Acquisitions as Corporate Money Hose

Among the small group of heterodox economics people interested in corporate finance, it is common knowledge that the stock market is a tool for moving money out of the corporate sector, not into it.  Textbooks may talk about stock markets as a tool for raising funds for investment, but this kind of financing is dwarfed by the payments each year from the corporations to shareholders.

The classic statement, as is often the case, is in Doug Henwood’s Wall Street:

Instead of promoting investment, the U.S. financial system seems to do quite the opposite… Take, for example, the stock market, which is probably the centerpiece of the whole enterprise. What does it do? Both civilians and professional apologists would probably answer by saying that it raises capital for investment. In fact it doesn’t. Between 1981 and 1997, U.S. nonfinancial corporations retired $813 billion more in stock than they issued, thanks to takeovers and buybacks. Of course, some individual firms did issue stock to raise money, but surprisingly little of that went to investment either. A Wall Street Journal article on 1996’s dizzying pace of stock issuance (McGeehan 1996) named overseas privatizations (some of which, like Deutsche Telekom, spilled into U.S. markets) “and the continuing restructuring of U.S. corporations” as the driving forces behind the torrent of new paper. In other words, even the new-issues market has more to do with the arrangement and rearrangement of ownership patterns than it does with raising fresh capital.

The pattern of negative net share issues has if anything only gotten stronger in the 20 years since then, with net equity issued by US corporations averaging around negative 2 percent of GDP. That’s the lower line in the figure below:



Note that in the passage I quote, Doug correctly writes “takeovers and buybacks.” But a lot of other people writing in this area — definitely including me — have focused on just the buyback part. We’ve focused on a story in which corporate managers choose — are compelled or pressured or incentivized — to deliver more of the firm’s surplus funds to shareholders, rather than retaining them for real investment. And these payouts have increasingly taken the form of share repurchases rather than dividends.

In telling this story, we’ve often used the negative net issue of equity as a measure of buybacks. At the level of the individual corporation, this is perfectly reasonable: A firm’s net issue of stocks is simply its new issues less repurchases. So the net issue is a measure of the total funds raised from shareholders — or if it is negative, as it generally is, of the payments made to them.

It’s natural to extend this to the aggregate level, and assume that the net change in equities outstanding similarly reflects the balance between new issues and repurchases. William Lazonick, for instance, states as a simple matter of fact that “buybacks are largely responsible for negative net equity issues.” 1 But are they really?

If we are looking at a given corporation over time, the only way the shares outstanding can decline is via repurchases.2 But at the aggregate level, lots of other things can be responsible — bankruptcies, other changes in legal organization, acquisitions. Quantitatively the last of these is especially important.   Of course when acquisitions are paid in stock, the total volume of shares doesn’t change. But when they are paid in cash, it does. 3 In the aggregate, when publicly trade company A pays $1 billion to acquire publicly traded company B, that is just a payment from the corproate sector to the household sector of $1 billion, just as if the corporation were buying back its own stock. But if we want to situate the payment in any kind of behavioral or institutional or historical story, the two cases may be quite different.

Until recently, there was no way to tell how much of the aggregate share retirements were due to repurchases and how much were due to acquisitions or other causes.4 The financial accounts reported only a single number, net equity issues. (So even the figure above couldn’t be produced with aggregate data, only the lower line in it.) Under these circumstances the assumption that that buybacks were the main factor was reasonable, or at least as reasonable as any other.

Recently, though, the Fed has begun reporting more detailed equity-finance flows, which break out the net issue figure into gross issues, repurchases, and retirements by acquisition. And it turns out that while buybacks are substantial, acquisitions are actually a bigger factor in negative net stock issues. Over the past 20 years, gross equity issues have averaged 1.9 percent of GDP, repurchases have averaged 1.7 percent of GDP, and retirements via acquisitions just over 2 percent of GDP. So if we look only at corporations’ transactions in their own stock, it seems that that the stock market still is — barely — a net source of funds. For the corproate sector as a whole, of course, it is still the case that the stock market is, in Jeff Spross’ memorable phrase, a giant money hose to nowhere.

