PERSPECTIVES by zhouwenjuan


  For clients and partners of Reuss Private                                                                                Issue 8 | September 2010

Beware “fake” stock corporations
Adriano B. Lucatelli

If you’re investing for the long term you               (see Table 1). If the economic value generated by     Life insurers are a very good example. Between
should not just be assessing profitability              its business primarily goes to customers, the or-     1997 and 1999 alone, more than a dozen mu-
and upside potential.You should also be                 ganization should be structured as a cooperative      tual insurance companies converted to stock
checking to see whether the company                     or mutual. If most of the profits go to manage-       corporations in an attempt to meet the chal-
whose shares you intend to acquire really               ment, it should be organized as a partnership.        lenges of deregulation and intense competition
functions as a stock corporation. If you                But in cases where the lion’s share of profits is     more effectively.The argument was that a stock
invest in a “fake” stock corporation, you               paid to the owners in the form of dividends, a        corporation would make it easier to raise the
are the one who bears the risks of its                  stock corporation (company limited by shares)         necessary capital on the markets, or that it would
business, while the lion’s share of the eco-            is the most appropriate structure. A failure to       help create better incentives for management in
nomic value created goes to the com-                    choose a legal entity appropriate to the balance      the form of equity or option schemes. In addi-
pany’s management or customers.                         of risks and returns will inevitably lead to con-     tion to this, it was argued, a share-based struc-
                                                        flicts of interest among stakeholders. The result     ture would enable companies to pursue new
Anyone keeping an eye on the long-term stock            will be chronic disappointment in terms of cap-       business models with greater value creation po-
market performance of life insurers and airlines        turing the full value creation potential of the       tential, for example building private and institu-
will soon have realized that there has been little      business.                                             tional asset management capabilities. The high
money to be earned on these shares in the long                                                                stock market valuations of these companies at
run. What these companies have in common is             Despite this clear relationship, many businesses      the time certainly did nothing to harm the pop-
the way the profits and financial risk of their busi-   still have the wrong legal form of organization.      ularity of their decision to go public.
ness are apportioned. While shareholders in-
vesting in a life insurance company or airline bear
the full risk of loss, the lion’s share of the eco-     Table 1:Who should be reaping the economic rewards?
nomic value created goes to the customers, ei-
ther via policyholder participation (in some cases
mandatory) or comprehensive frequent flyer                                                Management                  Investors           Customers
schemes set up by airlines to reward customer
loyalty. In both these cases, the risk borne by                    Stock corporation      Managers                    Shareholders        Customers
shareholders stands in no relation to the poten-
tial losses. So you could reasonably contend that                  Cooperative/mutual     Manager                     Members
since they do not function as “genuine” stock
corporations, life insurers and airlines should in                 Partnership            Partners                                        Customers
fact be organized as cooperatives or mutuals,
with a balanced appor tionment of risks and
returns ensured because their shareholders and                                               Economic value created
customers are identical.                                                                                                                 Source: Reuss Private, Swiss Re

Legal form has to match the allocation
of risks and returns

Essentially the chosen legal vehicle should prop-
erly reflect the allocation of risks and rewards
under the organization’s ownership structure
                                                                                                                                     Reuss Private | Perspectives | 1
Life insurers acting like mutuals                        Chart 1: Swiss Life vs. SMI since 1997

Ten years down the line, however, there is wide-                                 300%
spread disillusionment about the amount of
value actually created by these insurers. For ex-                                250%
ample according to a study conducted by OLZ
& Partners for the magazine Bilanz (12/2007,
12/2008 and 4/2010), life insurer Swiss Life de-                                 150%
stroyed almost CHF 2.6 billion in value between
2003 and 2009. Shareholders were asked to foot                                   100%
the bill in a number of rights issues, the share
price plummeted, and no dividends were paid.
Policyholders, by contrast, received their guaran-                                 0%
tees and surplus payments every year without
fail. So it hardly comes as a surprise to learn that                            – 50%
Swiss Life shares have done considerably worse                                 – 100%
than the SMI since the IPO in 1997 (see Chart














1). In this light, the words of the then-CEO of
Metropolitan Life (in an address to the US Sen-
ate back in 1915 when his company converted
                                                                                                 Swiss Life
from a stock corporation to a mutual society),
seem almost prophetic: “No longer would the
board be subject to the conflicting interest of                                                                                                                                             Source: UBS
shareholders and policyholders – their primary
responsibility would now be to the policyhold-
ers” (Swiss Re, Sigma No. 4/1999).
                                                         Chart 2: Credit Suisse vs. banking industry indices (2004 –10)
And wealth managers and investment
banks acting like partnerships
It’s a similarly sobering story for shareholders in
banks that are heavily involved in investment
banking and wealth management. The reason is                                     100%
that a large part of the value created in these
businesses goes to management and top advi-
sors. Here, too, there is an asymmetric balance of                                50%
risks and potential returns. If the business earns
a profit, employees reap a disproportionate
share of the value created; if it posts a loss, the
shareholder bears the entire risk. Given this ap-
portionment of risks and rewards, a partnership
seems by far the most appropriate legal entity to
choose. But most global players in this industry                                 – 50%
are organized as stock corporations. Once more
the result is that no shareholder value has been
generated in the longer term.                                                   –100%






