The Value of Everything (UK)

by Mariana Mazzucato

  As with care homes, the ratio of debt to equity in the water companies has increased sharply: a typical feature of companies owned by PE firms, as we saw in the previous chapter. Between 2003 and 2013 average net debt rose by 74 per cent while equity fell by 37 per cent in nine of the companies: Anglian, Thames, Northumbrian, Severn Trent, Southern, South West, United Utilities, Wessex and Yorkshire. The companies with the highest net debt – about 80 per cent of capital or more – were all PE-owned. Net interest payments by the nine English WSCs went up from £288 million in 1993 to an eye-watering £2 billion in 2012. Interestingly, the company with the lowest gearing (ratio of debt to equity) and the highest credit rating was Welsh Water, which is mutually owned. The four companies with the highest gearing and the lowest credit ratings were all PE-owned.

  Just like some of the care home groups, WSC ownership structures are often opaque. The combination of shadowy corporate structures and complex financial engineering may well explain high payouts to water company owners. Between 2009 and 2013 Anglian, Thames, United Utilities, Wessex and Yorkshire paid out more in dividends than they made in after-tax profits. Directors saw their share of the companies’ income rise from 0.1318 per cent in 1993 to 0.2052 per cent in 2013. Over the same period the share of the water companies’ income going to salaries and wages fell from 15.37 per cent to 10.22 per cent: in other words, the workers’ loss seemed to be diametrically opposed to the owners’ gain. It is true that the water companies have invested more than £100 billion in the country’s water and sewerage infrastructure since privatization. But the financialization of the industry was not anticipated in 1989, and neither price controls nor limits to returns on capital imposed on the companies by the Water Services Regulation Authority (Ofwat), the industry’s economic regulator, appear to have prevented what looks like value extraction.

  The cases of care homes and water in Britain are not a blanket argument against PE or financialization. But they do illustrate how financial engineering of socially essential services can change the nature of an industry. It is at the very least debatable whether the opaque ownership and excessive financialization which characterize these PE-owned businesses serve their customers more than their owners.

  THE RETREAT OF ‘PATIENT’ CAPITAL

  Agency theory and MSV, then, are essentially straightforward concepts. The purpose of the firm is to return as much value to its shareholders – the equity owners of the company – as possible. In public companies especially, the shareholder is detached from the running of the business even though he or she is legally an owner; professional managers run it. Here is the crux of agency theory: the agents (the managers) are in law answerable to the principals (the shareholders). But, in relation to managers, shareholders are disadvantaged: they have less information about the business; they are numerous where the managers are few; and they are last in the queue for rewards – after the managers, the workers, the suppliers, the debt holders and the landlords. They only see a return for their investment after the other recipients have been paid. The shareholders are the ‘residual’ claimants, as they are assumed to be the only actors who do not have a guaranteed return from their contribution to the business. They are justified in claiming the return the company generates in excess of the costs associated with other stakeholders in the company.15

  For a public company, maximizing shareholder value is effectively the same as maximizing the value of the equity shareholders’ investment, as captured in the share price. The same is true, for practical purposes, of private companies: the owners – whether a family, PE or venture capital – will value a company by what they can expect to get for selling it or listing it on a stock exchange. That value will be substantially determined by that of similar public companies, as revealed by their share price.

  MSV’s origins are often traced to the development of the ‘portfolio theory of the firm’, a popular explanation for the development of the large industrial conglomerates of the 1950s and 1960s. The portfolio theory of the firm held that companies – like other investors – could spread their risks by owning assets in diverse industries. It assumed that corporations were only a collection of asset-generating cash flows and that professional managers, who were emerging as the heroes of modern capitalism, were capable of running any type of industry equally well. Business schools aimed to train managers with exactly this purpose in mind. Perhaps the epitome of the conglomerate of the time was the Transamerica Corporation, which at one stage counted among its sprawling interests the Bank of America, the United Artists film studio, Transamerica Airlines, Budget Rent a Car and various insurance operations.

  Advocates of MSV argued that conglomerates were ‘destroying’ value, because managers (however competent and well trained) could not possibly be experts in getting the best out of such diverse operations. Diversification was more appropriately left to the shareholders, with the bosses of each company ‘sticking to the knitting’ and not venturing beyond their narrow zone of expertise. Conglomerates’ inefficiency could be practically demonstrated if their constituent parts, broken up and floated separately, could command a higher total share price than the coagulated whole. Whether right or wrong, the assumption about managers’ professionalism did not address the problem that they might not always act in the best interests of shareholders. When the US and other Western economies slowed down in the 1970s, Friedman and other agency theorists argued that because principals and agents are motivated by self-interest, the inevitable conflicts could best be resolved by giving the ultimate owner, the shareholder, the overriding interest. Conventional wisdom was turned on its head and conglomerates were broken up, a step also justified by seeing corporations as nothing more than a collection of cash flows. The interests of managers and shareholders should, the agency theorists reasoned, be ‘aligned’: if managers were also paid in the company’s shares or options on those shares, the argument went, they would be motivated to maximize the interests of all shareholders.

