Short-Termism and Shareholder Payouts: Getting Corporate Capital Flows Right

Posted by Jesse Fried, Harvard Law School and Charles C.Y. Wang, Harvard Business School, on Thursday, January 12, 2017

A fierce debate has been raging over whether shareholder-driven “short-termism” (or “quarterly capitalism”) is a critical problem for U.S. public firms, their investors, and the nation’s economy. Certain academics (Bratton and Wachter, 2010; Coffee and Palia, 2015), corporate lawyers (Lipton, 2015), Delaware judges (Strine, 2010), and think tanks (Aspen Institute, 2009) contend that quarterly capitalism, exacerbated by the growing power of hedge funds, is substantially impairing firms’ ability to invest and innovate for the long term. Pushing back against this view, a number of academics have forcefully argued that hedge funds play a useful role in the market ecosystem (Bebchuk and Jackson, 2012; Gilson and Gordon, 2013; Kahan and Rock, 2007) and that concerns over short-termism are greatly exaggerated (Bebchuk, 2013; Roe, 2013).

The empirical evidence on shareholder activism and short-termism is, in fact, mixed. Market pressures can lead executives to act in ways that boost the short-term stock price at the expense of long-term value (Bushee, 1998; Dichev et al., 2013; Graham et al., 2006) and may undesirably reduce investment at public firms (Asker et al., 2015). But these costs must be weighed against the potential reduction in agency costs created by greater director accountability to shareholders. One prominent study finds evidence of such benefits, reporting that shareholder activism increases the stock price at targeted firms in both the short term and the long term (Bebchuk et al., 2015). Subsequent work, however, seeks to challenge these findings (Cremers et al., 2016).

As the search for more and better evidence about short-termism continues, academics, market participants and policymakers have increasingly pointed to the large volume of dividends and repurchases as convincing evidence of activism-induced short-termism. Much of the focus on shareholder payouts is due to the work of economist William Lazonick, who has repeatedly and forcefully argued that these shareholder payouts impair firms’ ability to invest, innovate, and provide good wages. In the introduction to his most well-known work, an influential 2014 Harvard Business Review article entitled “Profits Without Prosperity,” Lazonick set out his main claim:

Since the publication of “Profits Without Prosperity,” Lazonick’s findings and similar shareholder- payout figures have been cited by economists at the Brookings Institution (Galston and Kamarck, 2015), prominent asset managers (Fink, 2015), leading corporate lawyers (Lipton, 2015), and senior politicians and policymakers as evidence that short-term pressures generated by activist shareholders are depriving firms of the capital they need to invest for the long term and pay adequate wages. Financial economists (Kahle and Stulz, 2016) have also pointed to the magnitude of shareholder payouts as a percentage of net income as evidence for concern about US public firms’ opportunities (or incentives) to invest.

In a paper recently posted on SSRN, Short-Termism and Shareholder Payouts: Getting Corporate Capital Flows Right, we explain that these shareholder-payout figures fail to provide convincing evidence—or indeed any evidence of harmful short-termism—because they are an incomplete and misleading measure of public-firm capital flows.

First, shareholder payouts tell only half the story of capital movements between firms and their shareholders. In particular, they fail to account for direct and indirect equity capital inflows through share issuances. U.S. firms issue considerable amounts of common stock to raise cash, pay employees, and acquire assets. We put forward and implement a methodology for estimating net shareholder payouts (shareholder payouts less equity issuances) in S&P 500 firms. Using this measurement method, we find that there is a massive wedge between shareholder-payout figures (that are cited as evidence of short- termism) and net shareholder payouts (that measure net capital movement between firms and shareholders). For example, during the period 2005-2014, S&P 500 firms distributed to shareholders more than $3.95 trillion through stock buybacks and $2.45 trillion through dividends. These cash outflows, which totaled $6.4 trillion, represented 93% of these firms’ net income during this period. But during this same period, S&P 500 firms absorbed, directly or indirectly, $3.4 trillion of equity capital from shareholders through share issuances. After taking into account equity issuances, our estimates indicate that net shareholder payouts from S&P 500 firms during the years 2005-2014 were only about $3 trillion, or 44% of these firms’ net income over this period.