The figure below shows dividends, gross equity issues, repurchases and M&A retirements, all as a percent of GDP.


What do we see here? First, the volume of shares retired through acquisitions is consistently, and often substantially, greater than the volume retired through repurchases. If you look just at the aggregate net equity issue you would think that share repurchases were now comparable to dividends as a means of distributing profits to shareholders; but it’s clear here that that’s not the case. Share repurchases plus acquisitions are about equal to dividends, but repurchases by themselves are half the size of dividends — that is, they account for only around a third of shareholder payouts.

One particular period the new data changes the picture is the tech boom period around 2000. Net equity issues were significantly negative in that period, on the order of 1 percent of GDP. But as we can now see, that was entirely due to an increased volume of acquisitions. Repurchases were flat and, by the standard of more recent periods, relatively low. So the apparent paradox that even during an investment boom businesses were paying out far more to shareholders than they were taking in, is not quite such a puzzle. If you were writing a macroeconomic history of the 1990s-2000s, this would be something to know.

It’s important data. I think it clarifies a lot and I hope people will make more use of it in the future.

We do have to be careful here. Some fraction of the M&A retirements are stock transactions, where the acquiring company issues new stock as a kind of currency to pay for the stock of the company it is acquiring.5 In these cases, it’s misleading to treat the stock issuance and the stock retirement as two separate transactions — as independent sources and uses of funds. It would be better to net those transactions out earlier before reporting the gross figures here. Unfortunately, the Fed doesn’t give a historical series of cash vs. stock acquisition spending. But in recent years, at least, it seems that no more than a quarter or so of acquisitions are paid in stock, so the figure above is at least qualitatively correct. Removing the stock acquisitions — where there is arguably no meaningful issue or retirement of stock, jsut a swap of one company’s for another’s — would move the M&A Retirements and Gross Equity Issues lines down somewhat. But the basic picture would remain the same.

It’s also the case that a large fraction of equity issues are the result of exercise of employee stock options. I suspect — tho again I haven’t seen definite data — that stock options accout for a large fraction, maybe a majority, of stock issues in recent decades. But this doesn’t change the picture as far as sectoral flows goes — it just means that what is being financed is labor costs rather than investment.

The bottom line here is, I don’t think we heterodox corporate finance people have thought enough about acquisitions. A major part of payments from corporations to shareholders are not distribution of profits in the usual sense, but payments by managers for control rights over a production process that some other shareholders have claims on. I don’t think our current models handle this well — we either think implicitly of a single unitary corporate sector, or we follow the mainstream in imagining production as a bouillabaisse in where you just throw in a certain amount of labor and a certain amount of capital, so it doesn’t matter who is in charge.

Of course we know that the exit, the liquidity moment, for many tech startups today is not an IPO — let alone reaching profitability under the management of early investors — but acquisition by an established company. But this familiar fact hasn’t really made it into macro analysis.

I think we need to take more seriously the role of Wall Street in rearranging ownership claims. Both because who is in charge of particular production processes is important. And because we can’t understand the money flows between corporations and households without it.


OECD: Activist Shareholders Are Bad for Investment

The OECD has just released its new Business and Finance Outlook for 2015. A lot of interesting stuff there. We’ll want to take a closer look at the discussion of the problems that low interest rates pose for pension funds and insurance companies — I’ve thought for a while that this is the most convincing form of the “reaching for yield” argument. But what I want to talk about now is the OECD’s apparent endorsement of the “disgorge the cash” thesis.

