Podcast: Fund Shack

Patrick Sheehan of ETF Partners talks to Fund Shack’s Ross Butler about creating sustainable prosperity with venture capital. 

Patrick Sheehan is a founding partner of ETF Partners, a leading European growth capital firm investing in innovative companies that have the potential to create a more sustainable future.

ROSS BUTLER

Patrick, welcome to fund shack. You set up ETF partners way back in 2006, then called the Environmental Technologies Fund. It must be strange that everyone’s caught up with you.

PATRICK SHEEHAN

It’s wonderful that people are much more conscious about sustainability and that’s great actually. You know, I’d like to think that haven’t quite caught up to be honest about it, but I’m being picky. No, we, that I I’ve been in venture capital over 20 years in Europe, in Silicon Valley back again and, and wanted to do my own thing. And so, so actually I and my colleagues sat down and thought what what’s worthwhile, right? What gives us a sense of being useful? And, and the idea that we could show that venture capital had a role to play in solving really big problems was it was just very attractive back then. And you know, I think the only thing we got wrong was we were a decade too early, but I think that’s by starting early and suffering the pains that any entrepreneur does actually of battling along for a decade has been good for us. And, and I think that’s probably why now we, we really feel we have a, an authentic leadership position.

ROSS BUTLER

Yeah. You were in Silicon Valley and had a successful venture capital career out there before you did any of this stuff.

PATRICK SHEEHAN

I’m really of confess to everyone listening, I started in venture capital in 1985, but back then it was a very different world that was in the UK sort of pre venture capital, if you will. And then Silicon Valley, my time, that was the.com era. So, so I’ve lived in a few different eras and, and the world keeps surprising us, right. We’re in a new one now.

ROSS BUTLER

Your thesis, while it was called the moments technologies fund, your investment thesis, must’ve evolved fairly significantly in the last 16, 14 years. 15. Yeah.

PATRICK SHEEHAN

I’d love to say yes, but not really. I think it was, I mean, in essence, it’s unchanged in, in the actually, you know, I’m an optimist and optimists are the people who can make change happen. I tend to think. So. I think it’s important to be optimistic. And I, I really feel that technology can supply a lot of the answers to achieving sustainable prosperity and venture capital can be really in a range of those technologies. And so that belief is unchanged. That’s, that’s what we do. And we’re never going to change what that is. We’re still investing across Europe, but change is not subtle under the hood. Actually, I’m happy to go into it, but it’s around learning where we can apply venture capital and where we actually it’s a bit harder because I think if we go back 15 years, we, we, we, we saw the needs. And so we wanted to apply venture capital, but it’s, you know, you can’t use a scalpel on every operation, right?

ROSS BUTLER

Well, this is exactly what I wanted to talk to you about actually, because we’ve got this global problem and it’s going to take a lot of solving, where does venture capital fit in?

PATRICK SHEEHAN

So I think it’s really important, but it brings, it has constraints as well as benefits, right? So venture capital allows people to take bigger risks and bigger opportunity, but, but actually we all typically all invest from 10 year fixed life funds. We need results in that timeframe where we have a potentially large, but still strange capital. So it works on, on some sets of problems, whether it can be quite quickly, very rapid growth. It works less well on a range of others, which are also important for the writer. So you know, I don’t think it works for nuclear fusion particularly well, there, there are some venture backed startups in that area. That’s I think massively important technology for 20 or 30 years time perhaps. Right. So, so we deal in the big term, which I think is, you know, results in, in a few years to 10 years, but not more. And, and we have to find companies that can grow pretty rapidly with relatively constrained capital, even in this venture capital environment. And so that’s a subset which has focused us more and more on digital technologies. And by the way, we can invest outside that area. But the sweet spot for us becomes digital technologies that deliver sustainable benefits. And it’s still pretty broad, but, but it’s not everything right

ROSS BUTLER

Out with the solar panel Passover or raised out with the wind farms. And then with smart digital technologies that help help us be more efficient.

PATRICK SHEEHAN

From our narrow perspective. Yes. But when we started out 15 years ago, there was a boom in solar, by the way, just to give you an illustration. And I remember when we talked to our investors at the time saying to them that there were then in 2006, seven over 50 thin film photovoltaics, it’s not just all federal tax, but just this one time. And, and there’s really the market for one or two, right. And revenue growth rates of those companies was probably 70% per annum, but there was very little margin in it. So we said, well, we’re probably never going to do those. Right. And that’s, that’s a low margin. It’s, it’s like the computer memory business used to be right. It’s all going to go to China. And, and sadly it has. So we have to be very careful of the sectors we play in, right. But there’s, there’s enough real innovation and added value to sustain and create durable businesses. So that really hasn’t changed going back to what hasn’t, hasn’t changed actually, Europe when we started was a great place to be. And it’s just got better. Europe’s really coming of agents. So we, we, our focus is Europe and we find some really really fabulous companies. Now,

ROSS BUTLER

In what sense is it, has it got better repeats entrepreneurs and technology is being spun out, that kind of thing.

PATRICK SHEEHAN

Yeah. Well then venture capital’s matured over the past 15 years, it’s become much more global industry. And, and so people know the roadmap now in a way that they didn’t before and, and people are much more focused on high growth companies and how to create them and know what the game plan is. And so it’s not just, there are more repeat entrepreneurs. There are people who have worked for successful entrepreneurs and there’s a much bigger ecosystem. So overall we just see better quality opportunities because there are people who are much more, you know, a greater number of people who are highly engaged and, and well, it’s really honestly refreshing if I think back over, there’s been a rapid change in the past 18 months around sustainability. Right. but, but it’s, it’s refreshing now that entrepreneurs have been selecting us in some of the recent investments we’ve made because of our brand values and our real values. And they quizzed us not on the usual venture capital, blah, blah, blah, but on the, you know, are you sincere? Cause we want, we want to deliver a positive impact and we want to make sure that you’re right behind us. And and we are, and so they’ve selected us and that’s, that’s, that’s, that’s so refreshing. Right? So having backing people where there’s aligned values makes life so much more simple.

ROSS BUTLER

That’s interesting because given that you aren’t doing like large renewable projects, but you are investing in more digital companies. To some degree, I look at your portfolio and I think, well, that, that could make sense regardless of the climate change pressure. And so you could get an entrepreneur that has set up a business that you find attractive for, for a set of reasons. And instead of for another set of reasons, but increasingly it sounds like they are

PATRICK SHEEHAN

That’s, that’s exactly right. So we’re, we’re not backing uncommercial companies. And what I like to say is the need is the opportunity actually. And so there is great need, right? And that’s why major industries are transforming that speed. And that’s why there’s opportunity for us, right? Our investors want to make as much money as possible to be clear right now, no one cuts us any breaks this. We say to them, we want to, to do well and to do good. It’s not all so on the entrepreneurs, we back could be backed by anybody, but, but they do tend to like the fact that we have a common agenda, the common mission. And I think that creates a better level of trust. Really. So our competition is, is quite diverse and it is some environmental funds. It is some mainstream funds.

ROSS BUTLER

I find your, your ETF’s flavor of environmentalism, very easy to swallow because it’s, you, you caught it optimistic and it is. But it’s also, I find very different to the kind of very pessimistic and is Knight anti humanistic anti-human view of environmental in the environment. And you’re, you’re effectively saying we, we, we have an efficiency problem. We just need to do more with what we’ve got or more with less. And, you know, that’s human progress in a nutshell, really.

PATRICK SHEEHAN

I mean, it’s the story of civilization really. And you know, I think the challenge of climate change is critical. The challenge of well, broadly of sustainable prosperity is critical, but, but good luck trying to convince someone, we need a more sustainable planet. Therefore everyone should be poorer. I mean, I would argue that that’s just not practical, right? We’ll spend so much time arguing about it. It’ll never happen. And so the, the, the way to make progress fastest is to use the system. We have capitalism, right? There’s many faults with it, but it’s there. Let’s not spend a decade changing it. Let’s just use it and get on with it. And, and to aim for delivering prosperity because there’s durable demand for it. And it isn’t incompatible by and large w we’re living more sustainably and a progress creates efficiency. And so I’m sure there are flaws with this argument at the nausea and by the way, and you know, it’s not innovation delivers unexpected things, so we’re not always right. But, but as a general theme, I think it’s profoundly important to think that way. And an innovation is absolutely the key.

ROSS BUTLER

You don’t say sustainable growth, you’re saying sustainable prosperity, which is a slightly different thing.

PATRICK SHEEHAN

Yes. Cause prosperity, I think is a better word. When people think of growth, they think of increasing consumption. I think actually, you know, you can have prosperity with decreasing consumption. You know, there’s only so much time you’re only going to eat in a meal, but we probably enjoy eating nicer meals. Right. So it’s, it’s moving towards a better quality world rather than a higher volume world, if you will.

ROSS BUTLER

So I’ve said that I liked your view of environmentalism, but I guess the flip side to that is to what extent does that view and how venture capital solves climate change really affects the big, the big problem? What, what’s the scale of the solution that venture capital brings? Is that a tiny piece or is it an important piece?

PATRICK SHEEHAN

It’s a really good question. It doesn’t solve everything to be clear. So how it fits in as an important piece of the puzzle though, I think so venture capital is not going to help with the rollout of solar. It’s not gonna help with, with delivering renewables at mass scale. That’s, that’s, you know, maybe a big infrastructure funds will do that. There’s different types of money, but it’s still an, a lot of money, but where venture capital plays a role as improving the efficiency of all that. So this is not solving the problem in the next year or two at all, right, when next year or two is urgent, we need more renewables, I think, but it is solving the problem of the next decade or two of making sure that we’re as efficient and effective as possible over that timeframe. And you know, you look at the cost curves of things like solar and wind.

Solar has probably fallen 90% in cost in the past 10 years, when more than 50% of costs in the past 10 years, that’s innovation and that’s and, and I think you can safely extrapolate that cost curve for another decade based on innovation. So it’s really critical. The impact of that is not quite so linear either because once these, these technologies become cost competitive or even cheaper, then they change other industries, right? And as you roll them out, the rate limiting step not becomes not the cost of their deployment is the intelligence with which you can use them. So other technologies are required. And then I think in that, in that, in that wave of know how to, to make efficient use of these new renewables of the electric car industry and the consequential problems, you know, et cetera. Now, I think venture capital has an enormous role to play and a lot of prior experience to draw on.

ROSS BUTLER

Yeah, it’s a classic venture capital conundrum though. The world is being disrupted by a mega-trend, what are the, all the unexpected con unintended consequences around that, that we can, we can explore it when people talk about this dramatic decline in the cost of solar and the learning curve and so on. It sounds amazing. Is it as amazing as it sounds though, because I mean, there are obviously the intermittency issues and so on. I kind of, whenever I hear it, I think, wow, the world is about to change dramatically and the energy companies are stuffed, but it doesn’t seem to be the case.

PATRICK SHEEHAN

Well I think we live in a world that’s quite hard to forecast. I think you can forecast cost reduction curves, by the way. I think you, it’s hard to forecast the consequences of the very easily. But, but if I go back in time 10 years ago, if I tried to talk to the CEO of an energy company, I couldn’t, and then I, then I might more recently you’ve talked to the marketing department who were claiming to do things on behalf of the energy company. And, and there was that, that sort of denial and obstructive constructive confusion. But in the past year or two, I can talk to the CEOs of energy companies. And by the way, I can say to them, you’re a bit stuffed, aren’t you? And they probably say yes. And so what’s important is these are bright and smart people. They live on the same planet as us. I’m not getting it. Then they are really engaged on how to solve the problem. And so they are beginning to innovate and do things. And so I, you know, I’m not one of these people who thinks big, big companies are the problem and evil. I think actually they are now beginning to change rapidly and will really be part of parts of the revolution. And so I think we need to support them rather than just attack them.

ROSS BUTLER

We live in a world where everyone wants to quantify everything, but it’s very difficult to be able to quantify potential impact. And, and so, so what I wanted to ask you was what are the most promising areas where the kind of incremental change, the incremental improvement could make a difference. But it’s going to be a very subjective answer, I guess you’re going to have to give.

PATRICK SHEEHAN

Yeah. And the best things tend to surprise us. Of course. So happy to answer that question, but there’s an implied agreement in what you said that, you know, that, that actually the most impactful things are often the hardest to quantify, right? Because you can quantify the predictable and the predictable is often less impactful. Holy See, now how it’s impactful. One of the problems of funding innovation suddenly the government and policy level is it’s really hard to quantify the benefits of the unknowns from innovation, right? And so that tends to be a stumbling block. So we are very focused on delivering innovation and impact, and we try to quantify it by the way for each of our companies, but we don’t get too hung up about it. Right. Otherwise you fall into let’s do that because it’s measurable as opposed to let’s do that because we think it’s impactful, right.

Even before the pandemic, we had started to look very hard at the logistics sector because it’s, it’s being quite, it had to been quite resistant to technology and actually quite a, quite a polluting industry. It depends on how you measure it. And so we we’d started to make one or two investments there. We made one before the pandemic certainly struggling. We made one after that, they’ve actually unsurprisingly and I’ll be doing very well. And so, so, you know, logistics and efficient distribution I think is, is a very important area for us. Mobility, I guess obviously remains profoundly important because the whole car industry is changing rapidly. And that, that has consequential impacts outside of its own industry into many things, not most obviously energy, but many other sectors as well. We we’ve looked and keep looking very hard at the what’s called the energy transition.

And again, this is a vast industry already changing rapidly, and we’re looking very carefully at very smart data companies. I’m hesitant here because I don’t really want to say AI because it’s such a buzz word, but I’ll say it anyway because that, but using intelligence to, to make smarter, better informed decisions. And in this past year, we, we, we invested, I’ll give you an example in a company called deep sea that uses genuine artificial intelligence to, to improve the efficiency of the shipping industry. And that’s a big polluter and, and enabling ships to operate as a measurably improved performance is, is very impactful. Now it doesn’t solve the problem that the shipping industry is polluting, but it it’s actually an incredibly efficient and quick way to, to improve the situation.

ROSS BUTLER

Oh, that makes total sense because obviously heavy transportation is one of the hardest things to, to, to get off of oil, to replace or oil. And so any improvement there,

PATRICK SHEEHAN

And, and particularly for us, we’re looking at where can we use technology to, to create improvement. And we’re, we’re looking increasingly at sustainable foods these days and at the, the impact of the rise of the green consumer, you know, we’re seeing very interesting companies popping up now. Not, not so long ago, we invested in another gentleman neobank had a digital bank, like, you know, there’s Monzo or Revolut, many others out there, and they’ve become very big, very quickly. And we found these guys in Germany who really able and nice people, who’ve created a green equivalent of one of those. So tomorrow is, is the green revenue, the green Monzo. And you know, I’m very happy with it. And it’s, it’s, it appeals very strongly to in, you know, engaged people, people who are engaged in sustainability want personally to do something with their money that that’s helpful for for climate changes, as opposed to potentially harmful. And so, and so if we’re finding different themes not all of them obvious where we think there’s big impact happening or about to happen. Let me try a

ROSS BUTLER

You did a deal called the modern milkmen. One component to all of this is, is behavioral obviously. And some of that behavior just harks back to the past. So I did a little bit of work with P and G who were introducing reusable, adamantium shampoo bottles. And that’d be rolled out across Europe this year. And, and you know, you might say great innovation, or you might say, well, that’s kind of 1950s

PATRICK SHEEHAN

Sort of back to the future sort of thing. But, but now the modern Melbourne is, is, is a really interesting company, actually, because if you’re English, you mean when you think of an old fashioned milk van and whistling and walking around in the morning and that all died. And they died in the name of efficiency and supermarkets delivering milk in much cheaper plastic containers. But the founder of Bob Milton, who Simon is a very able entrepreneur, very thoughtful guy. He told me he was inspired by, by David Attenborough’s blue planet actually decided that he really ought to do something now in his third startup, that to get rid of waste. And eventually he focused on essential grocery deliveries as an area where it would be relatively easy to get rid of waste. So it is a little bit of a back to the future thing and that the milk comes in glass bottles. There’s no plastic, you know, there’s no, there’s no waste wrapping. And, but there, the front-end may look delightfully traditional. The backend is, is you know, there’s a lot of digital science, a lot of know-how, there’s a lot of efficiency through micro distribution centers. And some of the jargon flips at the back end from old fashioned to very, very modern. And that company is doing extraordinarily well, actually.

ROSS BUTLER

I wasn’t being cynical by bringing it up at all. It’s like, no one wants to throw stuff away. And, and, and most people will even be put out a little bit, I would say in order to just feel like they’re not being unduly waste where you don’t have to be a greening to.

