Open Letter to Sergey and Larry

Dear Sergey and Larry,

Unless you've been under a rock, (that's where I've been for a couple of months,) every finance pundit in the world has proclaimed your stock split is abusive.  They won't say that, but that's what they mean.  You think you're an innovator at abusive corporate governance.  You're not.

As my sister says, here's the thing: You went about this all wrong.  What you have is a serious case of hedge fund envy!  Public companies have governance.  Hedge funds don't.  Hedge fund managers take 20% of "partner" asset growth every year, and partners have no votes on the assets themselves.  You poor suckers with public companies have to listen to your "board" and sometimes do what is right for the shareholders.

I have a business proposition for you: Announce that you have reconsidered the stock split.  That the market has spoken, whatever you want.  You'll look somewhere between "moderately shareholder friendly" and "heroic in a new age of market transparency".

At the same time, you launch a hedge fund.  Call it a family office, with a little "outside money" to provide incentives to the senior team.  (If you need help with any of the various technical terms here, please call me,) even though the two of you retain 97.4% of the equity in the new management company.

Target a $5 billion raise from outside investors.  Quietly take the assets up to $10 billion shortly after launch when investors are excited. Now, buy $10 billion of Google stock.  Obviously, these should be voting shares that you don't already control.  Presto!  You now increase your control block using other people's money, but the joy here is that if Google succeeds, you take their money, not just their vote!

If you need my consulting services on this project, Google me...


Best regards,

Marc

Dangerous Statements

In his column about the Facebook IPO, Holman Jenkins says "the stock market is perfectly capable of pricing a company's shares properly in light of any relative limitations on shareholder rights."  He makes this statement in light of the fact that Mark Zuckerberg, post-IPO, will still control the company.  The public shareholders essentially have no rights.

Although I'm an efficient markets guy, I have a tough time with this one.  Post-IPO Zuckerberg will "only" have 25% of the company or so, but he will have unchecked voting control.  So, do you give anyone, including a brilliant 27 year old, the right to manage your money with no actual checks on his behavior, actions and compensation?

What kind of intelligent investor signs up for that kind of deal?  Look no further than virtually every hedge fund in existence!

Hedge funds lack any semblance of corporate governance.  And, if hedge fund investors learned anything in the financial crisis, they learned that they mis-priced their lack of liquidity and lack of control.


Jenkins assumes investors can efficiently price extremely rare events that are not on their radar screens because their screens are clouded with euphoria over the greatest IPO of the 21st century.

I'm willing to bet this governance story does not end well...too bad I don't know when!

Dear CALPERS...and a Lesson on Recursion

State pension plans have an endless list of problems.  Start with those I discuss here: Politics allows those responsible to monkey with the numbers, meaning most of them are broke.

Today the Wall Street Journal reports about CALPERS new governance program.  The pension plan intends to develop a bench of potential directors to improve governance at the companies in which they hold significant positions.  this is not a terrible idea.  It's a complicated idea.

For years I've been a fan of CALPERS activist investing.  In a nutshell, they took the view that they own all the companies in the United States, so the only way to "outperform" was to make those companies perform better, via better governance.  There's good evidence that well-governed companies perform better.  This led them to invest with many activist equity managers.  These managers earned their living enhancing shareholder value, acting as a proxy for CALPERS.

CALPERS taking on direct governance responsibility has serious risks.  How will this program be governed?  My suggestion to CALPERS: Establish and independent board with the charge of ensuring that CALPERS governance program selects directors to enhance shareholder value. Neither the pension plan nor the taxpayers of California can risk political shenanigans corrupting the process of creating value for the plan.

Of course, I would gladly serve on this board.  I may even be qualified.  Or, should I choose to serve on the independent board that governs the independent board overseeing the governance program?  You see where I'm going with this?

Hmmm...so maybe CALPERS should stick with the old plan of outsourcing governance to individuals who govern for shareholder value.

Something Delaware This Way Comes!

Senator Ted Kaufman's righteous indignation is killing me.  I'm reminded of my all-time favorite South Park episode.  Wikipedia has an excellent summary...here's my not so excellent one: The kids want to stop the WallMart(sic) from opening in South Park.  They seek out the psycho-sage-current CEO who tells them they need to find the "heart" of the store and destroy it.  They find it.  The heart of WallMart is a mirror.

