Shareholder dispersion raises two related issues – the possible emergence of a control premium and how to protect minority shareholders from collusion between managers and controlling shareholders.
The growing size of firms requires an ever growing dispersion of shareholders and it becomes impossible or risky for a single investor to control 50% +1 of the votes. For instance, in 2015, the largest strategic shareholder (Mitchell’s Michael Kent) in the smallest cap constituent of the S&P 100 index - Devon Energy Corp – owned only 5.07% of the company, less than the 5.46% owned by The Vanguard Group which caters for retail investors. Moreover, the top 10 investors owned jointly less than 32%, while overseas investors from 30 different countries owned 28%.
So, since individual shareholders or groups of controlling shareholders often own less than 50% of the votes, it is normal that such control might be challenged by other investors, thus creating a market for company control. Of course, this requires the existence of an advantage in controlling a company sufficiently large to justify a so-called control premium.
Why should there be any advantage in being part of the control group if trading on insider information is forbidden and management has to treat all shareholders fairly? Finance literature usually explains such interest in terms of governance to discipline the incumbent management more efficiently than through internal control systems.
The assumption underlying such reasoning is that the influence it gives to controlling shareholders in terms of nominating and compensating managers following policies aligned to their interest is offset by a strong discipline preventing managers and controlling shareholders from engaging in tunneling and abuse of non-controlling shareholders.
Yet, even in large markets, like the USA where it is possible to have a lively takeover market, most of the takeover deals are driven by short term financial profits secured through buyout and arbitrage strategies, often at odds with the interest of long term investors. Moreover, even where the judiciary can be relied upon to prevent corporate raiders from expropriating the target’s resources there are still circumstances when some categories of investors can collude with management.
Elsewhere, Mendes (2011), I examined why trade investors may collude with managers to vote for star-like compensation, lowering the return to other investors which lack any self-interest market mechanism to prevent such predatory behavior. In the case of trade investors the materiality and scope for collusion depends on the possibilities to switch suppliers, their relative size and the greed of management. So, the question now is to discuss if it is possible to correct such inefficiency through regulation.
The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights or a combination of both. The first could be easily defined but it can be easily evaded. In particular, for suppliers of financial services, such limits could be easily circumvented by investing indirectly through investment funds managed by them.
Limiting the voting rights of trade investors who are major suppliers is probably a better solution. It does not disrupt arms-length trading relations and it is easily enforced. The only debatable issues would be about the classification of trade investor and the voting restrictions. Beyond the traditional restrictions on voting in related-party transactions, restrictions should cover voting for the election of management and their remuneration, but they could extend to voting in the governance and auditing committees.
Nevertheless, regulation always has its own costs, which cannot be disregarded lightly. In particular, discouraging trade investors may have its costs in terms of business intelligence and synergies.
Still, overall, I believe that easing takeover regulations and limiting the voting rights of trade investors are market perfecting policies, contributing to true market capitalism and the protection of minority shareholders.
Showing posts with label collusion. Show all posts
Showing posts with label collusion. Show all posts
Wednesday, 2 December 2015
Monday, 13 October 2014
Free Markets and Competition
Generally speaking, a free market is a contestable market with free entry. That is, a market where buyers and sellers are free to agree their exchanges without any undue interference on demand and supply.
To understand the importance of free entry let us imagine a remote small island community with a single store. Its population is not enough to sustain two stores and as expected the existing store is a natural monopoly. If one of the inhabitants decides to challenge the incumbent monopolist and opens a new store both will run their stores at a loss until one of them eventually is ruined and gives up.
While the two stores remain competing the islanders benefit from greater supply at a lower price, but once the monopoly is re-established they face reduced supply and higher prices so that the surviving store can recover the losses incurred while competing with the other store. Meanwhile, during the competitive period the two store owners engaged in both fair and unfair tactics to gain or keep market share through better customer service, credit terms, product quality, etc. Some of these sales tactics are considered beneficial while others disrupt the traditional rules of civility and trust in the community. Therefore, the islanders’ ruler received many requests to stop them or to let them fight to the end. Which are his options?
