Other People’s Money

I recently read Other People’s Money by John Kay – a great book exploring the role of finance in society, the transformation in the sector and society at large brought about by financialization, the structural causes of the financial crisis and ways to reform the financial sector to serve society again rather than itself. 

So, what is finance for?

In the words of John Kay, finance can contribute to society and the economy in four principal ways:

First, the payments system is the means by which we receive wages and salaries, and buy the goods and services we need, as well as enabling business to contribute to these purposes. Second, finance matches lenders with borrowers, helping to direct savings to their most effective uses. Third, finance enables us to manage our personal finances across our lifetimes and between generations. Fourth, finance helps both individuals and businesses to manage the risks inevitably associated with everyday life and economic activity. 

According to Kay, the evolution of finance in the last thirty years has increased the role of trading over relationships through the process of financialization. It has increased the complexity of the sector, increased the risks to the economy and transferred to itself a greater share of national income without improving the quality of the four key services it provides to society. 

Here are a couple of salient paragraphs from the book.    Other People's Money

The finance sector of modern Western economies is too large. It absorbs a disproportionate share of the ablest graduates of our colleges and universities. Its growth has not been matched by corresponding improvements in the provision of services to the non-financial economy – payments systems, capital allocation, risk mitigation and long-term financial security for individuals and households. The process of financialization has created a structure characterized by tight coupling and interactive complexity, and the resulting instability has had damaging effects on the non-financial economy. […]

The belief that the profitability of an activity is a measure of its social legitimacy has not only taken root in the financial sector but has spread its poison throughout the business world. […] There has been a wide failure to distinguish profit generation from wealth creation, or to see the difference between the appropriation of resources and their production, and a willingness to license activities that border on fraud and which sometimes cross that border. Both supporters of the market system and its critics have failed to recognize that the trading floor of the investment bank is not the epitome of the market economy but an excrescence from it. 

I took the liberty to quote two extended paragraphs from John Kay’s book hoping they will provide a motivation for you to pick up a copy of this very insightful and authoritative work.

What are we to do about it?

I am a very big proponent of DIY when it comes to large scale system change. No point in waiting for government action when we can take matters in our own hands and start moving the system in the right direction.

The first thing you should consider is moving all your banking business including your mortgage away from the large four banks and towards a regional bank or a credit union. This would be a no-risk way to support your local economy. While the regional banks and credit unions in the US control about 20% of the deposits in this country they are responsible for more than 50% of local lending.

The other thing you can do is learn the basics of portfolio management and investing (maybe by signing up for my webinar series) and shift some of your personal savings from the opaque and over-intermediated financial system towards your local economy and investments aligned with your personal values. You might want to look for a Slow Money group active in your area and join it to turn local investing into a fun team sport activity!

I am looking forward to supporting you in your quest to align your investments with your values and leave a positive legacy behind.

What Returns Could We Expect from Local Investing?

This is a key question that is often posed when talking about local investing, yet it is impossible to answer in a few words. To answer it properly I will take you on a little journey. First I will challenge the assumptions implicit in the question, then I will explore the meaning of return and finally I will attempt an answer.

First of all we must recognize that when someone asks what returns can one expect from local investing, one usually has some sort of expectation or comparison in mind. Most often the concept of expected return is associated with a particular asset class  – a group of investments that share similar characteristics and risk profile. Examples of asset classes are US stocks, US bonds, international stocks, international bonds, venture capital, real estate, etc., or subsets thereof, for example US small cap stocks, US large cap stocks, US short term bonds, US medium term bonds, US long term bonds, etc. In any case the common assumption is that investments that belong to the same asset class have similar risks, share similar characteristics and therefore have on average similar expected returns.

It is also common to assume that the historical return of an asset class is a reasonable estimate for its expected return going forward. More risky asset classes like venture capital are assumed to have higher expected returns than less risky asset classes like short and medium terms bonds.

In fact, over the last few decades the financial industry and specifically financial advisers and investment consultants seem to have adopted mythical “market rates of return” for the various assets classes which seem to abide by some sort of divine right of capital – a transcendent expectation impervious to the changing world we live in and sometimes even at odds with the actual historical performance of those asset classes. So, venture capital is somehow expected to generate between 15% and 20% return per year, stocks around 8%, real estate between 8% and 10% and so on.

