THE LOGIC OF SELF-DESTRUCTION by Matthew Blakeway

Author:Matthew Blakeway [Blakeway, Matthew]
Language: eng
Format: epub
Publisher: Meyer LeBoeuf
Published: 2014-03-14T16:00:00+00:00

It is important to distinguish between the volatility of the share price (which is the variable in the Black-Scholes model) and volatility in the operation of the enterprise. However, if the manager shakes up the operation as hard as he can, then he is increasing the likelihood that the share price will make a big move – either up or down. If you aren’t a natural mathematician, the simplest way to visualise this is to imagine that I take you to a casino and tell you that you can keep 10% of the winnings, but you bear none of the losses. Assuming that you act in your own self-interest, you would find the table that played the biggest stakes and would place the biggest bets. In other words, you would max-out the risk that I permitted you to take.

If the manager follows my simple advice, then he has a 50% chance of making $10 million on his share options and a 50% chance of wrecking the company. Nothing in Las Vegas offers better odds than this because he gets the upside but not the downside. What is fabulous about this strategy is that it requires very little business acumen. Obviously, the employees and shareholders must not realise that the manager is pursuing this strategy, but that is easy. To conceal it, he needs some really good business jargon that can be bought from any business school. If a single manager pursued this strategy it would be obvious, but the invisibility of the strategy is that almost all managers are doing it and so the strategy has become accepted business practice. Family businesses (where the family owns shares and not options) are invariably carefully and prudently run, and this is the way a business should be run in the CAPITALISMTM of Adam Smith – it benefits the owners and society. Share-option-owning executives dismiss this family business approach as archaic. But the swashbuckling strategy is rational when the decisionmakers get upside, but not downside. In this case, the capitalist benefits, but society does not.

Let’s get back to trickle-down economics. If the above is going on throughout the economy, then in which direction is the trickling going? Certainly, the manager is going to have to spend his $10 million (assuming the outcome is the lucky 50%). This could be to the benefit of some fortunate pool-boys, nannies and all the nice people who work at the Mercedes factory. But what if the outcome is the unlucky 50%? The manager has the incentive to max-out risk, and this increases the chances that the company will fail. The unlucky 50% means that lots of workers (who cannot fall back on savings) will lose their jobs. If the manager runs the business in a prudent fashion, then it will be safe and boring and will pay healthy dividends to its shareholders and nobody will lose their job. However, the value of the share option is not optimised. Managers might counter my argument by saying that they are professional or that they have an incentive to protect their reputation.

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