He can uphold the laisser-faire principle of no interference to ensure an absolute right to free entry. Alternatively, he may introduce a licensing system to grant the monopoly on a temporary or permanent basis. Both options could be improved to retain the benefits of competition and minimize its costs. For instance, he could ban unfair sales tactics or he could auction periodically the store license. These two options should be carefully assessed to determine which would be the most efficient in a Pareto sense. That is, which would allow competition to generate greater benefits.
This example is not a simple curiosity in remote societies. Indeed, we find many similar situations in developed countries. For instance, licensing is very common in public transport, pharmacies, funerary services, roads and other infrastructures, healthcare, telecommunications, etc. And, such licensing while often done under the guise of consumer protection is in fact used to regulate or limit competition.
In fact, free markets are only a foundation of capitalism as long as they contribute to enhance fair competition, that is to create competitive markets where prices are established in accordance with supply and demand.
The simplest form of a competitive market is a market without entry barriers and where there are many suppliers and buyers so that all parties are price-takers. But, this is not always required. For instance, Stanley Jevons (1871) one of the founders of the marginal utility theory of value, considered that a market could be made of only two counterparties.
Although one may idealize market structures that create a system of perfect competition, capitalism does not need such a stringent form of competition. Some imperfections or regulations are tolerable or even desirable to achieve what Churchill (1909) called the need for competition upward but not downward (e.g. competition that could drive labor into slavery or tax rates to zero).
Such departures from an idealized world of perfect competition may be more or less extensive depending on the nature of the market, e.g. largest in labor markets than in capital or in goods and services markets. Even among the latest one must distinguish between markets with prohibitive carrying costs (e.g. fish markets) and speculative markets where carrying costs are negligible. The second factor to bear in mind is whether the so-called market failures and divergences between private and social optimization are significant and susceptible of correction without secondary damages.
In modern capitalism the most relevant issue is whether monopolistic and oligopolistic markets still can be considered competitive. For instance, does the fact that the Coca-cola and Pepsico share of the soft drinks market has risen from about 50% in the 1960s to the current level of around 70% means that such market is no longer considered as competitive? Of course not, because there is no entry barriers in such market and in fact there are many small producers competing with these two giant firms. However, if their dominance had been achieved or preserved through licensing or any other form of government favoritism then we should not consider such market as competitive.
Currently, there is a market – the market for corporate control - whose freedom is essential to preserve because of the growing separation between ownership and control. In most big firms the degree of capital dispersion is sufficiently large to facilitate collusion between managers and a small group of shareholders who introduce many obstacles (e.g. poison pills) to prevent others from challenging their power within the firm and to seclude them from hostile takeovers. Moreover, invoking the risk of short-termism and the speculative nature of such markets these groups of insiders often succeed in persuading politicians to enact legislation to obstruct the development of markets for corporate control which are indispensable to protect minority shareholders.
In general, the risk of collusion between sellers is the same whether the oligopolies exist in regulated or non-regulated industries. As Adam Smith reminded us long ago “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. It also common to find businessmen who were enthusiastic free-market supports when they were challenging the incumbents but transform overnight into the most determined protectionists once they join the incumbents.
In fact, this is the reason why capitalists are not always among the main supporters of capitalism and free markets. Only consumers remain always beneficiaries with the greatest interest in free markets. This is the reason why some argue that, if it was not for Marx, capitalism would be better named as consumerism.
However, consumers are frequently too numerous to organize conspiracies or to simply oppose those of the sellers. That is the reason why, in the end, the existence of free competitive markets depends on the rule of law and governments prohibiting or limiting non-competitive practices.
To understand the importance of free entry let us imagine a remote small island community with a single store. Its population is not enough to sustain two stores and as expected the existing store is a natural monopoly. If one of the inhabitants decides to challenge the incumbent monopolist and opens a new store both will run their stores at a loss until one of them eventually is ruined and gives up.
While the two stores remain competing the islanders benefit from greater supply at a lower price, but once the monopoly is re-established they face reduced supply and higher prices so that the surviving store can recover the losses incurred while competing with the other store. Meanwhile, during the competitive period the two store owners engaged in both fair and unfair tactics to gain or keep market share through better customer service, credit terms, product quality, etc. Some of these sales tactics are considered beneficial while others disrupt the traditional rules of civility and trust in the community. Therefore, the islanders’ ruler received many requests to stop them or to let them fight to the end. Which are his options?
