Wealth Management

Notes on Wealth Management
H.B. Falkena

Notes on Wealth Management

by H.B. Falkena

Copyright © 2007 by H.B. Falkena All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without prior written permission from the author. The information and opinions contained in this book have been compiled or arrived at from sources believed to be reliable, but neither the author nor the publisher accept responsibility for any loss arising from decisions based on them. ISBN 978-0-620-38461-2 Fifth edition, first impression 2007 Previous editions were entitled Entrepreneurs Only Published by Roy Bamber c/o The Financial Sector Forum http://www.finforum.co.za P O Box 12028, Hatfield 0028 Set in Times New Roman/Arial 10/12 point by Roy Bamber

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PREFACE

Every level of wealth creates its own specific problems. This essay views some of the wealth problems of millionaires (in US dollars). Although some 20% of millionaires simply inherited their wealth, an ever increasing percentage is self-made. This last category consists mainly of entrepreneurs, fund managers, artists, sportsmen, fashion models and the executive management of large corporations. Leaving aside celebrities, in all their admired variations, this essay concentrates on the wealth management issues of entrepreneurs and executive management. For instance, what is the typical amount of wealth entrepreneurs can accumulate over their working lives; why are entrepreneurs always striving for more wealth even if greed, envy and obsession may scare off their friends and therefore adversely affect the quality of their lives; how does the total accumulated wealth of entrepreneurs in medium-sized companies compare with that of chief executives employed in large corporations; where should the line be drawn if it comes to unethical business practices or activities; how should wealth be invested and fund managers be managed; and who ultimately inherits an entrepreneur’s riches. In essence this essay covers the life cycle of an entrepreneur in a few pages. To do so, the tune, key and tempo of every chapter had to change materially. Generally speaking, the vaster the scope of the topic at hand, the more lighthearted the approach to the specific subject. Considering the issues at stake, it required some effort to remain serious at times. Where failures occur, no offence is intended, of course. Quantitative analysis will be done foremost in US dollars, as the topic under discussion is international in nature. Where local taxes and local costs of living are discussed, the required equivalents in rands will be given as well. The Author

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CONTENTS

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Wealth distribution: Internationally and in South Africa Executive remuneration Entrepreneurial remuneration The opportunity costs of wealth Growing your business Selling your business Retirement and financial restructuring Managing your fund managers Trusting your trustees The realm of Regina Pecunia Ruling from your boardroom in the sky Reflections on wealth and happiness

1 4 9 14 22 25 28 33 40 44 47 49

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CHAPTER 1

WEALTH DISTRIBUTION: INTERNATIONALLY AND IN SOUTH AFRICA

Wealthy people, or what is called in banking terminology “high-net-worth individuals (HNWIs)”, are usually defined as those with net financial assets (excluding their primary residence) of US$1 million (or some R7,5 million). Obviously this is only a ballpark figure and therefore somewhat arbitrary. Nonetheless only 0,1% of the world population (or an estimated 8,7 million people) qualifies for this exclusive club1. The largest number of wealthy people is found in North America and West Europe (namely 5,7 million individuals or 0,8% of their total populations). In South Africa the number of wealthy people is estimated at about 72 000 (i.e. some 0,2% of the total population or 1% of the working population of 7,2 million). Although small in absolute numbers, the total worldwide Table 1.1: Number of worldwide millionaires and their financial wealth we al t h o f m i l li o n a i re s Number of $ Total wealth of Total wealth of World GDP (estimated at US$ 33,3 trillion) millionaires millionaires Year 2 millionaires (as (in US$ trillions) (in millions)1 (in US$ millions)1 % of world GDP) is about 75% of world GDP 1996 4,5 16,6 30,0 55,3% (see Table 1.1), while in South 1997 5,2 19,1 29,9 63,9% Africa this figure may be about 1998 5,9 21,6 29,7 72,8% 100% of GDP. This means that 1999 7,0 25,5 30,8 82,9% around 0,2% of the South 2000 7,2 27,0 31,6 85,4% African population owns at 2001 7,1 26,2 31,5 83,3% least a third, and possibly even 2002 7,3 26,7 32,7 81,6% close to a half, of all household 2003 7,7 28,5 36,8 77,5% 2 wealth . Accordingly, it makes 2004 8,2 30,7 41,3 74,4% commercial sense for private 2005 8,7 33,3 44,4 74,9% bankers to concentrate on their 1 Source: Capegemini and Merrill Lynch. 2 HNWI’s, even if these clients IMF, World Economic Outlook, 2006. account for only a fraction of the population. Although the income distribution in South Africa is among the world’s most skewed, even in the majority of industrial countries the Pareto principle applies: i.e. 20% of the people own around 80% of all assets. In an economy based on the political philosophy of property rights and individual autonomy, wealth distribution is typically a steep rising curve, i.e. 1% of the population owns some 50% of all assets and 20% owns close to 90%. Only through progressive tax policies can wealth be more evenly distributed (as is done for instance in Sweden). The earnings pyramid remains relatively steep even passing the $1 million threshold. For instance, among the 8,7 million millionaires worldwide there are today an estimated 85 000 people with net financial assets in excess in $30 million (or 0,9% of the total number of millionaires – the so-called ultra-HNWIs), while there are probably only a thousand billionaires in the world3. Such amounts of wealth cannot be obtained by hard work alone. To rise above the average millionaire, you have to use other people’s money and other people’s time, as you can only sell some 3 000 hours of labour per annum4. Accordingly, if you aim for an annual income of more than, say, $5 million, you either
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Capgemini and Merrill Lynch, World Wealth Report 1997-2006, New York, 2006. According to the SA Reserve Bank total household wealth amounted to some R3 308 billion (excluding unaccounted foreign assets) and GDP was R1 523 billion in 2005 (SARB Quarterly Bulletin, June 2006, p.67) . If, on average, South African millionaires have financial assets of about R20 million each (which is probably an underestimation considering the importance of inherited wealth in South Africa), their total wealth should be at least R1 500 billion. By comparison, in the US the wealthiest 1% of all households controls 38% of the national wealth, while the bottom 80% of households holds 17%. An accurate estimate at these extreme levels is difficult, particularly as entrepreneurs have a great skill to fly below the radar screen. To emphasise the order difference between a million and a billion: a million seconds is 12 days; a billion seconds is 32 years. Should you be able to charge $2 000 per hour (which is about the maximum for professional services in the US), your gross annual income is limited to some $6 million a year. But, please note, ultimately the price of money is always paid in terms of time. From conception everyone is living on borrowed time, an aspect that becomes clearer with age.

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have to become the CEO of a large listed company (in South Africa about 0,01% of the labour force succeeds in doing so) or you have to start your own private enterprise (according to Paul Getty the door to the millionaires club is always open!). However, if you are a highly qualified professional, you are effectively only selling your own time (instead of selling other people’s time) and therefore your wealth can hardly exceed $5 million p.a. But then professionals run a far lower business risk and pursue a far more balanced lifestyle in general, so on a risk/return basis their remuneration is not out of line. In short, the climb to the Table 1.2: Worldwide number of millionaires and billionaires in 2005 absolute earnings peak is a Annual growth in very steep upward sloping % of No. of No. of Total wealth wealth path. In the OECD countries millionaires millionaires potential (over a 30- millionaires roughly 1% of the population year period) qualifies as HNWIs. Of these Real IRR % Distribution In absolute % of OECD US$ millions HNWIs only 1% becomes p.a. as % of total1 numbers2 population3 p.p.4 ultra-HNWIs, and of the ultra8% 50,000% 4 350 000 0,519% 1,0 HNWIs again roughly 1% 11% 25,000% 2 175 000 0,259% 2,0 becomes billionaires (see 13% 12,500% 1 087 500 0,130% 4,0 Table 1.2). Clearly as you 16% 6,250% 543 750 0,065% 8,0 approach Olympian heights, 18% 3,125% 271 875 0,032% 16,0 the air becomes thinner and 21% 1,000% 0,010% 87 000 32,0 24% 0,500% 43 500 0,005% 64,0 mountain sickness awaits you. 27% 0,250% 21 750 0,003% 128,0 Only those that really, really 30% 0,125% 10 875 0,001% 256,0 want to reach this summit have 33% 0,063% 5 438 0,001% 512,0 any chance of succeeding. In 36% 0,010% 0,0001% 870 1 024,0 this climb to the top you usually have to forget about 98,823% 8 597 558 1,026% Total your family, friends and even Notes: 1 The percentage distribution of HNWIs is estimated (very roughly) by halving the previous value. your own health. But “losers” 2 Number of HNWIs worldwide: 8 700 000 (Source: Capegemini). 3 Total population of OECD countries: 838 288 000 (Source OECD). can console themselves from 4 The estimated wealth per person is simply doubled for each interval, which is probably far too conservative. the words of Nietzsche, who noted “the best view from the mountain is neither in the valley nor at the top, but half way up”. The importance of your own enterprise in the accumulation of wealth is clearly reflected in hard statistics. Today’s millionaires have obtained their wealth mostly from the sale of a private business (some 40% of the total). Income generated (mainly by senior executives and professionals) account for some 25% of millionaires, while exceptional investment skills produced around 10% of millionaires. Around 20% of millionaires simply inherited their wealth5. Most wealthy people have not only excelled in making money, but they are usually multi-talented as well. To determine the relationship between talent and income is of course a pet research project for many politicians. However, casual observation indicates an impressive range of different talents in society – a range that is not dissimilar to the skewed income distribution. The new business elites – an aristocracy of talent, rather than of blood – are often uncommonly cosmopolitan in nature. The political consequences are bound to be far-reaching for any national state. To grow a business in a meaningful way requires foremost a “millionaire’s mentality”, i.e. the mentality of a true entrepreneur (according to Paul Getty, who knew how to make a “few bucks” quickly). Of course, running a large company profitably is a rare skill, and in terms of remuneration the CEOs of such companies easily outperform the entrepreneurs that started their own small businesses. At first glance the differences between a CEO and a true entrepreneur may not seem significant, but in reality the differences in mentality and risk appetite are still impressive. In the case of bankruptcy the CEO is propelled back into the job market, but the entrepreneur, who typically invested heavily in his own business, particularly during the initial growth phase, may lose all his accumulated wealth. And although the prime aim of an executive share incentive scheme is to align the interests of the owners with that of executive management, it often remains a poor proxy in practice. In essence entrepreneurs are a rare species, as they possess two uncommon traits: common sense and courage.

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Capgemini and Merrill Lynch, Ibid.

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These characteristics are profitably combined to challenge old and trusted habits. Such people usually have exceptional senses6. They are also better at anticipating potential problems than management in general. An entrepreneur is not interested in the ordinary, but strives for the exceptional. He faces business issues different from those confronting ordinary businesspeople, e.g. how to invest his wealth and diversify his company’s assets on a global scale, even if his home country imposes exchange controls. Such issues may well be legally difficult, but he has to “manoeuvre around them” in one way or another. It is in these grey areas where most of his problems (and also profits) are found. Indeed, it is usually considered somewhat impolite to ask a successful entrepreneur where or how he made his first million. Unless you are worth some $4 million at age 60, you should not really consider yourself an entrepreneur, even if you have your own shop. In such a case you could just as well have remained a senior executive, and invested your savings in a professionally managed fund. Alternatively those born with a silver spoon in their mouths should multiply their inherited assets in real terms7 at least a hundredfold during the last three decades of their careers to qualify for entrepreneurial status. This implies a real growth rate in equity capital in excess of 15% p.a.

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Such as a fine nose for business deals, a sharp eye for future developments and a sensitive ear to pick up the sound of bulls’ hooves on a bear market. Real values are equal to nominal values adjusted for inflation. All real values, irrespective of the currency, are based on the 2005 price level. The US dollar was chosen as a reference currency.

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CHAPTER 2

EXECUTIVE REMUNERATION

The question posed here is a simple one. If your salary grows in real terms at the same rate as the earnings yield of an average listed company, how much wealth could you typically accumulate during your career? Since the equities markets in the industrial countries had an average earnings yield of some 6% p.a. since 1960, your end-salary in a typical mediumsized company should be around $500 000 just before retirement (see Table 2.1). By that time your financial assets should have grown to roughly $3,5 million, provided that sensible savings occurred. The key difference between an executive and an entrepreneur is whether you put a significant slice of your own capital at risk in the firm. Executives do not, while entrepreneurs do. The so-called “entrepreneur executive” is in this context a misnomer and simply a form of title inflation, as even the CEO’s own shareholding in the firm is usually only a fraction of the total outstanding shares. Nonetheless, senior executives of large listed companies earn significantly more than young upcoming entrepreneurs. To experience such a steep rise in salary, and without any personal risk exposure to speak of, always involves a major effort. It clearly requires active participation in the socalled rat race and, if you succeed in attaining one of the leading positions in this race, you will soon be classified by your private banker as a “high-net-worth individual” (HNWI). 2.1 Current executive remuneration in the US Currently the highest paid executives are found in the United States. The typical income of a CEO of a medium-sized company in the US – i.e. a firm with profits in the order of some $5 to $10 million p.a. – ranges between $250 000 and $500 000 p.a. mainly depending on the type of industry. Expressed as a percentage of earnings CEO pay is typically between 5% and 7%, which is about the maximum such medium-sized companies can pay. In all likelihood the CEO then fulfils a number of key executive functions that, in larger companies, would be delegated, and which justifies a relatively high earnings/remuneration ratio for the CEOs of such companies. By contrast, the median income of senior CEOs of the 350 largest listed companies in the US was around $7 million p. a. in 2005 (or some 2% of earnings)1. Generally the top five executives of large corporations are very well paid by their shareholders, as their remuneration packages, inclusive of pension provisions, amounts to some 10% of company earnings (i.e. an earnings/remuneration ratio of some 2% on average for each top executive). For companies whose profits are measured in billions rather than millions of dollars “the winner takes all” principle usually applies. In this top-salary league the senior CEOs have to compete with demigods such as fashion models, fund managers, tennis players and tenors2. Here compensation is partly media-driven: e.g. running the 100 metres in 9,82 seconds can mean millions of dollars in advertising money, but completing the same distance in 9,83 seconds amounts to an absolutely worthless effort. Ultimately CEOs’ pay hinges on corporate earnings growth. If these are measured in billions, CEO remuneration rockets to tens of millions of dollars. Senior CEOs in the US earn anything between $20m and $50m p.a. today, which compares with annual salaries of some $50 million for investment bankers and in excess of $100m for top hedge-fund managers. It has to be emphasised however that these levels of remuneration are truly exceptional, as very few companies measure their earnings in billions of dollars (see Chapter 1, which emphasises the steep growth curve in earnings and talents). At the end of their careers the accumulated net worth of executives of medium-sized companies varies between 6 and 9 times their last earned gross salary (see Table 2.1). Note that this is a challenging financial goal for the average CEO, as it requires dedicated savings and a market-related return on financial investments. If the accumulated net
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The Economist, Supplement on executive remuneration: “In the Money”, 20 January 2007, p.4. In South Africa senior CEOs’ earnings are lower than in the United States and hardly exceed 1% of earnings. A “celebrity” or “narcissistic” CEO can be identified by six criteria: Has a large picture of himself in the company’s Annual Report; has prominence in the company’s press releases; has an extensive entry in “Who’s Who”; has a high frequency of use of the first person singular in interviews; and ensures a big gap between his pay and that of the second-highest paid in the company. See Chatterjee, A. and DC Hambrick, “It’s All about Me: Narcissistic CEOs and Their Effects on Company Strategy and Performance”, State University of Pennsylvania, 2006. Huge egos usually imply large risk-taking strategies, which can be a big hit, but also a big miss.

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worth of a CEO at retirement would be significantly lower than say six times last earned salary, it is not possible to maintain his standard of living during retirement. Accordingly, the average CEO of a medium-sized company would typically strive for financial assets in excess of $3 million at retirement, excluding his residential property. To succeed in this financial goal consumption expenditure has to be limited to about 20% of gross income on average 3 , while the residential property is likely to be worth some 30% of net wealth (see Table 2.1). Note though that for the very rich, residential property is usually well below 20% of their total assets. Financial wealth, i.e. total net worth less residential property, should be roughly 20 times desired income at retirement4.

Table 2.1: Relationship income, savings, investments and pensions (in 2005 US$ prices) (Excluding net worth in own business)
Starting salary 50 000 Real annual income growth 7,2% 6,8% 6,1% 5,1% 4,2% Savings ratio (% of 62,8% 59,8% 58,8% 60,7% 62,0% disposal income) Residential property 1 500 000 1 250 000 1 000 000 850 000 700 000 Real mortgage rate 6,0% 6,0% 6,0% 6,0% 6,0% Rental/After-tax income 76,4% 68,8% 63,0% 61,2% 58,5% ratio Real investment yield 9,0% 8,0% 7,0% 6,0% 5,0% (pre-income tax) Real annuity yield 5,5% 5,0% 4,5% 4,0% 3,5% Gross annual income at age 60 750 000 650 000 500 000 350 000 250 000 Gross pension after age 61 193 692 172 368 133 102 95 324 67 751 Consumption at age 60 133 647 122 381 94 502 69 586 50 813 Consumption after age 61 133 647 122 381 94 502 69 586 50 813 Total net worth at age 60 4 608 005 4 207 669 3 449 289 2 736 724 2 146 822 Financial assets 3 108 005 2 957 669 2 449 289 1 886 724 1 446 822 Consumption/Gross income ratio 17,8% 18,8% 18,9% 19,9% 20,3% Property/Net worth 32,6% 29,7% 29,0% 31,1% 32,6% Financial assets/ 16,0 17,2 18,4 19,8 21,4 Pension income ratio Net worth/Gross income 6,1 6,5 6,9 7,8 8,6 ratio at age 60
Assumptions: Income tax rate is 25% at $50 000 and peaks at 43% at $500 000 Portfolio expenses (TER) and taxes (as per Table 8.4): 2,5% of total financial assets Annuity yield is net of TER Life expectancy of 40 years at age 60

2.2 Determinants of wealth accumulation As a salary earner your wealth accumulation is an active interplay between income, savings and investment returns. Income is of course the prime driving force, as tax and savings are income dependent. Moreover, a significant part of your savings is locked up in contractual investments where you have little or no direct influence on investment strategy and therefore potential returns. Indeed, your contributions to the corporate pension fund are clearly at arm’s length, as the trustees determine overall investment strategy. Likewise, your participation in the executive share incentive scheme is passive, while even your investment in your own residential property is far from flexible. Unforeseen events, such as divorce, may indeed lurk around the corner if you try to maximise your returns on your housing asset by an overly active buying and selling strategy. Only your discretionary investments are fully under your own command, but these investments are bound to be meagre until your children have left their well-feathered nest. When you start your professional life as a salary earner with no private capital in any form, the accumulation of discretionary assets is initially very slow. Even if your salary rockets to ever higher levels, a mortgage has to be repaid, a spouse has to be kept happy, school fees have to be coughed up, while your motor cars have to reflect your social status. This implies in practical terms, at least for a salaried person, that there will hardly be any discretionary savings left over until you are well into your forties. Discretionary savings will only accumulate meaningfully during the last fifteen years of your professional life. Table 2.1 shows the typical pattern of income and expenditure of corporate executives in the US. If your starting salary was some $50 000 at age 20, your end salary is likely to vary between $250 000 and 750 000 depending on the size of the company. Table 2.1 emphasises a few important points. Firstly, timing is of the essence. The game of
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Consumption is defined here as gross income (including all forms of remuneration) less tax, less interest payments (on the mortgage loan) and less savings (both contractual and discretionary). The required multiplier is crucially dependent on life expectation and the net real return on annuity income.

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wealth accumulation lasts only some forty years or so and during this limited time you should neither be too relaxed nor neglect to live life to the full. Although a surprising statement to make in executive surroundings, there is more to life than work only (see Chapter 12). Try to avoid the predicament of those unfortunate executives who are informed in middle age that “the game is over”, with this final message flashing on the heart monitor. For most executives a proper savings plan from an early age plays a key role in their wealth strategy. The power of compounding interest should not be underestimated in this context. For instance, if the real net investment yield is 3,5% p.a. and the investor wants total investments of $3 million at retirement age, he needs to save on average $35 435 per annum over 40 years (see Table 2.2). However, to obtain this level of investments over a 20-year period requires three times this amount of annual savings (i.e. a savings plan doomed to fail), while annual savings have to be seven times higher for the investor who aims for a short Table 2.2: The power of compounded interest 10-year savings sprint towards Investment Net real Annual Present value Future value the end of his working life (a period investment savings (PV in US$) (FV in US$) (in years) yield (% p.a.) (PMT in US$) totally impossible strategy for 40 3,5% 1 000 35 435 3 000 000 the average CEO). Likewise it 20 3,5% 1 000 106 013 3 000 000 requires unrealistically high 10 3,5% 1 000 255 604 3 000 000 investment yields to make the 40 3,5% 1 000 35 435 3 000 000 target of $3 million at 20 13,3% 1 000 35 435 3 000 000 retirement age if you start too 10 43,7% 1 000 35 435 3 000 000 late in your life with serious savings (see Table 2.2 again). Secondly, if your salary rises on average by some 6 per cent per annum in real terms during your career, the impact of compounding is impressive. In fact, it is too impressive, particularly towards the end. Accordingly many companies slow down their executives’ real salary increases during the last five years of so. They can easily do so, as by that time your job mobility has decreased significantly. Anyhow, the global trend over the past few years has been for the tenure in the top job to reduce significantly. For some incumbents this has happened willingly; for many others, not. In the United States at present, the average CEO is in the job for less than four years. Clearly the CEO position has become “Darwinian”. Obviously very few (and most likely only CEOs) can maintain a real growth rate in their salaries equal to the earnings yield of the company they work for. But because of the power of compounding, even a moderate reduction in this real salary increase has a powerful impact on your wealth accumulation. For instance if your real salary rose by 4% p.a. over a period of forty years, your end salary will be only half that of an executive who received a 6% p.a. real increase on average. And at a 4% p.a. real salary increase, your total worth is also likely to be nearly half that of the king rat. Clearly, if you want to be part of the millionaires’ club, you have to run faster in the rat race than 99% of your fellow workers. Moreover, to maintain a high growth rate in your salary, you probably have to change your employment regularly, as familiarity has a creeping tendency to create contempt. In fact the biggest increases in salary and position typically occur after a “regime change”. In contrast to popular belief, corporate executives do not really work out of loyalty for their companies, but nearly always for prestige and remuneration5. So far as your expenses are concerned, tax and consumption expenditures are the largest items. Taxation is compulsory (for top earners usually well in excess of 60% of gross income – at least if all direct and indirect taxes are considered), while personal savings are a very individual affair, often influenced more by character than ability to save. But even if there is the desire to save, fate may cruelly intervene as major setbacks occur all too frequently, while the demands of the extended family on your purse cannot always be ignored either. Taxes are generally considered unavoidable for salaried people. At high marginal tax rates, tax becomes one of the largest expenditure items. It is quite normal that taxes on income and investments alone absorb more than half of your total gross income towards the end of your professional life. Being such a large expenditure item, it requires some careful thought, but for employees this is usually not a very productive field of investigation, as taxes, like death, are unavoidable. Your only hope rests with the skill of your tax advisers as they design your corporate remuneration
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Loyalty is very important, and particularly towards your friends (which includes of course man’s best friend, the family dog). But for a company it is not so much loyalty that counts as creativity; and generally it loves money much more than it loves you. For those who doubt, see: Bakan, J., The Corporation: the pathological pursuit of profit and power, London: Constable & Robinson, 2005.

