Sunday, November 6, 2011

The Capitalist Wants an Exit

Like a gratifyingly large proportion of posts here, Disgorge the Cash! got a bunch of great comments. In one of the last ones, Glenn makes a number of interesting points, some of which I agree with, some which I don't. Among other things, he asks why, if businesses really have good investment projects available, rational investors would demand that they pay out their cashflow instead. Isn't it more logical to suppose that payouts are rising because investment opportunities are scarcer, rather than, as the posts suggests, that firms are investing less because they are being compelled to pay out more?

One standard answer would be information asymmetries. If firms have private information about the quality of their investment opportunities, it may be more efficient to have capital-allocation decisions made within firms rather than by outside lenders. The cost of being unable to shift capital between firms may be less than the cost of the adverse selection that comes with information asymmetries. That's one answer. But here I want to talk about a different one.

Capital in general, and finance in particular, places a very high value on liquidity. But if wealth owners insist on the freedom to reallocate their holdings at a moment's notice, and need the promise of very high returns to let them be bound up in something illiquid, then investment in the aggregate will be inefficiently low. As Keynes famously wrote,
Of all the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets there is no such thing as liquidity of investment for the community as a whole.
Or as Tom Geoghegan recalls, from the last days of the old regime in the late 1970s,
Once a friend of mine from Harvard Business School came to visit, and I took him to South Works, just to see it.

"Wow," he said. "I've never seen so much capital just lying on the ground. At B School we used to laugh at how conservative these big steel companies are, but then you could come out and see all this capital, just lying on the ground..."
Capitalists, in general, do not like to see their capital just lying on the ground. They prefer it to be abstract, intangible, liquid.

There's no question that the shareholder revolution of the 1980s had a strong distributional component. Rentiers thought that workers were getting to much of "their" money. But if we're looking specifically at the conflict between shareholders and management -- as much a conflict between worldviews as between distinct groups of people -- then I think "the fetish of liquidity" is central.

As Keynes understood, liquidity is what stock markets are for. What they're not for, is raising funds for investment. That wasn't why they were invented (the publicly traded corporation is a relatively recent innovation), and it's not what they've been used for. Apart from a few years in the 1920s and a few more in the late 1990s, stock issues have never been an important source of investment finance for firms.

Let's talk about Groupon. Huge IPO, raised $700 million, the biggest offering in years. So, those people who bought shares, they're getting ownership of the company in return for providing it much needed funds for expansion, right?

Except that "Groupon has been shouting until it’s blue in the face that it doesn’t need the IPO cash, that it’s fine on the cash front, that the IPO is just a way of going public, and is not really about the money-raising at all." Cashflow is more than enough to finance all their foreseeable expansion plans. So why go public at all, then?

Because their existing investors want cash, that's why. Pre-IPO, Groupon was already notorious for using venture capitalist funds to cash out earlier investors.
Groupon is a very innovative company, and this is one of its most important innovations — the idea that the founder can and even should be able to cash out to the tune of millions of dollars very early on in the company’s lifecycle, while it is still raising new VC funds.... Historically, VC rounds have been about providing capital to companies which need it; in Groupon’s case, they’re more about finding a way to cash out early investors
But the venture capitalists need to be cashed out in their turn. After CEO Andrew Mason turned down offers from Yahoo and then Google to purchase the company, his VC bankers became increasingly antsy about being stuck owning a business, even a business selling something intangible as internet coupons, rather than safe pure money. Thus the IPO:
The board — and Groupon's investors — had a message for Mason, though. Someday, he was going to have to either accept an offer like that one he had just turned down, or take this company public.

One investor recounts the conversation: "We said, okay Andrew, you took venture capital, and remember venture capitalists want an exit.  It doesn't have to be tomorrow but you always have to be thoughtful when a company comes to buy your company, because it's not just you, it's your employees, options, investors and alike."
That's what Wall Street is for: to give capitalists their exit.

