capital markets – Escondido Framework

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.

Is Capitalism Killing America?

I was stopped in my tracks this morning by an email from the Stanford Graduate School of Business with the subject line “Is Capitalism Killing America?”. It is not the sort of thing that the world’s top business school (at least that was how it was rated forty years ago when I was there) normally sends to its alumni.

The key feature in the email newsletter was an article with the subheading “Young & Rubicam Chairman Emeritus Peter Georgescu says it’s time to end the era of shareholder primacy[1] which reviews Georgescu’s new book Capitalists Arise! End Economic Inequality, Grow the Middle Class, Heal the Nation (Berrett-Koehler, 2017). Georgescu, a fellow Stanford GSB “alumn”, is looking to chief executives to think about how, and for whom, they run their companies.

Capitalism is an endangered economic system, Georgescu says. He cites by economist William Lazonick, who studied S&P 500 companies from 2003 to 2012 and discovered that they routinely spend 54% of their earnings buying back their own stock and 37% of their earnings on leaving just 9% of earnings for investment in their business and their people.

“Innovation is the only real driver of success in the 21st century, and who does the innovation? Our employees. How are we motivating them? We treat them like dirt. If I need you, I need you. If I don’t, you’re out of here. And I keep your wages flat for 40 years,” says Georgescu, who points out that growth in real wages has been stagnant since the mid-1970s.

Georgescu continues by noting that the lack of investment in business and their people feeds back into demand, undermining sales growth. With median household income in the US less than 1% higher today than in 1989: “There’s no middle class, and the upper middle class has very little money left to spend, so they can’t drive the economy. The only people driving the GDP are the top 20% of us”. 60% of American households are technically insolvent and adding to their debt loads each year. In addition, income inequality in the U.S. is reaching new peaks: The top layer of earners now claim a larger portion of the nation’s income than ever before — more even than the peak in 1927, just two years before the onset of the Great Depression.

Georgescu blames the ascendency of the doctrine of shareholder primacy.

“Today’s mantra is ‘maximize short-term shareholder value.’ Period,” he says. “The rules of the game have become cancerous. They’re killing us. They’re killing the corporation. They’re helping to kill the country……..

“The cure can be found in the post–World War II economic expansion. From 1945 until the 1970s, the U.S economy was booming and America’s middle class was the largest market in the world. In those days, American capitalism said, ‘We’ll take care of five stakeholders,’. Then and now, the most important stakeholder is the customer. The second most important is the employee. If you don’t have happy employees, you’re not going to have happy customers. The third critical stakeholder is the company itself — it needs to be fed. Fourth come the communities in which you do business. Corporations were envisioned as good citizens — that’s why they got an enormous number of legal protections and tax breaks in the first place.

“If you serve all the other stakeholders well, the shareholders do fine,” he says. “If you take good care of your customers, pay your people well, invest in your own business, and you’re a good citizen, the shareholder does better. We need to get back to that today. Every company has got to do that.”

It’s refreshing to hear this from one of the grand old men of the commercial world in the United States. But in his critique of “shareholder value”, he fails to single out the principal beneficiaries, the chief executives and top management teams themselves (including our fellow business school alumni) who have exploited the system to cream off an ever increasing share of the rewards in salaries, bonuses and options, all the while failing to invest in productive assets, innovation, securing long term positions with customers and local communities, and in the people who work in the companies themselves.

[1] https://www.gsb.stanford.edu/insights/capitalism-killing-america?utm_source=Stanford+Business&utm_medium=email&utm_campaign=Stanford-Business-Issue-122-10-1-2017&utm_content=alumni

Failing the marshmallow test

The BBC World Service is the insomniac’s salvation. If you are lucky, a background of talk radio helps you back to sleep. If you are luckier still, you stumble on a piece of quality programming that Auntie has chosen to share with the rest of the globe but not with its domestic listeners.

“In the Balance”, a business programme presented by Andy Walker at 03:30 GMT on Sunday 2nd November, included a first class discussion of short termism between Bridget Rosewell, Geoffrey Franklin and Richard Dodds, following an interview with John Kay that marked the second anniversary of the publication of his report for HM Government on short termism in equity markets.¹

The essential conclusion of the Kay report [reference needed] was that there is too much short termism in UK corporate life at the expense of addressing long term competitive advantage. The top management of quoted companies focus unduly on hitting 3 monthly targets, which are a poor measure of management competence, and have been rewarded accordingly. The 1990s featured attempts to align management incentives with the interests of shareholders, but the net result was that “many people who were quite incompetent made quite a lot of money”. Kay concludes that regulation is not the solution, but that a change in culture is required, but that it is hard to know how to do this, and harder still to measure progress.

