How firms relate to markets – Page 2

Understanding ESG investment

The Financial Times has published a flurry of articles and the occasional letter about ESG (Environmental, Social and Governance) investing recently.

For example, Geeta Aiyer, president of Boston Common Asset Management, was the subject of a profile on 29^th August. This followed the success of Boston Common and other investors to secure the change of name of the Washington Red Skins American Football team by applying pressure on FedEx, the logistics company which sponsors the team’s stadium.

On 1^st September the paper published an article about write-downs at BP and Shell in response to “scores of asset managers who have doggedly pressed the oil companies to set targets to reduce carbon emissions and recognise the financial impact climate change could have on their operations” . The article cites a number of leading fund managers who comment on the “explosion” in ESG investing. It also notes the role of regulation in changing perspectives, citing the requirement now placed on pension fund managers in the UK take sustainability issues into account in their investment decisions and the impact of the EU’s sustainable finance package which will, from March 2021, push asset managers to incorporate ESG risks in their decision making.

A day later, on 2^nd September, the FT published an article by Chuku Umuna, former Labour business spokesman and now lead for ESG with Edelman, the public relations consultancy, arguing that “a company’s ability to manage ESG factors is widely viewed as a proxy for prudent risk management, and with good reason”, citing work by Société Générale on the impact of ESG-related controversies that found that “in two-thirds of cases a company’s stock experienced sustained underperformance, trailing peers over the course of the following two years.”

A few months earlier, on 9^th July, Gillian Tett wrote an article that opened by observing that the major ESG indices in the US and in Asia had outperformed the equivalent all share indices in terms of the financial returns to shareholders and cited a report from BlackRock making the same case, not only in the past year but also in 2015/16 and in 2018. BlackRock put this down to two primary reasons: the momentum created by ESG investors pushing up prices as they seek to acquire these stock for their clients and beneficiaries; and the value to companies seeking to improve their ESG ratings the scrutiny to which they subject their supply chains and employee practices and the consequent benefits that arise to their businesses.

Does the Escondido Framework approach to understanding organisations help us understand what is going on?

The Escondido Framework approach to looking at the firm is described in detail elsewhere. In essence, it explains that firms exist as a virtual space defined by their market interface with the suppliers of capital, labour, suppliers of goods and services, and customers, plus others whose needs may need to be satisfied, such as government or the wider community who implicitly or explicitly provide the firm with a license to do business. Their survival depends on creating value through the efficiency of their internal operations for there to be such a space. Where the firm places itself within the space will determine the distribution of economic rent to the stakeholders, how much may retained by the executive management, and how is available for reinvestment either in assets or long term relationships with one of more sets of stakeholders. As the market interfaces changes – through changes in supply and demand, competition, or the trade-offs made by the other parties to the markets place exchange – the virtual space (which can also be considered as the solution space available to the management team) may expand or contract (increasing or reducing the range of options, strategies and potential profitability available).

If a new external party intervenes, for example a government agency imposes regulation, the virtual space will be reduced correspondingly. Indeed, even the threat of regulation will have the effect of reducing the space as the firm is likely to take the view that it cannot afford to provoke the regulator.

Impact of new regulation to reduce solution space

So what is going on with ESG investment? ESG considerations have an impact on investment decisions in multiple ways.

Some investors will choose only to invest in businesses whose practices meet certain standards in terms of environmental and/or social responsibility and impact. When I was trustee of a large medical charity, we initially had a relatively limited list of sectors that we guided our fund managers to avoid, but progressively widened the list to avoid those whose products were implicated in contributing to the ill-health we working to address. Other charities have much wider exclusion lists, and many private individuals also choose to invest in ethical funds. Such investors are making an explicit trade-off between such potential increased returns as may be available from investing in companies (eg defence, tobacco) that don’t satisfy their ethical criteria.

Other investors decide to invest in ESG funds and businesses that meet ESG criteria because they believe that companies that with sound governance, ethical approaches to the communities in which they operate and setting high standards in their supply chains, and responsible approaches to the environment will ultimately deliver higher long term returns and be sustainable. Such investors may also take the view that these approaches also represent good business. Working in retail management as a merchandise director in the 1980s, I certainly took the view that being as environmentally responsible as possible was good business. I led a team that decided to adopt policies towards sourcing products from sustainable raw materials, reducing packaging, and developing “green” product ranges making extensive use of recycled materials on the basis that it was good for the business. It was good for our brand as it improved our standing with increasingly environmentally conscious customers. It was good for our sales, since people appeared keen to buy less environmentally harmful alternatives. It was also good for recruitment and retention of good staff, who seemed motivated (as I was) by working for a company that was trying to be environmentally responsible.

