When we say that a manager has Skin In the Game we are saying that this manager is playing his assets or a good part of it in business decisions, simplifying a lot. This term of risking one’s skin has been considered for many years as a way to choose good companies in which to invest, and it became fashionable again with the book “Skin in the Game” by Nassim Nicholas Taleb and is appreciated by many investors.
ButWhat if there was a way in which managers can pretend to have “Skin in the Game” and that they “risk their assets” in the business decisions they make every day but not do it in practice? This has been invented for years, it is a specific application of Equity Swaps, a derivative not well known to most people.
Skin in the Game
Skin in the Game or “playing the skin” is an easy concept to understand if we think about it in terms of “that the manager also plays the rooms”. We believe that a person will make better decisions or will make them thinking about those who make them wrong, if that person is with the same positive and negative incentives as those who suffer from the decisions. The concept of Skin in the game has been associated with Warren Buffet, who invested his assets in his fund, but there are also others who think that the sources are older.
Taleb proposes it in his book “Skin in the game” as a way by which se avoids the economic duality between principal and agent. It does not stop being that incentives must be made so that those who make the decisions have the same incentives as those who suffer them. For example according to Taleb the Hamubarbi code he contemplated that if a house collapsed killing its occupants, the builder must be executed. The duality between principal and agent is a problem that exists in economics or politics when the decision maker is not affected.
Also hoh who thinks that this concept is a bad idea. The Nobel Prize winner in Economics Josepth Stiglitz talks too much “skin in the game” can lead to bad decisions and negative returns. The Securtities and Exchanges Commission of the USA (regulatory body of the markets) obliges managers to show their positions in the companies they manage, as well as investment fund managers (for example, in this link we can see Elon Musk’s statements about Tesla). It is also considered that there may be problems with the “front running” because managers have confidential information before it is published.
Some investment banks and fund managers limit or prevent what the mutual fund manager can invest when the client’s capital is at stake. Despite this, the concept is popular and many investors like managers to have skin in the game.
A Swap is a financial derivative through which the gains or losses of two underlying financial products are exchanged. An Equity Swap is a Swap in which one or two of the underlying is a publicly traded share or a stock index.
For example a Equity Swap could be the exchange of the returns of a deposit at 4% against the returns of the investment in the Eurostoxx50, a stock index of listed companies in the euro zone. In this way the benefits are exchanged in the contract. If the index rises 2%, the counterparty will have to pay you the remaining 2%, while if the index rises 6%, it will have to pay the counterparty the difference with the fixed 4%.
Equity Swaps are not the best known derivative, but it allows you to have or be exposed to a financial product that is not easy to access. You can also trade the returns of an index against a specific stock, that is, the shares of Company X against the return of the Dow Jones 50 or the Nikkei. Or one index against another.
It may seem somewhat inapplicable to our daily lives as a retail investor, but the truth is that it is many small investors unknowingly have positions in Equity Swaps derivatives, at least indirectly. Exchange Traded Funds (ETFs) that track indices have been extremely popular in recent years with many investors. ETFs can be “physical” or “synthetic”. The physicists buy the shares, but the synthetics usually have one or more agreements with Investment banks with which their management company signs an Equity Swap, in this way they replicate an index of shares without necessarily buying them.
Equity Swaps and executives who skip the Skin in the Game
Well, suppose that company X hires a new manager, investors ask him to invest in the company, to make sure that the manager’s interests will match their interests as shareholders. This manager, after a good paid professional career, invests ten million dollars that he had saved. The shareholders are happy, their manager plays the rooms as they are playing it.
Although the manager trusts company X, he does not want to put all his assets or retirement savings, he considers that company X has problems that may be difficult to solve or that new technologies may arise that lead the company to irrelevance, such as It happened to Kodak when digital photography came along. So our manager opts to tell his private banker about this problem.
Your private banker offers you a financial product: an Equity Swap through which the returns of the investment in this company will be exchanged against those of the benchmark index out of a total of five million. The manager’s bank traders value the product and make the manager pay a commission for the contract. However, the manager knows that if the shares fall 20%, he will not lose two million, but one million will be compensated by his bank, which is very happy to have him as a client.
In a way, this manager would be betting against the company he works for, in addition to preserving his voting rights in it and leaves the investors in this company happy.
Is the use of this derivative by managers my invention? It’s something new? Well the truth is that no. An academic article was already published in 1996 on how to use Equity Swaps (with its advantages and disadvantages) for managers. Also in 2001 another academic study commented how they reduced effective ownership by 25% and used to occur among high-ranking insiders and the authors suggested more transparency about this type of transaction. Also an opinion piece by 2015 criticizing this practice. In 2016 a Spanish university professor commented on the issue regarding voting rights.
Ask the readers, Do you think managers should have Skin in the Game and have they decided their investments this way until now? Do you think that this type of position should be regulated when you are a manager of the company?
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