The end of “shareholder value”?
The news that Jack Welch, the sometime CEO of GE, has said that he doesn’t think that “shareholder value” was a good idea is quite an important moment, for two reasons. One, he was influential in creating the idea, in a speech shortly after he became top dog at GE. Two, because he made millions from it. The drive for (or obsession with) shareholder value was critical in sucking businesses into the financial sector – all but making businesses offshoots of the markets – but it was reinforced by narrow interpretations of the law and by over-whelming self-interest, handily supported by a dollop of management theory. New business frameworks will need to be strong to escape such a powerful legacy.
Welch’s original speech, in 1981, didn’t include the words ‘shareholder value’, and he’s always denied that he advocated it, but it might as well have done. It described the recipe: selling under-performing businesses and cutting costs, as well as some of the ‘rank and yank‘ human resources policies later perfected by Enron. By 1986, the model had been formalised in a best-selling business book:
With the share price of GE and other shareholder-focused companies soaring, executives from all over the world took up the credo Alfred Rappaport spelt out in his 1986 book, Creating Shareholder Value: “The ultimate test of corporate strategy, the only reliable measure, is whether it creates economic value for shareholders.” Fund managers encouraged this attitude, as pressure from their own quarterly reviews addicted them to the periodic improvements in earnings and stock prices promised by the prophets of shareholder value.
Last week, Welch told the FT:
“On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products.”
The logic of “shareholder value”, of course, is that markets are the best judge of company value, and that companies should be managed accordingly. It was clearly a ridiculous notion at the time, driven by the narrowest of economic rationalist vlews of human behaviour, and its prevalence is best understood as a measure of the dominance of a particular economic ideology.
Why ridiculous? Well, as several writers point out in a symposium on American manufacturing in Dissent magazine, markets are essentially short-term entities. They don’t price the costs of externalities (such as the cost of the people “yanked” into unemployment), they under-price long-term investments (for example in research and development), and they encourage short-term approaches to business relationships inside and outside of the firm, encouraging ‘win-lose’ behaviour. As business academic Jeffrey Sonnenfeld said in the FT, “Immediate shareholder value maximisation, by itself, was always too short-term in nature. It created a fleeting illusion of value creation by emphasising immediate goals over long-term strategies.”
As for the present, as Martin Wolf argued in the Financial Times:
If the financial system has proved dysfunctional, how far can we rely on the maximisation of shareholder value as the way to guide business? The bulk of shareholdings is, after all, controlled by financial institutions. Events of the past 18 months must confirm the folly of this idea. It is better, many will conclude, to let managers determine the direction of their companies than let financial players or markets override them.
This is alright as far as it goes, but the concept was also supported by prevailing interpretations of company law, in both the UK and the US, and some remarkably self-serving management theory.
The law first: the UK Companies Act, and its equivalent in the US, tend to reinforce the notion of ‘shareholder primacy’, that the role of the Directors on the Board of the company is to represent the interests of the shareholders (opens paper in pdf). As it happens, there’s a reasonable body of evidence which says that the long-term interests of shareholders are best served by managing for the whole community of interests around the busiess, from employees, to customers, to suppliers, to stakeholders. But in the face of the narrow phrasing in the law, this can be a hard argument to make in the boardroom (I’ve been in this position myself in the past).
It is doubly hard if some or all of the directors are likely to be enriched through short-run gains in the share price, and this is where the theory comes in. Agency theory is about how you align the interests of the managers of the business with its owners, and the answer – from the economic rationalist school – was that you rewarded them if the shareholders gained – almost invariably measured by the share price. There is no theory as powerful as one which enriches the powerful when they act on it, and this may be some of the reason why agency theory has held such a grip on the minds of managers, despite evidence that it creates perverse incentives and doesn’t correspond to the reasons why organisations exist in the first place (usually to do those things which are more effectively done without a transaction being involved in the process).
Once you start from a theory of human nature which says that behaviour is only ever self-interested, much of the rest follows, as Simon Caulkin has observed:
Self-interest and markets favour competition rather than co-operation, and mandate hierarchy to keep people in line. They also empty management of all moral or ethical concern. And, indeed, the typical firm has come to be structured around these principles, from governance based on agency theory and shareholder value, to internal markets and performance-related pay, sharp incentives and performance management lower down. Yet there is little empirical evidence that the assumption of exclusive self-interest is valid.
The final link in this is the business schools, and the assumptions which underpin most MBA courses, long since captured by a narrow set of functional interests, as documented in Rakesh Khurana’s book From Higher Aims to Hired Hands.
And, of course, all of this has been embedded in “financialisation of everyday life”, described by Robin Blackburn (and others), which I have written about previously, one of the many reasons why so many accountants end up as Chief Executives, compared to operations or production managers.
So, even if the notion of shareholder value has no credibility, its superstructure is still held up by a combination of law, theory, process, education, and the experience of those still in senior management roles. In other words, the ideas and values it embodies are still deeply embedded within business. If shareholder value is dead, in other words, it is not going to sink into its grave quietly.
Kicking away the underlying rationale, that markets are reliable judges of the value of a business won’t be enough. Martin Wolf sees some likelihood of public intervention to reduce companies’ exposure to financial agents: “A likely result will be an increased willingness by governments to protect companies from active shareholders – hedge funds, private equity and other investors. As a defective financial sector loses its credibility, the legitimacy of the market process itself is damaged. This is particularly true of the free-wheeling “Anglo-Saxon” approach.”
And there have been signs – even before the financial crisis – that people were moving away from the shareholder model. Fortune suggested in 2006 that smart corporations, and smart leaders, were already adopting different models, while business writers such as Robert Heller have been long-standing critics of the idea.
Different models will help, as will some government intervention. But it will need more to replace shareholder value decisively with something more socially sustainable, something which produces better public outcomes: better theory, better law, and probably some new managers, who haven’t been through the ideological induction programmes that pass these days for most of our MBA courses.
Update: 18th March 2009, additional material added on history of ‘shareholder value’ concept and its critiques.