PATRICK SHEEHAN

And honestly, when I tell people about it, they nearly all say, great. Is does that deliver in my area? Right? Yeah. That’s a fairly easy check. And then I think one of the things we are seeing is this is sort of an efficient localism, if you will. And it’s, it’s far more green to avoid transporting stuff around the planet. And, and frankly, there’s probably better quality produce if it’s more local and more fresh. Yeah.

ROSS BUTLER

1. So you are hesitant, you were hesitant to mention it, but it is very, very hot to, to what degree can it kind of create efficiencies that’s decreased simply put carbon emissions, would you, it,

PATRICK SHEEHAN

Well, I’m hesitant, hesitant to mention it because it’s overused as many buzzwords get, and it’s sort of from, from a, some cynical perspective, it’s just a good way to bump up valuation, to start waving your hands and start talking about AI. My second reason for cynicism is that the, the underlying science has not evolved very fast, right? Well, it has evolved is the speed with which computers can crunch numbers. And so using established, and if not old algorithms plus computing power, now you can deliver more. And so I think you know, I’d like to see more real innovation in the algorithms actually, but, but nonetheless computing power has evolved in such a way that there’s a far more applicability of these sledgehammers. And they’re very effective on certain classes of problems, right? So shipping is actually a really good class a problem.

And that, it, it it’s a bounded problem, as they say, it’s not, it’s not an open-ended question. You know, if you, if you wanted to use AI to find out about America, you know, forget it, it’s too vague question. But if you want to use AI to optimize a set of parameters that you know about, and, you know, you can’t have ridiculous parameters because it’s self-evident, then, then you’ve got a problem you can solve. So there, I think it’s really good for certain categories of optimization problem or certain categories of drug selection problem, but it, it’s not good for everything yet. And, and it will take a real intellectual revolution as well as a computing revolution. I think before we get to the science fiction end of the spectrum, it’s great for some things, but, but and we’re really keen that she’s to see more AI real-world applications that can drive efficiency. So we’re definitely on the lookout for those. And, and I think we will see more by the way, because of course, compute power continues to increase the storage costs continue to go down. And so, so applicability will rise for sure, but I think it’s, it’s, it’s nibbling at the real world rather than taking it over. Yeah.

ROSS BUTLER

I’m glad I asked that that’s fascinating and a slightly more prosaically you invest across Europe, even though you’re based in London. What’s it, you know, Europe has a pretty good reputation as as being environmentally aware and has been for some time, but what’s it like for entrepreneurial businesses doing business in Europe, perhaps in terms of government incentives, doing business with government, doing business with cities you know from a, from a, let’s say from a green perspective, and then just from a business perspective.

PATRICK SHEEHAN

So Europe is, is, there’s not one country, right? It’s complex and diverse and culturally different, you know, A-list but, but doing business with, with a sustainability agenda, I think is, is just a commercial advantage because there is more support, there is more Goodwill. And you specifically asked about governments and cities. Well, one of the outcomes of the pandemic is that European governments are gearing up to deploy a lot of in effect reconstruction money into the economy with a view as to the type of economy they want, and they want a green economy in Europe. And so, so actually we are expecting a lot of investment in and around the green economy and the acceleration of, of sustainability and that that’s, I think, going to be clearer and clearer as we go through this year. And you know, the UK is hosting cop 26 in November, I think, and there will be announcements in the UK, but actually the EU is putting money forward.

Denmark is putting money into its economy on, along this agenda, et cetera. So I think governments will be a source of capital of potentially large scale of capital, but it will move slowly and probably with a certain momentum rather than you know, what’s the phrase these days, this is not a speed boat. Cities you think should be faster, but, but actually when we have companies that they invest in smart or selling to cities, looking to become smart and intelligent, and it’s not an easy market because procurement cycles are still long, right? They’re still somewhat political, et cetera. So there’s great opportunity, but, but it’s not easy. But that said, if you’re an entrepreneur thinking about, or actually on sustainability, these are not the only benefits it’s, it’s frankly, much easier to recruit people. So we find our companies can by being genuinely focused on sustainability recruit better people more easily and how great to staff loyalty and greater satisfaction, you know, and that then extends beyond staff into their ecosystem generally. So, so I think actually in essence being green is increasingly just good business.

ROSS BUTLER

Hmm. Well, that’s such an important point because I mean, PE people in the businesses that you back is the most important thing. So if you were getting better talent for less money, or just better talent per se, it’s not the less money, sorry,

PATRICK SHEEHAN

But because you have to, you know, the deal is you have to give people the best opportunity. You have to give them as learning opportunity, but, but, but newer generations are find this much more appealing. And so it is easier to get better talent.

ROSS BUTLER

Good to go back to, you mentioned cop 22. And one of the criticisms of, of the the state led targets, I guess, is that that they can be seen as bad value for money. If you’re going to spend so much money on something that you pretty much know is going to be pretty inefficient, surely you should channel a bit more into an area that’s very, very kind of laser targeted on also making a return. Yeah,

PATRICK SHEEHAN

Innovation delivers a huge bang for the buck. And, and governments could sensibly deploy more capital there. But but, but typically infrastructure projects get more capital because they’re easier to quantify. So let’s, let’s make it pertinent to the UK. You know, only one of our geographies, but, but we’re spending 50 or 70 billion. I forget how much on a new train line from London to, to Birmingham Manchester. And, you know, maybe that’s a good thing, but it’s a hell of a lot of money. And a small fraction of that would have a profound impact on not just addressing climate change, but on the economic competitiveness of the entire country. So, so, but how would you rationalize that quantify? Well, that’s a bit harder, right? So, so the, the uncertainty and the femoral nature of innovation means it’s relatively underfunded. I think

ROSS BUTLER

Patrick, I wonder if you could leave me feeling really optimistic about the world, because, you know, w we’re all inundated with climate change doom and gloom, you have an optimistic outlook, you know, when you’re when you’re not in work mode and, and not in necessarily ETF mode, but just Patrick sheer mode, how do you generally feel about about progress on this score and, and where we’re headed?

PATRICK SHEEHAN

I am somewhat schizophrenia. I overall I’m optimistic because I think, well, there’s always a crisis, right? If you go through history I used to argue with my fellow students when I was a student about, about the upcoming nuclear apocalypse, right? And, and at least half of them thought there would be one before we got to the age we are now. And I was always on the, on the optimistic end of the spectrum saying the trend of civilization is, is positive. And that there are bumps in the road. If we apply ourselves, then we can do magical things. And you see that repeated through history. It does, I think bad news sells better, right? And it, and it is easier to stoke fear than to stoke hope. But, but, but actually there’s been an astonishing progress in the quality of living around the world, in our lifetime, right there, the, the there’s a billion, fewer Chinese people in poverty life expectancy’s gone up, Health’s gone up.

Education is going up. The internet has profoundly changed the way which we can collaborate. And by the way, you see the power of collaboration and the speed we can now deliver vaccines. People said it was impossible to deliver a vaccine in 18 or less has been less. And so actually, I, I think w w there’s a lot to go out. And if we, if we worry too much, you know, we’d like to fall off the tightrope, but there is no choice. Now, if we want to sustain a good standard of living for the, what is it, seven or 8 billion people on the planet we have to go forward and we have to be creative. And we, we have to be optimistic within that. I think we have to plan rationally, right? And on the concerns long-term planning long-term funding of innovation and technology being one sub sub set of that I think is really important. And there’s probably not enough of that. And so, so I’m a little bit schizophrenia, but not the optimistic.

ROSS BUTLER

I asked you to leave me optimistic and you’ve done exactly that. I’m really glad I asked the question, Patrick, thanks so much for sharing your thoughts and sparing your time.

Demystifying private equity on Fund Shack, with Oxford Said’s John Gilligan and the ICAEW Corporate Finance Faculty’s David Petrie

Private Equity Demystified is on the reading list of business schools from Boston to Singapore. It is now in its fourth edition, and in this podcast we speak with John Gilligan of Oxford Said and Visiting Professor at Imperial, who co-authored each editions alongside the late Mike Wright. We are also joined by David Petrie, Head of the Corporate Finance Faculty at the ICAEW, which has been a strong supporter of the initiative and, without whom, ‘the report would never have seen the light of day.’

We discuss the need to demystify, the outperformance debate, the power of M&A done well, and the need to adapt to a very uncertain future.

Ross Butler

David John, welcome to fund shack. I was wondering if we could begin by John giving us a little bit of an overview as to the provenance of private equity demystified, which is now in its fourth edition. And then we can get onto the process of demystification and talking about private equity in this brave new world that we’re in. So I believe that the first edition of private equity demystified in about 2008, which was at the very Dawn of a very different kind of crisis. John, take us through it.

John Gilligan

The backgrounds of this with a conversation over lunch, all good things happen over lunch. I was having lunch with Chris ward, who was the chairman of the Institute’s corporate finance faculty, the ICAEW. And at the time there was an investigation going on at the treasury select committee into the private equity industry. I was on gardening leave between leaving Deloitte and joining BDO. So I was one of the few people who was actually watching this live on tele because I was at home. Everybody else was obviously at work. So I said to Chris, have you seen the treasury select committee investigation? Cause it’s a little bit odd because the questions are very simplistic and the answers, therefore don’t make the industry look very show the answer in the best light. Shouldn’t somebody maybe write a note to somebody to just suggest how it basically works in principles so they could move on to the more interesting substance.

And what Chris said to me was, well, you’re not doing anything. Why don’t you do it? So I then phoned Mike Wright and Mike was my PhD supervisor at the time and said to Mike, well, you’re the leading academic in this field? Could you summarize all the academic stuff? And I had a sort of hidden agenda. I thought I’d get a free literature review for my PhD, but Mike saw through that one. So what happened was we did this and before we knew it, we went back to the ICAEW with Chris and said, well, we seem to have sort of written a bit of a book cause it got longer. And it just coincided with the ICAEW started to think about thought leadership and these sorts of things and such said, well, why don’t we just do it as a thought, a thought leadership piece and then the great, good fortune of life. We published it with a lot of help from people. And I said, it won’t be a huge amount of help from people actually. And then Harvard business school put it on their reading list and you thought, Oh, that’s handy. So that’s, that’s the background to it. And then once we were off the global financial crisis came along. We need to rewrite because the world changed dramatically. And we rewrote about every couple of years David and we’ve done it. So

Ross

A very kind of organic needs led process. David, why did you think that it was a project that was worth really kind of getting behind and supporting

David Petrie

Well, as John said, it, it, it had a very definite need at the time and you know, the, the BVCA does, does excellent work in this area. And it’s not to say, that, you know, they, they don’t constantly advocate the sector, but we, we felt that there was a little bit of a gap perhaps in the perception of politicians and policy makers really. You know, there is, there is this idea that if a particular professional body or a trade association comes to politicians and says, you know, well, you should be doing this because it’s in the national interest, they tend to say, well, w well, in the words of Mandy rice Davis, you know what you would say that wouldn’t you there is always this, this difficulty that they would tend to see them coming and say, well, of course you’ll pay to represent the, you are as it used to say, the voice of private equity and venture capital whereas the Institute of chartered accountants does as part of its Royal charter include the provision to act not only in the interests of the profession, but also in the wider public interest.

And so the analysis that John and Mike did, has kept things up to date really with what’s been going on private equity industry. Certainly, certainly hasn’t stood still, but as John has also said, it has become a really very comprehensive text. And it’s useful for members of the corporate finance faculty and more broadly people hoping to enter the private equity sector as well as principals and investors in it. I think these days, because it is such a comprehensive piece of work you know, I think they probably started off attempting to write a relatively short book and found that actually what it is an extremely complicated and nuanced sector actually, and to understand it properly, it isn’t possible simply to set it out briefly though our levels of complexity that I think that even people working in the sector may not fully appreciate. And the fact that it is it’s sites over 200 academic references means that when we’re having discussions with policy makers in white hall and Westminster about the importance of private equity and its contribution to the economy and so on, you know, the evidence is irrefutable.

It is grounded in very solid research is, is not simply the view of a trade body. This is really solid stuff, but it also works very well for practitioners, for our, you know, younger chartered accountants who are wanting to make their fortune and private equity. This is a really good place to start in terms of how, what are the nuts and bolts of the business. So this is why business schools above it. And I’m sure John would be able to talk about this a lot more because it really genuinely is on the reading list of business schools from Harvard to Hong Kong. So it works at all sorts of different levels. It, but it busts myths on the sector and explains that it does add to economic value. And it also is candid about some of the criticisms leveled against it, but it also provides a very useful how to guide and that’s what we like. So you know, we, we are delighted to support it and to continue to do so, because it works for us at so many different levels.

Ross

I think that’s a really great summary. That is really the impression that I got reading it as well. David, just to look at the political side, I mean, it’s not an apolitical book, but it is incredibly balanced. And I think there’s a lot of academic work out there. Even that’s highly critical of private equity. And I think where, where things are known and the facts are put forward and when then where they’re not known, I actually think you’ve got a section John saying, you know, look, look at the evidence base. And often it’s not there for private equity.

John Gilligan

Well, one of the things we set out to do was not to be an advocate for any particular point of view, but to allow people to get to the point where they can ask the question and decide for themselves. So the whole idea of gathering together, the evidence was we only use evidence that is rigorously academic. So we don’t, for example, use pretty much any evidence produced by people who have an ax to grind one way or the other. So we wouldn’t use evidence from a trade body without commenting on it. So it’s all of the, all of the reference cited a peer reviewed. So the first point is we’ve done the exercise to get the data in one place. If you look in the appendix in appendix six, I think it is, it’s all there. It’s summarized in one paragraph. So you’d have to read the paper either, but there are paper references there.

If you want to read the paper. So if you want to dive into there, you can go there if you want. And the idea is to say, well, this is what we know, but here’s, here’s what we don’t know. And here’s the stuff that, where people have strong opinions where their opinions are based upon evidence. That’s. I mean, the evidence has been growing, but evidence is incomplete because one of the problems, I mean, it says it on the 10th, private, you know, it, I don’t think private is private because deliberately secretive. I never, I’ve never believed that. I think the private equity didn’t really care about communicating outside of its closed circle for a long time, because they never really thought about it. When we started, we made the point that private just means not quoted. It doesn’t mean secrets. It’s become, there’s become a public interest in it because it’s not so big and that’s legitimate. But back in the day, people say it’s secretive. It wasn’t secretive. They just hadn’t really thought about communicating with the people who didn’t to that point, how an interest. So we have, we’ve been through this process of unpeeling, the onion, where data has become available. People would come or interested. And a lot of the early academic research turned out to be wrong because the data was wrong. So a lot of it’s been rewritten. Some of it good, some of it bad.

Ross Butler

Yeah. I certainly didn’t get the feel that I’d be, I was being preached to, and to David’s point that it can appeal to many different constituencies. It really does feel like a manual. I feel like if you gave me a hundred million, I can at least go through the motions of managing a private equity fund. And every time I get stuck, I could just pick it up. Now there’s a, there’s a, there’s a lot of skill that goes into it, but you certainly kind of hit all the points in terms of, you know, from start to finish.

John Gilligan

The thing that we learned as we were writing, it was we started by, we were the first people to sort of sit down and try and write something that wasn’t either aimed at the management of the company during the buy-out or the investor in a fund. But we’re trying to just say, look, here’s the big picture. And here’s how it works. So it was more curiosity than, than anything else. And what became clear as we did each edition was this is an industry that is very intricate. It’s not complicated, but it’s very, very intricate.

And if you don’t understand the intricacies, you can’t draw the right conclusions. So the classic one is taxation of current interest. Taxation carried interests top of the agenda at the moment. Most people don’t understand a really important point about the taxation carried interest. The definition of carried interest in, the tax legislation is that amount of capital that is taxed as carry that amount of, of return. That’s taxed as capital in an LP agreement, carried interest is 20% of the return. They’re two different things because the return has interest fees and capital. So in the tax legislation, it’s defined as capital in the LP agreement. It’s 20% of all the profit. If you do the arithmetic and look at how much return comes from interest fees and capital, you’ll find it’s Ferris and fund to fund, obviously, but a lot of return comes from interest and fees.

That’s taxes, income. So a large proportion of carried interest is taxed as income already, but unless you know, that the definition and the tax legislation is different to the definition in the LP agreement, you’d never know that. And you have no idea how much time I spend talking to journalists explaining that the thing that’s certain in the tax legislation is different to the thing that’s written in the LP agreement. And it makes a difference what the tax rate is and has any journalists picked up on it and written it in front of genders. They’re interested in, and now we’ve, you know, there was an article in the Ft recently, and that point has now been been made, but it’s not try explaining that in a headline. And it’s not very exciting either, but it’s important.

