Tuesday, December 09, 2008

Customers as shareholders or shareholders as shareholders

Learning new things should cause us to rethink our positions. The reevaluation is much preferred over stubbornly clinging to what once seemed to be a good idea. That said there must be a happy median between just shifting in the wind and obstinacy.

With that in mind, it is time for a fast finance lesson.

Within the nexus of contracts that make a firm there are many ways we can link the various stakeholders. One such linkage is that a firm could link its customers and owners. This was mutualization once somewhat common in insurance, savings and loans, and other co-op type businesses (food co-ops etc).

Over the years this linkage has grown much less common and many former mutual firms have demutualized. The reasons for this evolution were as varied as the firms themselves. Some wanted access to more capital, others wanted the so-called market discipline that is supposed to come through better shareholder monitoring, and still others no doubt did it at the urging of investment bankers who saw a big pay day from the firms' IPO.

FinanceProfessors also frequently urged this efficiency gain. For instance in my classes I talked regularly of papers (in particular Cliff Smith's 1977 piece) about how through evolution it seemed that shareholders as an independent group seemed to be more efficient and had beaten shareholder-customer based firms. Take for example what I wrote in July of 2000 FinanceProfessor newsletter (a precursor to the blog)
"In times of change, it is often useful to be a public company. The market imposes discipline and guidance. This is what Cliff Smith predicted in his paper on the demutualization of insurance firms (1977). This demutualization has not been allowed in Japan. However, it looks like it soon will be allowed and already life insurance firms are lining up to take advantage of the deregulation. Daido Life is set to be the first. Currently the life insurance firms are mutuals which means they are owned by their customers."
And again in April of 2005 when I quoted Ohio State's Ingrid Werner on the pending IPO/demutualization of the NYSE as a
"NYSE's move illustrates the advantages of demutualization to increase transparency, raise capital for technological improvements and increase the speed the process for future changes"
This view that stock firms were more efficient than mutual firms was given further support in 2004 when Mayers and Smith looked at the empirical evidence:
"We examine 98 property-casualty insurance companies that convert to stock charter from a mutual or reciprocal form of organization....our evidence suggests there can be important costs associated with the operation of a mutual or reciprocal insurance company. These costs can include the opportunity costs associated with foregone investments arising because of higher incremental capital costs inherent in the mutual or reciprocal forms of ownership. There also is a cost disadvantage if a mutual or reciprocal is operating in activities more appropriate for the stock ownership form. These costs can in particular circumstances offset the advantage mutual ownership affords in controlling incentives to transfer wealth from policyholders to equityholders."
That was my classroom spiel. Combining shareholder and customer roles might have some advantages in marketing (think loyal customer base) but overall the stock corporation wins out as incentives are better and managers can be replaced (hostile takeover in extreme case) if they do not do their job.

So it was with great anticipation (and some trepidation) that I read the following from Forbes:

Mutual Respect - Forbes.com:
"The sharpshooters at publicly owned insurers used to scoff at their stodgy competitors, the mutual insurers. Not anymore....

Without the shareholders' lash to whip them into shape and stock with which to buy rivals, policyholder-owned insurers were sure to get crushed by publicly traded rivals. So went the argument, and so began a flight from mutual ownership that included such stalwarts as Equitable, Prudential and Metropolitan."
But that has not worked out quite so well. Again from the article:
"...publicly traded insurers are scrambling for cash by cutting dividends and issuing new shares (diluting existing investors), begging regulators for a relaxation of capital requirements and lobbying Washington for a cut of the $700 billion Wall Street bailout.

Their mutually owned rivals haven't asked for a dime. Their statutory surpluses (the regulatory counterpart to book value) have held steady or even increased. Some are announcing plans to pay out near-record dividends to policyholders."

Acknowledging that there are some accounting differences which MIGHT be slowing the mutuals from admitting any failures, the article goes on to suggest that the root cause was that shareholders demanded too high of returns and that the only way to achieve these results was through increased risk taking.

"Life insurance analyst Arthur Fliegelman....puts the blame for their missteps squarely on the need to satisfy Wall Street and its lust for quarterly profit gains. Public companies felt they had to report a return on equity of at least 15%. "You just can't do that in a mature business without taking too much risk,""

"David Schiff, an industry gadfly and publisher of Schiff's Insurance Observer, has been warning since the late 1990s that earnings-per-share pressures would drive insurers to do dumb things. He was right. Since going public Prudential has spent $11 billion buying back shares at an average cost of $63, Schiff estimates. Those shares are now worth $19. Hartford spent $2 billion the past two years buying back stock. That's as much as the entire company is now worth"

(Quick time out. Are Peter and David brothers?)

Which gets us to what am I going to teach now?

I still maintain that decoupling the roles of shareholder and customer is generally the way to go. It does increase access to capital and allows firms to judge (albeit imperfectly) how well they are doing. There is also increased transparency and less entrenchment of management.

But that said, if the economy is growing at 3% per year, firms can not grow at 15% per year indefinitely without excessive leverage. Consequentially it is imperative that firms set realistic expectations for the future even when they don't have an incentive to do so. (Which I confess is a big problem!)

And finally there will likely always be a segment of the market that remains a mutual firm. That is fine. There need not be a single way. For some firms it may be optimal for a mutual structure but for the vast majority having shareholders as shareholders and customers as customers seems more efficient.

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