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.

About managerial capitalism

Managerial capitalism is the sector comprised by public companies with such a high degree of capital dispersion that in practice shareholders have little or no control over management and the profit motive is often discarded.

Managers' capitalism developed not as the result of any specific ideology but from the natural growth of companies.

So, all non-stated owned big firms are by nature part of this sector as long as their capital grows beyond the resources of a small group of shareholders. For instance, even if the three wealthiest billionaires in the world were to invest all their fortunes to buy a large cap stock like Apple they would own only 30% of the company.

In the managerial sector it is often useful to distinguish three types of firms. Those that operate in regulated sectors and often resulted from the privatization of state monopolies, those that have grown to a dominant position in their sector and the conglomerates.

The emergence of big firms is not a new phenomenon and since the late XIX century there has been a fear that business concentration threatens free markets, the rule of law and the profit motive indispensable in a capitalist society. The concern has always been that business concentration would lead to the abuse of market power, the collusion with politicians would result in an uneven playing field and tax arbitrage for the benefit of a few and the separation between ownership and management would erode the profit drive and encourage waste and self-aggrandizement.

Today’s novelty resides solely on substantial transformations in the governance system. While in the age of the Trusts and the so-called “robber barons” these were still mostly capitalists who paid professional managers a salary of about 20 times that paid to the other professionals, nowadays there is a new layer of professional money managers between the ultimate owners and the managers and these now earn about 300 times the average salary in their companies. For example, it is now possible to find CEOs who earn more in compensation than what they pay in dividends to a shareholder who owns more than 2% of the business.

So, the modern day CEO-cracy has little capital invested in their companies and a strong incentive to maximize the company size and his compensation at the expense of profitability. Indeed, finance theory has contributed for such behavior by replacing profitability with a more ambiguous concept of shareholder value and by promoting a culture of stakeholders responsibility instead of stockholders.

Moreover, the average tenure of Fortune 500 company CEOs was 9.7 years in 2013, with many being recruited internally and going straight into retirement. That is, nominations often are the result of political and internal power struggles as in any bureaucracy rather than business performance.

In fact, the growing mix of business and politics is evident not only in the regulated sectors but also in the remaining sectors of managerial capitalism because of the role played by banks and institutional investors in corporate control. This places the managerial sector somewhere between the state enterprise sector and the market capitalism sector.

Through political favoritism and managers’ desire for size it is not surprising that managers' capitalism has continued to grow despite its inefficiency. For instance, in the two groups referred to below the top 50 managerial firms used twice as much capital as the bottom group.

This raises the question of knowing whether the managerial sector is beneficial for its investors. For this, one needs to know if returns are greater in the managerial sector. Using as a proxy for managerial capitalism the free float, we did a cursory analysis of the top and bottom 50 companies in the S&P500 Index. It revealed that last year firms in the managerial sector had a median return on equity which was lower than in firms with a lower float by three percentage points. Furthermore, the annualized return of stock prices over the past three years was also lower by two percentage points.

Surprisingly, managerial capitalism does not seem able to extract any rents for its own shareholders despite being protected by the political sector. Overall, the system endangers competition, the profit motive and social mobility necessary to keep capitalism a mild Darwinian system where the stronger takes over the weak for the benefit of both.

That is, although there is some truth in the statement that “when we have strong managers, weak directors, co-opted accountants, and passive owners, don’t be surprised when the looting begins (Bogle, J.C. (2003))”, the problem with managerial capitalism is not simply a question of generating some “bad apples”. It is really a cancer that sooner or later compromises free markets, the rule of law and the profit motive.

Yet this should not be the inevitable result of growth. One could still benefit from company size as long as the agency problems had been tackled head on. Unfortunately, the emergence of institutional investors who were supposed to represent a dispersed constituency of individual shareholders has aggravated the problem rather than solve it. For instance, in the USA the 100 largest managers of pension and mutual funds represent the ownership of about 50% of corporate America.

