The Uneasy Case for Favoring Long-term Shareholders

Posted by Jesse Fried, Harvard Law School, on Thursday March 28, 2013 at 9:24 am
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Editor’s Note: Jesse Fried is a Professor of Law at Harvard Law School.

The power of short-term shareholders in widely-held public firms is widely blamed for “short-termism”: directors and executives feel pressured to boost the short-term stock price at the expense of creating long-term economic value. The recent financial crisis, which many attribute to the influence of short-term shareholders, has renewed and intensified these concerns.

To reduce short-termism, reformers have sought to strengthen the number and power of long-term shareholders in public corporations. For example, the Aspen Institute has recommended imposing a fee on securities transactions and making favorable long-term capital gains rates available only to investors that own shares for much longer than a year. Underlying these proposals is a long-standing and largely uncontested belief: that long-term shareholders, unlike short-term shareholders, will want managers to maximize the economic pie created by the firm.

I recently posted a paper on SSRN explaining why this rosy view of long-term shareholders is wrong. In my paper, The Uneasy Case for Favoring Long-term Shareholders, I demonstrate that long-term shareholder interests do not align with maximizing the economic pie created by the firm – even when shareholders are the only residual claimants on the firm’s value. In fact, long-term shareholder interests might be less well aligned with maximizing the economic pie than short-term shareholder interests. In short, we can’t count on long-term shareholders to be better stewards of the firm simply because they hold their shares for a longer period of time.

The paper begins by considering a “non-transacting” firm – one that does not repurchase its own shares or issue additional shares before the long term. In this firm, I show, the conventional view is correct: long-term shareholders’ payoffs depend solely on the size of the economic pie. Accordingly, long-term shareholders will want managers to maximize the size of that pie. Short-term shareholders, on the other hand, may benefit from earnings manipulation and distorted investment decisions, actions that shrink the pie to boost the short-term stock price.

Most U.S. firms, however, are “transacting.” They buy and sell large volumes of their shares each year: approximately $1 trillion market-wide. In 2007, U.S. firms conducted $1 trillion in share repurchases alone. The magnitude is staggering not only in absolute terms, but also relative to firms’ market capitalization. Over any given five-year period, the average U.S. firms buys and sells stock worth approximately 40% of its market capitalization.

In a transacting firm, I show, long-term shareholder interests become decoupled from the goal of maximizing the economic pie. I first consider a transacting firm that repurchases its own shares before the long term. In this repurchasing firm, long-term shareholder payoffs depend not only on the size of the economic pie, but also on the amount the firm pays to short-term shareholders selling their shares to the firm. For example, long-term shareholders benefit when managers conduct “bargain” repurchases—buybacks for at a price below the stock’s actual value.

Because long-term shareholders’ payoff in a repurchasing firm depends, in part, on the price the firm pays for its own shares, managers can benefit long-term shareholders in ways that reduce the pie. To begin, managers may distort capital-allocation decisions to maximize the value transferred to long-term shareholders through repurchases at a bargain price. In particular, managers may engage in “costly contraction”: diverting funds from valuable projects inside the firm to buy back sharply discounted shares.

In addition, managers serving long-term shareholders can (and in fact do) engage in price-depressing manipulation around repurchases. Once a firm decides to repurchase shares, long-term shareholders may benefit if managers expend corporate resources to lower the price before the repurchase. Such manipulation either increases the amount of value transferred to long-term shareholders (if the post-manipulation price is lower than the stock’s actual value) or reduces the amount of value transferred from long-term shareholders (if the post-manipulation price is still higher than the stock’s actual value).

I then consider the case in which the transacting firm issues additional equity. Now, long-term shareholders’ payoffs depend not only on the economic pie but also on the amount received from future shareholders buying stock from the firm. For example, long-term shareholders benefit when managers conduct inflated-price issuances (issuances at a price exceeding the actual value of the shares).

Because the payoffs to long-term shareholders in an issuing firm depend in part on the price at which the firm issues equity, managers can benefit long-term shareholders by taking steps that are pie-reducing. For example, when the stock price is high, managers may issue shares to finance additional investments even if these investments reduce the amount of value to be shared among all those owning shares before the long term arrives.

AOL’s acquisition of Time Warner in 2000, for $162 billion of stock, is a well-known example of long-term shareholders benefiting ex post from an issuance that destroyed economic value. The acquisition destroyed so much value that AOL and Time Warner were forced to part ways nine years later. Nevertheless, from an ex post perspective, AOL’s long-term shareholders undeniably benefited from the transaction; it enabled them to buy Time Warner’s valuable assets at an extremely cheap price. In 2009, their combined stakes in AOL and Time Warner were worth approximately 400% more than the AOL stake they would have held absent AOL’s acquisition of Time Warner.

In addition, whether or not the pre-issuance stock price is high, managers conducting issuances can benefit long-term shareholders by engaging in earnings manipulation and other actions that boost the short-term stock price but destroy economic value. If the post-manipulation price is high, more value is transferred to long-term shareholders. If the post-manipulation price is low (but higher than it would otherwise be), less value is transferred from long-term shareholders. Thus, the very same pie-reducing strategies that benefit short-term shareholders can also serve the interests of long-term shareholders, at least when the firm sells its own shares.

My purpose in this paper is to show that long-term shareholder interests, like short-term shareholder interests, are not aligned with maximizing the long-term economic value created by the firm. My analysis, by itself, cannot resolve the question as to whether long-term shareholder interests are better or worse aligned with maximizing the economic pie than are short-term shareholder interests. However, it does suggest that the case for favoring long-term shareholders – which is often based on a mistaken belief that long-term shareholders will seek to maximize the economic pie – is much weaker than it might otherwise appear.

The full paper is available for download here.

  1. Oh come on. We all know that Fried & Bebchuk’s continued attempts to champion the interests of hedge funds, raiders, and other short termers has to do with executive compensation and nothing else. Professor Fried has very cleverly found one aspect of determining firm valuations (stock buybacks) and used it to – once again – prove his theory that Wall Street knows best, and that managers, Boards, and “long term” shareholders (the good old boys) are only in it to enrich themselves at the expense of the shareholder.

    Comment by Roddy — March 30, 2013 @ 4:58 pm

 

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