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package. By contrast the self-employed are generally in a better position to limit their tax obligations and particularly so if there is a large gap between the corporate and the top personal income tax rates. Generally after tax payments, the major expense items in any household are living beings – you and your spouse, the children and their pets (particularly the polo horses). The expenses on housing and motor cars are not really that material in comparison. For instance, as your children have to do with an absolute minimum of your “quality time”, they have to go to a boarding school to master the elementary rules of good behaviour in polite society6. This alone may cost you over $25 000 per annum. All-in-all the opportunity costs of children will be anything between $1 million and $3 million per child before they become truly independent – all depending of course on the degree of pampering you apply. In this context nothing more needs to be said about the costs of polo horses and spouses. As already noted, your return on investments is an important form of income, but unfortunately largely outside your sphere of control. Nonetheless, if the trustees in their various positions do a good job, you could expect a real net return on your pension fund investments of some 4% p.a. The gross real return on your discretionary savings may be higher, perhaps some 9% p.a. but, after allowing for all types of portfolio fees (such as safekeeping fees, transaction fees, the buy-sell spread fees, and management fees), you are lucky if you make a 6% p.a. real return on a net basis but before taxes. After tax, your real returns may even fall below 4% p.a. in the long run. Not surprisingly, only a small percentage of millionaires make their money by superior investment strategies7. To make serious amounts of money as an employee, the share-incentive scheme is crucial as its financial gearing is so attractive. Senior CEOs make their real killings in this field and earn tens of millions dollars per year in the process. Of course the proviso is that the company’s growth is in line with the average performance of the stock market. From the company’s viewpoint the share-incentive scheme is just another expense item, while you may consider it a longterm investment. Usually shares in such a scheme may be sold after about five years. Many executives use the proceeds of their share incentive schemes for consumption, citing the standard excuses that “life is short”, the “future unknown”, and that “you only live once”. Most CEOs of medium-sized companies in the US are HNWIs and have total assets ranging between $3 and $5 million (see Table 2.1). Only the senior CEOs of large listed companies are ultra-HNWIs, with total assets well in excess of $30 million. But to repeat: only about 1% of millionaires make it to ultra-HNWIs. 2.3 Comparison between international and South Africa executive remuneration Although gross salaries of executives may differ materially between various countries, the amount of net wealth that can be accumulated by these executives differs significantly less. Equalising factors that are at work here include the following: ! costs of living: e.g. the same basket of essential goods and services costs nearly double as much in Frankfurt as in Johannesburg; ! cost of residential property: e.g. a similar type of residential apartment costs at least five times more in London than in Johannesburg; and ! taxes and social security payments: usually the richer the country, the higher the costs of the social security net. The average pay of a CEO of a middle-sized company in South Africa is currently estimated at some R2 million p. a. The executive management in large corporations earn roughly the same. These type of earnings are virtually impossible to be matched by an entrepreneur who started his own small business (the exception proves the rule here!). Obviously, the CEOs of large listed companies do significantly better than their colleagues in smaller companies. The earnings package of senior CEOs is typically in excess of R10 million p.a. in South Africa, while their total financial assets may well exceed R100 million towards the end of their careers. In a league apart are the CEOs of South African companies whose shares are listed abroad (i.e. dually listed and mainly on the London Stock Exchange). Here salaries are fully harmonised with executive pay in the US, i.e. salaries around $10 million p.a. (or some R75 million). These top CEOs are all ultra-HNWIs, while true entrepreneurs who started their own businesses from scratch will most likely “only” qualify as a HNWI before retirement. The higher a CEO’s pay package, the more internationally comparable it usually becomes, so that national
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Executives routinely neglect the family and their own health. Individual exceptions are all around of course. For instance, George Soros made his famous $1 billion profit in “one day” by betting successfully against the Bank of England (on 16 September 1992). Note though that his currency exposure on Black Wednesday was $10 billion, and that Soros routinely risked his entire wealth in a single day. Clearly if timing becomes so finely tuned, more than only luck is required. Moreover, the pain of investing – i.e. the fear of losing what you have risked – sooner or later becomes too much. Even Soros’s appetite for risk fell sharply after his biggest gamble. He summarised his philosophy in respect of money as follows: “Money is a means to an end; the end is a philosophy translated into action”.

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executive pay disparities are slowly disappearing at the very top. All top bosses nowadays look at the “going rate” in the USA, implying that future trends in executive pay ultimately depend on American shareholders getting tough on CEO pay. The major differences between CEOs in South Africa and their US colleagues are the higher savings propensity in South Africa and the lower expenses on residential property. Because of lower local living costs, many retiring CEOs have total assets in excess of 10 times last earned salary in South Africa, while housing at the higher income levels is usually below 10% of total assets which in turn benefits discretionary investments. Anyhow to directly compare CEOs’ income levels in the United States with those in South Africa is bound to be rather subjective, as use has to be made of the purchasing power parity (PPP) exchange rate, which currently is estimated at around R5 to the dollar8, compared with an actual exchange rate of around R7,50 to the dollar. Therefore the absolute income differences between executives in different countries do not imply that a CEO in New York, London, Tokyo or Zurich lives more affluently than, say, a CEO in Johannesburg9. Ultimately, the differences in wealth between the average CEOs (but not the senior CEOs) in these various cities are probably around a million dollars.

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The domestic purchasing power on an index basis is 100 in New York and 61,1 in Johannesburg (see UBS, Prices and Earnings, Zurich, 2006, p.10). A large house with a big garden, servants, a swimming pool, two or three motor cars in the garage, and overseas holidays are luxuries every South African CEO considers the norm, but would be considered an exorbitantly elaborate lifestyle for a CEO in a similar position in New York.

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CHAPTER 3

ENTREPRENEURIAL REMUNERATION

The question posed here is only slightly different from that of the previous chapter. If you started an enterprise of your own and you want to earn at least double that of the average CEO of a medium-sized company worldwide, what should the profitability level of your company be? As the average wealth of a CEO of a medium-sized company peaks at some $4 million, your target as an entrepreneur should probably be at least double that amount. As will be highlighted in this chapter a net asset target in excess of $10 million requires an exceptionally high profitability level for your company. In practice, this often means that the entrepreneur has to rely on his “edge” in the market, which in turn is only possible if there are some inherent market shortcomings. Entrepreneurship is then reflected in for instance extensive skills in networking or the ability to benefit from regulatory capture1 and/or monopolistic positioning in markets. However, exploiting these market failures is no easy task and requires intelligence, hard work and ambition – clearly very few qualify! 3.1 Real return on equity investments Entrepreneurs are generally at the mercy of “the market” which, as the saying goes, tames even tigers. If the market is indeed efficient, “excess” corporate profits should be a temporary phenomenon. In the long run there will then be a trend towards a “normal” profit level in all sectors of the economy. This does not mean that all sectors will have the same level of profitability, as “normal” profits are directly related to the degree of business risk in the sectors. The greater the fluctuations in corporate profits, the higher the business risk. The higher this risk, the higher the profit level as well as the equity capital of a firm to remain “normal”. A generally used yardstick for measuring a firm’s profitability is the return on equity after interest and tax (or net ROE). This net ROE in turn equals the internal rate of return (IRR) on own (or equity) capital. The make-up of the IRR ultimately depends on the following variables: ! gross return on equity employed (before interest and tax); ! debt/equity ratio (gearing); ! credit costs (rate of interest); ! tax rate; ! retention rate; and ! other income received. The key variables are gross ROE (i.e. before interest and tax) and gearing, as a company does not have to pay dividends at all (its retention rate is then 100%), and it may concentrate fully on its main business (“other income” received as a percentage of the pre-tax profit is then zero). Moreover, the tax rate and the rate of interest are outside a firm’s control, as these variables are determined by the authorities2. ROE and gearing are related concepts. For instance, those industrial sectors that are particularly exposed to swings in the business cycle need higher profit margins during good years to compensate for smaller or no margins during bad years (e.g. the motor car industry). In these types of businesses financial gearing, i.e. the use of debt to increase a company’s working capital, is more risky than in businesses where profit margins remain relatively stable (e.g. food retailers). In the case of smaller companies creditors are generally unwilling to prop up the working capital of such companies to a greater extent than shareholders are. So, for every dollar they borrow, they usually like to see at least one dollar of equity capital. This implies that for these firms the maximum gearing should be about one. For larger companies the gearing ratio usually fluctuates between 1,5 and 2,5 depending inter alia on stock market size and liquidity. There are a few exceptions though. Banks’ equity capital usually amounts to about 10% of total assets,
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A phenomenon in which a government regulatory agency becomes dominated by the interests of the existing incumbents in the industry that it oversees. Usually the lower fiscal discipline, the higher the tax rate and the higher the inflation rate, and therefore the higher the nominal rate of interest.

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which implies a gearing ratio of 9 if depositors’ money is seen as funding3. Likewise, food retailers are often in a position to increase their debt/equity ratio well in excess of unity, e.g. by making use of suppliers’ credit on an extensive scale. This is achieved by paying producers only when their goods are sold. But, even if on-balance-sheet gearing is not allowed or difficult to achieve, there is always the possibility of using derivative instruments. These off-balance-sheet instruments are not only ideal to achieve gearing, but may also obscure the true gearing picture of a company to competitors4 – in fact they are useful instruments in accounting camouflage. If it is assumed that the Table 3.1: Relationship between corporate returns, gearing and corporate tax rate on profits is inflation based on a desired real IRR of 9% p.a. 33% and that the company
Inflation Real credit Desired Assumed Required pays no dividends, while rate costs real IRR debt/equity nominal gross Scenario concentrating fully on its main (% p.a.) (% p.a.) (% p.a.) ratio ROE (%) line of business, Table 3.1 1,5% 0,5% 9,0% 3,00 22,0% 1 shows a number of ROE and 3,0% 1,5% 9,0% 3,00 32,0% 2 gearing scenarios that will all 6,0% 4,0% 9,0% 3,00 54,0% 3 produce a real internal rate of 1,5% 0,5% 9,0% 2,00 20,0% 4 return of 9% p.a. (which is 3,0% 1,5% 9,0% 2,00 27,5% 5 roughly what outside investors 6,0% 4,0% 9,0% 2,00 43,8% 6 expect of a company)5. All 1,5% 0,5% 9,0% 1,00 18,0% 7 these scenarios emphasise the 3,0% 1,5% 9,0% 1,00 23,0% 8 fundamental fact that the real 6,0% 4,0% 9,0% 1,00 33,6% 9 profit level has to rise the 1,5% 0,5% 9,0% 0,50 17,0% 10 higher the inflation rate goes, 3,0% 1,5% 9,0% 0,50 20,7% 11 unless the firm decreases its 6,0% 4,0% 9,0% 0,50 28,4% 12 financial gearing6. For many Note: Corporate tax rate is one third of gross profits newly established firms operating in a highly inflationary environment the implied profit targets may become so daunting, that gearing can only be very moderately used. Therefore, not surprisingly, few new companies celebrate more than a few birthdays. If your company operates in a low-profit environment, but has to produce a minimum real IRR of 9% p.a., it can succeed in doing so by increasing its gearing, provided the return on equity (ROE) is relatively stable over the business cycle and inflation relatively low. By comparison, companies operating in high-inflation countries will be subjected to major fluctuations in the real rate of interest and accordingly their degree of gearing will be severely limited. Such firms will be very dependent on a relatively high gross ROE to achieve the desired real IRR. In contrast to entrepreneurs, who typically evaluate the profitability of their firms in terms of real growth in own capital – i.e. a firm’s real IRR – investors usually value their equity holdings in terms of total real return (i.e. dividend payments plus share price appreciation, both in real terms). In practice the difference is immaterial though, as IRR and total return are closely related concepts. Indeed, entrepreneurs have to produce a minimum IRR at least equal to that of the market average to keep their shareholders happy. In the long run the total real return on equities was typically between 6% and 9% in the US and the UK (see Table 3.2), while the corresponding figure for South Africa was slightly higher. Using historical benchmarks and ignoring the short-term impact of business cycles, the entrepreneur should aim at achieving a total real return on his equity investment of at least 9% p.a. (which, in true entrepreneurial spirit, is a bit of a “stretched target”). Of course, this 9%

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Because of this large gearing ratio banks belong to the most regulated of industries, with central banks keeping Argus eyes on their operations. Anyhow this high gearing ratio is only commercially possible because banks are unique among corporates in that their interest earnings exceed interest payments. These derivative exposures are of course better brought on-balance-sheet for your own analysis. All derivative exposures can be transformed into on-balance-sheet equivalents by means of financial engineering. The difference between the gross ROE and net IRR is in essence: (i) the corporate tax rate; (ii) the real rate of interest; and (iii) the inflation rate. The higher these three rates, the higher the gross ROE needs to be in relation to the real IRR. Ultimately, inflation is a type of indirect tax on society by central government. Accordingly unless a firm can recoup the inflation expense from its clients, it is burdened with a major expense that may vitally undermine its competitiveness, and particularly so if the competition operates in a lower inflationary environment abroad.

4

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p.a. real return is an average for all listed equities in the long run. In the shorter term equity prices fluctuate sharply, and particularly so between various industries. Consistently outperforming the industry average Graph 3.1: Relationship between IRR, Inflation is extremely difficult. Every entrepreneur wants to be and ROE (Assuming a gearing ratio of 1) Inflation rate (%) in the best growth sectors and wants to operate in the 30% country with the best economic prospects. However, 25% Required ROE for IRR of 9% the higher you climb the profit performance ladder, Required ROE for IRR 12% the tougher the global competition becomes. 20% Accordingly, to maintain an IRR in excess of 9% p.a. 15% is difficult in the long run, particularly as a company 10% increases in size. If the company’s capital base is still relatively small, a few lucky deals may well result in 5% a doubling of the capital base, but as the firm 0% matures, it will become increasingly difficult to 0% 10% 20% 30% 40% 50% 60% Real ROE maintain the initial rapid growth rates in equity capital. Moreover, the more successful a specific company is, the quicker the industry’s inefficiencies will be eliminated, and the more difficult it will be to compete with other suppliers. As with chess, the opening game is relatively easy. In the middle game the masters show their class, but only during the end game do the grandmasters prove their true worth. To maintain a real IRR in excess of 20% p.a. over the long term is a challenge that can be met by only a few very talented entrepreneurs. Usually not only exceptional entrepreneurial skills are required but, as noted above, often a certain edge over the market is also necessary7. In fact, the concentration of economic powers differs materially between various industries. From an entrepreneurial point of view these differences in sectoral profitability may be tempting, but often not easily exploitable. For instance, you cannot really switch from one industry to another at the drop of a hat to exploit perceived profit opportunities, as your choice of activity will be severely limited by various factors such as: ! Creative skills: e.g. Picasso was a highly successful entrepreneur8 with a very specific skill. It is unlikely that he would have been similarly successful in other spheres of economic activity. ! Entry barriers: e.g. Rhodes could obtain control of his first diamond mine at very little cost. Nowadays mining is a highly capital-intensive industry, often requiring billions of dollars for a new development. ! Running costs: e.g. Rockefeller could still dump surplus oil and dirt into rivers, but today environmental laws dictate that the “polluter pays”, implying additional running costs and capital resources. ! Time and place: e.g. Onassis made his fortune because international oil politics changed abruptly in the early 1950s. Greek oil tankers were on the spot at the right time when the Arabs decided to switch to non-American transport ships. It is important to keep in mind that every sector has its own peculiar financial characteristics. Some industries are highly geared (e.g. the banking sector), while others depend on high operating profit margins (e.g. the mining and oil sectors). For the entrepreneur a lifetime is too short to master all the peculiarities of each sector. Usually the entrepreneur has to accept these sectoral characteristics – unless of course he is able to revolutionise an industry as a whole. This would require entrepreneurial flair of the first order, and is usually possible only if it goes hand-in-hand with a technological breakthrough. And it is exactly in such a revolutionary period of economic change that the gap between rich and poor increases significantly, and that billionaires are able to make their commercial killings9. 3.2 Wealth accumulated by entrepreneurs It often takes some time before you can start your own business. Firstly, you have to complete your basic training – either in the street and/or at school. Secondly, you have to learn the ropes in your selected field of business. In fact, to
7 8 9

True competition always comes from the outside: different country, different technology or different culture. His estate was grossly undervalued, for tax purposes, at $260 million in 1977 (or some $825 million in today’s prices). Revolutionary periods of this kind are, for instance, the 19th century industrial revolution (creating the land lords in the UK), the discovery of diamonds and gold in South Africa (creating the rand lords), the development of the New World, and the innovation of the internal combustion engine and corresponding demand for oil early in 20th century (creating the robber barons in the US), the IT revolution towards the end of the 20th century (creating the computer and internet billionaires), and the demise of communism in Russia (creating the plutocrats there).

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make it as a new entrant in any industry you will have to perform above average. Thirdly, you will need working capital. Suppose you are ready to take the plunge at age 30. To start up your own business requires sufficient working capital to avoid financial anaemia10. Suppose you need $1 million to fund your own specific company. If you are lucky, perhaps a quarter of that amount can be funded with bank credit. So the firm’s equity capital has to be at least some $750 000. Should your firm perform more or less in line with the average listed firm, your initial equity of $750 000 may grow at 9% p.a. to some $10 million at constant prices over a 30-year period. The “joy of compounding” is obviously crucial here. However, if you had started your working life with Table 3.2: Total real returns on cash, bonds and equities (% p.a.) no capital of your own, it is Period 1926-2006 1946-2006 1961-2006 1971-2006 1981-2006 1991-2006 unlikely that you would be Money market funds able to lay your hands on SA 0,8% 1,1% 2,1% 2,2% 4,2% 5,7% more than $100 000 at age UK 0,8% 0,9% 1,4% 1,5% 2,3% 1,3% 3011, in which case you have to USA 1,0% 1,0% 1,6% 1,8% 3,7% 2,9% engage the so-called “three Government bonds Fs” – family, friends and fools. SA 1,7% 1,3% 2,4% 3,1% 6,4% 11,0% For financial needs up to $3 UK 2,0% 1,4% 2,1% 2,7% 6,0% 3,8% million you have to rely on a USA 2,5% 1,2% 3,4% 4,0% 7,2% 5,6% business angel12, as a venture Equities capital firm13 will consider SA 8,2% 7,0% 9,4% 10,0% 9,3% 10,4% deals only if it can invest at UK 8,5% 8,2% 5,7% 5,9% 9,8% 8,6% USA 7,0% 6,9% 6,2% 5,6% 9,3% 7,1% least $6 million. If you succeed Inflation in obtaining the required SA 5,9% 7,5% 8,8% 10,4% 9,8% 6,7% external funding for the UK 3,0% 3,8% 4,3% 4,7% 3,1% 2,6% $750 000 and if your company USA 4,3% 5,6% 6,2% 6,6% 3,8% 2,6% performs in line with the Sources: average listed firm, your initial Barclays Capital, Equity-Gilt Study, 2007 SA Reserve Bank capital investment of $100 000 may then generate wealth of some $1,5 million in real terms over a 30-year period. Although attractive, this amount of wealth could also have been accumulated had you invested your savings in an equity fund and operated as an executive of a large public company. However, should your business partners elect you as the CEO of your company, you will earn a salary in addition. Your starting salary in this small firm may be about $100 000 p.a. at age 30, but this may grow to some $500 000 p.a. by age 50 – at least if your company is successful. As a CEO/owner your propensity to spend will be roughly in line with that of your colleagues in other companies. Even if you want to save more, for instance by living in a stoic manner, this may prove difficult in practice. The prestige of an entrepreneur requires that his appearance should convey prosperity – because since time immemorial, money attracts money. Because your firm is still relatively small, your gross income will be only slightly more than that of an executive of an average-sized company. On balance, your total real net wealth could grow from some $100 000 at age 30 to about $6,5 million at age 60 (see Table 3.3). Of this $6,5 million, about $3,5 million will be derived from savings on your salary income, while about $3 million will be derived from the investment made in your company (see Table 3.3 again). Of course, if your company does really well, your net wealth will be higher. For instance, suppose that you and your partners succeed in pushing the firm’s real IRR to some 15% p.a. Your initial capital investment of $100 000 will then grow, in real terms, to some $6,6 million over a 30-year period (assuming a 100% retention

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In this context also remember that cash is the life blood of the enterprise or as the business saying goes: “turnover is vanity, profit is sanity, cash flow is reality”. The traditional methods include: owner’s credit cards; a second mortgage; or a loan from a friendly, rich uncle. Business angels work roughly on the following rule of the thumb: “If it’s just an idea, it’s worth $10 000; if it has a credible management team in place, it might be worth $100 000; but if it has sold something for real money to real customers, it could be worth $500 000”. See The Economist, “Giving Ideas Wings”, 16 September 2006, p.83. The managers of venture-capital funds take an almost universal fee of “two and 20”: i.e. a 2% annual management fee and up to 20% of any profits made by their funds. Business angel investors set their own terms. Ibid. p.82.

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rate). But, the other extreme is also possible: had you invested in the South African clothing industry, you might have lost your shirt. Obviously, considering the financial risks at stake, an entrepreneur wants to do significantly better than an employed CEO. As the total wealth of CEOs in the US now typically grows to some $4 million at age 60, an entrepreneur probably aims for at least $10 million in net wealth after a 30-year working life, which in turn implies an average real return on invested capital of some 15% p.a. (see Table 3.3). Therefore to go it alone requires more than just attaining the minimum level of performance that your customers and investors expect. In fact, the above analysis implies that you, as a new entrepreneur, have to perform above average. Rather than merely staggering across the industry threshold, you should strive to be at the leading edge in your industry, which is the level of performance attained by market leaders only. Unless Table 3.3: Real net wealth accumulated by entrepreneurs (in US$ 2005 prices over a 30-year period) you can do this, your savings might as well go into a Likely Average Total real Total real success managed investment portfolio, real wealth wealth Annual Performance of Total real rate growth in derived derived growth in as an “industry threshold” entrepreneur wealth (as % of equity from from total real relative to listed accumulated the total performance is bound to give capital equity1 salary as wealth1 companies ($ million) population (IRR) investment CEO (% p.a.) “normal” returns (say, some in the (% p.a.) ($ million) ($ million) West) 7% p.a. in real terms). If you Well below want more, you will have to 3,0% 0,2 1,0 1,2 8,8% 1,000% average be in the forefront of the battle 6,0% 0,6 1,4 1,9 10,4% 0,750% Below average for intellectual leadership, Average 9,0% 1,3 2,4 3,7 12,8% 0,500% which will typically redefine Above average 12,0% 3,0 3,5 6,5 14,9% 0,250% the rules of the game for your 15,0% 6,6 4,5 11,1 17,0% 0,050% Good chosen industry. Ultimately, 18,0% 14,3 6,0 20,3 19,4% 0,025% Excellent your ability to learn faster 21,0% 30,4 9,0 39,4 22,0% 0,010% Outstanding than your competition may be 1 Assuming initial equity investment of $100 000 at age 30 the only sustainable competitive advantage. In conclusion, if you regard yourself as the king rat, you should rather enter the corporate rat race and aim to become a CEO. Depending on how well you run, your net wealth – as an employee – may then grow by some 5% to 9% p.a. in real terms on average. However, if you are a “dreamer that does”, it makes sense to start on your own and in time qualify as a true entrepreneur, but then only if your net wealth is going to increase at least a hundredfold in real terms during your working life. Accordingly, an entrepreneur is neither a small businessman nor the CEO of a large corporation per se, but somebody who continuously seeks new business opportunities and maintains an average real growth rate of his net wealth of at least 15% p.a. This growth rate may seem high for an outsider, but should be considered reasonable compensation for the risks involved. It is the reward the entrepreneur deserves for being alert, realising opportunities that others have missed, and propelling his staff forward with an “inspired shared vision”. Indeed, for anything less it would hardly be worth the risk.