However, they hardly even attend annual meetings. And, quoting Bogle again: “the focus of the mutual fund industry has gradually shifted—from management to marketing, from stewardship to salesmanship, and—just as in the case of corporate America—from owners capitalism to managers capitalism”.

So, with the money managers riddled by conflicts of interest and governance problems similar or even worse than those of the corporations they are supposed to oversee a rising managerial sector can only end in inefficiency.

However, since the alternative to state owned enterprises is often its transformation into a managers’ corporation one has to assess their relative merits. Likewise, since size and job security often come together, for those employed in such firms the managerial model seems similar to many of the ideals of the XIX century utopian socialism.

Is Finance Theory Responsible for the Rise in CEO-kleptocracy?

The unprecedented rise in the compensation of CEOs and other top executives in US listed companies began in the early 1980s. As documented in several studies, including that of Frydman and Saks (2007) from which we reproduce the following two charts. In the 1980s the average total compensation of the top three executives suddenly jumped from an historical multiple below 40 times the average worker compensation to a median multiple that is now close to a 120.

This trebling in relative compensation was achieved mostly by linking compensation to the stock performance during the strong bull market of the 1980s and 1990s. As shown in the next figure its contribution to total compensation now accounts for more than 50% of basic compensation (salary + performance bonus).

Since managers have little or no influence in the valuation of their companies, was their pay just a fortunate coincidence due to the exuberant valuations of the stock market during those two decades? Or, did finance theory legitimize in the eyes of the shareholders their hands in the till behavior? We can dismiss the first hypothesis by the fact that throughout the last seventy years managerial stock holdings remained always below 1% and by looking at Shiller's chart of the S&P Composite Real Price-Earnings Ratio.

Although the nine-fold rise in real valuations between 1980 and 2000 was unprecedented by historical standards we must notice that during the other two major bull periods ended in the crashes of 1929 and 1973 the median compensation multiple never exceeded 40 (despite a seven-fold valuation rise before 1929 and a four-fold rise before 1966).

Moreover, when valuations returned to their normal values after the stock market crash of 2001, executive compensation continued to rise instead of correcting downwards. For instance, in the period 2000-2005 the real value of total compensation of the three highest-paid officers in the 50th percentile almost doubled to 5.2 mllion while that of those in the 90th percentile more than doubled to 21.6 million dollars in today’s values.

So what led shareholders and the taxman to become so generous in overlooking this hands on the till behavior?

Until the 1950s the number of top executives holding share options was basically negligible. However, from 1965 to 1980 the fraction of those granted share options rose from less than 20% to more than 60% and by 2000 it had reached 100%.

Despite being traditionally indifferent to management issues, finance theory was seized by executives to demand and legitimize their new found wealth. The following is a short-list of the key developments in finance theory that played some role in this process:
1) The Modigliani and Miller theory on the neutrality of capital structures resuscitated the entity theory of the firm and provided the basis for a widespread belief that paying dividends was an inefficient way of making distributions (a view reinforced by the predatory tax regimes of the time);
2) It also created a tolerant attitude towards excessive leverage which was later used to drive buy-out strategies and risk arbitrage driven M&A transactions;
3) Modern portfolio theory, with its emphasis on diversification, promoted the wide dissemination o capital among minority institutional investors. This, in practice, left companies in the hands of their managers and investment bankers colluding on irresponsible corporate governance approaches sanctioned by ever obliging compensation consultants;
4) Financial innovation in the use of derivative instruments and the Black-Scholes formula to price stock options facilitated and ignited the recourse to dubious short-term market manipulations through earnings management and outright accounting fraud.

However, although finance theories were the facilitators of the process, what really ignited it was the replacement of previous values based on fairness and justice by the greed and no-taxes cultures promoted by the Reagan and Thatcher right wing revolutions. These were compounded by the subsequent corruptible nature of the regulated and regulatory industries brought in by subsequent left wing governments.

So, halting and reversing the hands on the till process will now require a change in political attitudes as well as a denouncement of the misuse of academic finance theories.