Why We Will/Won’t Always Think Short Term

Friday, 14 June 2013
By Tim MacDonald

This interesting exchange recently took place between Tim MacDonald, Senior Fellow at Capital Institute and Andrew Mark Clearfield of Investment Initiatives, LLC, over the Network for Sustainable Financial Markets.

One way the Network seeks to achieve that goal is to foster online discussions among network members. One such discussion thread grew into a conversation around what might be described as “Why We Will/Won’t Always Think Short Term”.

The thread emerged out of a conversation on comments to the OECD’s planned publication of High Level Principles of Long Term Investment and Finance. A discussion of long term investment horizons lead to a discussion of the need for systems thinking, which lead to a discussion of the different classes of participants in the dominant public markets paradigm, which led to Tim making these points:

If we sat down together with a clean sheet of paper to design from scratch a system for uniting large pools of capital built for longevity with large scale commercial enterprise, also built for longevity, what would be the optimal point of alignment between the two?
Bill Janeway of Warburg, Pincus and the Institute for New Economic Thinking shared in some remarks before a Ford Foundation convening on "Finance, Business Models and Sustainable Prosperity" last November his view that cash flow is happiness for commercial enterprise. I agree.
If our pool of capital is, for instance, a pension fund that has current and ongoing fiduciary obligations to pay out fiduciary benefits to successive generations of an extensive population of plan participants, wouldn't fiduciary returns in the form of regularly recurring cash flows equal to or in excess of their fiduciary obligations be happiness for them, as well?
If cash flow is happiness for both capital and enterprise, then cash flow would seem to be the optimal point for aligning their interests through investment. That is, unless there is some other, overriding factor that mandates a different approach.
I cannot think of any, and vote for a direct alignment through agreed splits in cash flows as the primary strategy for delivering returns both of and on investment to large pools of capital, like pension plans, that are built for longevity and also for paying out benefits on a regular and recurring basis (I call it sustaining corpus + benefits). As an ancillary benefit of this architecture for investment, direct alignment along cash flow splits will also empower alignment along other points of shared value. Some of these will be financial. Others can be more societal.
Do you see anything here that I am missing? Do others?"

To this, Andrew offered these counterpoints.

"One thing this proposal leaves out is investor psychology. Investors are enamored of higher-than-average returns. So are many corporate managers. This is what drives capital markets: the hope of outdoing everybody else. Cash flows are boring (except to CFOs) unless they come with a multiple attached. A rational division of current, real cash flows is, except in times when investors are shell-shocked after a major crash, going to be unattractive.
The issue becomes more insidious when we consider that more and more savers (employees in a pension-fund scheme, but also those investing after-tax income) have alternatives, and they tend to move their money to the highest-performing fund managers. (Like it or not, the defined-benefit pension plan is a dying species. Most companies feel they can no longer afford to bear the risk, and many employees are seduced by the prospect of potentially higher returns under a defined-contribution plan.) Of course, buying into the funds which have been the top performers means investors are chasing historical, rather than future performance, but that is another issue which many human beings will never understand . . . A pension fund which is quietly matching its outflows to its income will never excite anyone, excepting the CEO and CFO who might be in favor of such a plan, UNTIL THEY NEED TO RAISE MORE CAPITAL. Suddenly, they will want to sell securities based upon future prospects, not current cash flows.
By the way, we are assuming perfectly honest and perfectly-designed accounting systems. As any accountant can tell you, "cash flow" is not always cash flow, and sometimes there are going to be mistakes, misrepresentations, and outright fraud. Since everything would be based upon current flows, rather than future returns, injuries to pensioners would be difficult to cover in future years. With opportunities limited to attracting capital by posting more rapidly-rising cash flows, there will be all sorts of games played to enhance this critical variable.
Then there is the psychology of the management firms themselves. Managers will attempt to outperform one another. Senior managers will tend to reward those who outperform their colleagues. Those assigned to boring companies with stable cash flows, will attempt to find a way to enhance their returns by finding a way of boosting return through risk. No matter how one attempts to design a system to discourage this, once it is in place, others will lie awake nights attempting to find a way around whatever safety devices one has put in place. Thus, dynamic risk management will always be necessary. But this raises the overhead. What will pay for this overhead, if there are no excess returns?
Have two parallel systems, you say? One totally risk-averse and oriented toward stable cash flows, the other driven by trading and speculation, as Wall Street is now? Capital will tend to flow to the risky system with the higher potential payoffs. It is a law of nature. Talent will all move in the same direction. Any system based upon mechanical division of supposedly "straightforward" (dangerous word) cash flows would tend to become a backwater attracting only those with a minimum of talent and drive; rather as the S&L business was before deregulation in the late '70s. We all know where that led.
Which brings us to what is perhaps the most important point. Such a system would favor stable, established companies in low-risk, low growth industries over new and growing enterprises (or simply those investing in a major new product or strategy) where any significant cash flows are necessarily further down the road (assuming they materialize.) And this assumes that any enterprise which is not generating any cash yet, but still in the 'burn' phase, as well as any where cash generation is still low, will have to be funded solely by venture capitalists. But where will these latter get their capital from, if there will be no prospect of oversized returns from eventually selling off those enterprises which succeed at a large multiple to their current cash-generation value? All innovation would be stifled by the widespread use of such a system.
Such capital sharing would be an interesting idea for a particular kind of investment within a framework analogous to the present one, but I don't think its use could ever be widespread enough to cure the market evils of which we are speaking.
Oh, and one other problem: to be sure that the cash generated is being divided fairly, such investors would probably have to become insiders, and the investment would be totally illiquid. Alternatively, a management company, which would have to be a fiduciary, would have to be placed in the middle, to make sure that incomes and outflows were being fairly reckoned: in that case, the funds are not sharing capital with the actual productive corporations, but investing in another intermediary. This interposes an important level of incremental costs and some risks as well.
Sorry for all the yellow rain, but this particular idea seems to me to have some serious structural difficulties."

What do you think, Long Finance-ers? Who makes the better points?

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