David Petrie

Yeah, we certainly find it very useful when we’re talking to officials in the treasury and so on about fiscal policy and how that relates to government investment programs and the development of new funds and so on, which is what we’ve been quite busy attempting to assist within the faculty over the, certainly over the past nine to 12 months as the government has looked at other measures, which might increase the flow of funding into those bits of the, that are short of cash. And you know, there are all sorts of you know, in a crisis, all ideas are considered however, however, left field. And so sometimes it’s been quite helpful to us to be able to explain to people just how some of these things work, but in a context of an open meeting, you can’t necessarily do that. It’s actually quite handy to say, I’ll tell you what, I’ve got, something that I suggest you have a look at that just, you know, you can’t really say to people, you need to start with the basics, but if you are looking to do that, this is, this really is a very, very good place.

So I do use that to help people gather a sort of a background understanding of how some of these things really do work. And and, and it really is. It really is very effective from, from that perspective. And also, I think one of the other things that is particularly important about this latest edition is that John covers in some detail, not just some of the changes over the past two or three years in terms of the way that private equity funds have been well doing just that raising funds and structuring themselves and what this means for the broader economy in terms of systemic risk. So there are some important factors there that the government officials and the bank of England have been looking at, and we’ve had helped them use this addition to explain, but also more broader questions about, you know, how should public money be allocated to support businesses that might be struggling at the moment.

And again, that is touched on in the addendum to the text, which John wrote with Jim Strang after the original copy had gone to press. So there are a few, well, not a few, there were a lot of very important policy implications throughout the document, I think all throughout the publication, but we’ve certainly found it been very useful to support our work in determining policy, which then in turn leads to government intervention. So it’s it’s a useful underpin to actual fiscal policy when it’s working at its best. And I can say that there have been times when we have used it to to aid understanding and and it, and it’s proven very effective.

Ross Butler

I thought that the book was worth getting just for the penname that you wrote John with with Jim Strang, which is just a couple of pages, but I thought it was really interesting looking at how things are, you know, cause everything’s changed now. Right. But my impression from those pages was actually that I’d be relatively sanguine from the perspective of a private equity fund investor, but that perhaps some other constituents might feel some heat.

John Gilligan

Yeah. Jim Strang and I read that in April and it was the first thing that was first time we’ve ever tried to write anything with people when we couldn’t sit in a room together. So it was first time we did anything over zoom, which was the first word thing, but the private equity she’s been through a number of cycles. I mean, depending on how old you, I started in 1988, I lost track of how many crises I’ve done. This is obviously a longer and different one, but the industry has come through. Many of them and each time has gone in, there’s been this fear that the leveraging things will cause a problem. That’s essentially at the heart of what they, what the issue is. People concern that overleveraging things will amplify results that are bad and that will be bad. And we’ve argued for 13 years or whatever you were writing that because the funds haven’t been leveraged.

Now, there’s, there’s been changed in the fund structure, which means that’s creeping in. And we kind of said in 2007 that’ll happen. And it is a, but we don’t think at the moment is any evidence that that’s going to cause any kind of systemic risk. But the thing that is different is the structure of the banking market, which is radically different. And that’s, that’s the overflow from the last crisis. You know, the GFC changed the rules of banking to make the economics of leveraged finance different. There’s more catio on capital in banks now than they used to be against leveraged debt. And that allowed the debt funds to come into the market. So many of the debt funds in Europe essentially were the mezzanine funds. You started moving down the capital structure and then the us model came over here.

Those funds are leveraged and indeed some of those funds leverage each other and there’s as yet, that’s not yet been through the mill in Europe, it’s been through the men in the States. The concern is that some of the smaller funds, because these funds are actually relatively shorter, so privately funds 10 years. So if you’re going to have a crisis, every, every decade, you’ve got to probably hit war on average debt funds are shorter. So if you raised one in your first fund and you went into the crisis, you will have no ability to have no track record, to raise money for the next ones. So we have a, quite a fragile environment for some of the new entrance into that market over the last decade. And when we come out of that, of this crisis, which we will in the world will be better.

John Gilligan

It will be, it’ll be interesting who survives and who doesn’t, if you pitched yourself as a retail uni charge provider or a travel sector specialist, you know, the world got bad and there’s nothing you could done about it. It’s just, it’s just a caustic event. Conversely, if you’re a turnaround investor, maybe the world got more interesting. But the one thing we do know from each crisis, this is always been a good time for the equity investor writing checks. When the world has been bad, has been a good strategy over the years for the, for the GP. Interestingly for the LP, the evidence is that you can’t pick the time to invest because you don’t make the investment decision that the GP does. So when you can make an LP decision today, or your GP might not invest the money into three years, so you won’t miss this, this with this window,

Ross Butler

Which some could say is central to its inherent advantage because you can’t just flip flop and change your mind. You’re, you’re stuck in it through good and bad.

John Gilligan

That’s the reason it doesn’t spread risk is because you, you, you made your bet and you bet on it. Now the secondary markets and the ability to do leverage positions, changes out of bet and it’s eating away at the edges of it. The analogy that runs through my head is a bit like you know, when people used to snip the edge of coins in the 17th century, there comes a point when you’ve debased the coin. We’re not there yet, but that’s, that’s, that’s a sort of a similar analogy. We’re just chipping away at the model a bit, bit by bit. And the original model of you. And I set up something for 10 years at the end of 10 years, if I’ve made some money, you pay me 20% of it. And if we haven’t, you don’t, that models are now evolving very rapidly.

Yeah. And, and so the jury is out on the performance of debt bonds, but do either of you have a gut feeling with regards to the impact of debt funds on mainstream private equity. If we were to hit a situation where there was a lot of workouts and insolvencies and so on,

I mean, that’s organizationally, that’s the interesting thing about the smaller funds is they don’t have the internal organization to do that because they weren’t jumping around long enough and working things out is, is a labor intensive exercise. So then one of my, one of my colleagues I’ve been on the investment committee, a big issue, investor impact investor. One of my colleagues is of work is a partner of a workout fund. And what they do is they buy other people’s problems and solve them so that, you know, there are routes to, to solve these problems. But the original investor went to the benefit of that when you invest in. So there is a question as to are there enough people to know how to do this and all the in the right place, because they’re originally in the banks, the banks had workout departments. Now, maybe those people are all the people that are sitting in the, the debt funds now, because many of them would have left. But, you know, that’s the question

David Petrie

I think the other couple of other interesting things to say about that question, Ross as well. I mean, the first thing is that we’ve not really seen the level of insolvencies that we were anticipating, or indeed that many of us anticipated at the beginning of this back in back this time, last year, really all last March when we went into the first lockdown you know, the statistics are very, very clear. You know, the number of insolvencies is Cigna is, is less in Q4 of of last year than it was in 2019. So that’s, that’s the, that’s the first situation. I think many of these businesses are not that many of the difficulties for debt funds haven’t yet hit. As John has mentioned, you know, those private equity houses that have found themselves with businesses where they’re working, capital’s got stretched to such a level that there that businesses is unsustainable.

I suppose there’s no other sources of capital. Then they’ve, they’ve taken some fairly urgent action or some too desperate action in some cases. So there have been some high profile, private equity backed failures in the sort of within the sort of six months kind of horizon of the crisis biting. But they could, well, if some of those could well have been businesses that were already struggling for a variety of different reasons, I think what is also interesting is what you’ve seen or what we’ve seen more broadly with the actions that private equity took you know, over the past nine to 12 months. So the first thing that they did was look very carefully at their existing portfolio. Some businesses were doing well and others were clearly under a great deal of strain. So the things that private equities consistently argued that it does well is bring professional management into businesses.

So in, you know, ask providing an external perspective and looking at ways in which the business could be adjusted, working capital management could be improved yet further diff unfortunately difficult decisions could be taken in terms of reducing operating capacity and sadly reducing head counts. And so on the private equity funds took those. They, they move very quickly with their existing portfolio businesses, but then they also found that they had a lot of investee companies that were pretty much business as usual and alongside that they also changed their investment philosophy and private equity for, for many years is recognize that it can change the significantly changed the value of investee companies by building together similar companies as so-called buy and build approach. They recognized that this was a very, this was a, this was still a way you could do deals during lockdown. So John said they could, you know, you can, de-risk an investment because chances are what you already know the sector by definition with buy and bill, because you’ve got an investee company in it they’re already, so you’ve done your due diligence on the market and the dynamics of that, your content about that.

And there’s a very good chance that the management team probably also know personally, you know, the other people within the target company, they met, they certainly know the customer base, the dynamics of it and so on. So that the private equity houses are able to use their existing resources, existing management teams, and so on to help them do due diligence, due diligence, investment targets. So we saw that developing as a way for getting transactions done.

John Gilligan

The great truth of private equity is cost of capital drives a lot of things. If that’s cheap, then, then transaction sizes rise and the are recalled giving a lecture 18 months or so ago with a colleague from Goldman Sachs he said, look, it’s a bit like being in, in the final of the French open, which still has you still have to win by two clear games in the French open, so you can keep playing till the end. So it could be 17 all, you know, the ends on the way, but you have no idea whether it’s going to be 1917 or 39 37, but it felt like that before we came into the crisis, because we were at the top of the market. And so when we submitted the book to the publishers, we actually said, again, we submit this nine we’re at the top of the market.

We had no idea virus was going to be the thing that disrupted it. I was completely surprised it was all obviously, but it’s still the case that we have this strange atmosphere across the capital markets where the cost of capital is distorted by quantitative easing and low interest rates means that the asset value inflates and when that’s unwound, the asset values will fall. We just don’t know if that’s going to unwind quickly or slowly or how that’s going to happen because nobody’s ever done it before. And the change of government in the state Springs to Janet Yellen back to the table. And she was in the process of slowly unwinding that towards the end of the Obama era has moved. Music has changed because the world’s changed. But that’s the kind of the, the big unspoken elephant in the room is what happens if interest rates rise significantly, because that goes back to the evidence-based, doesn’t it? Because the majority of the growth in this industry, I mean, it was a cottage industry before quantitative easing almost, and now it’s huge for many years.

So yeah, nobody knows. And I guess the, the other thing going back to David’s point is, yeah, there have been some sectors that have done phenomenally well, you know, software being the quintessential beneficiary of lockdowns. And then there are the sectors that I think David was alluding to where they’ve they’ve had problems, but those that are backed by investors with deep pockets, see it as a time to go hunting. And they may well emerge even stronger because they will dominate their sector, I guess, having rolled it all up. I mean, there, there is that. I mean, there’s the buy and bill thing is an interesting change. One of the questions that perplexed me since I started doing this all those years ago is all the academic evidence. We have suggests the M&A generally destroys value and all the academic stuff we’ve got about private equities, generally private equity at a gross level, outperforms markets, private is an M&A driven business.

That’s what we did. So how come the business that is focused on M&A and pretty much something else is outperforming the market when all M&A token taken around generally suggests that it’s quite distorted. And this is the kind of question that we wrestled with for years and years and years. It’s what we call the paradox of private equity is people do M&A and they make larger gains that larger returns than if they didn’t.

Ross Butler

David, that a controversial statement, I guess, from your perspective as a chief executive, the corporate finance faculty.

David Petrie

We tend to take a slightly different view in a rather more optimistic view to the value added by M&A than than, than perhaps Johnson indicated in the academic evidence. We always used to be entertained by a report that used to be published by one of the major accounting firms suggesting that M&A destroyed value. And we thought, why the hell are these guys publishing this? But of course, what they were publishing this fall was because they, the, they are, their argument ran of course, well, smart M and a with good due diligence and so on and all of these things. But of course, nobody goes into a transaction expecting it’s a fail. You know, so what, what has happened that has may have resulted in reduction in value, and the answer is things haven’t worked out the way you thought they would.

Yeah. So why is that? And these, these can be systemic issues. They can be political, you know, it’s all the usual, the usual analysis that John and his colleagues teach their students in business school. One of the areas in their pastoral analysis has changed beyond their imagination, original imagination. If there’s something fundamentally wrong with the target, then even some of the largest examples illustrate that it is possible typically to take legal action against the the sellers. Americans are making a very unfair to Americans by the way, for any Americans watching, but in the unit in the U S I should say, I should preface my remarks by saying that the use of warranty and indemnity insurance is become much more widespread than it ever was 10 or 15 years ago. And also the propensity to claim against those policies, which is where my well, I’ve dragged my Americans into it.

You know, the, there is evidence that suggests that American acquirers are more inclined to claim against WNI policies than perhaps it’s typically the case in Europe. And that, again, I think is a function of the way that those transactions are done again on the basis of completion accounts rather than the lock box mechanism, which is you know custom and practice in the UK, but it’s not to say that these things, you know, won’t won’t change. And but I think, I think there are lots of probably lots of factors actually, which might contribute to things, not working in quite the way that people expect, but it’s not something that we tend to like to talk about. And a few years ago Vince cable had had a good look at this and commissioned a piece of piece of research.

Looking at the value that M&A did actually add to the markets and that particular research illustrated that the impact was, was relatively neutral. But in the corporate finance faculty, we give an award every year to the public company that has added most to shareholder value through the use of M&A activity. And this year we did an analysis to look at past winners of these awards, because of course, as many people know, a lot of companies fear the curse of the award. As soon as you get given an award values collapsed, and something goes horribly wrong. This is not the case, actually, in, in eight out of 10 of the businesses that we gave an award to. And given that they were all public companies, if you’d invested in the stock of each of those businesses, you’d have, you’d have generated a return. That was significantly ahead of any average industry and most tracker funds, because these businesses were making very judicious use of M&A and very effective use of M&A to add to shareholder value.

John Gilligan

Yeah. what, what, what may am I kind of pick to weigh out over the decade was trying to answer this question, how come this thing is happening? And we think on the conclusion of the book in a sentence is we think it’s about process. We think it’s the fact that private equity firms are good at doing this stuff because they do it in a fixed process. So there are other, like, there’s this idea that great deals get done over a napkin, sitting in a bar over a bottle of wine between two entrepreneurs. Those are the ones that probably go wrong, because if you do a process and you have a process that you do every time, what you do is you select out the failures quite, quite efficiently. You know, there, there are waves that can swamp you like this tsunami of, of, of the virus.

But if you select it are all the things that you could have selected out reasonably, then you avoid the losses when you avoid the losses, that makes a big difference to where you’re going. And we think, but we haven’t yet been able to demonstrate, cause we haven’t figured out. We never quite figured out how to do it. In fact, I’m doing some work at the moment that I called Tim Galpin, Oxford on this is what is defining the success of private equity is two things. One is the, on the way in, there’s a process that not only buys as well, but implements the purchase process. Post-Completion well, so the a hundred day plan thing. So due diligence turns into action. And secondly, the focus on exit makes people do it quickly, because if there’s one thing to say, I’m going to change the strategy of this business over the next decade.

And there’s another saying, I’m going to have to do it in the next three years, three to five years, and you can just work quicker. And we think those two things are at the heart of, or probably our conjecture is that those are at the heart of why this works. That sounds plausible to me, but could you not kind of zoom out a little bit further and say, well, the processes, the function of the structure of the LP structure, it’s not just the LP strip to think about the different surfaces. Imagine I sort of business GE some years ago, and they’re really good acquirers. They have an internal process, but it’s all internal. So it’s an internal process. And their level of knowledge in that process is limited by the number of transactions they do, which is a lot or used to be a lot when they were very inquisitive.

Now imagine that your, I don’t know, pick a fund, doesn’t matter. Most of those funds externalize the process. Private equity is a big user of the services provided by people like Amelia and other people know we did a lot more transactions than anybody else did. So we learned more. So the, you know, the big four accounting firms and GT and BDO below them do more transactions per year than any private equity fund in the world by orders of magnitude. So funnily enough, the people who have come across the problems tend to be in those footsteps. Some of them ended up moving into private equity. So one of the conjectures is that by externalizing a large proportion of that process to people that you work with consistently, you’ll get the benefits of their learnings. And therefore you avoid mistakes. You would have made had you not used external advisors, corporates use of external advice less, and therefore they’re more likely to fall for their own beliefs as it were. They don’t have an external check mechanism in the same way. So when we were conjecturing that, you know, you hear a lot about passion and vision, all these sorts of things in business schools, and my colleagues do all this, but maybe here competence is what we’re talking about. You know, being very competent, a process might make a hell of a big difference.