He can uphold the laisser-faire principle of no interference to ensure an absolute right to free entry. Alternatively, he may introduce a licensing system to grant the monopoly on a temporary or permanent basis. Both options could be improved to retain the benefits of competition and minimize its costs. For instance, he could ban unfair sales tactics or he could auction periodically the store license. These two options should be carefully assessed to determine which would be the most efficient in a Pareto sense. That is, which would allow competition to generate greater benefits.
This example is not a simple curiosity in remote societies. Indeed, we find many similar situations in developed countries. For instance, licensing is very common in public transport, pharmacies, funerary services, roads and other infrastructures, healthcare, telecommunications, etc. And, such licensing while often done under the guise of consumer protection is in fact used to regulate or limit competition.
In fact, free markets are only a foundation of capitalism as long as they contribute to enhance fair competition, that is to create competitive markets where prices are established in accordance with supply and demand.
The simplest form of a competitive market is a market without entry barriers and where there are many suppliers and buyers so that all parties are price-takers. But, this is not always required. For instance, Stanley Jevons (1871) one of the founders of the marginal utility theory of value, considered that a market could be made of only two counterparties.
Although one may idealize market structures that create a system of perfect competition, capitalism does not need such a stringent form of competition. Some imperfections or regulations are tolerable or even desirable to achieve what Churchill (1909) called the need for competition upward but not downward (e.g. competition that could drive labor into slavery or tax rates to zero).
Such departures from an idealized world of perfect competition may be more or less extensive depending on the nature of the market, e.g. largest in labor markets than in capital or in goods and services markets. Even among the latest one must distinguish between markets with prohibitive carrying costs (e.g. fish markets) and speculative markets where carrying costs are negligible. The second factor to bear in mind is whether the so-called market failures and divergences between private and social optimization are significant and susceptible of correction without secondary damages.
In modern capitalism the most relevant issue is whether monopolistic and oligopolistic markets still can be considered competitive. For instance, does the fact that the Coca-cola and Pepsico share of the soft drinks market has risen from about 50% in the 1960s to the current level of around 70% means that such market is no longer considered as competitive? Of course not, because there is no entry barriers in such market and in fact there are many small producers competing with these two giant firms. However, if their dominance had been achieved or preserved through licensing or any other form of government favoritism then we should not consider such market as competitive.
Currently, there is a market – the market for corporate control - whose freedom is essential to preserve because of the growing separation between ownership and control. In most big firms the degree of capital dispersion is sufficiently large to facilitate collusion between managers and a small group of shareholders who introduce many obstacles (e.g. poison pills) to prevent others from challenging their power within the firm and to seclude them from hostile takeovers. Moreover, invoking the risk of short-termism and the speculative nature of such markets these groups of insiders often succeed in persuading politicians to enact legislation to obstruct the development of markets for corporate control which are indispensable to protect minority shareholders.
In general, the risk of collusion between sellers is the same whether the oligopolies exist in regulated or non-regulated industries. As Adam Smith reminded us long ago “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices”. It also common to find businessmen who were enthusiastic free-market supports when they were challenging the incumbents but transform overnight into the most determined protectionists once they join the incumbents.
In fact, this is the reason why capitalists are not always among the main supporters of capitalism and free markets. Only consumers remain always beneficiaries with the greatest interest in free markets. This is the reason why some argue that, if it was not for Marx, capitalism would be better named as consumerism.
However, consumers are frequently too numerous to organize conspiracies or to simply oppose those of the sellers. That is the reason why, in the end, the existence of free competitive markets depends on the rule of law and governments prohibiting or limiting non-competitive practices.
Thursday, 14 March 2013
Warren Buffett on Dividends and Management Capitalism
Every year I wait eagerly Warren Buffett´s letter to Berkshire shareholders to benefit from his wisdom on investment. I consider him one of the great champions of shareholder-oriented policies and usually agree with him. However, this year I fundamentally disagree with his contradictory statement on dividends. Let me explain why.
Although concluding that “We like increased dividends, and we love repurchases at appropriate prices”, he relegates the payment of dividends for last, after share repurchases (a form of earnings distribution that he opposed in the past). His view replicates the logic of the so-called pecking order theory of financing which states that firms prioritize the various sources of funds on the basis of how easily they can be accessed. Likewise, Buffett advocates that CEOs should first look to deploy the company earnings on current operations, after look for acquisitions unrelated to their current businesses, then consider repurchasing their own shares if the price-to-book value is below 1.2 and finally pay a dividend.