High standards of governance should also be appealing to investors, and the evidence is strong notwithstanding the mercurial successes of a few mavericks. As chair of a committee investing £200 million for the charity on which I was a trustee, I was attracted to Edinburgh based fund managers, Baillie Gifford, precisely because of the demands that it placed on the governance of their investee companies and its willingness to vote the shares it held for client like us to improve governance of the investee companies – and we were rewarded for our confidence in the approach by returns that consistently exceed the benchmarks for the fund.

If, as the flurry of FT articles suggests, there is an increasing appetite for ESG investing for whatever reason, the impact on companies is that (at least for the visually minded) the shape and precise orientation of their interface with the investment market will change reflecting either the trade-offs (in the case of the first type of investor described above) or the beliefs about the sustainability and long term returns (in the case of the second type of investor). The consequence of the appetite for ESG investing on companies is that those with business practices that align with the demands and expectations of ESG investors will face a slightly lower cost of capital and consequently increase the size of the solution space for the management teams when looking at their strategies.

What happens to organisational “dark matter” when everything moves on-line?

Much of my working life moved on-line when Covid-19 hit. From time to time, I still go into the office although it feels as though a neutron bomb has hit: the building is there, but it is largely empty and most of those normally there are working from home. All the meetings that were conducted face to face before mid March now take place on video conferencing platforms (although half the time my colleagues have cameras switched off or their on-screen presence has frozen). Research appears to suggests that the productivity of most of the people now working remotely is higher than before. I miss my commute because it provided a welcome opportunity for exercise and included a delightful bike ride along the Grand Union Canal, but I am sure that I am in a small minority.

I miss the serendipitous conversations that take place in the corridor, making coffee, in the margins of formal meetings, and in the course of visits that I make as chairman to the front-line units and staff of my organisation. I have recruited a couple of new colleagues during the Covid-19 lockdown and we have had to manage their induction remotely, which clearly has its drawbacks. But other than these examples, I don’t get the feeling that the way that we do business has suffered much so far. However, is this sustainable?

David Robson has written an article in New Scientist[1], suggesting that “the coronavirus pandemic may be dismantling your social network without your realising it”. This echoes a concern of mine that the way most of us, and most organisations, have coped through the changes enforced Covid-19 has been only been possible as a result of the accumulated investment in relationships built up face-to-face. My board know each other well, know how to interpret each other’s contributions, will make allowances for each other and can generally anticipate how others will react to what they have to say. This has helped carry us through the past five months and will continue to assist through the next few months as, we all hope, we emerge from the crisis. This will apply to all sorts of established relationships around any organisation, will underpin day to day conversations and routine business, and will inform the diplomacy and political manoeuvring around the more tricky transactions. Assets on our balance sheet are liable to decay and, in our accounts for our business, we apply depreciation to them to reflect this. The intangible assets that are our social capital and which have carried us through new pattern of remote working are no different.

Robson’s article led me to a New York Times interview with Satya Nadella (personally heavily invested in video-conferencing, and consequently other people’s remote working, as CEO of the organisation that owns MS Teams and Skype). “Mr. Nadella said that raw productivity stats for many of Microsoft’s workers have gone up, but that isn’t something to ‘overcelebrate.’ More meetings start and end on time, but ‘what I miss is when you walk into a physical meeting, you are talking to the person that is next to you, you’re able to connect with them for the two minutes before and after.’ That’s tough to replicate virtually, as are other soft skills crucial to managing and mentoring.”[2]

Robson continues his article by summarising a wide range of research around social contact, and highlighting its value to us in terms of mental wellbeing and importance dimensions such as trust. In a sidebar to his main article, he quotes Peter Drucker writing in 1993 “It is now infinitely easier, cheaper and faster to do what the 19^th century could not do: move information, and with it office work, to where the people are. The tools to do so are already here: the telephone, two-way video, electronic mail, the fax machine, the personal computer, the modem, and so on.” Robson notes that it has taken the pandemic for people to realise that they can work with less face time and discusses why it has taken a crisis to realise the potential for more people to work remotely. But while he concludes that “the relative success of new ways of working in the pandemic would certainly suggest that we can get by with less face time” he acknowledges that it would be unwise to scrap it entirely.

