NEW TRENDS IN CORPORATE GOVERNANCE

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NEW TRENDS IN CORPORATE GOVERNANCE

• Michel Aglietta
• University of Paris X (EconomiX)
• and CEPII
• For the GRESS Workshop
• May 22, 2007

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New trends in Corporate Governance the prominent
role of the long-run investor

• Corporate governance revisited
• Who is the owner of the firm?
• Principal/agent versus team theory of the firm.
• Strategic complementarity and multiple models of
  corporate governance
• Conflicting trends in finance impact on
  governance
• Shareholder value and the rise of HF and PE funds
• Strategic asset allocation has a long-run impact
  on governance
• Institutional activism in corporate governance

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The problem of corporate ownership lies in the
labour contract

• The labour contract is radically incomplete
  because human capabilities are not alienable.
  Only the right to rent the use of labour
  capacities for limited lapses of time is
  contractualized.
• But the use of human capabilities implies
  subordination Whoever commands other peoples use
  of labour power does not predetermine the content
  of work.
• The more complex the work is, the more human
  capabilities become intangible assets bearing
  residual claims on the total value of the firm.
• Human capital is not tradable capital
  markets are intrinsically incomplete

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The corporation is the owner of the firm

• Subordination entails complementarity
  The firm is the domain where subordinated
  complementarity is co-ordinated under the aim of
  capital self-generating value
• This abstract aim pervading the whole of society
  has been formalised as a legal universal the
  corporation
• The corporation is the legal entity with property
  rights on the firm as long as it generates value.
  It is an owner by destination represented by its
  Board.
• The Board is the locus of strategic power. The
  accountability of the Board to its stakeholders
  is to trustee/beneficiary, not to
  agent/principal.

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The firm is a team co-ordinating intangible assets

• Strategic complementarity of specific assets
  generating a quasi-rent multiple
  interests and risks combined under max. total
  value expansion co-ordination game.
• Co-ordination games with strategic
  complementarity feature multiple equilibria
  different models of governance and possible
  governance failures.
• Since there can be good or bad equilibrium, the
  problem arises of which types of governance are
  likely to deliver better outcomes and via which
  mechanisms.

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Strategic complementarities and multiple
equilibria
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Strategic complementarities and anomalies to the
dogma of shareholder value

• Governance in the sole interest of shareholders
  is a poor principle facing multiple assets
  participating to the quasi-rent
• The relevant principle is Max long-run total
  value Max mark-to-market value under strategic
  complementarities.
• Multiple Nash equilibria mean that there is no
  best way to run a firm Diversity in the
  models of governance
• The composition of the Board and the principles
  of governance implemented by the Board are
  crucial
• Crisis of governance the Board captured by a
  sub-group of stakeholders interests (Enron,
  Vivendi, Parmalat, Worldcom and the like)

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Types of corporate governance
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Principle of shareholder value and control via
the Stock market

• The CAPM determines
• (i) Equilibrium real return on equities ? i
  ß (? m i)
• (ii) Cost of capital Cmpc ? (FP/K) r (D/K)
  ? (? r)(D/K)
• i riskless rate of interest, ? m yield on the
  market portfolio, ß systematic risk of the firm,
  r average cost on debts , FP book value of own
  funds, D la book value of debts, K FP D book
  value of assets and D/K leverage (d).
• The cost of capital is an increasing function of
  d as much as rlt? Cmpc ? (? r)(d/1d)

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Shareholder value and market value

• EVA R ? FP
• (ROE ?) FP
• (ROA Cmpc) K,
• With R net profit, ROE R/FP and ROA (RrD)/K
• Introducing Tobins q market value/Book value
  of equities
• One can show EVA
• Furthermore r is a decreasing function of q
  because the distance to default diminishes with
  the rise in the stock market.
• As a consequence shareholder value is uplifted
  by
• Share buybacks and MA that enhance the market
  price of the firm
• Higher leverage used in HF strategies and loaded
  on target firms by PE

r (q - 1) (?-r)(d/1d)K
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HF and PE what is common, what is different?