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CHAPTER 4

THE OPPORTUNITY COSTS OF WEALTH

Few things in life are really free, as even the most enjoyable activity has its opportunity costs. Likewise, the pursuit of wealth may be enjoyable for some, but it is never without its implicit costs. This chapter will highlight some of these costs. 4.1 The emotional costs of running a business Running a business is like running on a treadmill. On the one hand there are all the desires to make the business a roaring success, but on the other hand there are all the unavoidable disappointments and frustrations. Once on this treadmill, it is difficult to get off again – at least in one piece. Moreover, life as an entrepreneur can be a lonely affair. Before too long your marriage may be on the rocks, your colleagues may secretly be looking for new jobs, and your bank manager may contemplate repossessing your house. In short, on this treadmill you have to enjoy your own company very much indeed. A new business needs some time to bed down. Losses during the initial phase are not always avoidable (i.e. expected losses – but painful nonetheless), but you have to be careful that the enterprise does not continue along a negative growth path for too long (unexpected losses – which are even more painful). To avoid bankruptcy the standard mistakes have to be avoided. These mostly involve the following: ! Poor management. More than half of all business failures are due to management not being up to its tasks. Either planning is insufficient or execution is wanting because of a lack of managerial skills. The balancing of conflicting demands can be particularly difficult: e.g. what strategies are in place to balance short- and long-term results, or what is the balance between the corporate constituencies of customers, staff, suppliers and shareholders? ! Staffing problems. To attract the right person for the job is one of the biggest challenges for any entrepreneur. And even where you succeed for your own company, there still may be trade union trouble in the industry at large. Then there are the familiar problems of how to motivate your staff to do things they do not like doing. The skill of communication, a knack for developing talent and the taking of unpleasant decisions all require character traits you may lack. ! Poor accounting and record keeping. Poor accounting methods go hand in hand with poor planning, as you cannot plan properly without reliable figures. Moreover, all the outside participants in your business, i.e. mainly the taxman, other shareholders, and creditors require proper financial records to ensure that they are not being short-changed. Once these outsiders lose their patience, your chances of success will have fallen so dramatically that failure is virtually guaranteed. ! Adverse economic conditions. A sudden deterioration in the economic climate can be catastrophic if the enterprise is too heavily geared. To spot changing economic conditions ahead of time and implement the required changes in the overall corporate strategy are massive and ongoing tasks for every businessperson. When business conditions suddenly and unexpectedly deteriorate, adaptability becomes crucial. ! Sales and marketing problems. Without sales there will be no business. And there will be no sales unless your marketing strategy is up to scratch. Probably you have to operate as the company’s prime salesperson as well. Painfully, your sound ethical compass, so crucial to the business, may suddenly work less perfectly. ! Charm. Private business is very different from business in the public sector, and without some charm and selfconfidence you may never succeed in your networking goals. Although you may have started your own business with the idea that you have now become your own boss, you will quickly notice that every client is in effect your king. Soon you will also become aware that, as the owner of the business, you are the Corporate Trouble Shooter Number One. No serious problem is ever too dirty or too time consuming. In the end you will feel that the running of any business is a drudgery, which may drain you mentally in some unexpected ways1. Not surprisingly, the classics always considered business the ideal task for talented slaves.
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As McCaw, a US communication’s billionaire, rightly noted: “In business you have to be driven by competitiveness, which is usually driven by adversity”, The Economist, London, 15 July 2006, p.60.

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So what are the survival chances for your new firm in the end? Some evidence suggests a 1% survival chance after ten years on average. For instance, in the US nine out of ten entrepreneurs fail in the first five years; of the 10% that succeed 90% fail within the second five years. In a ten year period 99% of firms newly established in year one will be gone2. On the stock exchange, conditions are somewhat better, though: the average listed company has a survival age of roughly 12 years, while large multinationals survive, on average, for some 45 years3. But even if you succeed in business, the costs of your victories are forever present. On a personal level you could now suddenly be subjected to extreme scrutiny and even humiliation by the press. To preserve your privacy may turn out to be an ongoing battle, growing in intensity the greater your commercial successes become. As the global economy is in a permanent flux, time is always in short supply and particularly so if you are running a multinational business. Moreover, the delegation of tasks to executive management is possible only up to a point, as the fundamental requirements of command also stipulate that you remain on top of the massive information flow that finds its way across your desk. Archilochus’ fable remains true: the CEO as a fox has to know many things, such as the knowledge required to run the day-to-day operations. But as a hedgehog, he also needs to know the one big thing which could empower him with the insight and wisdom required to make a few major strategic decisions. Most successful CEOs pass the fox test, but only a few the hedgehog one as well. For many CEOs the job ultimately becomes too large to handle: corporate life becomes nasty, brutal and short. To avoid failure could become a permanent mental strain on young entrepreneurs. If you are one of the handful who succeed, you may well make pots of money, but whether you succeed or fail, you are likely to age like a dog in the process and obviously die far earlier than your less stressed friends. 4.2 The costs of business success in terms of personal honour It is a well established fact in business that the bad do not always do badly, while the good do not always do well. As emphasised by Oscar Wilde, “telling the truth makes one very unpopular at the club”. All this is true, as you cannot truly emphasise, for instance, the shortcomings of your firm’s products. Marketing, leadership, and management in general all contain, to a lesser or larger extent, deceit to succeed. In the competitive jungle a truth teller is often at a disadvantage compared with a manipulator and liar. But then again, telling outright lies is, even in business, considered too uncivilised and too crude. Accordingly, businesspeople have first to deceive themselves and then only say what they believe. Such motivated fantasy may well be viewed by others as a reflection of a weak reality principle, but has the advantage that it can be announced to the world at large in all sincerity. Most top dogs in society have the ability to deceive themselves thoroughly. What constitutes a fair trade or what is a fair price anyhow? These old questions have never been properly answered. For most entrepreneurs the overlap between personal honour and corporate responsibility is no easy matter. The fairest flowers often grow at the edge of the (moral) abyss, and nearly always some profits have been made in a way regretted later in life. Particularly when an entrepreneur becomes older, and money loses some of its lustre, he may be inclined to reflect on the specific way his profits were made over the years. Those with religious feelings may even reflect on teachings of the mediaeval church, such as: “The man who has most, leaves most behind, and his passage is the most painful. He leaves what he cannot take. He takes what he cannot leave4.” Usually entrepreneurs strive for the highest level of personal integrity possible. But, obviously, profits cannot be made and personal honour maintained in all fields of business. For instance, today’s multinational oil companies have to conclude deals with sovereign states in which the difference between public and private property is ill-defined (oil and ethics mix just as nicely as oil and water). Such deals easily become an ethical mess. In this type of business the counterparty may even consider cheating and corruption to be refined business techniques.
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In South Africa some 10 000 small businesses register each month. Within three years half of these would have ceased to exist. Source: Enterprise Support SA and Moneyweb, 15 July 2006. Geus, A. de, The Living Company, Longview Publishers, 1997. I.e. respectively riches and sins. Not surprisingly in the Middle Ages the practice developed among entrepreneurs to leave part of their wealth to wronged business partners. This money was then distributed anonymously by the liquidator of the will.

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Business now has to distinguish between good and bad corruption and illegal and legal commissions, and may be forced to rely on the loyalty of traitors. Corruption is often reflected in the accounts with ambiguous entries: e.g. expediting fees, facilitation fees, consultancy fees, and lobbyist fees. Obviously all these “fines and fees” are unavoidable in doing business and are therefore tax-deductible. The ultimate choice for these multinationals is then either to withdraw fully from such corrupt countries (which may amount to commercial suicide) or lower their principles of integrity. Over the years every sort of atrocity imaginable has been perpetrated by governments. Their excuse was usually “the national interest” (justifying e.g. genocide) or fulfilling “the wishes of God” (requiring e.g. an auto-da-fé). Companies cannot avoid involvement for a number of reasons. Firstly, governments are “sleeping” business partners, inter alia, using corporate taxes to finance part of their (unethical) expenditures; secondly, governments may be major business partners in their own right – either as providers of production inputs or buyers of a firm’s outputs; thirdly, the jurisdiction in which companies operate, and therefore the minimum standard of common decency prevailing in society, is set by governments; and last but not least, governments may use private corporations as pawns in their power plays, even if this would be against a company’s likings. Like it or not, on these ethical issues Niccolò Machiavelli, better known to some as Old Nick, has to be consulted for sound business advice. Corruption in business is particularly a problem for developing countries. But corruption is only one facet of the ethical problems facing business. Equally serious is the commercial exploitation of the innocent and outsiders – e.g. those who are not party to a “social contract”. The degree of personal integrity expected from corporate staff is always quite different from that expected from entrepreneurs. For staff the ethical issues are rather straightforward: to be trustworthy and honest servants of the company at all times. Under no circumstances should there be any conflict of interest between work and personal affairs. If staff engage in criminal activities such as hands in the till, a company can routinely take such matters to the courts of law. No company can work effectively and efficiently if staff relationships, both internally and externally, are not based on high standards of integrity and fair dealing. However, to deal only with clients of your own choice should be considered a luxury in business, as most firms have no choice in the matter whatsoever. For instance, De Beers has to deal with countries such as Angola, Congo and Russia to ensure an “orderly” diamond market. Shareholders of De Beers do not ask their directors for a moral evaluation of their partners before trading: wherever diamonds are found en masse – irrespective of the political regime and its moral standards – the commercial interests of De Beers demand involvement. This is the world of Realpolitik. Like the corps diplomatique, which will have to deal even with the devil himself if this is considered in the “national interest”, corporate directors can hardly afford to lose sight of the “commercial interests” of a company. Most business leaders are accustomed – out of necessity – to operate along an adjustable spectrum of personal business principles. The issue at stake is no longer integrity as such, but the Machiavellian conflict between justice and expediency. Here, there are no hard and fast rules, and ultimately the entrepreneur has to weigh the moral issues at stake against his own personal conscience. Accordingly, not everybody wants to carry the moral weight of power as, for at least some, power on any considerable scale is incompatible with moral innocence and purity. As Lord Acton remarked: “Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men”. To stand on the commanding heights of commercial power is no virtue as such. Indeed both the virtue of innocence and the virtue of experience can inspire strong emotions and great admiration5. In the camp of moral purity there are virtues such as absolute integrity, gentleness, a disposition towards sympathy, a fastidious sense of humour, generosity, and a disposition to gratitude. The virtues of experience are tenacity and resolution, courage in the face of risk, intelligence, largeness of design and purpose, exceptional energy, and habits of leadership. This is a dualism that cannot easily be untangled. But for those who elect to ride in triumph through the corridors of commercial power, Hampshire sets three mutually interdependent moral principles: ! Moral principle 1: Ensure a minimum standard of basic common decency Without the virtues of common decency, human life becomes nasty and brutish – less than human. If all constraints on common decency are removed, you move quickly towards a system where only the law of the jungle6 applies. Although many people maintain that there is nothing morally wrong with the laws of nature as

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In drafting this section, extensive use was made of Stuart Hampshire, Innocence and experience, London: Penguin Books, 1989. To what extent this law can operate fully in a technologically advanced society remains a mystery though.

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such, procedural justice becomes impossible in such an environment. Reason is replaced by brute force and accordingly the state (or a company) can slide inexorably towards a totalitarian system under which sheer ruthlessness becomes both a natural and an acceptable practice. Obviously such a type of civil society (or company) may constitute an unstable organisation, as those subjected to its authoritarian rules will sooner or later rebel against the injustices inflicted upon them. Even the mafia accepts that no one has ever become really rich through betrayal, ingratitude, theft and murder alone, and that some basic standard of common decency, and therefore some basic form of “law and order”, has to be maintained. ! Moral principle 2: Protect the reasonable interests of society (or a company) Those who accept the trappings of power have to ensure that they promote the interests of society (or shareholders) above their own personal interests. Clearly the interests of society (or shareholders) have to be reasonable and should not conflict with Moral Principle 1. However, this may prove difficult in practice. For instance, today’s Popes may have some doubts about the moral rulings of their predecessors (on issues such as the Inquisition or slave trade), but they have to make the best of a bad situation. Most state organisations and large commercial firms have been built on a history that included, at some time, unwanted compromises, embarrassing alliances, distressing manoeuvres and secret betrayals. Here the weight of history usually overwhelms those currently in power. Accordingly, it will always be expected of executives to understand a company’s predicaments in the light of its history. Executives certainly should not view a company’s problems as presenting an occasion for vindicating some ideal of personal integrity. This again amounts to the reality of the Machiavellian thesis that those in power should be clear-headed, and not divided in their own minds about their obligations. ! Moral principle 3: Be prepared at all times to make a choice between the lesser of two or more evils In business, as in politics, an entrepreneur easily becomes involved in situations that seem to exclude the possibility of a decent outcome, and in which all lines of action seem dishonourable or blameworthy. With experience comes the ability to choose between the lesser of two or more evils. For instance, injustice to a minority may be justifiable if the risk to national (or company) security is very large, and the injury done to the minority is not correspondingly great. In essence, a moral decision is a just and fair one only if it satisfies the minimum conditions of procedural justice, in terms of which the pros and cons are both heard and evaluated, and the procedure is not terminated before all the arguments are in. For those in power the weighing up of the abovementioned three moral principles is an ongoing process. But, this process of weighing up conflicting moral claims and competing concepts of the good, as implicit in procedural justice, is always to some extent subjective, as there is no completeness or perfection in morals. Time and place often dictate a trade-off between these three moral principles. For instance, in the political arena the desires of the majority should not be so extreme as to endanger the minimum standard of common decency in society. The lower the civil standards in society, the more justifiable it becomes for a minority to use immoral means to limit the powers of the majority. On these moral grounds, a multinational corporation is entitled to transfer its capital resources from a corrupt regime (which always applies exchange controls, as bad morals drives out good money) by way of “transfer pricing” – i.e. over-invoicing, fictitious transactions, dividend stripping, asset stripping or plain currency (gold) smuggling. Shareholders expect creative accounting from their directors under these circumstances, even if such actions may induce a sense of horror or disgust. To enhance power and profits there is always the temptation to lower the standard of common decency. Machiavelli even saw this development as unavoidable, owing to the very nature of power. He emphasised that “innocent virtues” such as friendship, kindness, gentleness, purity, integrity and personal honour take their toll through political (and commercial) disempowerment. The virtues that bring great political achievement and civic glory (which is one possible route to happiness – also for entrepreneurs) take their toll through the loss of integrity and the loss of virtue. Although Machiavelli’s basic line of argument is difficult to fault, his arguments should not be taken too far. First of all, an extreme and irresponsible reliance on Machiavellian principles, whether in the state or a company, will be unacceptable because of the risk to humanity (or a company) as a whole if a serious miscalculation occurs. Secondly, the state (or company) should preferably use power as an instrument of persuasion rather than an instrument of conquest. Parliament, the courts of law and civil society should play an important role in this respect, testing and cultivating the skills of bargaining and debate. It is through these institutions that procedural justice can be enforced. Machiavelli’s view that power is foremost an instrument of conquest, and should therefore be used for violent conquests wherever opportunities occur, is incorrect at least for those societies in which procedural justice is firmly

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established. In fact, an unrestrained drive towards domination violates basic justice, and is probably one of the greatest sources of evil. Thirdly, by ignoring minimum standards of basic common decency, as Machiavelli implied, the state (or company) becomes an inherently unstable organisation, inter alia, by forcing basically decent people into immoral actions to position themselves favourably in such an unjustified system. In a nutshell, to be an entrepreneur requires some hours of philosophical study as well. In business the trade-off between honour and expediency is not easy and often painful. 4.3 The costs of business success in terms of personal happiness The blessing “May you have health, love and wealth – and time to enjoy them”, emphasises that wealth alone is not enough to ensure your happiness. Happiness is foremost a state of the mind that may be influenced by material possessions, but is not necessarily dominated by them7. How much wealth is then required, as a first hesitant step, to ensure happiness? At what level of wealth do your family and your friends or hobbies become more important than a further increase in wealth? This is an old and favourite philosophical question. For more than two millennia the classical (Greek) view has been predominant: wealth had to ensure financial independence, after which the “man of leisure” was free to engage himself in, ideally, politics and culture. However, since the Industrial Revolution financial independence has become more or less a by-product of entrepreneurial activity and is no longer pursued in its own right as a critical condition for freedom and happiness. Obviously, the change from the classical to the modern view has been gradual. And even today many subscribe to the classical view that happiness ultimately depends on wisdom, freedom and culture. Great wealth results in financial power, and as such spills over into politics. It requires wisdom to ensure happiness if the striving is for both wealth and power. In fact, usually riches, power and happiness do not sit comfortably together. Often striving for one is detrimental to attaining the others. Ultimately moderation is vital: without any wealth individual freedom and happiness may not be within reach, while striving for great wealth (requiring a fair dose of greed and envy) implies that you have become a slave to money with corresponding worries. Moreover, with wealth comes responsibility. Therefore strong legs are required to carry riches. Those with weak knees would be happier if they could pass part of the load to those who are more capable of carrying it. Indeed, at times, wealth can be better enjoyed if you have less of it. A rich man’s lot is not an easy one and to know exactly how much wealth to aim for in life is therefore worth some thought. Traditionally the nobility aimed for three objectives in life: power, wealth and leisure. Obviously, these three objectives are interrelated, as a rich person has power and can afford a life of leisure. But if “too much is still too little” problems emerge. Ultimately, wealth is paid for in terms of time: a painful trade-off – at least for the greedy – as the desires for more power, more wealth and more leisure are impossible to achieve simultaneously.
Power and wealth

For millennia, power and wealth were directly linked to rank. You were either nobility, and therefore powerful, or not. For imperators (which include all the variations of strongmen such as autocrats and dictators) the difference between private and public wealth was mostly of academic importance. Strictly speaking, a distinction should be made between: (i) public property (which at times was referred to as belonging to Caesar); (ii) crown property (i.e. the socalled imperial patrimony); and (iii) private fortune. Public property was paid for by the Treasury. It could be managed by Caesar, but was never considered his property. Accordingly the block of stone taken from the public quarries and marked C(aesaris) n(ostri) belonged as much to Caesar as the British warships bearing the letters H(is/er) M(ajesty’s) S(hip) belong to the King/Queen of England. Crown property was considered the property of the ruling sovereign, not the person, and could be passed on only to the successive wearers of the crown. These assets usually included palaces, crown jewels, works of art and yachts. Lastly, private fortune included those assets that the sovereign could bequeath at will on whomsoever he chooses. The private fortune of imperators was usually modest. For instance, in his will Caesar left 100 million sesterces (about $300 million in today’s prices8) and Czar Nicolas II slightly less than one million roubles (or some $3 million

7

According to expert opinion, happiness stems more from internal psychology than external circumstances and is therefore largely genetically based. Happy people seem to have four characteristics in common: self-esteem; optimism; “a sense of being in control of their lives”; and an extroverted nature. The Olympians were of course known for their “inextinguishable laughter” and their capacity for “living easily” – an obvious requirement for those living forever. In the end this issue is rather personal as, for instance, for Socrates nothing could match the satisfaction of understanding. One sesterce was equal to 0,05832 grams of gold (1 Aureus = 100 sesterces = 0,1875 Troy ounce) but, because the purchasing power of gold was then more than triple of what it is today, the equivalent is some $3,00 per coin in today’s prices. See Cary, M., A history of Rome, London: Macmillan, 1962, pp. 412–413.

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in today’s prices9). But most of the money spent by the imperators was expended on crown property, which was funded by the Treasury. For example, annual expenses of the Royal Household of the Romanoffs, one of the richest monarchies of the immediate past, amounted to about 20 million roubles a year (some $68 million in today’s prices10). The Czar, like any other autocrat, could top up his private fortune by channelling funds from the Treasury, if need be. These transactions were considered legal, and a natural consequence of autocratic rule. In a nutshell, for imperators private fortune had little meaning: money was simply taken for granted and channelled from the public purse when needed. Usually such a need emerged in the public domain.
Wealth and leisure

The notables of a nation typically include its leaders, thinkers, and creators. Notables, “thanks to their fortunes” (i.e. the intellectual, creative and material wealth bestowed on them), were expected to be financially independent in the past. The essence of a notable was that he was a person of leisure, with an economic activity, a political dignity and perhaps a cultural profession11. The annual income of a notable was virtually exclusively derived from land ownership. He was free to engage in any kind of activity, provided it was not regarded as work. In contrast to, for instance, the merchants in those days whose financial “essence” was their economic activity, the man of leisure had no socially recognised profession, but merely a specialised occupation. The classics distinguished three modes of existence for the notable: (i) the life of enjoyment in which no ideal purpose is ascribed to existence; (ii) the political life, which is a career of dignity in which socially recognised titles can be acquired; and (iii) the life of the philosopher in which a notable becomes a person of culture. As Aristotle emphasised, only people of leisure are truly citizens. Financial independence involved a fine balancing act between desired annual income and required financial resources to generate that income. So Diogenes of Sinope could be financially independent – i.e. free and able to organise his life as he wished – because he preferred to beg, to make his home in an old barrel and had, besides his famous desire for some sunlight, no great material demands. Obviously, those notables who did not immediately see that the absence of desire was the height of wealth, required more capital. Wealth was supposed to be obtained through inheritance, marriage or conquest, as wealth based on robbery has always been considered highly dignified. According to the classics, under no circumstances should anyone strive for extravagant wealth, as was richly illustrated by the mythological figure of King Midas, symbolising what happened to a ruler who became a slave to money. Indeed, the ancients considered the vain pursuit of money above all else as one of man’s main follies. In the end, wealth depended on fate, not how hard you worked. The only profession that could overshadow the glory of the notables was that of the merchants. For millennia this threat was no more than a social irritation, but by the Middle Ages even the crowned heads had become financially dependent on their bankers. It must have been more than a mild irritation for Philip II – with dominions on which the sun did not set – to be dependent for his military campaigns on the credit ratings of his Italian bankers. During the Renaissance the net wealth of successful merchants could total some 100 000 florins12 (or some $150 million in today’s money13). This capital amply guaranteed financial independence, and hence wealth became pure political power. According to the principle that what cannot be conquered has to be absorbed, the nobility and the “princes of finance” started to intermarry during the Renaissance. The Medici for example, originally bankers, became sovereigns. Nonetheless no opportunity was missed by the nobility to air its disgust for the trading class.
Financial independence: the Classical view

Before the Industrial Revolution financial independence implied that current annual expenditure had to be equal to about 2% of capital invested. This capital was always tied up in land and, as family property, was not for sale. The return was similar to that on a perpetual bond. After the Industrial Revolution the net real return on capital rose gradually to some 3% p.a. on an investment portfolio containing both equity and fixed-interest securities. Translating the classical concept of financial independence into today’s money terms would roughly imply the following:
9

One rouble equalled 1/10 of a pound sterling up to the First World War, but by 1917 it had depreciated to some 15 roubles per pound and would be worth some $3,40 in 2005 prices. See Clarke, W., The lost fortune of the Tsars, London: Orion, 1994, pp. 333–339. This level of current expenditure requires underlying investments in excess of $1 billion in today’s prices. Veyne, P., Bread and circuses; London: Penguin, 1990, pp 42–54. See e.g. Origo, I., The merchant of Prato, London: Penguin, 1992, p. 342. One florin (of Florence) represented 3,53 grams of gold or some $50 per coin in 2005 prices. However, considering that, at the time, professionals were earning some 80 florins a year and that a rich man’s dwelling cost about 1 000 florins, an adult female slave 60 florins, and a good mule 100 florins, the purchasing power of a florin is probably closer to $1 500 in today’s prices. Ibid., pp. 23–24, 259.

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Minimum-wage class. Diogenes living like a squatter claimed to be totally content with a subsistence income. Today’s minimum living wage is about $15 000 p.a. in industrial countries, and financial independence would then require some $750 000 in invested capital (assuming a 2% p.a. perpetual real return). Forty years of hard labour is nevertheless required for the average skilled worker to accumulate this amount of capital. ! Middle-income class. Juvenal remarked that he and a few slaves could live easily on capital of 400 000 sesterces (or some $1,2 million in today’s prices). This was also the required capital sum for admission to the Equestrian Order (a typical middle class organisation). Assuming a 2% p.a. perpetual real return on such an investment, annual income for the middle class amounted to some 8 000 sesterces (or $24 000 p.a. in today’s prices) in those pre-industrial days. However, today the average income is about $50 000 p.a. in industrial countries, while the family income of the “middle middle class” (with both man and wife working) is probably closer to $75 000 p.a. To earn this income from land requires assets of at least $3,75 million). ! Executive-income class. A Roman procurator earned anything between 60 000 and 300 000 sesterces p.a., depending on responsibilities and experience. Assuming that executive pay was about 200 000 sesterces p.a. (or some $600 000 p.a. in today’s prices), invested capital of some $30 million would be required in today’s terms (again based on a real perpetual return of 2% p.a.). Accordingly, rounded off in millions and ignoring those who deliberately adopted a life of poverty (e.g. the Cynics or mendicant friars of the Middle Ages14), until the 18th century financial independence implied invested capital of between $1 million and $30 million in today’s prices, depending on lifestyle (i.e. all men of leisure in those days were HNWIs or even ultra-HNWIs)15. Of course wealth in excess of $30 million could come in handy, but was not really required. Freedom was more important than excessive wealth. The choice between being either a well-fed domestic dog or a sometimes hungry but free-roaming wolf presented no conundrum to the Hellenic race: it would always choose to be a wolf!
Financial independence: the modern view

!

