公司治理与资本配置：治理目标、公司治理与两大阵营

January 2016

Research Institute Thought leadership from Credit Suisse Research and the world’s foremost experts

How Corporate Governance Matters

Corporate governance and capital allocation The governing objective, corporate governance and the two camps.

Michael Mauboussin and Dan Callahan

Properly conceived, corporate governance is a sys- Countries that operate under civil law have weaker tem of checks and balances that a company designs protection for shareholders and stronger protection in order to serve its governing objective. A governing for creditors. They tend towards the camp that seeks objective is a clear statement of what a company is to balance the interests of stakeholders. These coun-trying to achieve, which ultimately shapes the firm’s tries include France, Germany and Japan as well as culture, communications and choices about how it most Scandinavian countries (La Porta and Lopez-allocates capital (Mauboussin and Rappaport, 2015). de-Silanes, Shleifer, Vishny, 2001). Formal and infor-In this section, we examine the link between corpo- mal rules about the interaction between constituen-rate governance and capital allocation. cies are vital for stakeholder-centered companies.

Since the world of business is dynamic, compa- Naturally, the mindsets of these camps lead to dif-nies must constantly assess trade-offs and make ferent structures of corporate governance and choices difficult decisions. A clear governing objective pro- about how a company invests and finances itself. For vides executives with a basis to mediate trade-offs in example, academics who study shareholder and the firm. It also provides the stakeholders, including stakeholder-oriented governing objectives have found employees, customers, suppliers, debtors, and that firms that are shareholder-centric have a higher shareholders, with information they need to assess a proportion of incentive pay for executives in the form company’s prospects and to evaluate of equity, more externally verifiable control mecha-its performance. nisms, more debt as a percentage of total capital, and Few companies explicitly state a governing objec- higher rates of labor turnover than firms that are stake-tive, but we can broadly define two camps: maximizing holder-centric (García-Castro, Ariño, Rodriguez, and shareholder value and balancing the interests of stake- Ayuso, 2008).

holders. As a general rule, countries that operate under Some scholars charge that balancing stakeholder common law have the strongest protection of share- interests cannot serve as a company’s singular gov-holders and hence lean towards the shareholder value erning objective because it is impossible to simulta-camp. These countries include the United States, the neously maximize the interests of all stakeholders United Kingdom, and most of the countries that were (Jensen, 2002). As a result, executives have discre-formerly part of the British Empire (e.g. Australia, Can- tion to make decisions as they see fit. The problem ada and India). Markets for capital and labor play a is that investors and other stakeholders have no reli-central role for companies in the shareholder able basis to evaluate a company’s strategy as well value camp. as the operating and financing choices its managers make.

Figure 31 Sources and uses of financial capital Capital sources Capital allocation

Capital expenditures Operational cash flow Working capital Business Asset sales Mergers/acquisitions Research & development

Cash dividends Access cash Equity issuance Return cash Share buybacks from claimholders Debt issuance to claimholders Debt repayment Source: Credit Suisse

The fundamental role of capital allocation

Capital allocation is the most fundamental responsibility of a public corporation’s senior management team. Successful capital allocation means converting inputs, including money, ideas and people, into some-thing more valuable than they would be otherwise.

The net present value test is a simple, appropriate and classic way to determine whether management is living up to this responsibility. A company passes the test when the present value of the long-term cash flow from an investment exceeds the initial cost.

There are two reasons value should determine whether a management team is living up to its responsibility. The first is that companies must compete. A company that is allocating its resources wisely will ultimately prevail over a competitor that is allocating its resources foolishly. This reason is par-ticularly important for firms that compete in global markets. The second is that inputs have an opportunity cost, or the value of the next best alternative.

Unless an input is going to its best and highest use, it is underperforming relative to its opportunity cost. Figure 31 (and in more depth, Figures 32 to 39)

shows the sources of capital and the ways that a company can allocate capital. The primary source of capital is cash flow from operations. Companies can also access capital by selling businesses or raising funds through the issuance of debt or equity. Companies can invest in the business through capital expenditures, increases in working capital, research and development, and mergers. Firms can also return capital to claimholders by repaying debt, issuing dividends and repurchasing shares. While a comprehensive consideration of capital allocation also takes into account human capital, we restrict our discussion here to financial capital.

Over time, a company’s results will reflect a com-bination of the opportunities it has and how the executives allocate capital. Industries and companies generally have a lifecycle where a start-up period is followed by a phase of growth, a fade in return on investment, and ultimately a state of maturity (Madden, 1999). Investment in the business is strongest in the early part of the lifecycle and the proclivity to return capital to claimholders is higher towards the end.

Capital allocation is a dynamic process, so the correct answer to most questions is: “It depends.”