Credit Suisse (CS) is a textbook example of this                                                                                                                                                      2010
(see Chart 2). While members of CS manage-
ment drew millions in salary even in years when                                                  Credit Suisse
the bank was posting a loss, as well as earning                                                  ESTX Bank Index
bonuses when it posted a profit (in 2010, besides                                                DJ Banks Titans Index CHF
a “normal” salary of some CHF 19 million, the
CEO earned around CHF 71 million from the                                                                                                                                                   Source: UBS
Performance Incentive Plan launched in 2004),
shareholders drew the short straw. Between
2004 and 2009, the bank destroyed approxi-
mately CHF 5.2 billion in value.The only people          manager who fails to meet the cost of capital, as             services requires sophisticated infrastructure and
who have made money on CS shares over this               was the case here, should not be paid a bonus.                involves considerable economies of scale; indi-
period are those who bought them at rock-bot-            If CS were a partnership, the chances are that                vidual employees cannot exert any great influ-
tom prices.                                              nobody would have complained about the                        ence on the way these businesses perform, so
                                                         CEO’s bonus, since the partners would be shar-                there is no justifiable entitlement to a large chunk
Of course you could say that CS shareholders             ing the profits and losses of the business among              of the profits. For this reason it is perfectly ap-
did better than people invested in other banks           themselves. On the other hand it seems fairly un-             propriate for banks of this type to be organized
such as UBS or Royal Bank of Scotland, and that          likely that CS management would have made the                 as stock corporations, although it may also make
the hefty compensation paid to management                same business decisions if they had had to back               sense to choose a mutual or cooperative model
was justified. And nobody would deny that the            them up with their own salary or pension fund.                if customers directly benefit from more favorable
CEO of CS has done good work in recent years,            It’s a different story at retail banks. Earning               savings and mortgage interest via “subsidized”
particularly during the financial crisis. Even so, any   money on net interest margins and payment                     prices.
                                                                                                                                                               Reuss Private | Perspectives | 2
Chart 3: Global airline industry, cost of capital (1996–2010)

                Return on invested
              capital/cost of capital   8%








                                                  Total             US                 Europe             Asia
                                             Cost of capital
                                                                                                           Source: IATA

Airlines: everything revolves around                           companies generate above-average returns for               In summary, investors should avoid “fake” stock
customers                                                      their shareholders.According to OLZ & Partners,            corporations where the chosen legal form of or-
Airlines are another good example of “fake”                    in the period from 2003 to 2009 most of the                ganization does not match the actual allocation
stock corporations. Unlike aircraft manufactur-                Swiss companies that ranked top in terms of                of risks and rewards. Life insurers who pay guar-
ers, airports or aviation-related businesses such              value creation were traditional industrial opera-          anteed benefits to policyholders, or financial
as catering companies, from their earliest days                tions: ABB (+37.8 billion), Geberit (+6.3 billion),        services companies where a large chunk of the
airlines have had a hard time covering their costs             Holcim (+8.0 billion), Lindt & Sprüngli (+3.9 billion),    value created goes straight to employees, have
of capital (see Chart 3).The statistics show that              Nestlé (+53.9 billion), Roche (+3.8 billion), and          no place in the portfolio of a long-term investor.
between 1992 and 1996, a period covering both                  Swatch (+6.3 billion).                                     It is advisable for these investors to opt for de-
very good and very bad years, the airlines earned                                                                         fensive industrial stocks, ideally companies man-
a mere 6% return on capital employed, which is                 Not surprisingly, it is precisely this type of indus-      aged by entrepreneurial investors.
around 2% or 3% less than the actual cost of                   trial company with major investment require-
capital (Rigas Doganis, Flying Off Course, 2002).              ments where the stock corporation comes into
And from 1996 to 2004, for the global airline in-              its own. Here the economic value contributed
dustry there was an average annual shortfall of                by individual employees is not enough to justify
around USD 11.7 billion between the actual re-                 paying large bonuses at the expense of share-
turn on invested capital received and the cost of              holders; at the same time, the amount of invest-
capital (Value Chain Profitability, IATA Economics             ment involved is too enormous to be financed
Briefing No. 4, 2007).                                         by members of a cooperative alone.This is why
                                                               any economic value created goes to the share-
Given the low cost of air tickets and the frequent             holders.
flyer programs on offer, you could conclude that
it would be better to organize airlines as coop-               Often the success of a stock corporation is due,           Dr. Adriano B. Lucatelli,
eratives or mutuals. Efforts to lower prices and               at least in part, to the fact that entrepreneurial in-     Managing Partner, Reuss Private AG
provide comprehensive loyalty programs are to                  vestors or groups of investors are involved, and
some extent similar to business models in retail,              exercise control over the business. Usually this
an industry whose two largest representatives in               type of investor takes a very long-term view, and
Switzerland, Migros and Coop, are both set up                  will not be panicked into changing strategy
as cooperatives.                                               merely because of temporary swings and fluctu-
                                                               ations. This is most true for Roche. The Roche
Symmetry between upside and                                    heirs who still hold a major stake in the company
downside risks boosts value creation                           systematically pursue a long-term, sustainable
long term                                                      strategy, with the aim of safeguarding the com-
                                                               pany’s independence and creating the ideal foun-
Naturally there are also examples of “genuine”                 dation for transferring the business smoothly to
stock corporations, where potential risks and re-              the next generation.
turns are evenly distributed. These are compa-
nies that safeguard the interests of their investors           The situation is similar at Swatch, another com-
and endeavor to create lasting shareholder value.              pany where top management has large share
Here management incentives are linked to the                   packages to provide an incentive to ensure the
achievement of profit targets, no bonuses are                  positive, sustainable development of the business.
paid if the company posts losses, and customers                This also makes the share a good buy for in-
are not lured with unprofitable prices. These                  vestors with a long-term horizon.
                                                                                                                                                 Reuss Private | Perspectives | 3
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