Michael Lindauer is co-CIO of Allianz Capital Partners. He joined the institution in 2003 and has been an influential decision-maker with regards to backing private equity managers, and a respected and informed LP. He is based in Europe and has responsibility for ACP’s global private equity investment programme.
He talks to Ross Butler of Linear B Group about Allianz’s investment business and market-view, approach to GP selection and terms, and much more. This is a must-watch conversation for any private equity manager who wishes to understand how an experienced and thoughtful institutional investor approaches fund investment opportunities.
In this Fund Shack private equity podcast, Michael discusses various aspects of private equity, including its growth potential compared to public equity markets and the importance of maintaining good governance models. He mentions the potential for private equity to gain market share from public equity over time, given its strong governance. Michael also emphasizes the importance of evaluating managers based on their track record, portfolio, and cultural fit. He highlights the significance of understanding a manager’s decision-making process, team dynamics, and succession planning in the due diligence process.
Michael discusses the growth of private equity firms and how their operational processes have evolved with their size. He touches upon the competition in the industry, emphasizing that competition remains relative regardless of the firm’s size. Terms and fee structures in private equity funds are discussed, with Michael noting that while some changes have occurred at the margins, the basic model of 2-and-20 fees remains largely intact.
The conversation delves into the topic of holding periods in private equity investments and the challenges of extending them. Michael suggests that longer holds can be beneficial if they result in higher returns. He also touches on the evolving role of technology and healthcare in the private equity landscape, emphasizing the need for adaptability as market dynamics change.
Regarding his own organization’s ambitions, Michael discusses their growth plan, particularly in expanding their program to external clients. He notes that their ambition is to grow the second leg with external clients while maintaining a diversified client base, which includes pension funds, family offices, and insurance companies.
Michael concludes the podcast by stressing the importance of open communication between limited partners and general partners in private equity. He believes that maintaining transparency and building personal relationships is crucial to a successful partnership.
David Ewing of ECI Partners talks to Ross Butler on the Fund Shack private equity podcast…
David joined ECI Partners, one of the UK’s oldest buyout funds, in 2001 and is now co-managing partner. He started out in software and has completed several landmark deals, including the UK’s first buyout of a native digital business and the UK’s first buyout of a native SaaS business.
We talk about software investment, the UK’s competitive edge, originating deals in the mid-market, expanding internationally, and the prospect for private equity returns.
David underscores the significance of adaptability and staying current in an industry characterized by constant change. David emphasizes the core mission of private equity, which is to identify and collaborate with innovative and passionate management teams to elevate good businesses into exceptional ones. He highlights the importance of being an appealing partner to decision-makers, frequently founders, and the role of experience and humility in nurturing successful partnerships.
David sheds light on ECI Partners’ approach to private equity, characterized by its adaptability and avoidance of a one-size-fits-all model. The firm tailors its strategies to each unique situation, recognizing that businesses come with their own architectures, platforms, and legacies. He mentions that a focus on product management, particularly in the United States, plays a crucial role in the success of portfolio companies. David discusses the challenges of managing succession in businesses acquired from founders and underscores how ECI Partners often supplements the management teams to drive business growth.
The conversation also touches upon ECI Partners’ diverse portfolio, which includes companies located in commuter belt towns and industrial areas across the UK and beyond. David explains the importance of expanding the international footprint of portfolio companies to tap into niche markets with sustainable growth drivers. He cites examples of portfolio companies successfully expanding to North America, emphasizing that international expansion often requires both organic growth strategies and strategic acquisitions.
David then provides insights into the challenges and pressures faced by co-managing partners in the private equity industry. He reflects on how the industry weathered the challenges posed by COVID, highlighting the resilience and adaptability of private equity. He emphasizes that private equity has become an increasingly attractive asset class for investors and a long-term solution for business owners and managers. Contrary to the belief that more capital inflow would lead to lower returns, he points out that historical data suggests otherwise, with private equity consistently delivering strong and stable returns.
Mirja Lehmler-Brown is the founding managing director of Hayfin Capital Management‘s Private Equity Solutions investment team.
She previously worked with Hayfin founder Tim Flynn (listen to his Fund Shack podcast here) at Goldman Sachs, before moving into PE fund investment with Aberdeen Asset Management and Scottish Widows.
You’re listening to Fund Shack. I’m Ross Butler. And today I’m speaking with Mirja Brown, a managing director with Haven capital management. Mirja started out in investment banking with Goldman Sachs and then worked in asset management with Scottish widows and Aberdeen. She joined Hayfin to establish and build its private equity solutions business. We talk about setting up and growing an investment function from the ground up manager selection, direct secondaries, and investment opportunities across Europe. Welcome to fund shack. You joined Hayfin in 2018. I think that’s correct. Tell me, how did you get involved with it
Yes, and we work together at leverage finance. In fact, we’re sitting next to each other and I left, Goldman Sachs to move, up to Scotland. My husband is Scottish, but we stayed in touch over the years. And so I, heard the story evolve from him leaving and then coming up with the idea to set up, HayFin. And, you know, we exchange ideas and views and, and shared learnings up in Scotland. I started to invest in private equity with Scottish widows initially. And that experience from an LP perspective was also interesting, you know, to Tim when we started out. So when he sat up, he, had discussions with a few different private equity funds and he asked my views on who they were and what potentially could be a good partner for him early doors. So, that then turned into him growing, uh, or him and his team growing the business.
And in 2070 that institutional investor changed to British Columbia investment management corporation. And he’d grown the business from lending and other different products within the credit space and never, ever kind of, I guess, before considered the equity, opportunity. And that’s where I then spent over 10 years up in Scotland. And, so he asked me if I would want to, what would I do if I would set up a private equity mid-market business for, British Columbia? How would that look? And would I be willing to do that on his platform? So I did that and come up hopefully with a compelling strategy because British Columbia certainly thought it was a good idea. And that’s why I moved over in 2018 to start from scratch with, with no team, no processes, but a fabulous platform and brand in form of Hayfin.
So that sounds like a great opportunity, but, quite an unusual one, because you had a very large institutional background. So you sat next to Tim and you were doing presumably were doing credits at the time, is that correct?
Correct? Yes. So Goldman Sachs, but from Scottish widows. So when I started, there was only private equity, only Europe, predominantly mid-market and across the spectrum from funds investing from co-investing and also secondary investing, which is three of the larger group of investing that you can do in the private equity market as an LP investor.
Very good question. I come from the middle of nowhere, in Sweden and I’m actually the first person in my family to go to university. So arrogance and Politics are something that I can say I’m allergic to. And in a large institution, I think when you start out working you’re so focused on delivering a good job that you don’t notice political aspects. I think as you grow older, more experience wiser, you start to figure out that it’s not just about that delivering. It’s not just about the excellent, it’s lots of other things going on as well. And at that point, after 10 years in a consolidating Scottish asset management market, it’s been a number of combinations that we had gone through much larger group and, the firm had become very political and that again is something that’s really frustrating. And I also just in itself, for me, I’m driven by delivering really good investment return based on facts.
And in that, the energy really needs to go to originate, discuss ideas, pick the best investing. If you need to worry about Politics, how you need to behave or not challenge or challenge. There’s so much energy leakage out of a team or an organization. So that frustrated me and triggered to think, well, if I start from scratch and I can set the culture, I can handpick a team. I can obviously ensure that we have none of that, that we can be a group of individuals with different backgrounds that burn from the same purpose in delivering those returns very often for pensioners, but in a way that then avoid negative aspects such as Politcs.
And so you’re only what three years in that state. I mean, how’s it going from a cultural perspective? Have you been able to, introduce that kind of different culture?
Yes. It’s, it’s um, it’s going really, really well. I mean, you know, back into the entrepreneurial aspect, it can be scary too, when you haven’t done that before. And you can question yourself whether you’re able to, I mean, from sheer experience, point of view, you build so many networks, you build so much pattern recognition that, that clearly you can take with you, but, but you know, where people come and join you as an individual, is scary. But I think the fact that we talk with so passionately about the fact that it’s team-based and that everybody is equal if you will. And we start, we start with the junior people, sharing their ideas fast up into the senior, and there’s lots of frustration. Now, the private equity industry has grown up and many of these organizations have been quite large.
That means lots of mid-level and junior, uh, uh, staff. If you’d be, look, people are frustrated with the same thing I was frustrated with. And if you see the people we were looking for, work Lilly, high-ability ambitious people, but then driven by the same values and principles of team, of responsibility of doing the right thing, are working hard clearly, but fact-based. And then also this continuous improvement mindset were also the senior people want to invest in the junior, learning by doing the type of job. You don’t read some books or become a good investor, but genuinely if you have as a mid-level and junior in a person genuinely feel that the senior person sit there for you, side-by-side they roll their sleeves up and want to transfer that knowledge to you. It’s a wonderful proposition. And hence it took a little while because it was not noon, you know, from a brand perspective on the equity side, but windows discussions, clearly lots of people that didn’t fit in.
But there were a lot of people that were intrigued and were really looking for the same things. So now we’re a team of eight people and again, operating very much under those types of ideas and principles, you know, living, breathing that culture. And hence, that’s the most satisfying we are, did the strategies working and the performance coming through strongly now after three years, which again is interlinked. It helps the culture help the feeling of wanting to come to work. You know, the belonging of being there when it all works. But I think it’s driven very much by the cultural elements of it.
Yes. Around our, so our investment processes such, institutional three steps, that’s no different, but when we, um, you know, start in the team, so the first lab level, the one-pager, everybody is expected to readapt to a certain degree and we start with the most junior person. They need to share their views fast. And, everyone comes in many have banking background when they come in more of the mid-level, people when they joined, came from private equity, but none had really had that experience before. So when they joined the team meeting and were discussing ideas, they were not prepared. She was say, first time around the fact that they needed to express their views. First, second time around, they were very prepared. And why we’re doing this is it’s the same thing. As many things you can’t tell to children to avoid mistakes, they need to do it themselves in order to properly learn and invest in.
There are so many different aspects in the pattern recognition. You know what you need to think about. And we obviously have strong protocols and processes to help along the way, but it’s really your judgment. Your thinking. If you listen to other people, you don’t really learn what is important. If you need to read about the company in a situation and you come up with your views, a unit of thought it through it’s your views. Um, and very often initially they are not filtered or the weightings are not, you know, where it should be, but it doesn’t matter because, for us, it doesn’t matter. It’s the only way to learn. So we look at a lot of things. We originate a lot of things. It’s part of our model, but we do be very, very disciplined. So we do very little, but the more we look at, the more we discuss, the more we learn and the more they learn in, changing, adjusting the way your thinking to become more balanced in their view and also go away from, is this used to good company and just come to a good company. It doesn’t necessarily become a good investment if you pay too much. So it’s just learning around companies is certainly important management teams and pricing and structure and part of value creation. And, and with that, quite quickly you can see the evolution in their thinking, their alignment with the filter, and how we assess where their, a situation is a good investment or not. And that’s also great to see
Tim said to me about, diversity, but from a very broad perspective, um, which is making sure that you’re not hiring in your own mold and making sure that, everyone, not just from the gender or racial perspective, but also in terms of, uh, the way people think and their economic backgrounds and all of that. But it can be in practical terms, it can just be very easy to, to, to instruct a recruitment agency to say, we want people from Harvard and Oxford and, you know, and suddenly you’re already going down that route. To what degree do you feel you’ve achieved some level of let’s call it intellectual diversity around the table so far.