Chapter 2, “Corporate Investment and the Stagnation Puzzle,” has a very interesting discussion of shareholder activism and its effects on investment. The starting point is the puzzle that while participants in financial markets are willing to accept unprecedentedly low returns, the minimum returns on new investment projects remain high, as evidenced by depressed real investment despite sustained low interest rates. I think this apparent puzzle is, precisely, a rediscovery of Keynes’ liquidity premium. (Perhaps I will return to this in a subsequent post.) There are a number of ways to think about this, but one dimension is the pressure corporate managers face to avoid investment projects unless the returns are rapid, large, and certain.

Stock markets currently reward companies that favour dividends and buybacks and punish those that undertake more investment … which creates higher hurdle rates for investment.

Here in one sentence is the disgorge the cash argument.

Private sector companies in market-based economies allocate capital spending according to shareholder value. Earnings may be retained for capital spending and growth, but only if the return on equity exceeds the cost of equity. If this is not the case then … they will choose to use their operating cash flow in other ways (by issuing dividends, carrying out cash buybacks…) … and in the limit may close plants and shed labor.

The bolded sentence is puzzling. Is it description or prescription? (Or description of a prescription?) The rest of the section makes no sense if you think either that this is how corporate investment decisions are made, or if you think it’s how they should be made. Among other reasons, once we have different, competing discount rates, the “return on equity” no longer has a well-defined value, even in principle. Throughout, there’s a tension between the language of economic theory and the language of concrete phenomena. Fortunately the latter mostly wins out.

The last decade has seen the rising importance of activist investors who gain the support of other investors and proxy advisors to remove management, to gain influential board seats and/or to make sure that company strategy is in the best interest of shareholders… The question arises as to whether the role of such investors is working to cause short-termism strategies [sic] at the expense of long-term investment, by effectively raising the hurdle rate… Activists… favour the short-term gratification of dividends and share buybacks versus longer-term investment. Incumbent managers will certainly prefer giving in to shareholders desire for more ‘yield’ in a low-interest world to taking on the risk of uncertain long-term investment that might cause them to be punished in the share market. …

To test this idea, an index of CAPEX/(CAPEX + Dividends & Buybacks) was created for each company, and the following investment strategy was measured: sell the highest quartile of the index (capital heavy firms) and buy the lowest quartile of the index (Dividend and Buyback heavy firms). … Selling high capital spending companies and buying low CAPEX and high buyback companies would have added 50% to portfolio values in the USA, 47% in Europe, 21% in emerging economies and even 12% in Japan (where activists play little role). On balance there is a clear investor preference against capital spending companies and in favor of short-termism. This adds to the hurdle rate faced by managers in attempting to undertake large capital spending programmes — stock market investors will likely punish them. … it would be fairly logical from a management point of view to return this cash to shareholders rather than undertake uncertain long-term investment projects… The risks instead would be born more by host-country investment in capacity and infrastructure.

This is a useful exercise. The idea is to look at the ratio of investment to shareholder payouts, and ask how the stock price of the high-investment firms performed compared to the high-payout firms, over the six years 2009 through 2014. What they find is that the shares of the high-payout firms performed considerably better. This is  important because it undermines the version of the disgorge argument you get from people like Bill Lazonick, in which buybacks deliver a short-term boost the share price that benefits CEOs looking to cash in on their options, but does nothing for longer-term investors.  In Lazonick’s version of the story, managers are on one side, shareholders, workers and the rest of society on the other. But if high-payout firms perform better for shareholders over a six-year horizon (which in financial-market terms is almost geologically long term) then we have to slice things differently. On one side are shareholders and CEOs, on the other are us regular people.

The other thing that is notable here is the aggregating of dividends and buybacks in a single “shareholder payout” term. This is what I do, I think it’s unambiguously the right thing to do, but in some quarters for some reason it’s controversial. So I’m always glad to find another authority to say, a buyback is a dividend, a dividend is a buyback, the end.

