Sunday 29 January 2012

Why the Building Society funding model is the best kind of corporate structure.

1. I have mused on this topic before, see e.g. Inefficient Markets Hypothesis, The multi-billion Chinese investment in Thames Water was no such thing and Beyond The Corporation, part 1, part 2.

2. Please note, I am not talking about the respective merits of banks or building societies, this is about having a system which has the benefits of public limited companies without the drawbacks and applies to all types of businesses (not just banks/building societies).

3. It is claimed that the big benefit of being able to switch your investments between different types of business, by selling shares in one and buying shares in another is that this leads to an efficient allocation of capital. If you do it properly and you are lucky, then yes, this leads to an efficient allocation of your own money, but there is a complete disconnect between what you are investing in (the shares) and the real underlying investment in productive capital (which is carried out by the companies whose shares are bought and sold). So whatever signals the secondary market in shares is sending, there is little or no link between that and what businesses are actually doing.

4. People are unfamiliar with Limited Liability Partnerships (which are a far better corporate structure than a limited company for small and medium sized businesses), so let's talk about how things would work on the scale of large plc's if their share capital/reserves side were structured in the same way as building societies. In other words, instead of a company having assets of (say) £1 million and share/capital reserves with a balance sheet value of £1 million, but whose shares might be worth a multiple of that, the company would just have 'members' deposits' with a balance sheet value of £1 million.

5. The gimmick being, that you cannot 'sell your shares' in a building society to a third party on the secondary market, if you want your money, you just withdraw it and somebody else invests in your place. Unlike with companies limited by shares, there is no distinction between the 'primary market', i.e. shares being issued (where an investor gives the company cash for shares) and the 'secondary market' where the first investor sells those shares to a third party, who can sell them on to a fourth etc.

6. If quoted plc's were like building societies, then at the end of every profit period (a year, a month, a quarter, it does not matter), the company would draw up a new balance sheet and allocate the increase in value (the profit) pro rata to all members' deposits, instead of paying out part of the profits as dividends on shares.

7. At any time, some members will want to withdraw some of their profits or their deposits and others will want to invest in that business, so the company will end up running simplified deposit accounts for all members (which is perfectly do-able - banks and building societies manage). The company might have to limit the amount which members can withdraw or limit the amount of new deposits which it can accept, so there might have to be some sort of waiting list approach or a cap on withdrawals/new investments. Withdrawals and new investments are to a large extent equal and opposite, so if a company accepts cash deposits it doesn't really need it will have spare cash to repay those who want to cash in immediately - which is how it works with banks and building societies.

8. So this would save investors the bother of doing two quite separate analyses: the first being an analysis of the health of the underlying business and the second being an analysis of how the share price is doing and what future dividend payouts are likely to be. Instead, you would just look at the list of public traded companies in the financial pages, and for each one it would say:
- what the profit share in the last profit period was as a percentage of deposits (the higher the better as far as investors are concerned;
- how long the waiting list is to invest in that company (if there is one), and
- whether there is a restriction on withdrawals, i.e. because the company is making losses, because it plans to expand in future and/or because not enough new investors want to put their money in.

9. To make a comparison between the two:

- Let's say that a quoted plc started the year with total assets £1 million, made profits of £200,000 (so now has £1.2 million total assets) and intends to pay out £120,000 as dividends (keeping £80,000 for future expansion). Dividend yields are currently 4%, so all things being equal, the shares in that company are worth £3 million. £1.2 million of that £3 million is real wealth (the real net assets of the business) and £1.8 million is pure speculative value; it's a nice capital gain for the original investors but a potential capital loss for future investors.

- Using the building society funding model, the total assets are also £1.2 million, and 20% is added to members deposits b/f of £1 million, and the directors announce that members may withdraw up to a tenth of the face value of their deposits (i.e. up to £120,000). If the directors know that there is a long waiting list of potential new investors, then the one-tenth figure will be increased of course, that's just details.

10. The two big advantages of the building society funding model are:

- There is no speculative capital gain to be made - either you are happy leaving your money with this business and earning 20% a year in profit share (or interest) or you want to withdraw your money, either to spend it or because you want to invest it in a different company which pays 25%, or which pays less than that but which has a safer business. Now, some people will bemoan this, but one man's capital gain is just another man's capital loss. If you are lucky to get into a successful company right from the word go, then you can sit back and be paid your 20% return each year, withdrawing or reinvesting it as you please, which is a better way of doing things that sitting there waiting for the right moment to sell your shares (i.e. just before the share price collapses).