Yeah. And there are so many layers to it and we are eight people, but we are all different nationalities. And many of us have, not even two, I’m half Swedish, half German, and that’s only part, but, you know, it’s the language, it’s also the culture, the way you have been brought up, which then, the principles and values, because while do want, diversity in thinking for sure, diversity in pattern, you want a different type of pattern that recognition, but you still want the same values. You need to find a group, that, that those principals on why we are here needed to be the same, even if we are value-add from the pattern recognition in analyzing deals
Now in terms of your actual business, maybe could you set up for us, you know, your mandates, what, what you are investing in and where are your sources of funds?
Yes. So we are, continue we’re backed by our Canadian as a British Columbia investment management corporation. And the strategy is the European mid-market. One of the things when I analyzed, uh, you know, setting up in 2018, because it was different when Haven was founded, they were very early into a new growing market that, the market of direct lending, private equities, quite mature. So one of the things that we did, I feel that the, in my view, the private equity industry has created silos very often. There’s a separate, product for primary funds or a second, separate silo bucket for co-investment or a sec, you know, secondaries have a different bucket. And I felt that for us doing mid-market, we don’t want any restraints. We want to be able to originate across the board and just focus on picking the right that the best opportunity is flexible across your mid-market.
The larger funds, larger companies to a degree, you can say, I guess it’s less risk. So it’s a different style of investing and different returns, mid-market, or to generate, a premium return in comparison to the larger market. But if you look in the dig into the track record, people have all failed in doing that. And it’s been too much volatility. So when we set up, but we want to do, if we have one bucket allows us to, one year, maybe they’ll be more opportunities in, in co-investor as of late, this GP led, uh, secondary, a single secondary, which we do in Medan, several of them, but it’ll go, you know, one year or another year, it’s slightly different. If you only could do one type of investing, it’s very hard. And also very often the solutions we do, the fact that the same team can do a combination of investing that otherwise might fall in between the buckets is very powerful.
All the guys, do everything to avoid things, falling off the cracks and allow for, for more opportunities and more discipline in what we do. And that’s been really helpful. And it’s already evolving, we’re now on our second program, and it’s gone from slightly more funds than you start out, also generate some of the co-invest opportunities to now coming out of the COVID where, this GP led market on the concentrated end, which has been around for a long time, but it’s really exploding. And that suits our skillset because we have built a team of stock pickers, very well. And we don’t, again, because we haven’t got a bucket. We don’t mind, it’s an asset opportunity. We don’t mind if you call it a secondary or a co-invest in what we do. And, also we find that the relationship, uh, from the primary side because the core thing with the GP led is also understanding why, why do they want to do this? And it’s the right thing for them and the acid, which if you have followed funds for 10 plus years, and they know the individuals in these funds, you will have a much stronger view on whether it’s the right thing to do. Not just numerically, but because we focus on both. So you gain that experience from primary funds investing is very helpful across the board. But particularly I would have said in the GPLS single secondary situation
When you’re setting up a new business like this, I guess the challenge is that you don’t have any existing relationships because the best managers will have long-standing relationships, although you were in the market yourself before.
Same thing, the principle of Hayfin, working with very experienced people. So, we hired Gonsalo Aras who co-led this, the private equity solutions team with me are very experienced from different some overlapping, but predominantly, uh, different parts of Europe and different types of relationships. So we bring that eminent relationship that you have as an individual is personal, it’s partially linked to the brand. It’s got its widows where you stand for, but moreover, when you’ve gone for, for, you know, over 10 years and, and quarterly knocked on the door on people to have a coffee, the Swedish way to have a coffee, that’s how you build trust that you take with you, because in the end now, in particular, there is so much capital the capital in it says, doesn’t matter. People want to choose an individual relationship that they feel they can work well.
It needs to be a high-quality type of capital, the quality of capital matters, but its excess. And then you go down to a more personal element. Is this an individual? I feel I can trust, is this, we can have a dialogue with somebody that is constructive and helpful to us. And that’s in the end to me why people choose, to work with somebody in a fundraise or in a co-investor opportunity or in this teepee lads, they’re really attractive opportunities. GPs have a choice. And the choice very often in who they select is just part capital and a lot about who you are and what you stand for and what type of relationship that you built.
And I do think the nice thing, the additional benefit from setting up the entrepreneurial side, which originally I didn’t think of. So originally we’re more of the strategy being differentiated, the culture, being different shaded, and also the discipline. And I guess the credit focus from Hayfin to avoid the volatility in the mid-market. But the additional benefit is we are not entrepreneurs. The whole team, we call, is the founder team, every single one of my team, we are together. We are, the founders are our track record together. And we built this from scratch that also when we sit down very often, the mid-market, they’re also founders of their funds. So we can discuss the challenges of hiring people, motivating people, motivating the younger generation with certainly different to kind of the older generation systems, how that work or I see, but it becomes a different type it’s equal partner to partner. And we’ve gone through the trenches in a similar way, which also add to that, you know, the strength of that relationship.
Can I ask, what proportion are you roughly, in terms of, direct fund payments versus the more tactical approaches, co-investment and secondary and so on, and where, where would you like to be?
You know, the core initially is the flexibility and the first program. So the first investment program was more than 55% funds and, you know, 45% asset opportunity because we don’t really split whether it’s co-invest or a GP-led opportunity. Out of COVID came an additional need for asset capital. It was too much, co-invest capital, but not always co-invest capital in the professional form. And, you know, out of it came, people want to work with a professional partner, a partner from the co-invest, not just in this indication, a partner that can be fast and have their own view, their own view of the asset that underwrite the asset themselves. They, you know, through COVID there were issues in co-invest and some, LP co-investors were worried about the performance and that created some friction in the relationship, the GP and LP so that, you know, the evolution of that was that the GP was happy or to work with somebody who did their own work.
So, you know, if we pick wrong, it’s not the GP’s fault, it’s our team’s fault that this, we would never blame a GP for offering us an opportunity. It’s our own process. And we would, you know, I don’t like blaming, but we will make mistakes, but we will be in ourselves. So that I think has been very, positive. So we’ve actually seen way more co-invest opportunities than I thought beyond the fund investments that we do. And then as I indicated, this deeply led market, this is full exploding. So the new program that we’ve started, or the second program we start,
It’s a different skill set, isn’t it? Assessing single asset opportunity versus, and so you’ve got a team of eight and they’re already looking at fund investment co-investments and these tactics, and, but they’re also looking at, company’s specific opportunities.
So the co-invest, that’s why in the secondary market, it’s been a lot of this LP stake. So when an LP center sells to another LP, we don’t focus on that. That’s very different. It’s broad, diversified portfolios, it’s more cashflow pricing. So that’s not, it’s a very good market to be, but it’s not what we do, but where we have married every single one that we have hired, our focus on developing skills, in picking an asset, which is also aligned with, HayFinn is just from a credit perspective versus the equity perspective. In addition, my view has always been that if you are a good fund investor, that will help you as well to understand because when we select an asset, it’s not used to kind of do the numbers on whether that is a good investment. We very often need to understand why is that GP the best owner of that assets?
Why would they be the good part of helping the value creation in that business? And that are more aspects that you focus on from a fund investment perspective. So certainly, you know, it’s certainly super value add even if the core skill to a degree is the fact that peeling the onion on the investment on an asset investment opportunity. That’s why, if you now go and look at very often the large secondary funds, they have predominantly priced cashflows because the market on the LP stakes side was so much bigger. They need to carefully think if they now, recycle their individuals to look at this more focused opportunities on the secondary side. One very often risk-return spectrum, very different from this portfolio, diversified cash flows. And as you rightly said, the skill set needed to do that is also very different.
So kind of from a philosophical perspective, your team feels almost more aligned with the GP mentality than perhaps the traditional institutional LP mentality. Would that be fair?
I think that’s a very good observation because we work very much like a GP. We source a lot of situations and we are very disciplined around the picking, and think much more like an act in that sense, much more like a GP.
That’s a very interesting question and actually linked, uh, the mid-market and pitfalls of the mid-market. Because if you look at the larger funds, CVC, or admin, it doesn’t tend to be people-dominated anymore. They have very strong processes. They have sector teams, they’ve got lots of operators around, they still need to be mindful about culture and how they drive organizations, but it’s a different type of diligence. In the mid-market, it’s much more, person and culture-dependent. When I started in 2006, the, um, the way people did fund investing back, that was much more numerical. You went through a track record and then, you know, from that track record, you looked at the processes and the track record. And I thought, oh, this must be good people in the future as well. And then I said, but how can that be?
Because that investment will never come back. So the motivation of, and the process of choosing it and the skill set in the people align, those are the more important elements to review in order to access future performance. So in my own learning, coming from the sell side, it took some work, but I really felt that that lots of people went about it the wrong way, just focusing on numbers. So from that came a completely different type of filter, a hundred-point scoring system that, in addition to strategy and, processes and track record very much focused on the culture. Leadership, what are the motivators? Why are these people doing this. Organization? And the room in the ration linked to organization. Decision-making, functional team, dysfunctional, and those elements are much harder to assess, and to figure out, you need to look for them and you need to build that pattern recognition to see what works, what doesn’t work.
We are very focused on team-based. Very team-oriented, team-based decision-making teams, where also remuneration tends to be diversified if you will, rather than very strong founder-led businesses, because we think it is, reducing risk as one element. And the fact that back to what we said, that you haven’t got the dominating individual that shut challenge out, it could temporarily look good, but again, that’s a risk from our point of view. And very often when we go in meetings, the questioning is very much. So why are you here? What motivates you over and over again, with every person in the team to get the sense for what they’re saying, what they’re not saying, and, the general, yeah. To try to assess that culture again, because that we have found is a core KPI in assessing future performance.
You need to have local reference points, not their reference points. Very often, I say, that’s why it’s so fundamental to us to be local. Well, I’ll figure out I’ve gone to school with you. Uh, you know, in that referencing is there is a joined connection. We’ll have worked together. We will have gone to the same school, I’ll know someone that knows someone that will know your neighbor in order to that picture, that you tend to portray of you and your team, whether we feel that that’s transparent and true. So we do that first-time funds, which we do. We tend to do 50 reference calls, most of them off a list, and that you can only do if you have long-standing relationships on the ground that trust. And we’ll tell you because they know that your integrity is integral to who you are.
They will tell you how it is, and that is impossible to recreate if you’re far away and impossible to recreate in the mid-market because the regions are so different. Yes. So the portfolio is doing, doing well. Is it really well? Yes. And I think the third thing with this and discuss starting in 2018, setting it up, I thought we would have had a recession since 2016. So I was a bit afraid of 2018 as a starting point in setting up a new program. And so the third part of how we were doing it was to focus on a really resilient, resilient sector and resilient business model. And that was predominantly the timing, the 2018, and that belief in, within the investment period, there will be a correction. And from that, and LinkedIn to in Europe, you haven’t got as many sector funds as in comparison to the US but we believe in sector funds in that, again, it’s the pattern recognition.
