Capital Allocation

I hazily recall reading an article a couple of weeks ago about an interview with one of the Democratic Presidential candidates, Tom Steyer, and the reporter asked him a question about the extremely large role finance plays in the U.S. economy – basically the financialization of the economy over the past couple of decades. I got a sense that the reporter was questioning the salutary effect of finance and Tom Steyer seemed to have picked up on that and got slightly defensive. Mr. Steyer, a former hedge fund manager, replied that the role of finance is efficient capital allocation.

That’s the typical response from Wall Street and other financial types: finance plays a role in efficient capital allocation so that money flows to where it can be best put to use and everyone in society wins through innovation, better quality goods, and cheaper products. That totally makes sense and I agree with that but with a caveat. Just like in running a company where the success of the company will come down to the quality of the people leading the company, the success of the overall financial allocations will come down to the quality of the decisions and the motives of the financial managers, Wall Street or otherwise.

It’s the motives of Wall Street, hedge fund managers, private equity funds, and takeover artists that are suspect.

Over the past thirty or forty years where we have had the “shareholder” philosophy take over businesses, we have moved from a broad prospering middle class to today’s massive income inequality. The capital allocation does not seem to have been very “fair”; it might have been very, very, very efficient in redirecting the money into the pockets of the wealthy to make them wealthier but it has not done much to improve society. Wall Street, hedge fund managers, private equity, the raiders have all been reallocating the money to their pockets rather than to the best use of capital.

Do I think all hedge fund managers, private equity managers, Wall Street have been bad? No, I’m sure some like Tom Steyer have become cognizant of the damage that has been done and are trying to rectify it. We have to remember, a lot of them learned these financial theories in their youth and those theories would work if the leaders have been acting in the best interest of society. The Great Recession probably was the wake up call that something was wrong. But I do suspect most of them still have not thought about the broader implications for society and are still relying on the theories developed back in the ’70s and ’80s.

This New York Times article provides a nuanced look at the role of hedge funds and private equity and how they have affected our economy. I say nuanced because the author does concede that there have been cases where the companies come out stronger after a hedge fund or a private equity fund takes over the ailing company. But there is a very interesting question of: if capital allocations are so great, why isn’t America doing better? So yes, capital allocation can and sometimes do lead to better things but it is going to depend on the skills and the motives of what the fund or raider is trying to do. If he is trying to just make a buck off of the “turnaround” or his “investment”, it’s likely that the outcome will not be successful over a period of time.