It turns out that the performance of an asset class is very much dependent upon its valuation, its recent performance and the trend in interest rates (we have experienced an unprecedented secular downward trend in interest rates now for a few decades which boosted returns for most asset classes). For example, real estate in the US experienced a bubble in the years leading up to  2007 leaving the asset class overvalued and poised to deliver negative returns over the following few years. Similarly, technology stocks rallied in the late 90s and ended up grossly overvalued by the end of 1999 delivering large losses to investors who bought them at the wrong time.

In 2012 the Kaufmann Foundation ​published a study[1] by based on their 20 year experience investing in venture capital funds which revealed that on average venture capital funds failed to return investors’ capital after fees. This means that rather than delivering between 15% and 20% per year, venture capital funds delivered on average a negative annual return to investors!

I believe this is just the early sign, an omen that the whole world of investing has entered a completely different phase and that the future of investing will bear very little resemblance to that of the past.

Since I left the industry in 2009 I have been on a quest to understand the big picture and the large systems shaping society – the economic system, the global system of finance and the money and banking system.

The key conclusion I reached is that we now have too much investment capital chasing financial returns around the world and that historical returns and return expectations based on historical performance are no longer a valid guide for what we are likely to experience in the next few decades.

Let me explain.

Speaking epigrammatically, investment capital originates as money and money originates through an expansion of the balance sheet of central banks and private banks around the world. Central banks create money when they purchase assets, mostly government debt; the private banking sector creates money when it issues loans[2]. There is theoretically no limit to the amount of money and therefore of investment capital that can be created through this magic of accounting. The world is currently swimming in an unprecedented level of private and public debt and in an unprecedented amount of investment capital – these two facts are manifestations of the same process of money creation[3].

A study[4] published by McKinsey Global Institute in 2011 revealed that the investment capital in bond markets and stock markets worldwide amounted to $212 trillion – about 3 times the global GDP (the sum total of all goods and services produced that year around the world). About 50 years ago, investment capital in world stock and bond markets was about 50% of global GDP. Now, how can we expect this ever increasing amount of investment capital, whose growth has outpaced that of global GDP for more than half a century, to continue growing by generating positive financial returns?

If we use an assumption of expected return of 5% per year, more than $10 trillion would be required to deliver such return. In other words, about 15% of global GDP would be needed to deliver the 5% financial return just for the portion of investment capital invested in global stock and bond markets. Do we really believe this can continue indefinitely? That investment capital will continue to grow more rapidly than global GDP and swallow an ever increasing share of it as “market rate of return” [5]?

One likely scenario is a global balance sheet recession, similar to what Japan has experienced in the last couple of decades, caused by the recognition that large amounts of the global debt outstanding will default or never be repaid. Such contraction in debt outstanding will reverse the process that created money and investment capital in the first place and cause the shrinkage of the global stock of investment capital. In other words, an overall negative return for global investment capital is not only conceivable but in my view probable in the next couple of decades.

There is no denying that global investment capital has overall enjoyed strong financial returns in the last few decades. A recent study commissioned by the UN sheds some light on how those returns were generated, at least in part.

The Economics of Ecosystems and Biodiversity (TEEB) is an UN sponsored global initiative focused on “making nature’s values visible”. In April 2013 TEEB published Natural Capital at Risk: The Top 100 Externalities of Business[6] – a 15-year study conducted by TruCost to identify the world’s largest risk to the natural capital and to quantify in financial terms environmental externalities such as damage from climate change, pollution, land conversion and depletion of natural resources, across business sectors and at a regional level.

The study demonstrates that the profits of high impact business sectors would be wiped out if the costs of environmental damage and unsustainable natural resource used were accounted for. The study showed that in 2009 the global economy used $7.3 trillion worth of unpriced natural capital in the creation of about $70 trillion of total global economic activity (World GDP).

Nature of course does not charge us for the natural resources it built over the millennia – forests, underground aquifers, oil, coal, metals, etc. nor does she charge us for its ecosystem services– water purification, oxygen production, pollination, soil fertility, nutrient cycle regulation, climate regulation, etc. Not only have we humans taken advantage of the ecosystem services provided by nature for free but we have started dismantling the very natural capital that makes those services possible.

