We are pleased to introduce this week’s guest blogger, Tim MacDonald, who is joining Capital Institute as a Senior Fellow. Out of his experience as an attorney organizing partnerships in tax-preferred projects like renewable energy and affordable housing, Tim has crafted a model for stewardship investing that we believe has real potential as an alternative to capital markets investing. We will be working closely with Tim on the proof-of-concept of this model, which will be the subject of our next, soon-to-be-released Field Guide to Investing in a Regenerative Economy study. In this week’s blog post Tim outlines the general design principles that will enable stewardship investors to fulfill their charters through partnerships with values-driven enterprises. Every business leader has values. The business of stewardship investors is to sponsor leaders who have the right values. In his recent Future of Finance post, Beyond Divestment, John Fullerton argues persuasively that university endowments should move beyond divestment, to become more proactive in choosing which businesses to sponsor through investment. John is right. A great awakening of pension plans, university endowments, charitable foundations and other such large, purposeful, perpetual stewardship investors began with the divestment campaign to end apartheid in South Africa. This showed these investors that the investment choices they make have impacts that go beyond their own portfolios, to drive prosperity – or its opposite – in the global economy. The next step in this great awakening—shareholder activism, however admirable, remains embedded in the old paradigms of investment banking, exponential growth, and transient ownership of trading positions in listed securities and other, alternative, liquid trading assets (i.e., derivatives), and not-so-liquid trading strategies (like the pump-and-dump forms of private equity). To reach real empowerment, stewardship investors need to let go of transient ownership, to embrace more purposeful investment. Stewardship investors entered the eco-system of transient ownership in the well-intentioned pursuit of the investment returns they require to achieve their charters of trust. Their entrance was induced by the promise that as long-term asset owners, they could ride through short-term fluctuations in share prices to profit from exponential growth over the longer term. That is the promise made by advocates of efficient markets and of modern portfolio theory. It is a promise that has failed its essential purpose. What stewardship investors are getting from their experiments with transient ownership are a mismatch of costs to benefits, miscreant market manipulation, erratic returns, inadequate returns, and loss of principal from participation in a perpetually recurring cycle of booms that always, eventually, go bust. The liquid trading system of transient ownership is broken, and it is stewardship investors who broke it. They broke it by participating in a system that is not designed to do what it is they need and want to be doing. Any systems engineer who looks at things this way will see that the problem is not with systems design or engineering, or even with the way we are using the system. The problem is, stewardship investors are using the wrong system. Transient ownership of liquid trading assets evolved in the 19th Century, at a time when prosperity within the Euro-American economy was defined by industrial expansion into a Western Frontier. This Frontier was so vast as to be, for all practical purposes, unlimited. This experience of unlimited possibilities for expansion created the defining expectation that underlies all mainstream finance ideology to this day: that industrial enterprise can expand exponentially, and unendingly. This means that capital, once invested in an enterprise, needs to remain invested in that enterprise, to fuel exponential growth, to infinity. This creates a problem for the individual investors, who were, at the time, the primary intended providers of capital to industrial enterprises of exponential growth. Individuals need, at some point, to get their money back. In the parlance of investment banking, industrial enterprise needs longevity, while individual investors need liquidity. The investment banking solution to this problem is the “relay race” of corporate share trading. Large-scale enterprise is broken down into smaller shares that can be bought and sold between investors, without removing capital from the expanding enterprise. An incorporated enterprise can always be reinvesting profits to go on expanding exponentially. Individual investors can buy, hold and sell shares as appropriate to their personal cash positions, as those positions change, from time to time. The take-away from this story is that corporate finance is built on transient ownership. Although the legal theory is that shareholders own the corporation, the practical realities are that investors only own the trading positions they hold. Their interest is in buying for a price, holding for a time, and selling at a higher price. Accountability in this system is to the next new buyer. That buyer must be supported in the expectation that share price will continue to rise, exponentially, to infinity. This is one reason why shareholder activism is only a transition phase. Investment banking is not built for accountability to current owners. It is built for accountability to the next new owner. Shareholder activists want to believe that stewardship investors can forego transient ownership of their trading positions to become long-term holders, and in this way wrest accountability for corporate decision-making away from the markets. That is not how that system works. Efforts to force this system to work in ways that are contrary to its design will eventually fail. Either that, or the system will crash. If the system is doing what it is designed to do, but what it is doing is not what it is that we want to be doing, the prudent path, then, is to find a new system, one that is designed to do what we want. The system we need will meet two key design requirements. First, it must deliver to stewardship investors the returns they need. This cannot be a system that booms and busts. It does no good for stewardship investors to earn paper returns during a boom, only to have them evaporate into the thin air out of which they are made, when that boom goes bust. What have we really achieved in this case, other than the extraction of huge fees from program beneficiaries to compensate trading experts who take credit for success during the boom, but avoid all accountability for failures when the boom goes bust? The second design requirement of this alternative system is that it must empower stewardship investors to earn the right returns by sponsoring business leaders who have the right values. Shopping for the best price on a portfolio of pre-packaged products will not deliver this result. Stewardship investors need a new architecture for more direct engagement, an architecture that empowers alignment of interest along multiple points of shared values, some financial, others societal.
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