The Value of Everything (UK)

by Mariana Mazzucato

  But rent-seeking is not limited to the financial sector. It has pervaded non-financial industries as well – through the pressures that financial-sector profitability, exaggerated by monopoly power and implicit public guarantees, place on the corporate governance of non-financial firms. If investors can expect a certain return by putting their money into a fund, spreading the risks across a wide range of money-making instruments, they will only sink the same funds into one industrial project if it offers a much higher return. The return on financial-sector investment sets a minimum for the return on ‘real’ fixed investment, a floor which rises as financial operations become more profitable. Non-financial companies that cannot beat the financial investors’ return are forced to join them, by ‘financializing’ their production and distribution activities.

  6

  Financialization of the Real Economy

  On the face of it, shareholder value is the dumbest idea in the world.

  Jack Welch, former General Electric CEO, 20091

  Finance’s extraordinary growth into an economic colossus over the past thirty years has not been confined to the financial sector; it has also permeated companies in the broader economy, such as manufacturing and non-financial services. The financialization of the real economy is in some respects a more extraordinary phenomenon than the expansion of the financial sector itself and is a central social, political and economic development of modern times.

  In exploring this phenomenon, I will look chiefly at the US and the UK, where financialization tends to be most advanced. As we have seen, businesses such as manufacturing and non-financial services have often been classed as the ‘productive sector’, unambiguously creating value, whereas finance is often a cost of doing business, and only contributes to value creation rather than creating value by itself. More loosely, the productive sector is often called ‘the real economy’.

  It’s a truism to say that the modern corporation is among the most important forces in the economy. In 2015, the 500 largest public US companies (those listed on a stock exchange) employed almost 25 million people worldwide and generated revenues of over $9 trillion. In the same year, the 500 largest UK companies on the stock market had more than 8 million employees and their total annual turnover was well over £1.5 trillion.2 What’s more, many of the largest companies at the forefront of innovation in the economy are publicly listed; to these we must add the many companies that are privately owned but controlled by financially minded owners such as private equity (PE) or venture capital (VC). The decisions these corporations take, particularly capital allocation, are critical to value creation.

  This is why it is so important that we understand the huge extent of the financialization of the productive sector. In the 2000s, for example, the US arm of Ford made more money by selling loans for cars than by selling the cars themselves. Ford sped up the car’s transition from physical product to financial commodity by pioneering the Personal Contract Plan (PCP), which allowed a ‘buyer’ to pay monthly instalments that only covered the predicted depreciation, and trade up to a new model after two or three years rather than paying off the balance. Adopted by most other auto-makers, and with the additional merit of being bundled into securitizations and resold on financial markets, PCPs drove car sales to record levels, alarming only the final regulators, who wondered what would happen if (as with houses in 2008) cash-strapped contractees walked away from their vehicles and handed back the keys. Over the same period GE Capital, the finance arm of the enormous General Electric (GE) group, made around half of the whole group’s earnings.3 Companies such as Ford and GE contributed heavily to the sharp rise in the value of financial assets relative to US GDP in the quarter-century after 1980.

  Lending money to customers to buy your cars does not necessarily mean that you are extracting value to the extent discussed in the previous chapter. But, as we shall see, financialization more generally can profoundly affect how companies behave. The strongest evidence of how financial value can damage real economic value can be found in the widespread practice of share buy-backs by public companies listed in the US and UK.

  THE BUY-BACK BLOWBACK

  Share buy-backs are a way of transferring money from a corporation to its shareholders. The company buys some of its own shares from existing shareholders. As a pure matter of finance and economics, these transactions are just like money paid out as dividends: shareholders receive, and the company pays out, the same amount. The only difference is that dividends are paid out evenly to all shareholders, while buy-backs give cash only to those who want to sell; and, what’s more, buy-backs avoid any penalty taxes imposed on dividends by governments that want more profit reinvested.

  A switch from dividends to buy-backs can, however, make a big difference to executive pay, because (unlike dividends) they reduce the number of shares. This automatically boosts earnings per share (EPS), which is one of the key measures of corporate success. Buy-backs typically increase the pace of EPS growth – a measure which is often used to determine just how exorbitant the rewards of senior executives will be. So bosses prefer buy-backs to dividends. Two basically equivalent measures have been made to diverge, unless accountants adjust the share count to ensure that identical transactions have the same effect on the reported results. But bosses are hardly likely to prod them to standardize their measures of corporate payouts.4

  Shareholders also seem impressed by rising EPS, preferring not to notice that buy-backs remove just as much cash as dividends from the funds available for investment. They also seem to ignore the fact that companies are more likely to buy back shares when the price is high than when the price is low,5 despite the inefficiency of this market timing.