The $7.3 trillion worth of unpriced natural capital used by human economic activities in 2009 represents a subsidy to our global economy at the expense of nature’s integrity. We are effectively treating nature as a business in liquidation and converting its very assets into economic activity and financial returns.

While it is impossible to make direct measurements, it is eminently clear that part of the financial returns obtained by investment capital in 2009 were subsidized by the destruction of $7.3 trillion worth of natural capital.

The conversion of natural capital into financial capital has been happening for a very long time but the process has accelerated as the amount of global financial capital has grown exponentially for at least the last half century and with it the pressure to generate financial returns.

We also have to keep in mind that investment capital and more fundamentally the money that created it, is at the end of the day a claim on real things – goods and services created by the economy and other assets whether man-made or natural. Since there is no limit to the amount of money and therefore investment capital that can be created with the disembodied magic of accounting, since we know economic activity and financial returns have been subsidized by the destruction of the natural capital and since we are now experiencing the early signs of the stress our extractive practices have caused to natural systems (climate change, species extinction, pollution, deforestation, etc.) it is logical for us to conclude that the current gargantuan amount of financial capital will not experience going forward the type of financial returns it enjoyed in the last half century and in fact might shrink as the constructed reality of money and finance collides with the physical reality of a diminished biosphere.

Having realized that financial returns going forward, far from being guaranteed by some sort of “divine right of capital” might more aptly be characterized as a chimera, we are now ready to take a closer look at the very concept of “return”.

Most of us[7] don’t invest with the goal of being able to die with the largest possible amount of money and personal property. We invest to have money in order to satisfy our future needs and desires. What we really care about is what money can buy to satisfy our physical and psychological needs. It would be ironic if the investments we make today were undermining the very conditions that make the satisfaction of our future needs possible! Yet, that seems to be our destiny if we don’t expand the concept of return.

An example might help clarify this concept.

Carol Peppe Hewitt in her book “Financing our Foodshed – Growing Local Food with Slow Money” tells the story of the Chatham Marketplace in Pittsboro, NC. Chatham Marketplace is not only a well-established co-op grocery store committed to local sourcing but is also the social gathering place of this small town of 4,000 souls. Carol said that if you lived in Pittsboro and wanted to meet someone, all you had to do was hanging out at the Chatham Market and the person you were looking for would eventually show up.

The Marketplace launched in 2006 and was financed in part by a large loan at nearly 9% interest from an out of state bank.  The $300K balloon payment for the balance of the loan was coming due in 2012 and the bank, reeling from the recent financial crisis, had made it clear it was not going to renew the loan. No one was sure where that money was going to come from and the Marketplace’s future was uncertain. Carol, upon learning of the challenge to this beloved establishment, organized a team of local investors and formed an LLC for the purpose of buying out the loan from the bank and refinancing it at 5%.  By fall of 2011 a group of 16 investors living within 100 miles of the Marketplace had raised $400K, and they bought out the Marketplace’s loan from the out of state bank, a year ahead of its due date.

Net of administrative fees the investors are receiving a 4.5% return. The lower debt servicing costs have also greatly helped the Chatham Marketplace. Moreover the interest payments that used to leave the state are now remaining in the community.

It is important to understand that in this case the “return” to the local investors was much greater than the 4.5% they are getting in interest – without their investment they might have lost a beloved market and a place to gather; they might have also lost access to the locally grown produce and locally crafted food products they enjoyed. The disappearance of the Marketplace could have also caused the demise of a number of the 200+ local food producers in the area that counted on the Chatham Marketplace as an important distribution outlet, with significant negative employment and economic consequences for the local economy.

When we invest in local projects we can experience or understand intuitively the non-financial benefits of our investments – they are tangible to us even though they might not be precisely measurable.

Another example of the opportunity offered to local investors for expanding their concept of investment return is Community Foods Market (CFM) in West Oakland.

West Oakland is a predominantly black neighborhood in the San Francisco Bay Area that has suffered institutional discrimination and neglect for many decades. Polluting industrial facilities have been located there; red-lining policies have starved the community of bank credit for decades; the construction of the Bay Bridge in the 30s eliminated the economic activity generated by the ferry link between West Oakland and San Francisco; the construction of Interstate 880 cut West Oakland off from its downtown and further reduced its economic vitality; and predatory lending practices by large banks in the run up to the real estate bubble about a decade ago further impoverished the community.