If you spend way more time in one sector, you can reuse your learnings much faster. And with that, the portfolio with them put into the ground in the first program is 70% healthcare and technology combined. And the rest is resilient service model. So clearly we had no idea about the health crisis, but we’re preparing for a correction. So with that sector waiting not only is our performance, the operational performance of the businesses doing exceptionally well, however, from being a high priced environment, the investment that we’ve done has rerated because now everybody wants to do healthcare and technology and resilient sustainable business model. So we have been fortunate not only to have an operationally well-performing portfolio but something that is also been rerated from a relations perspective.
It’s evolved initially the, GP leads were for assets. Maybe they hadn’t gone that well and maybe needed a little bit. They still, so the GP believed in that asset, in the value creation of it, but it had taken longer. So that was a position, I mean, necessarily not a weakness, but it wasn’t a strength. And that has evolved what people now are focusing are really trophy assets, assets that are significant winners and with the pricing environment and additional competition, that are now out there, it’s really hard to find really good businesses. So if you have built a great relationship or maybe even changed and put them place a phenomenal management team in a very resilient business, but the underlying structure of a private equity fund is such that after a period of time, you need to liquidate it, you can argue. So why would I sell this to a larger fund for them to create more value?
When I got hold of this company helped build this to better business, and my LPs can continue to be the beneficiaries of this good returned. So we think creativity is positive. It’s giving GPs more optionality in a market where it’s hard to find those assets. It’s not like every asset in a fund is of that exceptional quality that we are looking for, so that you de-risk it, from buying him to the next three to five years, you know, making a new plan and, and a feeling that this is a good thing to keep that business. I guess it’s linked to, if you look at the public markets, I don’t know the exact statistics, but a significant percentage of the increased market value or the value creation is actually linked to a very small group of companies. So again, the significant winners tend to be the one that continues to drive premium value creation. And those are the ones people tend to want to want to get hold on to. And with that, it needs to be high-quality process clearly, cause there can be conflict in that decision, but it also needs to be alignment. So you can’t just do it because you want to increase a UM you need to also align yourself also with your own, the GP capital, and behave as a buyer and a seller in that situation.
So depending on size, we tend to invest 20 to 15 million in an investment, either be the fund or a situation. So we have had a number of situations from these discussions going out, speaking to the GP community where we have been in a bilateral discussion to two LPs, if you will, into a situation. Cause we don’t want to be midority. We are minority investors if you will. An LP minority investors to then the largest situations where it’s more a larger group, you know, from five to 10 different investors into that asset.
Yes, it continued to go, we say, you know, let’s see right now it’s math, it’s the fastest-growing part of the second dairy market. No question. And there are a number of opportunities. So I think this will go on certainly for the next two to three years, but there’s always something else that happened. It could be one or two of them that maybe don’t perform that well, but you can also see a lot of people are hiring. A lot of different companies are hiring to address the growth in this market. So whilst it’s certainly going to grow for the next few years, I do believe some people are certainly banking on it growing for a long period of time ahead, but we don’t need it because we have other opportunities to, to invest in as far.
In terms of how your team, your business, as it was sits within Hayfin, sits within the culture, but also the strategy and any kind of cross-fertilization of ideas and opportunities. How does that work?
You know, initially again, more experienced people, more pattern recognition, and in different fields, that can be a value add. So just the fact that we know, GPs, where also from the credit side, they might lend into businesses is intelligence people, intelligence networks are always helpful, different angles based on different experiences. And that’s been very easy. It’s very easy because it’s easy to, to me, you need to be careful about some of the walls. So it’s, you don’t share detailed information, but quality of people or whether they got experienced or not in that type of field is something from the PE side that can be helpful. We came with much more of ESG processes because it started earlier on the equity side in Europe than on the credit side. So we work very closely together. You know, the PE team has been able to do ESG profiles of when the credit side work with P houses, we are involved from an ESG perspective from a profiling point of view, rather than they do the deal clearly kind of ESD analysis themselves.
So it’s very beneficial what we’ve now started to do. And that’s even more exciting, is we can make investments together back into what we’ve said instead of staying in silos. We have now two recent deals where we work together with the special opportunities side in creating a capital solutions for AGP into an investment where there’s a peak element and an equity element. And they are not that many of our competitors that actually can stitch together tailored solutions across credit and equity for a situation which, we are about to do our second now and I just expect that to continue. So that then start to, you know, even deeper working together across the teams and then the practice based on this team-based, culture in that, we are, we are super happy if we can work together and create solutions.
So it’s an equity co-invest with a credit element attached to it, all from the same provider. And how does your decision-making process in terms of governance work and how does it align with the rest of Hayfin?
So we have our own investment committee. So, you know, the private equity investment committee contains about the senior members of our team and senior members of Hayfin and the special opportunities have a different investment committee clearly. There are some joint members and the learnings from one will apply to the other, but it’s also the focus. Again, the credit focus is different. The type of analysis is somewhat different, different from depending on what angle you come from. Yeah. And, something that was super beneficial was coming into this, COVID, working together was actually, we have a tremendous high yield and syndicated loans team, which are operating in the liquid markets. And with that, a higher degree of macro focus, that goes into their analysis. So coming into COVID, nobody, we’ve experienced the financial crisis, but not this a health crisis members, senior members from the whole firm working together, trying to figure out what is this, is it temporarily or is it something that we’re going to go into. A lot of people are going to die for a long time and it’s going to be a very different type of situation. So Gina Germano and her team had lots of phenomenon analysis that was very helpful in creating scenarios, right?
Where do we think we’re going scenario setting that was helpful for all of us. And as a group, as a house, we then come up with a scenario that we used as a base case and, every week or so we were assessing, is these the data points that are coming? Is this a valid scenario? And I think that allowed us also in 2020, where a lot of people, at least up until after the summer did not deploy that much. We were able guided by facts and scenarios and analysis working together. Our conclusion was that we can deploy. And we had a record year in 2020, across the board deploying in our different, product areas based on his intelligence and views of working together.
Did the private equity industry is a little bit slow at deploying during, during 2020, but, I mean, it’s a very difficult time because the economic situation has never looked more uncertain. I personally, I think, it still looks incredibly uncertain, and most private equity firms don’t have a chief economist. They don’t tend to even worry about the macro view in my experience so much, they take a view on people, but in a situation of radical uncertainty, perhaps they might need to take more of a view. I mean, I’d be, I’m sure it’s all trade secrets, but I’d be fascinated to know in general terms, what your outlook is with regards to the economic prospects of Europe.
And I think you’re absolutely right. I think there are all sorts of elements that go into kind of the analysis of what you do. And I do think some of the larger houses definitely apply and have asset allocators based on more the macro, the research macro judgment helping in selecting the underlying businesses. And, you know, we are with that, you know, low growth, uh, for sure in general is something that we think will be here. We had the health crisis currently the aftermath of that is energy issues, supply chain issues, and still too much liquidity into the system. So whilst, you know, over the next little while is, seems like it’s still catch-up effects in a positive sense that are trending. There are certainly clouds out there that could lead them to volatility.
So I think volatility, in general, is here to say, that’s why with the math typically trying to focus on thematic sectors, which have then growth. So megatrends that, that provide tailwinds. And that’s also LinkedIn. So initially when we said we’re focusing on healthcare and technology, it was more around the fact that we liked that pattern recognition. We liked the defensibility of it in preparation for a correction, but as we evolve and the content constantly need to reassess what we do, we’ve come to think because of the volatility and because in general, lower growth in Europe, if we focus on an aging population, if we focus on digitalization, those are longer-lasting trends that are structural, and we’ll continue to see growth, even if lot of other areas will temporarily go down in a volatility in order downwards adjusted scenario.
In terms of your, your own, section within Hayfin, what does the future hold in terms of growth? And do you have a growth strategy? Is it to just gradually increase your number of relationships or would you consider introducing, I’m not sure of the exact term for it, but the new sources of funds or even grow by acquisition of competitors.
So, I think we were all growth-minded. So in order to continue to evolve, there needs to be some growth. And with that, we’re having a number of conversations with other similar parties, similar to BCI. So we will grow somewhat by adding, a more diversified investor base, but still though, and that’s very similar, across, Hayfin we do believe in being disciplined, you need to grow. That’s a positive for any organization also for the younger generation coming through. You need to show growth, but not for the sake of it. So disciplined growth. We still believe in ensuring that the right balance in how much you wanted the blot and that’s what’s leading us to the amount of capital we’ll take on. The strategy it’s scalable, particularly on a GP led or some of the co-invest we could have, instead of doing the 20 to 50 million, we could easily have invested a hundred million in several of those situations and the same goal with the fund, but not necessarily 500 million. So ask the market evolves, we will evolve with it, but we will stay on the discipline side because the discipline is also the guiding light that will allow us to act before.
You’ve been listening to the Fund Shack podcast, make sure you subscribe and visit our website at fund-shack.com for many more video interviews. It’s the private capital channel for alternative investment professionals. Thanks for listening.
Anne Glover is CEO of Amadeus Capital Partners. This is the story of how she saw the potential in Douglas Anderson’s break through optical medical device concept to create a world leading business from scratch. Optos has since saved the sight of, perhaps, millions of people.
A lot is written about how venture capital works, but this very human story conveys so well the uncertainty and challenges, as well as the judgement and persistence that it takes, to build a truly valuable company from scratch.
Anne Glover is the CEO of Amadeus Capital Partners, and her journey with Douglas Anderson’s breakthrough optical medical device concept is a testament to the unpredictable nature of venture capital, as well as the determination and foresight required to transform an innovative idea into a global success story.
This narrative begins with Anne Glover recognizing the immense potential in Douglas Anderson’s groundbreaking optical medical device concept.
At its inception, this technology held the promise of revolutionizing eye care and, in the process, potentially saving the sight of countless individuals.
This was more than just a business opportunity; it was a chance to make a significant and lasting impact on people’s lives.
The journey was far from straightforward, filled with uncertainties and challenges that are inherent to the world of venture capital.
Anne Glover and her team at Amadeus Capital Partners embarked on a remarkable endeavor to turn this concept into a thriving business.
This endeavor demanded not only financial investment but also the strategic acumen to navigate the complex landscape of healthcare technology and innovation.
Through moments of doubt and setbacks, Anne’s judgment and persistence played a pivotal role in shaping the future of this venture.
She had the foresight to see beyond the initial hurdles and recognize the long-term potential of the optical medical device.
Her unwavering commitment to the project, coupled with her ability to rally resources and expertise, allowed the concept to evolve into a world-leading enterprise.
The resulting company, known as Optos, stands as a testament to Anne Glover’s vision and dedication.
With its groundbreaking technology, Optos has indeed saved the sight of potentially millions of people around the world.
The story of Anne Glover, Douglas Anderson, and Optos is a powerful reminder that behind every successful venture capital endeavor, there is a human story filled with determination, resilience, and the pursuit of making a positive impact on society.
