In the woke sectors of business and finance, recent times have been rather eventful. In August, the Business Roundtable, a collaboration of 181 CEOs of major corporations, overturned their long-held principle of “shareholder primacy” – that companies exist to serve their shareholders. The Economist reported an emerging trend among Big Business to look beyond their bottom line.
In September, the Financial Times launched The New Agenda, the purpose of which was clearly described by the newspapers’ editor Lionel Barber:
“In the decade since the global financial crisis the [free enterprise capitalism] model has come under strain, [its] long-term health […] will depend on delivering profit with purpose. Companies will come to understand that this combination serves their self-interest as well as their customers and employees.”
Aspiring presidential candidate Elizabeth Warren wants companies run under public charter, guaranteeing that they take broader societal concerns into their decision-making. Colin Mayer’s book Prosperity: Better Business Makes the Greater Good has been making a splash in many finance quarters.
Economists have followed suit. A recent IGM poll – a questionnaire on current affairs that Chicago Booth School of Business regularly posts to top economists – showed an overwhelming share of economists agreeing with the following statement: “Rising inequality is straining the health of liberal democracy.” A similar poll in September showed that most top economists were positively disposed to having companies run in the interest of a larger set of stakeholders.
Clearly, Milton Friedman’s infamous quip, the so-called Friedman Doctrine that a firm’s sole responsibility is to maximize returns to shareholders, seems all but overturned.
Old Wine in New Bottles
The idea that businesses ought to be run with their employees or local communities in mind – or at least take their needs into consideration – is old and returns at regular intervals, often under the auspices of overturning our inefficient and harmful late-stage capitalism. The names come and go: Corporate Social Responsibility, CEO Force for Good, and initiatives for Inclusive Capitalism, but the message remains the same: the needs of workers, clients, community members or the environment must factor into business models.
Amid this renewed financial wokeness, Gillian Tett at the Financial Times wrote a piece titled “Does capitalism need saving from itself?”. She interviewed 88-year-old Marty Lipton, the lawyer whose career of defending companies from hostile takeovers in no small part contributed to overturning the Friedman Doctrine:
When Lipton looked at American Express’s hostile bid back in 1979, however, he knew that money did matter. Since the Amex bid offered shareholders a fat, immediate gain, Friedman’s creed implied that shareholders should accept it. But the McGraw Hill board insisted it would smash the long-term value of the company. So was there any way to stop this? Lipton decided his best route was to attack Friedman directly. In “Takeover Bids” [Lipton’s famous article], he asked whether “the long-term interests of the nation’s corporate system and economy should be jeopardised in order to benefit speculators interested not in the vitality and continued existence of the business enterprise in which they have bought shares, but only in a quick profit on the sale of those shares?”
We can find similar anti-capitalist (or really, anti-finance, anti-Big Business) mentalities in some of the most popular American movies too: the successful 1991 Other People’s Money saw Danny DeVito ruthlessly trying to acquire the New England Wire & Cable Company and selling it for scraps. Edward Lewis, the impeccably dressed ideal of a successful man played by Richard Gere in Pretty Woman, is a corporate raider who buys entire companies and re-sells them for parts.
The outside investor, the merciless and heartless pursuer of profit who engages in hostile takeovers, is the archetypical finance villain that we love to hate. But, I always wonder, if the company being bought up has all these amazing under-appreciated qualities – why would anybody sell?
Hostile takeovers aren’t hostile
On free – or even quite regulated – markets, only governments can compel others to sell goods, services or assets against their will. A “hostile” corporate raider can only buy shares that others voluntarily sell. While some jurisdictions do have clauses that require forced sales when a certain threshold – say 90% or 95% – of shareholders have accepted an outside bid, that doesn’t detract from the general principle: on free markets you can only “make” others sell by offering them something that they value even more.
Lipton is referring to the January 1979 bid by American Express on the information conglomerate McGraw Hill referenced by Lipton. The McGraw Hill management was “negative” to the offer, reported the Washington Post, even though it was at a 30% premium to current share prices.
