It’s Time to Replace the Public Corporation
Critics charge that in today’s heavily traded capital markets, executives are increasingly incentivized to manage in tiny, short-term windows, with an eager eye on their stock-based compensation and a fearful one on activist hedge funds. In any case, something isn’t working: The number of public companies in the United States declined by half from 1997 to 2015, while the number of companies with a dominant shareholder or a dominant group of shareholders in the S&P 1500 increased by 31% from 2002 to 2012.
In this article the author tracks the decline of the public corporation and explains why its most important shareholders—retirement investors—and the most critical part of its workforce, namely knowledge workers, are ill-served by this model. He proposes a new structure, which he calls the long-term enterprise (LTE): a private company in which ownership is limited to those two groups of stakeholders, who have the greatest interest in long-term value. The LTE, Martin argues, would also diminish the ability of activist hedge funds to extract gains at their expense.
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The public corporation is no longer fit for purpose, and its popularity as an ownership model is declining.
In today’s capital markets, the model incentivizes executives to manage in tiny, short-term windows, thus failing to satisfy the primary needs of its critical stakeholders: retirement investors and knowledge workers.
Switch to a model in which the owners are an employee stock ownership plan (ESOP) and one or more pension funds—thus focusing governance on ensuring real long-term performance rather than on short-term stock price fluctuations.
The professionally managed, widely held, publicly traded corporation has been the dominant structure in business for the past 100 years. It came to prominence in the wake of the Great Depression because it was effective at mobilizing capital from private investors—who by the 1960s held more than 80% of company stock—for productive ventures. The model enabled executives to focus on long-term growth and profitability, to the benefit of the many individuals who owned shares in their companies.
Over the past 40 years, however, the fitness of the public corporation has been called into question. Critics charge that in today’s far more heavily traded capital markets, the model increasingly incentivizes executives to manage in tiny, short-term windows, with an eager eye on their stock-based compensation and a fearful one on activist hedge funds. Whether or not they’re right, something isn’t working: The number of public companies in the United States halved from 1997 to 2015, while the number of controlled companies (those with a dominant shareholder or a dominant group of shareholders) in the S&P 1500 increased by 31% from 2002 to 2012. The number of companies with multiple voting shares among S&P 500 companies increased by 140% from 2007 to 2017.
In this article I’ll track the decline of the public corporation, explain why that model no longer satisfies the primary needs of critical stakeholders, and present a new one that I believe could well displace the public corporation as the dominant structure in business.
The shift against public corporations can be traced back to the late 1970s. A key marker was a 1976 article published in the Journal of Financial Economics by Michael C. Jensen and William H. Meckling, titled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”
The paper argued that professional managers are imperfect agents who, if left to their own devices, are inclined to maximize their welfare rather than that of shareholders. The solution to that problem came to be seen as stock-based compensation. That idea and its underlying assumption that the shareholder was the company’s primary stakeholder triggered an explosion in stock and stock-option grants over the following decades.
Public corporations no longer serve the interests of their most important shareholders—retirement investors—or the most critical part of their workforce: knowledge workers.
Unfortunately, there is little evidence (as I have argued elsewhere) that corporate performance has actually improved as a result. That’s partly because the shareholder-value revolution that Jensen and Meckling helped trigger has had the unintended consequence of focusing top executives on short-term movements in their companies’ stock prices rather than on long-term value creation. CEOs started meeting more and more often with investors and the analysts whose advice those investors followed. To demonstrate the superiority of their strategies, they would emphasize how much shareholder value they had created since last checking in. At the same time, falling transaction costs and new approaches to portfolio management encouraged the large, professionally managed investment institutions to trade more actively.
The corporate raiders who came to prominence in the early 1980s amplified the effects of these trends. Their activism gave executives an added incentive to pay close attention to the stock price. If they didn’t, a raider could launch a hostile takeover bid, gain control of the company, fire them, and possibly tear the company apart to wring maximum immediate value from it—as Carl Icahn famously did with Trans World Airlines after his 1985 takeover. Where the raiders led, today’s activist hedge funds have followed, but with far more capital at their disposal.
What constituted good or bad management performance became clearly defined from one perspective following the creation in 1980 of the First Call service, which aggregated analysts’ forecasts to come up with a “consensus forecast” of each company’s quarterly revenue and earnings. An executive team knows that if it doesn’t hit the consensus forecast, its company’s stock will be trounced by traders, increasing the danger of a hostile takeover. That provides executives with a powerful incentive to meet the quarterly consensus even if doing so means sacrificing longer-term goals. Research confirms that they do indeed make this trade-off. They may even engage in fraud: In the early 2000s executives seeking to boost their stock price were responsible for accounting scandals of a magnitude never seen before: those involving Enron in 2001 and Adelphia, Global Crossing, WorldCom, and Tyco in 2002.