  In any case, the numbers are striking. In 2014 the American economist William Lazonick chronicled the scale of share buy-backs in the top US companies in recent years.6 Between 2003 and 2012, 449 companies listed in the S&P 500 index deployed $2.4 trillion in buying back their own shares, mostly through open-market purchases. That sum constituted 54 per cent of their collective earnings. Add in dividends, which took out a further 37 per cent, and only 9 per cent of profits were available for capital investment. Over the same period, the ten biggest re-purchasers in the US shelled out a staggering $859 billion on share buy-backs, equivalent to 68 per cent of their combined net income. As illustrated in Figure 21 below, seven of those companies committed more than 100 per cent of their net income to buy-backs and dividends.

  Until recently, few investors seemed to grasp the scale of these disbursements. While regular dividends are often used by shareholders as a source of income – which is why shareholders get so upset when they’re cut – buy-backs, on the other hand, are often considered special payments. This ignores their status as an active choice not to invest to create long-term value.

  Some investors are finally waking up. In March 2014, Larry Fink, the CEO of Blackrock, one of the largest institutional investors in the world, wrote to the CEOs of the S&P 500 companies about excessive profit distributions. Observing that too many companies ‘have cut capital expenditure and even increased debt to boost dividends and increase share buy-backs’, Fink stated that while ‘returning cash to shareholders should be part of a balanced capital strategy’, such a practice could, ‘when done for the wrong reasons and at the expense of capital investment … jeopardize a company’s ability to generate sustainable long-term returns’.7

  However, Fink’s message has not been widely echoed by investors. The ratio of buy-backs and dividends to reported earnings has hardly declined. Having set a required return on reinvested funds that few managements feel able to meet, shareholders have grown accustomed to having a steady stream of funds paid out instead.

  Figure 21. Top ten stock repurchasers in the US (2004–2012), ranked by the absolute amount of share buy-backs8

  MAXIMIZING SHAREHOLDER VALUE

  Share buy-backs boost executive pay. To defend the idea that incentive pay realigns executive and shareholder interests, it is o
ften claimed that share buy-backs maximize shareholder value (MSV) and thus improve the efficiency of companies.9 Financial techniques, it is argued, are a legitimate way for managers to improve productivity and therefore benefit workers and customers as well as shareholders. If a company can earn a higher return at any given time from putting capital to work financially rather than directly selling cars or software, it is behaving rationally and in the best interests of the business. Having a choice between a financial or a productive use for capital helps to keep the (supposedly) core business of cars or software on its toes because it has to produce returns which compete with financial alternatives. By extension, it is argued that making it easier for customers to obtain credit, especially to buy your own products, is a service to ordinary people. There is something to this – but not much. Where did these ideas come from? And do they have validity?

  Back in the 1970s, as the economic crisis and stagnation of the decade impaired the performance and profitability of the corporate sector, shareholder dissatisfaction made shareholder returns the principal aim of the corporation. In 1970, Milton Friedman published in the New York Times Magazine an article which became the founding text of the shareholder value movement and, in many ways, of corporate management in general. Titled ‘The Social Responsibility of Business Is to Increase its Profits’, Friedman’s article advanced the idea that America’s economic performance was declining because a cardinal principle of mainstream economics – that firms maximize profits – was being violated. There was no longer any punishment for managers who failed to profit-maximize. Shareholders could not inflict such punishment because they were too dispersed and uncoordinated; and markets could not do so, because listed companies had monopoly power and would not be assailed by new competitors if their costs and prices drifted upwards. Some 1960s economists had viewed ‘managerialism’ as potentially good for society, if bosses allowed profit to be eroded by paying better wages to employees, meeting higher environmental or health and safety standards and investing more in new products. Friedman reset the debate by suggesting that bosses were more likely to be sacrificing profit to their own expense accounts and luxury lifestyles; and that even letting costs rise through ‘corporate social responsibility’ was fundamentally wrong. The piece spawned an academic literature that would become known as ‘agency theory’.

  Friedman’s idea was developed further by the University of Chicago-trained Michael Jensen, who was steeped in its ‘free market’ ideas. In 1976 Jensen, now a professor at the University of Rochester, wrote a paper with the Dean of Rochester’s business school, William Meckling (who, like Jensen, was a student of Friedman at Chicago), on how to implement Friedman’s idea. It was called ‘Theory of the firm: Managerial behavior, agency costs, and ownership structure’. The key argument was that managers (the agents) were not being disciplined by competitive financial markets or product markets, since they could misallocate resources or run up unnecessary expenses without incurring losses or endangering their jobs, and so it was hard for investors (the principals) to keep them accountable. The only way to do so was through strengthening the ‘market’, which was neutral and objective enough to make sure the company thrived. The result was a body of theory that argued that the only way for companies to be well run was if they maximized their ‘shareholder value’. In this way, investors would indirectly keep company managers accountable.

  In the decades that followed, an entire intellectual apparatus was created around ‘maximizing shareholder value’, with new developments in law, economics and business studies. It became the dominant perspective of leading business schools and economic departments. The overriding goal of the corporation became that of maximizing shareholder value, as captured in the corporation’s share price.

