Internal and external finance

Finance can be seen similar to a chain of command, just that it is a circle with the front line worker in the end providing the funding through pensions or life insurance. How corporations are run is very important in this entire system and with agency theory alreaddy hinting at the problems to link shareholder and management interest, corporate governance has increased in importance.

Market-based systems are one form of corporate governance and it’s a set of systems and strucutres, the “rules of the game” for top managers, set by the board of directors and showing what stakeholders can expect in how the corporation will be run.

In the USA, ownership and control is generally seperated but arguments have since started with Jensen and Mockling (1970) that this seperation means CEOs will not always maximise shareholder value. In the 1990s option schemes rose to more aling shareholders and managemnt. Now shareholders rebelled as underwater options weren’t converted.

Who ownes the companies? In the USA 60% of all shares are held by institutions (pension, mutual, insurance funds, …). In the UK that’s 66%. They control hundreds of billions of dollars worldwide. Their control is limited by a legal need to diversify (UK) and by the Glass Steagall Act (US). With 60 or more firms in their portfolio, they do not have the time, and do not see the need, to closely watch senior management, rather keeping their independetness.

Many investing institutions even give proxy votes to management making it unlikely that any (even organised) vote against management comes through.

Systems for corporate governance could be:

\- alignment of management remmuneration to shareholder interest

\- board seats to independent non-executive directors representing shareholders

\- the market for corporate control, as it is known, simply meaning that shareholders can sell their shares, forcing the stock price down, allowing for a hostile take over

\- creditors have high influence

\- change of financial statute for realignement

Increasing gearing meant that the bankrupty risk increased and management has to manage the cash flow more efficiently. This is a new form of LBO (leveraged buyout) if you want.

MBOs are often used when parts of the company are underperforming due to competition on funds and subsidisation of other parts of the company.

Relationship based systems are more used in Germany, Japan and France. Here the shareholding is less diffuse with large chunks being owned by corporates or banks. Relationships with these large shareholders are long-term and may or may not be formal like via supervisary boards over the board of directors.

Monitoring is the main form here and linking executive pay to the shre price is rare, as are hostile takeovers or mergers. There are even restrictions on voting rights underlying shares limiting them to not allow for control, no matter what the number of shares.

Partly due to the funding needs market-based systems are increasing and shareholder value is starting to replace stakeholder value even though this change is slowing down.

Internal v. external reporting

Internal (management accounting): planning, decision-making, control, often performance is measured.

External (financial accounting): decision making, stewardship, accountability, each stakeholder needs different numbers but the main one in the Anglo-Saxon model is the shareholder anyway.

Financial reports did not aling managers with adding value for shareholders and this has led to linking pay to shareprice via options or shareperformance in relation to an index or other sahre measures. This has lead to senior managers being valued based on economic value-based measured while other managers are measured on accounting-based measures.

Dillon and Owers (1997) argued that measurement metrics within a management control system need to be:

\- consistent with corporate objectives

\- perceived to be fair

\- variables must be SMART

\- inform management when to take action

Divisional busdget targets are normally set artificially low by the respective managers, to easily meet their targets and this is not inline with senior management objectives to increase revenue per share or economic value.

Leveraged buy-outs targetted firms with apparent low earnings (high P/E) but high cash flows (low P/CF). EV/EBITDA is another value that is often used. DCF brought in the importance of Cost-of-Capital for a firm’s value, which LBOs knew. They reduced WACC to improve operations, kind of.

All this, including dramatic changes in share value not reflected in P/E values drove a rethinking towards cash flow and the importance of WACC. Efficient use of capital resources grew more important than growth for growth’s sake.

Economic and accounting measures

An external market for corporate control can be most efficient but there is still an attempt to have internal systems. They are related to shareholder value and they look at returns only after those expected by investors. They are based on the concept of economic income, which is the generated income net of investors’ ROCI. Economic income started as a concept in the 1930s (Peinreich, 1938):

Accounting profit = NOPAT = C _t (A_ t — A_t-1)

where C= cash paid out to owners (all providers of capital)

A = accounting book value

Economic income = residual income = E _t = NOPAT_ t — WACC x A_t-1

This means you show the return after having given all owners the return they wanted for taking the risk of investment in the beginning of the period.

After that, the value of the company is: V _t = SUM ( C_ t+n / (1+WACC)^n )

V _t = A_ t + SUM (E_t+n /(1+WACC)^n )

While the first one is cash flow based, the second one is based on economic value added, but they should give the same values. This is actually similar to NPV in that it looks at the excess return.

It does require comprehensive income and clean surplus accounting principles though, which are not required at this time. This means that there might need to be 164 changes to the asset values in your books.

In response UK accounting regulators have introduced the Statement of Total Reconised Gains and Losses (STRGL, struggle) working in a clean surplus profit for shareholders method.

The ISB is also encouraging a move to economic vlaue and might require balance sheet items to be quoted in value in use, which requires a DCF method.

Economic income is actually the same as economic value added (EVA), a term trademarked by Stern Steward.

EVA _t = NOPAT_ t — WACC x A _t-1 = (ROCE_ t — WACC) x A_t-1

(As ROCE = NOPAT/A)

They do argue that due to the already quoted V _t calculation, a positive EVA will lead to a higher V_ t. And the last formula tell a company to work on activities that earn a ROCE above WACC and to minimise the WACC. The nice thing is that this is relatively easy to understand and this measure can be used both for internal managers as well as shareholders or top management.

