The Uneasy Case of Favouring Long-Term Shareholders

The Yale Law Journal, Jesse M. Fried

Common Assumptions

  • A firm’s managers should favour long-term shareholders over short-term and maximize the long-term shareholders’ returns vs the short-term stock price. The underlying assumption is that over time the size of the pie becomes larger.

  • “Short-termism” (i.e., favouring short-term shareholders’ interests to the potential detriment of every other shareholder) has been described mostly as a black check to destroy the long-term value (favouring activities boosting short-term stock prices, capital misallocation, cutting corners, etc.), while the long-term investors are put on a pedestal.

  • However, long-term shareholders can benefit from managers’ destroying value. And managers looking for long-term outcomes can in fact destroy more value than those focused on short-term shareholders. Thus, long-term is not a synonym of value creation.

  • The view that managers must focus mostly on long term is widely held in academia and is being taught to would-be Board Directors. In a way, this is the mandate for the managers to take the long-term shareholders’ interests more seriously, even though it’s technically illegal (the Board is responsible to all shareholders equally, which causes nothing but cognitive dissonance).

Suggestions for the Benefit of Long-Term Shareholders

  • A curious suggestion is to have voting power increase with length of share ownership (or give call options after a certain period of time, exercising which would lead to a similar outcome).

  • Or to favour long-term shareholders with higher dividends or other cash-flow rights.

  • In many countries there’s a discounted or waived Capital Gains Tax on the disposal of shares help for a long time (1-5 years, varying between jurisdictions).

  • MK: what’s interesting is that the article doesn’t mention the protection of the interests of short-term shareholders (Robinhood, anyone?) as more and more retail investors join the market.

The Findings

  • There’s a false dichotomy that because short-term shareholders are interested in the price increase, they’re the opposite of the long-term shareholders who care about the value over time. These two things are not contradicting each other.

  • And also, if the firm is doing transactions with large volumes of its own shares (buybacks or additional issues), this is known to increase the share price at the expense of all shareholders. This is not necessarily a long-term value creation – it may as well end up being value destruction. And there can be cases when long-term shareholders benefit from share buybacks, which may not be in the interests of the companies (to start with, this capital could’ve been reinvested in value creation activities of the firm, not the financial massage).

  • Exec compensation arrangements reflect the power dynamic of the shareholders; short-term shareholders are more likely to tie exec comp to the share price, while long-term shareholders would focus on the growing of the pie.

  • It is generally true that the long-term view of the management in firms not dealing in its own shares does in fact create long-term value. The interests of short-term shareholders most likely involve the incentives for the managers to engage in conduct that destroys the size of the pie – precisely what the theory says.

  • (2015) On average over the 5-year period US firms transacted in 30% of their market cap (i.e., for a $10B company they bought and sold $3B worth of its own shares).

  • When a firm repurchases its shares at a below-market price (a bargain), long-term shareholders actually benefit as it’s merely a value-shifting activity (from short-term investors to long-term ones). The managers’ interests of maximizing long-term value in this instance are in fact a good thing for the firm.

A Very Curious Example – Costly Contraction

  • A firm can buy its temporary cheap stock at a discount and eventually yield 40% to long-term shareholders (value transfer).

  • It can invest the same funds into capital projects yielding, say, 30% (value creation).

  • It can’t do both.

  • There’s a strong case to favour value creation above value transfer, even if long-term shareholders may not receive the highest bang for their buck. Value creation is what makes firms sustainable, not value transfers, but this is a good example when focusing on financial engineering may backfire.

Another Curious Example – Price Depression

  • Simply put, it’s a price-depression manipulation to make the bargain (see above) possible or increase the extent of it. Long-term shareholders win (see above), but the method is value destruction by the management.

  • It’s not a question of what’s legal and what’s not, but simply a working technique.

  • MK: Price depression is also a practical tool for justifying the sale price (and the premium paid to shareholders) in M&A.

Additional Share Issue

  • The higher the share price – usually the more money the firm can attract in additional share sales [MK: it’s the instance where equity financing becomes cheaper than debt]. In itself there’s nothing wrong if the company can use the funds for value creation activities, but it’s technically a value transfer from future shareholders to the current long-term shareholders. The same methods to boost short-term share price (not limited to earnings manipulation) are used – this time for the benefit of long-term shareholders.

  • An example of a value destruction activity, though, is using this additional capital raised (or even just paying with shares) to acquire an expensive asset (AOL + Time Warner) that will lose value shortly after the transaction closes.

Value Transfer Size

  • Almost 20% of the wealth created by publicly traded companies for their long-term shareholders is generated via transfer from other shareholders; for smaller companies it’s up to 50%.

  • Increasing the power of long-term shareholders is likely to increase these percentages.

  • This problem can become even bigger when there are controlling long-term shareholders in a firm, who are interested in and are capable of value transfer from other shareholders using the methods above.

Conclusions

  • Favouring one group of shareholders (say, long-term) to the detriment of others (short-term or future shareholders) has a potential to reduce the size of the pie going forward (damaging the firm itself). Symmetrically, the short-term share price doesn’t reflect the value flowing to long-term and future shareholders.

  • Including non-shareholder stakeholders into the mix (as prescribed by ESG) can supposedly shift the focus towards long-term (think corporate sustainability), but many business models rely on disadvantaging certain stakeholders, so unless the firm finds a working balance (and it should) – this will end up being a zero-sum game. (Think of underpaying employees to extract higher dividend as the simplest example.)

  • It’s also not clear whether the long-term investors are really better at controlling managerial transaction costs, as many of such investors are quite passive. Short-term shareholders often have higher incentives to hold managers accountable and shake the status quo.

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