THE BEAR'S LAIR Capitalism without leeches
By Martin Hutchinson
Over the past 50 years, the United States and most other wealthy economies have
moved to a system of managerial capitalism in which resources are controlled
not by the owners of those resources but by a cadre of professional management
that leeches more and more returns out of the system.
No viable economic theory suggests that a system of capitalism in which
capital's owners do not control its use is likely to prove effective in
creating or allocating resources. We had thus better start thinking about ways
in which this trend could be reversed, and the control of capital tied more
securely to its ownership.
I have discussed in a previous column the reasons for the
development of managerial capitalism, how shareholdings migrated over the
quarter-century after 1950 from primarily individual, often related to the
original corporate founders, to primarily institutional, in pension funds,
endowments and insurance companies. I have also discussed how tax changes, in
particular the huge increases in estate tax after 1932, over time abetted this
process and how their reversal might to some extent reverse it.
In this column I would like to consider whether, rather than attempting to
reverse-engineer the social changes of the postwar period, we might through
adept design of securities achieve much of the same effect, even while
shareholdings remained primarily institutional.
Currently, the great majority of companies' equity capital comes in the form of
common stock, the holders of which collectively control the company. Fifty
years ago, there was a significant volume of preferred stock issued, which
generally had votes in certain circumstances, but common stockholders have more
recently been in full control of the vast majority of non-bankrupt companies.
Since common stock is also the most widely traded security in most companies,
its holders, if dissatisfied with management, have always had the option of
selling their stock and investing elsewhere. With institutional shareholders
predominating, this has led to a concentration of voting power in favor of
company management, since it is cheaper and much less dangerous to a fund
manager's career to sell the fund's shares than to start a shareholders'
revolt.
With the major institutional shareholders favoring management, the chances of a
shareholder revolt are slim and management becomes correspondingly entrenched,
using consultants to increase its annual take, gambling in the derivatives
market, fiddling the accounts and empire-building at will.
If we were still in 1970, we would have little chance of solving this problem,
but then in 1970, we didn't have the problem to anything near the same extent.
Fortunately, modern finance has given us new techniques as well as new
problems, in particular the ability to design securities for any bizarre
cashflow pattern and governance outcome we want. This ability can be used for
good as well as evil, to design a new type of security that removes the
misaligned incentives of managerial capitalism.
The problem is the institutional investor's ability to sell the shares. If the
institution was stuck with the investment, it would be forced to participate
actively in corporate governance, ensuring that management stayed under control
and didn't overpay itself.
For most private investors and for some institutions such as banks and mutual
funds, the ability to sell the shares is crucial because those institutions
need liquidity to meet redemptions of deposits or fund shares. However, for
other institutions, in particular for the large college endowments, life
insurance companies and pension funds, superior long-term investment
performance is far more important than liquidity. That's why many college
endowments now follow the "Yale Model" of investment, in which they buy
timberland, private equity and hedge funds in order to diversify from the stock
market and (they hope) achieve superior returns. The result of this
diversification is mostly the payment of huge management fees to shysters, but
the principle of sacrificing liquidity to long-term return is surely correct.
Any security that is designed to improve corporate governance must thus be
non-transferable. In that way, the institution holding it will not have the
possibility of selling the shares if it doesn't like management's policies, but
will be forced to vote in a way that maximizes the return on its investment. I
propose that companies wishing to improve their governance issue "founders'
shares", with the following characteristics:
They are completely
non-transferable (this must be locked up tight
legally so some fast-buck takeover artist can't
find a way to unlock it).
They convert to common
stock after 50 years.
For the first 45 years of
their life, they get an additional 1% per annum
dividend above whatever is paid on the common,
payable in common at the average price of the
year/quarter.
They have all other rights of the common, as to voting and so forth.
Founders' shares should probably be issued for around 20% to 40% of the
company's capitalization, in order to give their holders a substantial and in
most circumstances controlling influence on the company's direction, while
preserving a sufficient volume of ordinary shares to maintain their liquidity
and the company's ability to raise equity capital. Their buyers should
primarily be pension funds and endowments, although in some circumstances they
might be offered to individual buyers, with a strict provision as to transfer
on death but not otherwise.
