I will be explaining why the public company universe has become much more concentrated in the U.S., how private equity is filling the breach on growth and innovation, and what it means for the future of management:
Also, the dangers of using financial accounting for managerial decision making. It’s a double-header.
If you’re a finance type in Dallas next week, stop on by. I promise a good show.
The long-awaited climate accord was signed in Paris. President Obama is taking a victory lap. The NYT breathlessly announced the implications for business:
It will spur banks and investment funds to shift their loan and stock portfolios from coal and oil to the growing industries of renewable energy like wind and solar. Utilities themselves will have to reduce their reliance on coal and more aggressively adopt renewable sources of energy. Energy and technology companies will be pushed to make breakthroughs to make better and cheaper batteries that can store energy for use when it is needed. And automakers will have to develop electric cars that win broader acceptance in the marketplace.
Perhaps. As long as investors, utilities, technology firms and auto makers can make money doing these things. Unfortunately, the climate deal does not prescribe any plan or policies to assure this, nor does it repeal the laws of economics, or the still-desperate need for global economic development. The obvious way to spur these results would be to implement a stiff tax on carbon, but that wasn’t a part of the deal, either.
With a carbon tax, all the other results listed above would follow. And if such a tax replaced income and sales taxes, it would achieve the key objectives of carbon reduction without stalling the economy, aside from dislocations in the energy sector. Politicians on the right wouldn’t propose such a replacement carbon tax because they don’t want to risk their support from oil companies, and many of them believe the problem of global warming is overstated. People on the left wouldn’t propose it because they are generally against replacing income taxes with something as “regressive” as a carbon tax. They would much prefer to add another layer of taxation, and use that money for their parochial purposes, including picking winners and losers in the technology development game, and to impose numerous new regulations on producers to restrict their emissions. Many of these people believe that central planning can get you as good results as market forces.
Unfortunately, the right has surrendered the discussion of climate change to the left, which means that to the extent that we get even ineffectual interventions, they are all but certain to hurt economic growth. People living in beachfront mansions may notice a two degree increase in global temperatures more than a two percent slowdown in economic growth. But people living in low-lying economies will be much more sensitive to an economic slowdown. Seventy five years ago, the Philippines and South Korea were at about the same place economically. The difference, with South Korea today having ten times the per capita GDP, was just two percent per year faster growth over that period. Which of these countries today is better able to weather warmer temperatures, rising waters, and more frequent storms?
The world may be warming with serious consequences ahead. Those who disagree with that prognosis are called “deniers.” What do we call those who deny the economic impact of their proposals? The last time we were told, “The experts are in complete agreement; give me a trillion dollars and control of one sixth of the economy,” things did not work the way their models predicted.
I spilled the beans regarding the titular question this Fall at an NACD event.
The talk was split into two TED-sized portions of about 20 minutes each. Part I is what the research suggests about pay practices, i.e., which practices are effective, which are probably a waste of money, and which actually hurt the shareholders. Part II explains the causal mechanism behind the most surprising research finding–that today’s bonus plans, on average, add no value to corporate performance.
The feedback was extremely gratifying. A couple of directors described the discussion about bonus plans and proxy advisory standards as “a tour de force.”
Massey Energy was one of a handful of mining and energy companies that tied its chief executive officer’s bonus to safety performance in 2010. Today, former CEO Donald Blankenship goes to trial on charges stemming from a West Virginia mine explosion that killed 29 workers, the U.S. industry’s deadliest in almost four decades.
The story goes on to note that in the mining industry there is no correlation between having executive bonuses tied to safety metrics and the actual result of safer mines. In fact, many of the safest companies offer no safety bonuses for their top executives. Nevertheless, all of the people interviewed in the article claim that CEO incentives ought to be tied to safety much more than they are today.
Jennifer Lawrence recently penned an essay about no longer being willing to earn less than her male co-stars. Her feisty critique received an outpouring of feminist support inspired by her willingness to challenge the system. She has a point, of course, about female talent potentially being undervalued relative to male talent. This post is not about that. It is about the question I get most often regarding the extraordinarily highly paid: Does deciding to pursue more money than one avowedly needs make a person greedy?
The ‘greed’ question seems to have hardly come up with regards to Ms. Lawrence. Yet she earned $52 million last year. It is a fair guess that whatever millions she left on the table would not have the slightest impact on her lifestyle, which she readily admits. Her complaint isn’t about the money; it’s about the principle that women should get paid the same as men doing the same job. She wants parity with her peers.
