As governments grapple with the public health crisis posed by Covid-19 globally, there has been an unprecedented level of government intervention in Western capitalist economies in an attempt to mitigate an unfolding economic crisis. As firms of all sizes see their revenue streams disrupted or entirely lost, many have sought government assistance to settle short term liabilities. Among them are some of the world’s largest listed companies, which now find themselves unable to pay staff and rent costs. The vulnerability of listed companies might be surprising given their size. Yet, these firms have spent the last few decades leveraging their profits to pay out dividends and share buybacks, maintaining only small reserves of highly liquid assets and cash.
The UK government was quick to announce emergency support for businesses. Tesco, for example, stands to reduce its tax payment by £585 million while it remains committed to distribute £635 million to shareholders in the form of dividend payments over the 2019-2020 financial year as reported in a recent Financial Times article. Why are firms, which may or may not be struggling with the pandemic’s disruption, still so focused on distributing profits to shareholders? In economics, this aspect of firms’ behaviour is explained by ‘financialisation’.
‘Financialisation’ broadly refers to the increasing role of the financial sector in the operation of the economy, affecting the way in which non-financial corporations do business. Professor William Lazonick argues this can be most explicitly seen in the huge increase in the disgorgement of corporate profits: financialised companies successively paid out an increasing proportion of their earnings. In terms of corporate governance, this is reflected in a shift from a ‘retain and reinvest’ business model to ‘downsize and distribute’. The transmission by which these firms and the economy undergo financialisation is referred to as the ‘shareholder revolution’.
Active investors take larger voting stakes in firms and pressure them to release money as dividends. Firms that don’t do so then fail to attract funds, causing the firm’s share price to fall. This then exposes them to investors acquiring the firm via hostile takeovers and forcing a change of management towards a ‘downsize and distribute’ model. Another innovation which allowed firms to distribute even more to their shareholders was the share buyback. Excess profits above dividend payments can be funnelled into the repurchase of the firm’s own stock. This directly props up the share price of many listed firms. Repurchased stock can then either be retired, boosting earnings per share and thus the firm’s share price, or granted to staff in the form of stock options, furthering the alignment of manager incentives with those of the shareholder. This process has resulted in an environment where it is difficult for firms to retain earnings and invest in anything above minimum capital expenditure.
To see how this theory plays out in some of the UK’s largest companies in the context of the Covid-19 crisis, two ratios are analysed (all data were provided by Refinitiv through Eikon). The first of these is what Prof Lazonick refers to as ‘total disgorgement’: the total amount paid out by firms in the form of dividends and share buybacks as a proportion of market capitalisation. This can be plotted against the quick ratio which measures the ability of a firm to immediately meet its short-term liabilities – the ratio of cash and short-term investments to short term liabilities. From this we can see if there is a relationship between how financialised a firm is and how prepared they are to meet their short-term liabilities. Figure 1 shows that all those firms with very high disgorgement (more than their market capitalisation) have low quick ratios and vice versa. The trend line suggests a clear trade-off between the firms’ buffer against revenue disruption and the amount they distribute to shareholders.
Figure 1: The relationship of the Quick Ratio to the Total Disgorgement (Dividend Payments and Share Buybacks, cumulative 5-years) as a proportion of Market Capitalisation. Data for year ending 31-12-2019.
Thus, there seems to be a clear relationship between the amount that firms are distributing to shareholders and their ability to meet their short-term liabilities. Tax relief issued by government in the face of the crisis has been focused on ensuring workers get paid. However, the willingness to assist business unconditionally has enabled firms to protect shareholder interests, leaving room for the problematic practices outlined above. Through the backdoor, tax relief is being handed on to shareholders, favouring capital owners over taxpayers. The decision that firms face, between distributing earnings and keeping them as a safety net, has been dangerously biased to the former due to financialisation, and the resultant losses are, in part, falling on the public. For now, the government and firms are struggling to mitigate the damage from the epidemic, but a lack of liquid assets or rainy-day funds on firms’ balance sheets makes that much harder to do.
Patrick Redman is a finalist BSc Economics student at SOAS. He is currently researching the financialisation of non-financial companies in the UK and consequences for productive investment as part of an independent study project supervised by Dr Sophie van Huellen.