The public corporation is no longer fit for purpose, and its popularity as an ownership model is declining.
Why It Happens
In today’s capital markets, the model incentivizes executives to manage in tiny, short-term windows, thus failing to satisfy the primary needs of its critical stakeholders: retirement investors and knowledge workers.
How to Fix It
Switch to a model in which the owners are an employee stock ownership plan (ESOP) and one or more pension funds—thus focusing governance on ensuring real long-term performance rather than on short-term stock price fluctuations.
The professionally managed, widely held, publicly traded corporation has been the dominant structure in business for the past 100 years. It came to prominence in the wake of the Great Depression because it was effective at mobilizing capital from private investors—who by the 1960s held more than 80% of company stock—for productive ventures. The model enabled executives to focus on long-term growth and profitability, to the benefit of the many individuals who owned shares in their companies.
Over the past 40 years, however, the fitness of the public corporation has been called into question. Critics charge that in today’s far more heavily traded capital markets, the model increasingly incentivizes executives to manage in tiny, short-term windows, with an eager eye on their stock-based compensation and a fearful one on activist hedge funds. Whether or not they’re right, something isn’t working: The number of public companies in the United States halved from 1997 to 2015, while the number of controlled companies (those with a dominant shareholder or a dominant group of shareholders) in the S&P 1500 increased by 31% from 2002 to 2012. The number of companies with multiple voting shares among S&P 500 companies increased by 140% from 2007 to 2017.
In this article I’ll track the decline of the public corporation, explain why that model no longer satisfies the primary needs of critical stakeholders, and present a new one that I believe could well displace the public corporation as the dominant structure in business.
The Turning of the Tide
The shift against public corporations can be traced back to the late 1970s. A key marker was a 1976 article published in the Journal of Financial Economics by Michael C. Jensen and William H. Meckling, titled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”
The paper argued that professional managers are imperfect agents who, if left to their own devices, are inclined to maximize their welfare rather than that of shareholders. The solution to that problem came to be seen as stock-based compensation. That idea and its underlying assumption that the shareholder was the company’s primary stakeholder triggered an explosion in stock and stock-option grants over the following decades.
Public corporations no longer serve the interests of their most important shareholders—retirement investors—or the most critical part of their workforce: knowledge workers.
Unfortunately, there is little evidence (as I have argued elsewhere) that corporate performance has actually improved as a result. That’s partly because the shareholder-value revolution that Jensen and Meckling helped trigger has had the unintended consequence of focusing top executives on short-term movements in their companies’ stock prices rather than on long-term value creation. CEOs started meeting more and more often with investors and the analysts whose advice those investors followed. To demonstrate the superiority of their strategies, they would emphasize how much shareholder value they had created since last checking in. At the same time, falling transaction costs and new approaches to portfolio management encouraged the large, professionally managed investment institutions to trade more actively.
The corporate raiders who came to prominence in the early 1980s amplified the effects of these trends. Their activism gave executives an added incentive to pay close attention to the stock price. If they didn’t, a raider could launch a hostile takeover bid, gain control of the company, fire them, and possibly tear the company apart to wring maximum immediate value from it—as Carl Icahn famously did with Trans World Airlines after his 1985 takeover. Where the raiders led, today’s activist hedge funds have followed, but with far more capital at their disposal.
What constituted good or bad management performance became clearly defined from one perspective following the creation in 1980 of the First Call service, which aggregated analysts’ forecasts to come up with a “consensus forecast” of each company’s quarterly revenue and earnings. An executive team knows that if it doesn’t hit the consensus forecast, its company’s stock will be trounced by traders, increasing the danger of a hostile takeover. That provides executives with a powerful incentive to meet the quarterly consensus even if doing so means sacrificing longer-term goals. Research confirms that they do indeed make this trade-off. They may even engage in fraud: In the early 2000s executives seeking to boost their stock price were responsible for accounting scandals of a magnitude never seen before: those involving Enron in 2001 and Adelphia, Global Crossing, WorldCom, and Tyco in 2002.
The Failure of the Public Corporation
Attempts have been made to improve the governance of public corporations. The 2002 Sarbanes-Oxley Act, for example, introduced new rules concerning the independence of directors and set requirements for financial expertise on boards in an effort to avoid further accounting scandals. CEOs and CFOs were made personally liable for their financial statements. Stock analysts were obliged to disclose conflicts of interest and breakdowns in buy, hold, and sell recommendations. But such fixes don’t address the root of the problem, which is that public corporations no longer serve the interests of their most important shareholders—retirement investors—or the most critical part of their workforce: knowledge workers.
Peter Drucker was, as usual, right in 1976 when he forecast the rise to prominence of pension funds, arguing that America’s workers would come to own the means of production through equity ownership by the pension funds that held their retirement assets, rather than through a violent revolution by the proletariat. People saving for retirement constitute the largest group of investors today.
These investors typically have a very long-term outlook—20, 30, or 40 years—and defined-benefit pension plans are strictly liable for established retirement benefits (as are life insurers, whose interests largely align with those of such plans). Although defined-contribution pension plans, such as 401(k)s, and IRAs carry no such liability, the managers of those investments share the goal of producing high long-term returns to maximize beneficiaries’ retirement income. They can and do invest in long-term bonds, real estate, and infrastructure. But to earn at the levels required, they must also invest in equities, which have typically offered the highest rates of return.Photographer Andrea Stone documents how reflections of cityscapes distorted by light, glass, steel, and stone invite the viewer beyond the rigidity and solitude of urban architectural forms. Andrea Stone
As things stand, however, executives’ incentives are clearly not aligned with retirement investors’ need for long-term value creation. What’s more, the investors are largely powerless to change this state of affairs. One might assume that large institutions such as BlackRock, Fidelity, State Street, and the big pension funds have so much capital that they can force executives to act in the interests of their clients. Although some are attempting this, their ability to do so is limited, because the large funds are so big that each of them has ownership in most of the market. That means two things: First, the big institutions can go only so far in punishing any one company, because if they sell out, depressing the share price, they will simply provide an opportunity for a leveraged buyout or an activist hedge fund. Second, big, diversified funds have no incentive to see any one company do particularly well, because they own all its competitors; any outstanding success on the part of one company will come at the expense of its rivals and their stock prices. One might think that an institutional shareholder of Kimberly-Clark would like to see the company come up with a fantastic innovation that enabled its Huggies disposable diapers to crush P&G’s Pampers. But because it’s likely to hold as big a position in P&G as it does in Kimberly-Clark, its gains on the latter’s stock would probably be offset by its losses on P&G stock.
The bottom line is that institutional investors have neither the ability nor the incentive to discipline executives, protect companies against rapacious hedge funds, or even encourage companies to compete aggressively.
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