Attempts have been made to improve the governance of public corporations. The 2002 Sarbanes-Oxley Act, for example, introduced new rules concerning the independence of directors and set requirements for financial expertise on boards in an effort to avoid further accounting scandals. CEOs and CFOs were made personally liable for their financial statements. Stock analysts were obliged to disclose conflicts of interest and breakdowns in buy, hold, and sell recommendations. But such fixes don’t address the root of the problem, which is that public corporations no longer serve the interests of their most important shareholders—retirement investors—or the most critical part of their workforce: knowledge workers.
Peter Drucker was, as usual, right in 1976 when he forecast the rise to prominence of pension funds, arguing that America’s workers would come to own the means of production through equity ownership by the pension funds that held their retirement assets, rather than through a violent revolution by the proletariat. People saving for retirement constitute the largest group of investors today.
These investors typically have a very long-term outlook—20, 30, or 40 years—and defined-benefit pension plans are strictly liable for established retirement benefits (as are life insurers, whose interests largely align with those of such plans). Although defined-contribution pension plans, such as 401(k)s, and IRAs carry no such liability, the managers of those investments share the goal of producing high long-term returns to maximize beneficiaries’ retirement income. They can and do invest in long-term bonds, real estate, and infrastructure. But to earn at the levels required, they must also invest in equities, which have typically offered the highest rates of return.
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As things stand, however, executives’ incentives are clearly not aligned with retirement investors’ need for long-term value creation. What’s more, the investors are largely powerless to change this state of affairs. One might assume that large institutions such as BlackRock, Fidelity, State Street, and the big pension funds have so much capital that they can force executives to act in the interests of their clients. Although some are attempting this, their ability to do so is limited, because the large funds are so big that each of them has ownership in most of the market. That means two things: First, the big institutions can go only so far in punishing any one company, because if they sell out, depressing the share price, they will simply provide an opportunity for a leveraged buyout or an activist hedge fund. Second, big, diversified funds have no incentive to see any one company do particularly well, because they own all its competitors; any outstanding success on the part of one company will come at the expense of its rivals and their stock prices. One might think that an institutional shareholder of Kimberly-Clark would like to see the company come up with a fantastic innovation that enabled its Huggies disposable diapers to crush P&G’s Pampers. But because it’s likely to hold as big a position in P&G as it does in Kimberly-Clark, its gains on the latter’s stock would probably be offset by its losses on P&G stock.
The bottom line is that institutional investors have neither the ability nor the incentive to discipline executives, protect companies against rapacious hedge funds, or even encourage companies to compete aggressively.
In 1959, almost two decades before his prediction about pensions, Drucker alerted the world to the arrival of a new breed of employee: knowledge workers. Instead of the muscles in their arms, legs, and backs, these workers would employ the muscle between their ears. He warned that they would be pickier about the nature of their work because it is done in and by their minds. They are their work.
That is at the core of the problem with the public corporation. Knowledge workers, the primary driver of a company’s value, are being asked to work for the benefit of its shareholders. They are asked to make sacrifices to meet quarterly financial targets. When activist hedge funds circle, they are asked to acquiesce in the firing of friends and colleagues across the company to improve earnings.
Who are the company’s shareholders? The share register will feature names such as BlackRock, Fidelity, State Street, and Vanguard. But those are just fiduciary institutions that invest on behalf of the real shareholders. The same holds for pension funds such as CalPERS, New York State Common Retirement Fund, and the Teacher Retirement System of Texas and for the activist investors Pershing Square, Third Point, and ValueAct Capital. Collectively, these institutions represent 80% of supposed shareholders. The actual shareholders have no conversation with the companies they own, and may not even know they own them.
So the dominant model asks workers to toil under executives whose financial welfare is determined by the stock price, in the interests of owners no one knows. That seems about right for a workplace in which, according to Gallup’s 2020 results, only 31% of employees are engaged in their work, 54% are not engaged, and 14% are actively disengaged. Drucker would probably have predicted those numbers had he known the environment in which his knowledge workers would be toiling. The modern public corporation has become a terrible home for them.
What might emerge in its place?