The 28,000 residents of West Oakland have access to hundreds of corner liquor stores but not a single full-service grocery store in more than a decade. Brahm Ahmadi, a former resident of West Oakland and a passionate environmental and social justice advocate has taken on the challenge and worked tirelessly for the last decade to build Community Foods Market – a full-service grocery store that would serve and employ people from West Oakland. For about a year he went around the country trying to raise capital from angel investors and venture capitalists and even from “impact investors” with no success. He was offering preferred equity shares that would pay a 3% dividend.

Angel investors and venture capitalists use the following arithmetic when investing. They know that early stage companies are risky and most of them will not succeed. In other words they know that between 6 and 7 out of 10 of their investments will result in a complete loss. One or two will do okay and return the capital and possibly a modest return, while one or two will be big winners and return 5 to 10 times their capital compensating them for the losses incurred in the majority of their portfolio. When they invest they therefore look exclusively for companies that have the potential for rapid growth and for delivering 5 to 10 times the original capital (therefore a return between 500% and 1000%) in a few years. On a portfolio level they therefore expect to make between 10% and 20% annualized[8].

When angel investors and venture capitalists, and even so called “impact investors” looked at the CFM investment through the narrow lens of conventional finance they made the following assessment – this venture, as any early stage pre-revenue enterprise has at least a 50-50 chance to fail therefore generating a -100% return. If it succeeds it will return 3%. The expected return for this investment would therefore be  R = 50% * (-100%) + 50% * (3%) = – 48.5%. In other words, rather than the usual expectation that the investment might provide on average a return between 10% and 20% once adjusted for the risk of failing, this particular investment had a negative expected risk-adjusted return. No investor motivated exclusively by the prospect of financial returns would take on equity risk in a start-up company for the prospect of a 3% return if the company succeeds.

That’s why Brahm decided to register the security with the state of California through a DPO (Direct Public Offering) and offer it to the local community. The investment is a preferred equity stock offering 3% cash dividend but also a 1% in-kind dividend as a store credit once the grocery opens. Beyond these dividends, for local investors the non-financial benefits of having a full-service grocery store are very real and tangible. I am also an investor and, although I don’t live in West Oakland, I find it unacceptable having a food desert just a few miles from my house, in the middle of the food abundance of the San Francisco Bay Area.

Are we going to condemn all great projects like Community Foods Market that attempt to solve a social or environmental challenge but don’t provide sufficient financial returns to investors to the dust bin of great ideas that will never be realized? Or are we going to expand our idea of return so that we can build together the world we want to live in?

Local investing, by making tangible the non-financial returns and benefits of a business or project, offers the possibility of escaping the straightjacket of conventional finance and helping us remember that we invest to eventually enjoy the goods and services money affords us. Money is just a means to a greater end and investing itself can become a greater end than just accumulating financial capital.

Now we are at the end of our journey and able to provide an answer to the original question.

If we are talking strictly about financial returns, the original question is simply unanswerable since local investing is not an asset class. Local investing is very idiosyncratic and spans a very large and creative range of possible investments that do not share common risks and characteristics. A 3-year collateralized loan to an established bakery looking to upgrade its bread mixer is a completely different investment than an equity position in a local start-up creating a new nanotechnology-based coating to improve the efficiency of solar panels. A two-year loan to an established CSA with interests paid in the form of a monthly box of produce is completely different than a royalty loan to a compost company still in the prototype stage. Therefore it is not possible to talk about expected financial returns for local investing in general terms.

What we can say is that a community can unlock the benefits of local investing only if its local investors are able to transcend the straightjacket of strictly financial considerations and appreciate the rewards local investing offers in terms of local economic vitality and community health. Odessa Piper[9] said “local is the distance the heart can travel.” Within that distance the promise of local investing has the opportunity to blossom.

[1]We have met the enemy…and he is us – Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience” May 2012 by Ewing Marion (Kauffman Foundation)

[2] As this bulletin of the Bank of England states “…the majority of money in the modern economy is created by commercial banks making loans”

[3] More information on this topic can be found on my website

[4] Mapping Global Capital Markets 2011 – by Charles Roxburgh, Susan Lund and John Piotrowski (August 2011)

[5] Prof. Thomas Picketty, author of “Capital in the Twenty-First Century” certainly does not think so.

