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 trade investors. Show all posts
Showing posts with label trade investors. Show all posts
Wednesday, 2 December 2015
Saturday, 23 July 2011
Financial Investment – Art, Science or Gambling?
In principle, everything we buy can be treated as an investment and therefore to a large extent investment is like breathing, something that everybody knows about. However when dealing in financial assets we should avoid the traditional statement that investment is the commitment of funds with the hope of gain, or a process of buying and selling securities with a view to get the greatest possible return, or, more plainly, the art of buying low and selling high.
This is so because the services provided by financial assets (money, securities, contracts or hybrids) include the protection and transfer of wealth, the facilitation of partial ownership and the provision of liquidity. That is the utility we derive from them depends primarily not on its material use but on rotating our exposure to them so that we may profit from distributions and changes in their market value (mostly in secondary markets).
Thus, we define financial investment as “a process of rotation between financial exposures which at the time of our choosing will allow us to attain the highest possible net liquidation value above that achievable without rotation and risk”. This means that at any given moment in time we may compare the valuation of our holdings in long, short and hedged positions in financial instruments with the valuation of such portfolio in a previous date.
The success of exposure rotation is the result of skill and luck. The skills required depend on the investment approach chosen (day-trading, event-trading or portfolio management) as well as on the strategies pursued. The net returns achieved may be amplified or reduced through taxation and leverage which also require specific skills.
Like in many activities the skills are both innate and nurtured through practice and education. Thus skills must necessarily be a combination of art, science and gambling. And, specific strategies and instruments require different combinations. For instance, investing in derivatives is closer to gambling while investment in fixed-income securities is more reliant on science.
In terms of science we could look at investment as an optimization problem defined as the maximization of total return over a given time horizon subject to a number of risk constraints. However, because of the uncertain nature of the investment outcomes, this mathematical formulation of investment is not feasible.
Alternatively we may look at investing as a form of gambling. To draw analogies with gambling we must distinguish games that combine luck and skill, like poker and football, from those that are purely games of chance like the roulette or the lottery. This distinction is fundamental because investment can clearly be considered as a game of the first kind, a game that mixes skills with luck but not a game based on pure luck or randomness.
Finally, we may define the investment activity as an art, an art not only in buying and selling but an art in forecasting prices and in undertaking calculated risks. What distinguishes science from art is not the degree of science and technique used in a particular activity but rather the creative and aesthetic nature of the activity. This is crucial to spot short-lived market imperfections and in this regard some view investment as a craft while others consider it to be the last liberal art.
Our preference goes to classify investment as a liberal art, defined as an activity based on worldly wisdom achieved by developing mental models enabling investors to extract knowledge acquired through multidisciplinary approaches (including the traditional disciplines of accounting, economics and finance, but also physics, biology, philosophy, psychology and literature). To a large extent, such an art form must be developed on an individual basis and as a self-satisfying activity.
Unfortunately not everyone can be an artist. However, the beauty of market capitalism is that not all investors need to pursue the art of investment. They may outsource it to honest professional investors.
This is so because the services provided by financial assets (money, securities, contracts or hybrids) include the protection and transfer of wealth, the facilitation of partial ownership and the provision of liquidity. That is the utility we derive from them depends primarily not on its material use but on rotating our exposure to them so that we may profit from distributions and changes in their market value (mostly in secondary markets).
Thus, we define financial investment as “a process of rotation between financial exposures which at the time of our choosing will allow us to attain the highest possible net liquidation value above that achievable without rotation and risk”. This means that at any given moment in time we may compare the valuation of our holdings in long, short and hedged positions in financial instruments with the valuation of such portfolio in a previous date.
The success of exposure rotation is the result of skill and luck. The skills required depend on the investment approach chosen (day-trading, event-trading or portfolio management) as well as on the strategies pursued. The net returns achieved may be amplified or reduced through taxation and leverage which also require specific skills.
Like in many activities the skills are both innate and nurtured through practice and education. Thus skills must necessarily be a combination of art, science and gambling. And, specific strategies and instruments require different combinations. For instance, investing in derivatives is closer to gambling while investment in fixed-income securities is more reliant on science.
In terms of science we could look at investment as an optimization problem defined as the maximization of total return over a given time horizon subject to a number of risk constraints. However, because of the uncertain nature of the investment outcomes, this mathematical formulation of investment is not feasible.
Alternatively we may look at investing as a form of gambling. To draw analogies with gambling we must distinguish games that combine luck and skill, like poker and football, from those that are purely games of chance like the roulette or the lottery. This distinction is fundamental because investment can clearly be considered as a game of the first kind, a game that mixes skills with luck but not a game based on pure luck or randomness.
Finally, we may define the investment activity as an art, an art not only in buying and selling but an art in forecasting prices and in undertaking calculated risks. What distinguishes science from art is not the degree of science and technique used in a particular activity but rather the creative and aesthetic nature of the activity. This is crucial to spot short-lived market imperfections and in this regard some view investment as a craft while others consider it to be the last liberal art.
Our preference goes to classify investment as a liberal art, defined as an activity based on worldly wisdom achieved by developing mental models enabling investors to extract knowledge acquired through multidisciplinary approaches (including the traditional disciplines of accounting, economics and finance, but also physics, biology, philosophy, psychology and literature). To a large extent, such an art form must be developed on an individual basis and as a self-satisfying activity.
Unfortunately not everyone can be an artist. However, the beauty of market capitalism is that not all investors need to pursue the art of investment. They may outsource it to honest professional investors.
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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