Of investment bankers, entrepreneurs, VCs, and life

One of the tragedies of investment banking as a profession is that although bankers are paid stratospheric amounts by the standards of most people they spend their entire careers working for the fraction of individuals who end up becoming (much) richer than they are.

Consider: a very successful fortysomething investment banker who has amassed some £5 million in net wealth is assisting in the public flotation of a company.

This company was started seven years ago by a 30 year old. This 30 year old managed to raise £2 million in capital from a VC in exchange for a 60% stake in the company after two years of trading.

Now 37 the entrepreneur is taking her company public, floating at a market cap of £500 million. The entrepreneur will sell half of her 40% stake (i.e. £100 million) to the market, and immediately reinvest half that amount (£50 million) in the business.

Her VC partners are similarly selling half their 60% stake (£150 million) to the markets, and reinvesting half this amount (£75 million) in the business.

The company will raise £125 million to invest in new plant and expand worldwide. If things go as expected the stake held by the entrepreneur will double within three years to £200 million.

Out of all this the bank takes a 1% fee for buying the shares initially. 1% of £225 million or £2.25 million. The banker expects to receive 10% of this in his bonus, or £225, 000. He has already advised on three similar transactions so far this year, and the year is nearly over, so he *expects* his bonus to be around £900, 000, on top of his salary of £200, 000.

Around half of this will be taken in income taxes (compared with 18% capital gains tax or £9 million in the case of the entrepreneur) leaving the banker with take-home pay of £550, 000. After the flotation the entrepreneur has £41 million in cash and a 20% stake in a company that is expected to be worth £1 billion in three years.

The banker end that year with net wealth of £5.55 million. The entrepreneur ends that year with net wealth of £141 million plus whatever is left over from dividends and what she paid herself over the previous 7 years.

This is the heart of the tragedy of capitalism. As the man said, you gotta serve somebody. The banker serves the enrepreneur who probably feels hard done-by that she didn’t keep a larger stake in her firm. The VCs will be happy, but they are accountable to their own shareholders who are themselves accountable to equity and pension funds, who are in turn accountable to clients who really just want to live a quiet life/retirement.

Overall, on average, society wins, but at the cost of everyone being just the tiniest bit pissed off at the place they ended up in the pyramid. So they’ll keep pounding away on the hedonic treadmill in the hope that something will come up.

Interesting times and not the end of Capitalism

As before, Wil Hutton in The Guardian:

This is not the end of capitalism, as some wildly claim; there is no intellectual, social or political challenge to a market system based on respect for private property rights, even by the Chinese Communist party.

Rather, it is a crisis of a particular capitalism that has set aside respect for trust, integrity and fairness as fuddy-duddy obstacles to 'wealth generation'.

Well thank goodness for that.

Now hopefully the Americans will get a handle on their borrowing; quit Iraq in as orderly and rapid manner as possible, invest in infrastructure, education, nationalise their healthcare as well as their banks and mortgage companies and leave running the world to the Europeans or Chinese.

In fact the ideal situation would be one where there were three Great Powers - the Europeans, Americans, and Chinese, with an influential G8 and India. According to this article by Jon Taplin, and based on The Great Transformation by Karl Polanyi, Taplin's analysis:

His conclusion is that the key to a long period of peace is a stable Balance of Power between three or more states, combined with a stable world financial system (he calls it Haute Finance) which constantly stresses that war is destructive to trade.

Also worth checking out is The Rise and Fall of Great Powers by Paul Kennedy and Charles Stross' commentary on this essay on the fall of the USSR by Yegor Gaidar:

Normally empires decline slowly; it took nearly half a century for the British empire to descend from planetary hegemony to the edge of bankruptcy in 1945, for example.

The USSR took a decade from the first serious worries about its balance of trade to the final abortive Putsch and Gorbachev's resignation.

But the US Empire has developed a uniquely unstable financial system over the past two or three decades, and we may be witnessing a catastrophic collapse. (I hope not; this sort of event is deeply uncomfortable and unpleasant to live through, even when it doesn't coincide with major environmental crises, a power vacuum, and a disciplined cadre of apocalypse-obsessed religious fanatics waiting in the wings to seize power if they can.)

Clearly I need to write a list of lessons to be learned from the current economic problems.

[image credit to thegoldguys, via luxamart on flickr]

The End of capitalism?