David Petrie

Yeah, yeah. I was just going to say that that certainly the view expressed of course by very many of the members of the corporate finance faculty who are themselves advisors and they do, as John says, they do, they do see the same things day in, day out. And you know, again even some of the larger or mid market houses, I guess in the UK might do 10, 15, 20 deals a year, but they’re certainly not seeing exactly the same thing in quite the same way. And the increasing specialism within the advisory firms as well, again, increases that level of expertise and that ability to be able to say you know, this, what this, this could be, this could prove to be one of those unforeseen difficulties that I was talking about a little time ago. They’re not really unforeseen they’re they’re things they’re factors in investment risk that people just might look at differently and be proud.

And to actually take a, perhaps an artificially optimistic view about at the time, because it happens to fit with company strategy. And I think that to, to sit alongside John’s analysis or perhaps to, to, to add to it or to add facto, no doubt they’re considering is that I think in private equity, they’re set up to monitor changes and KPIs within a business extremely closely and where things are going wrong. They will tend to know potentially anyway, not this is generalizing, but perhaps quicker than they might within a private company or public company, perhaps they will know sooner that something’s going wrong. And, and also perhaps they will be more inclined to take action sooner. You know, one of the facts and perhaps John I I’m worried that I don’t now have academic evidence to support this, but there is a lot of anecdotal evidence amongst the advisory community to suggest that private equity managers change management teams

There’s, there’s evidence of that. There’s, there is evidence that private actually changes management board, anybody else? Absolutely here.

John Gilligan

Yeah. And they’re doing that in order to, they are proactive managers, they will step in and intervene. And there’s not necessarily perhaps the giving an investment, the benefit of the doubt, if we could call it that, that you might get in you know, a, a public company transaction where it might be, well, we don’t quite know why this isn’t working, how much of what we’ve bought is, is now integrated within the much larger organization. And therefore it’s less easy to assess exactly how much value that it’s actually added to the, to the, to the whole. Whereas if you’ve got the thing running discreetly, it’s much easier to to assess its performance. So there’s a whole series of different factors that are at work here and academic support and analysis of these things does allow for directors to challenge some of these, these concepts, these ideas that, you know, we know that we need to be careful with M and a, because, you know, we’re concerned it doesn’t necessarily add value. And how can we change our processes, try and minimize risk, taking it back to private equity demystified. That’s where, you know, some of the principles in private equity may not think about some of this stuff quite that way all the time, but having, going back to the text and say, yeah, actually that’s an interesting trend. We need to have a bit of a think about that. It’s really great

Ross Butler

And he’s coming on again soon to talk about his new book on, on governance, which, sorry,

John Gilligan

I was reading Simon Witney’s new book on Governance last night, a friend, and there’s a point that he makes in that book, which is far more scholarly than I am, and often a lot, lot smarter than I am. But the point he makes is, is that if you stand back from this and look at the simple decisions you make as a shareholder shareholders in public companies have the option to sell. So the private equity shareholder has to have the option to fire because they don’t have the option to sell. And so the reason you change the management is because you don’t have the option to bail out. And that’s, that’s the sort of the contract you enter into. You have this simple idea of if I don’t like you I’ll sell and that we know that will be affected, the market will make the price of the asset fall because of that, you can’t do that in the private equity world, or couldn’t historically get this bit of secondary trading. You can do it on now. So you have to have the option to fire because what else can you do now? There isn’t a third option. And that’s, that’s again, one of these things that David was saying, I mean, it changes the game. If you can’t sell, you got to do something else.

Ross Butler

Yeah. There’s an interesting interplay between the advantages of the governance model and the advantages of the process that you outlined as well. And obviously they’re interlinked, but they are separate as well. Yeah.

John Gilligan.

Yeah. I mean the governance thing sort of comes from the process. And so there’s a process on the way in which is a bit I know. Well, cause you know, I was an M and a person and then there’s a process once you’re in, which is, which is kind of embedded in the, in the governance piece. And the thing that strikes you when you deal with a private equity fund year on year on year, is how consistent that process is a cost of pay.

Ross Butler

I’d really like to try and bring you two together on the point because I think it can be done listening to you both. And so let me try you on something, which is that the academics may have discovered that MNA may on average destroy value, but the average does not necessarily dictate the overall benefits of an activity. And David’s prize is highlighting people that have hits upon a successful formula and are accruing knowledge along the way. And your description of private equity does the same thing. And so while the average may destroy value the activity as a whole may be a creative

John Gilligan

That’s absolutely. Right. Right. So the, the whole, one of the biggest problems that the conversation about private equity has generally is the average is a coastal over the place. So the average return on compared to the average return on a market, is that a meaningful thing? And the answer is, well, not really, it’s not meaningful for a number of reasons. One, nobody buys the average. When you put leverage into things, you make the dispersion of the distribution bigger because you amplify everything. So th th this constant question of does private equity outperform the market. I sort of got to the point where I don’t think the question makes any sense anymore because there’s now leveraging funds. So I, as an investor in the fund, first of all, investors don’t get the same deal. If I put a hundred million pounds to a fund, I get a different deal.

And if I put 1 million pounds at the same site, secondly, there’s leveraging funds that comes in and out. So depending upon when I’m in that fund, if I’m trading in the secondary market, my returns would be different to yours if you stayed in across the whole piece. So even within one fund, the LPs are getting different returns. So what does the average mean? No idea. And then there’s this, this, this whole question of what does it, what’s the average of what if you’re doing turnaround investments in France and I’m doing buy and builds in Spain? Are we doing anything similar? I don’t know my organization, it looked very similar when we draw an organization chart. I mean, might all be in my book and, you know, we might put them down as a private equity fund, but is it really sensible to compare us?

Because the strategy is really the question. The real question is an investor is what do you say you’re going to do? Did you do it and give him the risks I took? Did I get a return for it? And comparing, I know every always picks on KKR. So I was picking know some large buyout fund CBC, God fed. Doesn’t worry about it too. LDC or inflection, or I don’t know somebody else, is that a sensible thing to do know? It’s a bit like comparing the performance of somebody in Chelsea football club to somebody in Harlequins rugby club. They’re both playing a sport with a ball on a field, but they’re not trying to do the same thing.

Ross Butler

Have you come across the American intelligence definition, the difference between a puzzle and a mystery, which helped probably mangle, but puzzles. Basically they have an answer, at least in theory, they can be sold computationally and mysteries don’t have a single answer. And even when you have all knowledge, it’s still unclear what it is. And so it strikes me that private equity demystified as a title is peculiarly appropriate. And obviously it’s very much needed as well. So it’s been a great pleasure speaking with you both. And I really commend the book. It’s it, it’s actually a good read as well. Thank you.

John Gilligan

And also, so that everybody buys it, I don’t make any money out of it. We give all the money to the big issue where I’m a trustee of the charity. So if people want to give money to charity and also learn about, about private equity, as I said in the post on LinkedIn, it’s not bandaid, but it does a bit.

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Hendrik Brandis is co-founder and partner at Earlybird Venture Capital

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Vania Schlogel is managing partner and founder of Atwater Capital, an LA-based international private equity firm. 

Vania Schlogel is managing partner and founder of Los Angeles-based Atwater Capital, a private equity firm with an exclusive focus on media and entertainment. Vania cut her teeth at Goldman Sachs and KKR. She was on the board of Pets at Home, and she was CIO of Roc Nation, Jay-Z’s entertainment agency. And she currently sits on the boards of private equity back to media and entertainment businesses across the US, Asia and Europe.

 

ROSS BUTLER:

Vania, welcome to Fund Shack. You are quite an unusual private equity investor in as much as the creative industries don’t scare you. In fact, that’s what you focus on, specialize in. How did you get interested and involved in it?

VANIA SCHLOGEL:

I saw so much value from marrying those two worlds. So the very kind of disciplined and rigorous private equity side of things with the innovation from the creative world. And I just always had the natural interest in it. The creative side of things, obviously as, as, as an individual who consumes content and music myself, and as an investor really experienced that marrying those two worlds could actually help an investment in terms of equity, value creation, generating returns on behalf of our LPs. And then I know this not many folks were doing it, so it seemed like a natural opportunity to get in.

ROSS BUTLER:

So what, what, when was your kind of Eureka moment that actually there’s an investment opportunity in this industry?

VANIA SCHLOGEL:

When I was at KKR one of the investments that I was involved in was the buy and build strategy that built what is BMG today. One of the world’s largest independent music publishers, and it was really my first foray and ability to actually invest in the creative industry. And I think one of the things that was very successful about that investment is we, as investors were able to go in and provide a body of knowledge and expertise as to what we were good at and focus on that. And I think what we did really well is let the creative guys focus on what they’re good at. And so we were backing a great management team and company with capital and M and a and integration expertise. But then we also knew when to not overstep our bounds. I can’t recall who said it, but there’s, there’s this joke in the music industry about the CEO that wants to see himself in the music videos? I think the most successful thing we did is we made sure that we were not the CEO that wanted to be in the music videos or the shareholders or board members, however, you’ll term it. And, and that was my Eureka moment where I said, this is a great investment. It’s a lot of fun. I tangibly understand it. I get along really well with these creative executives. And from there on, it just became as you know, what happens in life, you one thing, and then suddenly more opportunities keep coming in that vein.

ROSS BUTLER:

So you, you had it with a traditional private equity house, but why do you think the traditional private equity market doesn’t see it as necessarily a big sector ?

VANIA SCHLOGEL:

Well, I,do think they see it as a big sector. I think that there is more appropriately put there’s a lot of opportunity from actually investing in the sector, but then taking the next step of being really operationally involved and plugged in with the creative sector. And I think the primary reason, honestly, why it is not a big operational focus for large private equity shops is because they’re very, very good at what they do on an operational level. So implementing an ERP rollout or optimizing a supply chain, these are scaled replicable, operational strategies and processes that they can apply to their portfolio companies, really building a deep partnerships. And the operating level with creatives is time-consuming and not always replicable to other portfolio companies. And so it’s more of, I think, a scaling issue and we’re kind of happy being the smaller fund that goes ahead and steps into that role as a partner to a lot of larger GPS.

VANIA SCHLOGEL:

Yeah. It’s a chemistry thing, presumably that, you know, people that set up creative business are probably quite different to almost any other kind of business, I guess, and you have a good kind of chemistry with them. It sounds like.

VANIA SCHLOGEL:

Yeah. And I think at the core, in any case investing is a human centric business, but when you do delve into the creative aspect and, and partner with creative executives who are very much more around, you know, emotion and being led by intuition, it is very important to jive on a personal level and to really take the time and build those relationships. And I will say that despite the fact that we have wonderful working relationships with a lot of creative executives, myself and a lot of Atwater’s executives are also personal friends with our creative partners. I think that works really well for the industry.

ROSS BUTLER:

It’s quite a rare individual to be both creative and to be able to be more financially focused as well. Do you come across many creative entrepreneurs that can and do do both?

VANIA SCHLOGEL:

It is, I would say it’s more of a rarity. I definitely have noticed that a lot of a subset of folks that do this really well seem to be founders and entrepreneurs. So we back, for example, certain portfolio companies Oscar Hoagland, who’s the co-founder and CEO of epidemic sound. He does really well in terms of liaising with both communities. And so it’s not a common skill-set. We do see it, but I would say I see it most often among CEOs and founders, and maybe it’s because I don’t know us founders, we have a, a little bit of that craziness, the risk taking the innovative, whatever you want to call it, but just enough there that we’re willing to kind of get out of maybe the modality of thinking in a, in a typical private equity or consulting or whatever.

ROSS BUTLER:

So you will come your private equity firm Atwater it makes it a virtue of being operationally involved in these creative businesses. To what extent do the businesses that you invest in kind of welcome operational input and to what extent do they need it typically? Yeah.

VANIA SCHLOGEL:

Well, let me answer the second question first, because I think that’s the easiest every business, every individual, any organization of people can improve in one way or another. That doesn’t mean that our ideas are always right. And in fact, that’s one of the first things that we strive for in our relationships with management teams is feel free to kick us in the teeth and tell us if these ideas are completely asinine. And we genuinely mean that. And but is the, is the opportunity for improvement there? Absolutely. And the best founders and management teams recognize that then going to your first question about how welcome is that we as a fund, so we’ve invested about a hundred million dollars since I founded the fund in 2017. And in all our investments today, we’ve been a minority shareholder de facto.

VANIA SCHLOGEL:

That means that even if I wanted to, from a governance perspective, I cannot come down with edX from above and say, this is what you must do. And in any case, I genuinely think that’s kind of bad, bad governance and a poor way of managing these relationships because a lot of the CEOs and founders that we work with have been in the business for years, sometimes from inception. And so it’s incumbent upon us to actually come up with ideas an operating level to, to present a Rolodex within the industry that is exciting for management because we’re very open about the fact that yes, despite the fact that we may be represented on the board and can vote shares a certain way. My personal experience has been in less management really wants to work with you. Your operational strategy is not going to be that effective. And so it is a foundational thing for us to come in as investors and really form number one, deep personal relationships. And number two, actually show up with the goods because we’ll get called out right away by these very demanding founders and CEOs. If we’re not showing up with something that’s helpful for their business,

ROSS BUTLER:

And what’s the competitive environment like for attractive assets in this sector,

VANIA SCHLOGEL:

I would say our sector is more, is more right for proprietary deal sourcing than potentially other sectors. And it goes back to what we just talked about, which is that kind of creative and founder led group of folks. There’s so much that is based upon relationships and how well networked are you in the sector? How well-liked are you do founders talk about you in a positive fashion. And it’s interesting, both what I’ve witnessed is both on a positive and negative level founders. It will, it will spread like wildfire among founders, if you are seen as either a great partner or not a very good partner to management. So I actually think within the sector being, being well-networked and well-liked lends itself to proprietary deal sourcing, which means it’s outside of a normal process being run for example, by an advisor. And in that kind of case, that’s actually the ideal scenario because it’s not a competitive process. Aside from your main competition being against yourself, are you presenting a compelling case to the founder and CEO and the existing shareholders that you’re worth it, that they should sell some of their shares to you because you’re going to, going to bring value.

ROSS BUTLER:

Yeah, I can imagine that the LA creative great vine is quite sophisticated and active, so the word would get round, but you’re not just you’re based in LA, but you have an Asian presence and you recently did a European deal as well. Talk to us a little bit about your kind of geographic coverage.

VANIA SCHLOGEL:

It’s really funny because prior to parasite winning an Oscar, which is a South Korean movie, we would always get the strangest looks when I would explain that we have offices in Los Angeles and Seoul, South Korea, because most funds are based in New York and London and San Francisco. And then when they go to Asia, they immediately typically go to Hong Kong or Singapore, you know, kind of a financial hub. And the way that we explained it is we’re operational investors. And hence we launched in Asia in a very operationally relevant geography. So South Korea has the fastest internet speeds in the world. It’s a thriving and healthy democracy. It’s intellectual property protection laws are very robust. All that put together means that the monetization methods and kind of the business ethos, also legal protections endemic to South Korea, feel very natural for Western portfolio companies to launch into a, so you have to get over.

VANIA SCHLOGEL:

Obviously some of this is natural, no matter where you expand to globally, but, but you know, you need to be comfortable with the language barriers the cultural differences and being respectful and mindful of that. But once our portfolio companies launched there it feels much more like a fish in water in terms of them looking around and saying, Oh, okay, I can still sell my intellectual property for example, and monetize it the way that I would, whether I were based in Sweden or New York or, Seoul. So that’s one of the reasons that we set up a presence there. And going back to the example, also a parasite winning an Oscar, we identified very early on that for whatever reason, Koreans are very good storytellers. And so there’s always been a large body of a great intellectual property and content trends coming out of South Korea.

VANIA SCHLOGEL:

And so as the fund focused a lot on entertainment, media, and content, it made a lot of sense to us to be present in cities that were driving these trends. And it’s one of those markets where a company can launch. And admittedly, it’s a very small country and a very small core addressable market, but given the ability to export cross border a company can look into expanding into adjacent geographies, Japan, Southeast Asia, China from the, that kind of launchpad in South Korea. I would almost liken it to Sweden in that sense, what Sweden is to Europe, pretty small addressable market, but, you know, Spotify did all right.

ROSS BUTLER:

Absolutely. And so speaking of Europe, you’ve got some activity there too

VANIA SCHLOGEL:

Well. We’ve actually invested quite a bit in Europe. So we’re invested alongside KKR in a company called Neo nine studios, which is Germany’s largest production and distribution company in the country. I chair the board there were invested alongside EQT and epidemic sound, which is based in Stockholm. I also chair the board of that company. We just closed another investment alongside EQT in Malaga Spain, and a fantastic company called free pick.

ROSS BUTLER:

So under normal circumstances, your air miles are pretty significant,

VANIA SCHLOGEL:

Wonderful from the perspective of never having to pay for a personal vacation ever again. Yeah. I was spending a lot of time in Europe, I lived in London for six years. And so from a, from a sector perspective, I actually think it’s a wonderful geography to in, I think it’s multiples cheaper than a lot of us media.

