Overcoming Opportunism in Public‐Private Project Finance

The possibility of opportunistic behavior, whether by the private investors who operate public‐private projects or by the government agencies who oversee and administer them, can become a powerful deterrent to raising public‐private project financing, especially considering the scale of the investment in infrastructure. Nevertheless, both parties can protect themselves against the counterparty's possible opportunism by giving the investor an “exit” (or put) option and the public agent a “bail‐out” (or call) option on the private investor's shares. In describing the role and design of such puts and calls, this paper presents a mechanism for converting “natural monopolies” into competitive or contestable markets by using over‐the‐counter option contracts that combine the stability of long‐term contracts and the flexibility of short‐term contracts. In the language of economists, the exit/bail‐out option mechanisms presented here are seen as reducing barriers to entry by streamlining incomplete long‐term contracts and avoiding contractual problems related to “bounded rationality” and opportunism.     

Session V: Macro Perspectives: Bigger Problems than Corporate Governance

Columbia Business School's well‐known authority on value‐based investing begins by attributing today's economic problems to a “global economic dislocation,” one that is rooted in the ongoing—and in Greenwald's view, inevitable—decline of manufacturing and displacement by services. Like the other example of dislocation in modern times, the Great Depression of the 1930s, the 2008 global financial crisis and protracted recession— still very much with us—are viewed as originating in the sharp decline of a major “sector” of the global economy. In the Depression of the ‘30s it was agriculture; in the recent financial crisis it was manufacturing. In both cases, technological advances and economy‐wide productivity increases led to huge increases in stock and financial asset prices—but also to sharp drops in the prices of farm and manufactured goods, and massive overcapacity and ruinous competition in both sectors. According to the author, the working off of overcapacity in the agricultural sector was accomplished largely by the effect of World War II in moving huge numbers off the farm and into the mainly urban industrial sector at government expense. This labor force relocation, which occurred in all developed economies, was essential to a global economic transformation that for the next 50 years provided high productivity growth and greater equality of income and wealth. More recently, however, the global economy has been confronted with the challenge of accomplishing a transition from manufacturing to services that will feature lower productivity growth and more inequality. Foreseeing a long, difficult process, Greenwald's biggest concern is that government intervention will distract businesses from making this transition effectively—which means continuing to operate as efficiently as possible, downsizing when necessary—and so make the problems worse. And while business focuses on preserving its own efficiency and value, Greenwald urges governments to look for more cost‐effective ways—for example, expanded use in the U.S. of the Earned Income Tax Credit—to cushion workers from the consequences. Nobel laureate Edmund Phelps, while agreeing with much of Greenwald's analysis, has a different explanation of the U.S. productivity dilemma. Innovation is viewed as the primary driver of the prosperity of the advanced economies. Higher income and wealth matter less than job satisfaction, participation, and an array of non‐material “modern values” that have somehow been lost and that, for Phelps, are the key to restoring economic growth and “mass flourishing.”     

CHOOSING THE RIGHT FINANCIAL SYSTEM FOR GROWTH

Well‐functioning financial systems promote economic growth by channeling funds from those who save to those who invest in the productive capacity of economies. What are the main features of a well functioning system? Are well developed capital markets essential to the process? Or are commercial banks and other “private” sources of capital capable of bringing about the same levels of growth and prosperity? In this article, the authors use information about the financial systems of a large number of both developed and developing countries to examine various relationships between a country's financial structure and its overall economic performance. Perhaps most important, the authors report a significantly positive correlation, using data for 34 countries, between the size of a country's financial system—measured by the total of commercial bank assets, equity market capitalization, and bonds outstanding—and economic development (as measured by GDP per capita). At the same time, the authors also provide evidence that banks (or loans) and capital markets (or securities) are complements, not substitutes, in promoting economic development, and that the presence of foreign‐owned banks (though not state‐owned banks) has a positive association with growth. In other words, both private banks and capital markets are likely to play important, though different roles in channeling funds from savers to investors.     