The obvious candidate to replace the publicly held corporation is private equity ownership. Since 2002 the net asset value of private equity has grown more than sevenfold—twice as much as the value of public equities. That growth has been fueled largely by the major pension funds, which have become the biggest investors in private equity. Michael Jensen himself predicted the growth of private equity in 1989 in his provocative Harvard Business Review article “Eclipse of the Public Corporation,” and history has proved him right.
But private equity is not a substitute for public corporations, because it is predicated on their existence. Private equity investors expect to realize a return after five to seven years, so PE funds must sell the companies they’ve bought within that period. Traditionally that has meant returning them to the public markets, by way of either an IPO or sale to a public company. But those exit routes (especially IPOs) have become less easy to take of late, and a growing trend is PE funds’ selling companies to other PE funds. Of course, that doesn’t eliminate an eventual return to public markets—it merely kicks the can down the road.
The story of Dell provides a textbook example. In 2013 its founder, Michael Dell, and the PE firm Silver Lake Partners took the company private for nearly $25 billion, because they felt that as a public company, Dell could not transform itself from primarily a player in the commoditizing personal computer business to an enterprise services provider. As a private company, Dell was able to engineer the game-changing takeover of EMC, which owned a valuable stake in the cloud computing provider VMware. It took the transformed company back to the public market five years later at an approximate enterprise value of $70 billion. Pension fund investors who had sold out at $25 billion could buy back in at $70 billion, but in the meantime, $45 billion in value had gone to private investors—including, by some estimates, $28 billion to Michael Dell himself.
If public corporations and capital markets did not exist to enable PE funds to turn their investments into cash, a deal like that could not happen, and PE funds would not exist. That disqualifies private equity as the next new model.
The bottom line is that institutional investors have neither the ability nor the incentive to discipline executives or protect companies against rapacious hedge funds.
To understand what might displace the public corporation, let’s consider what’s involved in meeting the needs of knowledge workers and retirement investors—the critical creators and beneficiaries of sustainable value. To satisfy their needs, any new model must overcome the fundamental governance problem of widely held corporations: that CEOs’ incentives are at odds with the long-term interests of those stakeholders. In addition, the model must diminish the ability of activist hedge funds to extract gains at their expense.
I believe that the most likely successor is what I call the long-term enterprise (LTE), a private company in which ownership is limited to the stakeholders with the greatest interest in long-term value: retirement investors and employees. It would work like this: An employee stock ownership plan (ESOP), whether existing or specifically created for this transaction, would partner with one or several pension funds to acquire the company and take it private. Governance would focus on real long-term performance rather than on short-term stock price fluctuations—because there would be no stock price. Other classes of long-term investors might also find the model attractive. The likes of BlackRock, Fidelity, and State Street, for example, could create vehicles whereby their IRA investors could invest alongside ESOPs.
Let’s look at what this model would do for its key stakeholders.
The model is not completely unfamiliar to these investors. Two of Canada’s three biggest pension funds (which are also among the top 20 worldwide) have taken private very large Canadian real estate development companies. The Quebec-based CDPQ took Ivanhoé private in 1990 and Cambridge Shopping Centres private in 2000, and merged them to create a wholly private real estate giant. The Ontario Teachers’ Pension Plan (OTPP) took another large realty firm, Cadillac Fairview, private in 2000. Those were not typical PE deals. The investors were not seeking to turn the companies around and take them public again five years later. They were looking for steady returns over the long haul.
To be fair, those acquisitions were in a single business—real estate, not classic consumer or industrial enterprises—in which pension funds are major buyers of individual assets. For LTEs to become the dominant ownership model, pension funds and other retirement investors would have to become comfortable owning a wider variety of businesses. That does seem to be happening: In 2019 the biggest Canadian pension fund, CPPIB, took an alternative-energy company, Pattern Energy, private for US$6.1 billion.
This approach borrows from the playbook of the world’s most famous investor, Warren Buffett, who is best known for taking huge ($15 billion-plus) stakes in public companies such as Apple, Bank of America, Coca-Cola, Amex, and Wells Fargo. But those investments make up less than half of Berkshire Hathaway’s market capitalization of $313 billion (as of this writing). A larger proportion comes from its ownership of fully privatized companies such as GEICO, Burlington Northern Santa Fe, Dairy Queen, Fruit of the Loom, Lubrizol, and Duracell. The most valuable private stake is probably GEICO (worth about $50 billion), but perhaps the most intriguing is Burlington Northern Santa Fe, the parent of BNSF Railway, America’s largest railroad. In 2009 Berkshire Hathaway acquired the 77.4% of BNSF it didn’t yet own for $26 billion, which with the acquired debt made the holding worth $44 billion. The stated intention was to run the railroad privately—forever.