- Instead of focusing on things not directly related to the actual business (like the share price or the dividend yield), investors will just look at how profitable businesses actually are, i.e. how much interest they pay on deposits. So profitable businesses will find it easy to attract new investment and the directors of not-so-profitable businesses will have to up their game to prevent members wanting to withdraw everything (like a 'bank run', only this would be a 'company run'). In extremis of course, the members would sack the management and either install a new one or just sell off all the assets, shut the company down and take their cash elsewhere. For the investors, this will be a lot less risky than with a plc, because they won't have paid £3 million for their shares, they will not have paid more than £1.2 million (using the same figures as above).

23 comments:

Deniro said...

1.
"Worth 3 Million"
The shares can't be sold so no "3 million" valuation and assosiated capital gain.

2.
PPL is a reasonable option but the tradable shares gives a more liquid out than a waiting list.

3.If the traded share price goes down there is a price signal to the company that the people are not positive about what they are doing.

Shineymart said...

Mark

As an SME LTD Co Shareholder/Director why do you say LLPs are better?

Just interested in your POV.

Shiney

Sackerson said...

Like other of your ideas, Mark, I think this would work and that's exactly why it won't be permitted to happen.

Curmudgeon said...

Agreed, you make a very good point. The almost total disconnect between ownership and control in large modern countries doesn't do capitalism any favours.

Mark Wadsworth said...

Den.

1. Hpw do you mean the shares can't be sold? They can.
2. What's PPL? How liquid do you want things to be? What's wrong with investing for the long term? Chances are, the number wanting to invest and withdraw would even out so there'd be the possibility to withdraw all your money on the spot - exactly like with a deposit account with a bank of building society!
3. Yes I know, i covered that in para 3.

Shiney, less Er's NIC; less CGT on sale of business; easier to sell trade and assets; easier (and cheaper for tax) making an employee into a partner; only one type of contract covers all relations between partners (as opposed to three with a limited); easier and cheaper to get rid of a partner than to get rid of an employee/shareholder; it's a risk free strategy as can easily convert LLP to Ltd if you change your mind.

Anybody who think that "companies only pay 21% corp tax" has completely missed the point.

S, it would work fine (on a practical level), but members would always be tempted by the possibility of getting a few hundred of thousand quid's 'worth' of shares and so would always chooose plc (as happened in real life with the mutual building societies).

C, to be fair, the disconnect (or otherwise) between ownership and control would not be much changed. I'd assume that a building society member exercised just as little control over the directors of the building society as does the shareholder in a plc. The best way to fix that problem is to end tax breaks for pensions - because the end result of that is that most shares are held by fund managers and institutions who have less interest in the sound running of the business than an individual who owns shares in his own right.

Lola said...

Agreed about LLP - been thinking about making us an LLP, and would've done so by now if weren't for the sclerotic rules of the Failed FSA.

Various comments. one, having a choice of corporate structures is exactly what capitalism is all about - competition. I've always like BS model, but current rules permitted a few members to create the opportunity to incorporate and take out the accummulated reserves/goodwill/ etc etc built up in the past and agruably there for the future.

Furthermore your model directly connects true saving with production. As long as we had sound money elsewhere it would be almost impossible for highlly geared private equity / hedge funds to take soeculative positions.

Deniro said...

PPL woops that is LLP !

Mark Wadsworth said...

L, the FSA is a load of rubbish, on that we are agreed.

"having a choice of corporate structures is exactly what capitalism is all about - competition. I've always like BS model, but current rules permitted a few members to create the opportunity to incorporate and take out the accummulated reserves/goodwill/etc built up in the past and arguably there for the future. "

And that is the downside of capital-gains-ism as opposed to proper capitalism - members of BS's liked de-mutualising because of the windfall gain. It must be clear to a blind man that the value of shares you got when Halifax turned into a plc* were slightly less than the Net Present Value of all the extra benefits that would have accrued to you had it remained a mutual.

* About £1,800, I've still got the bit of paper showing that I sold my shares in protest on day one.

Den, that makes sense. As to liquidity - I don't think that this is an issue, because only a limited number of members will want to cash out at any time, and in the long run, there'll be an equal and opposite number of people who want to buy in.

Or in practice, the directors of such a company would know that having no limit on immediate withdrawals and a short waiting list (hours not days or weeks) makes the company more attractive as an investment and hence makes their jobs safer, so for every £1 million deposits, they'd keep £50,000 in spare cash at the bank to oil the wheels a bit.

So instead of having £1 million in assets financed by deposit accounts of £1 million and a 20% return on deposits, a cunning board of directors would have £1 million in assets, £50,000 in spare cash to pay for withdrawals and a 19% return on deposits.

Chances are, members would be happy to forego that 1% if it means they can withdraw their money straight away - which is exactly how it works with banks and building societies.

Deniro said...

once the company grows can it accept new partners. if it can how much interest does the new deposit qualify for. The old money would be invested in plant and investments and so be hard to value

Mark Wadsworth said...