So, maybe it matters why we want more money, e.g., to help others. Maybe that’s the difference between being greedy and not. Read more of this article »
I have written before about he staggering decline in the number of public companies since the late 1990s, and the concurrent growth in large, private companies. Doidge, Karolyi and Stulz published a working paper trying to explain this phenomenon. Their explanation begins with two facts:
1. The number of IPOs has slumped considerably since that period
2. The number of companies delisting from an exchange has gone up over that period.
They note that the overall number of companies has risen in that period, as well, so the loss of public companies is not a function of lower overall business formation. They also noted that it wasn’t just a drop in the number of small firms due to low IPO activity driving that reduction; de-listings were occurring across all sizes of firms. Finally, they note that voluntary de-listings are a relatively small portion of the total, with M&A being the largest driver. They conclude from this that new regulations, like SOX, could not be a significant driver of de-listings, contending that they would expect to see a regulatory effect to be reflected in voluntary de-listings. They conclude that “The number of mergers is puzzlingly high compared to both U.S. history and to other countries.”
Well, it’s not puzzling if you use a more realistic model of what would be driving those results. The model I have used for over a decade is quite simple:
A company will choose to be public when the benefits of being a public company exceed its costs, otherwise it will not join, or will exit, the public sphere.
The way it exits is of secondary importance.
So, for example, the fixed cost of being a public company for a $100 million firm (net assets) shortly before SOX was just over $1 million per year. After SOX, that number jumped up to about $3 million per year. Now, the cost versus the benefit of being public comes down to the cost of capital advantage of being public. If my cost of capital is lower as a public company versus as a private company by, say, two percent ROA per year, then if I were a $100 million company, and it cost me $1 million per year (i.e., 1 percent of net assets) to be public, then I would be ahead as a public company. If the cost of being public jumps to three percent per year, then a $100 million company with a fixed cost of $3 million per year to be public would prefer to be not public.
My one disagreement with Doidge et al. is that de-listing is not necessarily the only way to go once you have figured out that you are no longer viable as a public firm. In fact, it is easier to complete an M&A deal than to escape the public markets via a going-private route. So, the M&A spike seen by Doidge et al. should be counted as a reaction to proliferating regulations. That and the fact that private companies larger than $1 billion has grown five-fold in the period since 1996, making this phenomenon one of the more spectacular cases of capital flight ever seen.
My rough estimation is that post-SOX, it was no longer worth it for the typical $100 million company to be public. In fact, given the rising costs of being public, I estimated the a company had to be between $300 and $500 million in net assets to be viable as a public company. After Dodd-Frank, with its voluminous new regulations for public companies, I estimate that few companies under $1 billion in net assets can any longer afford to be public.
The broader question that is not being asked is: Is it good for capital formation in general, and public capital markets in particular, to no longer have the full range of companies that could be publicly available for all investors?
High pay is controversial because there are inherently two, generally opposed, sides to the debate. This was well illustrated in a recent WSJ article about highly paid, star college football coaches. Given the topic, it’s appropriate to label the two sides “offense” and “defense.”
This is a good name for an instinctive reaction that we all have; we are offended by other people’s high pay. It’s a natural response. The moment any of us hears that someone has made millions of dollars, our knee-jerk reaction is “who can be worth millions?” We can’t help it. We also can’t help trying to supplement that emotional reaction with logical arguments. This is almost always done via comparisons to other people’s pay.
Last year, the current Alabama [Crimson Tide] coach, Nick Saban, made $7.2 million, roughly 11 times the salary of Alabama’s president.
Messrs. Saban and Meyer make 50 times that of an average full-time professor at their respective schools; Mr. Harbaugh makes 32 times more than an average full-time professor at Michigan…
Much is made of the fact that Alabama is a poor state with a median household income of $43,253, some $10,000 less than the national average. Public funding for higher education in the state was slashed by $556 million from 2008 to 2013, a 28% drop. Mr. Saban’s salary has risen 80% since he arrived at Alabama in 2007.
What makes these comparisons compelling is that they bring the discussion somewhat closer to the scale of our pay. If we get paid much less than top college coaches, for example—a better than 99 percent bet, even for readers of the Wall Street Journal—then we get to share the outrage that these people are making so much more than we are. I mean, who are these people? Are they really any better than us?
Some people call this reaction an instinct for fairness. Some call it envy. Regardless of the name, it is the first thing that strikes us when hearing “millions.”