Kay expanded on the culture change required and the inherent difficulties. He referred to the “marshmallow test”, an experiment with 4 year old children. Most, when presented with a marshmallow and told that if they wait 5 minutes before eating it they will be given a second one, will eat it right away. (A celebrated study of children subjected to the marshmallow found that those who exhibited a lower personal discount rate and exercised sufficient self control to win the second marshmallow – or maybe just had the insight to understand the challenge facing them – prospered more in later life). Andy Walker asked John Kay whether he was saying that executives simply need to grow up, to which Kay responded “a lot of company directors would fail the marshmallow test.”

In the ensuing discussion among the panellists, Bridget Rosewell blamed her profession (economists) for promulgating the view that all the information about the future prospects of the company is captured in the share price, and consequently many board level remuneration packages have been structured around movements in the share price, and the panel as a whole seemed to conclude that we have spent years telling people to focus on the wrong thing. Further, Rosewell also observed that “All markets exist in institutional contexts and cultural contexts.”

Is John Kay right? Undoubtedly yes. But the supplementary questions are more interesting: why do so many fail the marshmallow test; and what can we do about it?

There are probably could be three underlying reasons for the behaviour Kay describes.

One is that, notwithstanding the experimental data that suggests that people who come out on top in later life are those who as small children passed the marshmallow test, perhaps some of those who make it to the upper reaches of commercial organisations respond disproportionately to short term signals. (Or maybe, by the time that they have reached the upper reaches they are no longer capable or responding to anything other than short term signals?). This is not something that I have observed myself, but there may be some revealing academic research lurking in the nether regions of a business school somewhere that addresses the personality types of chief executives and points to this failing.

A second explanation could be that human timeframes and organisational timeframes may be intrinsically misaligned. “In the long run, we are all dead.” The career time horizon for a typical chief is only exceptionally longer than twenty years on first appointment. Even then, the time horizon within the specific appointment is only exceptionally more than ten – and probably for very healthy reasons including personal boredom thresholds and the benefit from time to time for a fresh set of eyes on a problem. Whether it is desirable is irrelevant, it is entirely reasonable for individuals to consider the rewards – both material and emotional – that will flow from what is deliverable and measurable within their own term of office. And although they may also be concerned for their own legacy in the role, they also have to reflect that they have little power to stop those who come after them frittering it away.

The final explanation relates to the institutional and cultural frameworks about which Kay and the “In the Balance” panellists agonised. The evidence here is compelling (although I would not go as far as Rosewell in condemning the argument that share prices capture all the information about a company – the point, for discussion in more depth elsewhere, is that the prices of traded financial instruments are corrupted because they also capture information about expectations about trader behaviour (in an economist’s version of Heisenberg’s Uncertainty Principle). Many management teams have been presented by academics, consultants, brokers, investment bankers, and journalists, arguably in error, that they must respond to and seek to affect short term share price performance, and the regulator environment has encouraged rather than discouraged this. Given that the possibility that the first of these three explanations holds true for some executives, and the probability that the second of these three explanations holds true for most, it is all the more pernicious that the we have aligned cultural and institutional frameworks in this way. Instead, we need to bend over backwards to create a culture and institutional framework as a counterweight to the possibility that personal discount rates – driven by hardwired human appetites and instincts – are higher than those of companies and organisations in general, and society overall.

So, who’s eaten my marshmallow?

¹ The Kay Review of Equity Markets and Long Term Decision Making, July 2012

Marketing, not just about consumers

At some point in the late 1990s, I wrote a short piece for Word on the Street, the Brackenbury Group’s client newsletter, which demonstrates one of the core propositions behind the Escondido Framework very clearly. The relationship between the organisation and all its “stakeholders” is at its heart a marketing relationship:

Marketing is too important to be left to the marketing department. Marketing departments address only the consumers of the products or services that a company sells to those it thinks of as its customers. But the truth is far wider than this.

Companies should apply the marketing way of thinking in all the markets in which they operate. This means not just the “downstream” market, but also to the “upstream” markets: funding, labour, bought in goods and services. The company is marketing an investment opportunity to its shareholders and debt providers. It is marketing careers and contracts to existing and prospective employees. It is providing opportunities to its suppliers with markets and channels to other markets.

The marketing mindset involves understanding the differing needs of differing customer segments, thinking about how to adapt your offer to meet the needs of your target customer and then doing it consistently, understanding the trade-offs they make between different attributes of the product or service you provide – of which price is only one dimension, determining where you can achieve an advantage over your competitors. It also includes what most non-marketing people understand as “marketing”, communicating these benefits to customers in ways that lead eventually to a profitable sale.

