Lockdown is exposing the folly of reckless financial strategies
Pension funds need to spend less time on ESG and get back to basics
Imagine a driver who’s mad keen to get home quickly. Trying to shave a few seconds from his daily commute along a twisty mountain road, he overtakes other cars on blind bends. It all works swimmingly, until one day he hits an oncoming truck.
This is a concept known as a “Taleb distribution”, named after one of the themes in Nassim Nicholas Taleb’s celebrated book about risk, Fooled by Randomness. A Taleb distribution has the property that many small profits are mixed with occasional thumping losses. Cutting corners on mountain roads, it turns out, runs the risk of a Taleb-style loss.
It is possible to see the coronavirus outbreak as some sort of giant Taleb distribution in the way it has poleaxed corporations across the developed world.
True, anything like the Covid-19 shutdown would have caused great damage in any recent decade. But, thanks to choices made by managers and investors, what’s happening now will be more messy and painful than it needed to have been.
One reason is that investors have spent the past few decades encouraging companies to do the financial equivalent of overtaking on blind bends. Beguiled by dubious claims that funding businesses with borrowings would promote greater operational efficiency, they allowed managers to saddle companies with ever-growing amounts of debt.
In the quoted sector, managers were encouraged through lucrative incentives to make debt-funded acquisitions and buy back shares, even at elevated prices.
The mood also drove phenomenal growth in private equity. The net assets of buyout firms have grown more than seven-fold since 2002, twice as fast as global public equities, according to data from the consultants McKinsey. Investors now hold 14 per cent of their assets in private markets. A salient feature of private-equity backed companies is that they tend to run with higher leverage than quoted firms.
The result has been a steady erosion in the creditworthiness of companies. Globally since 1980, the median credit rating has declined from A to triple B minus, a single notch above junk, according to S&P data. Whatever their purported level of efficiency, these indebted firms are more vulnerable to external shocks. More are consequently likely to fail in the recession, leading to greater unemployment and persistent output loss.
It’s not just in the economic sphere that the pain will be intensified. Politically things will be more heated too. That’s because many of the people who are now begging loudly for assistance are those road hogs that have been the biggest financial participants of the overtaking-on-the-blind-bend game.
Note the scorn that has greeted requests from the tax-haven dwelling billionaire Richard Branson for a bailout of his airline interests. Or the US carriers that spent 96 per cent of their free cash flow on buybacks since 2014. A decade ago, the culprits were just the bankers. Now it is the whole big company sector, abetted not just by banks but by pension funds pouring money into shadow banking and “alternative credit” firms.
Imagine an economic stop like this one happening in the 1950s. There would certainly be pain but the level of resentment would be lower. The 1930s depression certainly did cause bitterness, but that came after a decade of Gatsby-esque excess. This one follows more than three decades of financial triumphalism.
The best way to stop this happening again in future would be for pension funds to spend less time burnishing their ESG criteria and get back to basics. As the stewards of capital, they have to take responsibility for what is done with their money. They need to design contracts that reward investment managers more for performance that makes the overall economic pie bigger.
Existing contracts that are poorly designed allow bosses of quoted companies to become rich by using leverage to game earnings per share and performance targets. They permit private equity firms to achieve Croesus-like wealth regardless of where those profits come from. Some private equity returns come from running groups better. But the majority come from leverage or simply from closet sector or stockpicking bets.
If policymakers want to encourage asset owners to make fund managers behave differently, they might also consider changing the rules of the game in advance. One idea, proposed by the economists Charles Goodhart and Rosa Lastra, is to curb or withdraw the privilege of limited liability for company managers and influential investors, such as private equity and activists. Another is to restore visibility.
One of the consequences of the political fallout of the 1930s depression was to push accountability up the agenda. It led to the creation of the US Securities and Exchange Commission on the principle that “sunlight is the best disinfectant”.
An under-appreciated consequence of the accelerating rush away from the public markets is that it has progressively snuffed out that illumination. Evermore of the economy has retreated to the pre-1930s shadows. Reckless drivers are more likely to cut corners if they know no one is looking. To avoid unnecessary pain in future then, that process should be rolled back.