ROSS BUTLER:

You’re relatively small funds to have a kind of what appears to be a completely global footprint and also personally global responsibilities, a portfolio of companies all over the place. And I guess that’s a function of being a sector specialist. Would you say

VANIA SCHLOGEL:

That’s exactly right. And I wouldn’t say we’re truly global because we genuinely as a operational fund, we have to spend time building relationships and liaising with folks. And so we’re very much present in Europe and Asia, we don’t touch geographies yet where we don’t have executives or very strong partnerships. So that would include, for example, South America Africa, those are geographies where we’re not present, but in Europe we feel very comfortable investing in the region you know, regulatorily regulatory perspective culturally even our role relationship Rolodexes, we feel very natural about investing in the region. And also importantly, we have such wonderful partners in terms of larger GPS that we work with as well as a lot of founders company founders that we know who also keep us connected on all the grounds.

ROSS BUTLER:

Well, I was going to come on to that because it’s very interesting, the fact that you you partner with some of the biggest buyer houses in the world on some of their deals. So they like you and they bring you in, they’ve got enough money of their own. What do they want from you?

VANIA SCHLOGEL:

That’s a great question. We feel a very strong duty towards our GP partners and today we’ve done, you know, we’ve, we’ve invested alongside KKR, EQT in TPG since the fund launched in 2017. And you’re absolutely right. We recognize very much that they have enough capital. They have a large committed funds and they certainly don’t need out water to come in to fill a hole. And hence there is a very strong expectation of performance on our side that in the Venn diagram of things not to get too nerdy, but they’re going to focus on, you know, these, these sets of operations. And we’re going to be over here focusing on our operational strategy and the two don’t really overlap. And that’s great that complimentarity of what we focus on and our expertise, I think is the reason why we get repeat business and repeat partnerships with these GPS.

VANIA SCHLOGEL:

And the other aspect is just we have a very, the way that we set up the operations of our fund are centered around our operational expertise. So I gave you one example, which is we’re present in South Korea because we understand it to be a trendsetter city in terms of content and technology trends, our LPs in South Korea. In fact, for example, Kakao is not only a partner of ours, but also an LP of ours. And if you imagine a digital media and technology group for a given country that owns the WhatsApp, Spotify, PayPal, Uber, and a few other assets of a country that is cacao, and they are one of our greatest partners in LPs. And so when we partner with the larger GP, we can actually go in as one of the only if not the only fund in the world that can say that and say, Hey, when, when this company, this portfolio company is looking to launch in Asia, we’re gonna consult and give a great body of expertise around having done this before. And Oh, by the way, we’ve got a fantastic digital media company there as an LP who now has a vested interest in making a success story.

ROSS BUTLER:

Yeah, that makes sense. So what, what specifically, what sub sectors, what types of creative companies are hot right now, interest you from an investment perspective?

VANIA SCHLOGEL:

We are very much focused on content and we focused on it from, from the inception and we built out a very strong investment thesis to the point where I almost feel sheepish saying content, because it’s such a broad umbrella term, the way that we segmented it is we got very deep into it. And so we’re looking for example, at content that is buoyed by the trend of online creator communities. We’re looking at content that has an over and exposure to growing over the top, or what’s called OTT streaming platforms like Netflix or Amazon. So while we spend a lot of time in content, we actually very delve down into those sub sectors that we feel have kind of acyclical component, but also from, from kind of a meta-thematic side being buoyed by digital trends and digitization, which COVID, by the way only helped to hasten quite frankly.

ROSS BUTLER:

Yeah. It’s interesting. Like when the, in the first internet, boom, like 20 years ago, everyone was constantly saying content is King, but looking back, I sometimes wonder whether actually for that first wave, but networks were King because the ones that did really well were the companies that capitalized on people’s people’s networks and kind of get the sense as you say, particularly with lockdown. And now that everyone’s got decent broadband and streaming services. And so on that the content might finally be having actually it’s it’s time in the sun. You’re gonna, when you think about that, like orthosis,

VANIA SCHLOGEL:

I’ve had this debate so many times about content versus distribution. And I think one of the most interesting case studies is what happened with Netflix. And I re you know, prior to launching house of cards in January of 2013 it was a pure play distribution platform, and I’ll never forget the production costs that were quite heavy for house of cards that Netflix had undertaken. If you actually have the interest and go back to a lot of the equity analysts and what they were saying about Netflix, it was brutal. I mean, it was just, this is daft, this is how many subscribers they would have to get to recoup this, and it just ripped them to shreds and what happens, they launched house of cards and in quick succession orange is a new black, the Marvel kind of TV series spinoffs, et cetera, and their stock price within the next year two and a half 10 next.

VANIA SCHLOGEL:

And, and so I think it’s I tell you that anecdote because where I land is that it seems more and more these days. It has to be the marriage both. Now, that being said I don’t know. I don’t mean that to say that there is not an opportunity for induction and content creators. I absolutely think that opportunity is there, but in, in order to really sell and continue selling in a systematic way and not be hit driven, these content creators need to focus on franchise defining or tentpole content to really have viable business models and also to try and own some of their intellectual. Are you going forward rather than just being a licensed, sor and working for fees in terms of the monetizing, their content? The other thing that I think is positive or content creators and intellectual property owners, is that pro in, in a, in a prior world, these content producers were selling into the traditional set of media buyers.

VANIA SCHLOGEL:

Then they were selling into the traditional set plus Netflix, and now the world has opened where now they’re selling into to Apple as well and other new entrance. And so it’s a great time to be a good content producer and intellectual property owner because the buyer set is proliferating. There’s just more and more buyers now of good and franchise defining content. I think one of the other things, and this is why we invested, for example, in Leonine is one. Yeah, the great things that happened from Netflix. And I actually mean this at associate level is because, so Netflix was able to aggregate eyeballs at a global level. There became this re-education process in the entertainment world that we are willing to watch local language, film, and TV, whether it’s the example of parasite, which is completely in Korean or dark, which is in German.

VANIA SCHLOGEL:

And so this put the emphasis and investment again in local language content. And I think that’s really important and social level. I don’t think we want to see a world where 98% of content is created and generated out of Hollywood and has an American perspective to it. I think we really want to honor diversity of content and also local traditions and cultures. And I think that’s one of the great not to go on a tangent, but it’s one of the wonderful things that actually has come from technological distribution is a refocus, any commercial case that now puts investment back again on local language content.

ROSS BUTLER:

I understand that a lot better now, because when you started speaking, I was going to say that all sounds great, but there’s, there’s only one Netflix, but I mean, Hey, that’s not quite true, but also it sounds like Netflix allows a whole ecosystem to happen as well in the same way, as, I guess, Amazon allows a whole ecosystem of suppliers to feed into it and get greater distribution. Yeah.

VANIA SCHLOGEL:

Yeah, absolutely. And I think to be fair, there need to any time one seeks a sustainability and health of an industry, there need to be countervailing forces. So while I’m also very positive on some of the positive things that Netflix has engendered why, why did we invest in Leo nine Leo nine took five companies and consolidated them into the number one player because scale at a local market level is a net necessary countervailing presence to a global technology player like Netflix. So I think for the health of the industry, also the, for the health of consumer choices going forward and for greater investment behind local content we as investors are placing our bets and trying to have scaled local players rather than just a fragmented market.

ROSS BUTLER:

Oh, these kind of film production companies, they, they are, they’re kind of like finance houses in themselves. Aren’t they, to some extent cause they’re then financing projects,

VANIA SCHLOGEL:

They are. Yeah. And that’s, that’s also why scale matters because content behaves very similarly to venture capital as an asset class, meaning you have a few real outliers in terms of performance and a lot of losses along the way. That is the nature of content that also scares a lot of investors. And so the way that we approach the sector is with eyes wide open and saying, we understand that’s how the asset class performs, but we also understand portfolio theory enough to know that diversification diversifies a way that unique hit risk. And so if a, an asset is scaled enough, it’s producing it. Number one, it’s producing enough new shows or films. And number two, it’s typically paired with an existing library that generates stable cash flows. And so I think there’s a perception versus reality gap. A lot of times when it comes to investors that investing in the content space, they just look at that unique project risk of it’s going to be great, or it’s going to be an absolute unmitigated disaster. We don’t view it that way. We view it as, as long as we can get into scaled ventures. A lot of that unique risk can be mitigated.

ROSS BUTLER:

Hmm. The fact that you’re partnering with big buyout firms also suggests that the risk profile isn’t that venturing. Yeah.

VANIA SCHLOGEL:

Yeah. That’s absolutely right. And, and Leonine, for example, spent the better part of two decades, for example buying up content and has eight, the best library in Germany. So as, as one example of why that’s so important when COVID hit and for a period in, in Germany productions completely shut down of new content, we were sitting on the country’s largest library. And so while we’re all hunkered down, bored out of our minds, looking for titles, and we’re going back to Tomb Raider and Home Alone and all those things that we watched in the past 20 years that library was generating fantastic cash flows for the company. And I think that’s a really good example of how an asset class that can be perceived as, so hit-driven actually ended up being one of the most sheltered and a cyclical assets as evidenced by what happened after COVID hit.

ROSS BUTLER:

Yeah. That’s amazing. Isn’t it? Do you want me, what’s your view of the future of private equity meeting, creative industries? Would it always be bore the specialist to some degree, or do you think there’s a larger opportunity opening up

VANIA SCHLOGEL:

Trend of a lot of pro previous operators within the media and entertainment space? Raising capital, for example, they’re, they’re doing a lot of fundless sponsor activity. I, I, you know, there are certain situations I can’t comment on now, but very well-known media executives who have identified proprietary deals as we talked about earlier and then going, and either partnering with private equity or with family offices, the rise of, of family offices, for example, has opened up a brand new and innovative kind of funding pocket. And, and they’re going about it that way. So it’s, again, it’s one of those industries that, and I mean, media and entertainment within private equity that is not only within it itself, but also the, the industries that are tangential to it. So media itself is constantly evolving, but also the way that private equity invest into media, it’s constantly open to evolution and sometimes outright tumbled. And so I do see that going forward, there’s going to be much more of a trend and continue trend of very well-known operators who have left their operating posts and want to try their hand at investing. And they’ll find funding, whether it’s through respect partnership. Spacs also, that’s part of the reason why there’s been such a rise in space.

ROSS BUTLER:

So is it because of the sector?

VANIA SCHLOGEL:

Exactly. Because who knows the media and entertainment sector better than, than folks who have a deep operating expertise within it. And so now they have creative ways of finding capital and because it lends itself to proprietary deal sourcing, I just think this industry is very unique relative to investing in other industries,

ROSS BUTLER:

Given that you’ve always been in investments and something’s doing creative, you’ve had quite a buried career cause you KKR, you’ve got your own shop. And in between you were a CIO ROC nation with, can you tell us a little bit about what Roc Nation is?

VANIA SCHLOGEL:

So rock nation is founded and helmed by Jay Z, who many people know. And, and one of the really interesting things about Jay, if you look at the history of his career. So yes, he is a very well known rapper and artist, but he’s also had a business savvy. So very early on, for example he structured the deal so that he the retention of his master rights reverted back to him, this is before artists were doing it at a broader scale. And I would say before Taylor Swift, for example, really got on that public messaging about it. And so he, he actually is, is a great example of someone who took his relationships and industry expertise and leverage that into an operational role by setting up rock nation. And so rock nation represents, I believe they started really in music now, they branched out to representing artists in outside of just music and then also athletes professional athletes and moving into those adjacent verticals and really what that comes down to is leveraging a Rolodex of relationships. And then having that credibility that, Hey, I care about your career, your art, I will be a good, good partner for you in a way that Jane the rock nation team can do.

ROSS BUTLER:

And, and culturally going from KKR to Roc Nation, and then to your own shop. I mean, they, they must be big leaps or was Roc Nation, very KKR-like?

VANIA SCHLOGEL:

Worlds apart. They are very, very different. And, and funnily enough, I would actually having experienced on the one, the Goldman Sachs and the KKRs and my career, and then on the other kind of the Roc Nation’s of the world I endeavored to set up the culture of Atwater to be a hybrid culture. So if you ever come to our offices, you know, you’ll see some funky art up, you know, music typically playing in the background. So it’s a little bit of a hybrid.

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World leading thinkers join Fund Shack’s 50th anniversary debate on Milton Friedman’s article The Social Responsibility of Business is to Increase Profits.

 

Ross Butler:

It’s half a century since Nobel prize winning economist, Milton Friedman wrote an AR opinion. Article entitled the social responsibility of business is to increase profits. With me to discuss this are four of the world’s former thinkers on the subject. Professor John Kay is one of Britain’s leading economists his work centers around the interplay between economics, finance, business and society. His most recent book is Radical Uncertainty written with Sir Mervyn King.

Joanne Ciulla is a professor at Rutgers’s business school of which I think Milton Friedman was an alumni, correct me if I’m mistaken. She is the director for the Institute of ethical leadership and she’s founding faculty member at the Jepson school of leadership studies at the university of Richmond, where she teaches courses on ethics, critical thinking and leadership.

Brad Cornell is professor of finance UCLA and has been involved in a number of challenging involving the application of finance theory and his research applies financial economic models of incomplete information to the problem of ethnic discrimination among other things.

Guido Palazzo is a professor of business ethics at the university of Losan in his research. He is passionate about the dark side of the force, which I like and examines an unethical unethical decision making from various angles. His studies include those on human rights violations in global supply chains.

The article represents in my mind an argument against corporate social responsibility, perhaps not in its entirety, but certainly broadly in the last 50 years, of course terminologies have changed somewhat. So CSR has been to some extent replaced by ESG, but I’d say that they’re broadly similar enough. And what I hope to do is have a first principles debate so that we can get beneath, these concepts and hopefully provide some form of bedrock for corporate executives to use in their ethical decision making.

Before I turn to the panel, I’d like to do a quick poll. Do you broadly agree with Milton Friedman’s article entitled the social responsibility of business is to increase profits? Yes. I broadly agree. No overall I am opposed or that’s what I’m here to decide and everyone’s voting. Interesting. So 17% broadly agree. 69% are overall opposed and 14% are here to decide. Great. So I’m going to start by asking each of the panelists in turn to provide some uninterrupted opening remarks on the Friedman doctrine. So, if I could ask Brad for you to kick us off, please

Brad Cornell:

Well, I think I’m probably in that 17%, but let me start with something where I do slightly disagree with professor Friedman and that is his characterization of maximizing profit. That’s not the way we in financial economics think of it anymore because profit is too ill defined profit win profit next year, profit five years from now, profit 10 years from now and so forth. The way we approach this problem is to say that in a free enterprise economy, what companies are trying to do is maximize shareholder value and shareholder value value is really the present value of the stream of all future profits. And when you think of it that way value is by definition a long-term concept. There can’t be any short-term value because all future profits enter and to maximize the value of a company executives must take account of long, the run impacts of their decisions.

Brad Cornell:

And that means that if, for example, if they treat their employees poorly this year they’re gonna lose employees and that’s gonna win the long run, destroy value. If they don’t respect their customers, privacy, they’ll lose customers and that will reduce their long run value. And if they fail to account, let’s say of environmental impacts of their decisions that may bring down regulatory limitations, and that will reduce the long run value. So when we think of the right criterion, which is maximize shareholder value, some of this distinction between pursuing ESG type goals and pursuing value maximization disappears, but it doesn’t disappear entirely. So let me take us to a, a short thought experiment, which hopefully will, will be interesting to the, the attendees and my colleagues can comment on it. Here’s the way this thought experiment works. It’s a very simple company, it’s a delivery company and the only decision it has to make, and I’m focusing on the E part of ESG.

Brad Cornell:

The only decision it has to make is whether to use gas or electric delivery vehicles. The company can compute the total cost of either one. And the question is, does the company fall the Friedman doctrine of maximizing shareholder value, or does it diverge from that in order to take account of environmental issues. And, and I’ve got three scenarios to run through here in the first scenario, they do their valuation analysis us and the electric vehicles are cheaper. Well, if the electric vehicles are cheaper, value maximization says, use the electric vehicles. And in that case, there’s no conflict with broader corporate executives that take account of let’s say CO2 emissions, because they both lead to the same conclusion. Use the electric vehicles. That’s scenario one, scenario two, there is a carbon tax that reflects the external cost of burning fossil fuels.