So, what's Ted Kaufman's mirror?  Corporate governance and Delaware corporations.  I've discussed corporate governance before.  To me, just about every investment decision comes down to principal-agent problems and governance.  In the end, people will do what's in their best interest.  You need to design structures that encourage people to solve these problems.  "Moral Hazard" has turned into the buzz phrase of the financial crisis, but there's nothing new here.

[This book on the subject, written by Robert Townsend, has great insights.  Although he was possibly the worst lecturer I've ever had in school, I loved the class.]

So, why do I blame Delaware?  Delaware won the original race the the bottom in corporate governance.  In order to attract businesses to the state, long ago Delaware set up a system that allowed managers to protect themselves from pesky shareholders.  One hundred or so years later, virtually every major corporation in the United States technically resides in Delaware.  Because you, the shareholder, can't really hurt them in Delaware.

No, I have no fix here...yet.  Logically, we, the people who own the corporations, would vote with our feet.  We'd stop owning companies with terrible governance.  But that doesn't happen.  In fact, our greed gets the best of us. 

What is the goal of corporate governance?

Jason Zweig, in the Intelligent Investor column in the Wall Street Journal writes about Lucian Bebchuk's research about CEO Pay Slice, (which you can find here.)

The most thought provoking comment in the paper is the following:

[CEO Pay Slice] is negatively correlated with the firm-specific variability of stock returns over time. This association could be due to a greater tendency of dominant CEOs to play it safe and avoid firm-specific volatility (which would impose risk-bearing costs on them but could be less costly to diversified investors).

Rarely does anyone take on the serious implications of this observation: CEOs and the Boards that oversee them must strike a balance between taking idiosyncratic risk that differentiates them from the rest of the marketplace and taking incremental diversifying risks that reduces firm specific volatility.

I served on the board of a public reinsurance company. Reinsurers take very risky bets by insuring, typically, catastrophic disasters. Catastrophic insurance has a particular type of risk I'll call short volatility: They collect insurance premiums and pay out very large claims. The claims are nowhere near normally distributed in the world of catastrophes. This means that writing "cat" reinsurance has very high returns on equity, although they aren't normally distributed. Also, cat reinsurers have ratings (A- or better, typically. See AM Best, for example.) This means they write protection on more risks than they can pay, because (re)insurance buyers accept a rating as evidence of ability to pay.

The first problem this raises for the Board is whether the board should be maximizing the expected return on equity of the company or maximizing the return to holding the stock of the company, or even maximizing the return on equity of the company subject to some limit on the risk of losing the rating and therefore destroying the enterprise value of the company.

At the time I served on the Board, I happened to also "control" more than 10% of the stock. However, that 10% of the stock was of little consequence to my firm's total risk. This gave me a serious conflict to address: As a Board member, what did I assume the shareholders of the company wanted me to do? I knew I was not necessarily a typical shareholder. Did I assume they held uncomfortably large blocks of stock, (which we all should view as irrational,) and therefore would want me to not risk the disaster of losing the rating? Was my goal to maximize the "value" of the rating, meaning the ability of the company to default on claims if something truly catastrophic happened, which is perfectly sensible if no one holds large positions in their own portfolio?

These are the interesting questions most boards, I suspect, spend too little time addressing.

Too big to fail? Limit sources of capital, not size.

There's a funny thing about law firms: You must be an attorney to own a law firm. I suspect this is the result of arcane tradition. Legal scholars probably debate this--I'll look into it. However, two simple implication are that (a) lawyers are on the hook for all the actions of their partners, (b) law firms capital will be constrained by the willingness of a collection of partners to share risks and monitor each others' actions.

Banking and financial services firms might take a lesson from this. If managers of financial firms were only risking their money, and their partners' money, they'd probably be more careful. Oh, and they could get big, but probably not nearly as big as they are today.

There are a lot of issues to consider in this area.

First observation: I think most market participants would agree that Goldman Sachs took far less risk (and still made monstrous profits) when it remained a partnership.

Second observation: shareholder governance as determined by the state of Delaware probably does not work for most if not all complicated financial firms. Here's an example: Non-employee directors of Citigroup receive base compensation of $75,000 annually. For $75k part time representatives of the shareholders are supposed to understand what is going on at one of the most complex financial firms in the world. I would think understanding what is going on within Citigroup to competently protect the interests of investors is a full time, potentially several million dollar a year job. On the other hand, the shareholders can't directly select directors, compensate directors or fire directors. That's Delaware.

So, let's think about financial institutions that may only be employee (and director?) owned.