Another way to see these two points is to think about so-called dividend recapitalizations. These are when a private equity firm, having taken control of a business, has it issue new debt in order to fund a special dividend payment to themselves. (It’s the private equity firm that’s being recapitalized here, not the hapless target firm.) The idea of private equity is that the acquired firm will be resold at a premium because of the productive efficiencies brought about by new management. The more or less acknowledged point of a dividend recap is to allow the private equity partners to get their money back even when they have failed to deliver the improvements, and the firm cannot be sold at a price that would allow them to recoup their investment. Dividend recaps are a small though not trivial part of the flow of payments from productive enterprises to money-owners, in recent years totaling between 5 and 10 percent of total dividends. For present purposes, there are two especially noteworthy things about them. First, they are pure value extraction, but they take the form of a dividend rather than a share repurchase. This suggests that if the SEC were to crack down on buybacks, as people Lazonick suggest, it would be easy for special dividends to take their place. Second, they take place at closely held firms, where the managers have been personally chosen by the new owners. It’s the partners at Cerberus or Apollo who want the dividends, not their hired guns in the CEO suites. It’s an interesting question why the partners want to squeeze these immediate cash payments out of their prey when, you would think, they would just reduce the sale price of the carcass dollar for dollar. But the important point is that here we have a case where there’s no entrenched management, no coordination problems among shareholders — and Lazonick’s “downsize-and-distribute” approach to corporate finance is more pronounced than ever.

Back to the OECD report. The chapter has some useful descriptive material, comparing shareholder payouts in different countries.

[In the United States,]  dividends and buybacks are running at a truly remarkable pace, even greater than capital expenditure itself in recent years. There has been plenty of scope to increase capital spending, but instead firms appear to be adjusting to the demands of investors for greater yield (dividends and buybacks). … [In Europe] dividends and buybacks are only half what United States companies pay … While there is no marked tendency for this component to rise in the aggregate in Europe, companies in the United Kingdom and Switzerland … do indeed look very similar to the United States, with very strong growth in buybacks. … [In Japan] dividends and buybacks are minuscule compared with companies in other countries. …

Here, for the US, are shareholder payouts (gray), investment (dark blue), and new borrowing (light blue, with negative values indicating an increase in debt; ignore the dotted “net borrowing” line), all given as a percent of total sales. We are interested in the lower panel.

from OECD, Business and Finance Outlook 2015

As you can see, investment is quite stable as a fraction of sales. Shareholder payouts, by contrast, dropped sharply over 2007-2009, and have since recovered even more strongly. Since 2009, US corporations have increased their borrowing (“other financing”) by about 4 percent of sales; shareholder payouts have increased by an almost exactly equal amount. This is consistent with my argument that in the shareholder-dominated corporation, real activity is largely buffered from changes in financial conditions. Shifts in the availability of credit simply result in larger or smaller payments to shareholders. The OECD report takes a similar view, that access to credit is not an important factor in variation in corporate investment spending.

The bottom line, though the OECD report doesn’t quite put it this way, is that wealth-owners strongly prefer claims on future income that take money-like forms over claims on future incomes exercised through concrete productive activity. [1] This is, again, simply Keynes’ liquidity premium, which the OECD authors knowing or unknowingly (but without crediting him) summarize well:

It was noted earlier that capital expenditures appear to have a higher hurdle rate than for financial investors. There are two fundamental reasons for this. First, real investors have a longer time frame compared to financial investors who believe (perhaps wrongly at times) that their positions can be quickly unwound.

From a social standpoint, therefore, it matters how much authority is exercised by wealth-owners, who embody the “M” moment of capital, and how much is exercised by the managers or productive capitalists (the OECD’s “real investors”) who embody its “P” moment. [2] Insofar as the former dominate, fixed investment will be discouraged, especially when its returns are further off or less certain.

Second, managers … operate in a very uncertain world and the empirical evidence … suggests that equity investors punish companies that invest too much and reward those that return cash to investors. If managers make an error of judgement they will be punished by activist investors and/or stock market reactions … hence they prefer buybacks.

Finally, it’s interesting what the OECD says about claims that high payouts are simply a way for financial markets to reallocate investment spending in more productive directions.