Brad Cornell:

Let’s say that William is the prime minister of this country. He’s figured out what the social cost, the burning fossil fuels is, and it’s reflected in the tax. But even after the tax, the gas vehicles are still cheaper. So value maximization says use the gas vehicles. Some of my students say, but ESG says use the electric vehicles. That is not correct from a purely economic point of view, from a purely economic point of view, even taking account of the social effects, it’s better to use the gas vehicles that’s because the government will collect the revenues from the carbon tax. And that can go to other benefits. And even after reflecting these external costs, it’s still better to use the gas vehicles. So once again, from an economic standpoint, there’s no dispute here. If the external cost of the fossil fuels is reflected in prices, then value maximization works.

Brad Cornell:

And, and it’s what people should follow now, where it gets confusing. And I’m sure my colleagues will wanna weigh in on this is scenario three in scenario three, the gas vehicles are cheaper, but there, there is no tax that reflects the cost of using them. There are social externalities, which are not priced. And in fact, in some countries, there may even be subsidies to using fossil fuels. So value maximization of course says, use the cheaper one, use the gas vehicles, but a broader ESG objective may say use the more expensive vehicles, even though you’re gonna damage shareholders because of the social benefits of it. And this is where I think the rubber meets the road where value maximization and a broader social criterion diverge.

Brad Cornell:

But here are the problems that arise if you’re gonna tax shareholders. And if you actually tax employees and customers as well, if you use the more expensive electric vehicles, because they’ll bear part of the cost, how much customer money should be used to subsidize these electric vehicles. Second, what training do senior managers have to make decisions regarding the cost and benefits of climate change and other externalities Associa with fossil fuels. If I’m running a social media company my godsend runs the social media company, snap. He’s incredibly busy with his job. How’s he gonna know how to take account of climate change? Three. What if different managers reach different conclusions? Some may be socialists and think the environmental impact is very important. Others may be right wing of free market people who think it shouldn’t be paid any attention at all. How do you reach a consensus ?

Brad Cornell:

Four, what right do corporate management have to make social policy that’s in effect what they’re doing when they’re taxing their shareholders to promote the electric vehicles they’ve but not been elected or appointed. So my conclusion, and this is why I’m part of the 17%, I suppose, the managers who believe that we do not have a so appropriate rules of the game that we do not properly price externalities should definitely take that view and attempt to make it part of social policy. They should vote for candidates. They think will promote the right policy. They should attempt to get taxes levied if that’s the appropriate policy, but somehow making corporations, the philosopher Kings that are going to decide public policy on their own in my view is a mistake. So ultimately I would agree with professor Friedman, the rules of the game have to be set through a fair democratic process. And then once the rules have been properly set private corporations should go back to attempting to maximize shareholder value. And that does it for me, Ross, at least my opening comments. Thank you.

Ross Butler:

Great, thanks. Thanks Brad. That’s very clear. Say from an economist and segues quite nicely to Joan more on the philosophical side of things, Joan, can I pass to you?

Joanne Ciulla:

Yes. Thank you. And, and Brad, thank you. That was a, a really nice defense of some of the points in Freedman. I’m a floser. So I’m gonna look at it in a somewhat different way. I actually took us is questioned seriously, and looked at the argument itself. I’ve been teaching this argument for many, many years, and it’s a fascinating one, and there are some really strong things in it that are important to the field of business ethics. When I started working in this area over 35 years ago it, it Friedman raises some of the most fundamental questions in business ethics. First of all, a question of what are the responsibilities of businesses what is the kind of, what kind of moral agency does a corporation have? Those were very important parts, especially in the early days of business ethics to ask.

Joanne Ciulla:

The second thing that’s interesting about this is the context of it. It’s a newspaper article by a very brilliant economist, and I think there are some faults in it because it is a much more casual writing than probably the more sophisticated work in economics. We have to ask ourselves, to what extent is this a period piece? What does the historical context have to say about this kind of argument? And that of course is the other question of, is there something about the period of time that he was writing that a stronger argument than perhaps today, but the strength, the other great strength of the piece is it forces us to consider who ought to be responsible for what as was pointed out by Brad, there’s a lot of dangers in business making social policy, not only their knowledge, but the political questions in a democracy of whether they ought to be doing it.

Joanne Ciulla:

And I would add a third, somewhat economic consideration that if, if businesses had social responsibilities, such as let’s say, running schools that could be very dangerous because what happens when the business goes out of business we want our wellbeing of society to be contingent on government because it is supposed to be something that goes on over time and businesses as we know, come and go. So I wouldn’t want to rely on business to take care of the public. Good. And I think Friedman’s exactly right about that. But the question is as we go on is Freeman’s article always seems to assume a zero sum gain that social responsibilities must always go against the interests of employers and profits. And he gives examples about, and I love by the way in, in today’s world, I cannot imagine a business thinking that they can’t raise their prices, cuz it might contribute to inflation.

Joanne Ciulla:

Obviously we think of inflation in a different way today, but it just strikes me as a strange argument. The second one he says is, you know, imagine reducing pollution more than necessary. He seems to who assume that if you do that in a business, it’s going to have all sorts of bad effects, lowering wages, increasing prices, affecting consumers, lowering profits, affecting owners, and all sorts of horrible things will Enue and his central notion is that you’re spending other people’s money. Well, it, the, it’s kind of interesting to look at that the idea of reducing pollution more than necessary because in, in business ethics, there are several sort of classic cases about businesses that did exactly that and commons engine, by the way, that’s one of the more famous old cases in business ethics. And what’s compelling about that case is the fact that Cummins did reduce pollution more than necessary.

Joanne Ciulla:

And it turned out to be a competitive advantage because they had the foresight, the strategic foresight to see that it would eventually come around that there would be regulations, which is really speaks to one of the points. I think Brad was trying to make with his examples. So there are ways in which social responsibilities are related to corporate strategy. Now the question is you know, does this, does it always make them money? And of course that I think is a tricky thing. People who have been doing research in business ethics for many years have tried to show that ethics pays and we can’t always show that. So that of course is a problem. I find it amusing that he mentions the GM crusade in this. I, I always found that a fascinating case for those of you who aren’t familiar with it.

Joanne Ciulla:

This was a crusade by Ralph Nader and Nader’s Raiders. And it was about a car that they produced called the Corver that was very unsafe on the road. And Nader went in to GM stockholders meetings and tried to make the company tried to have proxy, tried to get stockholders, to make the company decide to focus on safer and cleaner cars. GM didn’t go for this and neither did the stockholders and they spent their money on having Nader followed around by a private detective. They got sued by Nader. They lost money and of course, Nader prevailed and all sorts of legislation came into play about auto safety. So there’s a lot of ways in which Friedman argues that social responsibility is shortsighted. But when we look at actual cases, we see that that strategic social responsibility is farsighted.

Joanne Ciulla:

So what Freeman wants us to do is stay at the moral minimum and that moral minimum is, as I said, strategically unwise in many cases now here’s where I get to the part of the argument that I find the most fun as a philosopher and someone who does ethics. And that’s when we get near the end, there is this very odd notion that Friedman has. It’s a kind of moral purity where he seems to almost get himself in a tizzy over the fact that companies could have corporate social responsibility. That’s actually initiatives that are good for them. The hypocrisy of it, he tells us is, is horrible. And for some reason, if you’re going to be socially responsible, it shouldn’t be good for you. Well, that assumption really doesn’t make sense sometimes. He seems to have missed in Adam Smith that there is enlightened self-interest.

Joanne Ciulla:

And I think most companies that engage in corporate social responsibility are not moral martyrs. Who’ve decided to lose profits to do something thing good, but rather they’re people who want to do things that are good for them good for all of their stakeholders, et cetera. That’s why the theory that, that emerges in business ethics that responds to this is stakeholder theory, which is also always looked at as a theory. That’s also related to strategy. So ultimately when we get to the end of this argument, we see that there’s this assumption that is very much an individualist argument, as well as a kind of libertarian argument that if everybody took care of themselves, if a all the businesses just took care of themselves and followed the law and, and did what businesses were supposed to be, everything would be fine. The problem with this is it’s a kind of Robinson Crusoe argument it’s as if we all lived on desert islands where nothing else touched us, there was a lot of water around us.

Joanne Ciulla:

Don’t live on desert islands. We can’t take care of ourselves without the interactions with others. And that goes for individuals as well as companies last year, Tim cook from apple gave a speech where he said sometimes when governments seem to be failing at things, businesses have to take up the have to step up. He said, now that’s a very controversial notion going back to Friedman one, we have to examine carefully. But the real issue I think is, is not really whether a businesses ought to be socially responsible or at, or not. The real question is whether is then they should be and how they should be socially responsible. As we look at this time of COVID 19, we see that if businesses behave the way Friedman wanted them to behave, they would find themselves in quite a bit of trouble. They’ve got sick employees, they have people working at home.

Joanne Ciulla:

There are all sorts of things that are affecting the way their businesses run. And if they were only concerned about their stockholders and they were only concerned about the profitability of their business not in the way that Brad described value, but in the way that Friedman does. I think they’d find themselves in quite a bit of trouble. And just as the human being who work in the business would also probably not feel very good about sticking to the Freedman line. So in closing, I’d say there’s a lot of things people love about this argument. They love the fact that it’s simple. It’s a, my students, a lot of my MBA students adore this are, they say, that’s exactly what should go on in business. The rest is just messy, but so much of this is really wishful thinking about business and non-systemic thinking businesses exist in a system. So while I, I look at this, not as, I’m not an either percentage group, I, I am grateful to this article for the many things that it highlights that are important about corporate social responsibility. But I also think that in terms of the realities of business it’s a little naive and no business can really go it alone without engaging in many of the elements of corporate social responsibility. So with that I’m pleased to turn it over to an economist. Thank you

Ross Butler:

Very full provoking. Thank you very much. Joanne, if we move further west John, can I yeah. Move, move on to you.

John Kay:

Okay, indeed. Joanna’s talked about as a, were the moral critique of this kind of argument, but the elements in that of an operational critique and it’s the operational critique, which I actually want to focus on Brad set out right at the beginning. I think correctly, that if you interpret, if you make sense of read has to be about maximizing shareholder volume rather than profit in any particular time period. So how do you go about maximizing shareholder volume? Well, he gives us a very simple illustration of how you might do that with a choice between an electric and a gas vehicle. And to make that decision, all you have to do is forecast gas prices for the next, however long. The length of life of the vehicle is 20 years and electricity prices for the same 20 year period. Well, good luck with that. And then the carbon tax introduced as well.

John Kay:

And in order to impose a carbon tax, the government, or will come to the qualifications of that in the moment someone has to estimate the actual cost of putting a ton of carbon in the, in the atmosphere and good luck with that. And then you have to walk iron some wrinkles in relation to the tax, like, is it levied on carbon production, carbon consumption, and who is it levied by where? And then you have to persuade most of the governments of the world to agree to that. Well, good luck with that as well. The truth is that we can’t do this because the sums simply it cannot be done. And if we move into the, the real world and take that 20 year horizon a moment, if we go back 20 years and ask who has created the most shareholder value in the last 20 years we come up with apple, Amazon Google, three companies that have not only created most much of the shareholder value in the last 20 years, but much of the shareholder value that have ever been created in history of the world.

John Kay:

So when were they 20 years ago? Well, apple was pretty much on its knees. Amazon was five years old. Google was two years old where Steve jobs, Jeff Bezos, Sergi Brin and Larry Page sitting down with these kind of spreadsheets computing, the next present value of free cash flows for the next 20 years. I don’t think so. I think what they were doing was Steve jobs was trying to create the coolest product you could imagine which in that 20 years ago was actually, he was working on creating the iPod, Jeff, Bezo trying to build the everything store and trying to shut books out the door. And Larry Page, I think were trying to create some pretty smart algorithms. What all all of them were trying to do was to build fantastic businesses. And of course, all three of them succeeded.

John Kay:

Let’s contrast that with people who actually try to take the Friedman doctrine seriously, the example which I must often use is ICI Imperial chemical industries, which is actually Britain’s leading industrial company for most of the 20th century. And for most of that period, been a clear of what their mission and objective was. And that mission was described as responsible application of chemistry and related science to business. But in the early nineties, that company called the shareholder value back, they changed their mission statement to our job as to create, share over value by focusing on businesses, in which we had a, a competitive advantage, what they did was they hired off the pharmaceutical business, which had actually become a most interesting part of the company. And the, the company was left in more traditional chemicals. it was very successful for a period ICI share price peaked in 1997, declined steadily thereafter until in 2007, the rather pathetic rum of the company was taken over by a Dutch company X.

John Kay:

And about that was ICI story. Another British stories of Mark and Spencer, which almost everyone around the world has heard of has the iconic British retailer on the 20th century. Unfortunately they caught the shareholder involving bug two in the early 1990s and under a new chief executive called a green break. They decided they had a target of making a billion pounds of profits. So they edged up prices. They squeezed their suppliers. They started moving some of their offshore production offshore. And once again, it worked for a bit in 1998, they actually achieved their billion pound profit target. And the share the price of the shares hit six pounds a share. Then unfortunately sales fell off a cliff only in one year, since then, as the company made a billion pounds of profits and the shares, which peaked at six pounds in 1998 are now one pounds 25.

John Kay:

I can tell this story over and over again. I can take [inaudible] the company that was regarded as the paradigm of shareholder while creation for time, which was of course, gen of electric. And we now understand that the extraordinary performance of general electric was in fact largely based on our financial services business, which after 2008 was shown to be essentially Aira. And that had served to guys the weaknesses in term created by the cost reduction and lack of forward planning and investment in I GEs more traditional business. So the share price, which would zoom from $2 to $50. Well, I’ve now rooted been having a rather bad week this week. And it’s now just struggling to say about $5 a share all these people in their attempt to purportedly create shareholder value actually destroyed masses of shareholder value. And actually these are not atypical cases. I can tell this story, as I said over over again, I could tell it of Britain’s GC dis distinguished from the American general electric and Britain’s British general electric company, which was Britain’s second largest industrial company in 1990. And which went essentially the same way as ice. I could tell a story like this, about Boeing. I could tell a story about this, about Sears. I can tell it over and over again.

John Kay:

What business is about is actually about creating great businesses. And that’s what Steve jobs and Jeff be resource and SEI Bri and Larry Page actually did. They weren’t about creating shareholder value. They were about building great businesses and they did, and they created masses and masses of shareholder value along the way. And that’s what the earlier generation of business leaders that had created these businesses actually did. It’s what Harry McGowan had done at ICI. It’s what Simon marks had done at marks and Spencer. It’s what red Jones and Ralph cord before Jack had done generally left. These are people who are dedicated to building businesses. British law actually says that the duty of directors is to promote the success of the company for the benefit of the members. And that’s the way round it is. If you create a successful company shareholders, and everyone else will benefit from that, I should probably end with from Jack Welch, who famously said eight years after we retired from GE in 2009.

John Kay:

And so the chickens were coming home to roost shareholder value used said is the dumbest idea in the world. Shareholder value was a result, not a strategy. And he’s exactly right on that. And that echoes the words of other people as well. People like Sam Walton, who said I’ve concentrated on and all on building the finest retailer company that could, we possibly could period, creating a huge personal fortune has never been particularly a goal of mine. And of course, Jim Bezos adopted the same approach that Sam Walton had adopted 40 50 years earlier with the same results, including particularly in Bezos case, creating a quite extraordinary personal, or to go back a bit further. You of George me the executive of the Merck pharmaceutical business many years, he said medicine is for the people. It is not for the profits. He said the profits to follow. And if we have remembered that they have never to appear the better we have remembered it, the larger they have been, that is what, in my view is the social responsibility of business to create great businesses, to create returns for investors, serve customers while are convincing for employees and the calculations of shareholder value. It’s not within the bounds of possibility that we could imagine actually undertaking them. Thank you.

Ross Butler:

Thank you, John. And finally let’s move to if you, yeah.

Guido Palazzo:

Yes. Thanks Ross. I couldn’t agree more with you, John. We at a few more companies maximizing shoulder value that would even go one step further in, in your list, like companies like Enron, Deutsche bank or Wells Fargo. So companies who maximize profits so much that at the end, they misunderstood the limits of what is right and what is wrong. And that’s very often a consequence of maximizing profit. I would, would like to do, to make another 0.1 that we haven’t heard before and one that refers to or builds on what Joanne said about seeing Friedman in a historic context. When I was writing my PhD thesis in the, in the middle of the 1990s for, I wanted to work on, on corporate social responsibility. And I wrote this thesis with a philosopher in the philosophy department, and I started to read all around what I find in political science, sociology philosophy.

