• Thursday, March 28, 2024
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Spotlight on does business need a new model? it’s time to replace the public corporation

Spotlight on does business need a new model? it’s time to replace the public corporation

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 heavily traded capital markets, the model increasingly incentivizes executives to manage in short-term windows, with an eager eye on their stock-based compensation and a fearful one on activist hedge funds. Something is certainly not 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.

Attempts have been made to improve the governance of public corporations. But most 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.

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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. 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 offer the highest rates of return.

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. But 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 provide an opportunity for a leveraged buyout or an activist hedge fund. Second, big, diversified funds have no incentive to see anyone 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.

Knowledge workers, meanwhile, are being asked to work for the benefit of their companies’ shareholders. They are asked to make sacrifices to meet quarterly financial targets. When activist hedge funds circle, they are asked to acquiesce in the firing of friends and colleagues across the company to improve earnings.

Who are the company’s shareholders? The share register will feature names such as Blackrock, Fidelity, State Street and Vanguard. But those are just fiduciary institutions that invest on behalf of the real shareholders. The same holds for pension funds such as CALPERS, New York State Common Retirement Fund and the Teacher Retirement System of Texas, and for the activist investors Pershing Square, Third Point and Value Capital. Collectively, these institutions represent 80% of supposed shareholders. The actual shareholders have no conversation with the companies they own, and may not even know they own them.

So the dominant model asks workers to toil under executives whose financial welfare is determined by the stock price, in the interests of owners no one knows. That seems about right for a workplace in which, according to Gallup’s 2020 results, only 31% of employees are engaged in their work, 54% are not engaged, and 14% are actively disengaged. The modern public corporation has become a terrible home for them.

To understand what might displace the public corporation, let’s consider what’s involved in meeting the needs of knowledge workers and retirement investors. To satisfy them any new model must overcome the fundamental governance problem of widely held corporations: that CEOS’ incentives are at odds with the long-term interests of those stakeholders. In addition, the model must diminish the ability of activist hedge funds to extract gains at their expense.

I believe that the most likely successor is what I call the long-term enterprise, a private company in which ownership is limited to retirement investors and employees. It would work like this: An employee stock ownership plan would partner with one or several pension funds to acquire the company and take it private. Governance would focus on real long-term performance rather than on short-term stock price fluctuations — because there would be no stock price. Critical employees would also be satisfied, as they would acquire a long-term stake in the company through the employee stock ownership plans.

The model is not completely unfamiliar to retirement investors. Two of Canada’s biggest pension funds have taken private large Canadian real estate development companies. CDPQ took Ivanhoé private in 1990 and Cambridge Shopping Centres private in 2000 and merged them to create a wholly private real estate giant. The Ontario Teachers’ Pension Plan took Cadillac Fairview private in 2000. Those acquisitions, however, were in a single business in which pension funds are major buyers of individual assets. For long-term enterprises to become the dominant ownership model pension funds and other retirement investors would have to become comfortable owning a wider variety of businesses.

Little or no new regulation would be required to roll out employee stock ownership plans on a large scale, as a robust infrastructure is already in place. All shares vest after six years, and employee stock ownership plans are required to have a third party establish the fair value of the shares once a year so that when employees leave, their shares will be bought by the plan at a fair price, enabling them to benefit from capital appreciation much as employees of public companies do. Retiring employees benefit in the same way and enjoy favourable tax provisions for rolling the proceeds into their retirement accounts.

It’s surprising that employee stock ownership plans aren’t more widely used, but dominant models are hard to displace. Publicly held corporations are the default — the safe choice. Nonetheless, employees, shareholders and society would be better off if employee stock ownership plans were used more widely.

ROGER L. MARTIN Roger l. martin, a former dean of the rot man school of management, in Toronto, is an adviser to CEOs and the author of“when more is not better: Overcoming America’ s obsession with economic efficiency .”