Den, it is entirely up to existing members to regulate matters between themselves; and between themselves and potential new investors. It's called 'freedom of contract'.

The old P&M is not hard to value, it's whatever the existing members say it is worth. If they overvalue, they'll get no new investors and existing members will want to cash out (but there will be no available cash for them to withdraw); if they undervalue, then they will have to accept write downs on their own deposit balances and new investors will be over-rewarded. It all sorts itself out. It's basic maths and negotiation and there is no reason to assume that P&M would be deliberately over- or under valued..

Suffice to say, in the real world, we have large partnerships (mainly law and accountancy firms) and we have building societies, they work just fine in practice, I am just illustrating how that model works. It's capitalism without (spurious) capital gains.

Steven_L said...

The FSA is mindbogglingly bad. They have 4 fairly straightforward statutory duties and they simply don't know how to perform them.

Then if you suggest how they might perform them (and hand it them on a plate) they come across all bewildered and say:

Well we've never done things like that before, doing that would mean changing how we do things.

Derek said...

I like it. Very clever. Yet very simple and straightforward.

Bayard said...

The gamblers will always find something to gamble on. Perhaps a market would arise in waiting list places (membership futures). Remember what happened to milk quotas; what started out as a means of controlling excess production rapidly became a tradeable commodity.

Mark Wadsworth said...

SL, why does that not surprise me?

D, ta.

B: "Perhaps a market would arise in waiting list places (membership futures)."

Perhaps, but if you were director of a company and realised that people were happy to pay 50p merely for the right to invest a further £1 in your business (cost to them £1.50, benefit to you £1) then you'd just modify that waiting list so that people can pay the company £1.49 in exchange for £1 of deposits (the same as issuing shares at a premium). Or you could offer current members a 20p bonus for every £1 they withdraw, thus banking the difference of 29p for the company.

Like I'm saying, in the medium term and in most cases there would be neither limit on withdrawals nor a waiting list for new subscriptions, it would all sort itself out.

James Higham said...

Limited Liability Partnerships (which are a far better corporate structure than a limited company for small and medium sized businesses)

Are they really? Shall explore this.

dbcreed@hotmail.com said...

So its goodbye to the Stock Exchange then? Hooray!Macmillan wanted to do this according to Prudent Bear.Com "Which big country will default first?" Apparently he also wanted to nationalise the banks when they dared to raise interest rates-rather a better class of Tory eccentric in those days.

Mark Wadsworth said...

DBC: "So its goodbye to the Stock Exchange then?"

Well, I think the polite answer is "The Stock Exchange's role would be much reduced", or something like that.

Bayard said...

"And that is the downside of capital-gains-ism as opposed to proper capitalism - members of BS's liked de-mutualising because of the windfall gain."

If that's generally true, however did they get up in the first place and how come they lasted so long?

Mark Wadsworth said...

B: "If that's generally true, however did they get up in the first place and how come they lasted so long?"

Because of short-term-ism. If you demutualise, you get your £1,800 "free" shares (which are no such thing, that £1,800 is just the bulk of the NPV of benefits which you forego) and nobody ever wants to give up this illusory wealth.

It's the same as the [entirely artificial] selling price of land, it's a Ponzi scheme (although nowhere near as big or as damaging as the land market).

Bayard said...

So, are we more short-termist now than we were, or just more greedy?
More to the point, cui bono? I can see who would lose out under a switch to the mutual model - the gamblers, the speculators and the money-churners, but I can't see any particular group that would benefit, apart from the-economy-as-a-whole and, unfortunately, the the-economy-as-a-whole doesn't have any votes!

Mark Wadsworth said...

B: " are we more short-termist now than we were?"

South Sea Bubble.

" I can't see any particular group that would benefit, apart from the-economy-as-a-whole and, unfortunately, the the-economy-as-a-whole doesn't have any votes!"

Good summary.

DBC Reed said...

Is n't it the case that the Permananent Building Societies were not primarily commercial in orientation but political, being set up to secure the vote for working people who could only be enfranchised by owning freehold property? Somebody asserted that the building societies staved off revolution in this country by closing the class divide.Certainly Bradlaugh thought this and argued against early Socialists that the working-class did have some property.He was able to represent Northampton because it had an unusually high proportion of working-class voters who were prepared to do dome serious rioting every time they elected him and he was barred (once imprisoned in the Victoria Tower)for refusing to swear a religious oath on joining Parliament.

Mark Wadsworth said...

DBC, the article is not about Building Societies as such, as to history lessons, what do I know?

It's quite clear that The Powers That Be always liked to get some of the little people 'onto the property ladder' to embed Home-Owner-Ism in the popular psyche and to ensure an electoral majority in favour of it.