The Industrial Revolution turned the whole previously known world on its head: the Olympians gave way to political ideology. The hoi polloi became the driving force in constitutional democracies, the man of leisure was sidelined by homo economicus, the sovereign powers of the imperators were constrained by the rule of law, and financial independence became a by-product of entrepreneurial activity rather than a critical requirement for the good life. The key issues for leadership today are commerce, science and the arts. Glory no longer rests in men of leisure, but in men of talent, whether this is manifested in the fields of leadership or knowledge. Individual happiness has to be found in freedom (but now granted by the rule of law rather than by financial independence), culture (often financed out of a nation’s general wealth) and wisdom (with education, in principle, now open to all). Work has to be done to make ends meet, but the kind of work is no longer predetermined by class. To an important extent happiness has to be found in a chosen occupation. This choice is again dependent on individual talents. In short, knowledge has become the hardest and most precious international currency. The foundation of wealth has shifted from fate (as reflected in inheritance and successful conquest – whether on the battlefield and/or in bed) to productive output. Worrying about financial independence per se, or wealth in general, is seen as a bourgeoisie problem nowadays. The executives of modern companies are mostly non-conformist people. Like entrepreneurs, they enjoy high levels of innovation and entertain little respect for authority. They are the rats who lead the race, but often lacked the funds to start their own business16. Although an executive may not be financially independent, he still has freedom of professional choice and can select an employer to his liking. Obviously this professional freedom is not available to all, as it requires skills. But, provided a person has these skills, three broad alternatives are available in today’s corporate world: (i) to engage in true management (i.e. leadership), which by its nature involves extensive human relations work; (ii) to become a professional (e.g. an economist) who indulges himself in his chosen field of knowledge; or (iii) to start an own business the moment sufficient capital has been saved. At senior management level the choice between these three alternatives is not really determined by wealth considerations alone. For instance, a navy admiral does not see himself in competition with the owner of a small coaster, even if the last-mentioned person
14

The peasants, slaves, shopkeepers and other untouchables (i.e. all those who had to work to make ends meet) were considered hoi polloi in classical times. They had to wander dead among the living – as money constituted the blood and soul of a free man. This working majority had to be content with its lot. The “natural” income distribution in a free economy is very skewed indeed (see Chapter 1). Probably also in the pre-industrial era the men of leisure represented only some 1% of the population and owned about half of all households’ assets. For a satire on this topic, see: Noll, P. and H.R. Bachmann, Der kleine Machiavelli, Zürich: Pendo, 1988.

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may become financially independent sooner. Power is preferred to wealth in this instance. Likewise, a true professional does not regard himself as running in the corporate rat race. He enjoys the work as such, and perfection is preferred to power17. Usually people want to work on their own because of the challenge. For them private enterprise is a kind of game – you win some, you lose some – but profit maximisation is not the be-all and end-all. Clearly some minimum performance – say, an average real growth rate in equity capital of 10% p.a. – has to be set to avoid getting eaten alive by the competition, but corporate analysis has shown that those firms that do not try to maximise profits at all costs usually do better in the long run than those who try to. Profit as such simply becomes a by-product of more important corporate objectives, such as client satisfaction18. Accordingly, to start your own enterprise makes economic sense only if: (i) you already have some material wealth at age 30 (which is usually obtained from inheritance or through marriage – even today); and (ii) your business performance – as reflected in the average real growth rate in equity capital – is in excess of some 15% p.a. in real terms (assuming a 100% retention rate). This is a high, but not impossible, rate of return to achieve – at least if you have the right skills and spot the opportunities in the market early.

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Striving for both perfection and power may qualify you for bedlam: power dreams of indefinite expansion and is accordingly never fully satisfied, while true perfection requires a touch of the gods and can consequently be accommodated only by genius. The commercial issue underlying this view is a very fundamental one. In terms of the shareholder value model (as found in the UK and US) a firm exists primarily to maximise (short-term) profits, while the stakeholder value model (as found in Continental Europe) emphasises the importance of the firm for all stakeholders in the long term. For instance the chairman of VW and Porsche, Mr Ferdinand Piech, does not want his company to be “disciplined” by 30-year old hedge fund managers and notes: “Yes, of course, we have heard of shareholder value. But that does not change the fact that we put customers first, then workers, business partners, suppliers and dealers and then shareholders”.

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CHAPTER 5

GROWING YOUR BUSINESS

A successful business cannot depend on organic growth only. For instance, steep corporate growth in a domestic market of limited size can occur only if competitors merge or are taken over. Alternatively, if your company has become very successful, it will be a takeover target in its own right for your stronger competitors. Ultimately your business is driven by competitiveness and accordingly inefficient competitors have to be conquered (either by elimination or takeover) or you have to fend off a predatory takeover yourself. Therefore, even if you favour standing on your own two legs, you may be dragged into this game of takeovers and acquisitions against your will. One way to grow your already successful business even faster is to look for a takeover. Only those who seek the ultimate – a corporate marriage based on complementary talents – should go for alliances or, even more extremely, mergers. Takeovers always occur between unequal business partners. In contrast, an alliance is a bond between equals1. Mergers are formalised alliances and, like a marriage again, make sense only if they cast a long shadow and therefore run to succession2. It is the nature of those who specialise in takeovers – whether direct, reverse, inverse, friendly or hostile – to evade binding mergers and in extreme cases merely tolerate strategic alliances. A merger easily starts as a happy affair, but may end in a valley of tears soon afterwards. No room for mistakes here3. Obviously any weak company wants to present a takeover to the outside world as if it was a merger, but ultimately the gap between an acquisition and a merger cannot be successfully bridged. An inherent danger in the acquisition game is the reverse takeover. What starts out as a feast, deteriorates into you being the main course (ask Mr Praying Mantis for further details). To avoid being eaten alive from the inside out by your faithful business partner, your poison pills have to be ready for the taking during any lunch – even that rare free lunch. This chapter will briefly discuss, from an entrepreneurial point of view, the issues of takeovers, mergers and anti-takeover defences. For technical refinements please consult your friendly merchant bankers. 5.1 Takeovers Acquisitions usually come in two guises: either by a scavenger or a predator. Either way, it is always the stronger consuming the weaker. No industry can flourish without scavengers, and there are always some companies that pick over the carcasses of those who fall behind. Such meals require careful digestion of the good bits – usually an odd mixture of customers and technology – and spitting out of the rest – often many of the staff. Obviously making a living out of consuming the dead and dying is a specialist activity. Besides scavenging, there is also the conquest of the fit and healthy. As a predator your roving eye may fall on another firm for a number of reasons, such as: ! Technological changes in your industry may require the acquisition of new technology that would be easier to purchase than to develop. ! Globalisation may require a repositioning of your firm to meet aggressive international competitors, new markets and products. ! Market saturation may force you to “fish in other waters”. ! Industry consolidation may be forced on you, for instance if research and development costs are rising to ever greater heights. All of the above criteria constitute reasons for takeovers, not mergers, as any bondage based on weakness is doomed to fail. Once you have decided to go for a hostile takeover, go directly for the jugular.
1

Nothing new here. For instance, the strategic alliance between Aphrodite and Ares was so notorious and satisfying because it was based on complementary divine skills: the one broke hearts, the other arms and legs. A similar sentiment was expressed by Demosthenes (4th century BC): “We have mistresses for our enjoyment, concubines to serve our person, and wives for bearing of legitimate offspring”. Again to use some classic reference, Aphrodite’s happy marriage to Hephaestus was possible only because it committed nobody and was soon overshadowed by her strategic alliance with her soul mate Ares.

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In this context remember the golden rules of war: Never target more than one competitor at a time, as a war should not be conducted on two or more fronts simultaneously. ! Never start a meaningless war. There needs to be a substantial percentage increase in market share. ! Never start without weapons (e.g. business systems). ! Never go over to the attack with a one-step plan. Always have a backup plan in case anything goes awry. The more you develop your skills and tastes for hostile takeovers, the less you will be inclined to go for friendly ones. Anyway, you are an absolute nobody until at least somebody thoroughly hates you. Enemies serve practical purposes, such as focusing your mind on business, promoting corporate solidarity among your own ranks and reinforcing bonds of friendship in the face of common opponents. In any corporate predator, cruelty and affection coexist by nature (is revenge not merely the converse of gratitude?). Accordingly, you cannot succeed in business without the help of your enemies – only slaves like to surround themselves with slaves. In addition, which entrepreneur does not like to be a fox in a chicken run? Super killings – even those in business – result from Funktionslust, a delight in your skills and powers4. These killings may lack purpose at times, but then happiness flowers so often in an environment of utter uselessness. For powerful acquisitions you need piles of cash. You have to be extremely careful when issuing additional shares for the purchase of another company, as in essence you will be exchanging part of your company for the ownership of another firm. Therefore your shareholding will be diluted and, taken to the extreme, your new CEO may even swap you out of your controlling interest. Therefore takeovers financed by way of additional share issues are a second best solution, and resorted to only if your share price is relatively high. Takeovers financed by way of share swaps at relatively low price-to-earnings multiples make sense only for CEOs with aspirations to build empires. As your company grows, it will become increasingly difficult to combine size with speed, flexibility and cunning: indeed you cannot expect a whale to frolic like a dolphin. Unbundling is often the only way to address a conglomerate’s inefficiencies and bureaucracies. Therefore takeovers should not be done for the sake of growth, but rather to realise your strategic objectives, such as increasing your competitive position and adding value to shareholders’ wealth. Generally you want to take over only those enterprises which businesses have a strategic fit with your own business5. In short, the takeover target should have business activities that support your own corporate driving force.
!

5.2 Mergers Generally, mergers are far more difficult to bed down than acquisitions. An acquisition is simply a conquest, but a merger, like a marriage, involves a bit more. In a merger both parties should be of equal status. It is built on complementary skills, capabilities and/or technologies. In other words unique strengths inherent in one partner that cannot be copied by the other partner. This may be one reason why friendship with predators – true killing machines such as tigers and orcas – is so often more satisfying than fellowship with a hare or a chicken. However, because most people lack the moral fibre and courage for bonds of this nature, most mergers are doomed to fail, and often fail badly. Even the few that do succeed, i.e. those based on strengths, are often no more than friendly takeovers, presented as a “mergers” to the outside world. Accordingly, if you want to play it safe, limit yourself to acquisitions. To avoid “becoming lunch” you should not only be fit, but also look fit. Similarly, to make it as a successful entrepreneur today you not only have to fulfil a number of minimum business requirements (such as a satisfied clientele, a price-competitive product in the market and mastery of your industry’s core competencies), but also set your own requirements. The better your visible corporate assets are developed, the quicker you will catch the eye of a corporate Don Juan, and the more you can influence the conditions of a possible merger proposal. Such a proposal would for instance stipulate whether are you going to merge “in community of property” or with an “ante-nuptial agreement”. 5.3 Anti-takeover defences Any attempt to avoid being taken over should also avoid relying on a white knight to save your honour. In a hostile market, where often only the paranoid survive, you may lose your honour before you know what hit you. Accordingly, you have to consider your defences carefully.
4 5

Any cat’s preference (like the corporate predator) is as follows: foremost the chase, then the catch, next the kill and last of all the meal. In contrast, enabling technologies are best controlled (rather than owned), while differentiation facilities require unlimited access only. See Robert, M.: Strategy, pure and simple, New York: McGraw-Hill, 1993.

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To avoid a hostile takeover the following structures should be considered: Control structures. A good example is a pyramid company structure where you (and your friendly partners) own all the voting (A-class) shares and outside investors the non-voting (B-class) shares. Obviously this structure can be implemented only in those countries where the principle of “one share, one vote” does not apply6. Alternative arrangements in this area are holding companies, voting trusts or formal voting agreements between shareholders. ! Management agreements. Your key staff can be given golden parachutes or pension parachutes, which will make retrenchments and restructuring of the company extremely expensive after a takeover. Alternatively poison pills can be activated by registering proprietary technology or intellectual property rights in your own rather than the company’s name. ! Buyback of shares by your company. This will increase your power over your company, but it is not allowed in all countries (since it will reduce a company’s equity capital, which is not always appreciated by creditors). ! Extending a company’s bylaws or articles of association. In terms of this arrangement disclosure of shareholders’ identities can be stipulated to address “concerted action”. Any disregard of such rules obviously leads to a loss of voting rights. Alternatively, loyalty bonuses, together with increased voting rights, can be granted to “long-term” shareholders or the company can issue bonds with share warrants in favour of friendly investors. Such warrants can be exercised at any time and will increase the company’s equity capital. Yet another option would be to engage in pre-emptive or preference agreements in terms of which the majority shareholders agree a priori to sell their securities to third parties7. Last, but not least, the bylaws can delay the process of replacing the board of directors (e.g. through staggered tenure) or they may require large majorities for changes in specified company policies. ! Increasing takeover expenses. This can be achieved by for instance material contracts with penal conditions if there is any change in control (e.g. rent increases or loss of distribution profits). Note, however, that all the above defence mechanisms take their toll in lowering the competitive position of firms. It has been observed over the years that stock markets with liberal takeover codes have outperformed those with more conservative codes. Usually a favourable climate for hostile takeovers is to the advantage of the economy as a whole, although it may be painful for a few firms. Ultimately a high price-to-earnings multiple presents one of the best defences against “being lunched”.
!

6

In contrast to a democracy in which “one man, one vote” results from the involuntary nature of citizenship, non-voting shares in a company are not forced down the throat of any buyer. On average only some 60% of companies apply the “one share, one vote” principle in Europe (with Germany close to 100% and the Netherlands at below 20%). Anyhow, shareholder power is not always what it seems. For instance, in the US directors may still be elected by shareholders under the method of “plurality” which in practice means that only votes cast in favour are counted. Successful shareholder resolutions are often “precatory” for directors, meaning that they are only advisory and not enforceable. These agreements seriously affect “fair play” and are usually enforceable in court only if they were in place prior to a bidder’s offer.

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CHAPTER 6

SELLING YOUR BUSINESS

Many entrepreneurs are so busy running their enterprises that they simply lack the time to think of profits in the long run. You should leave this mental cul-de-sac to your loyal staff. Instead make time to think about the unthinkable. For instance, how would you adjust your business if its tentacles start to spread around the globe? What if you have to operate in both low-inflation and high-inflation countries or at what price is your business for sale? In a high-inflation country you find yourself in a sea of sharks. Here feeding time is always a frenzy, with no appreciation whatsoever of others. And small fry is always on the menu as an aperitif. To obtain a taste of what is expected of you – the potential seller of your own business – consider the following delicate bites: the impact of inflation on corporate returns, cash flow, gearing and the price/earnings ratio. 6.1 Real rates of return Inflation does its destructive work so thoroughly that the full consequences are difficult to gauge for the average entrepreneur. The higher the inflation rate goes – and the more the economy moves towards a type of barter economy – the greater the adjustments that have to be made to the financial structure of your firm as well as your long-term business strategy. The skills of an artist are required here. And, as you know only too well: “Art is I – science is we”. For instance, you should consider the following adjustments for high-inflation countries: ! Real interest rate: If the investment rate is, say, 107% p.a. and the prevailing inflation rate is 100%, any fat cat will smell a rat if he is told that the real rate of return is 7% p.a.1. What is more, real interest rates tend to rise in high-inflation countries (with serious consequences for your investment strategies). Once an economy is inflated at double digit figures, the fluctuations in the inflation rate become large and therefore the real interest rate unstable. Because of this uncertainty lenders secure a real return on their investments by charging even higher nominal rates. ! Return on equity (ROE): Even if a company’s assets and liabilities are being re-priced continuously in line with inflation, equity capital is still wholly exposed to the adverse impact of inflation. Therefore you have to raise the real ROE in an inflationary environment, at least if you want to protect the real asset value of your firm. To compare the ROEs of similar industries in different countries, without adjusting for inflation differentials, can easily result in strategic blunders. But it may be profitable if your competition does so out of ignorance. ! Compounding period: At a low nominal interest rate the effect of the period over which interest is compounded is relatively small. However, if the nominal interest rate goes to double-digit figures, the differences between, say, annual and monthly compounded interest can no longer be ignored. Accordingly, in a high-inflation country the rate of interest should no longer be expressed as a nominal rate, but instead as an effective (compounded) rate of interest. This compounded rate should be compared with the inflation rate (itself a compounded concept) to compute the real rate. 6.2 Inflation and cash flow The impact of inflation on your company’s cash flow can be frightful. The higher the inflation rate goes, the less real value will be embodied in successive interest payments on a long-term loan. In essence, high rates of inflation transform all long-term nominal interest loans into short-term loans, making them unsuitable for financing long-term investments2. Therefore, simply forget about long-term finance in a high-inflation economy, as the interest repayment
1

In a price-stable environment the nominal rate of return is equal to the real return. Should the inflation rate accelerate to, say, 100 per cent, this means that prices double each year so that each unit of currency can buy only half of what it could buy a year earlier. The lender of $100 therefore needs to receive $200 just to retain the purchasing power of the principal. In this environment, suppose you want a 7 per cent real return on your lending. At the beginning of the year 7 per cent interest amounted to $7, but to buy goods worth $7 a year later you would have to have $14. Therefore, at 100 percent inflation the lender of $100 requiring 7 per cent real interest would demand $214 at the end of one year or 100 per cent of the principal plus 114 percent nominal interest. Accordingly, the real rate of interest is only 3,5%, and need to be calculated as ir = [(1 + in)/(1 + P)] – 1, where i r = real rate of interest, i n = nominal rate of interest and P = rate of inflation. For instance, a five-year loan at a real interest rate of 10% p.a. with equal annual principal repayments implies that during the first year the

2

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schedule is usually far above your company’s cash flow capacity. Instead, fall back on retained earnings, which in turn emphasises the importance of securing the real ROE of your business (see also Chapter 3). 6.3 Inflation and gearing The more risky a business (measured in terms of its ROE volatility), the higher the return required by investors. Likewise, the higher the nominal rate of interest (owing to inflation), the lower the potential for financial gearing. Ultimately, the appropriate gearing for a multinational firm, operating simultaneously in different inflationary environments, becomes an optimisation exercise. Therefore, firms in low-inflation countries with low real interest rates not only benefit from relatively low credit costs, but also from higher gearing. In contrast, high-inflation countries do not only tax the poor with inflation3, but also squeeze small enterprises out of business4. All other things being equal multinationals prefer to do their capital funding in low-inflation (hard currency) countries, and then operate with relatively low capital costs in high-inflation countries (e.g. Germany lost this major commercial advantage over its EC partners when it switched from the D-mark to the Euro). For local firms this presents a lethal threat. In short, in those countries where the inflation rate suddenly accelerates, you may discover that you no longer have a pussycat by its tail, but instead are offered a free ride on a tiger’s back. If the government attacks small business with inflationary forces, defence seems the only sensible business strategy. You simply will have to wait for the return of sanity, before you can go over to the attack again. 6.4 Inflation and corruption Many ladies abhor the idea of selling their bodies to strangers, but quite a few of them would not give a second thought to marrying for money. Similarly, you may abhor paying bribes, but in corrupt countries these may not always be avoidable5 (see also Chapter 4). For politicians the art of bribery is always second nature, as even in respected democracies the trick is to bribe the majority at the cost of the opposition (parliament has known for long that creditors are always in a minority). If the government struggles to balance its own budget, it usually does not hesitate to tax the poor with inflation. There is then a high probability that its “civil servants” will be grossly underpaid and therefore have to operate as your “uncivilised masters” in daily life. Usually the higher the rate of inflation (i.e. the greater government’s incompetence), the more unstable the political elite, and the greater the temptation to employ corruption to stay in power. Endemic corruption, like inflation, imposes a disproportionately high burden on small firms. Such firms do not have the financial muscle to pay serious bribes to overcome the various entry barriers (e.g. monopoly benefits and regulatory laxness for selected bribers), and are too small to serve the power interests of current rulers. In contrast, large companies can flex their muscles by bribing state officials who do have power over the distribution of public benefits (e.g. procurement officials) and costs (e.g. tax collectors). Here bribers have to make a careful calculation of the potential benefits, the riskiness of corrupt deals, and the relative bargaining powers of the bribee. Generally speaking the lower the rate of inflation, the more it pays to be honest and trustworthy. Indeed, if governments cannot manage inflation, they most probably cannot eradicate corruption either, as both these evils demand more or less the same recipe: public sector reform; increased transparency; less state intervention; greater competition; more privatisation of state-owned enterprises; improved whistleblower status; and a better balance of power (e.g. more than one police force)6. 6.5 Selling the business The higher the inflation rate, or even the merest risk of a higher inflation rate, the higher the company’s ROE needs to be. Investors will now also demand a relatively high real earnings yield, which in turn implies a low PE ratio. This

payment of principal and interest will amount to 23% of the total payments. Should the inflation rate rise to 100% p.a. and the real interest rate remain at 10% p.a., the payments during the first year would amount to 60% of the total payment in constant prices.
3

In contrast to the rich, the poor cannot hedge themselves against inflation by buying, for instance, property. In high-inflation countries the rich get richer, and the poor get more children. This occurs in addition to the familiar “crowding-out” effect of large government budget deficits, which usually also go hand-in-hand with high inflation. For this very reason, in a few countries bribery expenses are still tax-deductible. For instance, Switzerland stopped this fiscal generosity only in 1998 to avoid further international political pressure. Till 2002 German firms were still allowed to bribe foreign-company employees, though not foreign officials. Rose-Ackerman, S., “Redesigning the state to fight corruption – transparency, competition and privatization”, in Public policy for the private sector, The World Bank Group, Washington, March 1996, pp. 49–52.

4 5

6

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obviously adversely affects the selling price of a company, as most enterprises are sold on a “fair” price/earnings basis. Usually your merchant banker will be able to calculate a full spectrum of “fair” prices for your business, since the selling price ultimately depends on specific assumptions made about an unknown future and speculations about the number of skeletons to be found in your company’s cupboards. For instance, potential buyers may be wondering to what extent last year’s earnings yield was a flash in the pan or a sustainable rate applicable to long-run valuations. If you want to sell your company to reap the fruits in the harvest period of your life (say before your 60th birthday), you primarily want cash for the business. The right time to sell is then of course when your enterprise performs better than the competition and the inflation rate is relatively low, implying that the real cost of credit will be relatively low, enabling potential buyers to relieve you relatively cheaply of your investment. In essence there is no great difference between selling your house or your enterprise: in both cases the asset for sale has to look attractive and, most importantly, the economic climate should be favourable.

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CHAPTER 7

RETIREMENT AND FINANCIAL RESTRUCTURING

Retirement does not have to herald the beginning of the end. But it does imply some major financial restructuring. Most executives retire in the late autumn of their life cycle, say between 55 and 65, but quite a few retire a lot earlier. In any case, with modern medical support, the winter of your life may last far longer. Nowadays life expectancy is on average some 25 years at age 60, but quite a few people celebrate their centenary. With money in the bank and the children out of the house, there is suddenly scope to simplify your lifestyle and finances. In winter you increasingly appreciate harmony, elegance and simplicity. Clearly, you now want to pay for not having. At this stage of your life you may even start to appreciate the words of Van Dyke: “It is wind and rain in the face on a treeless hill, the mud of a marsh beneath one’s feet, and the sound of whirring wings at sunset that gives examples of what joy and beauty are …” It has to be emphasised from the outset that the financial plan of business executives at retirement is fundamentally different from that of ordinary mortals. Indeed, if you are well-off there is no need to break your head about an issue such as how to maintain your standard of living during retirement. The proceeds of your sold business or your share incentive scheme simply imply an addition to your already impressive pile of discretionary investments. Traditionally, a sharp distinction was made between the rentier and the pensioner. The rentier is someone who lives solely on the return of his investments (e.g. dividends, interest, and rental income), while a pensioner consumes all underlying investments during his lifetime. For a rentier the risk of living too long (and therefore outliving his capital) is irrelevant, as the rentier per definition never digs into his capital1. But for the pensioner, life expectation is a crucial consideration in his financial plan. Only a fraction of millionaires ever become true rentiers – most are just pensioners. For the average executive the company’s pension fund constitutes about a third of his financial investments at retirement (based on 40 years’ accumulated pension fund contributions). If it should be significantly less than a third (because of job hopping) it should ideally be increased to this level by purchasing an additional pension from a life assurer. Accordingly, most executives have a contractual investment pool of about a third of their total financial investments and a discretionary investment pool making up the remaining two thirds. However, if total financial investments start to exceed the $5 million mark, the importance of the contractual investment pool decreases proportionately. Graph 7.1: Accumulation and consumption of assets Graph 7.1 gives an overview of the typical US$ 2005 prices 4 000 000 accumulation and consumption of assets of a CEO of Residential property 3 500 000 a medium-sized firm since entering the job market. Retirement fund assets Financial assets 3 000 000 In a forty-year business career the executive’s total 2 500 000 financial assets (excluding the house worth some $1 2 000 000 million) will rise from virtually nothing to some $2,5 1 500 000 million and will decrease again to nearly nothing towards the end of his life. Of course some 1 000 000 executives stay in more expensive houses, but a high 500 000 level of “life-style assets” will always be at the cost 0 1 7 13 19 25 31 37 43 49 55 61 67 73 79 of discretionary savings. Usually the executive’s
Years
1

Family property was the main source of income for the rentier in the past. Moreover, the real value of land increased gradually as it became an ever-scarcer resource in a world with an ever-increasing population.