• Hedge Funds
• Deal with publicly traded assets and are
  unregulated
• Quest of absolute return over short horizon (a
  chasing)
• An array of investment strategies in capital
  markets aiming at excess return shield against
  market volatility
• Funding by pension fundsand mutual funds (via
  funds of funds)
• Financial leverage via short selling, collateral
  and derivatives
• Opaqueness due to lack of regulation and biases
  in databases

• Private Equity Funds
• Specialize in privately held investments
• Value extraction by a rearrangement of corporate
  ownership
• Mainly Buyout of target companies for
  restructuring, asset stripping and resale over 3
  to 5 years
• Funding by pension funds, banks
• hedge funds, insurance cies
• Forced indebtedness of the target co
  redistribution of wealth to handful of owners
• Inbuilt opaqueness via mutation in ownership
  public private

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HF performances are not what they pretend to be

• HF performance indices are plagued with biases
• Self-reporting bias stems from voluntary
  reporting
• Selection bias databases cover small and
  disparate parts of the HF universe
• Survivorship bias withdrawal from the data of
  the funds that have ceased to provide information
• Adjustment for biases reduce returns dramatically
• B.Malkiel and A.Saha, HFs risk and return,
  Financial Analysts Journal, vol. 61, n6, CFA
  institute from TASS database

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Most HF strategies are vulnerable to extreme
losses

• To achieve returns they boast, HF managers resort
  to non-linear strategies grounded on non-Gaussian
  processes that entail negative skewness and (or)
  large kurtosis. The financial weakness induced by
  large losses is magnified by leverage.

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Is private equity a profitable bet for
institutional investors?

• The structure of risk is very far from being
  Gaussian
• Skewness and kurtosis risks are very high.
• Buy-outs are akin to event-driven hedge fund
  strategies skewness-2.6 and kurtosis20.
• It ensues that the standard measure of risk
  (Sharpe ratio) has no meaning and the standard
  method of portfolio allocation (linear
  relationship between risk-adjusted returns of
  individual assets and market return) is
  irrelevant.
• Private equity is a highly illiquid asset class
• The risk of illiquidity for an institutional
  investor is the risk of not being able to
  rebalance that part of the portfolio because the
  assets are stuck for several years.
• The risk should be compensated by a liquidity
  premium. Portfolio simulations show that it
  reaches about 3.5 to 4 on average.

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PE seemingly higher return and hidden risk

• Skewed and leptokurtic distribution of risks,
  illiquidity and variable correlation with other
  asset classes and high leverage make standard
  portfolio allocation inadequate and potentially
  dangerous.
• Portfolio bonds/marketable shares/private equity
  applying standard portfolio theory
  without correcting for biases gives a false sense
  of safety

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Impact of PE on corporate governance

• With PE, firms are treated like financial
  products 3 to 5 years horizon may have a
  negative impact on innovative investment in
  target companies.
• PE funds extract cash flow in indulging in asset
  stripping and distributing extra-dividends
  (recaps), thus weakening productive investment or
  loading companies with excessive debt.

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Impact of PE on social responsibility

• Change in employment jobs in finance,
  precarious and low-skilled jobs, - stable and
  skilled jobs in industry.
• Pressures on labor costs offsetting the heavy
  financial load and achieving the much higher
  financial return required by shareholder value.
• Deterioration of social climate PE general
  partners take the control of the board of
  acquired companies to maximize the capital gains
  in reselling the firm a few years later
  They have no interest in collective bargaining.
• Cuts of specific investment in human capital
  those investments are profitable for the firm as
  a going concern and are realized in a time span
  much longer than the horizon of PE.

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Impact of PE on public services

• Operating public services a target for PE
• Natural monopolieshigh and stable profit margins
• Capital intensive firms lavish cash flow
• Right to use public goods without due
  compensation
• Conflicts between long-run investments required
  to provide the services of public infrastructures
  and PE objectives
• Heavy debt loads restrain investment needs in RD
  and quality improvement of public services
• Threat on universal access of public services at
  affordable prices for everybody
• Regulatory authorities must strengthen the
  control on the governance of public service
  operators that have surrendered to PE funds.

