The debate of value creation versus value extraction is an important one when markets are developing and is a crucial driver of share prices. The danger, however, is that the impact on share prices is opposite to the impact on the value of the company. The result can be business destruction to the benefit of a single stakeholder.

What do we mean by value creation versus value extraction?

Value creation is developing the ability to keep producing value, e.g. building a productive asset.

Value extraction is monetizing, or liquidating, value, e.g. selling a productive asset.

Value Creation versus Value Extraction

Value creation is clearly not controversial. It is value extraction that is problematic. The core issue is why is value being monetized and what is the revenue going to be used for? I’ll clarify with two examples.

We are at the dawn of an era of electric vehicles. A car manufacturer who owns four factories that manufacture petrol based cars decides to sell one, which is monetizing it, and to invest the proceeds in developing an electric car factory. Two factors point to a good use of value extraction: 1. The asset that is liquidated is likely to begin losing value, and 2. The revenue extracted is re-invested into value creation. Some might even say that the value creation is greater than the value extraction, so on a net basis the company is creating value.

Consider another car manufacturer that has two factories, each manufacturing electric cars. Seeing a rush to the electric car market by established car production companies, they sell one of their factories at a great profit and use it to pay dividends and launch a share buyback program. Here, the company liquidated a valuable asset that was likely to be productive for some time. Worse, it did not try to replace the value it liquidated. Instead it gave shareholders a short term boost, and because equity markets are short term the share price also gets a boost. Which also boosts executive compensation.

The Principal-Agent Dilemma

At the core of the value creation versus value extraction debate is the principal-agent dilemma. The problem begins with agents, in this case the board of directors and executives, being able to take decisions on behalf of principals, in this case shareholders. When agents and principals have different incentives, for example executives care about bonuses and shareholders care about long term returns, then a conflict of interest emerges. Agents can then use the fact that they have better information than principals, called information asymmetry, to take advantage of the situation to enrich themselves to the disadvantage of the shareholders.

For the value debate it is clear how the principal-agent problem is relevant. Agents are incentivized to extract value in the short term so as to book large profits and get paid large bonuses. On the other hand, principals would prefer to keep creating long term value. One of the main reasons that stock based awards were introduced was to try and solve this problem.

Tunneling and Minority Shareholder Suppression

The information asymmetry that allows agents to exploit principals can be used in other scenarios. One example is tunneling in which a controlling shareholder extracts value from s company at the expense of the ordinary minority shareholders. A simple example is for the controlling shareholder to direct business to a related party.

To be more specific consider Company A that wants to issue sukuk. If a controlling shareholder of Company A directs its board to use Investment Bank B to issue the sukuk, the controlling shareholder of Company A is also a controlling shareholder of Investment Bank B, then the controlling shareholder will benefit at the expense of the minority shareholder of Company A. Why? Because Company A did not benefit from running a tender that ensured it got the lowest price in the market.

Tunneling Classifications

There are three broad categories of tunneling:

• Equity tunneling increases the controller’s share of the firm’s value but does not create value. An example is share buybacks. Controlling shareholders will usually have better information about the value of a share buyback, and by instituting such a program can increase their percentage shareholding (by not participating) while promoting the share buyback to entice minority shareholders to sell their shares.
• Asset tunneling sells productive assets at below market price or purchases unproductive assets at an above market price.
• Cash flow tunneling involves the income statement, e.g. selling products / services at below market, or purchasing products / services at above market prices. It can also involve the balance sheet, e.g. lending, or placing deposits, at a low interest rate or borrowing at a high interest are.

Information and Control Asymmetry Red Flags

There are many red flags to keep an eye that you can recognize with experience. Some of the major information and control distortions can include:

• Unsubstantiated Forward Looking Statements: If you repeatedly see statements announcing large future profits without any real independently sourced facts to back them up, then you might be being fed misinformation.
• Large Intangible Movements: Keep an eye out on the balance sheet and notes to the income statement for large movements in intangibles. If these aren’t separated out as extraordinary income then you won’t have a clear picture of true performance of the company.
• The Same Posse at Every Party: If you see the same group of people on a number of related company boards then what you have is the potential for lack of independence and potential minority shareholder rights suppression. Good corporate governance dictates appointing independent directors who are not influenced by the management of related shareholders.
• Large Related Party Transactions: Remember to not only look at income. Large asset movements can also subsidize targets. If you see a web of inter-related shareholdings with material related party income / expenses or movements in assets / liabilities then you might be witnessing tunneling.

A Web of Tunneling

Tunneling can be better disguised by using a web of inter-related companies.

Imagine that Holding Company A controls an investment bank, Investment Bank B. Holding Company A also controls Operating Company C. Operating Company C wants to issue a bond. So Holding Company A ensures that Operating Company C hires Investment Bank B. That is a related party transaction, sometimes difficult to uncover.

But Holding Company A is not done. Investment Bank B is struggling to find investors to buy the bonds, so Holding Company A instructs Commercial Bank D, which it controls, to purchase a large chunk of the bond to get things going.

But Holding Company A is still not done. Now that Operating Company C has funds due to the bond issue, it ensures that Operating Company C deposits the proceeds in Commercial Bank D at reduced interest rates. Commercial Bank D now has a boost in profit due to this related party transaction. Plus Commercial Bank D got its funds back, and more.

But wait, that’s not all. Commercial Bank D needs to place its new funds in a money market account. So it goes to Investment Bank B and deposits it in a money market fund that they manage. Investment Bank B now generates investment fees.

In the end Holding Company A uses the same money to generate profits for Investment Bank B, Operating Company C and Commercial Bank D. If Company A is private all the better. The management of Holding Company A look like heroes for boosting the profits of B, C and D even though it is the same money going round in circles. But who cares, right? The management of Holding Company A get handsome bonuses, not to mention great packages as directors of B, C and D.

The shareholders of A and those who remain invested in B, C and D are the victims.