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primary residential property accounts for some 30% of his total assets, and is normally left to the heirs. In terms of Graph 7.1 it is assumed that the retiree does not want to consume all his discretionary capital, and wants to leave something behind for the children or a charity. Accordingly, the planned retirement period is set at a conservative 40 years. Investment in the corporate pension fund is part of the financial assets in this graph, although, strictly speaking, this is only a memorandum item (i.e. a notional asset). This corporate pension is typically linked to a life insurance and dependent on the average life expectation. So the pension period of this fund is around 25 years, although its annual pension payout will be for life. So at retirement the retiree has to establish two distinctly different investment pools. Firstly, a contractual investment pool (which contains the corporate pension fund, retirement annuities (if any), and any purchased pensions), and secondly a discretionary investment pool (which consists of any additional assets). This chapter gives attention to these two pools in somewhat greater detail. 7.1 Your contractual investment pool In essence, the contractual investment pool has to address the following three inter-related issues: ! annual expenditure; ! inflation; and ! the risk of living too long. Expenditure is a matter of personal choice and is directly related to accumulated capital. The inflation risk can be hedged only by investing in a broadly diversified asset portfolio. The risk of you outliving your accumulated capital can be eliminated only through insurance (by sharing the risk of living too long with others). The contractual investment pool could be seen as a kind of “financial sanctuary”, giving the retiree not only financial, but also psychological security. As you cannot manage your accumulated pension fund investments yourself, your investment decisions in effect centre mainly on the type of pensions purchased and the amount of funds invested in your contractual investment pool. Obviously, a pension should be selected with great circumspection and in full knowledge of the ultimate benefits you will be receiving many years later. It is also advisable not to place all your golden eggs in one basket (although splitting up your purchased pension implies higher management costs). A purchased pension has to fulfil the following minimum criteria: ! Mortality-linked. The risk of living too long should be eliminated by a pension that is paid until death. ! Joint benefits. The pension should be based on your and your spouse’s life. On the death of the first partner, the pension should be structured to provide the surviving spouse with at least 75% of the joint benefit. ! Inflation-linked. Purchasing power is protected by linking a pension payout to the return on the underlying investment portfolio. As the investment portfolio is expected to grow in line with the real growth rate of the economy, the pension should do the same in the longer run2. ! Smoothed-bonus policy. Profits made on the investment portfolio underlying a pension may display significant fluctuations in the short term. To ensure a relatively stable income flow, pension payouts should be smoothed on a three- or four-year moving average. A smoothed-bonus policy (rather than a market-linked policy) is therefore advised. Most of the large life assurance companies sell pensions that fulfil the above requirements. There are, of course, many variations on this theme to suit individual needs. The major disadvantage of a purchased life annuity is not so much its lower yield (as the risk is also lower), but that your heirs are inheriting a smaller estate (which they, surprisingly, generally dislike). The relative low return on a life annuity is directly related to the implicit costs of such a financial product. Firstly, the underlying assets have to be invested in low-risk financial instruments, such as inflation-linked bonds, as the assurer has very strict payment liabilities to its retirees. This in turn implies a lower return than on more risky investments such as equities. Secondly, assurers have to eliminate individual mortality risk by spreading it over as many policyholders as possible. This spreading of risks comes at a price for those who have (in retrospect) a relatively short lifespan. Assurers pool the savings of retirees and invest these assets in the various lowrisk securities and property markets. The returns on these investments are market-related and actually quite competitive. They normally also outstrip the inflation rate. A crucial decision at retirement is how much of your total investments should be invested in a contractual pension
2

Unfortunately, employers’ defined-benefit pensions are usually not fully inflation-linked in South Africa – the annual adjustments average only some 80% of the ruling inflation rate. This is costly in the longer term, particularly if the inflation rate is high. For instance, should you retire at 60 and live for another 17 years, with inflation running at 6% per year, your real pension payout will have fallen by 22% by the time you die. This potential fall in real income from your employer’s pension fund has to be compensated for by your other savings. Accordingly, even if the employer’s defined-benefit pension fund scheme pays 100% of your final salary, you still need to save or have other sources of income to draw on.

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(basically a life annuity) and how much in your discretionary investment pool. This choice largely depends on your life style, as all basic consumption expenditure should be financed ideally from your contractual investment pool. Clearly the richer one is, the less the need for a life annuity, because basic consumption expenditure then becomes an ever smaller percentage of total income. As a rule of the thumb most executives with financial assets of between $2m and $5m invest about a third of their total wealth in a contractual investment pool (which includes the company’s retirement fund, retirement annuities, and any purchased pensions). All money in the contractual investment pool should be considered “notional” as, strictly speaking, these funds are no longer yours. A contractual investment means that you have purchased an annual income (preferably inflation-linked) until your death in exchange for a lump sum payment to the assurer3. A pure life annuity will lose all value the day you die (which may well be on the same day that you signed the contract). As noted above, there are more friendly alternatives but, whatever the variations, there will be no free lunch – you get what you pay for. Clearly, actuarial risk considerations underlie all cost calculations. Your state of health is obviously an important consideration if you buy an additional pension. Currently life assurers work on a life expectancy of 23 years for males and 26 for females at age 60. If the chances are good that you will outlive the average mortal, a pension is always a good purchase to cover at least your minimum living expenses. Even if the annual real return on a life annuity is less than what you could earn yourself by investing these funds in your discretionary investment pool, you nevertheless stand to benefit if you live significantly longer than, say, 90 years. Last, but not least, there are some specific tax aspects related to retirement. Of course taxation is a very countryspecific issue and generalisations are difficult in this respect. The United States has one of the most complex tax systems in the world, owing mainly to political lobbying of all kinds. But South Africa is on the way to catch up with the US in this respect. Particularly, the South African capital gains tax regime is quite onerous. Generally the funds in your company’s retirement fund as well as your retirement annuities were accumulated in a tax friendly way over the years. Now any pension received from this source will be considered taxable income. To minimise your tax obligations at retirement quickly becomes a very technical affair and it is money well spent to consult a good tax adviser. In this area do not be pennywise and pound foolish! 7.2 Your discretionary investment pool Whereas the contractual investment pool is basically there to keep the wolf from the door, the sole purpose of the discretionary investment pool is to augment your basic living expenses and/or to leave something to your chosen heirs. As assets in the discretionary investment pool are somewhat of a luxury – in the sense that they are used to finance non-essential expenditure or even expenditure beyond the grave – they can be of a more risky nature. Whereas you typically expect a 3% net real annual return on your contractual investment pool, the net real annual return on your discretionary investment pool before tax could well be of the order of some 4% to 6% in the long run (see Table 7.1). This large difference may tempt you to reduce your contractual investment pool by too much. Be careful, though. Unless you have discretionary investments in excess of $3 million, the additional profits you may garner by scaling d o wn s i g n i fi c a n t l y o n contractual investments will Table 7.1: Assets by investment class and their returns not be sufficient to compensate Gross real Net real Weights1 Total fees returns2 return for the financial worries that Money market funds 13% 1,5% 0,75% 0,8% may result. If you become Fixed income 21% 2,8% 1,00% 1,8% obsessive about optimising Equities 30% 6,0% 1,50% 4,5% every cent, your money is Alternative investments 20% 9,0% 3,00% 6,0% bound to ruin your life. During Property 16% 8,0% 2,00% 6,0% your retirement money should contribute to your happiness, Total 100% 5,7% 1,7% 4,0% 1 not to your stress levels. In Weights are based on the asset composition of HNWI. See Capgemini, Op.cit., 2006. 2 Gross real returns are based on the period 1961-2006. See Barclays Capital, Op. cit, 2007. short, running a too small
3

After you have purchased an inflation-linked pension, a life assurer will pay you a guaranteed monthly pension, based on the initial income percentage, plus a yearly (variable) bonus, based on the performance of the underlying investment portfolio. Your purchased pension will now increase roughly in line with the ruling inflation rate, and will be paid until your death. The flip side of this coin is of course that, should you die earlier than expected, the life assurer will make a “profit” on your pension policy. It is for this reason that contractual investments appear on the balance sheet as notional investments or memorandum items (as these assets, in effect, no longer belong to you). Moreover, these pension fund investments are always shown as positive notional amounts on your balance sheet, because the life assurer has to make provision for future payouts, based on your life expectancy.

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contractual investment pool may easily result in stress, particularly as most investors express their losses in cents and their profits in percentages! The day you sell your business or retire from your executive position in the company, your discretionary investments (as a percentage of total assets) will increase sharply. Now there is the possibility of reinvesting the proceeds from your business and/or the share-incentive scheme in more liquid alternative investments (such as listed equities and property). In fact, no longer constrained to reside close to your place of work, you can even sell your house and move to greener and cheaper pastures. Graph 7.1 depicts the typical pattern of your financial assets during your retirement phase. Working on the same basic assumptions mentioned in Chapter 2, the accumulated total assets of an average executive should be roughly $3,5 million at retirement and his financial investments some $2,5 million. Clearly, your financial plan during retirement crucially depends on the inherent characteristics of an annuity. Therefore, if you assume (i) a life expectancy of 40 years at age sixty (which is conservative indeed, as the working life styles of most executives ensures an early death), (ii) a net real return on your investment portfolio of 3,5% p.a., and (iii) total financial assets of $2,5 million, your annual withdrawals should be around $100 000 per annum in real terms. Of this $100 000 gross income roughly a third should come from the contractual investment pool and the balance from the discretionary investment pool. Clearly, not all available income from the discretionary pool has to be consumed – part of it could be saved for the unknown or specifically for your heirs. Note, however, that in a high-inflationary environment savings become essential. Inflation is in essence a tax on the government’s creditors (i.e. bond holders). This “informal” tax distorts your finely tuned financial plans very easily, and particularly your investments in fixed-interest securities. For instance, suppose the inflation rate suddenly accelerates dramatically. If there is central bank independence, this rise in inflation will result in a rise in the real rate of interest. Your reinvestment rate on coupon income now also rises, Graph 7.2: Annual real income and so will the total return on your bond investments obtainable from $1m bond investment Income ($ p.a.) (of course, provided these bonds are kept until 60 000 maturity). However, in many developing countries 50 000 the central bank is not truly independent, and a rise 40 000 in inflation may easily result in a decrease in the real rate of interest. Small decreases in the real rate of 30 000 interest can be coped with by increasing your savings 20 000 rate. However, if the inflation rate moves to ever10 000 higher levels, lower withdrawal rates become really crucial to protect the underlying value of your bond 0 -10% -8% -6% -4% -2% 0% 2% 4% 6% investments. Graph 7.2 depicts this relationship Real discount rate (return) between the real rate of interest and real income on your discretionary bond investments. 7.3 Expenditure level and available resources Working on the “20 times rule” and with total financial investments of $2,5 million, your real income should not exceed $125 000 per annum (i.e. $2,5 million divided by 20). Some executives prefer the more conservative “25 times rule” in which case real income would be limited to $100 000 p.a. Whatever your choice here, after retirement a few fundamental changes in your finances take place. No longer is there a need to save for retirement funding (as you are now retired), no need to contribute to the company’s pension fund any more (you now draw a company pension), and on your lower gross earnings after retirement your tax obligations also fall meaningfully. Besides the fact that your total taxable earnings will be lower, a large component of your income is now also investment income (which is usually taxed at a lower rate than profits, as corporate income has already been fully taxed in the past). The trick is to ensure that, after all these adjustments, your desired income remains unaffected. This is ensured if you stick to at least the “20 times rule”. Graph 7.3 depicts your expenditure (and income) after retirement in somewhat greater detail. In this instance consumption expenditure plus taxes were assumed to equal desired income. As emphasised repeatedly, your desired income is financed from two main sources: firstly your contractual income that should account for roughly a third of total income, and secondly, the balance from discretionary income. However, in a high-inflation environment your discretionary expenditure is reduced for two important reasons: firstly you have to save to pay for the inflation tax, and secondly the increased level of socio-economic uncertainty implies
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that discretionary savings become more desirable. Graph 7.3: Application of income Indeed in a hyper-inflationary environment all prices US$ 2005 prices are unreliable and subject to massive changes as 600 000 Savings socio-economic conditions change. Even inflationRental or Mortgage interest repayments Portfolio expenses and tax payments 500 000 linked bonds are suspect in such an economy as it is Consumption expenditure unlikely that the government will honour such 400 000 commitments if it is already undermining the 300 000 economy with its inflationary taxation policies (Zimbabwe comes to mind in this context). Hyper200 000 inflation means that you can never be certain about 100 000 the real value of your investments. To cope with all 0 these uncertainties implies in practice, that you have 1 7 13 19 25 31 37 43 49 55 61 67 73 79 to save more than initially planned, and this will be at Years the cost of discretionary expenditure. Ultimately, should there be a major risk of the currency being severely eroded, you have to invest a major part of your capital in hard currencies. To switch into hard currencies as hyper-inflation emerges, will be difficult to achieve, as such an event will almost certainly go hand-in-hand with very strict exchange control measures. Therefore, investing in foreign currencies has to be done during the good times when this is still legally allowed.

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CHAPTER 8

MANAGING YOUR FUND MANAGERS

“June is one of the most dangerous months for speculating in stocks; the others are October, July, January, September, April, May, March, November, December, August and February”. This sharp observation by Mark Twain presents a fair summary of the challenges facing fund managers. Whether entrepreneurs like it or not, sooner or later they will be drawn into this risky business as well. Because the future is unknown – note that Fortuna moves her rudder with near-divine skills – your assets have to be well-diversified. Even if your own firm is laying golden eggs, it is still good investment policy not to keep all those eggs in the same basket. Accordingly, a firm has to declare dividends, unless its shares are so marketable that shareholders can easily sell them in the stock market1. To attempt to manage all of your funds yourself is usually a bad idea. Firstly, fund management should be carried out on a global scale and it is unlikely that you possess the skills and business contacts to do so in all the major investment currencies. Secondly, investment portfolios have to be kept under constant review, inter alia, to ensure that your specified risk level stays in place. The average entrepreneur has neither the time nor the inclination to adjust his portfolio on a continuous basis. Thirdly, private investors compete with professional traders on a very uneven playing field, as they usually lack the technological expertise and network of information. Fourthly, the opportunity costs of managing your own funds are often too high. If you really are fond of managing a fund yourself, the best advice is to manage, as a hobby, some 5% of your investment capital yourself in the investment currency you know best. The other 95% of your investment capital should go to professional fund managers. This chapter deals with the issue of how to delegate the investment task and how to control your fund managers. 8.1 Managed global asset portfolios For the global investor there is more than one way to skin a fat cat. Firstly, you can buy units in a managed global asset portfolio, in which case you completely hand over the investment task to professionals. This strategy requires little capital, as these units cater specifically for retail clients. Usually three different types of managed portfolios are offered, each aiming at a specific investment horizon2: (i) a low-risk portfolio for investors with an investment horizon of less than one year, consisting mainly of fixed-interest securities with a short duration; (ii) a medium-risk portfolio for investors with an investment horizon of about three years, consisting of a mix of cash, bonds and equities; and (iii) a higher-risk portfolio for investors with a time horizon of more than five years, consisting predominantly of equities. A major advantage of fully managed portfolios is that you can abrogate your investment responsibilities and related worries, to a third party. Alternatively, you can decide to purchase specialised mutual funds (e.g. funds investing only in bonds, equities, emerging markets or gold), in which case you will handle the asset allocation yourself. Although such securities3 can be purchased privately, it is more efficient to do so through an offshore discretionary trust (see Chapter 9). Considering a trust’s running costs, this avenue is essentially open only to those with investable assets in excess of $500 000 abroad. To accumulate this amount of investment capital is a tough task for a start-up entrepreneur and one that can be successfully accomplished only later in life. Accordingly, most mini-entrepreneurs have to be satisfied with the purchase of a few foreign mutual funds (rather than local ones), which will give them some global asset exposure at a reasonable price. If you are really rich (i.e. an ultra-HNWI), it is also possible to create your own investment company offshore – provided you have at least $20 million to invest. You can even appoint your own fund managers, not only control the asset allocation process, but in addition place operational constraints on your fund managers. For larger investors managed portfolios are unattractive. Firstly, the rich only want to delegate, not rescind, their

1 2 3

Alternatively, and more correctly, dividends should be paid out if a company cannot invest at a better return than the cost of its capital. The investment horizon is determined by the future date on which you intend to liquidate your investments. Of course, if you have mastered the skill “of running with the bulls and dancing with the bears”, you can also buy equities and bonds directly, rather than specialised mutual funds. This approach is not only riskier, but also involves more administration and therefore entails opportunity costs.

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investment responsibilities. In a few crucial areas they want to keep a definite finger on the pulse. Secondly, managed portfolios are in essence retail products for people with little knowledge of investments and relatively little money. For large amounts such retail products are relatively expensive. Therefore even in the investment field, you find horses for courses: if you have a relatively small part of your capital invested abroad, the managed global asset portfolios are hard to beat in terms of convenience and costs. However, if you are seriously rich and your foreign assets run into millions of dollars, you will have to manage these assets more actively. You then want to look your fund managers in the eyes from time to time. 8.2 The riskiness of funds A frequently cited rule of thumb employed by fund managers is that an optimally diversified portfolio can be approximated by using country weights that correspond to countries’ market capitalisations. In terms of this rule some 80% of your equity investments should be invested in the industrial countries. But for most entrepreneurs it is difficult to place such a large slice of their investment capital abroad, because of local financial commitments. In practice this implies that the risk-averse entrepreneur will invest any surplus capital only in a global asset portfolio. If you have decided to invest a major part of your financial assets in the global rather than the local market, the next hurdle is to decide how much of your portfolio’s capital should be invested in cash, bonds or equities. You can ask for professional advice in this respect, but ultimately this decision has to be taken by yourself, as the appropriate asset mix crucially depends on your preferred investment horizon and your appetite for risk. The shorter your investment horizon and the lower your mental ability to absorb losses in your portfolio (owing, for instance, to a stock market crash), the less risky should be the composition of your global asset portfolio. In contrast, if you have nerves of steel, a heart of ice, and a long-term investment horizon (e.g. if you are an aged tycoon managing assets in essence for your heirs), you can assume larger risk exposures, and reap the rewards in the form of higher than average returns. The relative riskiness of a fund is measured by its so-called tracking error, i.e. the standard deviation of the fund’s return from that of a benchmark. Therefore a tracking error of 5 implies that there is a two-thirds chance that the fund’s return will fall within a range of plus 5 to minus 5 percentage points around that of the benchmark. Another way to think of this concept is through the analogy of taking a pack of dogs (markets) of different temperaments (volatility) for a walk along a path (benchmark return)4. You, the fund manager, are the dog handler, each market is a dog, while the allowed tracking error can be thought of as the length of the leash on which each dog is kept. Brazil (a medium-sized volatile market) is a red setter with a scatty personality. It needs to be kept on a short leash or it will drag the pack off course. South Africa (large and low-volatility) is a well-trained St. Bernard. It can have a relatively long leash, as it will not stray too far from the chosen path. Turkey is a terrier. As a portfolio owner you should give your individual fund managers sufficient freedom to demonstrate their investment skills. At the same time you do not want to give them carte blanche. This dilemma is solved by stipulating appropriate benchmarks and maximum tracking errors for each of them. As a rule of the thumb few portfolio owners (or trustees) would allow their fund managers tracking errors in excess of 5% (the exact percentage will depend on your investment horizon and risk appetite). Assume that a fund manager is running a fund with a tracking error of 10%. This is the notorious “take it all or lose it all” strategy. If the market moves in his favour, he will outperform the benchmark – which will no doubt be reported as “clever trading”. However, if the market moves against him, he may have some difficulty selling his underperformance as “bad luck” (fund managers running tracking errors in excess of 10% therefore update their CVs continuously). If markets are efficient, it will be difficult for a fund manager to outsmart other fund managers on a continuous basis. Today there are literally thousands of professional fund managers in the global investment field, all trying to outperform one another with superior timing and stock selection strategies. As this competition is after all a zero-sum game, you should be realistic. At times losses, or at least underperformance, will occur and these temporary setbacks will be bigger the larger you allow the tracking error to be. There are a number of reasons for fund managers finding it difficult to execute a profitable timing and stock selection strategy over the medium to longer term5. First of all, no business cycle upswing is similar to any previous one and nobody knows how long the upswing or, for that matter, the downswing will last. An economic upswing may be caused by increased exports, fiscal and/or monetary stimulus, restocking, a fixed-investment boom or even a
4 5

Union Bank of Switzerland, UBS Global Research: Emerging markets strategy, London, 2nd quarter 1996, p. 68. For a summary of economic factors influencing investments see Calverly, J., Pocket guide to economics for the global investor, London: Probus, 1995.

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consumer buying spree. In each of these cases the impact on the various sectors of the economy will be different. Secondly, to determine the exact state of the business cycle – and therefore the global liquidity cycle, which is a predominant factor in asset price movements6 – is usually possible only after the event. Thirdly, the state of the business cycle may differ from country to country, impacting differently on different stock exchanges. Fourthly, even if there is general agreement about the exact position of the business cycle and its interaction with the global liquidity cycle, asset prices may not react as anticipated, because the expected price movements have already been discounted in the market. Fifthly, timing analysis does not help to predict the size of asset price movements. While global liquidity conditions may drive equity prices in the short run, in the longer term corporate profits have a bigger influence. Lastly, even if a specific asset is bought at the wrong time, its return will nevertheless move towards the expected average return over longer holding periods, inter alia, because of reinvested cash flows such as dividend and coupon payments. Accordingly, a “buy and hold” strategy is often preferred, and a portfolio’s composition is best amended by allocating new cash flows. Your fund managers should run specialised funds against appropriate benchmarks. Moreover, they should have the operational systems to report to you their tracking errors and the attribution of their excess returns on at least a monthly basis. You should not constrain your fund managers with too many operational limitations (then you may as well do their jobs yourself). At the same time you should avoid the situation of your employees running excessive risk exposures. An acceptable spread in terms of risk is ensured by stipulating a maximum tracking error. A tracking error in excess of 5% should be exceptional, and allowed only to those who have a track record of really superior returns. In conclusion, give your fund managers sufficient rope to hang themselves, but not so much that they can strangle you as well. Always remember that markets are generally too sophisticated to be consistently outsmarted by some clever fund managers. After you have decided on: (i) the broad asset allocation (e.g. 60% equities and 40% bonds); (ii) the appropriate benchmark (e.g. the Global Asset Market Index as your benchmark for equities); and (iii) the tracking error for each of your fund managers (say, 3% against the benchmark), you can sit back and watch the results. 8.3 Selection of global fund managers The first question that should come to mind when considering the appointment of an additional fund manager is what value he can add to the existing portfolio and what the impact of his appointment will be on existing fund managers. As fund managers ultimately market their specific tracking errors, they have to specialise to make a living. Indeed, if they have no such specific skills, the various funds in your portfolio may run the danger of becoming carbon copies of each other with inefficient overlaps. Fund managers usually specialise in one of the following fields: ! asset type, e.g. bond, equity or derivative funds; ! country allocation, e.g. Asian, European, North American or emerging markets funds; ! currency allocation, e.g. currency derivatives or hedge funds; ! industry positioning, e.g. gold or mineral funds; ! style funds, e.g. large capitalisation versus small capitalisation stocks or value versus growth stocks; ! style rotation, e.g. funds switching between investment styles; ! stock selection, e.g. funds searching for mispriced securities; and ! market timing, e.g. funds of which the cash components are dynamically altered. Fund managers who sell all of the above in one package (i.e. the “We know it all and do it all” variety) should be avoided like the plague. The demand is rather for specialist fund managers with proven track records. Before being considered seriously, fund managers should be able to explain the composition of their tracking errors and the attribution of their returns (i.e. the excess return above the benchmark return). For instance, to what extent was the excess return a result of asset selection within selected markets (i.e. a bottom-up approach with emphasis on industry and stock selection) or of asset allocation between markets (i.e. a top-down approach, involving primarily country and currency selection and timing strategies). Generally, the more skilful a fund manager, the smaller the proportion that needs to be actively managed in a portfolio, while the larger the non-core proportion of the portfolio, the less aggressively it should be managed. Accordingly, the more fund managers are employed, the more aggressive the additional fund managers should become. Usually a portfolio is split among at least three specialised fund managers: (i) bonds; (ii) equities (asset
6

See for instance The Economist, “Of bulls, bears and financial clock watchers”, London, 19 November 1994, pp. 85–87.