It illustrates that building a truly valuable company from scratch is not just about financial gains but also about transforming lives and leaving a lasting legacy.
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.
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.
What is ESG, really? Is it good for the world? How does EU regulation change things? Is ESG an ethical construct? This is the conversation that first challenge complacent notions of ESG and set the ball rolling on a more sophisticated debate about the role and duty of corporates and investors in non-financial considerations. Recorded in May 2020. Cyril Demaria is a leading thinker on investment practices. He is currently Head of Private Markets Strategy at Julius Bär, and he lectures at top academic institutions, including EDHEC where he is an Affiliate Professor. He is author of the best-selling “Introduction to Private Equity” (Wiley, 3rd ed.) and “Asset Allocation and Private Markets” (Wiley).
Ross Butler: We’re going to talk about ESG, environmental, social and governance – insert noun – issues.
It’s very difficult to find any real critical or analytical thinking on the subject on the Internet. I’m really not sure there is any. And yet it’s huge. I think I read one article that said it counts for 30 trillion in assets. I don’t know how that compares to the private equity industry, but it’s like a multiple of that, I guess.
Cyril Demaria: Yeah, the industry is a bit creative also in counting.
I think there are shades of ESG, let’s call it like this. And so it’s very easy, as soon as you start to apply some form of filter, then to say, oh, it’s ESG. So it falls into the bucket. And then as you aggregate assets, it looks like a force you need to count with and to deal with. The reality is probably a little bit more complex than that.
And also I think that’s why the EU decided to express itself on that in terms of legislation, it’s to avoid greenwashing, because as soon as you start to put a label somewhere, then it just counts.
Ross Butler: So the EU’s proposed regulation has a definition of ESG.
Cyril Demaria: I don’t think that they agree on what it is and that’s actually looping back to your point about the fact that it’s a bit challenging to understand and to have an analytical or critical perspective on that, because nobody really has the same definition.
It’s the same with Sharia compliant products, which, by the way, share 90% of the criteria. With ESG, it depends really which colour you talk to and how you structure your product, and then it might be compliant with one scholar and not with another one saying you have to be more rigorous, and then it’s not compliant. So the EU had a very different approach. They said that if you make a claim, you have to substantiate it. And it’s not just slapping a label, you really have to demonstrate that it does indeed do something. And the idea is really to avoid the greenwashing.
And the industry complained because it’s still fairly theoretical and it’s not that easy to interpret if you’re a product provider.
Ross Butler: So I guess it begs the question, what’s the point of a label that no one can agree on what the label actually says? It’s oversimplifying something that it appears cannot be simplified in a way that allows it to remain meaningful.
Cyril Demaria: It’s an excellent point.
In the Bible they talk about the original sin, and here there might be one, in the sense that ESG has been designed as a series of private initiatives, but without any somehow coordination with the public authorities.
If you don’t agree on the basics, then it’s very difficult to act.
In that sense. You might take an action and I might take one under, let’s say, the goodwill of doing something good. But actually our two actions might cancel each other out because our perspectives are fairly different. So in the first book I published, which was back in 2003, it’s only available in French, but it’s not great literature. Anyway, it was the first attempt to have a look at what it is. And actually, for example, do you have the same approach in private equity and in ESG? Because the durations of investment are supposed to be fairly long. So I thought it would be interesting to learn what ESG means, because it started a little bit before actually modern private equity as we know it started in early seventy s, and private equity as we know it really had its boost in the 80s, essentially.
Ross Butler: It wasn’t called ESG back then, though, was it.
Cyril Demaria: Yeah, it was.
Ross Butler: Was it?
Cyril Demaria: Actually not really. It was sustainable development.
So ESG somehow is inheriting the efforts from sustainability. And sustainability was already environmental, social, but ethical, not governance. Governance replaced it ultimately. So in the book I tried to say, okay, if I can learn something from ESG, it might be helpful to understand what happens in private equity. And it turned out to be a book only on sustainable development because it was so complicated to understand and the definitions are so different.
So you have people on one hand, for example, who say, I don’t want to invest in these sectors. And then on the other hand, at the other extreme, you have people who say, all sector is good as long as I take the best performers according to certain criteria or certain scoring systems. And then later you had different approaches which came up with, for example, what they call triple bottom line. So you should be efficient financially, but you should be efficient also along other criteria. And then the three of them give you this triple bottom line approach. But all of that ultimately doesn’t answer a question what is actually ESG? How do you define a label? How do you make sure that we don’t get sold something which looks like it, which tastes like it, but isn’t the real thing, for example. And that’s a little bit the concern I have because the momentum that you’ve been referring to earlier, this 30 billion, obviously some of that comes from an appetite, a preoccupation, maybe some form of will to act. And I think this shouldn’t be criticized. I mean, if we act for the common good, then it should be encouraged. But I think there is a saying which says that hell is paved out of good intentions. Right?
My biggest worry is that we would do things with good conscience and really goodwill, but it might turn out to be counterproductive or actually a waste of resources, because that’s the whole thing. If I spend one pound in doing something, is this pound really well invested to the best capacity of the ESG purpose? And it’s never demonstrated the hidden agenda and that’s why the EU stepped in.
Is that because people want to do well? Then of course product providers jumped in and say, oh, this is the product you should invest in. But the question is, does it do what it pretends to do? If I invest in the best, let’s say, performers in a sector, but the sector overall is not doing so great in terms of ESG. I will just happen to invest with the less, worse one and it’s not necessarily what we want. So I think that’s the main concern and that’s the main dynamic, and that’s why the analytical part that you were referring to is so challenging.
Ross Butler: Do you think that there is or is supposed to be a link between ethics and ESG?
Cyril Demaria: Well, actually, yes, and I think that’s another part which is a little bit disappointing. When you look at something for quite some time, sometimes you get a little bit frustrated, sometimes you get surprised, and sometimes you get a little bit disappointed too.
Ethics was, in a way, if you think in terms of intellectual levels of compliance, then social and environmental, you can set up some sort of criteria. You can get metrics like number of employment created, suffering at work, number of days where you’re off work because of sickness. This you can measure, you can improve the same for environmental criteria, and we can discuss the validity or not. And actually, I wouldn’t go into that level of details because I’m not really a consultant specialized in that. But the ethics part, and that’s what I like in the original sustainability proposition, is that it forces you always to step back from this empirical, practical, operational steps and say, hold on, does it still make sense?
Of course, ethics is philosophical, and a lot of people in business say philosophy is great if I loved it when I was in high school, university. But now we are here to get things done and we cannot debate forever.
But the fact that ethics was replaced by governance, which is a much more actionable part in governance. I can also say how many union people sit at the board, how many employees can actually contribute, how many stakeholders can contribute to the governance of the company, including the extended perimeter, like suppliers, clients, et cetera. That’s all fine and great, but the great thing about ethics, it had this infinite feedback loop telling you, it’s like your mirror.
How do I look? Can I do something better? This was great. And this disappeared. It was an equivalent of a little bit the preamble of a constitution. I know that in the UK it’s a bit different, but on the continent we usually have constitutions, which really tells you what are the fundamental rights. But the first part is the preamble, and it’s a little bit philosophical, this ethical part, it’s like you have to look at the rest, including the laws and the regulations, all in this perspective of the initial principles which were guiding us. And the ethics were this part. And I think that was great for business, but business is not necessarily comfortable with that. That’s why they swept it away and they replaced it by governance.
Ross Butler: Yeah, you’re right to say we do things differently in the UK.
We don’t have a written constitution. And I think it’s for the same reason that your preamble is so important. It’s that when you’re dealing with something that’s very complex, it needs to be applied with judgment, not hard and fast rules. And so we’ve gone a step further and not written anything down. You have a preamble that can be interpreted in different ways. And I think allowing that flexibility when you’re dealing with very complex things. And ethical judgments are always complex because they always inhabit shades of grey. And I think the fundamental problem that I have with ESG is that it takes away that ethical dimension, because in its aim to ensure that everything can be measured, it makes everything black and white and good and bad.
And it means that fundamentally, then whatever is good for profits over the long term, let’s say, must be good. It must be ipso facto sustainable. And in that sense, I find it quite an extremist ideology. I mean, it goes way further than Milton Friedman ever did in terms of putting profits first. And yet it cloaks itself in virtue words. So I find it very challenging to analyze ESG.
Cyril Demaria: It’s a very important point, what you mentioned.
It’s not really spelled out like that very often.
It’s like having a critical perspective on ESG.
First of all, it’s like criticizing something or even just questioning something which is supposed to be good and people don’t like it. So it’s very surprising. Every time you come, it’s like, oh, yeah, but global warming is there. We have to do something about it.
Yeah. Okay.
Is ESG, for example, as we do it now, the relevant one? We are going to be judged by the future generations. That’s the original idea of sustainability and the definition of what is sustainable investment. We are going to be judged. And yes, our good intentions are one thing, but then you have actions. And the fact that we don’t criticize it is one problem. But then it loops back even further to what you were describing, which is, even though I would be able to criticize ESG, I would then start to criticize a whole system. And I think that’s the most difficult challenge now, because if you look at ESG, it’s inspired from other initiatives which are coming essentially from the US, which were about promoting minorities, which were about setting criteria to measure up a target versus the statue score. And unfortunately, it didn’t seem to work. In the US, minorities are still struggling. There are a few visible ones. There are some more efforts about the promotion of some gender minorities, for example, which actually happen to be the majority. If we talk about the female population and it’s all good and, well, you cannot be against promoting people who deserve it, but there are few things which are extremely challenging, and you cannot actually criticize it in the open, which is, is it the right way? The way we do it is quotas. A good thing is an ESG box to tick, the good way to approach, and you have a whole industry which is built on that, consultants, auditors, et cetera. People love what they can measure, but it doesn’t mean that it’s the right way to do it.
That’s paralyzing our thinking. And the thing is that it costs resources. We’re so careful about resources today, right? We say, oh, we should save this, and the money is there, but we should use for that purpose. One example is the bailout of the airlines, and it’s a little bit beyond my remit because I’m only in private markets. But now we start to have comments about, oh, should we have bailed out airline companies without setting up new targets which are more stringent?
It’s like we are running the machine reverse. First of all, what do we want to achieve then? Is the airline the best way to achieve it? And then what are the elements of implementation that you would like to think about before saying, oh, you should reduce your carbon emissions by x by this date, and then we give you the money? What if they can’t?
What if fuel that they burn cannot be burned safely, made out of something else? Or what if something else is actually not efficient? There is a big debate, for example, about the way that we’re moving from a fossil fuel to electric cars. And if you take the full account of how much does it cost in terms of resources and pollution to extract the rare earth and all of that, it might actually not be effective. And we’re just jumping into it. And the cruddle to a cruddle approach is actually to take this into account and say, well, there might be some lobbying behind. If I’m an electricity producer, I’m very happy, but suddenly everybody jumps on a scooter or buys an electric car. But the fact is that it might not be beneficial to the wider community, it might be beneficial to the western societies, but it might not be too beneficial to the less developed societies, which are extracting that and cope with the consequences which usually we are not equipped for.
