Thomas Piketty’s book ‘Capital in the 21st Century’ became a surprising bestseller earlier this year. It documents the increasing concentration of income and wealth in a few hands. And it raises the important concern that, because the rate of return on capital investment exceeds the growth of the economy, we face a future division of society into the ‘haves’ and the ‘have nots’ based on inherited wealth, with a return to the social conditions and class divide of Europe in the 19th century.
But, while there has certainly been an increasing concentration of wealth in recent years, it has little to do with high returns on capital investment, especially with high returns on investing inherited wealth. The fortunes of roughly 70% of those in the Forbes list of the richest 400 US citizens are self made. We are talking about people like Bill Gates of Microsoft, Mark Zuckerberg of Facebook, George Soros of the Quantum fund or Henry Kravis of KKR. These new fortunes are not about capital investment, instead they are about clever ideas and hard work. And they are about the ability today to translate clever ideas and hard work into a fortune without having much capital to get started.
Business ownership in the 21st century – the right to take business decisions and reap the business rewards – no longer goes primarily to those who make the capital investment. There are three reasons. Firstly – think venture capital, private equity, or hedge funds – risk capital investors grant managers the rights to an increasingly substantial share of the business profits. Counting the share earned by both fund managers and the managers of their portfolio businesses, the rights to thirty percent of the profits in large fund owned businesses and often fifty or more percent of the profits in small fund owned businesses belong to those who do the work and not to those who invest risk capital. For selected types of investment, venture capital, private equity or hedge fund business models are somuch more productive than traditional alternatives such as the public company, that capital investors in these funds can afford to part with their rights to a substantial share of the profits while still themselves making adequate returns. At a rough count, some 20% of the new billionaires in the Forbes list are partners in venture capital, private equity or hedge funds. And a further 10% or so have earned their fortune by working in other types of businesses where they have explicitly been able to negotiate a substantial share of the business income from their decisions and actions without investing much capital themselves. These include owners of other types of asset management firms, CEOs receiving stock options, film directors receiving a percentage of the proceeds on blockbusters, and even lawyers earning contingency fees on big commercial law suits.
Secondly, business value creation is increasingly about developing and managing intellectual properties and less about capital investment in plant and equipment to manufacture and distribute physical objects. We are talking software and information networks not steel mills and chemical plants. Building up big software or information network businesses requires quite limited capital investment. What is more, many of these businesses offer strong network benefits and are natural monopolies. The leading competitor achieves a dominant position and has a correspondingly strong profit opportunity – think Microsoft Windows computer operating systems, Bloomberg information systems, Google search, Facebook social networks. Those who come up with good ideas for software and information businesses can build a large new highly profitable business quickly and, since capturing the profits is no longer so closely related to putting up the capital, retain a substantial share of them. Of the new billionaires’ fortunes, around 12% by number come from software and information business – and a higher percentage by value, as some of the very largest new fortunes are in this category.
Thirdly, where businesses are dependent on heavy capital investment, you can still build a large business from small beginnings if you can finance investments with borrowed money. Real estate is a business where it has always been possible to operate on this basis. And it is no coincidence that that is where many large fortunes have been made. Roughly 10% of new billionaires are real estate investors. But what has changed in recent decades is the ability, starting with junk bonds in the 1980s to finance a much wider range of different types of investment by taking on a high level of debt. What is more, entrepreneurs have found additional ways of leveraging the value of their investment besides taking on debt from a bank. A franchisor sharing business revenues with franchisees can transfer to franchisees the responsibility for all store investment but still capture a share of the business income franchisees receive. Fred de Luca and Peter Buck, the owners of the Subway sandwich franchise have leveraged their investment in the fast food chain in this way to join the list of new billionaires. Add to this a generally low cost of debt thanks, pre financial crisis, to regulatory distortion permitting limited liability for banks with minimal equity capital and, post financial crisis, to governments’ attempts to stimulate the economy while letting banks gradually build up their equity reserves.
So what needs to be done about the increasing income and wealth divide? The opportunities for talented people to capture the full value of their business ideas and hard work unconstrained by the need to inherit capital to realize their ambitions should arguably be welcomed. It is a big step towards equality of opportunity. But opportunities should best not rely on regulatory and tax distortions or on creating and exploiting market monopolies. Both governments and other industry players are on the line to ensure this does not happen. To do so, they need to start from a better understanding of what is causing the new income and wealth divide. It is about business ownership in the 21st century. But, in the 21st century, this is not just about capital. With the right collaboration strategy, you can turn smart ideas and hard work into a big fortune from small beginnings.
Felix Barber is a Director of the Strategic Management Centre at Ashridge Business School and a former Partner at The Boston Consulting Group Inc. He is co-author with Michael Goold, of the new book, “Collaboration Strategy: How to Get What You Want from Employees, Suppliers and Business Partners” (Bloomsbury, November 2014).