The problem finance solves is not how to allocate society's scarce savings between competing investment opportunities. In modern conditions, it's the opportunities that are scarce, not the savings. (Savings glut, anyone?) The problem is how to separate the rents that come from control of a strategic social coordination problem from the social ties and obligations that go with it. The true capitalist doesn't want to make steel or restaurant deals or jumbo jets or search engines. He wants to make money. That's been true right from the beginning. It's why we have stock markets in the first place.

Historically the publicly-owned corporation came into being to allow owners (or more typically, their heirs) to delink their fortunes from particular firms or industries, and not as a way of raising capital.

In her definitive history of the wave of mergers that first established publicly-traded corporations (outside of railroads), Naomis Lamoreaux is emphatic that raising funds for investment was not an important motivation for adopting the new ownership form. In contemporary accounts of the merger wave, she says, "Access to capital is not mentioned." And in the hearings by the U.S. Industrial Commission on the mergers,  "None of the manufacturers mentioned access to capital markets as a reason for consolidation." Rather, the motivation for the new ownership form was a desire by the new capitalist elite to separate their wealth and status from the fortunes of any particular firm or industry:
after the founder's death or retirement, ownership dispersed among heirs "who often were interested only in receiving income" from the company rather than running it. Where the founder was able to consolidate family control, as in Ford or Rockefeller,
the shift to public ownership was substantially delayed.

The same point is developed by historians Thomas Navin and Marian Sears:
A pattern of ownership somewhat like that in the cotton textile industry of New England might eventually have come to prevail: ownership might have spread, but to a limited degree; shares might have become available to outsiders, but to a restricted extent. It was the merger movement that accelerated the process and intensified it - to a smaller extent in the earlier period, 1890-1893, to a major degree in the later period, 1898-1902. As a result of the merger movement, far more people parted with their ownership in family businesses than would otherwise have done so; and doubtless far more men of substance (nonindustrialists with investable capital) put their funds into industry than would otherwise have chosen that type of investment. ...

[As to] why individual stockholders saw an advantage in surrendering their ownership in a single enterprise in favor of participation in a combined venture ..., one of the strong motivations apparently was an opportunity to liquidate part of their investment, coupled with the opportunity to remain part owners. At least this was a theme that was played on when stockholders were asked to join in a merger. The argument may have been used that mergers brought an easing of competition and an opportunity for enhanced earnings in the future. But the trump card was immediate liquidity.
The comparison with New England is interesting. Indeed, in the first half of the 19th century a very different kind of capitalism developed there, dynastic not anonymous, based on acknowledging the social ties embodied in a productive enterprise rather, than trying to minimize them. But historically the preference for money has more often won out. This was even more true in the early days of capitalism, in the 17th century. Braudel:
it was in the sphere of circulation, trade and marketing that capitalism was most at home; even if it sometimes made more than fleeting incursions on to the territory of production.
Production, he continues, was "foreign territory" for capitalists, which they only entered reluctantly, always taking the first chance to return to the familiar ground of finance and long-distance trade. Of course this changed dramatically with the Industrial Revolution. But there's an important sense in which it's still, or once again, true.

14 comments:

  1. Hmm...I'm not sure even on account of the evidence you offer that you've got it quite right. Granted there are inherent limits on how much fixed investment can be rendered "liquid", (though that's even more the problematic case for maturity transformation in bank lending than for equities), isn't it more the diversification of risk rather than liquidity per se that's sought? And that goes together with mergers/consolidation to achieve scale, as the other means of strategic risk reduction. So then the existence of secondary markets in outstanding equities provides some indirect incentive or support for large-scale capital formation. (And I'm not so sure that little capital has been raised through stock issuance. It may be that during relatively stable periods with incumbent oligopolies, there is simply little need to raise capital that way, whereas during unstable periods of disruptive innovations and capital switching, equity sales would be more important). And then again stock prices become significant in the defensive/offensive strategies in the M&A field of further consolidations, if not always successful ones. But VC investment is equity investment and they would want to sell out to the secondary market both to cover their losing bets and to free up capital for further bets, once the most profitable part of scaling up had passed. SO the secondary markets are still a facilitating factor there.