If I look at open sky mines, that’s not necessarily an environmental success, is it? And we don’t really think about that, but collectively, it has a consequence.
Once again, it starts to be very theoretical, and people hate that. But it doesn’t mean that we shouldn’t think about it.
Ross Butler: Yeah, I think you’re completely right. So there are two things for me that come out of what you just said. One is the decision making authority around these, let’s call them ethical judgments, and the other is the competency around it. So in terms of the decision making authority, for me, ESG subverts the correct hierarchy that there should be in a free society. In a free society, democracy, we all vote, and we vote for politicians who create rules, whereas ESG puts corporate executives, who are, for the most part, merely agents, in the driving seat, and that allows them to make these decisions. So there’s one point which is it subverts the decision making authority. But then the other point is that these individuals, who are maybe very good at managing airlines, are not necessarily competent to make judgments about, let’s say, the environment.
Cyril Demaria: Exactly. And once again, straight. Really, that’s very important point.
There are two elements in what you say. The first one is the role of the citizen, who happens also to be a consumer. But something else. The fact that sustainability was captured basically by the private sector and somehow put in the background the public authorities means that we don’t have any control on, and the agenda is not set by us anymore. And we cannot even voice anything we could demonstrate, but it’s fuzzy and it’s short lived. And, Daniel, there is this never ending series of demonstrations, but doesn’t mean that we can voice a solution or we can set a framework. The other thing is that, and I agree with you, the fact that you are a corporate executive may be a brilliant one, doesn’t make you a very effective policymaker. And it goes very far. If we look at the airlines, and I don’t want to pick on them, I have no special judgment on it. It’s just an illustration, right? But one of the things we could have worked on is the carbon market. The carbon market has been a failure because it was badly designed. But if there was a price for the ton of carbon, which would actually reflect something, then we could start to think in a cradle to cradle approach and say, look, I’m an aligner. I need to burn high octane fuel so that I can bring someone from a to b in a safe environment, in an economical and way as well. Because plane tickets are supposed to be expensive, they might actually be more expensive in the future. And I cannot make it without emitting carbon. Okay? Which, by the way, it’s around 6% worldwide. So means that 94% come from somewhere else. But maybe I can engineer something upwards or downwards, not necessarily planting trees, which is what, by the way, you can do when you pay an extra contribution on your ticket to offset. It can be carbon capture, it can be a lot of other things. But if you don’t have a viable carbon market, which is, by the way, an efficient market mechanism, then of course you don’t price your ton of carbon correctly. And this is the part where this dynamic gets very strange, because public authorities step back so much from the debate. As far as I could see, unless you’re on the green versus non green debate, but it’s a different purely political phenomenon, then the discrepancy between the public authorities getting backwards and stepping back and the private one stepping forward and basically capturing the agenda and setting it up is actually very disturbing because you don’t get this balance of power, you don’t get this didactic approach, which is sometimes dysfunctional. You have all this lobbying, et cetera, but it’s part of a democratic process. And maybe I’m not comfortable, and to be honest, I’m not really comfortable about shifting from fossil fuel to purely electric, because I know that there are alternative to electric, which might be better, but for some reason there was a choice which was made somewhere where I did not have even a voice. Maybe it’s just one person to say, look, I’m not comfortable with this shift. Maybe I want that we go from fossil to purely hydrogen vehicles and not electric, but that’s a different strategy, that’s a different innovation, et cetera. Maybe nuclear power is not that bad if we go to the next generation, but if we don’t invest in it, then we will never know. So all these choices are very disturbing. And as you said, you can be a brilliant executive, but not a good policymaker. And the reason we know that is that sometimes some people make the jump from business to politics, and then we discover it doesn’t necessarily work.
Ross Butler: Yeah, well, I’ve always thought that the reason that the private sector is so much more efficient than the public sector is not because it has brilliant people in, and the private sector attracts brilliant people, but that they have this massive advantage, that they have a very simple organizing motive, the profit motive, and that falls away as soon as you go into the public sector. And therefore the environment is far more complex and you’re dealing with far more complex issues. So I’d agree with that. And I think effectively the scenario that you describe happens because people get frustrated that progress doesn’t happen fast. Enough on these important issues. And free countries of the world can’t seem to corral themselves and get their acts together in order to address them. And so I think, perhaps understandably, the private sector or the corporate world decides to take things into their own hands. But I think the outcome of that is actually ultimately poor because there are no shortcuts to solving complex issues. You just either kick the ball down the road or you make things worse because of these unintended consequences. And I think the ESG industry is a formalization of that shortcutting approach.
Cyril Demaria: I agree.
It’s very interesting because one of the things that people would tell you when they talk about, let’s call them ESG topics, is the very long term nature of these issues. There is these projections. If by then we have increased the number of degrees on average, by that the consequences will be this and that. What we know is that the corporate horizon is actually fairly short. So if your target is beyond, let’s say, six to twelve months, and we know that anywhere in any corporation, unless you’re in very large utilities or very, very specific industries, which think over the next 20 to 30 years, like the nuclear industry, but most of the corporations, like banks, even car manufacturers, their time horizon tend to be fairly, fairly short compared to these very long term targets. So there is a discrepancy between an executive which has a very specific target over a specific time horizon, and the very long term issue that you want to address. The fact is that there is a fair amount of executives which will change jobs. So their targets are going to be reevaluated changes by the next person. And usually whatever the previous one did is usually reviewed and then changed again. So all these constant changes make it very difficult to match this long term target. You can have a very long term plan, but if your successor doesn’t stick to it, it was just a good intention. So the public authorities have been suffering from two ills. The first one is that the complexity you refer to is very difficult to absorb by the general public because they are not necessarily as involved in the day to day activity of administration and politics. And the more complex the issue is, the more helpless they feel and the more likely they’re going to vote according to their, let’s say, guts more than their knowledge, because accumulating knowledge is very challenging and resource consuming for them. The second thing is that the long term target, even on the political side, requires a massive effort, because most of the, let’s say, members of parliament, are elected at least for five to seven years maximum in our modern democracies, I would call it like this, and then projecting for so long in the future is extremely challenging for them. So in that respect, it’s a bit like that. The government suffered from this double whammy of the lack of alignment between their time horizon is very long term targets, because you have to show voters that what you did is efficient, and then that they renew your mandate. And if it’s 25, 30 years down the line, it’s very challenging to align that. And the second part is the fact that, as I said, it’s very challenging for them to make things so complicated, understandable, so that actually the citizen can act and vote and commit. And the commitment of the citizen is crucial, actually. But what I’ve been looking at, for example, in the private market side, is that it’s even worse. At least on the public side, we try to somehow get the approval, because by construction, we get it from the citizens regularly. You have to ask them, right? And maybe their answers are flowed, that’s fine, that’s the nature of democracy, but at least they had a chance. On the private sector, we usually don’t get asked anything. I remember a long time ago, I even wrote emails to companies saying, can you do this, can you do that? And they never even replied. But it’s even worse today. It’s like you get bullied, basically, with a lot of innovation. For example, it’s like you see that it’s been designed to quarrel you.
You’re maybe a very nice sheep or a very nice cow, and for them, you’re just this. And then we want you to go in this direction, and then we will do everything to coral you there.
Ross Butler: Sorry, Cyril, are you talking about the relationship between a private market fund manager and their investee company?
Cyril Demaria: No, it’s more like, for example, the nature of innovation or the nature of business as it’s designed today.
Their perception of who you are as a client is very normative, and for that, you cannot even contribute on the ESG level.
The parallel I’m trying to make, maybe, which is not that clear, is that in a democracy, when you get as a citizen to choose, you can also align your behavior according to your principle and your standards and your voting pattern. Right? So I recycle, for example, because maybe I believe that recycling is a good thing, and maybe I vote accordingly. If I’m a private client of a corporation, the only thing which I’m offered is, do you want to buy or not? End of the story. And then there is no behavior, there is no principle.
It’s challenging. There is not even a way that you can contribute saying, for example, instead of doing this, can you do that? Instead of sending me pet bottles, can you do glass again?
Maybe I’m ready to pay the price.
It’s very challenging to see that. And ESG all. It’s a very top down approach. ESG. There is no grassroots there. Of course, you have attempts, like with these cooperatives, or back to the roots and farmers market. That’s all great, and I’m not criticizing that, but I think it lacks the scale, dimension and systematism that would be required to make a difference. On the private side, there is no feedback loop. That’s the idea of the cradle to cradle, is that if you want to have a top down approach, fine. Maybe that’s the way business is organized, as you said earlier, and maybe that’s the best way we can do so far. But then this top down approach has to have a cradle to cradle approach. It’s like a full circle. Where do I start? Where do I end? Where is the feedback loop? And then where do we start all over again? And so because of that, we are missing that. It’s very challenging.
Ross Butler: Yeah, but it’s not a top down approach. It’s a corporate top down approach, because the top down approach is the authorities.
Cyril Demaria: Correct.
Ross Butler: And then, so what you really want is to cut out the middleman. You do want the consumer activism and the customer awareness, but that’s slow, as you’ve correctly described. It’s slow and it’s imprecise and you have to stop buying goods. But then it takes ages for people to interpret, why have you stopped buying them? But it does happen eventually. Like, as you mentioned, farmers markets, like the whole organic food movement. As far as I’m concerned, that was a very bottom up. That’s what people wanted, and it came through very slowly. But you’re right, it’s kind of frustrating.
But then you’ve got politicians who are there to, and who are generally very good at interpreting what people want. That’s what they do. But it’s the people in the middle, the unelected agents of corporate shareholders, taking unilateral decisions, which seems to be the most efficient way of getting this stuff done.
That’s the danger, I think. And of course, you’re in Switzerland, where I don’t know a huge amount about swiss politics, but I understand that you have a lot of referendum on things, depending on which canton you’re in. So you know how difficult it is to get your head around complex policy questions. Presumably because you have to do it all the time, is that right?
Cyril Demaria: All the time? Maybe not, but fairly frequently. I would say on average, every two to three months, we have to formulate an opinion on some questions which we can ask ourselves or which are asked to us, which is a good way. I don’t want to idealize any system, but one of the great thing about this approach is that it helps cultivate this knowledge at the citizen level. So you’re informed and you have to think. And sometimes some of the questions are actually not that easy and straightforward.
But the great thing about it is that at least you have had the chance to talk and to think about it, and you can discuss with your friends, for example. That’s what I do. And usually the different parties also have a very clear position that is explained, so then you can start to think about it. The other thing is that it forces you, but also the whole system to think over the long term. And that’s one of the very strong benefit of this approach.
Some time ago, we voted about setting up a minimum wage, for example, in Switzerland, and it was rejected. And that was a very strange decision, if you think about it, because everybody would vote and would implicitly benefit from it. But the reason why it was rejected is because a lot of voters realized that might actually be including some rigidity in the economy, and that’s not the best way to do it. It’s a very strong decision.
It might hurt even yourself if one day you have to work in this kind of job where unfortunately, you have to fall back onto this minimal wage. And so the whole dynamic is really to say, okay, do I think responsibly, is it viable for me, but also for everybody going forward over the long term?
