Companies like Seventh Generation, Patagonia and Stonyfield have two big things in common. First, they embrace a mission that goes beyond the financial bottom line, a mission such as environmental stewardship, healthy farming practices or better labor practices. Companies like these pursue their chosen mission vigorously and profitably.
The other thing companies like these have in common is the need to raise money in ways that don't compromise the mission. It's relatively easy to do this when a company is small; angel investors help businesses like these get started, and enlightened funds like RSF Social Finance support their growth with debt financing.
But as mission-oriented companies grow they need more capital, and things get tricky. The pool of patient, mission-oriented capital is shallow. Companies are forced to turn to more conventional sources of financing, taking strategic investment from large exchange-traded companies, or selling shares directly to the public. Ironically, the more successful the business is, the more capital it must raise and the harder it is to secure sufficient capital from friendly hands.
Once conventional capital is raised in large amounts, the mission that made the company unique comes under attack. New directors join the board along with the new money, and these new directors often lack a commitment to the company's mission. The intense pressure to deliver steady growth in quarterly earnings becomes overwhelming.
Proponents of sustainable economic development have long sought to reengineer capital markets to solve this problem. They seek an alignment of mission-oriented patient capital with mission-oriented entrepreneurs and CEOs. This week Capital Institute published a research paper outlining one such alternative, which it calls Evergreen Direct Investment. It's based on the work of Tim MacDonald, an attorney specializing in tax-advantaged partnerships that have outperformed public stock markets in recent years.
Evergreen Direct Investment, or EDI, offers an innovative way to align investors that have predictable cash flow needs and mission-related goals (such as many pension funds), with mission-oriented companies that produce relatively stable cash flows. EDI is fundamentally different from debt, public equity, private equity and limited partnerships, but it incorporates some features of all of them. The key aspects of EDI investment deals are:
- Companies make payments to the investor over several years, as with conventional debt. But unlike debt, the payment stream isn't a fixed dollar amount. Instead, it can be set at a percent of distributable cash flow. The payout ratio favors the investor in the early years, but shifts to favor management and employees once a threshold rate of return has been achieved.
- The EDI structure promotes a close and ongoing partnership between the investor and the company that receives the investment. It takes inspiration from Warren Buffett's objective: to take positions in "outstanding businesses with outstanding managements" and have "a holding period of forever." The upside of the EDI structure, from the investor's point of view, is much greater influence on capital investment decisions and other strategic issues. The downside, again from the investor's point of view, is less ability to enter and liquidate positions quickly. Also, positions are harder to value objectively for reporting purposes.
- There is no need for an initial public offering or other liquidity event for the investor to receive a reasonable return, since investors are paid back at regular intervals. This helps keep the company in hands that are aligned with its mission. (Many pension funds have now embraced ESG goals – which stands for environmental, social and governance – in addition to achieving the rate of financial return necessary to honor their pension obligations.)
If Evergreen Direct Investment is implemented, it would benefit the economy in ways beyond providing financing for sustainable and socially–responsible businesses. If adopted at scale it could "enable enterprise to shed the tyranny of … our speculation-driven capital markets" says John Fullerton, founder and president of Capital Institute and a former managing director at JP Morgan.
For example, companies would not face pressure to take on dangerous and destabilizing levels of debt as they do under today's private equity system. Returns would be less volatile. Fewer companies would go over the edge when they encounter an ordinary cyclical downturn.
Another benefit involves the quality of capital budgeting decisions. When a growth company starts to mature (think about Microsoft in the 1990s) it faces enormous pressure from investors to sustain a high rate of organic growth. But reinvesting its cash hoard on internally-generated opportunities would crash its reported earnings and tank its stock price. And the alternative – paying a healthy dividend – could also crash the stock price because the stock would no longer be valued as a high growth investment.
To avoid these challenges, many companies go on an acquisition binge, often overpaying for companies and more often than not failing to reap added growth or operating synergies with the core business. This widespread practice is hugely destructive of value for investors and employees alike. But under a model like Evergreen Direct Investment, the shift from growth to cash flow would be anticipated by the investor, and welcomed. Management could focus on executing the shift smoothly rather than fighting to conceal it from the investing public.
Pension fund managers should welcome the new approach too. It has the potential to provide more stable cash flows, greater control and closer alignment with ESG goals. And it strips out some of the financial middlemen and their fees – as long as the investor has the scale necessary to screen and manage investments properly.
EDI meets the test of fiduciary responsibility. "By disintermediating Wall Street, investors can invest again with more predictable returns," adds Fullerton. "Managers can manage the complex long term challenges of their multiple stakeholders, and the economy will be healthier as a result." Let's hope some fund managers see these advantages and give EDI a try.
David Brodwin is a cofounder and board member of American Sustainable Business Council. Follow him on Twitter at @davidbrodwin.
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