“The Money Has to Go Somewhere” – 1

A common response to concerns about high payouts and the short-term orientation of financial markets is that money paid out to shareholders will just be reinvested elsewhere.

Some defenders of the current American financial system claim this as one of its major virtues — investment decisions are made by participants in financial markets, rather than managers at existing firms. In the words of Michael Jensen, an important early theorist of the shareholder revolution,

Wall Street can allocate capital among competing businesses and monitor and discipline management more effectively than the CEO and headquarters staff of the typical diversified company. [Private equity fund] KKR’s New York offices … are direct substitutes for corporate headquarters in Akron or Peoria.

But while private equity funds do indeed replace exiting management at corporations they buy shares in, this form of active investment is very much the minority. The vast majority of “investment” by private shareholders does not directly contribute any funding to the companies being invested in. Rather, it involves the purchase of existing assets from other owners of financial assets.

Suppose a wealthy investor receives $1 million from increased dividends on shares they own. Now ask: what do they do? Their liquidity has increased. So has their net wealth, since the higher dividends are unlikely to reduce the market value of the shares and may well increase them. The natural use of this additional liquidity and wealth is to purchase more shares. (If the shares are owned indirectly, through a mutual fund or similar entity, this reinvestment happens automatically). But this purchases of additional shares does not provide any funding for the companies “invested” in, it simply bids up the prices of existing shares and increases the liquidity of the sellers. Those sellers in turn may purchase more shares or other financial assets, bidding up their prices and passing the liquidity to their sellers; and so on.

Of course, this process does not continue indefinitely; at each stage people may respond to their increased wealth by increasing their cash holdings, or by increasing their consumption; and each transaction involves some payments to the financial industry. Eventually, the full payout will leak out through these three channels, and share prices will stop rising. In the end, the full $1 million will be absorbed by the higher consumption and cash holdings induced by the higher share prices, and by the financial-sector incomes generated by the transactions.

Now, not every share purchase involves an existing share. But the vast majority do. In 2014, there were $90 billion of new shares issued through IPOs on American markets — an exceptionally high number.  By comparison, daily transactions on the main US stock markets average around $300 billion. Given around 260 trading days in a year, this implies that only one trade in a thousand on an American stock exchange involves the purchase of a newly issued share. And that is not counting the many “stock market” transactions other than outright share purchases (closed-end mutual funds, derivative contracts, etc.) all of which allow income from shareholder payouts to be reinvested and none of which provide any new funding for businesses.

External financing for businesses is much more likely to take the form of debt than new shares. But here, again, we can’t assume that there is any direct link between shareholder payouts and funding for other firms. Corporate bonds are issue by the same established corporations that are making the payouts. Meanwhile, smaller and younger firms, both listed and unlisted, are dependent on bank loans. And the fundamental fact about modern banks is that their lending is in no way dependent on prior saving. There is no way for higher payouts to increase the volume of bank lending. Banks’ funding costs are closely tied to the short-term interest rate set by the Federal Reserve, while their willingness to lend depends on the expected riskiness of the loan; there is no way for increased payouts to increase the availability of bank loans.

New bonds, on the other hand, do need to be purchase by wealthowners, and it is possible that the market liquidity created by high payouts has helped hold down longer interest rates. But many other factors — especially the beliefs of market participants about the future path of interest rates — also affect these rates, so is hard to see any direct link between payouts by some corporations and increased bond financing for others. Nor do new bonds necessarily finance investment. Indeed, since the mid-1980s corporate borrowing has been more tightly correlated with shareholder payouts than with investment. So if payouts do spill over into the bond market, to a large extent they are simply financing themselves.

Defenders of the financial status quo suggest that it’s wrong to accuse the markets as a whole of short-termism, since for every established company being pressured to increase payouts, there is a startup getting funded despite even when any profits are years away. I certainly wouldn’t deny that financial markets do often fund startups and other small- financially-constrained firms; and these firms do sometimes undertake socially useful investment that established corporations for whatever reason do not. And in principle, shareholder payouts can support this kind of funding both directly, as shareowners put money into venture capital funds, IPOs, etc.; and indirectly, as higher share prices make it easier to raise funds through new offerings. But the optimistic view of shareholder payouts not sustainable once we look at the magnitudes involved. It is mathematically impossible for the additional funds directed to new firms, to offset what they drain from established ones.

Again, IPOs in 2014 raised a record $90 billion for newly listed firms. (Over the past ten years, the average annual funds raised by IPOs was $45 billion.) Secondary offerings by listed firms totaled $180 billion, but some large fraction of these involved stock-option exercise by executives rather than new funding for the corporation. Prior to an IPO, the most important non-bank source of external funding for new companies is venture capital funds. In 2014, VC funds invested approximately $50 billion, but only $30 billion of this represented new commitments by investors; the remaining $20 billion came from the funds’ own retained profits. (And there is some double-counting between VC commitments and IPOs, since one of the main functions of IPOs today is to cash out earlier investors.) Net commitments to private equity funds might come to another $200 billion, but very little of this represents funding for the businesses they invest in — private equity specializes, rather, in buying control of corporations from existing shareholders. All told, flows of money from investors to businesses through these channels was probably less than $100 billion.

