The genius of capitalism is to create incentives to solve some of mankind’s most challenging problems, writes Ben Andradi

We live in increasingly uncertain times and are facing what could be described as a perfect storm: the combination of pollution, overconsumption of finite natural resources, the accumulating risk of catastrophic climate change, unprecedented levels of financial indebtedness, widening inequality and a global population of seven billion that is rising fast. These problems require long-term solutions but we have a capitalist system, in particular capital markets, focused on the short term. It is short-term capitalism where most businesses are focused on quarterly performance. Any reform of capitalism needs to begin with how we get the capitalist ecosystem to be incentivised to avoid this short-termist outlook. This mindset chokes off much long-term investment to solve some of the major challenges facing our society and world.

The first area that needs to change is a redefinition of the purpose of business away from solely maximising shareholder value. There are many well-established case studies of the causes behind the demise of great British companies of the 1950s and 1960s like GEC and ICI. Their failure was caused by excessive focus on maximising shareholder value in the short term. These companies, which had prospered for many decades focusing on the long term, adopted the shareholder value mantra in the 1990s and cut investment and R&D to drive up their stock price in the short term and, not surprisingly, failed after a few years. In contrast, companies in the same sector in Germany, with a different institutional framework, like BASF and Siemens, have prospered over many decades, across multiple economic cycles, focused on the long term.

If you asked a British chief executive in the 1950s, an era of tremendous prosperity growth, what the purpose of his business was, the first reply would probably have been, ‘to make great products and services for customers.’ After that, the chief executive might have said something about looking after the company’s employees, making profits to invest in future growth – and then, finally, giving the shareholders a decent, competitive return. We need to see businesses as society’s problem-solvers rather than simply as vehicles only for creating shareholder returns. This is the genius of capitalism – to create incentives to solve some of mankind’s most challenging problems and create prosperity. For example, every item in a modern retail store (either physical or on the internet) can be thought of as a solution to a different kind of problem – how to eat, dress, entertain, make homes more comfortable, and so on. We need to shift incentives back toward long-term investment – after all, few complex human problems can be solved in one quarter. This is not to say that shareholders are unimportant. But providing them with a return that is competitive compared with the alternatives is a necessary condition for a successful business; but it is not the purpose of a business. After all, having enough food is a necessary condition for life – but the purpose of life is more than just eating.

There are a number of areas that need to change to reform capitalism across what is called the investment value chain. In a simplified way this chain consists of asset owners (mainly owners of capital like pension funds which employees contribute to), asset managers (who get mandates to invest the asset owner’s funds in businesses), to companies which are controlled by boards of directors that employ people who fund the pension schemes. There are key elements of the way the incentives, regulation and structure of this value chain lead to an excessive focus on short-term behaviour.

Some of the problems include, first, stock incentives of chief executives of businesses being focused on the short term. Many chief executives can game the system to drive their short-term earnings. Today FTSE 100 chief executives earn 120 times more than the average full-time employee, compared to 47 times in 2000. The median FTSE 100 director earns £2.4m and this is rising so fast due to stock incentives which are focused on a two-to-three-year time horizon. Many companies have decided to spend most of their operating cashflow on direct payouts to shareholders in the form of stock buybacks and dividends and not invest in projects that have a long-term payback.

Second, the fiduciary responsibility of directors. According to UK company law the directors of a company are required to act in good faith to promote the long-term success of the company, in particular, to focus on the consequences of decisions for the long-term interests of the company’s employees and operations on its community and its environment. However, most directors in reality focus on one thing only – to maximise the short-term share price and not to focus on wider stakeholders. This is a very narrow perspective of their fiduciary responsibilities.

Third, short-term owners who do not engage with their businesses. Asset managers who are the shareholders of all publicly listed companies should have greater incentives to engage with the companies they own, and own them for the long term, contributing more to business performance. We should also look to give long-term shareholders greater votes in annual general meetings compared to short-term shareholders.

Beyond such factors, reforming capitalism to focus on the long term is made impossibly difficult as our political system is also focused on the short term. Most politicians concentrate on short-term issues, are fixated on the 24/7 news cycle, and have a limited understanding of business and capital markets. The lack of attention by the political class to such a fundamental issue compounds this even further. Reforming the political system to focus on the long term has to happen in parallel.

———————————

Ben Andradi is chair of the Common Good Foundation and has worked extensively in private equity

———————————

Photo: open sourceway