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allocation); and (iii) equities (asset selection). More fund managers can be added as a portfolio grows in size, but still with the strict proviso that each additional fund manager should add value to the total portfolio, which in turn implies new fields of specialisation. Once a benchmark and a maximum tracking error are prescribed for each fund manager, there is little purpose in interfering with his day-to-day operations and speculative bets. Indeed, excessive gearing by way of derivatives or over-hedged currency positions (i.e. pure speculation) will clearly show up in the tracking error. Poor portfolio returns for too long require a “changing of the guard”, not necessarily a change in the maximum tracking error as well. 8.4 Expected long-term portfolio returns The return on your portfolio obviously depends on your asset weightings: i.e. local versus foreign investments, bonds versus equity investments, and so on. Your contractual investment pool is bound to consist nearly fully of local funds; while you have virtually no say in the asset composition of these funds. Therefore your investment choice is virtually limited to your discretionary investment portfolio. The first question to be answered is how much to invest abroad. There are two broad schools of thought. The first school relies on the great philosophy that “tomorrow will be like yesterday”. If you do indeed believe this, then historical data mining will determine the weighting of your local and foreign investments. The optimal local/ foreign mix for a growth portfolio is then something like 70% local and 30% foreign for South African investors, while for a conservative income portfolio the weights are likely to be around 90% local and 10% foreign. The second school of thought views South Africa very much from an international perspective. According to this school the total weight of emerging markets – which includes South Africa – in your portfolio should never exceed 20%. As your contractual investments are already a third of your total portfolio, your discretionary investment pool ought to be fully invested in the foreign market. Because South African exchange control regulations currently stipulate a maximum direct investment of R2 million per adult (or some R4 million per household), your foreign fund managers can handle only around $500 000 (i.e. using the foreign-exchange equivalent of R4 million), while local fund managers will have to invest in foreign denominated funds (but using rand investments). One possible investment portfolio is depicted in Table 8.1 (which assumes that a third of the portfolio is local investments, while the international fund allocation is based on the average asset portfolio of HNWIs in 2005 – see Table 8.2), but there are obviously other possible combinations – all depending on your insights and time horizon. You have to be realistic about the real returns such a portfolio can produce. Seen from a historical perspective, the period 1984 to 2000 was a golden era for the equities markets, with real returns of 8% p.a. on average (see Table 8.1 again). It is probably too optimistic to assume that such good times will roll on for ever. In terms of this school of thought “tomorrow may be quite different from yesterday”. Ultimately long-term economic growth is determined by the size of the workforce and productivity increases and these may well have peaked in the recent past. Accordingly, it would be dangerous to base profit projections on financial data of the past two or three decades. The reasons for it being unlikely that active portfolio management, such as hedge funds, will outperform passive portfolio management in the long run are briefly as follows7: ! Active trading does not come cheaply. Nowadays active fund managers typically turn over your entire portfolio during one year, compared with about a 20% turnover some 50 years ago. Compared with a passive portfolio, this active buying and selling will raise your portfolio costs by at least some 1,5 percentage points per annum. Most portfolio managers find it nearly impossible to consistently outperform the market index by some 2 percentage points per annum in the long run. ! Although hedge fund managers may make superior profits for themselves (with management fees as high as 3% p.a. of assets under management plus a 10% or even a 25% haircut, i.e. their share of the trading profit if they outperform a certain benchmark), your net returns after these management fees will be significantly less attractive. ! Even if all active portfolio managers are doing a great investment job (as reflected in the market index), per definition a large part of those will have to under-perform the index. Indeed the market index is the average of all fund managers’ performances, and they cannot all be above-average! ! Active trading strategies that focus on short-term results often do so by implicitly harming the strategy’s long-term survival chances. In a bull market, asset selection by a chimpanzee may be better than that of a
7

Coggan, P., “The long view”, The Financial Times, London, 12/13 August 2006, p.12.

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professional fund Table 8.1: Gross and net total real returns on cash, bonds and equities (% p.a.) manager, but how do (Before expenses and taxation) you differentiate Portfolio 1926- 1946- 1961- 1971- 1981- 1991between a lucky and a Period weights 2006 2006 2006 2006 2006 2006 good portfolio I South African contractual investment pool manager? Statisticians Cash or T/B's 3,0% 0,8% 1,1% 2,1% 2,2% 4,2% 5,7% Bonds 13,0% 1,7% 1,3% 2,4% 3,1% 6,4% 11,0% suggest that it takes a Equities 16,0% 8,2% 7,0% 9,4% 10,0% 9,3% 10,4% decade to distinguish Total 32,0% 4,9% 4,1% 5,9% 6,5% 7,6% 10,2% between luck and skill. II Global discretionary investment pool By that time irreparable Cash or T/B's UK 4,5% 0,8% 0,9% 1,4% 1,5% 2,3% 1,3% damage may have been USA 4,5% 1,0% 1,0% 1,6% 1,8% 3,7% 2,9% done to your portfolio. Total 9,0% 0,9% 1,0% 1,5% 1,7% 3,0% 2,1% ! If yo u r c a r e fu l l y Bonds selected active fund UK 7,0% 2,0% 1,4% 2,1% 2,7% 6,0% 3,8% USA 7,0% 2,5% 1,2% 3,4% 4,0% 7,2% 5,6% manager has discovered Total 14,0% 2,3% 1,3% 2,8% 3,4% 6,6% 4,7% a uniquely successful Equities trading strategy, he is UK 10,0% 8,5% 8,2% 5,7% 5,9% 9,8% 8,6% unlikely to succeed in USA 10,0% 7,0% 6,9% 6,2% 5,6% 9,3% 7,1% Total 20,0% 7,8% 7,6% 6,0% 5,8% 9,6% 7,9% keeping it secret for Alternative investments long. Success travels UK 7,0% 11,5% 11,2% 8,7% 8,9% 12,8% 11,6% very fast in the financial USA 7,0% 10,0% 9,9% 9,2% 8,6% 12,3% 10,1% markets, and soon his Total 14,0% 10,8% 10,6% 9,0% 8,8% 12,6% 10,9% Property strategy could be used UK 5,5% 10,5% 10,2% 7,7% 7,9% 11,8% 10,6% by everybody, and quite USA 5,5% 9,0% 8,9% 8,2% 7,6% 11,3% 9,1% possibly against him. Total 11,0% 9,8% 9,6% 8,0% 7,8% 11,6% 9,9% Years of profits may be Real portfolio return (growth) UK 34,0% 7,1% 6,8% 5,3% 5,6% 9,0% 7,6% sacrificed in one such USA 34,0% 6,2% 5,9% 6,0% 5,7% 9,1% 7,2% spectacular blow up. Sub Total 68,0% 6,7% 6,3% 5,6% 5,7% 9,0% 7,4% ! Active fund manageIII Total gross real return 100,0% 6,1% 5,6% 5,7% 5,9% 8,6% 8,3% me n t d e p e n d s o n Expenses and taxes 2,5% 2,5% 2,5% 2,5% 2,5% 2,5% extensive and expensive IV Total net real return 100,0% 3,5% 3,1% 3,1% 3,3% 5,9% 5,6% data mining. Lots of time Sources: Barclays Capital, Equity-Gilt Study, 2007 and deep pockets are Capgemini, Ibid, 2006 Assumptions: required – ultimately all Alternative investments returns = real equities return plus: 3,0% at your cost. For Property fund investments returns = real equities return plus: 2,0% Expenses and taxes (as per Table 8.4): 2,5% instance, active stock fund managers need to assess the probity of a company’s management, the appeal of its products, the threat from competitors in the sector, and the economic conditions before even attempting to calculate the fair value of its shares, using a host of different measures. How difficult this all is, is clearly evident from statistics: very few fund managers consistently beat the market index. If even the professionals fail so spectacularly, what is your claim to fame? After all is said and done, a gross real return of some 6% p.a. is a good performance for an investment portfolio in the long run (see Table 8.1). But you will also have to keep an eye on costs. From your gross return you still have to pay management and safekeeping fees, which should not exceed 1,5% of the value of assets under management on average. Accordingly, your net Table 8.2: Asset allocation of HNWIs real return will be of the order of 4,5% p.a. in the long term. Asset class 2002 2003 2004 2005 And don’t forget that on this 25% 10% 13% 13% Cash amount taxes have to be 30% 25% 24% 21% Fixed income coughed up as well: income 20% 35% 28% 30% Equities 10% 13% 19% 20% tax and capital gains tax being Alternative investments 15% 17% 16% 16% Real estate the most important ones. After this sacrifice you are probably 100% 100% 100% 100% Total
Source: Capgemini, 2005 and 2006

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left with a net after-tax real return of some 3,5% p.a. – i.e. not significantly more than the net returns on contractual investments. And, not surprisingly, only a few made their money out of superior investment strategies. And for those that did succeed the chances are good that some form of insider trading formed an integral part of their successful trading strategies. Table 8.3 summarises the Table 8.3: Net real returns after expenses and taxes (% p.a.) important differences between gross nominal returns and net Returns Portfolio A Portfolio B real returns on your Gross nominal portfolio return 8,7% 13,1% investment portfolio. Portfolio Total expense ratio 1,0% 3,0% A is a low-cost fund (e.g. Trust fees 0,0% 0,5% largely based on index funds), Pre-tax nominal return 7,7% 9,3% while Portfolio B is an Effective income tax on financial assets 1,0% 2,0% actively managed fund (e.g. a Capital gains tax 0,0% 0,5% hedge fund). Furthermore, the Net nominal portfolio return 6,6% 6,6% total expenses and taxes Inflation 3,0% 3,0% incurred in Portfolio A are at Net real portfolio return 3,5% 3,5% the bottom of the cost spectrum in the market, while Portfolio B Expenses & taxes (as % of portfolio value) 2,0% 6,0% reflects the top part of this Expenses & taxes (as % of gross return) 24,5% 49,7% spectrum. The following Total deductions (as % of gross return) 60,0% 73,3% aspects can be highlighted: ! In many industrial countries financial service providers have to disclose their total expense ratio (or TER). In South Africa this is still voluntary, but will be compulsory in the near future. TERs include all expenses incurred by the service provider such as: annual management fees, performance fees, administrative costs, custody, trustee and audit fees, bank charges, taxes such as uncertified securities tax, brokerage, stamp duty, as well as any other fees incurred in the buying and selling of the assets in the portfolio. Depending on the financial service provider chosen the TER fluctuates usually between 1% and 2% of the nominal value of the assets under management. Even if you would do all investment business yourselves it is unlikely that your expenses will be less than 1% of your nominal investments, particularly because brokerage for smaller trades can be very high. At the other extreme, should your total portfolio be invested in equities and/or alternative investments the TER can be a high as 3%. ! Trust fees will be incurred if your portfolio is located in a discretionary trust. As the fixed fee for a trust ranges between $5 000 and $10 000 per annum, this legal structure is economically viable only if total investments are counted in millions of dollars. On a portfolio of $5 million the trust fees typically account for some 0,2% of the nominal value of the assets under management. ! Total taxes and social security revenues as a percentage of GDP vary greatly between countries. In Sweden it is about 55%, in France 45%, in Germany and the UK around 35%, while it is around 25% in the US, Japan and South Africa. In the US wage, dividend and interest income are nearly all taxed at the same rate (with a maximum rate of about 43% of gross income depending on the specific state). In South Africa the taxation of financial assets depends on whether these assets are local or foreign holdings, while wage, dividend and interest income are all taxed quite differently8. In the Netherlands your financial assets are taxed at a flat rate of 1,2% of the current market value (i.e. irrespective of the actual income generated by these assets). Expressed as a percentage of the market value of your financial assets the effective tax on investments in the OECD countries ranges roughly between 1% and 2% (but in tax havens this percentage may be zero). ! Capital gains taxes (or CGT) are in essence a tax on top of the informal inflation tax, as in the long run most of the nominal share price increases are inflationary in nature. Fiscal competition between nations imply that tax havens avoid any tax on capital gains, but countries with overstretched fiscal budgets can mostly not withstand the temptation to levy this tax as well. For those countries that impose CGT, the tax rate usually ranges between 0,25% and 0,5% of the nominal value of the financial assets. ! Inflation is an informal, indirect tax on society that flows directly from the state monopoly on the issuance of
8

In South Africa, income in the form of wages, interest and foreign dividends is taxed at individual tax rates with a maximum of 40%; local dividends are tax free, whilst interest and foreign dividend income enjoy certain tax exemptions.

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money (i.e. the soTable 8.4: Net real returns after expenses and taxes (% p.a.) called “legal tender”). If 1926- 1946- 1961- 1971- 1981- 1991inflation becomes Period 2006 2006 2006 2006 2006 2006 hyperinflation, the state Gross nominal portfolio return 10,7% 11,6% 12,3% 12,9% 12,7% 11,1% is in effect involved in a Total expense ratio 1,0% 1,0% 1,0% 1,0% 1,0% 1,0% massive confiscation Trust fees 0,2% 0,2% 0,2% 0,2% 0,2% 0,2% policy. Fortunately, Pre-tax nominal return 9,4% 10,3% 11,0% 11,6% 11,5% 9,8% most central banks in Effective income tax on the Western world 1,2% 1,2% 1,2% 1,2% 1,2% 1,2% financial assets (including South Capital gain tax 0,2% 0,2% 0,2% 0,3% 0,2% 0,1% Africa) are now Net nominal portfolio return 7,9% 8,7% 9,4% 10,0% 10,0% 8,4% independent, and have Inflation 4,3% 5,6% 6,2% 6,6% 3,8% 2,6% inflation targets below Net real portfolio return 3,4% 2,9% 3,0% 3,2% 5,9% 5,7% 3% per annum. The South African Reserve Expenses & taxes Bank’s inflation target 2,5% 2,6% 2,6% 2,6% 2,5% 2,5% (as % of portfolio value) still ranges between 3% Expenses & taxes 25,8% 24,5% 23,4% 22,5% 21,9% 24,2% (as % of gross return) and 6% p.a. though. Total deductions Taking all the above factors 67,8% 74,6% 75,5% 75,3% 53,7% 49,1% (as % of gross return) in consideration, total portfolio Memorandum items: expenses and taxes range Real portfolio returns 6,1% 5,6% 5,7% 5,9% 8,6% 8,3% between 2% and 6% of the (as per Table 8.1) total nominal value of your Inflation rate (US) 4,3% 5,6% 6,2% 6,6% 3,8% 2,6% financial assets. Indeed, in a Assumptions: high inflationary country very Portfolio value in US$: 5 000 000 little may remain over from Total expense ratio: 1,0% Trust fees in US$: 8 000 your gross nominal portfolio Effective income tax on financial assets: 1,2% returns, which complicates the Maximum income tax rate: 40,0% funding for retirement in a Capital gains tax: 10,0% major way. But there is a silver lining around this dark cloud: hopefully high management fees go hand in hand with high portfolio yields (i.e. a superior performance implies a relatively high cost, as talent does not come cheap). If your fund managers do indeed succeed in outperforming the market yield by some 4 percentage points, your net real return will be similar to that of a low-cost portfolio. But to outsmart the market by such a large margin will be no easy task, and particularly so in the long run. Only very few talented portfolio managers succeed in doing so consistently, and therefore it is generally better to stick to a low-cost fund (e.g. index funds). As evident from Table 8.4 the difference between gross nominal return and net real return was on average some 70% during the last 80 years (i.e. based on the assumptions underlying this estimate). Clearly with contractual and statutory deductions on such a large scale, accumulating sufficient funds for retirement is going to be difficult for most people.

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CHAPTER 9

TRUSTING YOUR TRUSTEES

When your total net wealth starts to run into millions of dollars, the time has come to consider the creation of a discretionary trust. A trust will enable you to manage your private assets similarly to your company assets, because a trust has its own legal identity. Inheritance planning can now be done more elegantly, while your trust assets are protected against possible claims from creditors. This may come in handy in case of (heaven forbid) bankruptcy. The trust itself can be established in any country you desire. Usually this is done in a country where taxes are low or where the taxman is understanding (i.e. a so-called tax haven, which need not always be a safe haven). For instance, prior to its reincorporation into the Republic of South Africa, the Ciskei was such a tax haven, which advertised itself as the ideal place to “checkmate the taxman in one beautiful move”. The tax advantages offered by the Ciskei qualified it for immediate inclusion in the tax haven blacklist of the industrialised countries. In contrast, the South African tax authorities at the time were rather relaxed about playing chess with their counterparts in the Ciskei. Politics often dominate tax morality, a point which entrepreneurs should never lose sight of. Obviously not all tax havens are as notorious as the Ciskei. For example, Switzerland, one of the oldest safe havens in the world, is highly respected, while the Vatican City has even obtained divine approval. Safe havens come in many forms and disguises and offer a wide range of services. There are many possibilities here, and the relative attractiveness of various safe havens is mainly dependent on personal needs. So, although Switzerland is still a much preferred safe haven for the global rich (rendering about a third of all (non-domestic) private banking services in the world), the Swiss themselves prefer Liechtenstein as their tax haven. Depending on the degree of your offshore involvement you may either need an offshore discretionary trust (which is sufficient for your global fund management and inheritance planning) or an offshore company (which may engage in a wide range of activities such as investment portfolio management, trading, property holding, ownership of yachts, ships and mineral rights, captive insurance, and running offshore holding companies). The choice of jurisdiction for your offshore trust, or the country of incorporation for your offshore company, is totally dependent on your personal needs and no generalisation is possible in this context1. Because of their complexities offshore trusts do not come cheaply. The trustee and management fees of an offshore trust today amount to anything between $5 000 and $10 000 per annum, depending on the level of activity and institution used2. So your trust assets have to amount to at least $500 000 to make it worth your while. For those who have slightly less and who are already accustomed to being treated like a number in daily life, the numbered accounts of Swiss banks may present a cheaper option. Such accounts are also helpful in maintaining privacy, but are not as flexible as a trust. Ultimately a high cost is attached to the benefits of a low tax regime. The establishment, administration and taxation of a trust are legal matters, which at times may become extremely complex. It is exactly the sheer complexity of taxation that opens the opportunities to pay less tax. Accordingly, only a broad overview can be presented here, and you are well-advised to consider appropriate professional advice before making any final decisions. In this regard it may be noted that the Swiss banks are experts in imparting such advice. 9.1 Local trusts A discretionary trust is a legal entity that enables you to set aside part of your estate to be managed by trustees for the benefit of the beneficiaries of your choice. The beneficiaries may include yourself (“the settlor”), your family or charities. The powers of the trustees in dealing with the trust assets are defined in the trust deed and these may be as limited or as encompassing as preferred by the settlor (i.e. the individual transferring the assets to the trust). The trust relieves the individual of title to the assets as the trustees assume independent legal ownership. If required, certain important powers (e.g. the power to make a capital payment from the trust fund to a beneficiary) may be exercised only with the prior written consent of the settlor or of a person nominated by the settlor (“the protector”).
1 2

An excellent overview is given by Doggart, C., Tax havens and their uses, London: The Economist Intelligence Unit, 2002. Firms of attorneys are probably the cheapest, while the Swiss global banks are reputed to be the most expensive.

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As the trust is a separate legal entity, it continues after the death of the settlor and is therefore ideally suited to handle complex wills. A main feature of a trust is that it enables assets of many kinds to be accommodated effectively – the assets having been selected by a person who, for a variety of reasons, would prefer not to hold them himself. A trust (usually either a family or a charity trust) has a number of advantages such as: ! Continuity. Your death will not affect the assets in the trust, as the trustees manage these assets in terms of your letter of wishes. Your business partners or other interested parties will welcome the continuity of a business concern should you die unexpectedly. ! Protection against creditors. As the assets in the trust are no longer your assets (they now belong to the trustees), no creditor can claim these assets in the case of your bankruptcy. ! Tax efficiency. As assets allocated to the trust do not have to be transferred after your death, they are not subject to estate duty. Moreover, any distributions of the trust to individuals may be taxed at the (lower) incomes of the beneficiaries and thus at their (lower) individual rates. ! Simplified estate and succession planning. In terms of the so-called power of distribution, the trustees can manage the inheritances of minors or provide for the needs of the surviving spouse (all in terms of the letter of wishes). ! Fund management. The trust can take over all your discretionary investments. In addition, the trustees may give you (the settlor) power of attorney so that you can still manage these assets directly, without the trustees’ involvement. Although a trust seems ideal for people who are financially well-off, it obviously entails some costs. Running expenses amount to about 1% p.a. of the capital value of the trust. 9.2 Offshore trusts Ultimately, taxpayers vote with their feet, and exchange control regulations are seen by them as no more than a bureaucratic hurdle. In the South African legal context offshore trusts are particularly interesting for those residents who have multiple nationalities and tax domiciles or who stay abroad uninterruptedly for longer than 183 days a year (the so-called “taxpats”). Governments in developing countries often argue that exchange control is required to lower the domestic rate of interest, more specifically the interest costs on public debt, while entrepreneurs in these countries are increasingly attacking exchange control by claiming that a state has no moral right to limit the free movement of capital. The jury is still out on this issue, but the moral argument seems to have been settled out of court by improved technology, which makes the enforceability of exchange control virtually impossible. And any law that cannot be enforced is a bad law. Accordingly, the days of exchange control seem to be numbered. Offshore trusts hold even greater advantages than local trusts in that they can address the following aspects as well: ! International tax efficiency. Offshore trusts are, as a rule, located in tax havens (Isle of Man, Channel Islands, Liechtenstein, Bermuda, etc.). An offshore trust may assist individuals in their tax planning if their unit trusts, yachts or aircraft are held abroad. ! Fiscal and political risk management. An offshore trust can deal more effectively with confiscatory government policies (e.g. a marginal tax rate of 98% on investment income, as prevailed in the UK in the seventies) than a local trust by investing the trust assets abroad. ! International fund management. An offshore trust can look after your global investments without any difficulty. Furthermore, offshore fund managers have greater freedom to invest in what they consider attractive, as they are not subject to the prudential requirements of local governments (which often classify their own debt as a prescribed investment). The success of an offshore financial centre ultimately rests on six criteria3: ! Reliability. There should be social and political stability, proper business conduct, and well-capitalised financial institutions. ! Efficiency. Financial institutions should be backed by the most modern means of information technology. Staff should be technically competent, and available in sufficient numbers. ! Legal security. The laws of a country should protect individual freedom and property. Local and foreign citizens should be equal before the law. The courts and law firms should be competent. ! Privacy. Bank secrecy should be legally enforced on all bank staff, and there should be no requirement to register the trust in the offshore centre itself. Moreover, unauthorised bodies (such as foreign governments) should be barred from investigating an individual’s financial circumstances.
3

Banks of Switzerland, Switzerland – Excellence in Banking, Basle, 1992 and Doggart, op. cit.