It is arguable that if managers do not have profitable projects, it makes sense to give the money back to investors so that they can reallocate it to those with better ideas. However, the evidence … suggests that the buyback phenomenon is not associated with rising productivity and better returns on equity.

Of course this isn’t surprising. It’s consistent with the academic literature on shareholder activism, and on the earlier takeover wave, which finds success at increasing payments to shareholders but not at increasing earnings or productive efficiency. For example, this recent study concludes:

We did not see evidence that targets’ financials improved… The targets’ leverage and payout, however, did seem to increase, suggesting that the activists are unlocking value by prompting management to return additional cash to shareholders.

Still, it’s noteworthy to see a bastion of orthodoxy like the OECD flatly stating that shareholder activism is pure extraction and does nothing for productivity.


UPDATE: Here’s James Mackintosh discussing this same material on “The Short View”:



[1] It’s worth mentioning here this interesting recent Australian survey of corporate executives, which found that new investment projects are judged by a minimum expected return or hurdle rate that is quite high — usually in excess of 10 percent — and not unresponsive to changes in interest rates. Even more interesting for our purposes, many firms report that they evaluate projects not based on a rate of return but on a payback period, often as short as three years.

[2] The language of “M and “P” moments is of course taken from Marx’s vision of capital as a process of transformation, from money to commodities to authority over a production process, back to commodities and finally back to money. In Capital Vol. 1 and much of his other writing, Marx speaks of the capitalist as straightforwardly the embodiment of capital, a reasonable simplification given his focus there and the fact that in the 1860s absentee ownership was a rare exception. There is a much more complex discussion of the ways in which the different moments of capital can take the form of distinct and possibly conflicting social actors in Capital Vol. 3, Part 5, especially chapter 27.

Selfish Masters, Selfless Servants

Via Mike the Mad Biologist, a Confucian parable for the financial crisis:

Mencius replied, “Why must your Majesty use that word ‘profit?’ What I am provided with, are counsels to benevolence and righteousness, and these are my only topics.
“If your Majesty say, ‘What is to be done to profit my kingdom?’ the great officers will say, ‘What is to be done to profit our families?’ and the inferior officers and the common people will say, ‘What is to be done to profit our persons?’ Superiors and inferiors will try to snatch this profit the one from the other, and the kingdom will be endangered….

Indeed, there are deep contradictions hidden in that word “profit.” Reminds me of a classic article on corporate governance, Bruce Greenwood’s Enronitis: Why Good Corporations Go Bad.

The Enron problem is … the predictable result of too strong of a share-centered view of the public corporation… Corporate law demands that managers simultaneously be selfless servants and selfish masters. On the one hand, it directs managers to be faithful agents, setting aside their own interests entirely in order to act only on behalf of their principals, the shares. On the other hand, in the service of this extreme altruism, they must ruthlessly exploit everyone around them, projecting on to the shares an extreme selfishness that takes no account of any interests but the shares themselves. Having maximally exploited their fellow human corporate participants, managers are then expected to selflessly hand over their gains…

Altruism and rationally self-interested exploitation are extreme and radically opposed positions, psychologically and politically. … For managers, one easy resolution of these tensions is a simple, cynical selfishness in which managers see themselves as entitled, and perhaps even required, to exploit shareholders as ruthlessly as they understand the law to require them to exploit everyone else. …

Internally, the share-centered paradigm is just as self-destructive. Corporations succeed because they are not markets and do not follow market norms of behavior. Rather, they operate under fiduciary norms as a matter of law and team norms as a matter of sociology. However, the share-centered paradigm of corporate law teaches managers to treat employees as outsiders and tools to corporate ends with no intrinsic value. Just as managers are unlikely to learn simultaneously to be selfish maximizers and selfless altruists, they are unlikely to be simultaneously cooperative team players and self-interested defectors. Thus, the share-centered view undermines the prerequisite to operating the firm in the interests of shareholders. …