_Economic income in internal reporting_ are gaining popularity (EVA, SVA), but more so in the US than in the UK. They do mostly still use budgets, target profit, target cash flow, value drivers or balanced scorecard. Only 10% use EVA and 15% SVA. In the US, NPV, ROIC, CFROI (real IRR of the investment) or EVA are important.

The problem with NPV is that it is purely a cash flow measure and this is not so readily available in standard management accounting systems. But it is still used a lot for projects.

ROIC is calculated via NOPAT (adjusted as if there was no debt) and the opening or average capital by long term investors.

CFROA is both about the future as well as the present and past, but again a cash flow measure and it is inflation adjusted for easier comparison. It has to be compared to cost of capital in real terms and can be used as a means of valueing companies.

EVA is a money amount and no ratio. It also looks at NOPAT and removes a charge for WACCxAssets. The last three are really saying the same thing in the end. The disadvantage for EVA is that it is not easy to compare companies as it is an accounting measure and Stern Steward said that there are up to 164 accounting adjustments needed to be made to book values to reflect current value of invested capital.

There are three main adjustments:

\- goodwill that has been written off needed to be added back to invested capital and if deducted from profits added back to NOPAT. Companies that are bought need to earn about WACC on their true book value.

\- R&D expenditure needs to be treated as an asset and hence needs to be added back to NOPAT and included in invested capital.

\- Leases are part of invested capital as they are seen as debt finance.

Another disadvantage is that EVA is difficult to implement at the divisional level especially as it is very hard to apportion the invested capital of the company. But this is true for every divisional performance measure. Transfer pricing doesn’t make things easier. The problem is though that profits do not necessarily add value in terms of EVA.

The last problem is actually applied to value-based metrics in general, is that there is a lot of things like intellectual property, knowledge, IT systems, that aren’t fully reflected in the books. It only shows up as goodwill when an acquisition has happened. How do you value employees would be another question.

On top of that, how do you value social interests in corporate performance? Nobody has found any measures in this space though.

There is also ongoing concern about which measures to use in the public sector. Historically government spending has been monitored on a cash accounting basis. The problem there is that there is no difference made between one-off spendings and spendings on assets that generate future revenue. There is also no incentive to dispose of loss making assets. Government now turned to accruals accounting. This accounting method is introduced in the UK as resource accounting including: operating statement, balance sheet, cash-flow statement, a main objective analysis, output and performance analysis.

All in all, things are changing from monitoring of inputs to those of outputs, and linking executive pay to it.

Public-Sector Financial Management

Here things are driving by the VFM, the value for money. This can be linked to the three E’s (Economy, Efficiency, Effectiveness) and goes back to the fifth century BC (Dewar, 1989) and has grown in importance in the last two decades. In a move to control spending and improve resource allocation and accountability, there is now a drive towards more private like accounting methods. Now there is some confusion in relation VFM, mostly as there are different objectives, methodologies and standards. It moved from confronting managers about problems, to more checking of management’s account of achieving VFM targets.

There are several approaches and some can be suggested here (based on Bowerman, 1996):

\- Review of management systems, arrangements and procedures (how can value for money be improved)

\- Value for money procedures audit (are there objectives and are they checked)

\- Policy audit (Are the three E’s matched)

\- Audit of management represenations of value for money (Is presented information correct)

\- comparative performance audit

\- Quality audit (e.g. customer satisfaction surveys)

Best value is a new approach, mixing audit and what should be done, including quality.

Performance Measurement and Investment

How are investors subject to performance measures is the question of this part. Institutional investors are very important, especially where funds are used for savings in relation to people’s pensions.

In measurement of trustee performance it is important that the trustee represents those that gave their trust, and in terms of for example pension funds, this means that they need to be able to pay out the promised pensions, known as the minimum funding requirement. Above and beyond that, they should maximise the returns over the long-term.

These trustees do not need to know anything about investments, as they delegate that part of internal or external fund management. External fund management companies are growing strong and their managers make presenations to the trustees. They do need to maximise return but reduce risk through diversification. They need to report quarterly which might even make them perform less optimally in relation to their goal.

These funds also use the matching principle, meaning that they will try to match their investments with their required payouts. The fund managers that run these funds will try to stick close to the median of all pension fund managers as they are normally measured in relation to other fund managers and only need to be top of the list.

The problem is that these investments sometimes don’t follow CAPM, which would predict that with no prior expectation, investments should mirror market size internationally. But should trustees follow the herd and invest where CAPM predicts of where the average UK fund manager invests. If they take the CAPM approach, they might end up in the bottom band of UK fund management companies. This would be a breach of their contract to optimize performance. But without it they didn’t take advantage of USA stock rises as best they could, which they would have with CAPM.

Also, some pension funds add an ethical bit to the mix, excluding for example tabacco companies. This also can cause underperformance.

So how should the fund managers be measured. They will have to outperform and this can be done through better asset allocation than the median or a better stock selection than the benchmark. In the past they didn’t do well in asset allocation in general, not predicting US stock rise and being over-optimistic on Japan. Managers do believe that markets are not efficient at one level because they do believe that they can consistently outperform via their stock picks. With a higher return, they normally also have a higher tracking error (standard deviation on top of comparison index)

Many trustees are switching to passive funds.