Quoted companies, he wrote, have a grave flaw: “an absence of effective monitoring of managers”. Shareholders are too dispersed and too ill-informed to exercise proper control of chief executives. This causes several nasty problems.
One, said Professor Jensen, is that bosses will want to build up cash piles to give themselves freedom from capital markets. If companies held no cash, they’d need to raise funds in the market every time they wanted to invest. This would give investors control over the company’s plans. If, however, companies can invest internal funds, this control is lacking and so bosses are freer. Events have vindicated Professor Jensen; in both the UK and US, corporate cash holdings have soared in recent years.
Secondly, he said, when companies do invest the job is likely to be badly done. Bosses will prefer grand schemes that gratify their ego rather than humdrum projects that maximize shareholder value. Perhaps the worst economic decision of our lifetime was RBS’s takeover of ABN Amro – a move that was due to shareholders’ failure to control Fred Goodwin’s megalomania.
To these failings we can add that bosses plunder directly from shareholders by extracting big wages for themselves. The High Pay Centre estimates that CEOs are now paid 150 times the salary of the average worker, a ratio that has tripled since the 1990s – an increase which, it says, can’t be justified by increased management efficiency. “No countervailing forces have been deployed to stop this,” it says.
Failures such as these, said Professor Jensen, would cause quoted companies to be supplanted by private equity, as this permits a few well-informed investors to properly oversee managers. This is what has happened.