It has also some drawbacks. For example, decision taking might be longer.
The reason why, for example, we suspended somehow the parliament is because the government could take decisions which normally would have been debated for a very long time. So we had this state of unusual things where the government could decide without asking the parliament. And the other thing is that sometimes when you have to have a very strong stance, it gets a little bit diluted because you need to find compromise. The swiss system is based on the idea that everybody has to get on board.
So not only it introduces delays, but also it can dilute sometimes some decisions which have to be fairly bold. But the voting thing that you were referring to is a way to avoid dilution. So you can ask people, vote yes or no on this because we don’t want to go into this lensy and diluting process.
So it’s one approach and that’s why also, I would say sometimes from this perspective, you see that there is a kind of implicit bullying aspect in DSG. Someone decided for you and they decide without asking you and it creates a friction, if I can say, like this.
Ross Butler: Yeah, that’s exactly right. It may be difficult and time consuming to have to talk these topics over with your friends all the time, but if nothing else, it gives the entire country an understanding that there is no right answer to many of these problems and that they’re very complex. And so it will make people wary when people come up with facile slogans and labels. And that’s precisely what seems to be happening in one of the most sophisticated industries in the world.
Cyril Demaria: Yeah, it’s exactly true. It’s interesting what you just said because it also highlights the fact that as you go through this discussion process, there is some sort of, I mean, that’s a bit of a grandiose wording, but it’s like nation building in a way, because it forces you to discuss. Of course you can read the document on your own vote and then that’s it. But most of the time there are some issues you’re not very clear about. And then you start to talk around and then you can exchange opinions. It’s fairly diplomatic. We’re in Switzerland.
But at least sometimes I change my mind, actually, because I discussed with someone. I thought, actually, yeah, it’s not what I thought, which was the correct approach, so I voted differently for that. It creates some sort of very strong sense that collectively we took a decision. Maybe it’s not the best one. Maybe retrospectively we should have done things differently. But at that time, I remember that I took this decision and actually I discussed it with a few people, and that’s how we built our decision collectively. And so I think that’s important because there is another thing which we are experiencing today. It’s this historical revisionism.
Some of the decisions which were taken 1015, 2100 years, 200 years ago tend to be judged according to the common current standards, and then you get blamed for that. Of course, you could say people were living 200 years ago, they don’t care anymore. And maybe in a generation’s time we won’t care either because we will be out of the loop.
But it’s a bit disturbing because it forces us to take decisions which are maybe not the relevant ones, since we are so sure that our current values are the correct one, because we’re judging people harshly because of that. It doesn’t help us to be self critical or to think maybe we don’t know much or enough, and what we’re doing today, it might not be the best option. And so it doesn’t help us to progress this lack of self criticism or distance.
And that’s what I wanted to emphasize earlier. I was implicitly referring, for example, to the venture industry. Often you hear entrepreneurs coming to you and say, oh, I want to change this, and because it’s going to be better. But that’s an implicit conclusion that what you think today is the best way. But maybe what was designed over the course of decades is the result of trial and error, which were not disclosed.
And then the optimum we get today is unsatisfactory. But maybe it has its reasons to be there. And then you’re going to kick into it, destroy everything and replace by your solution. But who tells us that it’s effectively the better one? And it’s very disturbing, because now it’s very much entrenched, this idea that break things and get away with the rules and do your thing and then think about the consequences later. Well, the consequences might be that drivers are forced to drive unprotected and might be infected by the virus, for example. And it’s a bit late to think about it now. And maybe they’re going to starve if they don’t drive, which interestingly enough, is a problem coming from the less developed countries, but now is reemerging in developed countries. So it used to be at a time, if you were a taxi driver, you were employed, and then if you didn’t work, then you would be elected to be on an employment program, which is not great, but it’s better than starving. And today we’re coming back to the almost victorian time where basically it’s either you work or you die because you’re hungry.
So it’s either you take the risk to be contaminated or to be hungry. If you’re in a rig show in India, as we saw on tv, I understand that because unfortunately, we’re still in this progressive state of reaching a more developed stage. But as modern societies, I’m not sure that it’s something we should accept. I’m not sure that it’s ESG compliant, for example.
Ross Butler: Yeah, we don’t always move forward when we introduce innovations in English. There’s a phrase called Chesterton’s gates. It’s after GK Chesterton. It’s the idea that if you come across a gate and you don’t know what it’s for, don’t automatically remove it. Just because you don’t know what it’s for, it doesn’t mean it doesn’t have a purpose. And I don’t know if you’re also familiar with Herbert Simon’s idea of satisfying, which is that for certain problems of sufficient complexity, there is no optimal solution. And therefore, a solution that is good enough may well be the best possible solution there is, and attempts to impose efficiency on that system and find efficiencies can backfire. So your example of the taxi driver being a perfect one, you may not realize why the system seems a bit inefficient, but there may well be good reasons for it that have been time proven.
Cyril Demaria: Yeah, just to complement that. Because usually when I take this example, people get very emotional. And I’m not here to defend any lobby or industry. The point I’m just trying to make is that if you think in terms of system, even though having lived in Paris, I know exactly what does it mean to be waiting forever. A taxi which doesn’t arrive, or lack of taxis, or the fact that they’re extremely rude, et cetera. So I understand, let’s say, the very visceral reaction, because somehow, sometimes I got the same. But if you think in terms of system, then you realize that actually, that’s one of the few jobs that you can do if you’re not, let’s say, particularly intellectual, where you can have a decent living, et cetera. So it has consequences. I’m not saying we should encourage this very locked system with very strong rigidities, et cetera. But instead of destroying it altogether, maybe the first step would have been to see, is there a way to improve it incrementally. And that’s actually a very interesting thing, because what you referred to earlier is a very european way of thinking. In a way, we’re very self loathing, saying, oh, we don’t get these disruptions right? We don’t get the next Google and all of that. Okay, maybe. But who said that incremental innovation is a bad thing? If it creates resilience, for example, in a society, if it creates some sort of these positive externalities that we’re all after with ESG, what if we produce them as a society already because they are so difficult to measure? I understand that it’s frustrating. But instead of expansively generating them through an ESG process, maybe we generate some which are worth preserving just by tinkering with the system instead of destroying it. When you have this creative destruction that Schumpeter was writing about, which is a very interesting concept, et cetera. It doesn’t necessarily mean that you have to wipe off everything and then rebuild. Right. It’s more like you have a creative destruction when you go during a marathon in your muscles. They’re self destroying and rebuilding a bit, but they don’t wipe out your legs and then replace them with bionic ones. Right. You’re just improving over time. Right. I think the image is not necessarily that far with our strengths as Europeans, but of course it’s less visible. You don’t dream about someone who improved a way to make a windshield on a car. You dream about Google or whatever. Yes, okay. But there is still innovation, and the way it’s done might be more absorbable. I think ESG also highlighted the fact that there is a discrepancy between the speed on the economic system and maybe somehow within there with technical progress kind of acceleration. Even though it might be overstated, there is some form and the fact that society has its own way to evolve. At the end of the day, we’re humans. We didn’t change radically physically, but also intellectually. There is accumulated knowledge, but it still takes time for the social practices to absorb some of the innovation and to absorb some of the progress from the economy. And this discrepancy between these two areas, I think, is underestimated. And the fact that here you want to have ESG and here you don’t make so much faster progress means that you take the risk that what is done here doesn’t get absorbed properly there, or correctly, or it might even, as I said, cancel each other out.
This, for example, is something we should think about collectively. It’s very difficult to put on a table and say, let’s invite experts and think about the decent equation between technical progress and social progress.
It’s not that easy. I understand that, but the fact that we don’t even discuss it is actually a problem.
Or if it’s discussed, it might be in the confines of very academic circles and it doesn’t seem to get out anymore, or we don’t get fed with it. I’m just a normal, average observer of the market, but I don’t get this inflow anymore, or if I ever got it, or there is no transmission. And it’s very, very surprising.
Society produces things in terms of norms, values and evolution. But how does it overflow on the corporate world? At the moment, ESG is about overflowing in society the other way around. This is less visible unless you have these grassroots phenomenons that you were referring to, which show that there is a will.
But sometimes there is also, of course, a strong political sense into it. And I think that’s where corporations are uneasy. They don’t want to choose side or go green, go left, go right, et cetera. And that’s probably where they’re a little bit wary about adopting this kind of social innovations because they don’t know how politically marketed they will be or how they will be perceived. This I understand, but there still should be a dialogue.
It shouldn’t happen in the World economic forum only. It should be a little bit different.
Ross Butler: Yeah, that’s so interesting. I think on the creative destruction point, I think it’s very polarized.
I think on the one hand you’ve got, as you kind of described, the Silicon Valley style all in approach, and on the other you have kind of the leftist socialist parties that want to protect the status quo at all costs.
And these two are kind of ideologies and you very rarely allow them to meet through. And it’s a complex issue and it’s hard to say who’s right. So you need to discuss it. And it’s context specific.
Cyril Demaria: Exactly.
I think you put your finger in a much more synthetic way than me on something which is also something I observe. I’ve been 20 years now in the venture sector as an investor, as an observer, as a writer. I still do venture investments. And what I observed is two things. The first one is that the industry shifted massively from a function of control on an investment to something that they call entrepreneur friendly.
It’s a little bit like parenting, right? It used to be that parenting was about discipline rules, and now it’s like, oh, we should move them this direction because otherwise their psychological development is going to be hampered. We shouldn’t set limits, et cetera. Maybe that’s a good thing. Maybe that’s not a good thing. So there is a bit of that in the industry. And the other one is… It’s like you cannot criticize the venture industry, but first and foremost the innovation in the venture industry and the fact that they’re financing the startups, because otherwise you’re against progress, you’re against everything which is going to get better. Basically, you’re someone who is not able to grasp that. And questioning it is being part out of the club. And we saw the extreme to which it went. Some of the worst outcome in terms of governance. Since we were discussing that and it’s been replacing ethics have been appearing in the full light. It’s Terranos, it’s Uber, it’s wework.
Let’s be honest, these are disasters.
The governance issues there, I mean, Therranos, it’s even worse. We put the help of people in danger because of this messianism.
This mean you could even say that they took a playbook from the communist dictatorships. And then they applied with this cult of the leader, and it’s extremely detrimental. And ventures should be in the governance business. Private equity is supposed to be the governance superstar. That’s how they outperform. That’s why they managed to do all of that. But in these three cases, it’s actually terrifyingly worrying to see how bad the investors have been and how unprepared, how weak.
Ultimately, there were reports which were extremely worrying of the corporate culture in what is now a listed company. And I don’t see that they have changed dramatically.
It’s extremely worrying. And the venture industry should be one of the best. I mean, when you have to control 20 people, that’s the moment where you build a corporate culture. That’s where you set in stone some principles. That’s where the good recruitments are done for the long term. And we don’t seem to see that in some of what are the largest corporations which have been built by the industry recently. But it goes very far. You still have a dual shareholdership in some of these companies which have been listed. And so it shows that this cult of leadership still exists even after they have been public. So it’s not that the venture industry itself is a little bit, let’s say, is less efficient at what it used to be. It’s that the lack of initial power remains, and this very strong leadership remains in place for the very, very long term. And I think that’s highly producible. Prejudicial.