Managers constructing the firm as a tool to the end of share value maximization treat the people with whom they work as means, not ends. …they learn as part of their ordinary life to break ordinary social solidarity. Learning to exploit ruthlessly is surprisingly difficult. … But cynicism can be learned, and managers subjected to the powerful incentives of the share value maximization principle do eventually learn it. … This training, however, surely creates cynics, not faithful agents. … A manager whose lived experience is a pretense of selflessness (with respect to employees, customers and business partners) covering real disinterested exploitation (on behalf of shares) is unlikely to suddenly see himself as “in a position in which thought of self was to be renounced, however hard the abnegation” and voluntarily hand over these hard-won gains of competitive practice to his principal. If you can properly lie to your subordinates, why not lie to your superior as well? … In the end, the cynicism of the share value maximization view must eat itself alive.

Something like Enronitis was clearly involved in the financial crisis. Indeed, some of the most famous controversies around the crisis hinge precisely on disputes about whether a transaction was between the parties linked by a fiduciary duty, or was an arm’s-length one where predatory behavior was expected, and even a moral duty. You can get yourself out of legal trouble, as Goldman has in the case of the Paulson trade, by establishing that you were on the war-of-all-against-all side of the line; but obviously, a system where predatory and trust-based relationships are expected to exist side by side, or even to overlap, is not likely to be a sustainable one. (Of course if the goal of our rentier elite is simply to stripmine the postwar social compromise, then sustainability is moot.) Friedman’s idea that a corporation’s duty is “to make as much money as possible while con­forming to the basic rules of the society” isn’t coherent psychologically or logically, since it demands that management regard certain norms as absolutely binding and others as absolutely non-binding, without any reliable way of saying which is which.

Greenwood is talking about the “corporation as polis.” But the same point applies to the polis as polis.

It may not be the benevolence that makes the butcher, baker or brewer hand over the beef, bread or beer. But it is benevolence– or at least something other than self-interest — that ensures that it’s not full of E. coli. And if you say, well, it’s just their self-interest in avoiding the penalties of the law, that begs the question of why the authorities enforce the law. Or as Hume famously observed,

as FORCE is always on the side of the governed, the governors have nothing to support them but opinion. It is therefore, on opinion only that government is founded; and this maxim extends to the most despotic and most military governments, as well as to the most free and most popular. The soldan of EGYPT, or the emperor of ROME, might drive his harmless subjects, like brute beasts, against their sentiments and inclination: But he must, at least, have led his mamalukes, or prætorian bands, like men, by their opinion.

Boris Groys develops a similar line of thought in The Communist Postscript:

The theory of Marxism-Lenisnism is ambivalent in its understanding of language, as it is in most matters. On the one hand, everyone who knows this theory has learnt that the dominant language is always the language of the dominant classes. On the other hand, they have learnt too that an idea that has gripped the masses becomes a material force, and that on this basis Marxism itself is (or will be) victorious because it is correct.

This is a particular instance of Groys’ broader argument about the inherent power of rational speech:

The listener or reader of an evident statement can of course willfully decide to contradict the  compelling effect of this statement… But someone who adopts such a counter-evident position does not really believe it himself. Those who do not accept what is logically evident become internally divided, and this division weakens them in comparison to those who accept and affirm the evidence. The acceptance of logical evidence makes one stronger; to reject it, conversely, makes one weaker.

Similarly, the decisionmaker who acts on norms consistently is stronger, in the long run, than the Enronitic manager whose honest service to “shareholder value” requires dishonest, strictly instrumental treatment of workers, customers, regulators, and the rest of humanity.

All of which is another way of saying that, despite the fantasies of libertarians, and cynics, that it’s self-interest all the way down, we can’t dispense with intrinsic motivation, analytically or in practice.

UPDATE: Added Groys quote. Had intended to include it in the original post, but I’d lent the book to someone…