Sometimes acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and times to retire it. As the components that determine price and value are changing constantly, so too must the assessments that a chief executive officer (CEO) makes. As Warren Buffett, CEO of Berkshire Hathaway says: “The first law of capital allocation — whether the money is slated for acquisitions or share repurchases — is that what is smart at one price is dumb at another” (Buffett, 2011).

A basic equation in finance says that a company’s sustainable earnings growth rate is a function of its return on investment and the amount it pays out to shareholders. Companies with high returns on investment can sustain more rapid growth than companies with low returns, holding constant the payout ratio. As a result, companies in a country with a high return on investment can generally fund a greater percentage of their investments with internally-gen-erated cash than companies in a country with a low return. Figure 40 shows this correlation, using cash flow return on investment (CFROI) as a measure of return on investment. The data reflect the average of the ten years up to 2014.

Tying this idea back to corporate governance, countries with a bias towards shareholder value also generate higher CFROI than those that lean towards the balanced stakeholder approach. Specifically, the five largest markets under common law (USA, UK, Hong Kong, Australia, and Canada) have realized an average CFROI of 8.0% since 1994, while represen-tative countries under civil law (Japan, Germany, France, Switzerland, and Sweden) had an average of 6.4%. So for the same rate of growth, common-law countries can afford a higher payout ratio than civil-law countries.

Maximizing long-term value creation per share is the result of making investments that earn in excess of the cost of capital, including the repurchase of shares. A company’s governing objective and the corporate governance structures that support it have a profound influence on how the firm allocates capi-

tal. We now examine how capital has been allocated across different regions of the globe.

Capital sources: Business operational cash flow USD in billions, gross cash flow (real)

Source: Thomson Reuters DataStream, Credit Suisse HOLT, Credit Suisse Note: dollar amounts are not inflated. Data includes top 1,500 US industrial firms, excludes financial companies and regulated utilities.

Figure 33 Capital sources: Business asset sales (divestitures)

USD in billions, line (right axis) represents percentage of net sales

Source: Thomson Reuters DataStream, Credit Suisse HOLT, Credit Suisse Note: dollar amounts are not inflated. Data includes all industries; excludes debt tender offers, equity carve-outs, exchange offers, loan modifications, and open market repurchases.

Figure 34 Capital sources: Equity and debt issuance

Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F.103.

Figure 35 Capital allocation: Business capital expenditures USD in billions, line (right axis) represents percentage of net sales

Source: Thomson Reuters DataStream, Credit Suisse HOLT, Credit Suisse Note: dollar amounts are not inflated. Data includes top 1,500 US industrial firms, excludes financial companies and regulated utilities.

Capital allocation: Change in net working capital USD in billions, line (right axis) represents percentage of net sales

Source: Thomson Reuters DataStream, Credit Suisse HOLT, Credit Suisse Note: dollar amounts are not inflated. Data includes top 1,500 US industrial firms, excludes financial companies and regulated utilities.

Figure 37 Capital allocation: Business research & development USD in billions, line (right axis) represents percentage of net sales

300 3.0%

200 2.0%

100 1.0%

Figure 38 Capital allocation: Cash dividends USD in billions, line (right axis) represents percentage of net sales

Note: Dollar amounts are not inflated. Data includes top 1,500 US industrial firms, excludes financial companies and regulated utilities.

Figure 39 Capital allocation: Gross share buybacks USD in billions, line (right axis) represents percentage of net sales

Note: dollar amounts are not inflated. Data includes top 1,500 US industrial firms, excludes financial companies and regulated utilities.

Relationship between CFROI and internal financing capability (2005-2014 average)

Internal financing (percentage of total)

110 USA 100 Germany Netherlands 90 Finland

80 Denmark Portugal Austria

CFROI (percent)

Source: Europe: Eurostat European Sector accounts; U.S.: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F.102; Credit Suisse.

Table 3 Capital deployment by region Historical averages for USA, Japan, Europe, APEJ, and GEM

Economic returns and Uses of capital (as a percentage of sales) growth

Source: Credit Suisse HOLT.

Note: for uses of capital, historical averages are based on the following years: USA (1980-2013), Japan (1985-2013), Europe (1985-2013), APEJ (1992-2013), GEM (1992-2013), For CFROI® and real asset growth rates, historical averages are based on the years 1993-2013 for all regions.

The history of capital deployment •• Divestitures play a significant role in each of the regions, constituting roughly one-third to one-half Table 3 shows capital allocation in recent decades the level of total M&A. They are also larger than div-by region, including the United States, Japan, idends and share buybacks in all regions but Japan.