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    1. Liquidation puts an end to risk. This is true in VC where the exit is the end of the life cycle and a necessary component of the plan, and in speculative trading where unless you're Warren Buffett the purpose of the trade was again to exit on the winning side of price action.

      in Econospeak I might say the arbitrageur's role ends at some point. whereupon they want someone else to hold the "solid".

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  2. I'm not sure I've got it right either!

    Here are some things I am reasonably sure of:

    Liquidity and diversification are distinct conceptually. Mainstream economics emphasizes diversification, a response to risk, and largely ignores liquidity, a response to uncertainty. (Altho, that is changing a bit.)

    Keynes was talking specifically about liquidity. So was Braudel, tho he didn't use the word. I believe that's what the historical articles are talking about as well. The key difference is that liquidity preserves your freedom to do whatever you want with your wealth, at a moment's notice, and therefore separates your fortunes from those of any particular firm or industry. That's why you want to hold your wealth as money. A diverse portfolio of real assets doesn't deliver on the first goal at all, and in practice is pretty limited in its ability to deliver the second.

    Was Keynes right? I think so, but maybe not. We have to keep testing these ideas against reality. But what I do know, is that Keynes was not just using a funny word for diversification when he said liquidity, anymore than he was just using a funny word for risk when he said uncertainty.

    And again, while it's impossible to render fixed capital liquid from the point of view of society as a whole, it's certainly possible for an individual to do so, by transforming their socially-recognized claim on that particular asset into a claim on social wealth in general, i.e. money.

    I'm not so sure that little capital has been raised through stock issuance.

    This one, I am sure of. Biggest problem with this post may be that I didn't give any numbers. Will add some. It's true.

    the existence of secondary markets in outstanding equities provides some indirect incentive or support for large-scale capital formation

    Right. Keynes is very good on this. Given that the option of holding wealth in liquid form exists, a prospective borrower has to be able to offer liquidity as well.

    The key point I was trying to make in this post is that stock markets don't exist to get capital into firms, they exist to get capital out of them. You might say no one would put money into a business if they weren't assured that they would quickly be able to take it out. (No capitalist engages in M->C->C' unless it's immediately followed by C'->M', if you like.) Obviously, there's an element of truth to this, tho it may be more historically contingent than people tend to think. But even if you think quick money out is a necessary condition of money in, it's still important to understand what's doing which.

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  3. But to get back to my hobby-horse, the stagflationary crisis of the 1970's after the break-down of Bretton Woods was a global crisis in industrial profitability, which was expressed more in failing returns to financial "assets", with a secular bear market and capital losses to "fixed income" investors, more than through a liquidation of real capital stocks. Profitability was to be restored through successive waves of restructuring corporate rents through "cost reductions" aimed first of all at the wage bill and progressing to globalizing production platforming and financialized FX arbitrage strategies, thereby increasingly stove-piping those rents to the top. The alignment of top management with "shareholder value" interests through the fetishization of stock prices is as much a symptom as a cause of what has been happening. The problem with it, now come home to roost, is that it amounts to "maximizing" the value of existing investment at the expense of investment in future value-expansion. There is no global savings gut, but rather, by a well-known accounting identity, a global investment dearth. The only "glut" is in those rent-extractions that have been stove-piped to the top, at the expense of both adequate READ and further productive investment. Which is in the end self-defeating, and leads just to the popping of speculative financial bubbles into which the excess extractions flow. But that's not a specific problem with equity investment per se, but a broader systemic problem. If capitalists want an exit, then they can only achieve it by crashing their own system.

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  4. My second comment, prior to your response, got lost again.

    But I linked the issue of diversification to consolidation, not to liquidity preference. Going back to your New England textile mills case, whatever those gentile folks might have said, and without having any actual knowledge of the case, likely what was going on was a response to technological forces, (electricity?), dictating consolidation at increased scale. "Family firms" were no longer viable.

    More generally, there is a general aversion by "capitalists" to the high hurdle rate involved in large-scale investment, required for consolidation, and the diversification argument, (while, mind you, not ignoring the flip-side of investment in corporate equity, limited liability), helps to overcome, if only partially, such aversion, precisely by attracting investment from different quarters.

