Category: Finance

Rethinking the Purpose of the Corporation

Rethinking the Purpose of the Corporation

Our second article from the (JACF Spring/Summer issue), written by Edward Waitzer, reviews how over the last forty years, corporate governance and corporate law have focused on minimizing “agency costs” by aligning the interests of shareholders and managers through a series of techniques, including regulatory standards, independent directors, take-overs and activist shareholders.

These means, combined with implicit acceptance of the “Efficient Market Hypothesis” (EMH) reinforced belief that share prices reflected objective corporate performance and that maximizing shareholder wealth was the purpose of the corporation.

This author, however, argues that proper corporate governance requires more than just faith in efficient equity markets and strong managerial incentives. Despite the desire for simplicity, there is no one “right” governance model. Governance is highly contextual and, ironically, the existing corporate law and regulation have tended to frustrate dynamic adaption and have led to governance systems that underperform.

The author offers Systems Theory as a better way to think about corporate purpose and governance. Systems are more than the sum of their parts, they are comprised of subsystems which in turn are comprised of other subsystems on so on, and the overall health of the system depends on the continued health of each of its essential subsystems, as well as of the larger system.

Systems theory counsels against focusing on any single metric (and in favor of the need for new ones – the relevance of metrics inevitably run down over time). Metrics such as profits, employee turnover, and customer satisfaction are not ends in themselves. Rather, they are a source of information about whether the corporation is relevant, resilient and sustainable. The systems challenge is to bring about a paradigm shift that restores connectivity between investors, employees, management, other corporate stakeholders and governments. This will require thinking differently about how the constituent elements interact and produce results.

Authored by Edward J. Waitzer, Stikeman Elliott LLP

Investors as Stewards of the Commons?

Investors as Stewards of the Commons?

In our first article from the (JACF Spring/Summer issue) George Serafeim makes the case that business generally, not just government, should assume responsibility for social and environmental problems. The Sustainable Development Goals (SDGs) formally recognize the role of the private sector in addressing some of the world’s most pressing environmental and social challenges. What started as a corporate social responsibility movement now a focuses on integrating positive social impact into the core mission of the organization.

Encouragingly, studies document that improving firm performance on business-relevant ESG issues has a positive association with future financial performance. Investors can enable better societal outcomes by exercising ‘voice’ and voting rights in corporate governance.

He acknowledges that competitive businesses face a “commons” or “free-rider” problem where a defector avoids the full cost of his actions. Overcoming this problem requires legally sanctioned collaboration between business enterprises and large institutional shareholders, particularly pension funds. He also acknowledges that the corporate level free-rider problem has a counterpart that at the investor level. Investor engagement with companies involves resources, money and time. It is no simple matter to justify increased costs in the context of asset managers that compete on the basis of low management fees, such as index funds.

Collaboration between companies can mitigate some of these free riding problems. Large institutional investors with long time horizons and significant common ownership across different companies may have the best opportunities for collaboration. But, smaller activist funds and retail investors also have an important role in pushing large institutional investors to engage. While it is unlikely that investors will be able to solve all of the pressing societal problems, progress can be made.

Authored by George Serafeim, Harvard Business School

What Really Drives “Short-Termism”?


What Really Drives “Short-Termism”?

Earlier this month, the CEO of Pepsi Co. suggested to President Trump that eliminating quarterly reporting (and shifting to biannual reporting) would reduce the pressure on managers to focus on the short-term. As impulsive as Elon Musk, the president bought this view hook, line, and sinker and tweeted his proposed shift to the world (and a probably startled SEC).

But what will be the actual impact? Those who have a law and economics orientation will predictably respond that widening reporting frames will present investors with greater uncertainty and risk, with the result that stock prices should decline (and the cost of capital should increase). Some corporate managers will point to offsetting cost savings from reduced reporting, but cost savings are trivial in comparison with even a small stock price decline. Nonetheless, the argument that moves more managers is that, under six-month reporting, they can focus more on the long-run. Yet, this argument may be precisely backwards; that is, the shift to six-month reporting is more likely to exacerbate than alleviate this problem.