  Another constituency shared the managers’ interest in rent-seeking: the asset managers, a driving force behind the fashion for breaking up conglomerates to extract greater shareholder value. Economically and socially, asset managers were closer to corporate managers than they were to their real customers, the remote and probably poorly informed members of pension funds or holders of life insurance policies. MSV offered asset managers the chance to get rich alongside the managers of the companies in which they invested their clients’ money. Asset managers became the major holders of public equities, the ‘residual’ shareholder acting at least nominally on behalf of others. Their demands on the public corporation and later – through PE – the private corporation would profoundly affect the behaviour of the productive economy.

  As we saw in the previous chapter, fund managers have played a central role in the development of contemporary capitalism. In theory, equity shareholders – largely institutional shareholders – monitor corporate performance. They act as gatekeepers, resolving the agent– principal problem generally and in particular monitoring how corporations use and allocate their capital. Their role should lead to better distribution of productive resources and make better use of resources already employed: for example, drawing on agency theory, a positive link has been made between institutional ownership and innovation.16 But these assessments often seem to neglect the broader picture. It is no coincidence that the case for shareholder activism and supervision often accompanies palpable breakdown of corporate governance: witness the string of corporate scandals such as Enron and WorldCom in the US, Sports Direct in the UK and Volkswagen cheating on diesel engine emissions.

  Shareholders are not the only gatekeepers. Others include auditors, rating agencies, government regulators, the media and equity analysts – specialists who assess companies for investors. The cause of many of the corporate scandals of recent years, the standard argument goes, is the failure of these gatekeepers to do their job. Rather than being critical observers of companies, equity anal
ysts have become their cheerleaders, and largely failed to see that banks were heading for the rocks. Independent auditors and rating agencies became business partners of the companies they oversaw instead of guarding the interests of investors and the wider community. Governments moved to ‘light-touch’ regulation of finance, often under pressure from the industry lobby. The media were slow to spot the scandals and uncover them. Corporate directors – who, let’s not forget, in the UK have a legal responsibility to act in the best interests of shareholders – were only a limited counterweight to managerial over-reach.17 There is no doubt that the incentive to generate fees – from advising, analysing and auditing companies, for example – resulted in collusion and conflicts of interest between the gatekeepers and the public corporations that led to failures of governance.

  But the failure of the gatekeepers to fulfil their responsibility also owed much to the MSV mindset with which they perceived the fundamental role of the public corporation. And the key actors in the economy whose interests were most closely aligned with MSV’s objective were the institutional investors. Principal and agent were meant to eye each other warily, but instead an unholy alliance developed between them to extract value from the company. Their relationship worked against other stakeholders, not least workers, whose pay lagged further and further behind that of CEOs and senior managers.

  SHORT-TERMISM AND UNPRODUCTIVE INVESTMENT

  In the Great Depression of the 1930s, long before financialization entered the modern lexicon, Keynes observed that:

  [most] expert professionals, possessing judgment and knowledge beyond that of the average private investor … are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional valuation a short time ahead of the general public.18

  A successful speculator himself, Keynes knew what he was talking about. He warned that the stock market would become ‘a battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years’.19 He would be proved right. The time within which shareholders seek to make profit, through a flow of dividends or a share price movement, is determined by the time for which they hold a particular share. And the average holding time for equity investment, whether by individuals or institutions, has relentlessly fallen: from four years in 1945 to eight months in 2000, two months in 2008 and (with the rise of high-frequency trading) twenty-two seconds by 2011 in the US.20 Average PE holding times jumped to almost six years when stock markets froze in the wake of the 2008 global financial crash, but were on a firm downward course again by 2015.21

  The ‘short-termism’ which Keynes anticipated is encapsulated in index fund pioneer John Bogle’s concept that institutional investors rent the shares of the companies they invest in rather than take ownership for the long term. Consider the increased turnover of domestic shares: according to the World Federation of Exchanges, which represents the world’s publicly regulated stock exchanges, in the US turnover of domestic shares was around 20 per cent a year in the 1970s, rising steeply to consistently over 100 per cent a year in the 2000s. Turnover measures how often a share changes hands and is calculated by dividing the number of shares traded in a given period by the number of shares outstanding in the same period. Increasing turnover is a sign that institutional investors’ sights were trained on the short-term movement of stock prices rather the intrinsic, long-term value of the corporation. High turnover can be more profitable for institutional investors than passive, long-term holding of shares. It should also be said that the short-termist behaviour of institutional investors reflects mounting pressure over the last four decades from clients who, expecting quick results and with a dislike of surprises, quickly withdraw their funds when disappointed. The result has been a corporate fixation on quarterly performance, which encourages consistent earnings growth to generate acceptable share price performance.