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Strategic asset allocation of long-run
institutional investors goals and requirements

• Universal owners hold a scale model of global
  capital
• Social commitments beyond financial performance
• Accumulating long-term assets and preserving
  their purchasing power
• Providing steady income streams to their
  beneficiaries
• Socialising household risks in the life cycle to
  implement retirement plans
• Immunising liability risks in life insurance
  contracts
• Therefore they are concerned with macroeconomic
  returns and risks in the long run

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Principles of strategic asset allocation

• Defining a small number of large asset classes
  substantially differentiated along functional
  criteria
• Debt/Equity, credit/No credit risk,
  liquid/illiquid, domestic/foreign, vulnerable to
  inflation/deflation
• Using a mix of quantitative analysis and
  qualitative judgement
• Time dependency of asset returns and structural
  changes in financial markets make historical data
  unreliable to assess the relationships between
  asset returns.
• Fundamental analysis is of the essence in shaping
  assumptions on future returns and risks.

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Benchmarks for strategic asset allocation

• The riskless asset for a long-run investor is a
  public, high-quality, option-free bond
• A nominal, fixed-coupon bond in a deflationary or
  a stable money regime
• An indexed bond in an inflationary regime
• Long position in marketable domestic equities
  makes the core of a high-yield, well-diversified
  portfolio
• Equities and bonds benefit from mean-reverting
  forces for sufficiently long horizons.
• Volatility in bonds, equities and correlation
  bond/equities declines with multi-year investors
  horizon.

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The virtue of mean-reverting forces
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The dominance of equities in strategic asset
allocation
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Active use of alternative asset classes

• Alternative asset classes are powerful tools to
  diversify risks (absolute return strategies, real
  estate) or to enhance long-run returns (private
  equity)
• Embodying them in institutional portfolios
  requires active management and control
• Those assets are outside organised markets no
  benchmark available and strong dependency of
  performance on the skill of asset managers
  crucial importance in selection process of
  delegated managers
• Improving disclosure and stress testing are
  requirements institutional investors should
  insist on to handle those asset classes.

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Strategic choices by six of the largest pension
funds
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Institutional investors as agents of market
discipline on HF and PE funds

• Institutional investors have a fiduciary duty to
  perform due diligence in monitoring the funds
  they hold as alternative assets
• They should lobby to close information gaps under
  the pressure of their own regulators
• Specifying disclosure requirements to invest in
  hedge funds exposure, vulnerability to market
  risk factors (stress tests), leverage
• Info delivered in standardised template to ensure
  easy aggregation on strategies and investment
  zones
• Disclosure of concentration of HF trades that
  might impair meaningful diversification of
  institutional investors

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Institutional activism in corporate governance

• A relevant model of corporate governance for the
  rising importance of intangible assets as sources
  of growth and the subsequent enforcement of
  stakeholder interests a common goal requires a
  strategic view that encompasses all interests and
  that can be designed in the board as a business
  model.
• Institutional investors as possible integrators
  in corporate governance because they are both
  public equity holders and private equity owners
  they should impinge on the structure of the board
  and on the conditions of its decision-making.

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Institutional activism in corporate governance

• Universal owners have social as well as financial
  responsibilities. They undergo real risks
  (political, demographic, economic) to ensure that
  invested capital yields a reasonable
  risk-adjusted return in the long run.
• They get directly involved in corporate
  governance to solve their pb how influencing
  corporate management with small ownership
  involvement in each firm?
• Manifold actions
• Investing in corporations whose structure have
  inbuilt countervailing powers under the authority
  of a Board independent of executive management.
• Exerting voting rights in general assembly.
• Lobbying in networks of public pension funds to
  assure equal treatment of all shareholders and
  compliance to checks and balances. Requirements
  in governance must be clearly communicated.
• Checking the long-run sustainability of firms
  strategies allowance for all stakeholders
  interests, ethical code, internal control systems
  of environmental and social consequences of
  investment policy.