Tuesday, October 25, 2011

Re-Writing the Investment Compact

Being raised in New England, my history of the American Experience tends to begin with the Mayflower Compact.

This is a very short document, signed by the Pilgrims as they disembarked to found their colony at Plymouth, evidencing the agreement of all to "combine ourselves together in a civil body politic, for our better ordering and preservation and furtherance of the ends [of forming a colony in the New World] and by virtue hereof to enact, constitute and frame such just and equal laws, ordinances, acts, constitutions and offices from time to time as shall be thought most meet and convenient for the general good of the colony".

Thus began the rule of law by common consent that we, as American, cherish to this day.

This notion of a compact, and of "combining ourselves together" is a quintessentially American experience that permeates virtually every aspect of our commercial as well as governmental and community activities.

It's how we allocate our resources, and decide what work is going to get done, and by whom.

Many of these decisions are arbitrated by the financial markets, and those markets also operate on the basis of a fundamental compact between Enterprise and Capital regarding investment and returns.

The essence of this compact is that Investors will be allowed to realize returns by selling shares in the public markets.  I call it the Wall Street Compact

This Compact served us well for some while, but it is increasingly showing signs of no longer being so well-suited to our needs as we now experience them.

Increasingly, we feel the need for an investment compact that allows us, as a community, to balance financial returns with non-financial choices: the environment, society, governance.

The Wall Street Compact doesn't meet that need.

When an Enterprise agrees with Capital to adopt Gain On Sale as the primary strategy for investment return realization, that Enterprise commits to always being up-for-sale.  Running the business is not about either the Enterprise, or its Investors.  It's about the next would-be buyer, and the drive to support a rising stock price to continually attract those buyers.

This effectively erects a wall that keeps the Enterprise from reaching agreement with its Investors on the proper balance of financial returns, environmental concerns, social decency and sustainable prosperity.

It doesn't have to be this way.

One small change can take down this wall, a small adjustment in the agreement between Enterprise and Capital on the strategies employed to realize investment returns.

The change requires financing solutions that stay within the four corners of the Enterprise, offering Investors cash-flow based strategies for realizing investor returns by taking positions in the cash flow waterfalls of the Enterprise.

These solutions are available and widely used today in Real Estate, in Energy and Infrastructure, and in Tax Benefit Monetization (where I learned how it is done).  

Why not apply them more generally, to finance any Enterprise that has strong enough customer support from within a stable enough competitive context to generate stable, steady cash flows, at least sufficient to repay principal to investors, with additional opportunity for earning incremental returns as well?

There is reason to believe Investors will respond to such an innovation.  It can be found in the themes of Investor Activism, Socially Responsible Investing and Impact Investing that are current today within the Institutional Investment community.

Investor Activism is a return to the original theory of the investor as stockholder.  In the strictest legal sense, a corporation is owned by its stockholders, and the values and practices of the corporation are established and enforced by those stockholders.  The stockholders elect a Board of Directors, who then appoint Officers who, in theory, are supposed to execute the decisions of the Board, taken as an expression of the will of the stockholders.

When, however, Investors are really stock traders (not holders), this structure loses its integrity.  The market in which stocks are traded is really the holder of the shares, defining the values of the corporation, and the market really only values one thing: transaction volume.  That's how the market earns the commissions and profits that it exists to earn.

Socially Responsible Investing is an effort being made by many very large institutional stock traders to act like true stock holders, and demand that the corporation share their values - or at least not make market-driven choices that are too much at odds with the Greater Good, as articulated by these large investors.

Impact Investing pushes the envelope one step further, and attempts to align the programmatic and financial objectives of the institutional investors, by seeking to make investments that pay returns but are also aligned with the underlying beliefs and values of the investor.

Unfortunately, the impact of all this, to date, has been small.  What sounds good, in theory, is proving difficult to realize in practice.

The problem is the wall.  As long as investors, institutional or otherwise, are required by the available mechanisms of finance and investing to adopt Gain on Sale as their strategy for realizing investment returns, it is the motivations of the next new buyer that will shape the values that drive decisions being made within the Enterprise, not the values of the current holders.

If we are going to change the way Enterprise values get set, and decisions get made, we are going to have to change the way investment returns get realized.  Not just on the margin, with those few special businesses that also align with the public good, but right at the center, at the very core of our economy, with those businesses that meet all the different needs and wants of the community, at the scales required to be both effective and efficient within the competitive context as it applies.

We are going to have to re-write the Investment Compact.


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