[6] Natural Capital at Risk: The Top 100 Externalities of Business

[7] A minority of the US population, mostly among the wealthy, is engaged in the positional game whereby a 50’ yacht becomes a liability as soon as a neighbor shows up with a 70’ yacht. Someone trapped in the positional game, will unfortunately never experience “enough” and will behave as if his/her ultimate life goal is to die with the largest possible amount of money and property.

[8] Let’s imagine 6 out of ten of their investments failed therefore generating a -100% return, two just returned the capital therefore generating 0% return and two were big successes, one generating 5 times and the other 10 times the capital invested within 5 years. The total portfolio return over five years would be R = 0.6 * (-100%) + 0.2 * (0%) + 0.1 * (500%) + 0.1 * (1000%) = 90%. In other words the investment portfolio almost doubled in 5 years for a (simple) annual return of 18% per year.

[9] http://en.wikipedia.org/wiki/Odessa_Piper

Local Investing and State Crowdfunding Securities Laws

After shopping locally and eating locally, the next step necessary to building a livable future is investing locally.

I make the case for it in this podcast – From Wall Street to Main Street: an interview with Marco Vangelisti on local investing and Slow Money.

Most understand by now the importance of local investing yet very few people have actually made any local investments.

Why is local investing so difficult?

The answer lies in part with our securities laws introduced at the beginning of the Great Depression to protect investors.

An Interview with Amy Cortese of Locavesting

From Wall Street to Main Street: A Conversation with Local Investor Marco Vangelisti

Amy Cortese | June 5, 2015

This interview originally appeared on Locavesting.

Marco Vangelisti left his job as an investment fund manager in 2009, after an eye-opening discovery about the kinds of companies the fund, and its mission-driven clients, were investing in. The first thing he did was to liquidate his Wall Street portfolio and reinvest it in local and sustainable investments. The second thing was to embark on a quest to understand the big picture and the large systems shaping our society—the economic system, the global system of finance and the money and banking system. This inquiry forms the basis of his recent talks. We spoke with Marco about what he’s learned along his journey—and what anyone thinking of local investing should know.

Amy Cortese: You had a lucrative career as an investment manager… what caused you to walk away from that?

Marco Vangelisti: I spent the last six years of my career in finance working for a very well respected investment management firm. I was part of a team managing a $20 billion equity fund investing in emerging markets. We were quantitative managers, meaning that the fund was constructed by a series of algorithms that used statistical models we had built, rather than being the result of stock picking by members of the team. The fund was performing very well and our clients, mostly endowments and foundations including environmental foundations, were very happy with us. I discovered that one of the best performing stocks we owned was a palm oil company in Malaysia that had taken down tens of thousands of acres of rainforest and planted a monocrop of palm oil plants for the international commodity market. Its earnings and therefore the stock price got a big boost that year since the company earned lots of carbon credits for planting trees!

“One of the few investments I made that resulted in a total loss was due to my investing prior to gaining sufficient understanding of the entrepreneur’s character”

I’ve always been a nature lover and a big supporter of the environmental foundations whose money we were managing. When I found out that their money, and therefore my own charitable contributions, were implicated in funding the destruction of the natural habitats those very foundations were created to protect, I realized that the financial system was a very destructive force in the world. The level of opacity and intermediation in the global financial system had concealed until then the disconnect between my personal values and my own livelihood, a cognitive dissonance that, once recognized, made it impossible for me to continue working in the finance industry. That’s what led me to leave a very well paid and rewarding job in the middle of an economic recession in 2009.

Local investing is about intergenerational justice

Originally published in Slow Money State of the Sector Report (2014)

I worked in finance for about 20 years, the last 6 managing investment portfolios for institutional investors. As fiduciaries we were tasked with preserving and growing the capital of our clients. Our fiduciary duties were discharged by delivering financial returns with moderate risk by investing in our area of expertise.

Many of our clients were foundations and no one seemed concerned that some of the investments we were making on their behalf caused or worsened the very social and environmental problems those foundations were created to address.  A case in point was one of our best performing stocks, a Malaysian palm oil company that had destroyed tens of thousands of acres of original rain forest and replaced it with a monoculture of palm oil plants. Such operation destroyed the Borneo habitat of the Orangutan, yet a few of our clients were environmental foundations trying to protect such habitat with their grants!