Ross Butler: Prejudicial, yeah. That’s a difficult one.
Yeah, that’s interesting. It sounds to me like it’s a moral failing, actually, because my sense is that the private equity venture capital governance model is a robust one and can work very well. And from what you describe, it sounds like a moral failing to put in the correct cultural correct culture leads to a diluting of the governance mechanism, whereby you end up with governance mechanisms that aren’t robust. And I think that is really telling when it comes to ESG, because it means that governance is actually a second order issue, not a first order issue.
It’s ethics come first, and a sense of what’s right and what’s right is context specific. And so it’s not a first principles analysis, a first principles analysis is the one that you just gave, which is, what are we actually trying to achieve here, and how do we achieve it?
Cyril Demaria: Yeah, it’s a multidimensional question that you just asked now, and I think that’s probably the most central one in the industry.
What we know is that we have very powerful governance instruments in buyout in venture. All these instruments are very well known.
They are very powerful. It’s like having drones. Right. You can do a lot of things with drones today. It’s very impressive. You can deliver to people, but you can also shoot them from 100 km with very high precision. Right. So we have these instruments which are extremely powerful.
And then the question is, what do you want to achieve with it?
Are you sure that you have all the context and the background to use it to the best possible action? Right. And what I observe, for example, is that the due diligence time in venture has been compressed dramatically. When I started to work 20 years ago, I had six to nine to twelve months to do a due diligence. Today I have at best three months, but often it’s a question of weeks. So I have to use these very powerful governance instruments as an investor. But my information background is actually very weak. And so it tells us two things. The first thing is that if I have to think about ESG within this compressed time, it’s going to be very challenging, almost an afterthought thought. Sorry.
The second thing is that because of the lack of information, I cannot check everything and adjust the instruments to the best use possible.
Let’s be more concrete, because now I sense that I’ve been a bit too theoretical.
If I get six to nine months to speak with an entrepreneur, but also the key collaborators in a company, I will get a sense of what’s going on there, how do they work, what are the behaviors?
Maybe then I will set my governance framework saying, look, they might need some help here. Maybe I will ultimately have to change that person, because I don’t feel that he or she is able to step up to this kind of issue. Or maybe we should have an initiative which is going to control for a specific need from the management that I will have identified. If I’m in a three months compressed time, I will just check. Do they have this? Yes. Do they have this? No. Then, okay, they don’t have it. I will just put this standard close, because I know that this is how it works, and that’s a very bad way to control your risk, but also bad way to impulse positive change. And so the ESG would require, actually extra information, which we know is very expensive to produce. But it will also probably have this needed alignment of interest between the investors. My perception of ESG as a VC investor might not be the same than the next one. And then the question is, how do you add this extra level of governance on top of something which is already complicated to negotiate? The instruments are powerful, but they are complicated to negotiate. And to set an equilibrium between everybody around the table is complicated. The other thing that we have to remember is that ESG might be a concern from investors, but less from the founders. I mean, there is this philosophy of getting rich quick and making it and all of that, faking it, until you make it, as they say, often. And then you wonder, where does ESG sit there? I mean, what’s the sense of faking ESG?
It’s a bit weird to set this in the context.
Having said that, I don’t want to sound too negative. There is, of course, other investments where they do that. There was this B corporation framework, where your social targets, for example, or environmental targets would be part of the bylaws of your corporation. And then you have to live up to these expectations. There were examples like Zappos, which this very innovative holocratic management. I don’t know if it works out or not. So there are some attempts. I’m not saying that everybody is bad, and we should always criticize the industry, but what I’m trying to highlight is that we can be creative, but we have also to learn from what works well and what doesn’t. And for that, we need a more systematic approach, probably a more generalized best practice approach.
The most challenging part, that’s why the venture corner is so interesting, is that since the corporations are so small, since the resources are so limited, and since the entrepreneurs tend to be new, there are very few repeat entrepreneurs. By the way, when I started 20 years ago, the figure of the repeat entrepreneur would be around now. It became that I’m a good entrepreneur, I make it, I become an angel or a venture investor. So this idea that you get repeat entrepreneurs is a little bit now in the background, it’s less relevant. So it means that we deal with a lot of newcomers all the time. But since we have this compressed time, we cannot get them up to speed. You would be surprised to see how many entrepreneurs don’t have a proper business plan. The best you can get is a vague PowerPoint presentation.
So it’s also reflective of the lack of background, I would say, the lack of diffusion of the best practices.
That’s not reassuring. When you want to implement an ESG environment.
Ross Butler: You say a more systematic approach to ESG. My sense is that you’re really talking about governance.
So I once worked with a growth capital investor and it was focused on sustainable technologies. And my sense was that both the manager and their investee companies were very frustrated with the highly systematic approach that institutional investors take to ESG because they were all scoring averagely to pretty low when they thought that they should be. In terms of the big aspirations of ESG, they should have been right at the top. And the reason, of course was that they were small and they were investing in innovation, I. E things that don’t exist yet. And the ESG model is all about tracking and measuring and recording, and you can’t track and measure something that doesn’t exist, that is theoretical, that might not ever work.
And they’re looking at your carbon footprint when there’s actually just four guys in an office, and to boot they’re all kind of white males, it all looks terrible. And yet what they’re trying to do is save the planet. And so you can have a systematic approach that’s just completely inappropriate.
Cyril Demaria: I agree. And it’s because in many respects just become a risk management tool.
It’s a reputational concern. Did we show that? We did something in the topic? What are the box to tick and the boxes to tick? And as you said, then it becomes a very strange exercise where you have to contort yourself to fit in a kind of mold, and the mold is predefined, it is not very flexible. And so in that respect, it’s a very strange exercise. And I agree with you. I usually take this example.
If tomorrow I have a health problem and someone has to open me, will I care if he or she is a man or woman, or will I care where they come? In terms of background, what I want is the best surgeon possible because I have a problem and I want to make sure that they can fix it. The rest is just secondary. Now, if we have to think in terms of ESG here, it’s not about making sure that you have quotas or et cetera. It’s about the fact that the surgeon will operate in the best context possible with the best ambition possible. So what would it be? It’s a very interesting case, actually. What would be an ESG application?
A real one now, not just box ticking to a surgery.
That would be probably a kind of acid test, right? Because now we say that, yeah, the background doesn’t matter. It’s all about technicity, education, up to speed and able to solve the problem. But there might be some dimensions in terms of how do you operate, how do you deal with, let’s say, the aftermath, and how do you minimize, for example, the consequences? What kind of arbitrage do you do as a surgeon between maybe go for a certain procedure which might have long term consequences, versus another one which might have different long term consequences? Of course, they think medically, and I think that’s the priority. And the image with the corporation is the same. Corporation still has to make money, but the surgeon can also think about the long term consequences for the social life, the environmental part of the patient. So his family life and all of that. This can also somehow feed in the medical decision. Today, we tend to think about the patient with a very specific context, with a very medical perspective. If we extend it, and that’s the value of ESG, saying, maybe the procedure will be changed because this person lives alone, and on the long term, he or she cannot really make it without additional support, then the medical decision will be adjusted. It won’t be a better or worse, it will be a different one. And I think that’s where the acid test of ESG comes in.
It’s not necessarily that ESG is going to make things better, but the fact that we find you used the term optimum with this philosophical reference earlier, and I think that’s the relevant one, actually, because all these ideas of reducing growth or growth zero, et cetera, doesn’t make sense. So we know that companies and societies have to grow in terms of GDP and create more, but then the optimum might be different, and ESG is here to contribute to that. And I think that’s where the externalities and all the rest feed in, even though we don’t know how to measure it, as you said, and your example is perfectly relevant.
Ross Butler: Great. Let’s try and round this up a little bit.
So there’s this whole ESG industry, obviously, which is proactively investing in ESG type stuff, but there’s also some pressure on all mainstream fund managers to sign up to ESG principles. There’s the PRI, the principles for responsible investment, which is a whole other thing, which we haven’t had a chance to discuss.
But their approach to ESG is very much the one that I personally think doesn’t make a whole lot of sense because it doesn’t allow for these ethical conundrums to be fully assessed, or at least it just excludes them from their view of the world. And what’s your view of how mainstream let’s call them generic fund managers should approach, I don’t want to say ESG, but more ethical conundrums in the round. How should they be communicating about them? Should they be adopting these top level schemes?
What do you think would be best practice?
It’s a really tricky one.
Cyril Demaria: I’m sorry. It’s very challenging.
I think the UNPRI are somehow, as you said, it’s a bit toothless.
You can sign it. It involves a bit of reporting, a bit of extra work, and then you do it. Does it hurt? Probably. It costs money. So it creates barriers to entry, to the small managers. And if I had to start today, a fund manager from scratch, and I have to add that up to all the rest, of course, extra work, and that might actually limit my capacity to launch.
So it indeed creates some sort of, I would call it barrier to entry, or at least to limitations. So every time we add a layer of regulation, we know that it entrenches interest and creates some barriers to entry.
What kind of output does it create?
It’s difficult to estimate, I think, and for that, it’s a first step. But I wouldn’t say that it’s a magical or massive progress. The second part of your question is much more challenging.
And actually, when I published the book in 2003, that was one of the first questions people asked me. It’s like, you’re very good at criticizing, being French originally, and also swiss, but what do you recommend? French are always criticizing, but when they’re very short, they’re very good at criticizing, but very short in solutions sometimes.
And I must say that actually, it’s a very difficult solution. It’s not that I have a magical wand that I could wave and say, oh, this is the answer to all our problems.
The thing which you highlighted, which I think makes a lot of sense, I usually run a business case, I happen to do a lot of trainings.
I usually try to play a little bit on the ESG dimension.
And the business case is about a mid market buyout structure in the UK that we have to analyze as fund investors.
And the team is composed of fairly know, or middle aged, let’s call them like this, white gentlemen. And of course, one of the ESG dimension is, well, where are the women, where are the minorities and all of. And what I usually want people to experience is the difficulty of doing it from the investor side and from the fund manager side, because this is the status quo and there is no magical way of changing that. Are we satisfied with the status quo? Probably not. But what are the solutions. And this is where I think you can start to experience not only the challenge but the nitty gritty part of it. Because if you start to promote too fast some individuals, it creates some rent, which we know in economy is not necessarily good. It creates some disincentives as well, because maybe some people got promoted for reasons which are beyond their intrinsic quality. That’s the surgeon issue I was referring to earlier.
And then there is also a question of readability. It’s like, is it going to be the trophy executive that we always put forward just to say that we comply with certain set of predefined rules which we don’t necessarily agree with, but we have to because otherwise we cannot work anymore.
Unfortunately, the industry has been institutionalizing a lot. When I started 20 years ago, you could discuss with people and say, look, I just didn’t happen to find anyone to fit in this position. The best professional I have is here. And so if you find someone else, tell me. We’ll look at it. Definitely. But that’s the best we can do today. This kind of reasoning doesn’t fit in boxes.