    An individual investor might benefit by cashing out,- and there is no reason why individual interests should be aligned with aggregate social welfare,- but hoarding cash in favor of other investment opportunities is unlikely to be optimal for that investor. Of course, capitalists in general can not cash out their investments, without crashing their system as a whole and destroying the value of their capital, though that has never been known to happen.

    I think, by focusing on the current dysfunctions of the equity markets, in terms of "maximizing shareholder value", you're possibly liable to be confusing symptom with cause, rather than focusing on unearthing the "deeper" system problem.

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  5. I agree that the stock market is mainly about liquidity and not fund raising. The stock market is an expensive funding method, only used as a last resort (and often by scam artists).

    Liquidity is a big deal since it enables everyone to effortlessly hold a diversified portfolio, including small investors and people who can't make a long term commitment. It's not a fetish, it's a real advantage.

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  6. Anon-

    Glad to get some agreement on the most important point. That there are advantages to liquidity from the point of view of the individual asset owner is inarguable -- otherwise, people wouldn't pay a premium for it. How it plays out in the aggregate is a different question, tho, one that hopefully I'll return to.

    jch-

    the stagflationary crisis of the 1970's after the break-down of Bretton Woods was a global crisis in industrial profitability, which was expressed more in failing returns to financial "assets", with a secular bear market and capital losses to "fixed income" investors, more than through a liquidation of real capital stocks.

    This is the big question, obviously. I basically believe the wage squeeze story, as for instance in Armstrong, Harrison and Glyn's Capitalism Since 1945. But, funny thing. The late 1970s actually saw the biggest investment boom in US history. There's an important sense in which inflation redistributes income from rentiers to entrepreneurs, and is favorable to accumulation. I wouldn't be surprised if we start seeing more liberal Keynesians beginning to revisit the 1970s and ask if the cost of inflation hasn't been exaggerated.

    There is no global savings gut, but rather, by a well-known accounting identity, a global investment dearth.

    Couldn't agree more. I'm presenting a paper next week that includes that sentence almost verbatim.

    Going back to your New England textile mills case, whatever those gentile folks might have said, and without having any actual knowledge of the case, likely what was going on was a response to technological forces, (electricity?), dictating consolidation at increased scale. "Family firms" were no longer viable.

    OK, I can't blame you, since I just linked to the book and didn't provide any explanation. But Dalzell argues really convincingly (IMO) that this is not the case. The early New England industrialists really were sociologically different from later American capitalists, in the sense that their orientation wasn't toward the endless accumulation of money but the reproduction of elite families by providing their sons with enterprises to run, just as earlier generations had passed on farms. So there wasn't the same pressure to liquidate businesses at the death or retirement of the founder that gave rise to publicly traded firms elsewhere, and instead you saw a pattern of cross-ownership between a set of manufacturers, banks, railroads and insurance companies that were also socially linked. (A bit like the bank-centered industrial groups that later developed in Germany and Japan.) Though it didn't survive in the end, in the mid-19th century this system had a lot of advantages -- it was much more resilient in the face of panics and crises than businesses that depended on more arms-length financing.

    To me, the most interesting thing about this is the reminder that capitalism has a sociology. I think there's an interesting way in which Marxists (I'm including you in this group, maybe wrongly) and neoclassicals converge in seeing capitalism as a more or less mechanical process, in which the logic of profit maximization produces unique, determinate outcomes. One of the reasons I'm such a fan of Dumenil and Levy is they are among the only contemporary Marxists who take Veblen seriously. They recognize that the abstract "capitalist" is really composed of a bunch of different social groups, and that which of them are the actual decisionmakers varies in important ways depending on the historical context.

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  7. My textile mill reference wasn't to the 19th century, but to what your authors said occurred around 1900. (Though I typed "gentile" instead of "genteel", but, hey, if the shoe fits...)

    But my basic interest here is in how productive investment is brought to sufficient scale, which is usually a big problem for basic innovations in processes and products, and I would suspect that the existence of equity markets might play more of a role there, even if indirectly, than you would seem to allow, (based on the intuition that something can't become dysfunctional without first having some basic functionality). Just to puzzle out the relations between the monetary and financial economy and the "real" productive economy, though granted neither could exist in abstraction from the other.

