Alan Schwartz delivers remarks at The Harvard Club on the problem with profit

Updated: Sep 4, 2018


The Harvard Club of Australia

6th of July 2017

Remarks as prepared


What’s wrong with profit


Let me begin with some acknowledgements and some thank-yous.


Firstly, congratulations to the Harvard Club for this Nonprofit award. I have known a number of recipients over the years and I have seen the thrill of recognition and what a confidence booster it has been to them and, in the longer run, the momentum it has added to their careers.


Let me also congratulate Jane Hutchinson and John Hutcheson for winning this year’s Award.

I want to thank Sarah Buckley, who is the CEO of our family foundation, for challenging and poking holes in some of my arguments and for helping me put this speech together. Having said that, I don't presume to say that she agrees with, or endorses, my views.


Finally, a thank you to my son Oscar, one of the smartest people I know, for his insightful review of tonight's speech. As a warning of what is to come, let me quote the final sentence of his email to me.


" This is a great speech, and like I said, a great provocation. It will make people feel uncomfortable, which is always good"...


I am delighted to be here today to make my contribution. Thanks for inviting me.

Four things that irritate me


For the last 40 years, I have been diving in and out of the profit, not-for-profit and philanthropic sectors, listening to a range of ‘voices’ debating the roles, responsibilities and relative merits of these sectors. Some of these ‘voices’ have bemused and even mildly irritated me. My reactions have made me feel a bit confused – sometimes I feel like a naive idealist, a bit of a “lefty”, and sometimes I feel a like a reactionary conservative, a bit of an old-school capitalist.


Let me bring this to life for you with four examples:


Firstly:

I get irritated with those ‘lefty’ voices (and there are many) who think there is something wrong with profit; that organizations which seek profit are somehow less worthy than those who don’t. This makes no sense at all to me, and I wonder whether they understand the nature of profit. Our entire economy, our standard of living, is underpinned by the free market’s efficient allocation of capital and resources. At the heart of this is the pursuit of profit. There is no inherent moral high ground for “not for profits”. I am a free enterprise loving capitalist.

Secondly:

I believe accounting profit is an overrated measure of value creation and I disagree with those who believe that the sole purpose of a company is to maximize profits to shareholders. I believe business should be responsible to all its stakeholders and be held accountable for the social and environmental externalities they create. Business should not be able to use accounting profits for reinvestment and/or payment of dividends if the profits have been earned at the expense of society or of the environment. When I propose this radical idea, my friends in business tend to label me as a bit of a naive idealist.


Thirdly: I get irritated by the self-righteous, holier than thou, “not for profit” voices who believe that they do not need to be efficient and accountable, simply because they are doing “important work” and because they are not driven by “personal greed”. Fortunately, this attitude is less common these days, but I still see it raising its ugly head from time to time. "You don't understand Alan" they say "we are different because of the important work we do". To these people, I am insensitive and uncaring; an old-school capitalist.

Fourthly: I feel very frustrated when I come across efficient and accountable, “not for profits”, doing amazing work on the smell of an oily rag, and yet are unable to scale because they cannot access the funds they deserve to do their important work. When I advocate for more “not for profit” funding, the “hard heads” and the “dry’s” see me as soft, a bit of a "lefty"...

For 40 years, I have tried to make sense of these voices and of my inconsistent and contradictory, reactions to them. More recently the stakes have been raised. The emergence of "social enterprise" and "impact investing" has generated a lot of excitement and grand statements about how they integrate the commercial and the social worlds into one model.


Our family office and our foundation have dived in enthusiastically, making a number of impact investments in some excellent social enterprises. We are so excited to see the emergence of a new asset class that seeks to integrate “profit” with “purpose”. For the first time, a range of stakeholders, from government to private investors, are asking for social impact to be quantified and integrated with profit.


But while social enterprises and impact investing are a hugely important and positive development, I suspect they will not provide the solutions needed to address my irritations. Too often I am seeing impact investments and social enterprises that seem to draw on the worst aspects of the “for profit” and “not for profit” sectors.


For example:


I get irritated when we are asked to invest in a social enterprise or make an impact investment which has a poor underlying business model and/or business plan but we are asked to overlook that because of the unquantified social returns that will be generated.

I get even more irritated when I see ordinary businesses dress themselves up as social enterprises, because, for example, they donate a proportion of their profits to a worthy cause. Too often these enterprises are simply exploiting well-meaning but inexperienced investors.


What does all this mean?

For me, there are two possibilities: Either I have become an irritable, cantankerous old man or there is something wrong with the way we are thinking about these things. Naturally I would prefer the latter to be true, so I have been doing some thinking over the past few months.


Source of the itch...if only...


We know from the history of science that when theories become increasingly hard to defend (for example the theory that the sun rotates around the earth) it is often time for a paradigm shift; a new theory (the earth rotates around the sun). And we know from social history that when a theory serves an elite, and is used to justify inequality and injustice (for example the divine and absolute right of Kings) it may be time for a revolution (off with King Louis’ head).

I think the time has come to re-examine the two assumptions that sit behind our belief that accounting profit must lay at the centre of our free enterprise system.


The first assumption is about measurement. The prevailing wisdom is that, in contrast to profit, which is an enduring and precise metric, social and environmental returns are hard to measure.

