Short-Termism, Shareholder Payouts, and Investment in the EU

Jesse Fried is the Dane Professor of Law at Harvard Law School and Charles C.Y. Wang is the Glenn and Mary Jane Creamer Associate Professor of Business Administration at Harvard Business School. This post is based on their recent paper. Related research from the Program on Corporate Governance includes The Myth that Insulating Boards Serves Long-Term Value by Lucian Bebchuk (discussed on the Forum here); The Long-Term Effects of Hedge Fund Activism by Lucian Bebchuk, Alon Brav, and Wei Jiang (discussed on the Forum here); The Uneasy Case for Favoring Long-Term Shareholders by Jesse Fried (discussed on the Forum here); and Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling Ideological Mythologists of Corporate Law by Leo E. Strine (discussed on the Forum here).

In both the US and the EU, commentators and policymakers have expressed concern that shareholder-driven “short-termism” (or “quarterly capitalism”) has become a critical problem for public firms and the economy. Frequently, the main evidence offered for short-termism is cash payouts to shareholders, through share repurchases and dividends, that are large relative to firms’ net income. The leading exponent of this view is William Lazonick, who has argued that high ratios of shareholder payouts to net income impair firms’ ability to invest, innovate, and provide good wages.

The high ratio of shareholder payouts to net income has been cited by corporate lawyers such as Marty Lipton and asset managers such as BlackRock’s CEO Larry Fink as evidence that market pressures deprive firms of the capital needed for long-term investment. Lazonick’s payout-ratio figures for the US have been cited by Joe Biden as evidence of short-termism, and by Senator Elizabeth Warren as justification for her 2018 Accountable Capitalism Act.

In a 2018 Harvard Business Review article and a 2019 academic paper, both of which focused on the US, we explained that the ratio of shareholder payouts to net income is incomplete and misleading. First, shareholder payouts fail to account for direct and indirect equity capital inflows caused by firms issuing equity to raise cash, pay employees, and invest in fixed or intangible assets. Second, a focus on shareholder payouts as a percentage of net income 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). Indeed, a firm that spends more on R&D will, everything else equal, have a lower net income and a higher shareholder-payout ratio.

In this earlier work, we showed that adjusting for equity issuances and R&D dramatically changes the picture. For example, during the period 2007-2016, the ratio of shareholder payouts to net income in the S&P 500 was about 96%. But the ratio of net shareholder payouts to net income was only about 50%, and the ratio of net shareholder payouts to R&D-adjusted income was only about 40%. This left trillions of dollars for investment, much of which was in fact used for that purpose. In fact, R&D expenditures climbed to record highs by the end of the period. The remaining cash was used to build up massive cash stockpiles, leaving ample dry powder to take advantage of any attractive opportunities.

Unfortunately, Lazonick-inspired shareholder-payout figures are now being offered as evidence of short-termism in the EU. For example, a recently released Ernst & Young report, commissioned by the European Commission, claims to find evidence of short-termism in the EU by looking at dividends and repurchases and ignoring equity issuances.

We have thus turned our attention eastward: in a paper recently posted on SSRN, we examine shareholder-firm capital flows and investment in the EU. We find that during the period 1992-2019, listed EU firms distributed to shareholders more than €664 billion through stock buybacks and €2.6 trillion through dividends. These cash outflows, which totaled €3.26 trillion, represented approximately 60% of these firms’ net income during this period. But during this same period, listed EU firms absorbed, directly or indirectly, €2.5 trillion of equity capital from shareholders through share issuances, far exceeding repurchases. After taking into account equity issuances, we show that net shareholder payouts from listed EU firms during the years 1992-2019 were only about 14% of these firms’ net income. This figure was unusually low because it includes a decade (1992-2002) where net shareholder payouts were negative—investors contributed more equity capital to firms than they withdrew—an obviously unsustainable investment equilibrium.

For the most recent decade (2010-2019), the figure was 38%, somewhat lower than the 50% figure figure for the US S&P 500 for 2007-2016, but very similar to the 41% for all US public firms during that period. We also show that smaller EU public firms, like smaller US public firms, were net importers of equity capital during almost every year in our almost 30-year sample period: their equity issuances exceeded dividends plus repurchases. We then examine net shareholder payouts as a percentage of R&D-adjusted net income. For 2010-2019 the figure was 29%, slightly lower than the 33% for all US public firms during 2007-2016.

We also show that these net payout levels in the EU did not constrain firms’ ability to invest or innovate. For example, during 1992-2019 EU public firms generated €6.1 trillion of investment-available income (the difference between R&D-adjusted net income and net shareholder payouts), €2.6 trillion of which was generated in the most recent decade. To understand how this investment-available income was deployed, we consider the level and intensity of investment at EU public firms, as well as their cash levels. Using various measures of investment, we find that investment levels and overall investment intensity increased over the period and over the last 10 years (when shareholder activism became more prevent in the EU). Moreover, during 1992-2019, cash balances have jumped sevenfold from €133 billion to €960 billion (and grown by nearly 40% over the last decade, from €703 billion to €960 billion). Thus, investment by EU public firms is apparently limited by the lack of opportunity, not by a lack of cash.

We cannot rule out the possibility that short-termist pressures are causing some EU public firms to distribute too much cash to shareholders (or are generating other costs unrelated to capital flows). However, it is clear that the level of dividends and share repurchases in the EU is neither depriving firms of capital needed to invest nor providing any other evidence of systematic and harmful short-termism.

The complete paper is available here.

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