Europe, Asia Pacific ex-Japan (APEJ) and global •• Dividends substantially exceed share buybacks in emerging markets (GEM). The exhibit also shows all regions except the USA, where they have been CFROI and asset growth, adjusted for inflation, over roughly equivalent on average. Buybacks are the last 20 years. modest in Europe and fairly insignificant in Japan, The main observations on spending in recent APEJ and GEM.

decades include the following: •• Share buybacks have been meaningful in com- •• M&A is the largest use of capital in the USA, mon-law countries and inconsequential in nearly all Europe and GEM, the second largest use in other regions. This pattern reflects cultural and APEJ, and the fourth largest use in Japan. The regulatory constraints.

rarity of M&A in Japan is of particular note. A country’s legal tradition appears to lead to •• Capital expenditures are the largest use of capital implicit assumptions about what the governing objec-in Japan and APEJ and the second largest use in tive should be as well as the society’s rules the USA, Europe and GEM. and regulations.

•• R&D is the second largest use of capital in Japan,

PHOTOISTOCKPHOTO.COM/CERCHI the third largest in the USA and Europe, and the fourth largest in APEJ and GEM. Developed markets spend substantially more on R&D than devel-oping markets.

Incentives and capital allocation earnings. Indeed, research shows that a large major-

One of the enduring lessons of economics is that incentives matter. It is also the case that incentives designed to achieve one objective can lead to unin-tended consequences. The goal of this section is to consider whether the incentives a company has in place encourage judicious capital allocation. Most of these incentives address compensation.

Agency theory is the classic way to explain why the managers of a company may not act in the interests of the shareholders (Jensen and Meckling, 1976). The idea is that conflicts can arise when there is a separation between a firm’s ownership (principal) and control (agent). There are three areas where these conflicts tend to arise (Lambert and Larcker, 1991).

The first is that while it is clear that shareholders want management to maximize the value of their holdings, management may derive benefits from con-trolling resources that don’t enrich shareholders. For example, if remuneration is roughly correlated with the size of the firm, management may seek value-destroying M&A deals to grow.

The second area of conflict is with risk tolerance.

Since shareholders tend to hold stocks as part of a diversified portfolio, whereas managers are dispro-portionately exposed to their own company, managers may seek less risk than shareholders would deem appropriate.

The final conflict is with time horizon. To the degree that compensation plans have a shorter time horizon than the period shareholders use to assess the merit of an investment, there can be a mismatch. So managers may dwell on short-term boosts in ity of managers are willing to forego value-creating investments to deliver near-term earnings (Graham, Harvey and Rajgopal, 2006).

The principal-agent problem arises in capital allocation choices. For example, some companies repurchase stock to offset the dilution of equity issuance to employees (Kahle, 2002) or boost earnings per share (Hribar, Jenkins, Johnson, 2006) without consideration of the economic merits of such repurchases.

Further, research shows that companies with strong anti-takeover provisions, which are less subject to market pressures, are more likely to pursue acquisitions that build an empire and destroy shareholder value than companies with fewer such provisions (Masulis, Wang and Xie, 2007).

There is also a link between compensation and capital allocation. Recent research suggests that over-all CEO compensation and the use of compensation based on equity have a positive correlation to institu-tional ownership and board independence, variables that academics commonly use as proxies for quality and governance. Further, convergence in ownership structure and the globalization of capital markets have led to a narrowing of the dispersion between US and non-US CEO pay (Murphy, 2013).

The main point is that compensation practices should be consistent with a firm’s governing objective. The goal is to encourage executives to allocate capital so as to maximize their long-term remuneration. While the structure of incentives depends on the governing objective a firm selects, the main task is to ensure that remuneration is congruent with those objectives.

Five principles of capital allocation 4. Zero tolerance for bad growth: Companies that wish to grow will inevitably make invest-Here are five principles that investors can use as ments that do not pay off. The failure rate of a sound benchmark to measure management’s mind- new businesses and new products is high. set regarding capital allocation (McTaggart, Kontes Seeing an investment flop is no sin; indeed it is and Mankins, 1994). essential to the process of creating value. What

1. Zero-based capital allocation: Companies is a sin is remaining committed to a strategy generally think about capital allocation on an that has no prospect of creating value, hence incremental basis. For example, a study of draining human and financial resources.

more than 1,600 US companies by McKinsey 5. Know the value of assets, and be ready to found that there was a 0.92 correlation take action to create value: Intelligent capital between how much capital a business unit allocation is similar to managing a portfolio of received in one year and the next. For one-third stocks in that it is very useful to have a sense of the companies, that correlation was 0.99. In of the difference, if any, between the value and other words, inertia appears to play a large role price of each asset. This includes the value of in capital allocation (Hall, Lovallo, the company and its stock price. Naturally, Musters, 2012). such analysis must incorporate considerations The proper approach is zero-based, which sim- including taxes.

ply asks: “What is the right amount of capital With a ready sense of value and price, man- (and the right number of people) to have in this agement should be prepared to take action to business to support the strategy that will create create value. Sometimes that means acquiring, the most wealth?” There is no reference to how other times that means divesting, and fre-much the company has already invested in the quently there are no clear gaps between value business, only how much should be invested. and price. As we have seen, managers tend to Research by McKinsey suggests that those prefer to buy than to sell, even though the companies that showed a zero-based allocation empirical record shows quite clearly that sellers mindset, and hence were the most proactive in fare better than buyers on average. reallocating resources, delivered higher total shareholder returns than the companies that Summary took more of an incremental approach.