The empirical research in this area (while limited) tends to show that financial managers will indeed sacrifice long-term shareholder value in order to meet a quarterly earnings forecast. In a well-known study, three respected financial economists surveyed 401 senior financial executives and posed a hypothetical problem to these executives: If they saw they were likely to fall short of a quarterly earnings target, would they cancel or delay an investment or project with a positive net present value (“NPV”)?(1) The majority conceded that they would. In addition, more than three-quarters of the surveyed executives agreed that they would sacrifice shareholder value (by deferring NPV investments) to smooth earnings—apparently because they believe that missing the earnings target (or experiencing earnings volatility) will cause a stock price drop.

So, there is a problem (which my neoclassical friends in the law and economics field tend to ignore). But does a shift to less frequent reporting help or hinder? If we shift to six-month reporting, financial managers may face even greater pressure to meet their earnings target (or the consensus forecast). After all, impatient investors will have waited longer and faced greater uncertainty. The failure to “meet your forecast” would cast even a greater cloud on management’s reputation and competence.

Consider the problem this way: If it were possible to report earnings on a monthly basis (or—and this is sheer fantasy—a weekly basis), missing the monthly or weekly target would not mean that much. A short fall in one week could be offset by a compensating gain in the next week. But a failure to meet a six-month forecast could not be corrected until the annual audited results were posted some eight or nine months later (when the issuer filed its Form 10-K). Thus, self-interested managers will be even more incentivized to sacrifice NPV projects to meet the earnings target.

Ironically, logic thus suggests that the narrower the reporting frame, the less that the long-run will be subordinated to the short-run. To be sure, nothing here is certain. The UK moved from six-month reporting to quarterly reporting in 2003, and then moved back to six-month reporting in 2013. No one has detected any measurable change in capital investments on either of these shifts. Still, cultures and pressures may be different on opposite sides of the Atlantic, and there is both much greater use of incentive compensation in the United States and much greater pressure from activist hedge funds focused on the short-run. These factors may incline managers in the U.S. to focus more on the short-run to please the market.

Some other impacts do seem more certain. Under a six-month reporting cycle, information asymmetries will increase, and this will make insider trading even more profitable (and probably even more predictable). Stock volatility seems also likely to increase in the face of greater uncertainty.

So what should be done? Probably the simplest and best answer would be for financial managers to give less guidance about future earnings. Once a financial manager makes a forecast, he has effectively pledged his reputation and needs to protect it by manipulating earnings. Hence, less in the way of earnings forecasts implies less pressure on managers. The SEC and the stock exchange could discourage forecasting in a variety of incremental ways, but, of course, they cannot prohibit forecasts.

Can the SEC simply shift from quarterly to six-month reporting? This is a legal question that may cause the SEC to assert its powers under Section 36 of the Securities Exchange Act of 1934. Section 36 (“General Exemptive Authority”) authorizes the SEC to “exempt any person, security, or transaction, or any class or classes of persons, securities or transactions, from any provision or provisions of this title or of any rule or regulation thereunder…” But exercise of this authority requires the SEC to find “that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” To date, the SEC has used this provision only sparingly. Suppose then that such an exemption is granted by the SEC, based on cost savings justifications and the claim that it will protect investors from short-termism. Suppose next that a large group of institutional investors (including the Council of Institutional Investors) sues, claiming that the SEC’s exemption is very inconsistent with the “protection of investors.” How much deference should the SEC get?(2) Indeed, does this exemption even qualify for Chevron deference? This is a short column that will not attempt to resolve the current status of Chevron deference, but my bet would be that a conservative Supreme Court would back a conservative SEC.

But maybe I am just a pessimist.

John C. Coffee, Jr., is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.

(1) See John R. Graham, Campbell R. Harvey and Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, (available at (2005). This study later appeared in the Journal of Accounting and Economics in 2005).