Guido Palazzo:

And I was stumbling over a lot of analysis that had been written by political scientists like David held by philosophers like [INAUDIBLE] by, sociologists like Manuel castells or Urich back who were reflecting upon the profound consequences of globalization for our society. And then I went into the CSR, the corporate social through responsibility literature. And I was surprised that even if they went a bit further than Milton Friedman, they somehow reflected one thing. He had written in this article and they took it for granted as well that companies should follow, the, the roots of the game in their respective contexts, which is the laws and some, some moral roots that are necessary for economic transactions. So they should follow the law. What the other guys in these other scientists were telling us is, well, the nation state is disappearing. It is weakening, it’s eroding.

Guido Palazzo:

We have multinational corporations suddenly, and they are escaping this container of the nation state regulatory system. And nobody in the discuss on, on CSR had taken that into consideration. So what we now had was a situation that companies could pretty much escape from regulation because they could bargain with governments as they do until today. They could say, if, if, if you ask me too high taxes, I go somewhere else. If you have two strict on pollution, I can go somewhere else. So they became stronger than governments. They could run away from regulation to the lowest regulator. That was one thing. The other element that was striking me was that Milton Friedman had written this theory in the seventies part of it in the sixties already at the climax of the fight between communism and capitalism. And of course he was super extreme, cuz any step in the other direction, would’ve been unacceptable from that kind of position.

Guido Palazzo:

But what he had in mind was a theory of economic transactions within a well regulated context because at his time capitalism existed in, in, in Japan, in the USA in parts of Europe. So it was always embedded in more or less well-functioning democracies. Now with the fall of the Berlin wall in 1989, what happened was that corporations invented global supply chain management and they’re stretched out into regions like the Congo, which is a civil war region with no government in the parts where they dig the the Quan into Bangladesh, which is a highly corrupt and weak government all into China and, and other Iran that are repress regimes, at least partly so suddenly we had capitalism in context that had nothing to do with how mid Friedman saw the world in the 1970s. And the consequence was that companies suddenly were connected if not directly involved in all kind of human right violations and atrocities for which they would go to prison in their own countries.

Guido Palazzo:

And there was no one to regulate them because there was, there is no global regulator. There is just international law for governments, but not for private actors. So we moved into a kind of regulatory vacuum which made this idea of myth and Friedman highly dysfunctional that’s 0.1 0.2. If you look into this article and you look at how he is environmental issues, pollution, it’s almost funny. It’s a bit of pollution in the river. So, and if the government wants to regulate that for everyone to create a level playing field, then they should make a law. And then the pollution disappears. Now the world in which we are moving now is a world in which the pollution that for him was local and small and controllable is a threat to our very existence as a human species, just to go through a few bits of information from, from recent month and weeks today, the world, the WWF published a study in which they showed that 20,000 species of mammals, fish and bird have lost up to 70% of, of, of, of, of their, of their animals over the last 20 years.

Guido Palazzo:

A study in, in Germany that was published in nature, says that we have lost 80% of the insects in Germany. The us army published a study last October saying we are running into a, of the us army and the us infrastructure because of global warming within the next 20 years. Another study in science published in may this year says that most trees that are currently existing on this planet will not survive the next 40 years. So this is not the world in which you out the river a bit. And then there is a democratic government and that will step in and keep you from polluting it if necessary. This is a world in which we are collapsing because we have globalized the narrative of neoliberalism. So these are two elements that connect to, to, to globalization that in my view of course we not visible to him, but that make his theory today. Totally inappropriate. That’s it.

Ross Butler:

Great. Thank you very much. I’ve got lots to come back to you all on. But I wonder if I can just put one question to you all, which is, we all agree the responsibility has to be taken, but where does that responsibility reside? My reading of the article is not that no responsibility needs to be taken, that it doesn’t reside at the corporate level. Brad, please.

Brad Cornell:

And, and that’s my reading too Ross. I agree with that climate change is an absolute preeminent issue of extreme importance, but I don’t want to turn it over to managers of thousands of corporations. This is something that has to be done at the, the governmental level and probably at the international level and trying to have businesses weigh in on it when they’re not prepared. And don’t have legal standing is just not the way to go.

Ross Butler:

Guido

Guido Palazzo:

Look at some of these globalized supply chains. Imagine you are apple. And, and one of your suppliers is is a, a mining company in the Congo. And there is slavery and child labor and civil war around the minds. Now, who is the government who interferes and who should solve these problems, there is no government. So it has to be done by other actors. And who are these other actors? Well, the most powerful actor is in that context, the, the Western, my mining company can the Western mining company say, we just follow the rules of the game. Well, they could, but is that an acceptable argument today? I don’t think so. Or if you are a company that, that, that produces chocolate and you have your plantation or your farmers somewhere at ivory coast, and there is child labor all over the place can say, let the government solve that problem. Well, the go, you know, exactly what will happen. They will do nothing. They, they don’t have the power, they don’t have the will to regulate you further because you are more powerful as a corporation that kind of context that

Ross Butler:

Isn’t there. A isn’t there a third way. So we’re not saying that governments need to do it. We’re not saying that corporations need to do it, but corporations are made up of people and people can still take ethical decisions,

Guido Palazzo:

But who are the people? If, if you are Glenco the, the mining company in the Congo, who are the people who, who should be that person who is responsible in that case, it has to be the company I see. So it’s interesting,

Ross Butler:

I suppose, you know, that you have a CEO and the CEO owes in one sense, it’s a role, but in another sense, it’s a human being and the CEO as a role perhaps just has to follow corporate policy, but the CEO as a human being can take ethical decisions and take a moral stand. And so I wonder if there is that third way. And I think, I wonder if that’s what mil Friedman’s arguing. UJohn would like want to comment and John first, then Joe,

John Kay:

I’m not sure there is, in that sense a third way. We we’re confronted with two kinds of situations. One is the situation we have in Western democracy where I don’t agree with the proposition that where governments are failing to act appropriately, it’s up to corporations and to step up to the plate. And I think particularly in the United States, but also in much of Europe, a corporate influence on politics is not too small, but too large. I would like to get business the business of lobbying and Washington. And the way it moment on the Julio is talking about the situations we face in countries, where there is no government in the sense in which we mean government in Britain or the United States or, or Germany. And in that case, I think there is no alternative for countries which want to operate in the Congo to take his example of saying either we just accept, we can’t operate at all in these jurisdictions, or we have to take in these jurisdictions, some of the responsibilities, which would be taken on by a government if if there were a government in a meaningful sense in these countries.

 

John Kay:

So we have to be somewhere in between. And I think what companies have to do when they operate internationally is see if they can operate in a way, which is a good by local standard, but consistent ethical standards, which their executives, their shareholders, their customers would almost all subscribe to. And in way we may well be in some cases and the congos and getting sample of this, that it is simply too difficult to reconcile these and you can’t great there, but that’s a real dilemma which corporate executives have to face. And I don’t think Ross, there is another group of people who are in a position to make these kind of decisions. It’s the it’s the executives of the corporation, which wishes to operate in these jurisdictions to decide whether they can do it consistently with ethical behavior or not.

Ross Butler:

Didn’t make myself clear. I meant the same thing, not a third group of people, the same group of people taking individual responsibility, not hide, not sheltering under, under a kind of an artificial non-human construct, which is the corporation. And you can see there if, if they’re acting as individuals, rather than in the role of a CEO, suddenly they’re taking personal risk, cuz it could be that they’re going against what compliance is telling them, for example. And Joanne, anyway, let me move on to, sorry.

Joanne Ciulla:

Okay. Just a couple short points. First of all, in large corporations, there are whole separate units that are engaged in CSR of specialists and people who actually know the field. So it’s not like Friedman’s day where somebody decides to do something good. Secondly, we are living in a fascinating period in America right now because the current administration has dismantled a number of environmental laws. And what I think is gonna be interesting is you can burn dirty coal. Now you can put more pollution into the air. Now you can put coal dust into water and streams. This is all allowed now. So it’s all permitted. And the question is, are companies gonna say, oh boy, now, now you, the energy companies say, let’s, let’s fire up those old coal plants because we can use them now. Well, of course they’re not going to do it.

Joanne Ciulla:

So it’s, it’s kind of interesting. And then my last point, when you look at the financial services industry, it’s fascinating to hear them talk because the thing they really hate is getting regulated. And I think most businesses don’t like being regulated by the government. And I know in financial service they often say, well, look, we’ve gotta take care of this on our own or the government’s gonna step in and regulate us. So there’s a way again, in which businesses can think about this, that requires them to do things on their own speed and their own time within industries, without waiting for the government to step in and, and some find that highly proud.

Ross Butler:

Joanne, let me stay with you for a moment. You mentioned that Milton Friedman takes a bit of a zero sum approach and that sometimes social responsibility can align with corporate responsibility, but in such an instance there’s no conflict in the sense. There’s no moral, no dilemma. And so I, as it plays out, there’s, you know, you, you are not necessarily opposed with the, the Freeman world view. And let me add something to that as well, which is that the, the vaguely I agree, humorous conclusion to the article where he takes Umbridge with, with people kind of getting cued off from doing good things. <Laugh> but isn’t there a moral problem with that in Sofar as if you’re doing something because you want to look good. I E and therefore get a good reputation and therefore sell more stuff. Isn’t isn’t that somewhat imoral because you are, you are presenting yourself as someone that’s as an entity. That’s doing good because you are good, whereas you’re doing good in order to sell stuff.

Joanne Ciulla:

Well, Ross, that’s a very sophisticated, philosophical question you’ve asked me, and you sound like a good because in one theory of ethics, you know, the only good is when you do something entirely from good intentions, but there’s a whole lot of other ways to think about ethics. And if you take that view, then companies, you know, McDonald’s has a promotion and they say, we’re gonna give $1 to every, every sale of a hamburger to this charity. Well, they’re doing it to promote their hamburgers, certainly, but they’re still giving the money to charity Ross. And if we preclude that kind of moral action, then you’re just saying, oh, don’t give the money to charity because it benefits. Mcdonald’s, where’s, where’s the logic in that in terms of how companies operate. So yeah, you may hold your nose a little and say, you know, it kind of stinks.

Joanne Ciulla:

And I agree with that, but, and everybody nowadays knows the game. They know that companies often do promotions and they give to charity and they know that it benefits them in PR in terms of customers, it’s easier to recruit bright, young people to companies that behave this way. So there’s, there’s a whole lot of reasons why you do it, but it doesn’t make it unethical. And it doesn’t undercut the fact that you’re actually helping people. So that, that, that argument pops up all the time in business ethics. And I have to say, I have to take the utilitarian approach and say, well, do people actually benefit from it? And if the answer is yes, then it’s probably okay.

Ross Butler:

The trouble with that. And I find this particularly with ESG rather than CSR that it’s ESG is full of kind of performative contradictions because of this. Yeah, because people are able to, I keep saying people, corporations are able to wallow in the reflected glory of making moralistic statements and doing moralistic acts. But without actually living it or without actually doing a proper, you know, cost benefit analysis of such overtly charitable actions. We in a complex world can very often backfire. And if this is a project that we are undertaking at colosal scale, then, then I just think that little bit more thought rather than just, you know, reputational gloss needs to come into it. John, is that your hand?

John Kay:

It is this suit here, I think, which is that I, I agree that a lot of what is called CSR or ESG is essentially performative. And the classic illustration of that for me was I told I remember giving a talk about what happened at ICI in 2006, just before ICI finally disappeared. And I got a follow up a few days letter later in the form of a letter from a vice president for corporate social responsibility at ICI. And to paraphrase the letter said, we might have screwed up the business, but we did a great job on corporate social responsibility and include included the brochure, which we’ve all seen on corporate response, social responsibility, as it was then in this corporation printed on recycled paper with pictures of happy minority and diverse groups. Some of them in wheelchairs. And I thought you are so far from getting what the real corporate social responsibility of business is, which is to produce goods and services that people want. It is to give satisfying employment to the people who work there. It is to generate returns for investment. That’s what the social responsibility of business is about. It is not to subvert democratic governments either because in order to promote corporate interests or in order to remedy what they believe to be the deficiencies of democratic it, government it’s about running good businesses. And that’s what we need to focus on. And that’s my understanding of social responsibility in business.

Joanne Ciulla:

One response to that is that part of what we are arguing. And, and your example, Ross is yes. When, when are anything else is done badly, it’s done badly, but that doesn’t mean you throw it all out. And so, yeah, you’ve gotta do it, right. It has to be all of those things. I totally agree with you, John. It has to do all of those things and it has to be done thoughtfully. Yeah, some people do it badly. Some people do it in a phony way, but that doesn’t mean you throw it all out,

Ross Butler:

Right?

Brad Cornell:

Yeah. I wanted to, to stress too the point that much of value creation in business is about relationships. Like John mentioned Amazon. Well, I have a relationship with Amazon. I buy products from them all the time. They deliver them on time. If the product is shotty, they take it back. They make useful recommendations to me. So that much of business value creation is improperly managing your relationships with people. So there really isn’t in many situations, a conflict. If Amazon refused to take back a shotty product, I wouldn’t order the next one. If faced book, doesn’t protect my privacy I’ll log off. So value creation needs to be thought of in a, in a broad context, that includes human relationships.

Ross Butler:

I just keep coming back to this idea of look who’s heads on the block. You know, we are only 10 years out of a global financial crisis. And one more way of viewing that was that it was a, a result of collective responsibility. And one way of looking at that is that collective responsibility clearly means no responsibility, cuz I’m not aware of many people that you know, were sent to prison, for example, over the global financial crisis. And so is that not a warning at least that perhaps we need to be clearer on where responsibility resides. I’m sorry to ask kind of the same question again, but Guido go.

Guido Palazzo:

Well there two answers fir first I agree partially because since years I say in the very moment where managers of multinational corporations will go to of prison because they have slaves in their supply chain, slavery will stop in their supply chain. That’s one point. So we, we have to help hold managers responsible on the other side we give corporations all kind of rights and why, or shouldn’t we give them duties as well. And in a globalized world, these duties extend over their duties in a well regulated context. If you, if you give this responsibility to people companies can escape the responsibility and you put these people inside. The companies may be in, in, in a situation where they, they have to manage contradictory things. And that is not possible. So it has we, and as society, anyway, we do this already. We assign to corporations, the responsibility to keep their supply chains clean. We do this already and companies react to the price from civil society. So what we see right now is a changing context of how we assign legitimacy to organizations. And that is something that also is not considered into the calculation of myth and Friedman, if you don’t have legitimacy, that can be very expensive. Yeah,

 

Ross Butler:

John,

John Kay:

I think it’s perfectly clear what a responsibility for financial crisis lay and that was with the senior executives of very large financial companies. And the fact that they didn’t go to jail is a demonstration of the inadequacy of corporate law for dealing with these kind of situations. Not a QUT of that. And right. I I’ll tell, give two illustrations. I remember going to one event at which the chief executive of a major bank actually said, you know, we were just the waiters at the party and the remark, which I thought it would be inappropriate to to make was you’ve got quite, you’ve got tips that were quite more larger than the waiters at the party typically get, or another event right. This was a, another senior executive or a bank saying to me, gosh, the regulator should have stopped us from doing that. And I thought what ,uresponsibility for proper conduct for social responsibility lies with, senior executives of corporations. There shouldn’t be any doubt about that. And I think we have, unfortunately in the financial sector has been the extreme of this, got into a frame of mind in which if the corporations write very large checks in settlements that somehow reckon to absorb both the corporation and the more importantly, the individuals in the corporation from further responsibility for what they’ve done, I think we need to stop that.

Ross Butler:

John, you went into some detail in your opening remarks about the detrimental effect of perhaps a fixation with profit maximization that’s had on some notably large companies. I’m not sure though that that’s entirely in conflict with Friedman insofar as you can have a goal, you have a strategy and they’re, and they’re different things and you, your strategy may be excellent customer service, but if your goal is excellent customer service, then pretty soon the business doesn’t become is no longer sustainable in the kind of in the literal sense. And in that sense, Milton Friedman’s very simple focus on profits means that well, a very unsophisticated view of it, just if you’re going head long towards profits, yes, you’ll run a business into the ground. But if you view that as a goal, and then you have a sophisticated corporate strategy to get there, then they’re not necessarily incompatible.

John Kay:

No, I think that’s right Ross, but let’s remember how the Friedman doctrine actually went. And we ought to understand that the Friedman doctrine was actually part of what was essentially a concerted campaign in the 1970s and early eighties to create a different frame of reference for thinking about corporations. It goes along with the, the famous Louis Powell memorandum in 1971, which leaks back to the remarks you made earlier about Nader and the attack on corporations. The Friedman doctrine goes into the, the notorious Jensen article in 1976, which talks about the need to align incentives of of, of corporate executives, of those of shareholders, and which provides the basis for the widespread use of stock options and the explosive growth, then shareholder remuneration and the preoccupation with share prices on the part of the, on the part of senior executives. Now I made to, in response to Brad, the point that it’s very difficult to work out whether you are creating shareholder value or not, that if you believe seriously in the efficient market hypothesis, as many economists and most economists of the time do and did do and did then you don’t have to worry about that calculation because the market is doing it for you.