Star CEOs or Political Connections? Evidence from China's Publicly Traded Firms

This paper studies China's “star CEOs” defined as members of the National People's Congress (NPC) or the National Committee of the Chinese People's Political Consultative Conference (CPPCC) and “politically connected” CEOs who have previous government or military experience. We evaluate the effect of “star CEOs” and “politically connected” CEOs on firm performance and CEO compensation. We find that announcement date returns, CEO compensation and incentives are all higher in firms that appoint “star CEOs”. However, the mechanism explaining these various premiums is largely political connectedness of these star CEOs. Our study finds only modest evidence that star‐CEO status directly determines firm performance. Our analysis strongly suggests that compensation and performance premiums are mostly driven by CEO political connections, as opposed to CEO talent/star effects.     

REVISITING MARKET EFFICIENCY: THE STOCK MARKET AS A COMPLEX ADAPTIVE SYSTEM

Well‐functioning financial markets are key to efficient resource allocation in a capitalist economy. While many managers express reservations about the accuracy of stock prices, most academics and practitioners agree that markets are efficient by some reasonable operational criterion. But if standard capital markets theory provides reasonably good predictions under “normal” circumstances, researchers have also discovered a number of “anomalies”—cases where the empirical data appear sharply at odds with the theory. Most notable are the occasional bursts of extreme stock price volatility (including the recent boom‐and‐bust cycle in the NASDAQ) and the limited success of the Capital Asset Pricing Model in accounting for the actual risk‐return behavior of stocks. This article addresses the question of how the market's efficiency arises. The central message is that managers can better understand markets as a complex adaptive system. Such systems start with a “heterogeneous” group of investors, whose interaction leads to “self‐organization” into groups with different investment styles. In contrast to market efficiency, where “marginal” investors are all assumed to be rational and well‐informed, the interaction of investors with different “decision rules” in a complex adaptive system creates a market that has properties and characteristics distinct from the individuals it comprises. For example, simulations of the behavior of complex adaptive systems suggest that, in most cases, the collective market will prove to be smarter than the average investor. But, on occasion, herding behavior by investors leads to “imbalances”—and, hence, to events like the crash of '87 and the recent plunge in the NASDAQ. In addition to its grounding in more realistic assumptions about the behavior of individual investors, the new model of complex adaptive systems offers predictions that are in some respects more consistent with empirical findings. Most important, the new model accommodates larger‐than‐normal stock price volatility (in statistician's terms, “fat‐tailed” distributions of prices) far more readily than standard efficient market theory. And to the extent that it does a better job of explaining volatility, this new model of investor behavior is likely to have implications for two key areas of corporate financial practice: risk management and investor relations. But even so, the new model leaves one of the main premises of modern finance theory largely intact–that the most reliable basis for valuing a company's stock is its discounted cash flow.     

Limiting the ACA's Threats to Small Group Health Insurance Markets

We identify three threats to small group health insurance markets that may result from the 2014 implementation of certain provisions in the Affordable Care Act (ACA). First, small employers with predominantly low‐income employees may tend to opt out of small group markets because their employees will be better off with subsidized individual coverage. Second, small employers with employees of heterogeneous income levels will have strong incentives to offer coverage that is either “unaffordable” or fails to provide “minimum value” in order to preserve the availability of government subsidies for their low‐income employees. Finally, small employers that continue to offer group plans will face increased incentives to self‐insure those plans, further contracting small group markets and subjecting them to adverse selection. Collectively, these forces may destabilize small group markets and increase the ACA's fiscal cost. We therefore conclude by offering various reforms aimed at offsetting these risks and preserving the viability of small group markets.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