And that is why any explanation or justification of other people’s millions can be viewed as a “defense.”
The easiest, and ultimately only way to defend high pay is to reference its negotiated nature. People don’t get what they deserve; they get what they negotiate. This negotiation is invisible to us, a distant, unwritten prequel, by the time we are reading about something like “$7.2 million.” When we say, “I can’t believe so-and-so is being paid that much,” we are really saying one of two things:
(1) “I can’t believe so-and-so was greedy enough to ask for or accept that much,” or
(2) “I can’t believe the person paying them that much really needed to.” Both criticisms represent a kind of an arrogance, if you think about it.
On the one hand, we are accusing the person who made a lot of a moral failing that any of us would likely succumb to if we were in their position. In my experience, the people who complain most loudly about other people’s pay are the least likely to turn down a windfall were it to come their way. On the other hand, we are accusing the person who paid the salary of being stupid, lazy, or corrupt with reference to their compensation decisions. We’re calling the owners, who are generally very successful themselves, financial dolts. On its face, this seems implausible. So, the sensible thing is to first ask the people paying millions what they were thinking.
Former Alabama President Robert Witt (now the chancellor of the Alabama university system), once told CBS’s “60 Minutes” that Mr. Saban was “the best financial investment this university has ever made…”
Mr. Saban had an immediate financial impact on Alabama. In 2007 the school was closing a $50 million capital campaign for its athletic department. After Mr. Saban arrived, the campaign exceeded its goal by $52 million. Alabama’s athletic-department revenue the year before Coach Saban showed up was $68 million. By 2013-14 it had risen to $153 million, a gain of 125%. (The athletic department kicked $9 million of that to the university.) Mr. Saban’s football program accounted for $95 million of that figure, and posted a profit of $53 million.
In other words, they were thinking that offering those millions in salary would pay them back in dividends. That bet doesn’t always work, but it was clearly working for Alabama. And these owners are considering all of the revenue streams likely to be impacted by their hire, the way any professional team owner would look beyond the gate receipts and TV licenses.
Mr. Witt said Mr. Saban also played a big role in the success of a $500 million capital campaign for the university (not merely the athletic department) that took place around the time the football coach was hired…
Ohio State has benefited in a similar way since luring Mr. Meyer, 51, out of a brief retirement in 2012. The university’s athletic-department revenue was up 14% to $69 million during the season last year, one in which Ohio State won the national title. In the aftermath of the title, the school’s merchandise sales totaled $17 million, some $3 million more than the previous year. More than half of that money goes to academics.
So, the defense of high pay is that if we give the recipient a portion of his or her value to the organization, the organization will benefit. That is true whether we are talking about coaches, or players, or real estate agents, or investment bankers. Economists call this paying for the individual’s marginal revenue product, and a principle of economics is that society as a whole is generally better off if every person is paid according to his or her marginal revenue product. Paying too much is a waste; paying too little risks ‘misallocation’ of that person’s talents.
The End Game
Whether we are talking about college football coaches, professional entertainers, or corporate executives, the debate often comes down to what game you’re playing. If you’re playing the game of fairness or envy, then you simply don’t want some people to make too much more than others, regardless of the economic consequences. If you’re playing to maximize overall social welfare, then you allow people to earn a significant portion of what they make for others, and let the chips fall where they may.
One might admit to a mix (or confusion) of motives in order pursue some middle ground. But in football, at least, no one scores in the middle ground.
I came across an article about frat boys doing tasteless things. (Which one, right?) So, at the risk of being accused of Godwinning any of a number of ‘national conversations’ we are having today, I offer this brief article in its entirety from 1939…
NAZIS TOO SERIOUS STUDENTS ASSERT
West Virginia Students Amazed At Row Over ‘Hitler Party’
MORGANTOWN, W. VA, Jan. 11 (AP)—West Virginia University students expressed astonishment today at the international comment raised by a fraternity’s “Fuehrer” party here several weeks ago and declared “we thought ‘twas funny.”
“You take things too seriously over there, ” the campus daily newspaper, The Daily Athenium said in an open letter addressed to Das Schwarze Korps, official organ of the goose-stepping black-uniformed Nazi Elite guard.
“What,” it asked, “is the world coming to when 80,000,000 inhabitants of a great nation become agitated over the pranks of college students?”