This use of earnings will inevitably transform CEOs into asset managers and strengthen what I call management capitalism. I define management capitalism as a system where managers may choose the investors rather than the other way around.
Management capitalism is mostly found in the regulated sectors of the economy (banking, transportation, utilities and other former state-owned companies), but also among public companies where capital has been so diluted that the former owners or their heirs no longer have a controlling interest in the business. For example, Berkshire is the single largest shareholder in Coca-Cola but owns only 8.98% of the company and appoints 2 of the 22 directors.
To simplify we may include in the management capitalism sector all public companies whose float exceeds 80% and the largest shareholder owns less than 15% of the total stock. Using these criteria, 3/4 of the 41 companies in Berkshire´s portfolio of listed companies are in the management capitalism sector. This bias in his portfolio is partly explained by the fact that he only invests in large cap stocks. Equally, his preference for CEOs with the profile of a private equity fund manager may be reasonable in his special case. Since he runs his huge portfolio with a team of only 23 people (including support staff) it is obvious that he has to rely on his CEOs as a kind of portfolio managers.
However, managerial capitalism is inferior to market capitalism because it relies on collusion with government policies (namely to inhibit the payment of dividends and distort competition), carries excessive governance costs, is highly exposed to agency problems, undermines competition and has fewer shareholder-oriented CEOs. Those that do not pay dividends often aggravate these problems.
Unfortunately, the alternative to dividends advocated by Buffett does not solve these problems. He argues that instead of receiving an annual dividend, investors pursuing an income objective would be better off by selling annually the number of shares needed to cash in an amount equivalent to the desired dividend. He gives an example assuming no-taxes and constant returns on equity and price-to-book ratios. Under such conditions the sell-off is obviously better. He adds two more advantages of sell-offs, namely that sell-offs do not impose a cash-out policy upon all shareholders and are more tax-efficient.
However, with rising capital expenditure one must expect diminishing returns on equity. For illustration, in the Buffett example, if the return on reinvested earnings after 10 years had fallen to ¼ of the starting return, the sell-off advantage over dividends (about 4%) would be halved. Given the overriding tendency to grow big at all costs there is a major danger that such returns may even turn negative.
Buffett himself, in his 1989 letter, recalling the lessons learned in his first 25 years as an investor, alerted that: “(2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops”.
There is a possibility of controlling this trend, acknowledged by Buffett in his 2012 letter as the pursuit of intrinsic value. That is, to require that net worth grows faster than investment. I checked how his current portfolio of listed stocks had performed on this count over the past four years and the result is not brilliant – less than half (17/41) had a positive elasticity of net worth in relation to capital expenditure and only two companies had an elasticity greater than one. So, if a major shareholder like Buffett cannot enforce this rule imagine how hopeless the average investor is.
Overall, the (uncertain) advantage of sell-offs over dividends is too small to compensate for the greater inefficiency of management capitalism in relation to market capitalism (the present value of his 4% estimated advantage is less than 1.6%). Moreover, it does not justify complacency with the frequent collusion between management capitalists and tax authorities to discriminate against dividends.
So, I am left wondering whether the recent softening of Buffett’s stance in relation to share repurchases and dividends has contributed for his weakening performance and if we risk losing a supporter of shareholder-oriented managers. However, I still hope that he will prove me wrong.
Although concluding that “We like increased dividends, and we love repurchases at appropriate prices”, he relegates the payment of dividends for last, after share repurchases (a form of earnings distribution that he opposed in the past). His view replicates the logic of the so-called pecking order theory of financing which states that firms prioritize the various sources of funds on the basis of how easily they can be accessed. Likewise, Buffett advocates that CEOs should first look to deploy the company earnings on current operations, after look for acquisitions unrelated to their current businesses, then consider repurchasing their own shares if the price-to-book value is below 1.2 and finally pay a dividend.
This use of earnings will inevitably transform CEOs into asset managers and strengthen what I call management capitalism. I define management capitalism as a system where managers may choose the investors rather than the other way around.
