ROCE) would show spectacular performance gains. Given such improvements, it was a simple matter to sell the firm on at a favourable price/earnings ratio. The new owners would find a business in disarray, with demoralised staff, declining orders and worn-out equipment. They had bought a shell and were about to lose a fortune.

Time moves on, and we are in a different world with a different set of challenges. It has been argued that companies in the 20th century were able to make good profits only because they could form cartels and customers paid over the odds because they were ignorant about market conditions. Where competition put pressure on margins, companies would try to improve profitability through tight (but objective) cost control. But the internet has revolutionised the way that businesses must be managed, since customers now know far more than they did. Gary Hamel argues in his book Leading the Revolution (Harvard Business School Press, 2000) that directors must strive to meet the ever-increasing expectations of shareholders. Against a background of falling margins, how do they squeeze more growth out of the current business model or drive costs down further after years of downsizing? He suggests that directors have tried to unlock shareholder wealth through financial moves such as:

* spinning off companies that command a significantly higher price/earnings ratio than the parent company;

* dumping inflexible and expensive capital assets on to someone else through outsourcing arrangements;

* effecting mega-mergers to cut out another layer of cost.

* initiating share buy back policies.

There is no evidence to show that any of these strategies are sustainable in the long term. Firms that sell off their assets suddenly find the cupboard bare. Studies have found that the benefits of mega-mergers are illusionary, because the integration costs cancel out the savings of consolidation. And directors who have proposed share buy backs are admitting that they have run out of ideas. Leading the Revolution suggests that directors must become "gray-haired revolutionaries" and give their companies the following characteristics:

* a passion to make markets of all kind efficient;

* abroad definition of business boundaries;

* a vibrant internal and open market for talent;

* fluid organisational boundaries.

Unfortunately, it cites Enron as a key example of such a company. In hindsight we know that Enron's only real innovation was in hiding its liabilities. But, as the updated edition of Hamel's book points out, there's nothing wrong with innovation. He writes: "Enron's mistake wasn't that it innovated, but that it tried to be as innovative with its balance sheet as it had been with its core business--that and the fact that it rushed pell-mell over the line that separates ambition from hubris Y

Many people realise that innovation will be the key to success in the 21st century. People and intellectual property will become more important than tangible assets. But a vital question must be: how do you fund and manage innovation? After all, innovation is risky and is sometimes seen as the preserve of the venture capitalist or private equity provider.

Following the logic that tangible assets will become less important in the knowledge economy, the risk is that firms will fund innovation by selling these assets and leasing them back. The advantages of such a strategy are that a sudden injection of cash will make the balance sheet look good and, with declining assets, ROCE will increase to levels well above the cost of capital. In some eases, the real picture of falling margins and effective returns below the cost of capital will be hidden. But it's a high-risk strategy. In addition to the problem of having nothing left to sell, the company can follow such a path only if the contracts it signs offer little protection, as any attempt to control the asset being sold will initiate SSAP21, whereby it will become a financial lease--an asset to be shown in the balance sheet as well as the lease liability--rather than an operating lease.

The danger is, of course, that desperate directors will accept this risk on the basis of taking the pleasure now, safe in the knowledge that they will have moved on before the pain arrives. We may be heading for another version of shell company syndrome.

Malcolm Howard FCMA is lecturer in financial management at the University of Surrey