Holders of founders' shares would receive an additional annual return, to
compensate them for the lack of liquidity. For institutions with long enough
time horizons, that compensation should be sufficient incentive to purchase
them. Such holders would be motivated solely to maximize the long-term value of
the company and would oppose all strategies that increased the share price
short-term while depressing the ultimate value.
They would approve acquisitions only if they were clearly in the long-term
strategic interest of the company, rejecting such deals as Prudential/AIA or
Kraft/Cadbury that muddied the company's strategic focus, increased its risk
and diluted shareholders. They would object to management's self-enrichment
schemes and excessive stock option grants, and would be forced to oppose them
through their votes, since they would not have the option of selling their
shares. They would reject excessive leverage, since that would increase the
chance of the company going bankrupt before their long-term value was unlocked.
In other words, holders of founders' shares would behave in the same way as an
economically rational strategic shareholder in the company. By doing so, they
would restore rationality to the company's operations and reduce bloated costs
in its management. That in turn would make the company more competitive against
its domestic and international rivals. Research and development would be
adequately funded, regardless of the short-term hit to earnings, because they
would offer the best avenue to increase the company's long-term value. Thus you
would once again see the equivalents of Bell Labs in the 1940s and Xerox PARC
in the 1970s (although one hopes without the latter institution's total
disregard of commercial realities).
Acquisitions would only be undertaken if they offered long-term strategic
benefits. Product quality would not be sacrificed because its sacrifice would
provide only short-term benefits at the expense of long-term value.
With institutional shareholders taking control of the companies in which they
invest, and forcing them to act in those companies' long-term interests, the
incentives in capitalism would be realigned along lines that actually made the
system work to create wealth for all. Without such a realignment, large
corporations will remain primarily wealth-destroying entities, providing rents
for their top management but reducing the welfare of society as a whole, as
they pursue short-term strategies that destroy long-term value.
The Kraft takeover of Cadbury has destroyed an iconic British company that had
existed for over 200 years and was family-run until 2000. Tempting though it
was to urge the British government to intervene and stop the takeover, that
would not have been the appropriate response. Such an action would merely have
handed control over to government, a proven destroyer of value. Instead, the
takeover should have been stopped at the Kraft end, by shareholders' resolving
to oust the Kraft management that was engaging in such value-destroying empire
building (and if the corporate statutes allowed management to proceed without
shareholder approval, then management should have been removed at the first
opportunity and the statutes changed). Warren Buffett, holding 9% of Kraft
shares, attempted to stop the Cadbury takeover; by issuing founders' shares, we
will lead their holders to vote like Buffett and put a stop to such
transactions.
Other reforms will be needed to transform capitalism back into a system that
creates value. In particular, 15 years of sloppily over-expansionary monetary
policy need to be reversed, and the inevitable economic costs in terms of
bankruptcies borne that will come with that reversal. However, only when
founders' shares or some equivalent instrument are introduced into the
financiers' arsenal will incentives be properly realigned so that managers are
forced to manage in the long-term interests of shareholders, thus ensuring that
research is adequately funded, takeovers do not threaten the existence of value
producing operations and product quality is not compromised.
The final question to be answered is whether existing market participants have
enough incentive to organize founders' shares issues. For existing
shareholders, the dilution of value through founders shares' additional
dividends is significant but should be more than counteracted even in the
medium term by better and cheaper management.
For management, the chance of huge wealth through empire building and stock
options is lost, but so also, almost completely, is the chance of job loss
through takeover (because founders' share holders will almost always vote
against such a takeover), while the chance of corporate bankruptcy is greatly
reduced.
For employees, the quality of existence is enormously improved, as the
company's activities are refocused on its core operations and innovation in its
products is increased, while management's distractions are removed. Needless to
say, each company that stops producing bonanzas for management and job losses
or bankruptcy for everybody else will greatly improve the long-term wealth of
the population as a whole.
The incentives thus exist. All that is needed is a pioneer of the new
shareholding structure.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2010 David W Tice & Associates.)
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