I wish commentators wouldn't blather on about the current economics problems being "the end of capitalism" - it's a lazy use of words. As John Gray has it in The Guardian:

There has been a good deal of talk in recent weeks about imminent economic armageddon. In fact, this is far from being the end of capitalism. The frantic scrambling that is going on in Washington marks the passing of only one type of capitalism - the peculiar and highly unstable variety that has existed in America over the last 20 years.

David Cox on The First Post has it that this is a crisis of democracy, not capitalism:

Some see our current plight as a crisis of capitalism. It may become instead a crisis of democracy. Already, we have cheerfully sacrificed free speech, habeas corpus and personal privacy to lesser threats than economic cataclysm.

My personal feeling: there is nothing wrong with capitalist, free-market systems that are effectively-regulated by democratic states. I don't think what has happened in the debt derivatives market has been effectively regulated by anyone. This is the root of the problem.

A failure of ownership

An interesting article by Chris Dillow in The Times concerning the current financial crisis:

...one form of ownership has caused a crisis, and another hasn't. The reason for this lies in what economists call the principal-agent problem, and what everyone else calls the difficulty of getting your employees to act in your interests rather than their own.

Big, quoted companies have been unable to solve this problem. Shareholders - often, ordinary people with pensions - have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn't understand the complexities of mortgage derivatives.

I'll give you this for some lovely CDOs...

So traders were free to gamble with other people's money. They got multimillion bonuses if they did well, but faced almost no meaningful sanction if they failed: John Thain, Merrill Lynch's chief executive, is rumoured to be in line for an $11 million payout. The result was excessive risk taking.

This makes a lot of sense: free markets are powerful tools, but like many powerful tools they need to be carefully controlled, primed, and monitored.

Creating situations where the ownership of firms results in employees and owners having different aims and agendas is a recipe for this sort of failure.

Dillow refers to a book called The Subprime Solution by Robert Schiller:

The solution to our troubles, he says, is more markets, not fewer. He proposes the introduction of markets in livelihood insurance, so that people can buy protection against job losses, and better markets in house-price futures, so we can insure against falling house prices.

People need to learn to respect the free market: understand what it does, how it does it, and what its limitations are.

It isn't a case of more regulation and state control vs. less regulation and state control, it is a case of finding the appropriate levels of state control.

Muscular socialism

Interesting article by Matthew Parris in The Times. He points out that all this "caring and sharing" Christian socialism that he says Tony Blair was so enamoured with, with it's obsession with the poor and disabled, has little to do with what Marx talked about:

Away (the socialist should say) with caring and diversity: let's hear about investment, not subsidy; progress, not equality; about Crossrail (what's the betting Mr Brown cancels it?); about how Britain generates its own power, how we rescue our rail network from impending insolvency, how we get from London to Scotland by train in two hours, and how we stop the planning system throttling every big project; about how we develop a global positioning system that the Americans don't control, how we pay for better highways and uncongested streets with proper road pricing, and how we research and market carbon-free transport, heat and power.

Muscular socialism

From a pluralistic, or agonistic point of view it is necessary that there be a muscular, statist, centralising, collectivist alternative to the economically liberal, capitalistic, federalising tendency of the past few decades.

The problem with Labour at the moment is their complete lack of ideological candour and legislative narrative.

Parris claims he is an economic liberal: but he observes the necessity of a socialist or social democratic tendency in the political debate with the coming economic difficulties.

This is very astute.

(So much muscularity! I will need to go and have a lie down!)

[image from Trevor H]

Business and Capitalism

In recent months there has been an extensive debate in the NewsCloud (I'm fed up with talking about newspapers, media, the press, the blogosphere - the NewsCloud will suffice) about capitalism; where it is going, where it now, and how it got here.

Two articles in the Cloud today highlight two different issues:

1) Luke Johnson writing in the FT comments:

"Innovation and progress come from embracing markets and encouraging entrepreneurs. The world is more competitive than ever; we cannot rely on old industries and the state to maintain our standard of living."

I happen to agree with this. When commentators go on about how awful the credit crunch is and how evil all these userous capitalists are in dragging us into this mess they always fall foul of the fact that they do not have a coherent alternative strategy.

I also agree with Peregrine Worsthorne that a squeeze on the financial industry might lead to an egress of talent away from finance and towards more useful things like medicine, pharmaceutical research, and entrepreneurism.

Johnson goes on to say:

"Markets are naturally dynamic, whereas governments resist change and fresh thinking. According to the Global Entrepreneurship Monitor, overall early-stage entrepreneur activity in Britain involves about 5.6 per cent of the population, a much lower rate than in the US, Brazil or China."