I worked remotely for much of the 1990s (with a dial up modem and Compuserve email address that consisted of numbers alone). Consequently, the revelations about the productivity of people working from home come as no surprise. However, I was working as a consultant and on private equity projects at the time. The work from home was interspersed with face to face activity with clients, selling projects and ideas, negotiating deals and persuading investors to back me. I was operating on my own or in small teams rather than a large organisation that was creating a greater value than could be achieved by a series of discrete market transactions and with the benefit of what I have described elsewhere as organisational “Dark Matter”. Having moved in and out of varied working arrangements and organisations differing in size over the past forty years, I know the importance of face to face contact in building relationships that are strong enough to be effectively maintained at a distance.

The large, global consultancy firm where I worked in the early 1980s employed a variety of devices to build relationships within the local office and the world-wide firm: consultants were expected to return to the office on a Friday to lunch together and receive a short presentation about a colleague’s project and piece of training; at each stage in your career development you attended residential courses with your peer group; practice groups would hold regional conferences to share learning; and the international partner group would meet for an annual conference. All this contributed to building a shared set of values, common approaches to solving client problems, and the ability to work remotely while remaining part of the firm.

It is important to recognise the corollary of Robson’s thesis: with remote working there is a risk that the quality of relationships will decay over time, particularly if the context in which the relationships were developed changes, if you don’t make this sort of investment. The “new normal” may involve much more remote working, but organisations need to recognise that the success of this approach over the past five months has been made possible by years of investment in social capital by having people working together previously. They will need to invest in “maintenance social capital” by getting people to getting people together sufficiently frequently to address the depreciation in this asset if they want to continue remote working in the longer term.

[1] New Scientist, 20th August 2020, pp32-36. “Missed Connections”

[2] New York Times, Dealbook Newsletter, 14^th May 2020

Moody’s says Lloyds’ ethnic diversity plan is ‘credit positive’

The Financial Times reports today that Lloyds Banking Group’s plans for promoting more black employees have been described by Moody’s as “credit positive”, the first time that a credit agency has explicitly linked a company’s stability to ethnic diversity measures. Moody’s has not gone as far as to upgrade Lloyd’s credit rating at this point, but it clearly indicates that Lloyds’ plans are “credit positive [implying that they have the potential to reduce the company’s cost of capital, even if not immediately] because they will improve staff diversity at all levels and reduce Lloyds’ exposure to social risk”.

Lloyds has stated that it recognises that some groups are under-represented in its ranks. Anyone viewing the current TV advertising campaign for its domestic mortgage lending arm, Halifax, showing a diverse mix of staff ready to serve customers despite working under Covid-19 restrictions at home, can see that Lloyds is not talking about front-line staff in this instance. It has set a target to increase five-fold the number of black staff in senior roles by 2025 and will be publishing data on its ethnicity pay gap.

Investors and rating agencies have been taking increasing account of environmental, social and governance (ESG) risks, reflecting the importance of sustainability, on all measures, to the corporation and to those who invest in it or lend to it. The note about Lloyds published by Moody’s on Thursday is a welcome acknowledgement of the work Lloyds is undertaking. Action of this sort should improve internal culture, communication, engagement and ultimately operational performance and profitability. The motivation behind showing a diverse face to the TV audience is that it contributes to winning customers and increasing revenue. The response of Moody’s suggests that yields benefits in addressing the capital market interface, ultimately increasing access to capital and reducing its cost.

Let us hope that Moody’s response to Lloyds’ efforts spurs others to recognise that action on equality, diversity and inclusion is good for business.

Lessons from a Warzone, by Louai Al Roumani

My NHS Trust has an annual “Lessons Learned” conference, for sharing the lessons that teams have drawn out from incidents that have taken place in the previous twelve months. Don’t waste a crisis by failing to learn from the experience. This book is about lessons learned from a crisis, but is much more than just another business book.

Louai Al Roumani was the fairly newly appointed CFO of the leading retail bank in Syria when the Arab Spring turned into the Syrian civil war. Most of his family fled to the safety of Kuwait as conditions turned nasty (ironically, they had been living in Kuwait when Saddam Hussein invaded in 1990, but missed the occupation because they were on vacation in what was then a very safe Damascus), but Al Roumani chose to remain, loyal to his home city and his company.