The State of the Public Corporation: Not So Much an Eclipse as an Evolution

By some measures, the U.S. public corporation appears to be in the midst of a significant decline, as Michael Jensen predicted 25 years ago in a Harvard Business Review article called “The Eclipse of the Public Corporation.” Based on an analysis of ten industries during the 48‐year period from 1966 through the end of 2013, the author reports a 60% drop in the number of publicly traded U.S. companies, as measured from each of the industry peaks to the end of 2013. Mergers and acquisitions, together with the private‐equity transactions hailed by Jensen in his 1989 HBR article, have contributed significantly to this reduction in numbers. But so has the remarkable growth of “uncorporate” (or pass‐through) structures such as Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs), both of which address governance as well as tax problems faced by public C‐corporations. But along with this drop in numbers, the author's analysis of the performance of U.S. public companies—as measured both by operating returns on equity and Tobin's Q ratios—also shows a growing separation of the “best” from the “rest” over time. Intense global product market competition, the growing benefits (and urgency) of achieving efficient scope and scale, high U.S. corporate income tax rates, and a vigorous market for corporate control are all significantly “thinning the herd” of public corporations. The “winners” have been emerging as larger, more efficient, and more influential enterprises than ever before, as the rise of massive U.S. multinationals (and, in countries outside the U.S., state‐owned enterprises) over the past two decades has increasingly blurred the line between private business and government. Viewed in this light, the overall trends, both in the U.S. and abroad, suggest an evolution rather than an eclipse of the public corporation. Such trends also suggest that over the next 25 years, the success of the public corporation will increasingly depend on issues such as its ability to resolve conflicts between controlling shareholders (including sovereign governments) and minority shareholders, regulatory (in particular, antitrust) policy, and the role (and investment horizons) of activist shareholders.     

The Strange and Futile World of Trade Wars

U.S. President Donald Trump has a misguided, mercantilist view of international trade. He believes that an external (or “trade”) deficit is a “problem,” and that this deficit is caused by foreigners engaging in unfair trade practices. Accordingly, the president and his followers feel that the U.S. is being—and has long been—victimized by foreigners. The reality, however, is that the negative external balance in the U.S. is neither a “problem” nor is it attributable to foreigners engaging in nefarious activities. The U.S.'s negative external balance, which the country has registered every year since 1975, is “made in the USA.” External balances are always and everywhere homegrown; they are the reflection and the result of the relationship between domestic savings and domestic investment. And it is the gap between a country's savings and domestic investment that is the fundamental driver and determinant of its external balance. Specifically, the current account balance, or “trade deficit,” is the sum of the private savings‐investment gap and the public savings‐investment gap, or what is known as the “fiscal balance.” From 1972 until the end of 2018, for example, the cumulative private sector savings‐investment gap in the U.S. was a positive $12.8 trillion; that is, U.S. companies and individuals collectively saved—that is, earned and retained—some $12.8 trillion more than they consumed and invested domestically. But this positive balance was completely overshadowed by the cumulative negative government gap—or cumulative fiscal deficits—of $24.2 trillion during this 47‐year period. And thus the U.S. as a whole experienced a savings‐investment gap of negative $11.4 trillion that is entirely attributable to the country's fiscal deficits. What's more, the fact that the U.S. recorded a cumulative current account deficit of $11.5 trillion during this period confirms that the U.S. external deficits simply mirror what is happening in the U.S. domestic economy, just as the savings‐investment identity suggests. And, of course, the savings‐investment identity holds true for all countries, even those with significant external surpluses. Japan and China have both long experienced savings surpluses, and both have run current account surpluses that have mirrored their positive savings‐investment gaps. If the U.S. mercantilists understood what causes trade and current account deficits, they would direct their ire at profligate government spending rather than at foreigners. But they don't understand. And the leader of the mercantilists, President Trump, is flying blind and presiding over ever‐expanding fiscal deficits—which will only ensure that the current account deficits not just continue, but get bigger.     