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Professionalism. Financial institutions should exhibit professionalism in their daily (global) activities. Staff training should be of the highest quality to ensure the best advice to clients. ! Accessibility. An offshore financial centre should be physically and legally accessible. On this score the Maldive Islands are too remote and the Vatican City is too exclusive (reserved for the pope and papal staff only). According to the above criteria offshore financial centres such as the Channel Islands score very high, while you are bound to raise an eyebrow when evaluating, for instance, Costa Rica or the Seychelles. Between these extremes there are many shades of grey. In making your final choice you will have to depend largely on your trust advisers. According to volumes, many people have elected Switzerland as their offshore centre, usually with the jurisdiction of the trust either in the Channel Islands, the Isle of Man or Liechtenstein. The choice of jurisdiction depends mainly on your specific needs and whether you want to be subjected to common law (i.e. the British concept) or civil law (as reflected in the Stiftung and Anstalt structures in Liechtenstein). In all these safe havens there usually is complete freedom to choose a trust’s beneficiaries. Offshore centres are in keen competition with one another, each claiming specific advantages: e.g. the Channel Islands consider themselves among the best safe havens for the ordinary rich; Liechtenstein, with its Stiftung (“foundation”) structure, is particularly suited to deal with inheritance needs, while its Anstalt (“establishment”) structure is very flexible for corporate tax planning; Monaco claims its elegance as an advantage; Svalbard Island touts its nice and icy approach to tax matters; the Netherlands Antilles see as their strong point their extensive doubletaxation treaty network (operating via the Netherlands – which is indeed very attractive for multinationals); while Switzerland emphasises its size and long-term status in this market. It should be noted though that the large industrial countries themselves are also tax havens to some extent. For instance, in the UK the so-called “non-domiciled resident” is only taxed on his foreign income remitted to the UK. In terms of the amount of offshore foreign wealth managed, the size of the various countries is today as follows4: Switzerland 35%, UK 15%, US 12%, Caribbean Islands 10%, Channel Islands and Luxembourg 6% each, Hong Kong 5%, and the rest 11%. So fiscal competition as a tool of economic development is attractive to many countries, even the US and UK! 9.3 Avoiding the blacklisted spots If the taxmen of the world were as united as the workers, many offshore financial centres would face ruin. But unity among taxmen seems difficult to achieve, because government action is anchored in political ideology. At the heart of the matter lies the value put on individual freedom. Many liberal states are of the opinion that: (i) the individual should always remain the major shareholder in his own endeavours5 (i.e. the effective marginal tax rate should not exceed 49%); (ii) a capital-gains tax is fundamentally unfair6; (iii) private property and individual freedom can be truly effective only if an individual’s financial circumstances are shielded from the gaze and intrusion of unauthorised bodies; and (iv) “refugees” from non-liberal states should be offered sympathy, help and a safe haven for their capital. As long as there are major differences of opinion among national states on how to address these “human rights”, business in offshore centres will boom. Increasingly, national states have become aware that, if they do not harmonise their tax rulings with international (liberal) standards, their air may soon become thick with the flapping wings of flying capital. Moreover, there is a fine balance between a taxpayer’s morality and the appetite of the taxman. Great and long-term harm can be done to a country’s tax morality if the appetite of the taxman becomes insatiable. The moment tax cheating becomes both endemic and respectable – a near hopeless combination, as found in Italy today – the government faces major fiscal problems. Moreover, to avoid a tax revolt government should have its own interests at heart by keeping tax burdens bearable7. To keep off the blacklist of the industrialised countries it is in the best interests of offshore centres to avoid becoming involved in the laundering of “dirty” money made from drug trafficking, insider trading and other organised crime. Moreover, those with “clean” capital8 are becoming increasingly sensitive to the company they may have to
4 5 6

!

Doggart, Op.cit., pp. 4-5. Confiscatory taxes imposed by 51% of the electorate on the other 49% may be legal, but still illegitimate if the consent of the people to be taxed is not obtained. A capital-gains tax violates the basic fairness principle of income tax – i.e. two similar individuals with the same income should pay the same tax – because the primary sources of capital gains are inflation and retained earnings. Nominal income gains should be adjusted for inflation, while retained earnings have already been taxed at company level. Anyhow, to many taxpayers, morality seems out of place in a matter that concerns only what is rendered to profligate Caesar. See Doggart, Op. cit., p. 7. I.e. non-criminal tax evaders and capital hoarders.

7 8

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keep in their chosen offshore centres. The last thing these people would like to experience is being caught in the crossfire between the authorities and organised crime. Accordingly, Swiss law grants no protection to money made by criminal means (note: tax evasion is not a crime in Switzerland, it is an administrative offence only). In summary, little has changed since the 13th century, when wealthy monks entering the Franciscan Order, harmonised the order’s vows of poverty with their vast personal fortunes by transferring their assets into a trust, where it was owned by a few chosen trustees and thus kept firmly within their control.

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CHAPTER 10

THE REALM OF REGINA PECUNIA

Virtually all dog fights are caused by disagreements over status, i.e. questions about rank. The rich are very much like man’s best friend in this respect. And not surprisingly scent marking now becomes a crucial occupation for the retired “celebrity CEO”. Once your wealth has ensured your financial independence, its main function becomes securing an appropriate ranking among your circle of friends and acquaintances. The target is now no longer wealth as such, but obtaining social capital. At times this may be even more difficult to acquire than material wealth. When you have struck it rich in life, one major problem is how to move your expenditure mix in line with that of the income class you have joined. You cannot make too many mistakes or you risk becoming the laughing stock of your friends1. Indeed, few things concerning man are more significant than the way in which he chooses to spend his money. This chapter looks more specifically into the problems that come with major changes in your income. In essence, the topic is essentially of a social nature, as it deals with the interaction of money, power and prestige. 10.1 Old versus new money Old and new money should not be confused with snobs and Sloanes. Snobs have the pretensions but no money. These pretensions increase – almost as a law of human nature – in inverse proportion to actual achievement. Indeed snobs are never famous: they are far too busy keeping up to the mark ever to make a mark2. In contrast, the old and new rich are wealthy and famous, the difference lying only in the holding period of their fortune. The social gap between old and new money often seems virtually unbridgeable. Old money is always based on inherited wealth and associated with a distinct lifestyle from birth (and therefore imprinted). As such it forms the backbone of the social class in any country. Old money – in contrast to new money – does not need to change its expenditure mix during its lifetime, as it had already arrived in the land of Queen Money some generations ago. But its existence is often ravaged by what is called the “dreaded three D’s”: death, which results in major tax payments such as estate duties; divorce, which may cost you half your fortune; and debt, on which interest has to be paid. Old money is in a continuous battle against decay, because it usually lacks the skills to make a new fortune for itself. The old rich have to preserve all they have at all costs. The faithful attendants of Queen Money – viz, Deceit, Usury and Theft3 – may even have to be called in to make their lives more bearable. In a sense the old classical ideals are still very much alive among old money, namely that, following financial independence, you should distinguish yourself in the cultural, philosophical and political spheres (see Chapter 4), and that work should be regarded merely as an occupation and not as a profession. Unfortunately the “three D’s” make this philosophical outlook increasingly difficult to apply in practice, and accordingly cultural pursuits have become – mostly against the likings of old money – much more déclassé and commercial in modern times. The lifestyle of new money is not easy either. Although new money often has entrepreneurial spirit, flair, selfesteem, optimism, a love of risk-taking and the like, the new rich have to adapt their needs continuously as they grow richer. The tastes of a person usually vary with his level of income, and the larger the change in income, the greater the need for the consumption mix to change4. To determine the new optimum expenditure mix can be costly, particularly in terms of time – the most expensive item for any entrepreneur. For instance, new consumption items have to be tried and tested. Interpersonal comparisons will have to be made, and often plain imitation is the only way out. Without fellow-travellers social elevation may become a very lonely experience indeed. Shock, bewilderment and even envy are possible negative outcomes.

1

According to expert opinion, irrespective of sex, age, race, nationality or rank, Midas’ ears are always evident from under the headdress. See Erasmus, D., Moriae Encomium, 1508. Barr, A. and P. York, The official Sloane Ranger diary, London: Ebury Press, 1983, p. 1. Schama, S., The embarrassment of riches, London: Collins, 1987, pp. 327–328. Triantis, S.G., “Changes in income, behaviour and tastes”, South African Journal of Economics, 63, 3, 1995, pp. 459–472.

2 3 4

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New money acquired its slightly derogatory epithets (e.g. parvenu and nouveau riche) from an often unbalanced consumption mix as well as the envy of old money. The old rich, growing up in wealth, have tasted many more of the fruits of life before they reached maturity than the new rich. To catch up quickly later in life is no easy task for new money. Moreover, to save time, the new rich – in contrast to old money – can afford to make a few small and quick mistakes in their expenditure pattern or to taste only superficially. The danger then is always that the new expenditure patterns will be somewhat unbalanced for the experienced eye (e.g. extraordinary jewellery, exaggerated novelty or variety, and even the bizarre in unthinkable guises). In short, the new rich are often harassed consumers with little time for leisure. They usually work too much and are continuously running out of time, while the old rich have all the time in the world, but no meaningful occupation. 10.2 The burden of a rich man With wealth come a few specific problems that the less wealthy often oversee. The biggest problem is usually the impact of wealth on their children and grandchildren. In essence the underlying issue is here that your children inherit only half your genes and that they grow-up in a palace with servants all around, while you would like to see them streetwise. Of course endless problems may ensue as a result. For instance how do you: ! Motivate your children, especially in work ethics, when they know that all job effort is essentially artificial? “Normal” staff treatment of the corporate “crown prince” is of course impossible. ! Ensure that your children are given a fair chance to do their own thing? Be fair. Small oaks grow with great difficulty under the branches of a massive parent tree. The pressure on children may become virtually unbearable if they are expected to match the achievement of the creators of wealth. Often in such cases you could quickly be dealing with mentally crippled offspring. ! Ensure that your children are not being spoilt rotten? To avoid this is all far easier said than done. Formal education may be a nightmare. Boredom and idleness may also become particularly big problems. Drug addiction may be lurking around the corner, as they try to master the art of intoxication. ! Avoid that your offspring start killing each other for your inheritance? This type of in-fighting may well occur while you are still alive. ! Prevent your son from marrying a gold-digger? The children often see only romance and innocence. Any mistakes here can cost a fortune. Interference is difficult and delicate. In the end you fear the Chinese observation: “Wealth does not last for more than three generations!” Apart from the children there are a few other problems that come specifically with money, such as: ! Security. To protect your family against armed robbery and kidnapping requires careful thinking and a vastly different lifestyle. Like a little bird you may prefer your “golden cage” above the open sky, because you are too afraid of the birds of prey. Of course kidnap insurance is now a must, like living in a “gated ghetto community”. And soon the isolation makes contact with the rest of society much more difficult and often plain impossible. ! The relationship with money. The rich often develop a complex psycho-relationship with their wealth. For instance, if you define “rich” as more than what you have, there will always be chronic discontent irrespective of the size of your bank balance. Or alternatively, where do you draw the line between greed and wealth? Perhaps you have to look for a couch, not a coach, in these circumstances. ! Idleness, boredom and exclusion. Like the famous dog that caught the bus, what are you supposed to do thereafter? Unless you have strong outside interests, many self-made millionaires find it nearly impossible to relax. They become bored, and are soon a bore to others as well. Loneliness is the burden to carry thereafter. ! Loss of privacy. With success comes celebrity status. The price for this status is being targeted relentlessly by the press, crooks and lunatics. Ultimately you may start to hate all the social pleasantries that usually come with always being in the public spotlight. ! Loss of friendship. How do you distinguish between the courtier and a friend if you are the top dog? For Michel de Montaigne5 the greatest disadvantage of high rank was the lack of true friends. 10.3 Social capital Even for the rich the law of diminishing returns comes into play pretty quickly after reaching a certain level of income. After you have obtained financial security, money as such becomes secondary, maybe tertiary, in importance. Indeed, the seriously rich see little incremental benefit in incremental capital. What now counts in life are the things that
5

Montaigne, M. de, The Complete Essays, London: Penguin, 1987, p.1041.

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cannot be bought or stolen. Social capital, for instance, is not really for sale, but has to be earned over the years – many years in fact. This highly valued asset will come within your reach if you can display, besides wealth, inter alia, the following attributes: ! Friendship. This often misused concept requires a little more than just camaraderie and enjoyment. For instance, unless you are willing to make enemies, you cannot enjoy the pleasures of friendship. The desire of giving rather than taking (besides the classic virtues such as honesty, generosity, loyalty, and courage) is perhaps the most fundamental characteristic of friendship. In this context, you should not give, like Croesus6, from your surplus pile. Instead try to force yourself to give from what you really like yourself and have in short supply. For Aristotle at least: “No one would choose to live if he lacked friends, though he possessed all other goods”. And indeed what would Heracles, despite all his prowess, have been without his friend Theseus and vice versa? ! Love. It is often defined as friendship with wings! Odysseus summed it up nicely in his darkest hour beneath the walls of Troy: “One more time, Athena, love me as much as you can”. Indeed with Pallas at your side, few things can really go wrong. Good spouses, those that can scuttle up the social ladder with you, are worth their weight in gold and more. ! Intelligence and wit. You are born with this. You prefer an elegant, not a copious feast7; more wit than waste! ! Taste. A true feeling for art and culture cannot be learnt8. Without this it is extremely difficult to enjoy the best fruits of life. And remember: shared pleasures are double the fun! ! Skills. Production skills are now no longer required, but what about your consumption skills? The classics already considered those who could “neither swim nor read” beyond repair, but of course in your circle of friends a bit more is required. What are your skills in languages, music, gardening, riding, sailing, fencing, and culture in general? Ordering your caddy around elegantly is no doubt difficult, but it may be even more challenging to master the “half halt” in riding or to steer your yacht with full sails into a gale. All of the above attributes are difficult to master and extremely expensive in terms of time. Your friends and loved ones need your time more than your money. Skills and knowledge absorb massive amounts of time, and taste is cultivated only over time. But, if you have money and the abovementioned attributes, you will notice that there always is room at the top. Like Heracles, after having seen the world, the entrepreneur has completed many energy-sapping labours before he arrived. Like Heracles he looks rather tired towards the end of his journey. But was there a future labour waiting for Heracles after he had been elevated to the ranks of the immortals? How much time and effort would be required to adjust his consumption mix to that of the gods? “Ambrosia and nectar only please!”

6 7

At the end of his life Croesus could offer only his chains out of true generosity to his beloved Delphi. “You should be less concerned with what you eat, than with whom you eat” (Seneca). Wit at the table is highly valued. Accordingly Chilo’s refusal to promise to come to a banquet at Periander’s before finding out who the other guests were. See De Montaigne. Op.cit., p.1252. Indeed, it does not really matter how long you train a donkey – it will never become a horse.

8

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CHAPTER 11

RULING FROM YOUR BOARDROOM IN THE SKY

Your final years should herald a particularly happy period of your life. You can slacken the sails, gather the ropes1, and head for the harbour. But a few minor tasks still have to be performed. For a start you have to hand over all your earthly possessions, as nothing can be taken along on your last trip. Besides the pleasure of giving – including a few poisoned gifts to show your true talents as a respected entrepreneur2 – there is the enjoyment of planning how to influence events on earth long after you have departed. This requires careful consideration, and should be done long before you hear the rivers bubbling underground. Indeed, ruling – in this sense – constitutes looking forward. 11.1 The legacy hunters As you approach the harbour, you will notice a rather unusual concentration of crows and ravens in the air. With luck you may even spot the rare Cape vulture. These lovely scavengers are scouting for their carrion. And their feeding frenzy is approaching. To get hold of your legacy the captaturi, or those about to grab, will either promise you anything under the sun or threaten you with hell. Inspired by the motto “to make money you have to spend money” they may offer valuable presents. In ancient times fat quails were a delicacy reserved virtually exclusively for the aged without children, but with money. Modern technology has made it possible that they can even offer you – what Juvenal could only speculate about – the ultimate sacrifice, namely an elephant, with tusks, on your chosen altar3. As long as you recognise the true nature of these birds, profits of a different feather can still be made. Legacy hunting is a favourite pastime of any rentier and should be accepted as such. It is a game in which the hunted and the hunter swap roles continuously. Like Volpone4 you could turn the tables on your new friends by accepting all their presents and best wishes and then returning their kindness by solemnly emphasising your bad health and promising them pride of place as the inheritors of all your earthly goods. Those friends of yours who promise you a nice spot in hell, unless you pay up, are often more difficult to please. Rationality and fear do not sit comfortably together at the same table. Remember, though, that in the northern celestial sphere, where Wotan’s will rules, the “Lord of the Ravens” also used fear to protect what was closest to his heart5. Are the Elysian Fields open to those who are fearless or to those who have done no wrong? If you think that there is little purpose in agonising over the few things you did morally wrong in life, and that these are currently all water under the bridge, you are grossly mistaken according to the pardoners. By their lights, all mishaps have to be cleared before departure. Indulgences have to be bought en masse, and the more property given into the Dreaded Dead Hand, the smoother your passage to paradise. But fear of hell, so profitable for the Princes of the Church, is a bad motivation for action. An alternative route is quite possible in this context. Machiavelli, for instance, figured out, after years of studying all the known maps to Elysium and paradise, that hell was located within paradise. In fact, he discovered it to be the special retreat, or the garden on God’s right hand, where the fair and goodly company gathered. Strangers to this part of the garden were kept at bay by fear. Niccolò had a vision just before he died6: “... he sees a long file of people, ragged, sick, weary. Asking who they are, he is told that they are the blessed of paradise whom one reads about in scripture: ‘Blessed are the poor for theirs is the kingdom of heaven.’ As they fade from sight he sees gathering a group of impressive persons in courtly attire, walking and gravely discussing matters of state. Among them he recognises Plato, Plutarch, Livy, Tacitus, and other famous men of antiquity. These, he is told, are the damned of hell, because it is written: ‘The wisdom of this world is the enemy of God.’ As they stroll off, Niccolò hears himself
1 2 3 4 5 6

Alighieri, Dante, The divine comedy, Inferno, 1321, XXVII, 81. Since ancient times the poisoned gift has played a major role in strategy: “Beware of Greeks bearing gifts” (e.g. the Trojan Horse). Juvenal, Satires, XII. Jonson, B., Volpone, 1606. For further details see Wagner, R., Der Ring des Nibelungen, Siegfried, 1876, Act III, Scene 2. Grazia, S. de, Op. cit., p. 341

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being asked: ‘With whom would you rather go?’ ‘Me?’ he said, ‘I am not tagging along with those ragbags to go to paradise. I am staying with that other company, to talk about the state and go to hell.’” Fear seems to ensure the select membership of hell: “The place jokingly called hell by those who know it is a corner of paradise, a garden for God’s elect, well presided over not by a fallen angel but by Pluto the Rich One, the brother of Zeus and Poseidon, the Giver of Wealth, possessor of a beautiful wife – ‘woman beautiful above any woman in the world’ – traveller to earth and back, and benign spirit of an academy, a garden of delights, a place for the society and conversation of liberal spirits”.7 But before your final departure at least two other issues will have to be settled: your succession planning and your largesse. 11.2 Succession planning The assets you have accumulated over so many years will have to go on without you. In fact, one generation is too short for building a really great commercial empire. Like the builders of the great Gothic cathedrals, you have to plan well beyond your own lifetime. In doing so your discretionary trust (or Stiftung if you preferred civil law to common law procedures) will now come in very handy. In your letter of wishes you can dictate under what conditions your trustees could make your money available. For instance, minors or your spouse can obtain a specified stipend. Should your children marry, no wealth should overflow to the bride (a last line of defence against gold-diggers8). Certain grants can be made over and above the yearly emoluments, for instance if an exam is passed. All these niceties can be thought through carefully while you coolly await the arrival of death. Likewise at corporate level you have to ensure that able people take over the rudder, as a fool and his money are easily parted. Usually it is impossible to think about any worthy replacement for yourself and therefore it is best to grant maximum freedom to the board of directors in choosing the executive management of the day. To preserve certain key positions in advance for your family members usually does not work because, as already noted, only half your genes land up in your children. 11.3 Largesse Philanthropy is a luxury, of course, and should not be engaged in too early in life. But in your will you can be generous. In time to come this may even increase the esteem in which you are held. For example, Alfred Nobel showed a fine sense of humour when the money he made from dynamite for the war machine was used to fund his “peace” prizes, and Paul Getty created a foundation to fund one of the best art collections in the USA, modestly located in – no surprise here – the Paul Getty Museum. If you have serious money, there is a lot you can do with your largesse: you can even give to the less fortunate in life, to the environment, to culture or the arts. Usually it is not such a good idea to offer the city of your birth a statue of yourself. Over time such effigies have too often been used as public latrines – or worse9. Rather look for your ideal rainforest – you may even do so at the cost of the proposed charity. It should be noted, though, that largesse or charity as such has little impact at the macro-level. For instance, if you are really motivated to stop the suffering inflicted on animals or to improve the life of the blind and crippled, it is better to support a political pressure group with your money. The wrongs need to be corrected at the political level, through improved legislation, rather than pampered at the micro-level. A charitable foundation has the further advantage of being a good training school, particularly for your children if they are still relatively young and inexperienced. Rather than letting them loose in your family business, you can put them in command of such a charitable foundation. In this way they will learn hands-on money management, hiring and firing techniques, how to be amicable with a board of trustees and how to stop quarrelling among themselves. Only when they have successfully negotiated this hurdle, should the gates to your family business be thrown open to them. To handle wealth does not come easy for those who grew up with it. Experience has taught that the greater part of an estate is frittered away by the inheritors10. Often the largest portion of the inheritance goes to the lawyers as the children fight for their respective shares. Another big chunk disappears when the family business is mismanaged by the second and third generations. Tax also takes its ample slice of the cake. This type of damage could have been avoided entirely had you given some timeous thought to ruling from your boardroom in the sky.
7 8 9 10

Ibid., p. 385. Eros seduces the intellect, even of those of sound mind. Juvenal, Satires, I. Horace already observed: “A worthier heir shall consume your Caecuban / preserved with a hundred keys and drench / the pavement with a fine wine / too good for priestly banquets”. See Horace, The complete odes and epodes, London: Penguin, 1983, p. 119.

