It had a good run but the era of shareholder primacy ‒ the idea in simple terms that firms exist first and foremost to deliver returns to their shareholders’ capital ‒ is starting to break down, Bain & Company partner James Root, head of the consulting firm’s Asia-Pacific practice, told a Directors’ Breakfast in Sydney last week.
The era, which lasted around 50 years, has been good, Root says. “We’ve shed non-core assets, we’ve focused on the core. We have improved profitability with outsourcing and margin improvement programs… [We had] unprecedented returns for about forty years from the 70s to around the 2000s.”
But that era is now breaking down due to a range of factors and firms will need to adapt.
“Complexity has ballooned over that era of shareholder primacy and the demands on executives’ time are more pressing than ever. For instance, a typical executive now faces about 30,000 touch points ‒ which includes emails and messages ‒ a year, according to Bain’s data. “This [constant communication] is a tapeworm that gets inside organisations and sucks time away,” Root told the audience of directors.
The workforce is changing. “There is no doubt that the hearts and minds of young talent are simply no longer captured by a total shareholder return mission. It is just not enough. People want to work for a firm with a higher purpose,” Root emphasised.
The influence of technology in driving the end of the shareholder primacy era is overstated but still critical, according to Root. “The pressure on the current model was already there before the mid-2000s [technological] moment,” Root said.
What’s next for the firm?
There are five emerging themes that are defining the firm of the future in the post shareholder primacy era, according to the Bain partner.
1. Scale and customer intimacy
In the shareholder primacy era, firms could either be low-cost or differentiated but they can’t be both. The scale leader in the industry was often the least successful in terms of customer intimacy. That is changing, most obviously in the algorithm and software-based models. Tech-based disruptors like Google, Facebook, Tencent, Alibaba and Amazon are leveraging their scale while also offering personalisation to customers. But more established companies like Vanguard, Starbucks, Haier and LEGO are also pursuing similar strategies.
2. Assets vs ecosystems
Industry ecosystems have been created through outsourcing. There is no part of the value chain that cannot now be outsourced, Root says. For small- and medium-sized businesses, there is a revolution enabled by outsourcing businesses like Amazon Web Services, whereby they get access to scale without needing to own the assets or capabilities themselves.
“I am jumping on the experience curve of all the other clients that those outsource service providers work with. That is truly a revolution in cost dynamics in an industry,” Root told the audience.
3. Capital gets a reset
The shareholder primacy era in some sense evolved because of a conviction that the interests of managers and shareholders were not aligned, a product of classic agency theory, according to Root. Managers, who did not own shares, were not aligned with the wealth creation ambitions of the people who actually own the firm. So incentives were created to link management incentives to shareholder returns in one way or the other, many of which have been successful but many of which have been distorting, causing sometimes extreme short-termist behaviour.
“We are now in this very strange place where it’s actually quite hard to get executive teams to invest in the long-term growth of their businesses,” Root said. “We are living in a world where the weighted average cost of capital for most medium to large entities is about five to six percent—capital superabundance. But the hurdle rate in most large firms, last year, 12.5 percent... Many would say the public markets have just failed to deliver that anchor long-term investor mindset that all large companies want.”
4. Professional managers vs. mission-critical roles
For the last hundred years or so, the professional manager has been central to an organisation. That is changing to making mission-critical roles the heart of the firm, Root says. Those are the roles that are critical to delivering on the promise of the firm to its customers. “In the future with so much work being automated and so much outsourced, most of the roles in your organisation will be the mission-critical roles,” Root told the audience.
There are two implications of this: 1. Headcounts will shrink; and 2. the mission-critical talents will work in project teams, often self-managing, making functional silos less relevant.
For instance, music-streaming company Spotify has maximum eight person squads. The squads decide what to build, how to build it and who they need to work with to make it inter-operable.
“The extreme version of this is that most firms today exist to perpetuate the professional manager class,” Root offered as a provocation. “The promise of employment [has been] come, stay with me for a while, I’ll turn you from being a doer into a manager of other doers. In the future... I suspect that almost all of our intuitions about leadership development are just obsolete.”
5. Engine 1, Engine 2
Firms increasingly need to manage two types of businesses: “Engine 1” is its core business and “Engine 2” is its more innovative business, according to Root. The governance around resource allocation is absolutely vital in making this work, Root says. Firms need to answer questions like do they house Engine 1 and Engine 2 in the same building; do they take people from Engine 1 to Engine 2; does existing management run Engine 2 or do they bring in corporate venture capitalists to help?
“Most companies today very quickly get pegged as either growth stocks or dividend stocks. And if you’re pegged as a dividend stock today, the valuation that you receive, and therefore the funds that you can deploy to grow your business long-term, [is] severely constrained... you’re just the ATM and then the investor can take their money and put it in [a] startup business,” Root said.
“Engine 2 if you’d asked me two years ago: optional. If you ask me today: mandatory.”
For more on the Firm of the Future, visit Bain Insights.