There are only three ways that a hostile bid can succeed:
- Shareholders don’t see the value that an outsider sees
Every investment strategy pursued by long-term investors or shareholders boils down to projections of future earnings: how much can the company earn in the future? That’s obviously uncertain and individual guesses have a range: for well-understood businesses with little competitive or technological change, that range is going to be fairly small; for technological hot-shots like Facebook or Netflix or Amazon (not to mention the various unicorns that proclaim to overhaul the way we do things) – most of whose value lay in how big their future global market shares can become – that interval is huge.
The market price, argue most people who oppose hostile takeovers, doesn’t reflect the value inherent in the company. That’s exactly right; if it did, we would expect a lot higher daily turnover of shares. By the fact that most shareholders don’t sell at the prevailing market price – or after daily fluctuations of +/- a few percent – we know that they value the business much higher. How much higher? No idea; what their reservation price is, is entirely unknowable to us.
If an outsider, like Amex or Richard Gere’s character or any other corporate raider wishes to acquire a company, they must persuade shareholders to sell; in essence, they must pay above the reservation price. If they see a 30% upside to a company (through synergies, missed potential, or cost-cutting), but their owners see a 100% upside to current share prices – nobody will sell, and the takeover bid will fail. If the shareholders’ estimation of fair value lies only 10% above current share prices, and Amex sees value above 30%, why shouldn’t they sell?
In essence, this is no different than any other transaction: I value my coffee a lot higher than the price charged by the coffee shop; the coffee shop owners value my dollars higher than the commodities, capital and labor that goes into producing coffee. Trading makes us both better off. Why would that be any different when the object of our transaction is the entire coffee business rather than a single mug of coffee?
2. Shareholders have higher discount rates
It could be that the estimation of future earnings is higher for current shareholders than the outside investor, but that the former have much higher discount rates. Discounting the future is a fundamentally human attribute, a perfectly acceptable practice among finance practitioners or economists, but often dubious and strange in the view of non-economists. A dollar earned today is worth more to me than a dollar earned next year, partly because of the uncertainty of the future, partly because I can invest that dollar today and end up with more than a dollar next year.
Discounting future earnings is how we “translate” them into the present, making them comparable to today’s money. If current shareholders are greedy and suffer from short-termism, as Lipton and McGraw Hill’s management suggest, they discount the company’s future earnings steeply. If an outside investor doesn’t, then changing owners is a good thing if we care about the long-term success of the business. That’s what low(er) discount rates mean: you put a relatively larger weight on the future than the present.
3. The outside bidder is overpaying
This is almost the same as (1) but looked at from the opposite perspective. If a corporate raider pays way above the reservation price of most shareholders (their estimation of fair future value, properly discounted) – but selling would somehow “destroy” that long-term value – couldn’t shareholders simply accept the bid and plunge this new money into re-creating their better-run business?
If it were true that a hostile takeover would “destroy” value, even though the Richard Geres and Amexs of the world overpay, and current management and shareholders know a better way to run the business – they could just take this massive up-front gain (remember, above the company’s current value), set up a better-operating business and pocket the difference!
A few years later, when the unreasonable Richard Gere and silly Amex have run the original company into the ground, and the original shareholders’ new venture has succeeded, they can simply repeat the process. In economics, we call this a “Money Pump”. In real life, those don’t last very long since their assets are routinely siphoned off to others better suited to manage them. Contrary to the allegations of Tett or Lipton – and perfectly in tune with common sense – accepting bids above fair value enriches those who accept it, not the corporate raiders who mismanage their new asset.
If all the non-pecuniary values that Lipton & Co claim exist, and they contribute crucially to the business, then he and his colleagues a) must argue that his own stockholders are tempted to sell, they don’t actually believe that talk, b) ought to buy shares themselves.
Wanting companies to fix the ills of the world is a strange demand; it’s highly doubtful that companies have any particular insights into how to do that. Hostile takeovers are misnomers, as there is no way for outside investors to take over another company unless they pay top-dollar to induce current shareholders to sell. Objecting to them on principle is naïve: if corporate raiders underpay, their bid will fail; if they overpay, current shareholders and management can take the new funds, restart the business and outcompete the raider – pocketing the difference and living happily ever after.
Capitalism, especially seen as a system conducive to hostile takeovers, does not need saving.