Re‐imagining Infrastructure*

A senior executive of Booz Allen Hamilton and co‐author of a business bestseller called Megacommunities argues that the United States is locked into an obsolete pattern of dealing with infrastructure investment, even as the country's population growth and technology have raced ahead. Three of America's basic “lifeline” infrastructures—energy, transportation, and water—are nearing the end of their useful operating lives and in desperate need of modernization. U.S. capital spending on infrastructure has been inadequate, amounting to less than 2% of GDP, as compared to 9% in China and 5% in India. But if infrastructure renewal will be costly, money is not the biggest obstacle. History shows that modernizing existing infrastructures tends to be even more challenging than creating new ones because of the drag caused by legacy hardware and the associated human “software.” And so the real problems are conceptual, institutional, and political—problems whose solutions demand transformational vision and leadership that will encourage collaborative participation by both the public and private sectors. What is lacking, then, is an oversight and coordination mechanism that restores government's traditional integrating role without creating either new monopolies or a larger, more centralized government. To that end the author issues four imperatives: First is the need to rethink the form and function of our old infrastructures. Second is the need for design principles that make future infrastructures robust and adaptable as technology advances, funding changes, and the needs of our citizens evolve. Third is the need for leadership that succeeds by convening, integrating, and aligning the interests and actions of all important stakeholders. Fourth and last is the need for a national vision for America's infra‐structure that defines the function and performance of the entire system over its total lifecycle. A new kind of collaboration by different constituencies, which the author refers to as the creation of “megacommunities,” is held up as a way for stakeholders with conflicting interests to cooperate on compelling issues of national importance with a shared set of practices and protocols.     

MERTON MILLER'S CONTRIBUTIONS TO MODERN FINANCE

Winner of the 1990 Nobel Prize in Economics, and widely regarded as the “father of modern finance,” the University of Chicago's Merton Miller died last June at age 77. This article attempts to sum up Miller's career in terms of a single governing principle: the role of arbitrage in ensuring the “efficiency” of financial markets and, more generally, the effectiveness of such markets in promoting economic growth and creating social wealth. Starting with the formulation of Proposition I (also known as the capital structure irrelevance proposition) with Franco Modigliani in 1958, Miller's research over the next 40 years is seen as applying—with remarkable clarity and consistency—the principle of arbitrage to the study of many aspects of financial markets. Miller's main accomplishment, according to the author, is to have made arbitrage arguments the cornerstone of modern finance. The arbitrage proof of Proposition I introduced a new standard in finance—namely, that any finding in financial research deserving serious consideration must have the critical property that it cannot represent opportunities for riskless profit by investors. And the article goes on to show that arbitrage is a constant theme in Miller's writings, from his work in corporate finance to his later studies of financial innovation, derivatives markets, and financial crashes and crises. Having started and presided over the transformation of financial studies from a “glorified apprenticeship system” into a scientific discipline, Miller devoted much of the last 15 years of his life to a different, though clearly related undertaking: the defense of financial markets against the attacks of politicians and regulators, as well as businessmen intent on stifling competition (including hostile takeovers). Whether it was the alleged role of the stock index futures markets in the 1987 market crash, the claims of “overleveraging” in the LBOs of the '80s, or the derivatives fiascos in the mid‐'90s, Miller was there to provide careful economic analysis of the problems. In the early '90s, he explained why the “myopia” of the U.S. stock market was likely to cause far fewer problems than the “hyperopia” induced by regulatory distortions of the Japanese market. And in one of his last speeches, Miller showed that the primary cause of the recent Asian crisis was not “too much reliance on financial markets,” as claimed by politicians and the popular press, but “too little”—in particular, the heavy dependence on bank financing (particularly state‐owned banks) and the failure to develop alternative sources of capital that continue to depress the Japanese economy.     