Management capitalism is mostly found in the regulated sectors of the economy (banking, transportation, utilities and other former state-owned companies), but also among public companies where capital has been so diluted that the former owners or their heirs no longer have a controlling interest in the business. For example, Berkshire is the single largest shareholder in Coca-Cola but owns only 8.98% of the company and appoints 2 of the 22 directors.
To simplify we may include in the management capitalism sector all public companies whose float exceeds 80% and the largest shareholder owns less than 15% of the total stock. Using these criteria, 3/4 of the 41 companies in Berkshire´s portfolio of listed companies are in the management capitalism sector. This bias in his portfolio is partly explained by the fact that he only invests in large cap stocks. Equally, his preference for CEOs with the profile of a private equity fund manager may be reasonable in his special case. Since he runs his huge portfolio with a team of only 23 people (including support staff) it is obvious that he has to rely on his CEOs as a kind of portfolio managers.
However, managerial capitalism is inferior to market capitalism because it relies on collusion with government policies (namely to inhibit the payment of dividends and distort competition), carries excessive governance costs, is highly exposed to agency problems, undermines competition and has fewer shareholder-oriented CEOs. Those that do not pay dividends often aggravate these problems.
Unfortunately, the alternative to dividends advocated by Buffett does not solve these problems. He argues that instead of receiving an annual dividend, investors pursuing an income objective would be better off by selling annually the number of shares needed to cash in an amount equivalent to the desired dividend. He gives an example assuming no-taxes and constant returns on equity and price-to-book ratios. Under such conditions the sell-off is obviously better. He adds two more advantages of sell-offs, namely that sell-offs do not impose a cash-out policy upon all shareholders and are more tax-efficient.
However, with rising capital expenditure one must expect diminishing returns on equity. For illustration, in the Buffett example, if the return on reinvested earnings after 10 years had fallen to ¼ of the starting return, the sell-off advantage over dividends (about 4%) would be halved. Given the overriding tendency to grow big at all costs there is a major danger that such returns may even turn negative.
Buffett himself, in his 1989 letter, recalling the lessons learned in his first 25 years as an investor, alerted that: “(2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops”.
There is a possibility of controlling this trend, acknowledged by Buffett in his 2012 letter as the pursuit of intrinsic value. That is, to require that net worth grows faster than investment. I checked how his current portfolio of listed stocks had performed on this count over the past four years and the result is not brilliant – less than half (17/41) had a positive elasticity of net worth in relation to capital expenditure and only two companies had an elasticity greater than one. So, if a major shareholder like Buffett cannot enforce this rule imagine how hopeless the average investor is.
Overall, the (uncertain) advantage of sell-offs over dividends is too small to compensate for the greater inefficiency of management capitalism in relation to market capitalism (the present value of his 4% estimated advantage is less than 1.6%). Moreover, it does not justify complacency with the frequent collusion between management capitalists and tax authorities to discriminate against dividends.
So, I am left wondering whether the recent softening of Buffett’s stance in relation to share repurchases and dividends has contributed for his weakening performance and if we risk losing a supporter of shareholder-oriented managers. However, I still hope that he will prove me wrong.
Sunday, 25 April 2010
Why trade investors collude with managers to vote for star-like compensation
The star-like compensation of CEOs and other senior managers is undermining the trust of people in the fairness of capitalism. The spiraling of shocking compensation packages continues because the market system does not have built-in self-interest incentives that prevent collusive behavior between trade investors and managers. The problem is more acute in listed companies with high levels of float and with significant shareholdings by trade investors that do not compete to supply or finance the company.
A simple numeric example is enough to illustrate the problem. Consider the case of an investor who is contemplating investing in two almost identical companies—Companies A and B—trading at the same multiple of earnings, with the same expected risk and a rate of return on equity of 20%. Company B is a potential major supplier or financier of A, but is not currently trading with Company A. Both companies have the same asset turnover and leverage. After paying the current market rate of 1% of profits as management compensation, they each generate a net profit of 10%.
Prudence dictates that the investor should diversify by investing in both companies. However, given that A and B have the same expected return and risk, regardless of how the investor chooses to split his investment (whether 50/50, 10/90, or any other way), his expected return will be always 20%.
Imagine now that the CEO of Company A only needs 10% to control the board of directors and approve a pay raise that triples his compensation to 3% of profits. Management approaches the trade investor and asks him to invest 10% in company A and vote for the proposed pay rise in exchange for A giving B 10% in new business, provided that B matches the price of the suppliers replaced.