 

John Kay:

The stock price at the moment is the best estimate that could be made of the long term shareholder value that you created. So taking that set of arguments together, that was the basis of seeing management attention on what, what happened to stock prices. And that was what was behind the whole series of corporate failures and disasters, which I described. So, although it’s absolutely right to say that a sophisticated interpretation of the Friedman doctrine takes you into maximizing shareholder volume and over sophisticated application of the Weedman doctrine takes you back to say, this is about getting the stock price up. And what happened in the next 20, 30 years was corporate executives did focus on getting the stock price up, which for short periods they did. I described how Welch did I describe how green did I described how I see I did. We saw that playbook being played over and over again, always with the same, in the same way you get this short term sugar rush. Cause there are things that you can do that make the business look better in the short run. And they don’t mostly, they don’t certainly they don’t always, and they don’t often work out well in the long run.

Brad Cornell:

Well, the way I would respond to John in my view, maximizing shareholder values a little bit like going to sleep. If you’re having trouble sleeping, the solution is not to lie in bed and say, I’m gonna figure out how to sleep it’s to do something else. And I think John is right. What companies need to do is think about making their business as effective as possible. Warren buffet has often said, you create a great business by watching what’s going on on the field, not keeping your eye on the scoreboard because the market may get things right. May get things wrong. You really shouldn’t pay attention. You should do what Jeff Bezos does. And I think what John agreed to is do what you have to do to make a great business. And eventually a relatively efficient market will recognize you if you’re successful in that effort,

Guido Palazzo:

I just wanted to highlight a point that I made already. I think efficiency is not the only issue for companies and, and markets are not the only criteria they have to take into consideration when they make decisions because they have to be perceived as legitimate. If they’re not perceived as legitimate, they will run into all kind of limitations of what they can do. Just look at the tobacco industry. Their legitimacy is perceived as very, very low and in return for that, they are limited in what they can do by a lot of laws that other industries do not have a lack of legitimacy makes you less efficient creates costs. And that is a purely ethical thing. It’s how you are perceived in how you do things. Is it perceived as appropriate or not? So this is something, if you don’t keep it in mind, when you make decisions you create paradoxically pro profit problems. So you have to manage efficiency, profit, but also legitimacy.

Ross Butler:

Just wanna raise one. Oh, so go, go ahead, John.

John Kay:

Well, I think Guido’s made a very important point there, which is what has happened and it’s to, to some degree directly attributable to the Friedman doctrine is to undermine the legitimacy of business in the, of the public with this paradox at the moment that Google and Facebook each have 2 billion customers. Each that’s more than anyone has imagined any business having in the history of the world. And yet I can read every day, an article flagging off Google and Facebook, but in this where we love the products, but we hate the producers. And there’s something very wrong with that. And what business ought to be saying is not the social responsibility of a business it’s to maximize its profit. It’s saying the social responsibility of business is to make the contribu, which business can make to the community, which is producing goods and services that people want. It’s providing good returns to investors it’s providing satisfying employment for the people who work there. It’s making a proper contribution through corporate taxation, to the other activities of the community. That’s what responsible business in my book is about fall, right? And businesses presented a description of itself and Friedman takes a lot of responsibility for this, a description of itself, which is both repellant and full as a description of how good business actually operates.

Ross Butler:

I could make a, an entirely opposite argument for the deterioration of trust in businesses though, which is that rather than kind of a focus on profits, you, I think you’ll find that most of these large Silicon valley tech giants are very much focused on their social responsibility, certainly in their outward pronouncements. I mean, I think Google listed when it listed its corporate motto is do no evil and these places are full of what they call social justice warriors. These days, it’s deep within their culture to take social responsibility very seriously. And yet trust in these organizations is falling and falling. And so you could take the opposite view and say that people just don’t buy it. And they, they, they just don’t see a real world link between what these companies say and what, what they do. And if you could just come back and then Joanne.

John Kay:

Yeah. And that’s not very simple. One of the most incredible things happening at the moment is I don’t know whether anyone on this zoom has followed the case of it’s a class action led by Arkansas teachers against Goldman Sachs. And the basis of the class action is that Goldman Sachs ethics statement said, and still does say our client’s interests always come first. Now, the, the, the case being brought by Arkansas teachers and others is that it’s essentially, they were misled by this statement into thinking this was a respectable company, which would be a rewarding investment for Arkansas teachers and others, the defense, which is being put up to this and don’t get me wrong. If the defense is to say that actually is to provide a list of over 30 occasions on which conflicts of interest in, within Goldman Sachs were reported adversely in the papers.

John Kay:

So defense is producing this list of things in order to argue that the revelations that Goldman Sachs did not follow its ethics statement was well known, public information. That market participants didn’t take the statement seriously. And its what is in legal terms called am mere path. And the us chamber of commerce has actually weighed in with an Amika’s Curi brief in defense of Goldman Sachs, which says all companies make statements like integrity and honesty at the heart of our business. And they says, they say this actually almost defies belief that if the case against Goldman were to succeed, companies would in future make these statements at their per well, they should make them at their per they should make them, they should make them at their per and the way of dealing with it is not to say that these things are a mere puffs.

John Kay:

Like red bull gives you wings or Heineken refreshes the parts have a beers, cannot reach, which is what they are claiming. It is to say that these statements ought to be true about the business. And people ought not to make them if they’re not true. And if they’re not true, they probably ought not to be in business very well. But that’s what I mean by saying businesses presented itself as being birth repellent and thoughts. And that’s why people do not want business near the hospitals, those schools and, and indeed their water supply and their electricity business

Ross Butler:

Inflation is a problem. Just a different kind. Joanne, did you want to make a comment?

Joanne Ciulla:

Yeah. Just, just to comment on that, there’s, there’s another way you to look at your question and, and one of the reasons why people don’t like these companies is, is not only the SI it, it’s not their social responsibility statements alone, but it’s also the me size and wealth of these companies in a time of growing inequality. So I think there’s, there are social reasons why everybody’s getting very nervous about these large companies, as well as of course, some of the political reasons, certainly in the us that these companies are, are impinging on things like our privacy and other things. But I I’m glad that John brought up the, the Goldman case, cuz that is amusing. And I think every company on wall street is probably looking at their ethics statement to see if they can move up to it. And you know, it is a lesson to learn. I worked, I did a case study Harvard case study many years ago of a company that had their ethics codes on these beautiful big wall posters. All it was a manufacturing concern and it started with our employees come first. And as soon as I finished writing the case study, they shipped 500 jobs overseas. So, you know, <laugh> the question is what, what, what is our understanding of what companies say to people?

Ross Butler:

Great. I wanna address some of the audience questions now. Some people have suggested empowering stakeholders, such as employees on the board boards of trustees, et cetera, representing broader society. Do you see this as part of the solution or is potentially problematic due to conflicts of interest among stake themselves? Does anyone wanna tackle that?

Brad Cornell:

I’ll just say one thing about it and turn it over to my, my colleagues, but it certainly causes a big agency problem. And when you say employees, who, what employees, how are they elected? Why is it employees rather than customers or suppliers or distributors in a John Kay type of outlook? How do you actually make this work and work effectively? It seems like it would be very difficult.

 

John Kay:

I basically agree with that. I don’t think the way you make business take proper account of its stakeholders is to have representatives of all the stakeholder groups on the board to say we in the, in the shop floor at X, think the following indeed most, most people outside the management of the company and don’t have the expertise to make. So the kind of decisions of out the corporate strategy of the company that are needed, what we need is professional managers with a proper sense of the responsibilities of the job. And that’s what I think certainly what I would be arguing for

Guido Palazzo:

If you look at some economies who are working very well, like the German economy, what you have, there is a, a power balance between governments, worker, representatives and corporations. So I think the idea of giving power to workers to have a say in how companies make decisions isn’t that bad, it works, it works under certain conditions. And in Germany you have a good example for that, but we probably have to go much further Pula tour. The sociologist has recently written a book on the climate crisis where he says, well, we have to give stakeholder rights to nature. Otherwise they will never have a, a say on board. So it can be the river next to my factory. It can be a mountain, it can be a species that disappears. We have to give a voice to these actors as well in our decision making, if we don’t currently

Ross Butler:

Great, okay. We are actually, I’m afraid running out of time. So does it anyone want to go first in perhaps summing up their thoughts on this topic or from this conversation?

Brad Cornell:

I’ll start cuz I started the first time, but given what I’ve heard, it’s my view. We have some major problems related to business and society. And I think climate change is probably at the top of the list, but there’s there’s many others, but I just don’t see, particularly in light of John’s comment about Goldman Sachs and the Arkansas teachers, how turning more power over to corporations and asking them to make these decisions is the right way to go. I think we need fundamentally rethinking certain government policies include those dealing with climate and we should start there.

Ross Butler:

Great. Thank you. Who wants to go next?

Joanne Ciulla:

Well, since I was second, I might as well go next. I’ll follow in. Brad’s thinking here. Well first of all, I, I learned a lot from this conversation, so I wanna thank my co-panelists here and I guess, you know, there, there’s a couple things that gel together that really have to do with how we construct certain ideas. John, you talked about great companies and what great means and Brad, you mentioned something similar. What great means is really what’s on the table. Does does great mean taking into account the obligations that businesses have to their stakeholders and, you mentioned stakeholder rights. I actually prefer to think of it in terms of duties because rights are a political kind of construction. And so while I know that it has to be a kind of a notion part of what Friedman’s talking about is what is the business’ responsibility and with stakeholders, they do have responsibilities to different stakeholders and they, the stakeholders have that standing, whether they’re on committees or not like they are in Germany.

Joanne Ciulla:

I leave that question aside, but so, so I think what, what there is a consensus on is the great company has to be one that functions well and serves the purposes of giving goods and, and services to society. But great, but it’s a loaded term. And I think it’s a socially constructed term in terms of what society expects from business and what their obligations are. We haven’t talked about social media, but the awareness that people have of what businesses do nowadays is unprecedented for good or for evil. And so I think you can’t, you can’t be a socially responsible business unless you’re in business. That’s one thing and you certainly can’t ignore social responsibilities in business today because it will eventually be a detriment. So I think that in terms of Milton Friedman, I still admire some of the questions he’s put on the table that I think are serious and that we’ve touched on here. But I don’t think many companies can afford to follow his advice in today’s world.

John Kay:

That I think has taken the German case, which is parti really interesting because article 14 of the German basic law which is effectively the constitution of the federal Republic of Germany says that property confers obligations and must be used for the public will and interest. That means as BARR, Germany is concerned, Friedman’s article fails at the first hurdle because his very first paragraph is a comprehensive denial of that. One of the problems we have is that much of this debate has been conducted. It hasn’t been true this evening. But it is if you read if you read it in both the academic and the popular literature, much of this debate is conducted as if the only country in the world was the United States of America. And it’s not

Guido Palazzo:

Maybe I finish by saying what I always say to my MBA student. And some of them are here listening to us so they will hear it again. You have to imagine this Neo liberal ideology as a narrative, very similar to the narrative of the ancient Greek when they believed in the gods on on some Hills or whatever, it’s a narrative that is for a certain moment in time in history belief by many people, but it is not more based on facts than the story of the gods in the ancient Greek mythology. It, it says that markets regulate themselves. It says that markets are creating welfare for everyone. It says that we are rational egoistic actors. It says that governments are bad. It’s all kind of beliefs that are gather into one narrative. And it’s a myth, it’s a fairytale and we need a new one. I’m not saying it’s, it’s worse than other fairy tales. It’s just one that we need to replace because it is running out of steam right now.

Ross Butler:

Great. Thank you. I wasn’t going to, but maybe I’ll allow myself a brief comment as well. Well, first of all, it’s been absolutely fascinating. And I also learned a huge amount in the last hour. Thank you so much. But I guess on that last point, I would say that, you know, we do tell ourselves stories and one story we’ve been telling ourselves for at least 2000 years, if not, if not longer, is that the, the entity that navigates the moral landscape that is, you know, the world is the individual and the individual was the hero of the Bible, and the protagonist of the ancient Greek mythologies all the way up to about 30 years ago when it became the collective or maybe a hundred years ago. And so perhaps narratives do evolve, perhaps they need to evolve, particularly since the world’s changed so much. Thank you so much everyone it’s been absolutely fascinating. I feel like we need to do a follow up and perhaps we shouldn’t wait 50 years. But it would be great to do it in person at some point as well.

 

Avi Turetsky leads Landmark Partners’ Quantitative Research team, which just co-authored a new way to measure private equity performance, called the Excess Value Method.

In this Fund Shack private equity podcast, Avi Turetsky, who leads Landmark Partners’ Quantitative Research team, discusses the groundbreaking “excess value” method, which has the potential to reshape how LPs and GPs measure and reward performance in private equity.

Avi introduces the concept of the excess value method, an innovative approach that quantifies the value a private equity manager adds compared to public markets. Private equity investments aim to outperform public markets, and excess value aligns GP compensation with the objective of justifying illiquid investments for LPs.

Traditional carried interest models have limitations, including rewarding GPs even when public markets excel and a fixed 8% preferred return threshold.

Avi illustrates how excess value calculates the value added by private equity managers beyond what public markets offer. It provides greater granularity, allowing LPs to quantify sources of return such as sector selection, market timing, and operational value creation.

Despite financial markets embracing sophisticated tools, private equity lags in adopting advanced metrics, often relying on rudimentary measures like IRR and TVPI. Excess value grants compensation flexibility, enabling LPs and GPs to structure payments according to their preferences. However, implementing excess value prompts considerations about timing, benchmarks, and NAV accuracy, enhancing transparency and alignment.

Avi predicts a significant adoption of excess value within 5-10 years, reshaping private equity compensation toward performance-based models.Excess value offers fairness, transparency, and precision, encouraging stakeholders to rethink their investment strategies.

In an evolving private equity landscape, excess value introduces a perspective that can benefit LPs, GPs, and the industry at large.

Subscribe on Apple Podcasts | Spotify 

Wol Kolade is the managing partner of Livingbridge, a mid-market private equity firm with offices in the UK, Melbourne and Boston.

 

Subscribe on Apple Podcasts | Spotify 

Mark Tluszcz is co-founder and CEO of Mangrove Capital Partners. He was the first investor in Skype and currently chairman of Wix.

In this Fund Shack private equity podcast, we explore the intersection of private equity and environmental, social, and governance (ESG) principles.

Cyril Demaria  shares his insights on how these two worlds can work together more effectively.

Today, ESG considerations are crucial for investors and companies. It’s no longer just about financial returns; social and environmental impacts matter too.

Demaria discusses the importance of ESG in the broader investment landscape. It’s about making investments that align with your values and the future you want to see. Private equity faces specific challenges in incorporating ESG principles.

One challenge is the long investment horizon; it can be challenging to predict ESG impacts over decades. Private equity investors also lack transparency compared to public markets. Demaria explains that ESG considerations can impact financial performance in both positive and negative ways.

Demaria acknowledges that ESG can act as a risk management tool. Companies that ignore ESG factors may face legal, operational, or reputational risks. Investors must factor these risks into their decisions. Demaria highlights the differences between private equity and venture capital in terms of ESG. Venture capital is often seen as more progressive, but some areas, like corporate culture, remain problematic.

The challenge lies in aligning investors’ perceptions of what’s right. Demaria raises the issue of incentives. What motivates investors to prioritize ESG? External positive impacts, like carbon savings, are hard to quantify, making it difficult to reward ESG efforts. The industry needs a system where ESG is recognized and incentivized.

Mainstream fund managers are under pressure to adopt ESG principles. However, Demaria criticizes some top-level schemes like the Principles for Responsible Investment (PRI). They often exclude ethical complexities and can be more about ticking boxes than true ESG commitment.

Demaria suggests alternative principles for ethical investing that reflect the world’s complexity and nuances. These principles would recognize ethical considerations as exceptional items and focus on explaining why certain decisions were made. The industry has become more process-oriented, diminishing the role of human judgment. Demaria advocates for reintroducing the human element into decision-making.

Human interactions, stories, and relationships often drive critical decisions. While the conversation remains open-ended, Demaria believes the private equity industry, with its intellectual power, can find innovative solutions to integrate ESG effectively and reintroduce the human factor into investment decisions.

Subscribe on Apple Podcasts | Spotify 

Mark Pinner is a world-leading China expert. We discuss risk scenarios for corporate boards in the wake of Covid-19.