“Lessons from a Warzone: How to Be a Resilient Leader in Times of Crisis” recounts the lessons learned by Al Roumani over the next five years. In this time, despite mortar bombs falling in Damascus and ISIS reaching the outskirts, his bank, BBFS, didn’t just survive but thrived. It did this by doing things that when explained by Al Roumani, and you should already have realised if only you thought about them for moment, make lots of sense even if they fly in the face of what many less insightful managers and directors might do (and, indeed, was evidence by departure of the two directors appointed the one of the major investors).

The lessons include going the extra mile to look after customers (airlifting safe deposit boxes out of a local branch as ISIS overran a provincial town), providing them with reassurance (displaying piles of cash when they queued up to withdraw their deposits and not restricting the amount they could withdraw), looking after staff and avoiding redundancies and cost-cutting around workplace hygiene factors ,and robust systems testing and disaster planning.

He draws on his heritage as a Syrian, living in a city that claims to have been longest continuously inhabited community in the world (a claim of Damascus that Aleppo contests), but also sharing the nomadic transitions of hospitality and reciprocity of Arabi culture. There are great insights relating to thinking about the long term health of the company, informed in part by a different “concept of time” from the one that he had been exposed to during his Harvard MBA. He argues that you should not treat profitability as a critical success factor but that if you see your objective the long term wealth of your shareholders you will from time to time have to sacrifice short term profitability. Although his bank was a creation only of the 1990s, he argues for playing “the long game as a third generation family business does.” He tells a charming anecdote of a large purchase from a shop in the Damascus souq where, in contrast the lady ahead of him who haggled hard and secured no discount, the old gentleman who been silently observing the young man serving Al Roumani gave the instruction that Al Roumani should receive a discount to reward him for not haggling. The account provided by Al Roumani explains why BBFS displayed such resilience through the Syrian civil war that it both maintained sustainable positions in relation to the marketplaces it deals with and also built the corporate and social capital inside the organisation not just to survive but the thrive.

Don’t read this book just for the business lessons. It is a powerful tale of the resilience of a man and a society in the face of enormous threat and massive upheaval. You will learn about the experience of a slice of Syrian society during the last decade and about the cultural hinterland that supports it. It is also a human tale, which keeps resurfacing through the book and continues right through to the acknowledgements at the back – just for once, make the effort to read these as the book keeps on giving right up to the final page.

Lockdown – through the Escondido lens

We are in lockdown with Covid-19. Large parts of the economy are in suspended animation. Other businesses are operating on a hugely reduced scale. Others have recognised that their sales have dried up but have redeployed that assets and staff to help address the pandemic. The Chancellor of the Exchequer has become the “employer of last resort”, funding 80% of staff wages as an inducement for companies to keep people on their payrolls.

How should we interpret the reshaping of businesses through the lens of the Escondido Framework? In particular, what does it do those market interfaces that define the firm as visualised in a simple form by the Reuleaux Tetrahedron?

Are companies in the same business now that they were last month, before lockdown? In some cases, it easy to say that, at least temporarily, they are: the Lymington sail maker who has turned over his computer fabric cutting capability to turning out fabric pieces for others to sew up as scrubs for NHS front line staff and the university engineering departments that have deployed their 3D printers to make components for surgical masks. These companies have moved from one market into completely different one. Their staff, capital, and suppliers are relatively unchanged, but they have exchanged the customer market with which they usually interface with a completely different one.

Others have been transformed into agents of the state: temporary distributors of transfers by a government that has banned their businesses (particularly those in consumer services: retail, hospitality, entertainment) from operating. In their cases, the regulatory interface (not displayed in the 4 market interfaces of the Reuleaux Tetrahedron that describes the simplest companies, but has to be imagined in a multi-dimensional context) has moved inwards to the degree that the company is no longer creating value other than as a channel for transfer payments.

Another way of looking at the interpretation is that the company exists only in a shadow form, some ghost of what the company could become once again. I suspect there is a quantum analogy here – the locked down company with furloughed staff as Schodinger’s Cat. Certainly, the physical assets remain present, the staff remain employed, the wiring of the corporate structure remains in place, and the Dark Matter of the soft things such as relationships, corporate memory, social glue, shared assumptions, implicit operational and communication protocols continue – albeit that they may be vulnerable the longer that the lockdown continues. Zoom and its competitors keep some of the Dark Matter alive. The efforts that the investor, directors, and managers make in supporting and communicating with their staff will help, but the longer the uncertainty remains, or if the companies scrimp on their effort and investment in maintain this soft stuff, the greater the risk that the Dark Matter will leak away.