Brand India—Where Next? A Panel Discussion

Three large‐company top executives, a prominent journalist, and a representative of India's Ministry of Tourism discuss the country's recent transformation into “the world's fastest‐growing, free‐market democracy.” Much of the discussion concerns the recent accomplishments of Indian companies and executives, both those working inside the country and the many who have risen to prominence outside it. But the recent rise of India is more than a matter of economic success. Brand India is also, in the words of one panelist, “a soft brand as well as a hard brand… It is not only about efficiency, but about democracy and reverence for learning and the past, about art and architecture, and Bollywood and yoga, all of which have a cultural and even a spiritual dimension.” As for India's material progress, journalist Vir Sanghvi traces the origins of India's recent economic growth back to 1991, the year the country launched its ambitious program of economic liberalization. In this view, the Indian success story is one that begins with the opening up of markets, a gradual (though uneven) privatization of industry, and increased foreign investment. These are the main contributors to India's recent burst of economic growth, which in turn has generated the tax revenues necessary to fund large‐scale spending on education and healthcare. But whether the rate of economic growth and social progress accomplished by this combination of private‐sector growth and public spending can be maintained will depend heavily on a political process that has often been hostile to the ideas of free markets, privatization, and foreign investment.     

American Enterprise Institute Roundtable: Was Milton Friedman Right about Shareholder Capitalism?*

In this look back at Milton Friedman's famous essay in The New York Times 50 years ago organized by the American Enterprise Institute, three well‐known panelists discussed whether executives should continue to be guided by Friedman's oft‐cited statement that the “social responsibility of business is to increase its own profits.” One pretext or prompt for this discussion is the Business Roundtable's recent rethinking of the corporate mission, with its emphasis on all corporate stakeholders, employees and local communities as well as shareholders. Among the panelists, Marty Lipton takes the most enthusiastic view of this alternative to shareholder primacy. Now often identified as “stakeholder capitalism,” this alternative is embraced by Lipton as part of a “New Paradigm” in which large, universal owners act more or less in concert to pressure private companies to play a greater role in protecting the environment and lifting people out of poverty. By contrast, fund manager Cliff Asness and former Bush advisor and Columbia Business School dean Glenn Hubbard find considerable relevance and resilience in the old shareholder paradigm. Hubbard, for example, emphasizes the impossibility of maximizing long‐run value in highly competitive product and labor markets without taking care of all important stakeholders. And while sympathetic to the intent of the Business Roundtable—and the value of ensuring enough investment in corporate stakeholders—both Hubbard and Asness are troubled by the prospect of a corporate governance system trying to hold corporate managers accountable in a stakeholder‐centric world.     

A Look Back at Merton Miller's “Financial Markets and Economic Growth”

The author begins by agreeing with Miller's characterization of the fragility of U.S. banks and of the shortcomings of the Asian model of bank finance‐driven growth. The article also expresses “emphatic agreement” with Miller's arguments that the protection of banks through deposit insurance, regulatory forbearance, and other forms of “bailout” have created costly moral‐hazard problems that encourage excessive risk‐taking. And the author endorses, at least in principle, Miller's main argument that the development of capital markets that do not require the direct involvement of banks should make economies if not less prone to financial crises, then at least more resilient in recovering from them. But having acknowledged the limitations of bank‐centered systems and the value of developing non‐bank alternatives for savers and corporate borrowers, the author goes on to point to the surprising durability of some banking systems outside the U.S.—notably Canada's, which has not experienced major problems since the 1830s. And even more important, the author views banks and capital markets not as “substitutes” for one another, but as mutually dependent “complements” whose interdependencies and interactions must be recognized by market participants and regulators alike.     

Financial Markets and Economic Growth*

In this reprinting of the Nobel Prize‐winning financial economist's classic statement about the origins of financial crises, the Southeast Asian crisis of the late 1990s is attributed “not to too much reliance on financial markets, but to too little.” Like the U.S. economy a century ago, the emerging Asian economies did not then—and do not now—have well‐developed capital markets and remain heavily dependent on their banking systems to finance growth. But for all its benefits, banking is not only basically 19th‐century technology, but disaster‐prone technology. And in the summer of 1997, a banking‐driven disaster struck in East Asia, just as it had struck so many times before in U.S. history. During the 20th century, the author argues, the U.S. economy reduced its dependence on banks by developing “dispersed and decentralized” financial markets. In so doing, it increased the efficiency of the capital allocation process and reduced the economy's vulnerability to the credit crunches that have recurred throughout U.S. history. By contrast, Japan has not reduced its economy's dependence on banks, and its efforts to deal with its banking problems during the crisis of the late'90s served only to destabilize itself as well as its neighbors. Developing countries in Asia and elsewhere are urged not to follow the Japanese example, but to take measures aimed at developing financial markets and institutions that will either substitute for or, in some cases, complement bank products and services.     

