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Capitalism’s fatal flaw

08 December 2017 by Anthony Hilton

Capitalism’s fatal flaw - Read more

Business and shareholder interests are not always aligned

Capitalism only works, we are told, if shareholders take an active interest in the companies they own, and are willing both to challenge and support executives.

Reality is rather different. In smaller businesses the executives are often the shareholders and although that alignment works for the first generation it causes problems thereafter.

It is often impossible to accommodate all the second generation of shareholders in meaningful managerial roles while still having an eye on quality. Even when this can be done, someone has to be the first among managerial equals and that is a breeding ground for jealousy, resentment and dysfunction.

By the third generation the shareholdings are so diffuse that keeping the rest of the shareholders onside can be almost a full-time job for the one member still trying to run the business.

Shareholders by then are largely absent and inevitably have competing objectives, though the majority probably see the business as a source of income rather than anything else.

Engagement works in private equity to the extent that the shareholders drive the business, taking a major interest in the development of an appropriate and agreed strategy and being brutal with executives who fail to deliver. But even this has its limitations.

A surprisingly high proportion of companies fail to do anything exceptional while under private equity stewardship. This suggests that alignment, while thought to be desirable, is not itself sufficient to guarantee success.

Joint deals, where the shareholding is spread across more than one private equity house, usually do not work. The relationships are notoriously difficult to manage and often lead to feuding among the shareholders – who are also rivals – and disappointment with the outcomes.

“Alignment, while thought to be desirable, is not itself sufficient to guarantee success”

Even with just one owner it is rare for their participation to run beyond five years, or one elongated business cycle. This relatively short-term horizon derives from the private equity business model and its need to deliver returns to the underlying investors so they will support a follow-up fund.

However, it also hints at the limits of how long alignment is likely to operate at peak effectiveness.

There are also problems on the next rung up, which is the smaller end of the quoted-company sector. Regular readers will be familiar with the challenge issued by former business executive Tom Brown in his recent book on the decline of British engineering.

Brown says that throughout his career he would have welcomed engagement from informed shareholders, but that is not what he got.

Instead he criticises City analysts and fund managers for their woeful ignorance of business matters, their willingness to see a divestment or a deal as the solution to every problem, for taking a tick-box approach to corporate governance, and for operating on a time horizon that totally fails to appreciate how long it takes for management to deliver genuine organic growth.

If big institutional investors are therefore found wanting, what about the activists who buy a stake in a company for the sole purpose of achieving change? Here it is best to confess to a degree of cognitive dissonance.

On the one hand, there is something to be said for a system where even a giant company like HSBC can be forced to acknowledge and respond to the criticism of an activist with a shareholding of only a few per cent, as the bank was a few years ago when attacked by Elliott Advisers.

On the other hand, there is something disquieting about an activist with a holding of only a few per cent seeking to bend a board to its will, with no regard as to whether this is in the long-term interest of the company or the other shareholders.

All this has been capped in recent weeks by a still more questionable innovation. TCI, an activist hedge fund run by Christopher Hohn, has called for an extraordinary general meeting of the London Stock Exchange Group to oust chairman Donald Brydon, who has already agreed not to seek re-election.

This was originally part of a strategy to pressure the board to reverse its earlier decision to accept the retirement of its current chief executive Xavier Rolet and search for a successor.

As we go to press, the crisis is still playing out. It is worth asking, however, how boards can be expected to manage if they are to be subject to this kind of challenge.

If sensitive and difficult decisions are to be reopened by shareholders and examined under the full glare of publicity, boards will shy away from taking them. That is hardly likely to further the interests of good governance, and seems a strange way to foster the building of a successful business.

Anthony Hilton is financial editor of the London Evening Standard

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