Male students attending the party had imitated the appearance of Adolf Hitler, and when the German newspaper caustically criticized the affair as pictured by “Life” magazine, four students facetiously cabled they were severing “diplomatic relations.”
Das Schwaze Korps replying described the students as “sprigs of war-profiteering Babbits” and said this could not be expected to “make less frivolous play with ‘diplomatic relations’ between two nations than would Jews and free Masons around President Roosevelt.”
The Athenum’s letter asserted the “whole episode, including your reply, will cause only a passing ripple of interest here,” and recalled Oliver Goldsmith once said “little things are important to little men.”
Editors said the letter would be mailed to Germany.
In hindsight, of course, we countenance any ridiculing of Hitler, and discount any protests from Nazi Germany. But in early 1939, when Roosevelt was committing to keep us out of any European conflict, there were arguably a number of sensitivities relating to our relationship with an ascendant Germany, not to mention a significant American minority.
It would have been ironic if those kids were somehow punished for offending those sensitivities soon before having to face death in defense of America’s most fundamental ideals.
A few weeks back, Hillary Clinton unveiled her proposed tax complication scheme and other proposals to combat “short-termism.” People generally being more conservative with regards to their own professions than other people’s professions, I was tempted to suggest that trusting Hillary (or any politician) to remedy whatever was ailing corporate America was like trusting a medieval doctor to cure…well, just about anything. You just know that whatever the ailment, the treatment will involve bleeding the patient. But recalling the above-noted bias, I realized that I was merely responding to quackery with quackery, and that I was in no better position to give Mrs. Clinton political advice than she was at giving anyone economic advice.
So I refrained from calling her out on her proposal, including addressing the irony of politicians accusing corporations of short-termism, and left it to the pundits to debate her prescriptions. What I didn’t expect is a spate of articles refuting her diagnosis, i.e., that corporate America was suffering from an acute case of short-termism.
The CEO Pay Ratio mandated by Dodd-Frank is finally here. The rule sounds simple enough: Companies must disclose the ratio of their CEO’s pay to that of their median worker. Interesting information, perhaps, but the SEC supposedly exists for a more lofty purpose than mandating nice-to-know data. It must, by law, act in the interests of investors. In fact, the Administrative Procedures Act requires the SEC to “base . . . decisions on the best reasonably obtainable scientific, technical, economic, and other information concerning the need for, and consequences of, the intended regulation.”
The CEO Pay Ratio rule is, indeed, of great interest to certain people. Union leaders believe that the rule will give them another crowbar with which to negotiate their members’ wages and benefits. Class warriors believe it will give them more ammo to shame corporations into reducing inequality. Fair enough. But the SEC does not normally allow itself to be used by unions for getting involved in labor relations, or by class warriors in anti-corporate crusading. So, why are they bothering with this rule?
Quite simply, because Dodd-Frank requires them to. The CEO Pay Ratio provision was inserted into the law, without debate, at the last minute by Senator Menendez. His rationale, explained after the fact, was, “This simple benchmark will help investors monitor both how a company treats its average workers and whether its executive pay is reasonable.”
How, exactly, will this “simple benchmark” help investors do those things? What number, or range, for this ratio tells an investor that a company is treating its average workers well or poorly, or that a company is paying its CEO reasonably (given that CEO pay is already thoroughly disclosed)? What economic or financial standards can be created using this or other data to enable investors to figure these things out?
As someone who has been asking this over the five years it has been debated, I can assure you that those questions have never been answered, neither by the rules proponents nor by the investors they claim to want to help. That’s because there is no logical basis for believing that the pay ratio can usefully inform investors either with regards to the company’s treatment of workers or the reasonableness of their executives’ pay. Consequently, there is no scientific or economic evidence that this ratio, alone or in combination with any other data, can be used to judge how well the company is being managed, or otherwise be related to company value—i.e., the nominal concern of investors. The Pay Ratio provides no more useful information than the ratio between the company’s highest cost office space versus its average cost of warehouse space, or between its highest cost commodity inputs versus its average cost of materials.
In other words, the SEC is simply being used in an experiment in social engineering. The expectation is that this ratio will shame boards into changing how they pay their CEOs. That goal might have some redeeming value if this experiment hadn’t already been tried, twice. The “shaming” theory was, in fact, largely behind disclosure rules enacted in 1992 and in 2006. A rational person would have looked at these and similar results, and decided it was time to try another hypothesis. Alas, it appears we are not dealing with rational persons. So today, ideology trumps science.