## Sunday, May 01, 2011

### Democracies are more stable

Autocratic countries often appear to have a clean and stable political system. A government is clearly in charge. Businessmen like to deal with such a government, because you can go into a room with a powerful person and walk out holding a deal. You can do business with them.

Democracies, in contrast, are messy. The essence of a democracy is the dispersion of power. When power is dispersed between many individuals and institutions, decision making is slow and messy.

Differences are visible in public. A businessman finds it difficult to deal with such a government: He can't walk into a room and do a deal. Instead, deals (such as an airport contract or a mining concession) go through a contentious procurement process in the public domain. In the third world, the procurement and regulatory procesess are often riven with corruption, which makes a benevolent dictator look good.

While an autocracy may appear to be calm and stable, it actually suffers from two dimensions of instability. The regime suffers from the silent reproach of a million tear-stained eyes: You never know when an upheaval will come about. And autocracies suffer from problems of succession. When the strongman dies or gets killed, you never know what's going to happen next. When power and decision making is centralised, succession becomes difficult.

When the caudillo comes towards the end of his life, this triggers off instability because people around him are solving dynamic programming problems. I suspect this was part of the story of how Mubarak's world fell apart.

### A business with a strong CEO is like an autocracy

Many firms have centralisation of thinking, power and decision making in the hands of one person or one family. This often looks nice for a while. There is clarity about who is in charge; the CEO is generally well incentivised; the CEO generally works hard and many such firms are highly successful.

But such firms face difficulties of succession. Precisely because so much power and decision making was concentrated in one person, it is difficult to replace him or her.

As with good countries, good companies evolve from concentrated power to dispersion of power. A good country is one in which power is highly dispersed, where thinking and problem solving is taking place in millions of places by empowered individuals who are not waiting for instructions. In similar fashion, a good company is one in which the CEO does not dominate the landscape: the board of directors (above) and the management team (below) play a much stronger role when compared with conditions of dictatorship. As with a country, if one person is doing all the thinking, the firm is capable of little. In a good firm, the energy and imagination of dozens or hundreds or thousands of people is harnessed.

For small problems, one thinker is often adequate. As an example, to run a coffee shop, one mom and pop suffices. But to run a large, complex, modern knowledge-intensive firm, we need to harness the energy and imagination of hundreds or thousands of people. When such a firm is limited to the capabilities of one person, no matter how good he or she is, that yields stagnation.

In an autocratic company, there are serious problems of succession. A dominant CEO is hard to replace even if one were recruiting from the open market. Matters are often made worse by limiting CEO search to a family. In contrast, when power is dispersed, succession is inherently safer. Even if there is a lot of sound and fury in succession, there is less that can go wrong.

It takes a long time for a country to learn how to live within the complex checks and balances of democracy. In similar fashion, it is not easy to be a sophisticated modern firm, where the CEO is not a demigod. It is a difficult transition to make, to go from an autocratic environment to a democratic environment.

I believe that political analysts, globally, make the mistake of overstating the stability of a dictatorship and underestimating the stability of a democracy. In similar fashion, I feel that many people underestimate the succession problem of a family business and overstate it in a professionally managed company.

### On the other hand, agency problems

This case against family run companies is very strong, for large organisations where it is essential to have many people thinking. However, the key problem that the professionally managed company faces is that of agency conflicts. With a family company, the incentives of the CEO are clear. With a professionally run company, it is not easy to ensure that the management team works for the interests of the shareholders.

On one hand, power needs to be dispersed because otherwise we can't have hundreds of people who are empowered and thinking. But when power is dispersed in such fashion, there is the heightened danger of theft.

The management of a professionally run company is therefore all about the tension between the efficiencies (economies of scale + large number of people who are thinking) on one hand versus theft on the other. Once again, it isn't so different from the agency problems that democracy is riven with.

### Infosys

When a dictator is succeeded by his son, it looks like a smooth and easy transition, but it is actually a situation that is fraught with risk.

Succession at Infosys has been contentious and in the public domain. As with an Indian general election, it looks messy. But the problems here are overstated. Infosys is doing something relatively new in India: they are a professionally-managed dispersed shareholding company with disperson of power. While such succession looks messy, there is greater stability under the hood.

### Governance problems of Indian firms

India is remarkable in having high quality firms. But at present, very few firms have the checks and balances of dispersed shareholding, a genuinely powerful board of directors, a professional management team, and the absence of dominant founders or family. There are a few such examples -- L&T, Infosys, ITC, Axis Bank, ICICI -- but as of yet, it is rare.

Many of the successful giant firms of the present Indian landscape are a bit like China: They look great today but they run the risk of a USSR event as they face the transitions of the future. The Indian corporate sector has a lot of work in store, in refashioning the giants of today, using the governance DNA of firms like L&T, Infosys, ITC, Axis Bank and ICICI. Those transitions will not be easy. As Lant Pritchett says: I recently did a study examining the growth consequences of sudden large democratisation (a shift in the POLITY index of more than 6 points). Of the 22 cases that experienced rapid democratisation with above average growth: (a) all but one had a growth deceleration, (b) the average deceleration was 3.5 ppa, and (c) the predicted deceleration was increasing with growth—roughly, post-democratisation countries reverted to world average growth. Transitions out of dictatorship are not easy.

1. Excellent article!

Would you not consider Mr. Deveshwar as a powerful CEO? ITC's largest shareholder, British American Tobacco (BAT), has seats on the board but no control on what happens at ITC. IMO, ITC faces the star-CEO problem. Mr. Deveshwar has been the CEO for 15 years now. Where is the succession planning? Nowhere else in the world BAT does anything more than selling tobacco.

Similar is the case of L&T. Mr. Naik has been at the helm for 12 years now. He runs the show.

2. Very well written! Disagree in parts with the ITC example though (as pointed out by the previous comment).

3. Your examples of Indian companies which manage succession well are all companies where there is no dominant shareholder (even in case of ITC).

May be it suggests that no one entity/ person should hold more than 5/10% in any company. What say??

4. i think the length of tenure should not matter so long as the business or political regime delivers on its promises--adequate dividend payments to shareholders and acceptable standard of living to voters. Look at China in your immediate neighbourhood. lately i read on the web that people in Shangai have higher life expectancy than the US average. even though that the average life expectancy in China is only a few years behind than that of the US. in addition china's leadership have made enviable reputation in fighting poverty for hundreds of millions of their citizens. now compare this with India's messy democracy and the formidable level of poverty.

5. Interesting article.

I would think the Tatas and HDFC groups are worthy of mention due to the their governance and to an extent non-individual based management style even if the media focuses on the current CEO or Chairman.

Reliance will be interesting to watch and material for a case study as it reaches the point of transition.

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