In most companies, marketing activity occurs sporadically in the functions that face “upstream”. Presentations are given to investors and financial PR consultancies are returned to put a positive gloss on results. Advertisements are placed, glossy brochures and upbeat web pages prepared, and roadshows taken round campuses to attract prospective recruits. Invtitations to tender and requirements lists are circulated, and subscriptions taken to web-exchanges as part of the sourcing process, whether for services, real estate, or components and real estate.

But in few companies does marketing explicitly underpin the way in which directors and managers in finance, HR, buying and purchasing, IT, property approach their responsibilities. They need to think about their “customers” in the same way that their downstream facing colleagues do about the people or businesses that are customers for the products and services the company sells. Applying tried and tested approaches from the downstream markets to the upstream markets to dealing with the financial markets will yield precious basis point reductions in the cost of capital and reduce paranoia about awkward investors or even takeover. In HR policy, it will reduce total employment costs – not just outlays on wages and salaries, or even improved retention, but also through enhanced productivity. And in purchasing it will translate into competitive advantage through lower total costs of supply, higher service and priority treatment.

A new way of looking at the firm

The Escondido Framework starts from the assumption that the company (in common with many other forms of organisation) is defined by its interfaces with the various market places in which it operates, in the simplest form the markets for labour, raw materials, capital and finished goods or services. These are, in effect, its boundaries. And while there are differences between markets, in essence they all reflect an exchange between two parties for mutual benefit – the employee receives payment and other non-financial rewards for his labour; the supplier of raw materials payment for the goods provided; the supplier of funds either interest or dividends and the prospect of capital growth for forgoing use of those funds for his own short term benefit; and the customer goods or services in exchange for payment. The Framework also reflects the view that being a party to the exchange does not of itself mean that the other party has a “stake” in the company or “own” it in any absolute sense. There may be a contractual relationship between the party and the company which reflects the terms of the exchange and provides structure for enforcement but essentially this is a mutually beneficial relationship in which both parties have duties to deliver their side of the bargain.

Within the Framework, there is no assumption that any of the providers to the company – of labour, raw materials, capital or revenue – any superior rights or claims over the company, in traditional parlance, “ownership”. Legal devices may be put in place by the state, or may exist in the form of contractual agreements that provide these other parties with rights, for example: in the form of wages and employment rights; to payment for goods at a particular point in time; to payment of interest or dividends; and to return of capital under prescribed terms and with differing degrees of confidence. The contracts and legal frameworks may also define mechanisms under which these other parties may enforce these rights, but enforcement is also be a function of other considerations that reflect market conditions rather than the law, for example: what alternatives are available to a workforce with a specific set of skills and ties to a particular geography; what other customers are available for the raw materials, and how much are they willing to pay; what will other prospective providers of capital pay for these shares or bonds, and how easily can we replace the existing board and executive team; and how often do customers in consumer markets consider, let alone read terms and conditions.

The Framework suggests that the company can be considered as a “virtual space”, existing between these market interfaces. The location and shape of each of the market interfaces reflects what economists think of as the demand function and marketing academics describe as indifference curves, i.e. how customers make trade-offs between the various attributes of a product. These are also shaped by the competition that the company faces: when recruiting from a limited pool of skilled employees; for sourcing scarce raw materials; seeking funding from a limited capital market, or seeking the custom of consumers who can buy from other companies or who may be able to substitute one item for other goods. Remove the competition and the market interface or boundary moves outwards, increasing the volume of the “virtual space” available to the company. Improve the operating efficiency within the company or secure a competitive advantage over other participants in one of the markets concerned and the volume of the “virtual space” will also increase.

At any particular point in time, for any particular product or service it sells, these interfaces will be brought together, or resolved, at a single virtual point at which of each of the providers is rewarded at prices that are, all things considered, satisfactory to them. In perfect market equilibrium, all prices would be at market clearing levels, no-one would realise economic rents, and there would one point at which the interfaces would be resolved. No self-respecting economist has ever viewed the perfect market paradigm as anything other than a useful benchmark for understanding a world which is dynamic and virtually always distant from the paradigm, and in this the Escondido Framework is no different. In reality, the “virtual space” is just that, an available set of points at which the price levels may be resolved. Depending on the scale of the external market failures that allow for the internal organisation of economic activity to generate greater efficiency, there is potential for the management of the company to elect where to set prices and where on the indifference curves to locate the marketing proposition to each of the other parties (suppliers or labour, raw material, capital and custom), and how to allocate the economic surplus that the absolute volume of the “virtual space” represents.