Markets, State and People by Diane Coyle

Rousseau observed that “Man is born free but everywhere is in chains”. Many people in business, politics and media talk about markets in a similar way, as though “free markets” are the natural state and desirable order and any intervention by an agency of the state or collective popular action is represents an undesirable fettering of enterprise.

Economists since Adam Smith have recognised that markets can fail and may need to be subject to intervention. Even figures as inspiring to simplistic supporters of free markets as Milton Friedman recognise that there are proper roles for the state where markets fail.

Diane Coyle starts in much the same place as other economists who look at limits of markets and the place of government intervention in markets. She starts with conventional analysis of market failures, listing seven instances of failure in the conditions required for free markets to be efficient. She returns these seven types of failure throughout her examination of the relationship between markets, the state and people, and description of the appropriateness of state intervention or collective action to address.

In cataloguing the failures and the responses to them, Coyle assists the reader, from the economics or politics undergraduate or MBA student getting their first exposure to welfare economics and public policy, through to the general reader seeking a better understanding of how the world works. She draws on and explains clearly the work of people like Coase, Ostrom and Thaler who have broadened and deepened our understanding of how people both cause and respond to the seven types of failure she describes. The book is furthered enriched, and the lessons consequently rendered more accessible, by a peppering of case studies illustrating the core arguments.

Coyle also tackles government failure, highlighting the shortcomings in bureaucracies (or among public servants) and as a consequence of political failures (or failures of politicians) that result in the application of the wrong policies to address the market failures. The text seems to peter out in the final chapter where she addresses what she appears to hope is the solution to the problems of government failure, which is the application of evidence to economic policy. In this chapter that she reveals the limitations of her experience as a career academic and regulator, with a rather slight addressing of the use of statistics and cost benefit analysis. This doesn’t detract from the power (or readability) of the previous nine chapters, but point to the opportunity for someone else to write something of similar tone and quality to fill the gap on how to test public policy initiatives to address market failure.

Employee activism: what does the Escondido Framework say?

Staff at Wayfair, the online furniture and household goods company, have been protesting at their employer selling furniture to a company equipping migrant detention centres in the US.[1] What does this say about the relationship of companies to their staff, about limits on the ability of shareholders to exercise power over the behaviour of that conventional theory suggests that they own, and about the rights and responsibilities of every one of us in relation to the organisations that we work for?

The relationship of companies to their staff

An organisation should consider ethical and political behaviour as part of the marketing mix when it thinks about its strategy towards its employees. Charities and other not for profit organisations are generally able to employ staff at a lower cost than organisations without an ethical mission because their staff make trade-offs between the income they receive in cash and feeling that they are achieving something for the wider good. As I have written elsewhere, when I headed up the buying and merchandising for the UK’s largest retailer of stationery in the 1980s, I argued to my bosses that the halo effect of developing environmentally responsible product ranges would be to enhance our standing among the students graduating from universities where we were recruiting. By selling to a company equipping detention centres, Wayfair has effectively shifted its positioning on one of the marketing dimensions of its interface with employees. This decision may blow over, but in the longer term Wayfair needs to consider whether to adopt a clear stance about the larger customers it sells to or it may ultimately have to accept that is will need in some way or other to change. This might involve paying staff a bit more in order attract staff to replace those who don’t want to be involved doing something they view us unethical. Or, if we make the assumption that one of the benefits of employing ethically informed staff is they are more trustworthy, it may need to put controls in place to cope with the risk that staff who are not as ethically sensitive to offset a lower level of trustworthiness. Or, if the values of the staff protesting against the sales for the detention centres reflect cultural norms in the location of the offices or warehouses in which they work, Wayfair may need to go to the expense of moving its operations to locations where the local population is less sensitive to such issues.

Limits on company owners

Ownership is a complex subject. Ownership of a piece of paper that says you have a share in the common stock of a company gives you a right to residual profits of a company and (assuming it is voting stock) in decisions about the appointment of directors of the company. And even if you are the owner of the entire voting share capital, it does not give you the ability to dictate everything that the company can do. Others who interact with the company can exercise their rights too. The Wayfair employees have made it clear their views and are attempting to limit the ability of the company’s owners to sell to whoever they wish. It is not a matter a law, or at least not law alone, the practical balance of power between an incumbent workforce, the managers and directors, as well as those of people who have invested in the company all come into play. In the case of a company with publicly traded shares that offer the opportunity to exercise votes once a year, if at all, and then only as a very blunt instrument, the shareholders can hardly been exercise ownership rights in relation to decisions about whether to sell to the developer of a migrant detention centre. The managers and directors will have to consider what is best for their own interests: do we concede to the employees’ demands, or do we shift the company’s market positioning in relation to the explicit and implicit interests of the workforce?

