Japanese Shareholder Value: Aligning Human Capital and Financial Capital

Who is the Japanese shareholder? One image is the rapacious foreign financial investor who seeks to strip the fruits of decades of hard work and leaves a trail of corporate husks behind. While it is easy to anthropomorphize such a villain, the truth is more nuanced.

In fact, there are other corporate stakeholders that think like shareholders. Prime examples are newly minted employees. They are the future of the company. They are important stakeholders whose goals also are aligned with shareholders. Their future depends on finding new investment opportunities and generating sufficient investment returns for the company. New employees are also equity risktakers in the modern corporate world of Japan.

While counter-intuitive from the viewpoint of the classical Marxist struggle between capital and labor, the concept of the new employee as a shareholder makes sense if you consider the real meaning of equity, i.e., the residual claim on the assets after other obligations are satisfied. It is true that labor has a contractual claim to the value added of the company before the residual equity. But, consider the structure of the Japanese labor markets. New employees’ contractual claim on capital is structurally subordinated to senior employees, making their interests more closely aligned with residual claims. Senior employees take a greater share of value added in terms of compensation and fringe benefits, and when they retire, they take a lump sum of capital directly out of the company. New employees are left holding a residual claim in the form of a subordinated tranche. As time passes, new employees become the senior employees. From the employee perspective, a swap of equity for debt gradually occurs as they exchange their residual claims for contractual obligations that are structurally senior to a new generation of subordinate employees. And the cycle re-commences.

Meanwhile, a new generation of junior employees must hope that there is a strong business left when their seniors retire. New employees simply cannot rely on today’s excess financial cushion. But too often, excessively risk adverse senior employees are in charge, and they do not want to take on any risk that might endanger their ability to claim their already earned contractual stake. From a self-serving perspective, their actions are justified. If they take risk and succeed, their upside is not meaningfully enhanced, but if they fail, their ability to claim their full retirement benefits may be jeopardized. But from a new employee perspective, if the preceding generation has not created sufficient new investment opportunities to grow into, then they will be left with an empty cupboard.

And here is the real conflict of Japanese corporate governance. Japanese management practices are often praised for being able to take the long view. But this is not happening anymore. The current risk aversion of senior employees is mortgaging the future of the next generation and, consequently, the country. If companies are not willing to generate sufficient returns on equity, they need to return it so that it can be allocated to someone who will. Pensions and contractual obligations must be honored, but today’s excess financial capital is not a reward for past deeds well done. Those past deeds were already compensated for with yesterday’s cost structure. Instead, residual capital needs to be put to work into productive uses. Otherwise, there will not be sufficient economic activity to support the cost structure for today’s new hires when they become senior.

So what is a young prospective employee to do? Think and act like a shareholder: if a company is not efficient in utilizing its financial capital, how can it efficiently utilize its human capital? If financial capital is treated badly, it goes somewhere else and prices fall. Similarly, the human capital markets need to allocate the best talent to the best growth opportunities. Don't think about your entry level salary and current financial condition of the company. Think about the future of the company. An excessive focus on job security has turned the labor force into risk adverse entities that are not looking to grow the economic pie. Going where the pie of financial assets is currently the biggest and hoping to get your slice in the future is short sighted. Not only will others get their share first, those companies with excess financial capital generally do not have attractive re-investment opportunities. Otherwise, those financial resources would be put to work today. And if financial capital is not being put to work, then the human capital will probably not be effectively developed either. Young employees need to play a long term game and develop their own human capital so that they can create their own financial capital.

What should senior executives do?… (continued)

By Kouji Yamada; Chief Investment Officer, JCA Partners

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