The second one is about values. We cannot imagine a world in which the market allocates resources based on something other than profit.

Please indulge me for a few more minutes as I challenge these assumptions.

Challenging the status quo


The first assumption:

“In contrast to profit which is an enduring and precise metric, it’s hard to measure social and environmental returns”:


Despite the reverence with which it is held by many in the commercial world, profit is just a human construct. It is a highly contested and narrow measure of surplus that is constantly evolving.

The work of Jonathan Levy at Princeton demonstrates that profit is an evolving measure. Before 1850 it was a crude balancing of income and outgoings (buy low, sell high); from 1850 to 1920 it became the “operating ratio” (sales revenue less direct costs); from 1920 to 1980 it became the “rate of return on capital invested” and since 1980 it has been the “rate of return on equity”. The pattern is clear. The measurement of profit has evolved and has become more sophisticated over time, starting with “buy low, sell high” and, over time, adding direct costs, overheads and the cost of capital.


Because we increasingly live in a world of finite resources and high interdependencies, it is entirely possible that the next evolution of profit could accommodate an even broader definition of costs and liabilities – by including effects that are external to the organisation – that is, the social or environmental impacts of an organisation’s economic activity. This may sound radical but it isn’t. Global accounting standards are already evolving to reflect elements of this...

What about the measurement of social and environmental impacts? In the past, governments and philanthropists were happy to fund “not for profits” that were focussed on producing social outcomes, without much measurement. The emergence of social enterprise and impact investing has introduced a new type of investor who wants both financial and social returns – they want to be satisfied that the total return makes sense. A whole industry and raft of approaches have emerged to serve this need (IRIS, GRI, SROI and blended value to name just a few), but consensus has been relatively limited and it will take time to evolve.

I think we are often drawn to precisely incorrect answers. A great example is IQ tests. This pseudo-scientific measure actually doesn’t tell us much about a person’s intelligence at all...other than, of course, their IQ.

80, 101, 131; precise metrics, but largely meaningless. When assessing a person would you prefer to know their IQ or would you prefer to ask some close, trusted friends what they think? Would you prefer to use IQ and be precisely wrong or would you prefer to be approximately right by asking your friends?


It’s the same with profit. It measures profit accurately but what does it tell us about value created? In the case of tobacco, alcohol and gambling companies, profit is a precisely wrong measure of value created. I would prefer to be approximately right and say, with complete certainty, that the profits of each of these industries far exceed the total value they add to society. I would prefer to be approximately right and say that an exceptional not-for profit deserves more funding, even if it produces no profit at all.



The second assumption:

It’s challenging to imagine a world in which we agree to allocate resources based on something other than profit – for example, ‘net value created’

Whilst I am a strong advocate of free markets I believe that profit, as currently defined and measured, is not, and should not be, the exclusive allocator of resources. Even Adam Smith believed in government intervention to correct market failures. Governments intervene all the time to enhance efficiency, limit monopolies, and to redistribute wealth. Our tax and social welfare systems are prime examples, and more recently carbon credits and market based social initiatives such as the NDIS demonstrate how flexible our concepts of the free market have become.


What I’m attempting to highlight is that:

  • While it’s hard to measure social and environmental returns precisely, profit is a contested and excessively narrow measure that continues to evolve

  • While it might seem difficult to imagine a society in which resources are allocated via something other than profit, this already happens in many ways \


The solution

I hope I have loosened up our thinking enough to ask you to join me in a thought experiment. I am asking you to imagine a world where we have found a way to measure “value added” (being positive social and environmental effects, plus profits) and a way to measure “value destroyed” (being negative social and environmental effects, and losses).


Let’s imagine we use these measures (value added, value destroyed and net value created) to create a single currency FOR BOTH "for profits" and "not for profits". And imagine that this single currency of “net value creation” is used to allocate resources in our society rather than the narrower measure of profit.


The outcome would be roughly as follows:

  1. A business that made a good profit and had no hidden social or environmental costs would be able to hold its head high, knowing that, on the commonly accepted view of "net value created", it was up there with the best “not for profits” and the best social enterprises.

  2. A business whose profits were created at the expense of society and the environment would have a “net value added” score that was lower than its profits. Market forces would transfer some of its profits to enterprises that had a higher “net value added”. It would become starved of investment capital and shrink or disappear.

  3. Inefficient “not for profits” would be held to account for the fact that the social return they provide is less than the government and philanthropic funding they receive. Their “net value added” would be low - and their funding would significantly decline or dry up altogether.

  4. Efficient and effective “not for profits” that produce large social returns, but little or no profit, would earn a high score for “net value added”. Market forces would enable them to attract capital and expand

Wrap up


With this new currency of “net value added” all those irritating voices would vanish into thin air. Businesses, “not for profits” and social enterprises will have access to the financial and human resources they deserve. “For profit” businesses would continue being funded by investors who seek a financial return, and those who create no negative externalities would flourish. “Not for profits” will continue being funded by Government and philanthropists but only the efficient and effective ones will flourish.

Social enterprises will be able to consolidate their business model and attract investors who seek blended financial and social returns. But even more importantly....


I, will be cantankerous, no more!


Thank you for listening and I very much look forward to your questions and comment



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