The challenges with modern corporate structures

The conventional wisdom about a market economy is that reduction of entry barriers (or deregulation) engenders competition, which encourages businesses to innovate and differentiate from their competitors, which in turn increases the quality of goods/services supplied, reduces costs of production, and lowers their prices. All this expands the market, raises consumer welfare, and increases business profits.

This simple narrative is complicated by the complex nature of the modern economy. In the simple model, the economic activity in a sector consists of the interplay between privately held (and owner managed) companies and consumers. There is a neat positively reinforcing set of incentives aligning among both companies and consumers. 

However, in the modern economy, there are several important actors. The company itself has its corporate entity, its investors or shareholders, and its executives. Then there are the consumers. The interests of each of these are different, and often run in conflicting directions. 

Consider the following. The company in its corporate form wants to be a growing and enduring concern. The public shareholders want to maximise the stock value and dividends. The executives want to maximise their compensation and bonuses. Both feed into each other. In simple terms, while the corporate entity wants to endure and grow, the primary objective of public shareholders and executives is to maximise stock valuations. While the former has a long time horizon, the latter two take shorter-term views. And while the former cannot vote or decide, the latter can. 

I have written about the consequences of these conflicting trends in the context of infrastructure financing where not only the ownership and management are fully divorced, but the ownership is both diffused and short-term as to seriously distort incentives. The result is asset stripping and pass the parcel, leaving everyone well-off except the taxpayers and the infrastructure asset itself. 

It's no different in case of today's private equity led firms, where both the general partners (typically also the management) and limited partners are primed to maximise profits and dividends. The incentives of entrepreneurs and venture capital investors in today's start-ups are primed more to boost valuations and less to build enduring companies. And both GPs and LPs have limited skin in the corporate entity to play the long-term game. 

In fact, the financialised version of modern capitalism can be considered akin to equity without ownership. In the absence of promoters with sufficient skin in the game, equity ownership is effectively (not legally) something like a higher return and higher risk subordinate debt. The serious problem is the near total absence of incentives in this corporate structure which encourage taking a long-term view or interest in building enduring corporate entities.  

This creates several problems. In their profit maximisation pursuit and given their limited time horizons, the executives seek to cut costs, skimp on investments, increase efficiency even at the cost of resilience, and increase prices where possible. As long as this keeps boosting the stock prices, the shareholders go along. 

However, this goes against the interests of the corporate entity and its employees, and to a lesser extent bond holders. More importantly, the incentives of executives and shareholders (and their associated outcomes) conflict with the consumer welfare requirements of higher quality and lower prices. This is the central problem with today's free market capitalism. It's hard to imagine this can be resolved without regulatory interventions.