As long as the investor is able to lead a majority of shareholders in Company B, they will keep the Company B managers’ pay at 1%, so that his total return from both companies will now increase by 8.81% to an average return of 21.76%. Since there is no new value creation, the gains obtained by management and the new insider investor are made partly at the expense of the remaining shareholders in Company A, but mostly at the expense of the replaced vendor. The reduction in return incurred by the shareholders in A would be just 0.39 percentage points (i.e. 1.94%). This small loss could be either concealed or compensated if the other 40% of insiders supporting management protest.
It remains to be shown if there are any self-interest market mechanisms to prevent this predatory behavior. There are three candidates to oppose the insider investor’s actions in the above example: the managers of company B, the suppliers displaced, and the other investors in Company A—but none will be able to prevent such behavior. Here’s why:
The managers of B could try to get a similar pay raise by threatening to leave and bid for the job of A’s managers. If they were to get a similar raise, this would offset a large share of the investor’s gain. However, as a controlling shareholder, the investor can easily collude with A’s managers and other insider shareholders to stop such a bid. Thus, the managers of Company B can only threaten to shirk on their increased workload and ask for a modest raise. For instance, if they manage to get a 20% raise, this would only reduce the trade investor’s return to 21.72%.
The suppliers replaced may or may not be among the current group of insider shareholders. In the first case, they would try to fight the managers, but unless they can attract other shareholders to their cause, the only way they can retaliate is to sell their position to hurt the stock price. However, this would mean the supplier’s adding a self-inflicted capital loss on top of his business loss as a supplier, while simultaneously lowering the entry price for the new rival investor.
Next, imagine that the non-insider investors of Company A wished to retaliate against the managers’ pay raise by selling their stock. This would result in a self-inflicted loss for the late sellers. This loss could only be prevented if the insiders stepped in to buy the shares, or if management acted to offset a possible decline in the stock’s price by promising to pay an increased dividend or by introducing a share buy-back program. Forced to choose between certain loss and a promise, they will be more inclined to bet on the manager’s ability to avoid a decline in the stock price.
Finally, if the replaced suppliers were not yet shareholders, they might try to keep the business by outbidding the investor and invest the same amount while supporting A’s management in a bid to get an even higher pay raise. However, they could not outbid the rival investor. The pay incentive would only work if they could compensate the other insider investors, and their investment in A would have a lower return than that of the new investor since they would not gain from increased sales to their business.
The numeric example given above can be replaced by a model to work out the optimal investment allocation between A and B, including the more common situation where Companies A and B are different, but it is easy to see that the optimal outcome will also depend on the possibilities to switch suppliers and the greed of Company A’s management. It is nevertheless unquestionable that there is a large incentive for collusion between management and trade investors against other investors in A and its current suppliers.
Are the costs of this market failure large enough to damage the working of market capitalism? If so, then the question now is to assess if it is possible to correct this inefficiency through regulation.
The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights, or a combination of both. The first could be easily defined, but it can be easily evaded. In particular, in the case of shareholdings by suppliers of financial services, such limits could be easily circumvented by investing through investment funds managed by those financial institutions.
Limiting the voting rights of trade investors who are major suppliers of Company A is probably the best solution. It does not disrupt arms’-length trading relations, and it is more easily enforced. The only debatable issues would be about the qualification of trade investors and the voting restrictions. These should cover voting for the election of management and their remuneration, but they could also extend to voting in the Governance and Auditing Committees.
Regulation always has its own costs, which should not be disregarded lightly in a full assessment of this proposition. In particular, the possibility of discouraging trade investing may have its costs in terms of business intelligence and synergies. However, overall, limiting the voting rights of trade investors would be a market-perfecting policy that would contribute to achieving the ideal of true market capitalism.
A simple numeric example is enough to illustrate the problem. Consider the case of an investor who is contemplating investing in two almost identical companies—Companies A and B—trading at the same multiple of earnings, with the same expected risk and a rate of return on equity of 20%. Company B is a potential major supplier or financier of A, but is not currently trading with Company A. Both companies have the same asset turnover and leverage. After paying the current market rate of 1% of profits as management compensation, they each generate a net profit of 10%.