Second, a focus on S&P 500 firms—which generally have fewer growth opportunities than smaller and younger firms—creates a misleading picture of net shareholder payouts in the public markets as a whole. We show that while S&P 500 firms are net exporters of equity capital, public firms outside of the S&P 500 are net importers of equity capital, absorbing $520 billion of equity capital, or about 16% of the net shareholder payouts of S&P 500 companies, during the period 2005-2014. Across all public firms, net shareholder payouts from 2005 to 2014 were only $2.50 trillion, about 33% of the net income of public firms over this period.

Third, during the period 2005-2014 public firms engaged in approximately $800 billion of net debt issuances, equaling 32% of the $2.50 trillion in net shareholder payouts. When a firm borrows $X and issues a dividend of $X, there is no reduction in the firm’s assets. Rather, such a transaction merely rebalances the firm’s capital structure, substituting $X of debt for $X of equity. Thus, $800 billion of the $2.50 trillion in net shareholder payouts by public firms in this period are effectively debt-for-equity recapitalizations, rather than downsizing distributions. Across the entire market, only $1.7 trillion of net shareholder payouts, about 22% of aggregate net income, are not offset by net debt issuances.

Our analyses of net shareholder payouts, along with our findings on the extent to which net shareholder payouts are offset by net debt issuances, have important implications for the debate over short-termism. They indicate that capital flows from public firms to shareholders—which have been described as convincing evidence of short-termism—are (a) substantially smaller than they appear and (b) because of offsetting debt transactions, likely to have an even smaller impact on public-firm financial capacities.

To be sure, we cannot rule out the possibility that short-termist pressures are causing some firms to distribute too much cash to shareholders (or are generating other costs unrelated to capital flows). However, a close look at the data reveals that there is little reason to believe that short-termism is, as is commonly believed, systematically stripping firms of the capital needed to invest, innovate, and pay higher wages.

In our paper, we also offer three additional reasons why concerns about shareholder payouts from public companies are likely to be overblown. First, the focus on shareholder payouts as a percentage of net income is highly misleading; it wrongly implies that “net income” reflects the totality of a firm’s resources that are generated from its business operations and are available for investment. In fact, net income is calculated by subtracting the many costs associated with future-oriented activities that can be expensed (such as R&D). These amounts are substantial. On average, firms spend approximately 25-30% of their net income on R&D alone. In other words, much of the resources generated by a firm’s business operations have already been used for long-term investment before net income is calculated.

Second, even net shareholder payouts (adjusted for net debt issuances) tell us little about the effect of such capital flows on public firms’ financial capacities–because firms can always choose to issue more stock. The amount of equity issued by any given public firm in any given year does not represent a cap; the firm could have chosen to issue even more stock to raise cash, acquire assets, or pay employees. Thus, if that firm has a valuable investment opportunity, but little cash, the firm should generally be able to use equity financing to exploit the opportunity.

Third, the concern about the volume of shareholder payouts appears to be based, in part, on an implicit assumption that there is no economic benefit to putting cash in the hands of public shareholders. But net shareholder payouts from public companies do not disappear down the economic drain. Just as much of the net shareholder payouts from S&P 500 firms flow to smaller public firms outside the S&P 500, much of the net shareholder payouts from public companies in the aggregate are likely to be invested in firms raising capital through an IPO, or in non-public businesses backed by private equity or venture capital. Historically, these firms have been generators of tremendous innovation and job growth in the U.S. economy. Thus, even if net shareholder payouts were to reduce public firms’ ability to invest, innovate, and provide higher wages, some of these funds will find their way to private firms and enable these firms to invest, innovate, and provide higher wages. In short, any economic costs borne by stakeholders of public firms as a result of net shareholder payouts must be weighed against the economic benefits generated by the investment of at least some of these funds in private firms.

Our analysis thus suggests that the volume of share repurchases and dividends by the largest public firms is highly unlikely to indicate that short-termism, or some other factor, is causing public firms to distribute too much cash to shareholders. Those arguing that short-termism is harming the economy will need to look elsewhere to find support for their claim.

The full paper is available for download here.