An Entrepreneur

A nation of shopkeepers? I think not. However Johnson makes the point that:

"A slowdown in the economy and rising unemployment might just stimulate more to start their own business as an alternative. This would be the silver lining of the credit crunch cloud."

Although the UK is not openly hostile towards entrepreneurs, they are not afforded the same respect as accountants, physicians, architects, or academics. Johnson describes entrepreneurism as just as much a calling as these respected professions but (partly because of our confused and irritating emphasis on class) in the UK "entrepreneur" is not listed on the job sheet.

2) The second article is from Edward Pearce in The Guardian:

"Modern capitalism has become etiolated. It has flourished lately upon deals ever more remote from raising capital investment for steel mills and biscuit factories, upon leverage and derivatives, upon credit and the ghost of credit, upon financial rice paper."

Speculation seems to be endemic to capitalism. Fortunately all this credit crunch nonsense seems to be having a negligible effect on actual global economic growth. China makes things.

From a science fictional perspective there is something reassurring about this. Times change, technologies change, but wherever there are financial markets there are speculative bubbles, and crashes and crunches.

The two ends of capitalism: the rarified ivory tower of deriveratives of deriveratives (George Soros et al) and the coalface of business and wealth-creation (Felix Dennis, Richard Branson) and the inbetweeners of capital allocators like Warren Buffett.

How it worked in the good old days

The whole wagon will continue rushing into the future. If it all breaks down completely (a situation where "end of the world" insurance would come into play, from Pearce:

"The existence of such manic trade created secondary explosions (or do I mean secondary deposits?) in the insurance world. Here the rule is the greater the likelihood of damage, the higher the premium. But the least probable horrors may be insured against at modest cost. The top point is called "end of the world" insurance, the unthinkable: Hugo Chávez takes over the White House, the moon coming perceptibly nearer. It's so remote it's cheap, $2,000-$3,000 a year rents $10m worth. Or it did. That volume now sets you back $20,000-$30,000."

I know! WTH?) then at least capitalism, or at least the concept of trade, will survive.

Morals and Markets with Robert Skidelsky

Economics boffin Robert Skidelsky has written an interesting article over at CiF about the morality of capitalism, this is my paragraph-by-paragraph response:

"...Because no social system can survive for long without a moral basis..."

This isn't really correct. Slavery persisted for centuries in the ancient world as the economic prime mover and yet was and is morally suspect.

"...It has often been claimed that capitalism rewards the qualities of self-restraint, hard work, inventiveness, thrift, and prudence. On the other hand, it crowds out virtues that have no economic utility, like heroism, honour, generosity, and pity..."

I think this depends on other cultural factors. Capitalism may encourage or discourage certain characteristics, but it doesn't mean these don't exist.

Also it isn't entirely true that honour and generosity are "crowded out" - good businessmen and businesswomen know the value of honour and generosity.

"...For quality of life, we have to rely on morals, not markets..."

This is very true.

"...But it is truer to say that the market economy is sustained by the stimulation of greed and envy through advertising..."

I wonder if it is useful to distinguish between capitalism and consumerism, and if it is useful to distinguish between "good" (buying organic, locally produced, low-CO2-profile vegetables) consumerism and "bad" (cigarettes) consumerism?

"...In a perfectly competitive market, with full information, models of the market show that all the factors of production receive rewards equal to their marginal products, ie all are paid what they are worth..."

As in the market, so in life. If everyone had "full information" we'd all be much happier. But because having "full information" is unfeasible it isn't useful to use this as a stick to beat capitalism with.

"...But no actually existing capitalist market system spontaneously generates justice in exchange..."

This is why liberal democracies have (democratically elected) representatives who control the state and who provide justice.

"...That is why the liberal theory of justice demands at a minimum equality of opportunity: the attempt - as far as is compatible with personal liberty - to eliminate all those differences in life chances arising from unequal starting points..."

Sorry, I should read down further before I comment. I agree completely.

"...Finally, the claim that everyone is - under ideal conditions - paid what they are worth is an economic, not a moral, valuation..."

Yes, I agree with this.

"...The simplest way of doing this is to restrict advertising. This would prune the role of greed and envy in the operation of markets, and create room for the flourishing of other motives..."

Governments do restrict advertising. "Re-moralising" wants is an interesting idea. But I don't see how "restricting" advertising accomplishes that.

Promoting morality is a difficult thing to do without being morally puritan and judgmental of other people's pleasures.

I would say that a good step would be to replace "RE" lessons in UK schools with "morality and ethics" lessons where students were taught about different moral and ethical structures and asked to consider moral and ethical problems.