Prudence dictates that the investor should diversify by investing in both companies. However, given that A and B have the same expected return and risk, regardless of how the investor chooses to split his investment (whether 50/50, 10/90, or any other way), his expected return will be always 20%.
Imagine now that the CEO of Company A only needs 10% to control the board of directors and approve a pay raise that triples his compensation to 3% of profits. Management approaches the trade investor and asks him to invest 10% in company A and vote for the proposed pay rise in exchange for A giving B 10% in new business, provided that B matches the price of the suppliers replaced.
As long as the investor is able to lead a majority of shareholders in Company B, they will keep the Company B managers’ pay at 1%, so that his total return from both companies will now increase by 8.81% to an average return of 21.76%. Since there is no new value creation, the gains obtained by management and the new insider investor are made partly at the expense of the remaining shareholders in Company A, but mostly at the expense of the replaced vendor. The reduction in return incurred by the shareholders in A would be just 0.39 percentage points (i.e. 1.94%). This small loss could be either concealed or compensated if the other 40% of insiders supporting management protest.
It remains to be shown if there are any self-interest market mechanisms to prevent this predatory behavior. There are three candidates to oppose the insider investor’s actions in the above example: the managers of company B, the suppliers displaced, and the other investors in Company A—but none will be able to prevent such behavior. Here’s why:
The managers of B could try to get a similar pay raise by threatening to leave and bid for the job of A’s managers. If they were to get a similar raise, this would offset a large share of the investor’s gain. However, as a controlling shareholder, the investor can easily collude with A’s managers and other insider shareholders to stop such a bid. Thus, the managers of Company B can only threaten to shirk on their increased workload and ask for a modest raise. For instance, if they manage to get a 20% raise, this would only reduce the trade investor’s return to 21.72%.
The suppliers replaced may or may not be among the current group of insider shareholders. In the first case, they would try to fight the managers, but unless they can attract other shareholders to their cause, the only way they can retaliate is to sell their position to hurt the stock price. However, this would mean the supplier’s adding a self-inflicted capital loss on top of his business loss as a supplier, while simultaneously lowering the entry price for the new rival investor.
Next, imagine that the non-insider investors of Company A wished to retaliate against the managers’ pay raise by selling their stock. This would result in a self-inflicted loss for the late sellers. This loss could only be prevented if the insiders stepped in to buy the shares, or if management acted to offset a possible decline in the stock’s price by promising to pay an increased dividend or by introducing a share buy-back program. Forced to choose between certain loss and a promise, they will be more inclined to bet on the manager’s ability to avoid a decline in the stock price.
Finally, if the replaced suppliers were not yet shareholders, they might try to keep the business by outbidding the investor and invest the same amount while supporting A’s management in a bid to get an even higher pay raise. However, they could not outbid the rival investor. The pay incentive would only work if they could compensate the other insider investors, and their investment in A would have a lower return than that of the new investor since they would not gain from increased sales to their business.
The numeric example given above can be replaced by a model to work out the optimal investment allocation between A and B, including the more common situation where Companies A and B are different, but it is easy to see that the optimal outcome will also depend on the possibilities to switch suppliers and the greed of Company A’s management. It is nevertheless unquestionable that there is a large incentive for collusion between management and trade investors against other investors in A and its current suppliers.
Are the costs of this market failure large enough to damage the working of market capitalism? If so, then the question now is to assess if it is possible to correct this inefficiency through regulation.
The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights, or a combination of both. The first could be easily defined, but it can be easily evaded. In particular, in the case of shareholdings by suppliers of financial services, such limits could be easily circumvented by investing through investment funds managed by those financial institutions.
Limiting the voting rights of trade investors who are major suppliers of Company A is probably the best solution. It does not disrupt arms’-length trading relations, and it is more easily enforced. The only debatable issues would be about the qualification of trade investors and the voting restrictions. These should cover voting for the election of management and their remuneration, but they could also extend to voting in the Governance and Auditing Committees.
Regulation always has its own costs, which should not be disregarded lightly in a full assessment of this proposition. In particular, the possibility of discouraging trade investing may have its costs in terms of business intelligence and synergies. However, overall, limiting the voting rights of trade investors would be a market-perfecting policy that would contribute to achieving the ideal of true market capitalism.
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