Our rights and responsibilities in relation to the companies we work for

The workforce at Wayfair may have put their jobs at risk. Those who have walked out are likely to have breached their contracts of employment. But acting in line with your conscience is not a matter of exercising a right as discharging a responsibility. The staff at Wayfair will be making trade-offs (or need to realise that this is what they are doing) between doing what they believe is right and their immediate financial self interest. The level of risk they take will reflect their own market power: can their employer find substitute staff with the requisite skills at a price that it can afford, or will it respond to the pressure from the protest, and furthermore, are they supported by the legal framework surrounding their employment or not?

[1] “Activist employees pose new labour relations threat to bosses: Wayfair walkout shows CEOs cannot duck political risks by claiming neutrality” FT 4^th July 2010

Should customers have come first in the GKN battle?

I don’t disagree with Michael Skapinker often, but his commentary on the successful bid by Melrose for GKN in today’s Financial Times “Customers should have come first in the GKN battle” had me getting out a metaphorical red ballpoint to mark his homework.

It was a shame. He made such a good start, rehearsing points that he has made well in the past about shareholder value:

Whose interests should companies serve? For decades, the answer, particularly in the US and the UK, was shareholders’. Total stock market return, the argument went, was clear and measurable and it kept managers focused — until Jack Welch, former General Electric boss and one of shareholder value’s greatest champions, denounced it as “the dumbest idea in the world”.

That was in 2009. Mr Welch was not the only business chief to notice that the financial crisis had shredded the idea that if companies looked after shareholders, everything else would follow. Josef Ackermann, then-head of Deutsche Bank, said: “I no longer believe in the market’s self-healing power.”

A little later in his article, I also awarded him marks for citing the late Sumantra Ghoshal of London Business for arguing in 2005 that:

the people whose contribution should be recognised first were employees, who also took the biggest risks;

shareholders could sell their shares far more easily than most employees could find another job;

and employees’ “contributions of knowledge, skills and entrepreneurship are typically more important than the contributions of capital by shareholders, a pure commodity that is perhaps in excess supply”.

Not content with citing Sumantra Ghoshal with approval, Skapinker moved on later in the article, in the context of the intervention by the Tom Williams, chief operating officer of Airbus’s commercial aircraft division, about the need for long-term investment and strategic vision in the aircraft industry, to cite “the great” Peter Drucker for saying that

the purpose of business was to create a customer. Without that customer, there are no jobs for workers, no returns for shareholders and no strategic skills for nations.

All good stuff, and essentially consistent with Escondido Framework thinking, but Skapinker and others who were unhappy at the outcome of the bid seem to have missed the point about what was happening.

During the takeover battle, much was made of the heritage of GKN, whose origins lay in the founding of the Dowlais Ironworks in the village of Dowlais, Merthyr Tydfil, Wales, by Thomas Lewis and Isaac Wilkinson ion 1759. John Guest (whose name survives in the “G” of GKN – formerly Guest Keen and Nettlefold) was appointed manager of the works in 1767, and in 1786, he was succeeded by his son, Thomas Guest, who formed the Dowlais Iron Company. However, the links to the multinational automotive and aerospace components company of 2018 are slight and accidental.

The company acquired by Melrose consists of four major divisions: GKN Aerospace (Aerostructures; Engine Products; Propulsion Systems); GKN Driveline (Driveshafts; Freight Services; Autostructures; Cylinder liners; Sheepbridge Stokes); GKN Land Systems Power Management; PowerTrain Systems & Services; Wheels and Structures; Stromag); and GKN Powder Metallurgy (Sinter Metals; Hoeganaes). This is a collection of businesses that is the outcome of over a hundred years of acquisitions and disposals across the globe¹. At least at the parent company level, there is little to suggest the opportunity for much value creation from them all being part of the same corporate entity.

What business was GKN plc in? The management of a portfolio of business units, primarily in manufacturing but some in services, spread across a range of different industries and technologies serving a variety of different types and classes of industrial customers, many but not all being OEMs.