CARE Conference Hong Kong Polytechnic University,June 9, 2014: Equity Financing for Early‐Stage Companies in China

Many of the smaller private‐sector Chinese companies in their entrepreneurial growth stage are now being funded by Chinese venture capital (VC) and private equity (PE) firms. In contrast to western VC markets, where institutional investors such as pension funds and endowments have been the main providers of capital, in China most capital for domestic funds has come from private business owners and high net worth individuals. As relatively new players in the market who are less accustomed to entrusting their capital to fund managers for a lengthy period of time, Chinese VCs and their investors have shown a shorter investment horizon and demanded a faster return of capital and profits. In an attempt to explain this behavior, Paul Gompers and Josh Lerner of Harvard Business School have offered a “grandstanding hypothesis” that focuses on the incentives of younger, less established VCs to push their portfolio companies out into the IPO market as early as they can—and thus possibly prematurely—to establish a track record and facilitate future fundraising. This explanation is supported by the under‐performance of Chinese VC‐backed IPOs that has been documented by the author's recent research. Although they continue to offer significant opportunities for global investors, China's VC and PE markets still face many challenges. The supervisory system and legal environment need further improvement, and Chinese funds need to find a way to attract more institutional investors—a goal that can and likely will be promoted through government inducements.     

Private Equity,Corporate Governance,and the Reinvention of the Market for Corporate Control

In the early 1980s, during the first U.S. wave of debt‐financed hostile takeovers and leveraged buyouts, finance professors Michael Jensen and Richard Ruback introduced the concept of the “market for corporate control” and defined it as “the market in which alternative management teams compete for the right to manage corporate resources.” Since then, the dramatic expansion of the private equity market, and the resulting competition between corporate (or “strategic”) and “financial” buyers for deals, have both reinforced and revealed the limitations of this old definition. This article explains how, over the past 25 years, the private equity market has helped reinvent the market for corporate control, particularly in the U.S. What's more, the author argues that the effects of private equity on the behavior of companies both public and private have been important enough to warrant a new definition of the market for corporate control—one that, as presented in this article, emphasizes corporate governance and the benefits of the competition for deals between private equity firms and public acquirers. Along with their more effective governance systems, top private equity firms have developed a distinctive approach to reorganizing companies for efficiency and value. The author's research on private equity, comprising over 20 years of interviews and case studies as well as large‐sample analysis, has led her to identify four principles of reorganization that help explain the success of these buyout firms. Besides providing a source of competitive advantage to private equity firms, the management practices that derive from these four principles are now being adopted by many public companies. And, in the author's words, “private equity's most important and lasting contribution to the global economy may well be its effect on the world's public corporations—those companies that will continue to carry out the lion's share of the world's growth opportunities.”     

The Achievements and Future of Business Education

The dean of Columbia Business School is joined by the deans of Stanford, Harvard, and Wharton in discussing the challenges and opportunities facing today's graduate business schools. Most business schools aim to provide students with a certain body of knowledge—in disciplines such as marketing, finance, and accounting—as well as some general management and leadership training and skills. The biggest challenge to this model of business education is now coming from the high cost of the traditional two‐year MBA program and the threat of disruption by “online” alternatives. But the consensus of the four deans is that the combination of training and experience provided by today's top business schools will enable them to withstand the threat from online alternatives. And thus for the leaders of these top schools, one of the main challenges in designing and maintaining a successful business school program is to find the right mix of theory and practice, classroom and “experiential” learning. To the extent the schools succeed in achieving and maintaining this balance, they should continue to produce graduates who are sought by employers that include not only companies large and small, but non‐profits and, at some points in their careers, even the public sector. What's more, the deans all sense the growing demand for business to play a larger role in addressing social problems that have traditionally been seen as the responsibility of government and non‐profits. And one implication of this demand is that business schools, besides producing talent that finds its way to the public as well as private sectors, should prepare to play a greater role in the public debate over solutions to social challenges, such as protecting the environment while at the same time trying to stimulate enough economic growth to limit rising inequality.     