You fill these questionnaires which are kilometers long, have you been arrested? Blah, blah, blah. And then there is next section, ESG. Do you employ x percent of this? There is no space for commenting here. There is no space for thinking and reasoning. And the worst part is that if someone decides to invest in your fund and you didn’t tick the box, he or she will be on the hook. And then they could always explain that at that time it made a lot of sense. As I said, there is this constant revisionism which says that, no, it wasn’t correct. You should never have done that at that time. The fact is that at that time it made sense and there was no alternative.
Ross Butler: So for this reason, my view of ESG and the PRI is that it’s not just doesn’t work, it’s actually amoral or potentially immoral because you are forcing people to make decisions that they actually think might not be the right ones in order to comply with what looks good.
Cyril Demaria: Yes, and the worst part will be if one day there is a major revision of these principles. Fortunately, they’re drafted in a way that it’s not going to happen, but where a major part of the puzzle will have to move and will be replaced by a new one. And then we will reset the whole filter, and then some of the decisions will appear as completely misconstrued or completely wrong. That’s actually one of my biggest worry, because since it’s a very pragmatic, operational, process driven approach. And there is no ethical part anymore. There is no principle, there is no value part anymore, which is explicitly something you can rely on even though they’re in the background. There is still this process which is the prime aspect. Then it means that you’re right. If one day we change our perspective, then it’s going to be very challenging to handle the past decisions.
Ross Butler: Yeah, I think it’s very unfair on those managers that choose not to adopt this stuff because of their ethical position and then get punished for it.
We should come up with an alternative principles that reflect the complexity and nuance in the world that allow them to carry a badge.
Cyril Demaria: I agree with you. Normally the industry should be well positioned to do that because we know that we are not living in a quant world in the private market sector, so we should be well equipped to do that. The fact is that the freedom, or let’s say the room for interpretation, the margins have been reduced dramatically. It’s more of a processing approach now. And that’s related to the institutionalization of the industry.
It had some drawback when it was a cottage industry, forged on relationships because we heard about strange stories or there were even some scandals. There is always, in any case, in any system, a part which is dysfunctional. Does it mean that it was worse than what it is now? I’m not completely sure.
The fact is that besides the institutionalization, most of the important stuff happens outside. It happens when you meet people, when you discuss, you hear about this story and that story, and then it forces your opinion. Besides, what is said is in the private placement memorandum or in the very polished communication that you received, you know that this manager shift or this one is planning to retire, and that’s going to change the dynamics. And that’s not something you can extract from a very process oriented fund selection approach.
The invisible part is actually what matters.
Unfortunately, that’s something which tends to be more constrained today.
So if I had to take you up, and I think we agree on what would be the idea, it would have been to reintroduce this part. But reintroducing the human in a process oriented approach is actually against the grain of history. Right? We always want engine software and all these very reassuring aspects. And when you say, I want to put back the Humans. Whoa, whoa, whoa. No. We’ve been trying to eliminate that, to make scientific decisions, as we call them.
And humans are supposed to be not scientific, apparently.
But I would agree with you. That would be the logical way.
Maybe we will find a way. I mean, we have to be optimistic. Maybe ultimately, as humans, we can also define new systems where we would be able to discuss and document that and say, look, we took a stance, maybe the history will judge us harshly, but these are the reasons, and then we stick by it. But for that, you need rewards.
There is one thing about ESG.
What is my reward?
I mean, collectively, we might be better off or not, but what does it bring to me to stick my neck out and to take a risk and to say, look, that’s what we should do, because it’s the correct way.
You cannot be evaluated on external, sorry, positive externalities.
If you save 10 million carbon tons of carbon, are you going to be paid in saved carbon tons? I mean, how does it work?
Ross Butler: Well, I think this is the whole point. It sits above rewards.
These are not financial considerations, and therefore they must be treated as exceptional items and they should be treated not as PR and things to brag about, but things to account for yourself and explain why you took this decision against your primary goal.
Cyril Demaria: And now I think actually that’s where the industry could work, because this industry is built on governance and incentives. And so if you say this is above financial incentives, which I tend to fully agree with you, it means that we need to define a system where the approach is slightly different. And that’s where the industry is probably with the brains and the power that they have. They are probably some of the smartest people in the financial industry work in our segment of the industry. So if they sit down, they would probably come up with something which makes a lot of sense because it’s not anymore about carried interest or management fees, it’s about something else. But we could think about a system there and where people can stick their neck, and then there is an incentive to do that still and not just playing politics or playing it safe and to take some risk, because this industry is built on taking risks, ultimately. So that would be great.
Ross Butler: Actually, when we follow up offline, if anyone listening to this is interested, they can get in touch with us.
Cyril Demaria: Of course. Yeah, it has to start somewhere. I’m not sure I’m well equipped to lead this kind of discussions, but probably you are, because you seem to have given a lot of thought. But I would say that the industry counts probably some of the brightest elements, and so if they take the time and a little bit of the effort, they might come up with very interesting solutions.
Great.
Ross Butler: Well, this sounds like the start of the conversation rather than the end, but Cyril, thanks so much for your thoughts. It’s been really fascinating.
Professor John Kay on his new book co-authored with Mervyn King, Radical Uncertainty.
In this Fund Shack private equity podcast hosted by Ross Butler, we explore the intricate realm of decision-making in the face of radical uncertainty.
Our guest, Professor John Kay, co-author of the book “Radical Uncertainty” with Mervyn King, provides valuable insights into this challenging subject.
Radical uncertainty is the concept that in certain situations, there is no clear answer or predictable outcome to decisions. Conventional problem-solving techniques prove inadequate in such circumstances.
Professor Kay notes that problem reasoning, while useful for games like cards, falls short when it comes to grasping complex issues. During the 17th century, there emerged attempts to extend these ideas to diverse domains. The initial extension of radical uncertainty was seen in mortality tables, akin to Unitarian mathematics.
This application made sense since the determinants of human longevity, while not precisely akin to physics, were reasonably understood and remained relatively consistent over time.As time went on, these principles were applied to other domains. Weather forecasting, for instance, started to embrace uncertainty. While you might hear forecasts like “a 40% chance of rain tomorrow,” the explanation can be quite convoluted. In essence, this means that on 40% of occasions where experienced meteorologists make such predictions, it actually rains. Modern weather forecasting models, though criticized for their reliability, perform well in the short term, typically up to 35 days.
The challenge arises because the underlying factors driving weather patterns change over time, making long-term predictions difficult.
Models play a crucial role in understanding and managing uncertainty. However, it’s important to recognize their limitations. Often, models are used to justify decisions already made, rather than serving as impartial tools.
Manipulating a model to produce a desired outcome is a common issue in finance, politics, and business.The financial crisis of 2008 highlighted the pitfalls of relying too heavily on models for risk management. For instance, the models used by banks were based on a data set where banks hadn’t gone bankrupt. Predicting bank failures using such a model proved unreliable.
Professor Kay observes that culture plays a significant role in decision-making, especially in financial institutions. There’s a pervasive belief that decisions must be backed by unassailable data and logic. However, when dealing with highly complex scenarios, this approach can be limiting. Those who dared to question the prevailing narrative before the 2008 crisis often found themselves sidelined or discredited.This cultural element extends beyond finance into various sectors, contributing to a broader lack of trust in experts.
Experts, too, often feel compelled to offer methodologically explainable recommendations rather than embracing the inherent uncertainty in complex situations.In an environment fraught with radical uncertainty, practical decision-making requires a balance between faith in one’s judgment and experience and a structured approach.
Private equity, for instance, involves creating business plans that project financial outcomes five years into the future. While these projections rarely materialize as planned, the exercise of constructing such plans can help organize one’s thinking about the market, costs, and necessary resources. The key is not to view these projections as predictions but as tools for better understanding the business landscape.A reference narrative is a story one tells oneself when dealing with uncertainty. It’s the mental framework for navigating unknown terrain. When encountering uncertainty, people often default to a reference narrative, which represents a scenario where things go relatively smoothly. Risks, then, are elements that could derail this reference narrative.
In private equity, Professor Kay advocates the construction of a reference narrative, which helps identify critical factors and potential risks. The goal is not to predict the future but to ensure that the narrative remains robust and resilient to potential disruptions.
Economics, at its core, should be about addressing practical problems. Yet, the discipline has veered toward methodological approaches rather than solving real-world issues. The shift away from the original intent of economics has led to a lack of trust in experts and a failure to appreciate radical uncertainty.
Navigating radical uncertainty in decision-making requires acknowledging its presence and embracing a structured yet adaptable approach. Models have their place, but they should be viewed as tools, not ultimate authorities. Developing a reference narrative and assessing its resilience to risks is essential. In economics and beyond, recognising and addressing radical uncertainty is crucial for making informed decisions in a complex and ever-changing world.
In this Fund Shack private equity podcast hosted by Ross Butler, Thomas Meyer, co-author of private equity best seller ‘Beyond the J-Curve’, shares insights into the industry’s challenges and the role of regulation, with an emphasis on the need to understand behavioral aspects and not just empirical data in academic input to the industry.
Thomas underscores the importance of considering how people respond in different situations, rather than solely focusing on absolute numbers.
Discussing regulatory initiatives, he criticizes the crude approach taken in some cases. He cites the Alternative Investment Fund Manager Directive (AIFMD) as an example, highlighting how it was driven by the belief that sophisticated investors had failed, leading regulators to become prescriptive in their requirements. He questions whether regulators are better equipped than experienced investors to guide industry behavior.
Thomas notes a limitation of AIFMD: it primarily addresses operational and compliance risks, neglecting financial risk. He recalls experienced limited partners dismissing fund managers’ focus on risk management, emphasizing that smaller buyout and venture funds cannot effectively manage financial risks on a fund level.
Thomas argues that AIFMD has created moral hazard among institutional investors. They assume that regulated funds are safe and no longer prioritize risk management. He likens alternative assets to the “Formula One” of the investment industry, where regulators focus on what they can see and touch, regulating behavior rather than addressing financial risk.
Thomas discusses the challenges in regulating financial risk. Few papers delve into this subject, and regulations tend to oscillate between being overly stringent and diluted cyclically. He suggests that regulation has removed incentives to better understand financial risk.
The limited partnership structure’s historical significance is highlighted, dating back to Arab traders in the desert. Meyer explains how it is a robust heuristic for asymmetric risk-sharing, where limited partners trust general partners to generate returns over a longer time frame.
The concept of “satisficing” is introduced, emphasizing that simplicity can be a virtue in complex environments. Thomas cites the example of hedge funds trying to replicate the efficiency of Black-Scholes models in private equity, which doesn’t apply due to the industry’s unique characteristics.
He discusses the misconception that innovation only needs more money. He suggests that governments should act as buyers of technology, similar to how the U.S. military historically drove innovation in Silicon Valley. The government’s role should be to buy innovative technology, even if it’s unproven, which would drive innovation more effectively.
He concludes by highlighting the need for governments to focus on purchasing innovative technologies and promoting simplicity over complexity in innovation.