It makes sense that Buffett would figure out something good before everybody else did. He has made a career of doing so. He favors concentrated and focused ownership, works toward a long-term horizon, and positions chief executives to be incentivized by value enhancement, not stock price movements, protecting them from activist hedge funds, stock analysts, and traders: market actors pushing for short-term gains.
Working at a company solely owned by Berkshire Hathaway has many attractive features for employees. They know for whom they are working: shareholders who have legendarily long holding periods. But it’s not enough to know your shareholders. In the modern economy, critical employees themselves need to have a long-term stake in the company. And as we have seen, stock options don’t provide an incentive to engage for the long term. That’s where employee stock ownership plans come in.
Large companies wholly owned by ESOP participants perform remarkably well. Take Publix Super Markets, which is 100% owned by an ESOP. With $36 billion in revenue, Publix ranks 87th in the Fortune 500 and is the 29th-largest private-sector employer by head count in America. Perhaps most impressive, shoppers rank it the number one supermarket chain in the United States. Other large supermarkets that have ESOPs include WinCo Foods, Brookshire Brothers, and Metcash, the parent of IGA. Outside retail, we have W.L. Gore & Associates, the famous creator of Gore-Tex; Graybar, one of the top distributors of electrical, communications, and data-networking products; and Gensler, the top-grossing architectural firm in the United States.
As that list suggests, many of the biggest companies with ESOPs are either retailers, for which the interaction between customers and frontline employees is critical to success, or enterprises dependent on a large number of professionals, such as architectural, engineering, and consulting firms. They are typically innovative and highly competitive.
Little or no new regulation would be required to roll out ESOPs on a large scale. A robust infrastructure is already in place to protect the interests of individual employees enrolled in them. (An ESOP is not equivalent to an employee retirement plan, which should not be wholly or even largely invested in company stock. It is, rather, a way to reward and motivate employees for value creation.) All shares vest after six years, and ESOPs are required to have a third party establish the fair value of the shares once a year so that when employees leave, their shares will be bought by the plan at a fair price, enabling them to benefit from capital appreciation much as employees of public companies do. Retiring employees benefit in the same way and enjoy favorable tax provisions for rolling the proceeds into their retirement accounts.
It’s surprising that employee stock ownership plans aren’t more widely used, but dominant models are hard to displace. Publicly held corporations are the default—the safe choice. Bankers, lawyers, and accountants can facilitate that structure in their sleep, whereas few specialize in creating ESOPs. Additionally, no single person or small group has a huge incentive to drive toward an ESOP solution. When a private company goes public, a few people—the founding group and the initial angel or VC investors—tend to reap very large rewards. Under an ESOP, each of many employees stands to benefit by a meaningful but modest amount. If an employee group starts in that direction, it will have to explain why it’s trying something different, and no bevy of advisers will be standing by to help. Nonetheless, employees, shareholders, and society would be better off if ESOPs were used more widely.
In sum, the model I propose would satisfy the primary needs of both retirement investors and knowledge workers without taking away any of the advantages offered by the public corporation’s structure. Long-term enterprises can help channel retirement savings toward investments that will reliably deliver high returns 20 or 30 years later. They also motivate workers in dynamic, knowledge-intensive industries to create the value needed to generate those returns.
Supporters of the current model point out that public markets have been highly effective mechanisms for aggregating and processing information about value and for taking cash in and out of investments—which is why the publicly traded corporation was such a successful model.
But it’s no longer clear that this model is the best way to determine fair value. The dominance of short-term factors in corporate decision-making and the activities of short-term investors are making quoted market prices a less-reliable indicator of value than they used to be. At the same time, the widespread availability of information online and the increased sophistication of formal modeling are dramatically improving the quality of market-independent business valuations.
Publicly traded corporations and the capital markets won’t become extinct. Not all investors take a long-term perspective, and in many industries it can be difficult, if not impossible, to do so. But the stock market increasingly sabotages rather than supports the creation of long-term value, reducing the investment options available to retirement savers and demotivating the people most likely to create the value those savers need. The model I propose here will better serve the interests of these critical stakeholders.
Active investor oversight is a plus, not a minus.
It’s Time to Replace the Public Corporation
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