THE REVOLUTION IN CORPORATE RISK MANAGEMENT: A DECADE OF INNOVATIONS IN PROCESS AND PRODUCTS

The explosion of corporate risk management programs in the early 1990s was a hasty and ill‐conceived reaction by U.S. corporations to the great “derivatives disasters” of that period. Anxious to avoid the fate of Barings and Procter & Gamble, most top executives were more concerned about crisis management than risk management. Many companies quickly installed (often outrageously priced) value‐at‐risk (VaR) systems without paying much attention to how such systems fit their specific business requirements. Focused myopically on loss avoidance and technical risk measurement issues, the corporate risk management revolution of the '90s thus got underway in a disorganized, ad hoc fashion, producing a curious amalgam of policies and procedures with no clear link to the corporate mission of maximizing value. But as the risk management revolution unfolded over the last decade, the result has been the “convergence” of different risk management perspectives, processes, and products. The most visible sign of such convergence is a fairly recent development called “alternative risk transfer,” or ART. ART forms consist of the large and growing collection of new risk transfer and financing products now being offered by insurance and reinsurance companies. As just one example, a new class of security known as “contingent capital” gives a company the option over a specified period—say, the next five years—to issue new equity or debt at a pre‐negotiated price. And to hold down their cost, such “pre‐loss” financing options are typically designed to be “triggered” only when the firm is most likely to need an infusion of new capital to avoid underinvestment or financial distress. But underlying—and to a large extent driving—this convergence of insurance and capital markets is a more fundamental kind of convergence: the integration of risk management with corporate financing decisions. As first corporate finance theorists and now practitioners have come to realize, decisions about a company's optimal capital structure and the design of its securities cannot be made without first taking account of the firm's risks and its opportunities for managing them. Indeed, this article argues that a comprehensive, value‐maximizing approach to corporate finance must begin with a risk management strategy that incorporates the full range of available risk management products, including the new risk finance products as well as established risk transfer instruments like interest rate and currency derivatives. The challenge confronting today's CFO is to maximize firm value by choosing the mixture of securities and risk management products and solutions that gives the company access to capital at the lowest possible cost.     

Sustainability at Dow Chemical

Dow Chemical Company, which was founded in 1894, is now the second‐largest chemical company in the world. From the outset, the company has been committed to high‐technology research and commercial innovation in chemistry, advanced materials, and agro‐sciences. But if Dow's long history of innovation is impressive, the greatest change in the past few years has been the company's use of innovation to reinforce its commitment to sustainability. In 1996, the company produced its first set of 10‐year sustainability‐related goals. In an effort to meet such goals, the company invested a total of $1 billion in environmentally beneficial products such as new seeds and traits in Dow's AgroSciences business, solar shingles, and advanced battery technologies. Along with the social benefit of higher crop yields and reduced carbon emissions, the company's return on this investment has been estimated at $5 billion. The company was even more ambitious when setting its next set of 10‐year goals in 2006. In this statement, Dow's leadership aimed to create a culture that saw sustainability as a business opportunity from the perspective of a “triple bottom line”—a performance evaluation scheme focused on “people, planet, and profit” that construes success in terms of social benefits, environmental stewardship, and economic prosperity. Dow is now starting the process of developing its third set of 10‐year goals, with the aim of producing a plan that will ensure the viability of the company 50 years from now. With this end in mind, Dow's leaders understand their obligation to continue investing in the health and well‐being of their employees, their communities, and the environment while still creating value for their shareholders.