Seth Klarman: Business models are broken, here’s how they can be fixed

Baupost
Group CEO Seth Klarman.
Getty Images/
Scott Olson

• Baupost Group CEO Seth Klarman gave a speech calling for a
  shift away from what he sees as toxic short-termism.
• He believes this is the result of the theory of shareholder
  primacy, and that other stakeholders like employees and community
  need to be considered for the sake of long-term growth.
• He called for companies to reconsider their actions as
  society’s calls for change become increasingly stronger.
• This article is part of Business Insider’s ongoing series on
  Better
  Capitalism.

Seth Klarman, the renowned founder and CEO of the $30 billion
hedge fund the Baupost Group,
recently gave a speech on the ramifications of shareholder
primacy.

“Business schools have sometimes taught that shareholder value
maximization is the Holy Grail, the sole proper focus of
corporate managements,” he said. “So I ask, should managements be
focused solely on a company’s share price, which itself is
ephemeral, and do everything within their power to levitate it?
What longer-term good would this possibly accomplish? And does
anyone really believe that shareholders are the only constituency
that matters: not customers, not employees, not the community, or
the country, or planet Earth?”

Klarman gave the speech at a dinner celebrating the opening of
Klarman Hall at Harvard Business School on Oct. 1.

Klarman is an avowed value investor, which means that his
approach to managing money involves buying shares of companies he
thinks are cheap relative to their peers. It’s a philosophy
employed by other industry heavyweights, such as Warren Buffett
and Joel Greenblatt, the managing
principal and co-chief investment officer at Gotham Funds.

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It makes sense, then, that he’s in favor of an approach creating
long-term value. But his speech declared the notion of
shareholder primacy, as it’s been practiced for the last 40
years, as an impediment to the health of the economy and society
at large.

“A capitalist economy should be judged not just on the aggregate
economic improvement driven by its innovation but also on the
design and strength of the social safety net that cushions the
ill, or disadvantaged, or those who simply fail to thrive in
their particular setting, geography, industry, or trade,” Klarman
said.

What is the role of business in society?

The debate over the pursuit of short- versus long-term value, and
how that is related to the responsibilities of public
corporations,
has been drawn out over many decades.

In the wake of the Great Depression, the economist John Maynard
Keynes wrote in “The General Theory of Employment, Interest and
Money” that the American stock market encouraged public companies
to prioritize short-term gains, temporarily benefiting their
stock price, over long-term gains, benefitting both their
business and society as a whole. It frustrated Keynes and the
Keynesians that followed.

But for free-market economists like Milton Friedman, who
published “Capitalism and Freedom” in 1962, there was no need to
differentiate between the short and long terms. For Friedman, a
company’s sole social responsibility was to make as much profit
as possible, as long as it followed the rules. A free market
would reward the best companies, which would take care of all
stakeholders.

American executives and politicians embraced Friedman’s ideas in
the 1980s, and
judicial precedents in the United States cemented the notion
that public companies existed to maximize profits for their
shareholders.

This debate has resumed in earnest, however, during the recovery
from the financial crisis of 2008, and this time, the other side
has more momentum. Klarman isn’t the only billionaire calling for
change.

In 2013, investor Paul Tudor Jones, for example, cofounded JUST
Capital, which measures public companies’ value added to all
stakeholders, not just shareholders. It launched an ETF in
partnership with Goldman Sachs earlier this year. On the
corporate side, more large companies, like food giant Danone, are
seeking “B Corp” status (the “B” stands for “benefit”) — this
certification proves they received high marks from the company B
Lab, founded in 2006, that measures a company’s societal benefit.

And, notably, this past January, BlackRock CEO Larry Fink wrote
in his annual letter to CEOs that, “To prosper over time, every
company must not only deliver financial performance, but also
show how it makes a positive contribution to society.”

At the New York Times DealBook Conference in October, Fink
defended himself against accusations from critics like Wall
Street Journal columnist Holman W. Jenkins, Jr. that he was just
trying to be en vogue or “buy indulgences” from the public. As
Fink put it, the demand from customers and employees for
customers with purpose has become so strong that he wrote his
letter as a way to improve his clients’ performance.

There’s evidence this is more than just intuition. Boston
Consulting Group found that companies pursuing initiatives that
benefit ESG (environmental, social, governance) metrics actually
boost their bottom lines. Fink said that in the near-future — as
early as the next five years — all investors will measure a
company’s value along ESG metrics.

Where Klarman stands

While Klarman called for an improvement of capitalism in his
speech, he did not consider his suggestions to be drastic.

He specifically mentioned as something he considers too radical
to be Sen. Elizabeth Warren’s Accountable Capitalism Act, which
would require billion-dollar public companies to obtain a federal
charter that binds them to creating value for stakeholders beyond
shareholders, as well as have 40% of its board members elected by
employees.

The way he sees it, businesses should determine how they are
going to grow more responsibly before regulators decide for them.

He noted that, “when capitalism goes unchecked and unexamined,
and management is seduced by a narrow and myopic perspective, the
pendulum can quickly swing in directions where capitalism’s
benefits are discounted and its flaws exaggerated, thereby
leaving its future even more clouded and uncertain.”

“While it’s hard to see how this proposed regulation would solve
the problems that I’ve raised tonight, it’s exactly the kind of
proposal that business will have to contend with when complex
issues go unexamined, and when character, sound values,
restraint, and long-term thinking fail to gain the upper hand.”

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