(2) If one wishes to read more on this topic, see Daniel T. Deacon, Administrative Forbearance, 125 Yale L.J. 1548 (2016); Lesley Chen, The SEC’s Forgotten Power of Exemption: How the SEC Can Receive Deference in Favor of Internal Whistleblowers Even When the Text is Clear, 67 Emery L. J. 1043 (2018).

Ending quarterly reports will not stop corporate short-termism

Requiring less information would favour better-connected professional investors

Progressive critics and chief executives decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases

Larry Summers has written a remarkable piece in the September 3, 2018 issue of the Financial Times, which can be found here by subscription.

President Donald Trump has asked the US Securities and Exchange Commission to investigate moving public companies to a six-month rather than three-month reporting cycle to combat an excessive corporate focus on the short term.

Progressive critics and chief executives alike decry what they see as a myopic market’s pressure to cut back on investment and increase dividends and share repurchases. In her 2016 presidential campaign, Hillary Clinton proposed raising capital gains taxes for investments held for less than six years to combat short-termism.

Few ideas command such widespread support as the notion that companies should be induced to concentrate more on the long term. Unfortunately, while there are important ways in which corporate governance can be improved, the idea that a myopic market forces companies to forgo highly attractive investment opportunities is unsupported either by logic or evidence.

It is no surprise that the idea is attractive to many. Just as my students often suggest that the grading system forces them to study a particular syllabus rather than pursue their intellectual passions, managers prefer to avoid frequent accountability for results. The former chief executive of GM, Rick Wagoner, who presided over tens of billions of dollars of unsuccessful investment during the 2000s, was a leading voice against market-generated pressures for short-termism.

There is also an apparent worker interest in resisting payouts: employees at existing companies naturally prefer them to retain cash and grow, while the potential new groups that could be financed out of cash payouts do not yet have workers.

But popularity is not the same thing as validity. A variety of facts about market behaviour belie the systemic short-termism thesis. First, there are large numbers of companies, of which Amazon is only the most prominent example, that trade at huge multiples to current profits because of credible long-term plans.

There are now hundreds of unicorns — private start ups valued at more than $1bn — almost all of whom have little or no profits. This suggests that investors are happy to buy into credible, long-run corporate visions.

Second, many studies have now confirmed that companies where cash flows are highest relative to stock prices earn the highest returns. If, as the short-termism thesis suggests, these companies were over-valued, one would expect them to earn abnormally low returns rather than unusually high ones.

Third, private equity firms and venture capitalists expect companies they own to report on a monthly basis. Capable chief executives set a similar standard for divisions within their company. Otherwise they fear that problems will fester without being addressed. If companies with a sole owner in possession of a professional staff are expected to report frequently, why should not the same be true for public companies?

Fourth, companies differ greatly in their management quality. It is natural that those with better management and more opportunities will reinvest more of their profits and earn higher returns over time. To infer — as many advocates of the short-termism, including a 2017 McKinsey study, do — that this proves all companies should invest more, is to commit the obvious fallacy of confusing correlation with causation.

Reducing the frequency of corporate profit reporting would make big surprises and drastic market moves more likely. It would also allow managers to wait longer before they revealed large problems. Think of how much longer it would have taken for the issues at GE to become clear if the company reported only every six months.

Less frequent reporting would favour professional investors who are in constant touch with management over those whose information would be even more limited than it is today. In an age of big data and transparency, moving towards less would be a very odd step.

What, then, should be done? The rules limiting activists’ ability to distort corporate behaviour should be updated. More transparency on share accumulation would protect ordinary shareholders. At the same time, new restrictions should be imposed to prevent corporate activists from voting as shareholders in companies where they have divergent economic interests from other stockholders — because, for example, they used the options markets to hedge their risk.

Wise corporate leaders should give a sense of their long-term vision on at least an annual basis. Investors who insist on such information are only being reasonable.

The writer is the Charles W. Eliot university professor at Harvard and a former US Treasury secretary.

