The rise and likely fall of the talent economy.
Since the mid-20th century brains have overtaken natural resources as the basis of America’s biggest companies. But, argues Roger Martin in the Harvard Business Review, as those brains make ever more money on trading assets rather than building them, a correction is needed to prevent wealth from concentrating and the social compact from breaking down.
They were paid in stock and profits. In 1976 Michael Jensen and William Meckling published the now legendary “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” in the Journal of Financial Economics. The article, which brought agency theory to the world, argued that corporations needed to align the interests of management and shareholders—talent and capital—to keep agency costs from causing damage to shareholders and the economy in general.
Investors must prioritize value creation. Those with by far the greatest opportunity to contribute positively are pension and sovereign wealth funds. As Peter Drucker correctly predicted in 1976, pension funds (and sovereign wealth funds) have become the largest owners of capital in the world. The top 50 pension and sovereign wealth funds combined invest $11.5 trillion. They currently engage in three practices that facilitate abuse by talent:
- They supply large amounts of capital for hedge funds. Because pension funds have ongoing obligations, they are hurt by dips in asset price levels. The often-illusory promise of high returns has caused them to channel substantial quantities of capital to hedge funds. The problem, as we’ve seen, is that hedge funds achieve their returns by encouraging volatility; they can and do profit whether company stocks go up or down. But pensioners want and need steady appreciation.
- They lend stock. Pension and sovereign wealth funds are the world’s leading lenders of stock, and short-selling hedge funds are its leading borrowers. Every pension fund makes a small contribution to its annual returns through the fees it earns from lending stock, and the amount each one lends has an imperceptible impact on the market. Their lending facilitates approximately $2 trillion worth of short selling on a perpetual basis. The continual placing and unwinding of these short positions generates volatility that is great for hedge fund financial engineers but bad for the pensioners whose funds they use.
- They support stock-based compensation. The funds usually vote in favor of stock-based compensation for executives of the publicly traded companies in which they invest, believing that it benefits the pensioners and citizens they serve. But if anything, broad returns on public equities have gone down while volatility has increased as stock-based compensation has increased. Thus these funds—the longest-term investors in the world—are voting against their own interests.