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 control. Show all posts
Showing posts with label control. Show all posts
Wednesday, 2 December 2015
Monday, 30 November 2015
Wealth accumulation and the profit motive
From the early XX century the rise of large corporations and consequent separation between ownership and control has dominated the debate on entrepreneurship and capitalism. The debate naturally turned to whether – business concentration and owner absenteeism – would reduce the role of the market and the profit motive as foundations of capitalism and wealth accumulation.
In itself, wealth accumulation neither goes always pari passu with status and power nor does its regional and occupational origin follows a rigid stratification. Nevertheless, some periods are usually associated with a particular source of wealth or class of individuals.
For instance, at the turn of the XIX century in Britain, London commerce and finance were seen as the origin of the largest fortunes of the epoch. Likewise, at the turn of the XX century in America, the Silicon Valley internet entrepreneurs and the New York hedge fund managers were regarded as those more likely to accumulate great fortunes.
So, both in relation to the sources of wealth and to its distribution, we may identify cycles that are usually due to various causes but never as a direct result of capitalism.
Nevertheless, the path to capital accumulation does affect the efficiency of capitalism since different groups have different propensities to save and pursue different investment strategies. In particular, the rise of institutional investors adds new agency problems in relation to portfolio allocation and a possible dilution of the profit maximization motive caused by the owners absenteeism and a growing rent-seeking monopolization.
Indeed, these agency problems were already felt in the early XX century by authors like Thorsten Veblen (1921) who stated that: “The company … is, therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.“
The questioning of the role of the firm culminated in the classical book by Berle and Means (1932) arguing that: “The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital... [Such owners] have surrendered the right that the corporation should be operated in their sole interest...”.
This trend led finance theorists to treat shareholders as if they were debt holders and to a growing influence of managerial capitalism; with firms turning into bureaucratic organizations without the entrepreneurial spirit of the early promoters.
Many large firms frequently collude with governments and become more driven by rent-seeking than value added under competitive conditions. Often they are also managed through planning and search to grow through mergers rather than entrepreneurship. These fears, which were already present before the 1940s, are obviously a threat to capitalism, but they do not mean that modern capitalism is already following the path of Venice which transformed from a thriving trading city in the XV century into today’s museum city.
Accountants’ ever increasing recording of non-cash transactions in financial reporting also eroded the traditional use of profits as the right bottom line metric to measure business performance. As net income becomes less and less meaningful, investors moved up the income statement and use other measures such as operating and gross income. And, as these progressively become subject to creative accounting, they had to turn also to cash flow statements. This proliferation of metrics did not help the profit motive.
Moreover, finance experts progressively substituted profits by shareholder value which blurred further the use of profits. And things are getting worse, since many increasingly replace this concept by the broader one of firm value. Because these metrics are based on specific theories, they are easily abused by managers with self-perpetuating and self-aggrandizement agendas .
To conclude, the rising wealth created by capitalism facilitated the emergence of ever bigger firms, creating a growing divorce between owners and management, fostering the replacement of profit maximization by vague metrics of shareholder and firm value, which, together, compound the erosion of the profit motive as a foundation of capitalism. Fortunately, this is largely confined to the managerial sector of capitalism and, although a serious threat to be fought, the erosion of the profit motive will not be lethal to capitalism.
In itself, wealth accumulation neither goes always pari passu with status and power nor does its regional and occupational origin follows a rigid stratification. Nevertheless, some periods are usually associated with a particular source of wealth or class of individuals.
For instance, at the turn of the XIX century in Britain, London commerce and finance were seen as the origin of the largest fortunes of the epoch. Likewise, at the turn of the XX century in America, the Silicon Valley internet entrepreneurs and the New York hedge fund managers were regarded as those more likely to accumulate great fortunes.
So, both in relation to the sources of wealth and to its distribution, we may identify cycles that are usually due to various causes but never as a direct result of capitalism.
Nevertheless, the path to capital accumulation does affect the efficiency of capitalism since different groups have different propensities to save and pursue different investment strategies. In particular, the rise of institutional investors adds new agency problems in relation to portfolio allocation and a possible dilution of the profit maximization motive caused by the owners absenteeism and a growing rent-seeking monopolization.
Indeed, these agency problems were already felt in the early XX century by authors like Thorsten Veblen (1921) who stated that: “The company … is, therefore, an impersonal incorporation of liabilities to the stockholders, and by employing these liabilities as collateral (formally or informally) it will then procure further capital by an issue of securities (debentures, typically bonds) bearing a stated rate of income and constituting a lien on the assets of the corporation.“
The questioning of the role of the firm culminated in the classical book by Berle and Means (1932) arguing that: “The property owner who invests in a modern corporation so far surrenders his wealth to those in control of the corporation that he has exchanged the position of independent owner for one in which he may become merely recipient of the wages of capital... [Such owners] have surrendered the right that the corporation should be operated in their sole interest...”.
This trend led finance theorists to treat shareholders as if they were debt holders and to a growing influence of managerial capitalism; with firms turning into bureaucratic organizations without the entrepreneurial spirit of the early promoters.
Many large firms frequently collude with governments and become more driven by rent-seeking than value added under competitive conditions. Often they are also managed through planning and search to grow through mergers rather than entrepreneurship. These fears, which were already present before the 1940s, are obviously a threat to capitalism, but they do not mean that modern capitalism is already following the path of Venice which transformed from a thriving trading city in the XV century into today’s museum city.
Accountants’ ever increasing recording of non-cash transactions in financial reporting also eroded the traditional use of profits as the right bottom line metric to measure business performance. As net income becomes less and less meaningful, investors moved up the income statement and use other measures such as operating and gross income. And, as these progressively become subject to creative accounting, they had to turn also to cash flow statements. This proliferation of metrics did not help the profit motive.
Moreover, finance experts progressively substituted profits by shareholder value which blurred further the use of profits. And things are getting worse, since many increasingly replace this concept by the broader one of firm value. Because these metrics are based on specific theories, they are easily abused by managers with self-perpetuating and self-aggrandizement agendas .
To conclude, the rising wealth created by capitalism facilitated the emergence of ever bigger firms, creating a growing divorce between owners and management, fostering the replacement of profit maximization by vague metrics of shareholder and firm value, which, together, compound the erosion of the profit motive as a foundation of capitalism. Fortunately, this is largely confined to the managerial sector of capitalism and, although a serious threat to be fought, the erosion of the profit motive will not be lethal to capitalism.
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