Corporate Finance and Sustainability

The Case of the Electric Utility Industry

In our last article from the (JACF Winter issue) we discuss how although the electric utility industry is in transition, it still needs to move faster for the country to meet its emissions goals. The industry has historically moved cautiously, but policies and regulatory approaches must avoid unintentionally reinforcing the status quo. Incentive-oriented policies and redesigned regulations must balance environmental sustainability with economic sustainability. The authors draw on well-established corporate finance principles to guide more effective policies. Shareholder-focused utility executives must make investments conditioned by three elements: (1) the return on equity the utility can expect to make on each project; (2) the investors’ required return on equity capital for each project; and (3) the size of the investment.

The well-established economic value added (EVA) model can assist policy analysis: V=(r-k)I; where V is the shareholder value created, r is the return on equity, k is the return investors require if they are to invest in the stock, and I is the scale of the project. Any new incremental V translates into higher stock prices.

All three elements of their model (i.e., risk, return, and scale) require attention by regulators and policymakers to create value for shareholders. The authors show how the right state policies could create powerful incentives for shareholder focused utility executives to support such transitions.

Authored by Steven Kihm, Seventhwave; Peter Cappers, Lawrence Berkeley National Laboratory; Andrew Satchwell, Lawrence Berkeley National Laboratory; and Elisabeth Graffy, Arizona State University

Global Trade – Hostage to the Volatile US Dollar

Global Trade – Hostage to the Volatile US Dollar

Brian Kantor says that (JACF Winter issue) every financial manager ought to have a multi-decade historical perspective on foreign exchange rates to appreciate how quickly and dramatically rates can change. Managers should understand how domestic politics influences central bank policies and, ultimately, foreign exchange rates, even if unintentionally. Longer-term historical perspectives are a necessary part of a solid decision-making foundation.

He provides a summary foreign exchange history from the perspective of the South African Rand (ZAR) and the US dollar (USD). What is most remarkable about such exchange rates, perhaps, is not just the variation around established trends but the tendency of apparently well-established trends to reverse completely. Kantor explains that, since 1970, the global economy has had to cope with flexible exchange rates that do not necessarily trend to Purchasing Power Parity “equilibrium.” This is a highly unsatisfactory feature of the global financial and trading system.

The chance of a reintroduction of genuinely fixed exchange rates seems very small, however. Business decision-makers will have to cope as best they can with unpredictable real exchange rates.

Authored by Brian Kantor, Investec

How to Evaluate Risk Management Units in Financial Institutions?

How to Evaluate Risk Management Units in Financial Institutions?

Continuing in our series of articles from the JACF Winter issue our authors discuss the existing Enterprise Risk Management framework and current government regulations, “banks are required to establish risk management units (RMUs) to review and evaluate their risks, monitor them, and to advise top management.” Currently an integral part of the risk governance and management process, RMUs in financial institutions have become increasingly important since the 2007-2008 financial crisis.

This article details the authors’ creation of an index to evaluate the performance of risk management units in financial institutions, and then examines some of their findings. The index transforms twelve parameters into a simple and convenient index that isolates the RMU’s activities from the rest of the organizational risk management process, its risk preferences and the activities of the rest of the units. The index’s parameters are divided into three dimensions of the RMU’s performance: professionalism, organizational status and relationship with top management and the board.

The authors found a positive relationship between their RMUI and some important risk governance characteristics: CROs who are among the five highest paid executives at the bank, banks with at least one independent director serving on the board’s risk committee having banking and finance experience and boards with greater efficacy.

Authored by Michael Gelman, Ben-Gurion University of the Negev, Doron Greenberg, Ariel University, and Mosi Rosenboim, Ben-Gurion University of the Negev

Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation

Biomarker of Quality? Venture-Backed Biotech IPOs and Insider Participation

Corporate financial managers of biotech firms need long-term financing to reach key milestones, and that requires a long-term capital structure.