    It wouldn't surprise me if there was a surge in investment in the late 1970's, though how well it was realized would be another matter. My bio-empirical memory is that U.S. disinvestment waves first took hold in the 1980's, (when, e.g., U.S. Steel bought Marathon Oil and changed its name to USX, in the face of world-wide steel over-capacity).

    I self-identify as a meta-Marxist, with Frankfurt Schoolish "origins", not the orthodox kind. As for Marx, though his work is often taken to imply some sort of institutionalism, his concept set is Hegelian, whereby the world is a human objectification and thus institutional orders are "objective spirit", even if he claimed to invert idealism into materialism. More adequate conceptual means for specifying the structuring of social action and institutional orders were only gradually developed later.

    So are D. and L. heirs to the regulation theorists?
    http://en.wikipedia.org/wiki/Regulation_school

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  8. JW - I thought you might find this piece of interest. Not only the subject matter (rising US inequality post-1978), but the fact that it's another sign of the FIRE sector itself recognising the phenomenon - with concern!

    http://ftalphaville.ft.com/blog/2011/11/10/738151/what-does-it-take-to-get-a-new-lobbyist-around-here/

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  9. "There is no global savings glut, but rather, by a well-known accounting identity, a global investment dearth."

    Surely the ol' Sector Financial Balances approach gives the right answer, as usual. The real issue is that S-I is too big. Blaming S for being too big (savings glut) is just as erroneous as blaming I for being too small (investment dearth). The magnitude of I per se doesn't appear to be very informative - as a large number may well result from horrendous malinvestment.

    Also, whilst your post feels broadly correct, it seems you can address the same ground with two separate phenomena. First, if you can learn to stop worrying and live with it, maturity transformation should provide the obvious bridge to render capitalists' desire for liquidity less dysfunctional for the economy as a whole - ie by replacing equity claims with deposits and bank loans.

    I would make a separate point which is that, of the total financial claims in an economy, there should be a lot more equity(-like) claims than at present. Not sure how this would be brought about, especially as dividends and capital gains already get a cushty treatment tax-wise

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    1. Anders, I think you're saying fractions of profit are better incentive wise than fixed lumps. I kind of see that, but lumps don't require accounting/valuation, andas far as incentives go it's unclear to me that peodit sharing should beget more productivity.

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  10. The real issue is that S-I is too big. Blaming S for being too big (savings glut) is just as erroneous as blaming I for being too small (investment dearth).

    There's an important sense in which this is true. But if we are comparing the current situation to some alternative -- either an earlier period in time, or the outcome of some policy --- then it's perfectly reasonable to ask about the relative importance of changes in the parameters governing S vs. those governing I.

    if you can learn to stop worrying and live with it, maturity transformation should provide the obvious bridge to render capitalists' desire for liquidity less dysfunctional for the economy as a whole

    Absolutely. That's the whole history of modern capitalism, or at least a main strand of it. But financial innovations that make illiquid assets appear liquid (it's liquidity rather than maturity per se, I think, tho obviously they're connected) have their own costs, as we've recently seen.

    of the total financial claims in an economy, there should be a lot more equity(-like) claims than at present.

    Here we disagree. If we must have rentiers, I prefer the functionless coupon-clipper. Of course what I really want is to reduce the proportion of claims on the social product that take the form of financial assets of any kind.

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  11. (Re maturity transformation, remember Schumpeter:

    "It is one of the most characteristic features of the financial side of capitalist evolution so to ‘mobilize’ all, even the longest, maturities as to make any commitment to a promise of future balances amenable to being in turn financed by any sort of funds and especially by funds available for short time, even overnight, only. This is not mere technique. This is part of the core of the capitalist process.”)

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  12. We can trace risk sharing to long before legal corporate entities, which I think bolsters your argument. t.co/de8j7c8f

    Also worth tying in is that it's broadly acknowledged that public markets make terrible owners of firms due to their shortsightedness. In fact private equity firms or active investors can take firms off public listing for a few years then float them again at improved valuation. Even though that's theoretically impossible

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