VALUE EXTRACTION, NOT VALUE CREATION - CAPITALISM TAKES THE WRONG TURN DOWN A DARK ALLEY.
Partnership - Nascent Capital Markets funded the Industrial Revolution
In the dawn of modern industry, the creation of markets for capital was a breakthrough innovation. Without it, the first Industrial Revolution would not have happened.
Prior to this, owners struggled to attract capital needed to invest in growth and technology. The emergence of capital markets brought together those with cash to invest and capital-hungry enterprises.
For more than a century, the system worked well - managers were responsible for creating value in the customer-markets - investors provided the capital for growth, and expected a fair return for their investments.
The fundamental facts behind value creation:
- Value is created at the interfaces between enterprises and their customers.
- The core of any market-serving enterprise is the functions that create, support and develop its customer offerings. These nuclear activities depend on the energy and skills of people.
- Managers are responsible for optimising value creation, because they, not investors, should be in touch with the value-creating nucleus of the enterprise and the competitor markets.
- Distant institutional investors do not create value - they extract it in return for providing capital. Up to recently, they were often known as 'rentiers', and there was much debate about their value. Keynes for example, felt that 'rentiers' were much less useful than real value creators.
- Rentiers can be easily distinguished from value-creating investors, who invest for the very long term, understand and get close to the companies in which they invest and develop trusting relationships with management - Warren Buffet has been a value-creating investor. There are very few value-creating investors left in contemporary financial markets.
The system becomes distorted.
In the 1930's there was a lively debate about the roles and rights of investors. Tawney, Keynes and others advocated limiting the rights of 'rentiers' because they simply supplied money and did not add value to enterprises.
The balance between managers as value-creators and investors changed radically in the post-war period as a number of ideas became generally accepted:
- Financial investors are the owners of the companies, with a primacy of rights over all other stakeholders. This concept, which has its roots in the feudal system and was affirmed by a number of seminal legal judgments in the inter-war years, is currently accepted in law particularly in the US and UK.
- Managers therefore are the 'agents' of owners and bound to act in their interests.
- Managers are likely to act in their own self-interest, rather than those of the 'owners' - therefore inducements and penalties are needed to align their interests with those of investors. This idea is enshrined in Agency Theory, which underpins current thinking about shareholder capitalism.
- Thus Agency Theory encompassed the idea that the primary purpose of quoted companies was to create value for their shareholders, and managers' role was to act in their interests. An elaborate system of inducements and sanctions has been created to ensure that managers understand their primary obligations. The whole Corporate Governance industry is based on Agency Theory. Managers who play the 'shareholder value' game well can become rich - those who don't are out of a job. Whatever company law may say, this is the de facto reality.
The effects.
- Managers and investors now share a common interest in value extraction. As managers in effect have become an extension of the capital markets, they are distanced financially and psychologically from the value creating core of the organisations they purport to lead.
- The culture of value extraction, rather than value creation shows in the performance of larger quoted companies - for example the 20-year aggregate performance of the FTSE 100 demonstrates sales and profit growth at or below the rate of the underlying economy; whilst dividends and top executive pay vastly exceed performance - at the expense of low investment levels. The picture is completed by an enormous mortality rate on the part of the biggest companies, representing destruction without performance improvements.
See FTSE 100 for the facts.
Currently, a more extreme version of value extraction is emerging in the form of private equity funds - which are set up to generate huge rewards for investment and company managers - representing an extreme version of the Agency Theory concept.
We are left with a version of shareholder capitalism that is fixated by value extraction at the expense of value creation. - and captures huge rewards for a tiny minority.
Healthy, sustainable enterprise is now commoner in non-quoted sectors of the economy. Foreign-owned companies, partnerships such as John Lewis, smaller private companies, family-owned companies and social purpose enterprises are carrying the UK economy.
We will not return to health in the capitalist economy until there is a fundamental re-alignment of interests and rewards between the providers of capital and those stakeholders who create real value.