In Hans Jeppsson’s article on venture capitalists and IPOs from our JACF Winter issue the author discusses how corporate financial managers of biotech firms must balance a mix of investors with different objectives and different investment horizons that includes traditional venture capitalists and also hedge funds and mutual funds. This study helps practitioners understand the complex role of exit decisions, as venture capitalists seek better exit strategies and performance. IPOs are financing but not “exit” moves.

In addition to certifying firm value, insider purchasing of shares in the IPO offering has two major consequences. First, venture capitalists reallocate large sums of capital from early-stage to late-stage deals that are expected to have lower risk (but also lower expected return) and shorter time to exit. Second, the speed at which VCs exit after the IPO depends on the firm ownership structure after the IPO and the stock liquidity. Going public with a significant participation by venture capitalists will probably increase the post-IPO ownership and decrease the free float of the stock, implying a delay of the exit and the realization of the capital gains from the investments.

Although this study has focused exclusively on the biotechnology industry, insider participation is not unique to it. Biotech’s venture brethren in the software and technology industries also have insider participation in IPOs. During 2003-2015, approximately 41 venture-backed firms outside of the biotechnology sector had insider participation.

Authored by Hans Jeppsson, University of Gothenburg

An Improved Method for Valuing Mature Companies and Estimating Terminal Value

An Improved Method for Valuing Mature Companies and Estimating Terminal Value

The theory underlying discounted cash flow (DCF) models is uncontroversial in academia. Nevertheless, in practice, DCF models are applied inconsistently with very different valuation results.

In David Holland’s article on discounted cash flow models from our JACF Winter issue the author writes that the theory underlying discounted cash flow (DCF) models is uncontroversial in academia, the economic intuition behind them is straightforward, and the mathematics reassuringly simple. Nevertheless, in practice, they are applied inconsistently with very different valuation results. Because of the assumed infinite life (“going concern”) of a business enterprise, DCF models implicitly assume the ability to forecast future cash flows forever. This forces analysts to make assumptions about the terminal period using simplistic metrics such as P/E or EV/EBITDA to estimate terminal values or to embed a perpetual stream of excess profitability and value creation in the terminal period.

The author offers an uncomplicated alternative to these unrealistic assumptions. The first step is to introduce an adjustable fade rate called f. A fade rate of 100% brings about immediate convergence, and a fade rate of 0% specifies no fade and perpetual excess profitability. The notion that excess profits get competed away over time can be modeled by assuming that the spread of (ROIC – r) fades to zero and that economic profit dissipates.

Intrinsic value is very sensitive to the fade rate assumption and this helps explain the risk premium for quality stocks. The risk of owning quality stocks is that they lose their economic moat and competitive advantage. An adjustable fade rate provides an excellent means to value the effect of profitability attenuation in a DCF model.

Authored by David Holland, University of Cape Town Graduate School of Business

Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”

Fundamental Investors Reduce the Distraction on Management from Random Market “Noise”: Evidence from France

Some temporary market enthusiasm may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility

In another of our articles from the JACF Winter issue. the authors find that financial markets have real effects on corporate decisions but that, unfortunately, some temporary market enthusiasm, unrelated to firm intrinsic value, may cause management to make value-destroying decisions as the result of random and uninformed stock market volatility. In particular, they are prone to making bad decisions after stock market overreactions to “surprise” earnings announcements.

This study shows a positive effect of greater long-term ownership on French listed firms. Fundamental investor ownership reduces the degree of market mispricing which serves long-run shareholder value maximization. A fundamental investor is one that, on average, hold his shares for at least two years, is in the top quartile of a firm ownership, and has an active allocation strategy. They are about 8% of all investors. Compared to non-fundamental investors, fundamental investors hold their positions on average three times longer and have positions 1.5 times larger. Fundamental investors are more present in firms which have more liquid stocks, which pay dividends, and which are relatively poorer performers and have relatively lower market-to-book than their industry peers.

Authored by Alexandre Garel, Auckland University of Technology, and Jean-Florent Rérolle, Morrow Somali