Meanwhile, total shareholder payouts in 2014 were over $1.2 trillion. So at best less than one dollar in ten flowing out of publicly-traded corporations went to fund some startup. And this assumes that shareholder payouts are the only source of funds for IPOs and venture capital; but of course people also invest in these out of labor income (salaries are a significant fraction of even the highest incomes in the US) and other sources. So the real fraction of payouts flowing to startups must be much less. There simply isn’t enough room in the limited financial pipelines flowing into new businesses, to accommodate the immense gusher of cash coming from established ones. Apple alone paid out $56 billion to shareholders last year, or nearly twice total commitments to VC funds. Intel, Oracle, IBM, Cisco and AT&T together paid out another $70 billion. [1] It’s hard to understand why, if finance is able to identify such wonderful investment opportunities for its cash, the management at these successful technology companies is unable to. You would have to have a profound faith in the unicorn hunters at Andreesen Horowitz to believe that the $1 billion they invested last year will produce more social value than $10 or $20 or $50 billion invested by established companies — or an equally profound pessimism about the abilities of professional managers. If this is what people like James Surowiecki really believe, they should not be writing about the dynamism of American financial markets, but about whatever pathology they believe has crippled the ability of mangers at existing corporations to identify viable investment projects.


[1] These numbers are taken from the Compustat database of filings by publicly traded corporations.

8 thoughts on ““The Money Has to Go Somewhere” – 1”

  1. “Secondary offerings by listed firms totaled $180 billion, but some large fraction of these involved stock-option exercise by executives rather than new funding for the corporation.”

    But the strike price for options exercised by employees (not necessarily executives, although executives get the bigger awards) goes to the corporation, so some of that money does represent new funding for the corporation. Every time I’ve exercised an option (as a non-executive employee), it’s involved either a check from me to the company treasury, or a so-called “cashless” exercise in which the exercise and sale in the public market occur simultaneously, with the company credited with the strike price, and employee credited with the difference.

    The strike price will depend on the circumstances under which the option was granted. For public corporations granting new options, the strike price will be tied to the company’s stock price at time of grant. When there is a big discrepancy between strike price and current market price, it usually means either the option was granted when a company was privately held as a small startup, or the company has been growing really fast over the life of the option.

    1. This is a valid point. Unfortunately, I don’t know of any good data on the average ratio of the strike price to the market price at the time shares are exercised. I need to explore this further.

  2. @JW Mason

    Do you believe that USA economy is undercapitalised?
    If the USA economy is not undercapitalised, additional investiment will just prop up the price of land or similar rentier assets, which is what apparently is happening.
    So in my opinion the problem is not that money paid out to shareholders is not invested elsewhere, rather the opposite, an excess of investiment/savings.
    I believe that your opinion is the opposite? If so, could you explain the reason?

    1. Your comment hints at where else the money might go: foreign economies which ARE undercapitalized. Theoretically, bidding up the price of American rentier assets ought to to increase the incentive to invest abroad, as foreign assets become cheaper by comparison. Obviously shifting investment overseas is far from friction-free, but it would be strange if it weren’t happening on the margins.

      1. True. But we need to be clear here about what foreign investment actually entails.

        If we are talking about FDI, the investor is actually taking control of a productive asset in the target country, with potential benefits in terms of technology transfer, more favorable access to foreign markets and suppliers, and so on, and also potential costs of political influence and strategic decisions being made in the interests of the parent company. You can weigh those as you like but in any case FDI, precisely because it involves a large stablished company integrating a foreign company into its own activities, is not a plausible use of disgorged funds.

        Outward portfolio investment might indeed rise as a result of larger payouts from American companies. But let’s be clear what that’s providing to the destination country — not “capital,” not “savings,” but foreign exchange. The only benefit of inward portfolio investment is that it allows a country to finance a current account deficit, or to accumulate more foreign reserves, or in the case of a country maintaining a fixed exchange rate to hold interest rates than would otherwise be possible. These aren’t negligible benefits but they create their own dangers since portfolio flows are subject to sudden reversals. If high shareholder payouts helped finance the portfolio inflows that allowed Korea, Malaysia, etc. to run large c.a. deficits with fixed exchange rates in the 1990s — I think in retrospect that’s a benefit they would happily have foregone.

        Rentiers are socially useless parasites, basically — in the international case most of all.

    2. Well, it depends what you mean. A lot of interviews with corporate executives suggest that for a new project to be undertaken, it needs to have an expected return of at least 10%, or even to fully recover its costs in three years. Now clearly there are a great many potential investments out there whose expected private returns are less than 10%, but greater than zero. Of course it’s true that land and similar nonproduced assets can compete with new investment — Keynes has a good discussion of this — but this is more likely precisely when the surplus is disposed of by rentiers rather than internally by the firm.

      Now, if you ask, is this hypothetical additional investment going to contribute to human happiness? — then sure, the answer may be no. But the same goes for increased consumption. Normatively my preference is no increase neither, but rather to expand the scope of nonmarket activity, e.g. by shorter workdays. But in narrow economic terms I don’t think there is any question that there is a large volume of investment that would be worth undertaking if the required rate of return was say 5%, but not if it’s 10%. So in that sense the US is certainly undercapitalized.

      In addition, I see major positive externalities from higher investment — narrowly, it boosts employment; a bit less narrowly, it contributes to technological progress, assuming we still want that; and most broadly, allocating capital within the firm is part of the process by which corporations “socialize themselves,” as both Marx and Keynes hoped/expected. So I don’t think you have to believe that the US “needs” more capital goods in an absolute sense to be interested in a program of encouraging greater investment.

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