NEW TRENDS IN CORPORATE GOVERNANCE

1. NEW TRENDS IN CORPORATE GOVERNANCE Michel Aglietta University of Paris X (EconomiX) and CEPII For the GRESS Workshop May 22, 2007

2. 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

3. 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 people’s 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

4. 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.

5. 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.

6. Strategic complementarities and multiple equilibria

7. 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)

8. Types of corporate governance

9. Principle of shareholder value and control via the Stock market • The CAPM determines: • (i) Equilibrium real return on equities:  = i + β (m – i) • (ii) Cost of capital : Cmpc =  (FP/K) + r (D/K)=  – ( – r)(D/K) • i riskless rate of interest, m yieldon the market portfolio, β 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 r<ρCmpc =  – ( – r)(d/1+d)

10. Shareholder value and market value • EVA = R –  FP • = (ROE – ) FP • = (ROA – Cmpc) K, • With R net profit, ROE = R/FP and ROA =(R+rD)/K • Introducing Tobin’s 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 M&A that enhance the market price of the firm • Higher leverage used in HF strategies and loaded on target firms by PE [r (q -1) + (ρ-r)(d/1+d)]K

11. Hedge Funds Deal with publicly traded assets and are unregulated Quest of absolutereturn over short horizon (α chasing) An array of investment strategies in capital markets aiming at excessreturn + shield against market volatility Funding by pension fundsand mutual funds (via funds of funds) Financialleverage via short selling, collateral and derivatives Opaquenessdue to lack of regulation and biases in databases Private Equity Funds Specialize in privately held investments Valueextraction 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 Forcedindebtedness of the target co redistribution of wealth to handful of owners Inbuiltopaqueness via mutation in ownership: public private HF and PE: what is common, what is different?

12. 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, n°6, CFA institute from TASS database

13. 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.

14. Is private equity a profitable bet for institutional investors? • The structure of risk is very far from being Gaussian: • Skewnessand kurtosisrisks are very high. • Buy-outs are akin to event-driven hedge fund strategies: skewness~-2.6 and kurtosis~20. • 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.

15. 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

16. 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.

17. 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.

18. Impact of PE on public services • Operating public services: a target for PE • Natural monopolies=high 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 R&D 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.

19. 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

20. 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.

21. 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 investor’s horizon.

22. Annualized standard variation Correlation of real returns Stocks/5-year bonds Equity Bonds Bills Horizon Horizon The virtue of mean-reverting forces

23. t (proportion of stocks) Strategic Allocation Tactical Allocation Buy-and-hold Strategy xt (state variable)  The dominance of equities in strategic asset allocation

24. 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.

25. Strategic choices by six of the largest pension funds

26. 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

27. 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.

28. 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.