  However, far from being a lodestar for corporate management, maximizing shareholder value turned into a catalyst for a set of mutually reinforcing trends, which played up short-termism while downplaying the long-term view and a broader interpretation of whom the corporation should benefit. In the name of MSV, managers sought profits anywhere they could, directly fuelling globalization and outsourcing production to locations from China to Mexico. Jobs were lost and communities wrecked. Meanwhile, the added external pressures on corporate management did little to enhance its quality. Rather than become properly trained managers with sectoral expertise, who could make decisions on what to produce and how to produce it, top graduates in business schools preferred to go to Wall Street. While in 1965 only 11 per cent of Harvard Business School MBAs went into the financial sector, by 1985 the figure had reached 41 per cent and has risen since then.

  Figure 22 shows how the influence of PE, one of the most aggressive manifestations of MSV, grew in the US in the first decade and a half of the twenty-first century. The arguments of Friedman, Jensen and Meckling suggested that shareholder value was going to waste. So a new type of investor that could capture this leaking value would be instantly rewarded, through bigger dividends or share price gains. PE funds and acquisition vehicles led the pack of new, value-hungry investors that now assailed the world’s stock markets.

  PE is MSV turbo-charged. Many of the companies in which PE firms invest are not financial ones; often, indeed, they can be found on the productive side of the production boundary. But whereas traditional institutional investors were often satisfied to ‘buy and hold’, and to await share price gains via profit being reinvested rather than paid out, PE seeks to buy and resell at a higher price within a few years. What this means is that many firms owned by PE funds are pushed into taking a significantly shorter-term view than they might have done otherwise – the exact reverse of ‘patient capital’ and raising productivity to benefit society in the long run. If the influence of PE on the productive economy seems exaggerated, consider this: Blackstone, one of the largest PE companies, has a portfolio of over seventy-seven companies, which together generate over $64 billion in combined annual revenues and employ more than 514,000 people globally.11

  Figure 22. PE-backed companies as a percentage of all US companies (by enterprise size)10

  The recent history of the care home and water industries in the UK shows how PE can change a business – and not necessarily for the better. Until the mid-1990s the country’s care homes were owned either by small family firms or by local authorities.12 Today, for a combination of political and financial reasons, many local authority homes have closed. A new breed of financial operator has moved into the market, largely following a PE model, often ‘selling’ many of its places to local authorities but also generating private profit. In 2015, the five biggest care home chains controlled about a fifth of the total number of care home beds in the UK. These operators were attracted by stable cash flows, part of which came from local authorities, and opportunities for financial engineering: cheap debt; property which could be sold and leased back; tax breaks on debt interest payments and carried interest; and – ultimately – frail and vulnerable residents whom the state would have to look after if the business failed. The corporate structures of some care home owners became exceedingly complex and often hidden in tax havens, while corporation tax payments were low or nil. Given that local authorities still funded many care home placements and that the nurses employed in the homes had been state-trained, opaque corporate structures and minimal tax payments are hardly the way to provide an essential public service.

  Four Seasons Health Care displays many of these characteristics. The company owns the biggest chain of care homes in the UK, with 23,000 beds in 2015. But it was only a small Scottish chain until its acquisition by Alchemy Partners, a PE firm, in 1999. Having enlarged the company, Alchemy sold it in 2004 to Allianz Capital Partners, another private firm, which two years later sold it to Three Delta, yet another PE firm. By 2008, during this game of pass the parcel, the company’s external debt had ballooned to £1.5 billion, carrying an annual interest charge of over £100 million – or an unsustainable £100 per bed per week. In 2012 the company was bought by
Terra Firma – you’ve guessed it, a PE firm – controlled by Guy Hands, a well-known British financier who had cut his teeth at Goldman Sachs. Despite a financial restructuring involving losses for equity holders, bondholders and banks before Terra Firma acquired the business, by 2014 Four Seasons was losing money, and a pre-tax loss of £70.1 million in 2015 deepened to £264 million in 2015.13 The cost of debt-servicing was at least partly to blame. The company blamed local authorities for freezing the amount they would pay for residents, although the authorities themselves were suffering severe budget cuts under the Conservative-led government’s austerity programme. The Care Quality Commission, the government body which monitors standards in care homes, was sufficiently concerned about the business health of Four Seasons that at one point it embargoed twenty-eight of Four Seasons’ homes, meaning that they could not take in new residents.

  Similar patterns can be seen in England and Wales’s water industry, which was privatized in 1989.14 The ten water and sewerage companies (WSCs) were listed on the London Stock Exchange as part of the then government’s policy of creating a ‘shareholder democracy’. Today, only two remain listed. Asian infrastructure conglomerates own three of the companies; another is a mutual company (Welsh Water, or Dŵr Cymru); and PE firms own four – Anglian Water, Thames Water (the biggest water company), Southern Water and Yorkshire Water.