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CHAPTER 12

REFLECTIONS ON WEALTH AND HAPPINESS

Even with piles of money, the pursuit of happiness remains problematic. Old age can be cruel (e.g. no taste, no teeth, no sight, and/or no memory1). You may suddenly notice that you are left with more rations than road2, and that Epicurus was right: “being rich does not alleviate your worries, it simply changes them”. Therefore in the winter of your life you might find it difficult to hunt down this elusive prey. Happiness so easily slips through your fingers the moment you think you have it firmly in hand, e.g. bad health, increased loneliness and boredom, or even a totally unexpected financial calamity. This closing chapter will sketch a few issues concerning the relationship between wealth and happiness. Broadly speaking, happiness consists of various layers or building blocks3. Firstly, there are the basic bodily needs for food, clothing, and shelter. These are largely material requirements, which any entrepreneur can easily fulfil. Nonetheless, money cannot always buy what is most required. The moment your body resembles a bag of bones,4 you should know that you have passed your due date and that money has lost its glitter completely. Secondly, the mind needs ongoing occupation. Despite being well-off and therefore having no need to work at all, you still need to invest in intellectual pursuits to ensure dividends, i.e. mental satisfaction, later in life. Thirdly, your soul also needs ongoing attention. It is no good to be alone in a grand villa and not being able to share these pleasures with friends and loved ones (note again: shared pleasure is double pleasure, while grief is halved by sharing). Lastly you have to appreciate that material wellbeing, work satisfaction and the pleasures of the soul all have their implicit opportunity costs. Accordingly, contentment, this highest stage of richness, is obtainable only by ensuring a balance between the various conflicting demands of the body, mind and soul. Happiness is foremost a striving for the golden mean – i.e. not too much, but also not too little. For the classics, Beauty was simply moderation and proportion5. Therefore not too much material wellbeing (learn e.g. from King Midas), not too much intellectual pursuit (lessons from e.g. Dr Faust), and not too much lust and love (study e.g. Ovid). Since all these components of happiness are interdependent, too much success on one score inherently comes at the expense of another. Ultimately the opportunity cost of all human striving is expressed in the loss of time and freedom. For example, the striving for more material wellbeing implicitly occurs at the cost of your striving for intellectual satisfaction and the pleasures of the soul, as there are only 24 hours in a day. Traditionally, philosophers had their doubts about the quality of man’s character and therefore his chance in becoming content. According to Homer (Iliad) “Zeus found nothing so miserable on earth as man”, while Schopenhauer noted in one of his more friendly moods: “Man is at bottom a savage, horrible beast”. He felt man needed to be tamed and restrained by civilisation, for in “the boundless egotism of our nature there is joined more or less in every human breast a fund of hatred, anger, envy, rancour, and malice, accumulated like the venom in a serpent’s tooth, and waiting only for an opportunity of venting itself and then, like a demon unchained, of storming and raging”. For such characters, evidently the vast majority of mankind, contentment remains terra incognita. For people such as Schopenhauer, who feel surrounded by all those who can “neither read nor swim”, the only choice is between loneliness and vulgarity. And not surprisingly he concludes: “Almost all of our sorrows spring from our relationships with other people”. 12.1 Wellbeing Of course you can easily finance six square meals a day, but health requirements have to be respected as well. Anyhow, to enjoy your meal you have to be a bit hungry. Discomfort precedes enjoyment as a rule.
1 2 3 4 5

Even more painfully, you cannot forget things you want to forget. See Montaigne, M. de, Op.cit. p.551. “The youth should make provisions; Old Age should enjoy them” (Seneca). Falkena, H.B., Banking on Happiness, London: Athena Press, 2002. Remember, you are not dying because you are ill: you are dying because you are alive. “The power of the Graces is not to be underestimated (“a privilege of Nature” according to Plato), as they hold the highest rank in human intercourse: carrying off your finest judgments and biases with their great authority and their wondrous impact”. See Michel de Montaigne, Op.cit., p. 1199

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As age progresses you have to eat more like a pauper than a prince, while tiresome bodily exercise also becomes crucial. Often your pets become the best fitness trainers and companions. For example, Odin would not easily travel without his favourite horse, wolves and ravens. So why should you? Your canine friends generally release stress and give you prolonged friendship, provided of course that you reciprocate their kindness. All this involves time and only a little money. For the ancient Greeks, good health was the prerequisite for all other kinds of good fortune6. Simonides has noted: “To be healthy is the best of all things for mortals, the second best is a noble character, the third is wealth obtained without dishonour, the fourth to spend one’s youth with dear friends”. Although ancient philosophers argued about some sequences, for instance, whether wealth should supersede a noble character, they all agreed that health was number one. Money can buy only a certain amount of wellbeing (e.g. food, clothing, and housing). Indeed, you can sleep only in one bed at the time. Tibor Scitovsky famously referred in this context to the trade-offs between novelty, comfort and pleasure7. Newness initially has an enjoyable positive stimulus, but too much novelty soon becomes painful. Likewise, a bit of comfort may be pleasant; too much comfort quickly results in loneliness, fatigue and boredom. Novelties can be purchased, but not their ongoing positive stimuli. For example, take the purchase of a motor car versus a riding horse. The first week in your new motor car may indeed give you some enjoyment of novelty. However, this novelty wears of quickly, as it is used up (like food) in the act of its enjoyment. Soon the motor car is just another asset and a bore, unless of course it is treated as a status good, in which case you have become dependent on the opinion of others for your own happiness. All these “positional” goods (i.e. those goods and positions that are limited in supply and that you can enjoy only if others cannot) depend on vanity, which in turn is the born enemy of happiness. Vanity depends on jealousy and is accordingly dependent on others: it is therefore ultimately self-defeating. Status anxiety always results if people become uncertain about their proper place in society. In contrast to motoring, horse-riding is skilled consumption and has been regarded throughout the millennia as both a science and an art. Accordingly, the novelty of your new horse will not quickly wear off. Even with a 4x4 vehicle in the field, the weekend in the country cannot be properly enjoyed, unless you are able to lead or follow your friends in the chase. However, the benefits of riding cannot be reaped, unless you have made the appropriate investments. Proper riding requires many years of intensive training and discomfort. But then enjoyment and struggle form a natural combination bringing unexpected benefits: you may even develop a close friendship with your new horse (plenty of examples here: e.g. Caligula made his horse Incitatius a leading senator of the Roman Empire, Hadrian honoured his charger Borysthenes in verse, while Napoleon adored his stallion Marengo). It is in the nature of the golden mean that the most pleasant experience borders on the unpleasant and that there is even usefulness in a useless activity. The basic problem with comfort is that it requires no skill and therefore quickly becomes boring. For those without proper consumption skills the danger of boredom and fatigue is always lurking. For instance, money can buy you the best suite in the most expensive hotel, but it is often a lonely affair, with too many trimmings that you do not require. If you really had the choice, you would perhaps rather choose to spend the night with your lover in a haystack. Moreover, a high level of comfort and luxury usually goes hand in hand with more formality and etiquette. These “mini-morals” are of course an absolute necessity in polite society, but etiquette tends to create distance and therefore loneliness (note Louis XIV ruled France with etiquette)8. Like novelty, comfort has only a limited initial positive stimulus for happiness, and soon becomes negative – particularly if you get overburdened with it. This is also the reason for experienced travellers, regardless of how rich they are, preferring to travel light. Usually your possessions quickly become a bore, but more worrying is that all these assets absorb far too much of your precious time. Before you know it you are packed like a donkey. Clearly, the striving for great wealth requires a corresponding lifestyle, namely that of a slave. But where do you ultimately draw the line between greed and wealth? This again is a question of character rather than money. According to Cicero all you need is a garden and a library. But there are other views as well. Mrs Gucci, ever so loyal to her class, rather preferred to be unhappy in her Rolls Royce than happy on a bicycle. In nature the wellbeing of an elephant requires some 18 hours of continuous grazing a day, while a falcon is fully
6 7 8

Burckhardt, J., The Greeks and Greek Civilization, London: Fontana Press, 1998, p.83. Scitovsky, T. “The joyless economy: An inquiry into human satisfaction and consumer dissatisfaction”, London: Oxford University Press, 1976. For instance, Marquise de Merteuil was of the opinion: “The more I see of the world, the stricter my principles become”. See Laclos, C. de, Les Liaisons Dangereuses, London: Penguin, 1961, p.77.

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fed after only an hour of hunting. Similarly, some people prefer to go through life like an elephant – always chewing; others prefer the lifestyle of a falcon – always watching. For ascetics simplicity is the most pleasant way of life and they accordingly fully subscribe to the old dictum “the more the trappings, the less the freedom”. They clearly understand that those who want much, lack much. And indeed in the end no man is poor by nature’s own standards. 12.2 Satisfaction No amount of money can compensate you for a life spent on a job you hate doing. But fortunately the talents and likes of people are greatly different. Work satisfaction is in essence a dividend payment. Even leisure activities require major investments, without which they quickly equate to idleness, boredom and exclusion. Enjoyable leisure in the company of friends does not come for free. A bit more is required than citing your memoirs9 or playing skilfully your favourite percussion instrument, the money marimba – or cash register – for your guests. Scitovsky emphasised that culture was the learning of the leisure class, which they developed and needed to enhance their efficiency in enjoying leisure. No wonder it is suspect in the eyes of productive, working members of society!10 In contrast to production skills that demand specialisation, consumption efficiency requires the very opposite. Skilled consumption requires the generalist’s skills of judgement and wisdom. The enjoyment of culture is skilled consumption that presupposes learning and discomfort: i.e. ultimately you are faced with the trade-off: comfort gained, pleasure lost! The nouveaux riches (with production skills, but no consumption skills) usually aim for too much comfort; and therefore have to forgo many pleasures11. The above also explains why money cannot be used as the measure of a person’s worth. If you succeed in becoming a true friend of the Muses, however, you have made it as a very fortunate person. Indeed, if it is already clear form birth that you never have to work for a living, the importance of culture and education – and therefore time management – becomes absolutely crucial. “Plutarch predictably lays stress on the conditional and unreliable nature of all earthly possessions in order to support his doctrine of culture and education as the infallible means to attain virtue and happiness. Noble birth, he says, is a fine thing, but credit for it only due to past generations; wealth is respected, but a matter of chance and precarious too, exposed to wicked enemies and often in the hands of the basest men; fame is sublime but not immutable; beauty envied but of brief duration; health precious but uncertain; physical strength valuable but vulnerable to age and illness, and puny compared to that of bulls, elephants and lions; of all we have, only culture is immortal and godlike.” 12. Accordingly, languages13 are not studied to make a living abroad, but as keys to open doors to other cultures, while the study of sciences is seen foremost as a pleasant discovery game. But suddenly to transform a retired CEO into a Renaissance prince is impossible. Mr Bill Gates emphasised the implied costs of his commercial success when he announced his “retirement” from business: “If you go back all the way to the early days of the company, I took no vacations of any kind and I wouldn’t even read many things that didn’t have anything to do with software. I was pretty monomaniacal.”14 An obsession with commercial success clearly rules out the enjoyment of culture and a life in the shade (the classical ideal of vita umbratilis). To occupy your mind pleasantly there are a number of basic options open to you at your retirement. Firstly, you can decide not to retire fully, as you have, unfortunately, only production and no consumption skills (i.e. the opportunity cost of making all that money in the past). You reluctantly continue to run your business, but at a slower rate than you used to. A few skilful assistants may do the trick. However, this approach usually fails, as private business knows only one pace: full speed ahead! Anyhow, even if you see trade as a game with its own rules, playing this specific game has its limits in terms of honour, courtesy and of course longevity. Therefore choosing this option implies in practice that you will continue to run on your treadmill, leading to increased fatigue and probably a premature death. Secondly, you can join the Muses, which involves cultural activities such as writing, playing music, gardening,
9

Schopenhauer remarked: “According to Herodotus, Xerxes wept at the sight of his enormous army to think that, of all these men, not one would be alive in a hundred years’ time. So who cannot but weep at the sight of the thick fair catalogue to think that, of all these books, not one will be alive in ten years’ time”. Therefore keep your memoirs short! Scitovsky, Op.cit., p.228. Culture is knowledge, that part of knowledge that provides the redundancy needed to render stimulation enjoyable. Consumption skills are therefore part of culture, while production skills are not. Since only the enjoyment of stimulation is skilled consumption, while the enjoyment of comfort requires no skill, only stimulus enjoyment is a cultural activity. Ibid., p.226. Scitovsky, Op.cit., pp. 33-72. Burckhardt, Op.cit., p.85. To master the language of nature, i.e. mathematics, is likewise skilled consumption and therefore a form of culture. Financial Times, London, 17 June 2006.

10

11 12 13 14

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sailing, riding or perhaps doing some scientific research. Unless you have invested in your chosen field of expertise in a meaningful way well before retirement (again with all the huge opportunity costs in the form of forgone profits!), it is too late to do so later in life. This option is accordingly available only to a selected talented few. Thirdly, you can apply your mind to philanthropy, which is familiar territory for any CEO, as the running of a charity trust is very similar to the running of a business enterprise. Philanthropy is in essence no more than a prioritisation of capital allocation, as your fortune will be allocated, anyhow, one way or another after your death. For instance, if your heirs decide simply to leave all your wealth in a bank account (rather than donating it to charity), the bank will do the reinvesting. Nonetheless, it remains a problem what to do with your cargo, particularly now that the harbour is so quickly coming into sight. The easiest way out, and a most popular option as well, is to spend it all on salaries for the do-gooders in all their fine feathers and variations15. No doubt applying insight and imagination in charity work is a true challenge and predictably many entrepreneurs wreck their ships right here. “Harmless” philanthropy in the Machiavellian sense, involves the familiar goals of building libraries, hospitals, museums, concert halls, universities or even supporting the local fire brigade. The production skill of giving then becomes an enterprise again similar to the money-making business: i.e. annual and strategic reports, tax planning, staff issues, capital budgets, et cetera. These “harmless” philanthropists usually underwrite Andrew Carnegie’s dictum: “The man who dies rich dies disgraced”. Probably you will then regret, on your death bed, that you did not pay even more taxes or attend even more board meetings. In a way all this “do-good philanthropy” is a bit bizarre, as the supply of these public goods (equivalent to a voluntary tax payment) usually implies much political and economic wastage, which, similar to taxation without representation, is always encouraged and enjoyed by politicians. Finally, you can decide to throw yourself into politics proper, also called “imperial philanthropy”, and try to address in an “expedient” (rather than “harmless”) way the true problems of the world: overpopulation (and the resulting problems of nature’s massive exploitation by “homo rapiens”, pollution and global warming), the arrogated sovereign importance of man in nature (and therefore the farming of the natural order for humankind’s comfort and pleasure) or the sovereign rights of states in a mutually dependent world, the drug trade in all its variations, or the conflicting requirements between private and public life16 as well as between the current and future generations. A lifetime spent in private enterprise is not going to be immediately helpful in solving these problems – even if you throw lots of money at them. If experienced business leaders are helpful after all, it is mainly because the public sector is so often not up to its task – it is, virtually as a rule, under-funded, understaffed and bleeding talent17. The difference between “harmless” and “expedient” philanthropy is in essence similar to the difference between politics written with a small or capital “p”. The defining difference is “excepting the necessity of getting dirty hands in politics”18, particularly the letting of (human) blood. Most philanthropists prefer “politics” and only a few dare to select “Politics”. For instance, only hardened philanthropists will try to implement Herbert Spencer’s philosophy of “the survival of the fittest” (whether in business, society or nature at large). The survival of the fittest, i.e. social Darwinism, implies a public policy where “the fittest members are allowed to assert their fitness with the least hindrance, and where the least fit are not artificially prevented from dying out”. Imperial philanthropists therefore typically support the elimination of hindrances to inequality of access and opportunity, rather than generally supporting the less well-off19. Ultimately, all large scale philanthropy falls in the political domain. Most entrepreneurs soon notice that material support for The Truth, The Good, and The Beautiful (the famous trinity that always justified yet another war) is
15

Wolfgang Goethe, with his vast experience as a senior civil servant in Weimar, knew this only too well: FAUST: “…who are you”? MEPHISTOPHELES: “A part of that force which, always willing evil, always produces good”. The imperial philanthropist expects the opposite to be true as well. Do-gooders, like the youth generally, often lack experience, which in turn brings them all the unexpected pleasures of the wild chase: for them no need to harmonise their moral standards with the Law of Nature. For instance, deceit, violence and war are moral issues of public, not private, life. From a morality viewpoint civil war is particularly complex. An old experience though, as De Montaigne already noted: “O wretched ship of State, hauled in different directions by the waves, the wind and the man at the wheel”. See Hampshire, S. et al., “Public and private morality”, Cambridge University Press, London, 1978, pp.23-53. Imperial philanthropists often seem misanthropic, as their summum bonum is one where mankind lives in harmony with the rest of nature. For example, imperial philanthropy may aim at defusing the looming population time bomb or ensuring maximum biodiversity – this type of charity work always involves “dirty hands”. In this context China has “dirty hands” by prescribing mandatory abortion for any woman who falls pregnant with a second child without official sanction. Singapore has a child-tax, while Paul Getty, for instance, foresaw a new world where the State is forced to issue “breeding certificates” to only approved couples, i.e. eugenic breeding (see his “As I see it”, Los Angeles: The J. Paul Getty Museum, 2003, p.172.). A far more extreme population policy was followed by the citizens of Sparta who declared war on their own slaves annually to control their numbers, while the ancient Greek oligarchs targeted the masses; they swore an oath: “I will be an enemy of the people and will devise all the harm against them I can”. According to Homer (Iliad) and Euripides (Orestes) Zeus organized the Theban and Trojan Wars to relieve the earth goddess of her burden of too many people: “… to liberate the earth from the impudence of countless throngs of mortals”. For more detail see Burckhardt, Op.cit. p.88.

16 17

18 19

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inefficient in itself. Politics, the heartbeat of imperial philanthropy, requires foremost the skill and knowledge of how to ride a tiger20. According to Plato only philosophers should apply for this joy ride. 12.3 Pleasure “Pleasure is the beginning and end of living happily” noted Epicurus. No doubt then that your passions need to be satisfied. But again, much time is involved in doing so properly (e.g. for Don Giovanni it was a fulltime involvement). Ultimately desires have nothing to do with reasoning or as Pascal famously noted: “The heart has its reasons that the reason does not know”. Therefore the soul relies foremost on ethics, not the intellect, to constrain its destructive desires (i.e. all those aspirations, passions, lusts, obsessions and ecstasies). Usually the heart completely dominates the brain, and for David Hume this was preferable: “Reason ought to be a slave of passion”. Nonetheless, happiness can be only ensured by constraining your desires. Or stated mathematically: “happiness is wealth divided by desire”. Many types of pleasures come to mind. For instance, imperators have a traditional passion for land; politicians have ideological passions which so easily become destructive obsessions; while businessmen often have the more innocent passions for accumulating material possessions (often no more than toys). But ultimately all passions in nature can be reduced to the forces of spring or autumn, and therefore centre on erotic lusts and blood lusts21. Does not love conquer all? Truly new pleasures are rare and not easily created. Accordingly Xerxes’ offer of “a bag of gold for him who discovers a new pleasure” never really endangered the Persian Treasury. From a wealth management viewpoint it has to be emphasised that all pleasures come at an implicit cost. Some pleasures, such as giving, may come relatively cheap while, by contrast, the pleasures of receiving can so easily become mentally draining. It may even bankrupt you (e.g. a Greek gift or a white elephant). Table 12.1 depicts various categories of desires in both having sex and killing (as the extremes of the life cycle22). The driven force in each of those categories requires a certain character trait. Although character has always been judged to be innate Table 12.1: Desires and the circle of life and therefore a reliable Sexual lust (to start life) Blood lust (to end life) compass (captured already in Desire Desire Heraclitus’ dictum “Fate is 1 No sex 1 No hunting man’s character”), changes in 2 Procreation, without sexual pleasure 2 Culling, without pleasure style do occur over time, which 3 Procreation, with sexual pleasure 3 Hunting for the pot, with pleasure is also important in the context 4 Sports sex 4 Sports hunting of wealth management. For 5 Commercial sex 5 Commercial slaughtering instance, hunters often start in 6 Rape of the fair sex 6 Rape of nature their youth with quantity goals 7 Sadism 7 Vivisection (how much has been shot), then gradually move to quality and rarity (what has been shot), then to necessity (the culling of surplus game and the killing of poachers), and ultimately they frequently hesitate even to shoot at all. The hunt for money often has a similar pattern. Obviously Table 12.1 is a simplification, which only tries to emphasise that your character determines similar pleasures of spring and autumn. They are in essence two sides of this same coin. That spring and autumn are the most essential pleasures in nature is easily checked by asking any tiger. This gentleman23 considers summer and winter as simply extensions of respectively spring and autumn, and concentrates all his desires exclusively on sex, killing and a life in the shade.
20

“We all know what has to be done, but we do not know how to be re-elected thereafter” noted Jean-Claude Juncker, the prime minister of Luxembourg, while reflecting on his own specific tiger ride in a democracy. In contrast to professional politicians, imperial philanthropists do not need to be elected, and they spend their own money. Therefore they can operate in those sensitive areas where politicians fear to tread. Similarly, the core issues in the debate about private and public morality centre on sexual relations, the taking of life, family duties, duties of friendship, and property rights. See Stuart Hampshire, Op.cit., p.7. An old philosophical question is the psychological relationship between sexual lust and blood lust, which was stated as follows: Are predators (including man) generally more attracted by the goddess of love or the goddess of the hunt? Or alternatively stated, are predators more attracted by Artemis’ thrills of the chase, or the joys of delights offered by Aphrodite? Although a difficult call, field research seems to indicate a slight preference for the chase. But then you have to add immediately that without Aphrodite, there would be no procreation and therefore no role for the virgin goddess of the hunt. Of course, procreation is the ultimate “blood sport”, as death haunts life from its conception and succeeds without failure. Life is a process of dying at different rates. In the end the difference between procreation and death, or sex and hunting, is only the passage of time. Jim Corbett confirmed this at the end of his hunting career: “The tiger is a gentleman!”

21

22

23

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It is of course useless and self-defeating to try to harmonise the conduct of people who are driven by different psychological (and moral) values. But leaving aside for a moment the moral aspects (indeed what is a lustful delicacy for the one may be disgusting for another), costs do differ materially between these categories. Traditionally virtues (such as prudence, fortitude, and justice) were considered within everybody’s reach, while vices (such as pride, envy, anger and greed) were seen as costly, not only in monetary terms but particularly emotionally24. Note that virtues are mutually supportive, and so are vices, which contribute powerfully to both individual happiness and (business) success. 12.4 Contentment Life is a fragile bargain, where character and Lady Luck, rather than money, are the determining driving forces. As the Spanish saying goes: “Money and honour should not be kept in the same purse”. Indeed, honour and fortitude cannot easily be harmonised with commercial striving. A code of honour underlies the manners (and accordingly the morality) of society, and ultimately an “ideal way of life”25. Contentment, embodied in an ideal way of life, requires an Aristotelian balance between private and public life – for example, a balance between the moral claims of friendship and the duties of public life. This balance also entails a trade-off between virtues and vices as well as between conflicting loyalties, as loyalty always implies partiality. In essence all the classical vices refer to fears, particularly the fear of remaining unsatisfied (want): gluttony – a fear of missing out on some nice titbits; lust – a fear of lacking the full scale of sexual experiences; sloth – a fear of insufficient rest; pride – a fear of being given insufficient respect; greed – a fear of losing control in the face of the unforeseen; envy – a fear of losing out to others; and anger – fear itself. All these phobias keep you well-focused on whatever you might decide to do. In fact these fears (in moderation though) ensure your survival in business. Take, for instance, the average financial trader. If he takes a trading position in the market and consequently starts to lose money, he immediately fears even greater losses and gets annoyed or even infuriated with himself for being so stupid (anger); if later this position moves into profit, he will be unhappy because he did not take a larger position at the bottom of the market (greed), and particularly so if some other traders did exactly that (envy). In any case the secrets of his success have now to be concealed carefully (jealousy), while he is increasingly disappointed by the lack of respect shown by his colleagues – respect that had to be in line with profits made (pride). To survive on this treadmill he needs to kick the bottle and a few dolls around to regain his sanity (respectively gluttony and lust). Of course keen competition in the financial markets demands continuous use of the above power tools (i.e. the classical vices) to secure ongoing trading successes. Usually greed does not even stop here. More profits can be made for instance by fraud and tax evasion. Now two fears are being opposed: the fear of not being fully satisfied (greed), against the fear of being caught by tax inspectors. And in the long run, and after many fat profits26, yet another fear may appear: the trader may start to lose his hunger for more money, lose his edge and become, heaven forbid, a sloth. Fearing all, he now strikes out at all. In the end it all becomes a farce, but one that leaves its marks. Not surprisingly, most traders look at forty as they deserve to look (George Orwell was right here). Contrast the above life style with that of a happy fly (citing here William Blake’s The Fly, which so nicely complements his more famous poem The Tiger). “Little Fly Thy summers play, My thoughtless hand Has brush’d away Am not I A fly like thee? Or art not thou A man like me?

24

For instance the Marquis de Sade nearly bankrupted himself through his obsessive research project about sexuality, not to mention the lack of freedom he had to endure for many years while documenting his research findings in the Bastille. Hampshire, Op.cit., p.45. Remember at Trimalchio’s estate (in The Satyricon) the following three gods were specifically honoured: Fat Profit, Good Luck and Much Income.

25 26

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For I dance And drink & sing: Till some blind hand Shall brush my wing If thought is life And strength & breath: And the want Of thought is death Then am I A happy fly, If I live, Or if I die. This little fly may well dream of a mighty fly empire stocked with jolly good fellows who all believe in the classical ideals of one creed, one race and one language, but ultimately also flies yield to the philosophy that only beauty and friendship count. In short, it has all been said before: the price of (commercial) success is paid for in terms of freedom and fear. It is foremost this fear of losing out (in that never ending comedy of more money, more power and more prestige) that defines a slave’s character27. And like a fire, the more fuel you throw on, the more destructive your desires become. In essence all these slavish traits are driven by only six life principles: 1. 2. 3. 4. 5. 6. What is in it for me

Clearly business cannot operate without its (wage) slaves. Enterprises expect of their staff to put up with all their clients (“the client is king”), those same people you would normally not even want to greet in daily life. And beauty itself does not even appear on the corporate radar screen. But then the ultimate purpose of an enterprise is profit, not beauty or contentment. Contentment can be reserved only for those lucky few who know how to strike a sensible balance between fortitude (honour) and fear (money).

27

This in contrast to the free-man, defined as a person free of guilt and of fear. Traditionally the tyrant (always overreaching and completely enslaved by his desires) was seen as the biggest slave in society. Epictetus already referred to the “futile” slavery at court, where the rich were torn by fear and wants; Choderlos de Laclos (Les Liaisons Dangereuses) refers to the Sultan with his favourite Sultana: “he is either her tyrant or her slave”; while Nicolas Berdyaev (Slavery and Freedom) aired similar views on the psychological relationship between a tyrant and a slave.

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