Who were the customers of the corporate entity, as opposed to the subsidiaries (which are the entities that interface directly with the purchasers of goods and services, with their employees, and with suppliers)? Perhaps the subsidiaries themselves, insofar that they derived value from the parent company and investment funds, in return for cash returned to the parent? Perhaps the employees of the subsidiaries, at least in so far as they were beneficiaries of a corporately administered pension scheme (that, incidentally, Melrose committed to topping up with an extra £1 billion)?

Much has been made, including by Michael Skapinker in his article, of the 25% of the shares that were in the hands of hedge funds and other short term speculators who had only bought them very recently in the hope of a quick return. Presumably they bought these shares from owners who were willing to sell at a lower price against the possibility that the Melrose bid failed and the share price under the existing management team would fall.

Melrose’s argument during the takeover battle was essentially that it is a management team with a record of successful managing corporate assets who would replace a management team that has been destroying value in its management of the GKN portfolio. The commitments Melrose made along the way to the customers for the GKN subsidiaries’ goods and services and to their employers (in part evidenced by the promises relating to the pension scheme), suggest that they are not old fashioned asset strippers, selling off assets as part of strategy to wind down wealth creating business units. Rather, they appear to understand the business that the GKN plc is currently in, which is managing a portfolio of businesses, adding value to those where it can, and selling those to which other companies can add more value.

If this is indeed the approach that Melrose takes, it will reflect a mindset in which the board thinks about the businesses within the portfolio as customers for the corporate centre, recognising that if there are other corporations that can provide individual business units with a better deal, let them go. And that will make it easier to keep their customers in the capital markets, to whom they have spent the last few months marketing themselves, happy, loyal, and committed.

¹ Wikipedia history of GKN plc since 1966

It takes a village to maintain a dangerous financial system – and a corporate governance system too

Hillary Clinton popularised the African proverb “It takes a village to raise a child” when she adopted it as the title for her 1996 book. A lawyer representing victims of abuse by Catholic priests in Boston extended when interviewed in 2015 by observing that “If it takes a village to raise a child, it takes a village to abuse a child.” Anat Admati, George G.C. Parker Professor of Finance and Economics at the Graduate School of Business at Stanford University, translates this sentiment to the financial sector in her in chapter in Just Financial Markets? Finance in a Just Society, a collection of essays edited by Lisa Herzog, published by Oxford University Press[1].

Admati’s focus is on the banking system. Her thesis is that the failings in the system, illustrated by the 2008 crash, are a result of the failures of a wide range of players, not just those working within financial institutions, but a host of regulators, commentators and other stakeholders. Very powerfully, she comments on the contrast between the finance industry and other industries (eg aviation) where safety is paramount and all consequently all the stakeholders work together to design effective regulation and where the case for compliance is compelling. But, as she points out, even the most obvious case for regulation to drive safety may require disasters and egregious failures before regulation and compliance catch up with the need (eg in nuclear power and the motor industry).

Her chapter provides a compelling account of the “wilful blindness” of principals, stakeholders, regulators and commentators on the financial system and suggests that even after the dangers inherent in the design, operation and lack of necessary regulation of the banking system were revealed in the crisis, the underlying problems remain unaddressed.

Her arguments are applicable far more widely. She has written an important paper about that should be read with an eye to how her observations can be applied to other industries and, indeed, beyond the commercial enterprises into public sector organisations and not for profit bodies.

[1]Chapter 13, It Takes a Village to Maintain a Dangerous Financial System. Abstract: I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate.

Workforce – “not assets to be managed”

I owe thanks to Ali Webster, Assistant Director for Workforce at West London Mental Health Trust, for opening her presentation at a meeting yesterday with a compelling quotation from a 2015 King’s Fund paper on talent management[1]:

“Successful deployment of workforce talent is about rethinking your view of your employees. They are not assets to be managed but rather people with options who have chosen to invest their aspirations and motivations with your organisation for a while and who will expect a reasonable return on their investment in the form of personal growth and opportunities.”

This is Escondido Framework thinking. You do not own the people who work for you – even if the way that you treat them may leave them thinking of themselves as wage slaves. You have secured their services in a market transaction in which there are two parties, selling to each other and offering opportunities to each other. And both parties are making an investment in the relationship, with both “expect[ing] a reasonable return on their investment”.

[1] Sarah Massie, “Talent Management: Developing leadership not just leaders”. Kings Fund 2015