2. Fund strategies, not projects: The idea here A governing objective is what a company says, is that capital allocation is not about assessing capital allocation is what a company does, and cor-and approving projects, but rather assessing and porate governance is the mechanism to make sure approving strategies and determining the proj- companies do what they say. Most companies around ects that support the strategies. Practitioners the world don’t articulate a clear governing objective, and academics sometimes fail to make this vital but countries under common law tend to favor share-distinction. The key to this principle is recogniz- holders, and those under civil law tend to favor ing that a business strategy is a bundle of proj- other stakeholders.

ects and that the value of the bundle is what Over time, capital allocation determines a compa-matters. The CEO and board must evaluate ny’s growth, cash flows, and viability. It is the most alternative strategies and consider the financial important responsibility of management. Thoughtful prospects of each. investors need to understand the history of a compa-

3. No capital rationing: The attitude at many com- ny’s capital allocation and critically assess its actions panies, which the results of surveys support, is in light of its goals (Mauboussin and Callahan, 2015). that capital is scarce but free. The sense is that the business generates a limited amount of capital, which makes it scarce, but since it comes from within it is free.

A better mindset is that capital is plentiful but expensive. There are two sources of capital that companies can tap beyond the cash gen-erated internally. The first is redeploying capital from businesses that do not earn sufficient

PHOTOISTOCKPHOTO.COM/JOHNNYGREIG returns. Management can execute this inside the company or sell the underperforming businesses and redeploy the proceeds. The second is the capital markets. When executives have value-creating strategies that need capital, the markets are there to fund them in all but the most challenging environments.

References and further reading

Buffett, Warren E., “Letter to Shareholders,” Berk- Mauboussin, Michael J., and Dan Callahan, “Capital shire Hathaway Annual Report, 2011. See www. Allocation—Updated: Evidence, Analytical Methods, berkshirehathaway.com/letters/2011ltr.pdf. and Assessment Guidance,” Credit Suisse Global Financial Strategies, June 2, 2015.

García-Castro, Roberto, Miguel A. Ariño, Miguel A.

Rodriguez, and Silvia Ayuso, “A Cross-National McTaggart, James M., Peter W. Kontes, and Study of Corporate Governance and Employment Michael C. Mankins, “The Value Imperative: Manag-Contracts,” Business Ethics: A European Review, ing for Superior Shareholder Returns” (New York: Vol. 17, No. 3, July 2008, 259-284. Free Press, 1994).

Graham, John R., Campbell R. Harvey, and Shiva Murphy, Kevin, “Executive Compensation: Where Rajgopal, “Value Destruction and Financial Report- We Are, and How We Got There,” Chapter 4 in ing Decisions,” Financial Analysts Journal, Vol. 62, George Constantinides, Milton Harris, and René No. 6, November/December 2006, 27-39. Stulz, eds., Handbook of the Economics of Finance, Volume 2A (Amsterdam: Elsevier, 2013), Hall, Stephen, Dan Lovallo, and Reiner Musters, 211-356.

“How to Put Your Money Where Your Strategy Is,”

McKinsey Quarterly, March 2012. Zweig, Jason, “Peter’s Uncertainty Principle,”

Money Magazine, November 1994, 143-149.

Jensen, Michael C., “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Business Ethics Quarterly, Vol. 12, No. 2, April 2002, 235-256.

Jensen, Michael C., and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics, Vol. 3, No. 4, October 1976, 305-360.

Lambert, Richard A., and David F. Larcker, “Executive Compensation, Corporate Decision Making, and Shareholder Wealth: A Review of the Evidence,” in Fred K. Foulkes, ed., Executive Compensation: A Strategic Guide for the 1990s (Boston, MA: Har-vard Business School Press, 1991), 98-125.

La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, “Investor Protection and Corporate Governance,” Journal of Financial Economics, Vol. 58, No. 1-2, June 2001, 3-27.

Madden, Bartley J., “CFROI Valuation: A Total System Approach to Valuing the Firm” (Oxford: Butter-worth-Heinemann, 1999).

Mauboussin, Michael J., and Alfred Rappaport, “Transparent Corporate Objectives— A Win-Win for Investors and the Companies They Invest In,” Journal of Applied Corporate Finance, Vol. 27, No. 2, Spring 2015, 28-33.