  In 2013 the management consultants McKinsey and Company and the Canadian Pension Plan Investment Board surveyed 1,000 board members and senior company executives around the world to assess how they ran their businesses.22 The majority of respondents said that the pressure to generate strong short-term results had increased during the past five years to a point where managers felt obliged to demonstrate strong financial performance. But while roughly half of the respondents claimed to be using a time horizon of less than three years in setting strategy, almost all of them said that taking a longer-term view would improve corporate performance, strengthen financial returns and increase innovation.23

  Another important trend that further demonstrates the scale of MSV’s impact on corporate behaviour is that of rising hurdle rates. A hurdle rate, as we saw in the previous chapter, is a return on investment below which a company will not pursue an investment opportunity or project. It could be that, over time, there are fewer suitable opportunities available because the most profitable projects have already been taken up. Excess capacity in car-manufacturing, for instance, would naturally suggest that building a new plant would not be logical (though investing in other technologies very well might be). Fundamental economic forces may also be at work. Yet what has been happening to the hurdle rate seems to suggest that something else is also going on.

  Hurdle rates are critical to the way in which companies allocate capital, but they are deeply affected by expectations – or what Keynes called ‘animal spirits’.24 The hurdle rate of a project is usually determined relative to the cost of capital – basically, interest rates on borrowing and dividends to shareholders. The project should generate returns, calculated as an Internal Rate of Return (IRR) or Return on Invested Capital (ROIC),25 higher than the firm’s cost of capital. But an odd discrepancy has appeared. On the one hand, the cost of debt-financing has been at record lows and could reasonably have been expected to encourage that kind of finance. On the other hand, according to the investment bank J. P. Morgan,26 the weighted average cost of capital remains quite low at 8.5 per cent but the median hurdle rate (minimum return on investment needed to justify a new project) reported by S&P 500 companies is 18 per cent. This suggests that companies are not pursuing investment opportunities unless the differential between their expected returns and their cost of capital is around 10 percentage points. Why would they leave such opportunities on the table? One explanation, given the exigencies of MSV, is that they have easier alternatives – such as share repurchases.

  MSV, then, sets off a vicious circle. Short-term decisions such as share buy-backs reduce long-term investment in real capital goods and innovation such as R&D. In the long run, this will hold back productivity. With lower productivity, the scope for higher wages will be limited, thus lowering domestic demand and the propensity to invest in the economy as a whole. The spread of financialization deep into corporate decision-making therefore goes well beyond the immediate benefits it brings to shareholders and managers. As Hyman Minsky observed, there appears to be an inevitable dynamic of the capitalist system: unless properly regulated or with the right buffers, it will expand too fast. Steady growth caused by increased borrowing – which speeds up value extraction – is matched by the rising value of assets. Everything seems to be fine – until people start to query the value of assets. Then trouble brews.

  FINANCIALIZATION AND INEQUALITY

  One of the key precepts of MSV, as we’ve seen, is that the incentives of management and shareholders need to be aligned, and that the best way to do this is to compensate management by awarding them shares. Senior managers soon embraced MSV when they realized how it could help them to increase their pay (Figure 23). The original spirit of MSV has been perverted: the massive share options which have been a major part of many CEOs’ pay packages do not really align with managers’ and shareholders’ interests. Managers – depending on the terms on which they are granted options – enjoy an almost free upside, with no downside. They are part
ly insulated against the ups and downs of share prices that are the lot of long-term investors via anti-takeover devices such as the ‘golden parachute’, a cash reward if they lose their job, or ‘poison pills’, which trigger an event such as the sale of a valuable corporate division to reduce the company’s value when faced with an unwelcome takeover attempt.

  Figure 23. Median CEO pay in the US ($m, constant 2011 $)27

  Shareholders were not the only stakeholders whose interests were imperfectly aligned with those of managers. Despite a period of downsizing (corporate speak for firings), which – especially after the late-1980s conquest of conglomerates – was meant to strip away surplus management and raise the productivity of employees who survived the cull, the ratio of CEO pay to workers’ pay also soared (Figure 24).

  The emphasis on short-term results has also led to another self-fulfilling outcome: the reduced tenure of management. As seen in Figure 25, the average tenure of CEOs has over the past few decades dropped from ten years to six. When one considers that CEO pay is heavily weighted towards share price performance, the need for companies to perform in the short term can be viewed not as pressure from an external gatekeeper gone rogue but as a mutually advantageous set-up that has served the interests of an elite few at the expense of the many.

  The importance of EPS (earnings per share) growth as a measure of corporate success has become as much a proxy for MSV as the share price. But EPS has not always enjoyed this totemic status. While Samuel Palmisano (IBM President from 2000 to 2011, and CEO from 2002 to 2011) argued that IBM’s main aim was to double earnings per share over the next five years, half a decade earlier in 1968 Tom Watson Jr (IBM President from 1952 to 1971) argued that IBM’s three core priorities were (1) respect for individual employees, (2) a commitment to customer service and (3) achieving excellence. Although they are anecdotal, the two pronouncements by two different CEOs of IBM at two different times illustrate how priorities have evolved.