The Future of Capitalism (and Commission Sharing Arrangements)

Two weeks ago I attended an all day session, “The Future of Capitalism,” put together by the the World Economic Forum (WEF) and The Forum of Young Global Leaders, with a big attendance by and assist from the World Policy Institute. While this session was under Chatham House Rules so I can’t go into great detail, it is safe to say that the general thrust of a series of wide-ranging discussions was that, in its current form, Capitalism has yet to prove it can function in a sustainable manner on a planet approaching a population of 9 billion.  There was much discussion of what could or should happen–some naive, but most quite pragmatic with some actionable steps. My favorite actionable step  was to require that CEOs, in addition to preparing their annual report to shareholders, should prepare an annual report to their children and grandchildren, describing what they do and don’t do and why, in clear understandable language relevant to these inheritors of what one would hope to be a sustainable planet.

More recently I attended a meeting where some activities in the financial world were described that may have more immediate negative impact on the Future of Capitalism. This is where Commission Sharing Arrangements (CSAs) have relevance.  A CSA is an arrangement in the investment community whereby an institutional investor does a security transaction with a broker and directs that a portion of the commission on the trade be paid out to a third party.  The third party is typically a smaller specialized firm that has provided research services to the institution. The institution has chosen to do the trade with a particular broker, usually one of the ten largest  broad-based broker-dealers (BDs), because of the belief that the BD will provide better execution at a lower commission than if the trade were done with a smaller firm. The larger BD typically has broader reach and visibility to get a larger trade done, including use of electronic trading systems developed by the BD or more accessible to the BD. In addition, the larger BD is more likely to be willing and able to commit capital to complete a trade in the event that the market place doesn’t. CSAs, a variation on soft dollar payments, that now is used with smaller BDs,  have come into vogue over the last several years, with help from the larger BDs, and already account for upwards of 30% of all commission dollars generated by institutional investors.

The above is a long explanation of what may appear to be a minor thing happening to Capitalism, in contrast to the grand ideas that came out of a WEF meeting. In my view it is not minor and has significant unintended consequences. Historically, smaller BDs have been an important part of the capital allocation and capital raising functions of the financial markets. They have provided research on smaller companies, been a part of price discovery in the marketplace through their trading desks and provided investment banking services including IPOs and secondary offerings for these companies that typically could not command the attention of the larger BDs. As institutions have elected to pay for the research by check vs trades, the ability of the smaller BDs to service these small companies as investment bankers has become problematic.  As trading becomes more concentrated among the big guys the economics are forcing many of these companies out of the trading and capital raising function and lessening their ability to hire and retain high quality professionals. The larger BDs do not step into the breach to service smaller private and public companies because the economics just don’t justify it. Thus, the capital markets business becomes more concentrated among a smaller number of bigger players. In a way, it is Capitalism at work within the financial services industry where unfettered Capitalism leads to concentration into fewer entities and, ultimately, monopoly positions.

Unfortunately, it doesn’t stop there. Concentration in the capital markets affects the role of Capitalism in the broader non-financial world as well. The less apparent outcome of this concentration, is a stunting of the capital-raising function for private companies leading to more limited access to the public markets. It produces an approach by early-stage investors of less reliance on the public markets providing liquidity and more focus on the direct sale of a company. I see that working its way into the investment decision process by venture capitalists and others, and the subsequent strategic process around the growth of a small company. If the expected exit or liquidity event for the investor is a sale, that becomes a big part of the way capital is allocated to “grow” the company. It also appears to shorten expected time frames from start-up to potential liquidity. And, it leads to the creation of products as opposed to companies, with an eye on where the product would fit into the business of potential corporate buyers. It changes the nature of the skill sets at the investment banking firms from understanding and supporting functioning capital markets to advisory merger and acquisition talent. Finally, it has the insidious effect of leading to concentration and lack of innovation in the corporate world as well. A large company can survey the universe of start-ups and smaller companies and snap them up before they become a threat or to fill a gap in their skill sets or product offerings. It is no longer a “make or buy” decison. It is just a “buy” decision.  With lower odds of a smaller company ultimately getting liquidity and raising capital through the public markets, the focus internally becomes one of positioning the company for a sale to one of the behemoths in its industry. Once the acquisition takes place, I have seen, in many instances, the innovation pace slowing or in many cases just disappearing. In some instances it can actually add to the portfolio of products offered by the larger entity, but not always. Ultimately, concentration increases, stifling growth and innovation, and creating less-free markets. It then takes big government to “regulate” these entities to prevent the ultimate outcome of true capitalism–a monopoly position.

So we end up with big financial firms, big corporations and big government—most likely all too big to fail or change, but more dependent on each other for their raison d’etre and most likely less responsive to leaving a better world for their children and grandchildren.  It’s not a pretty picture. It’s not all because of Commission Sharing Arrangements, but the pace at which concentration is happening is accelerated by this small change in the way business is being done in the financial sector.

I was actually encouraged by the discussions at the WEF meeting and walked away with some hope that the upcoming generation of Young Global Leaders might actually find ways to get this right. But, the small changes which have big implications and are taking effect daily will make their job tougher.