Financial Capital & Human Capital

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A tectonic shift in the nature of capital is occurring. The world is awash in financial capital. Harder to find and identify are the human abilities necessary to deploy this financial capital effectively, ranging from the technical savvy that creates the computer and the internet to the entrepreneurial skill that puts great enterprises together to the managerial talent that keeps them humming.

Whereas a generation ago most of the value of an enterprise was accounted for by its hard assets, such as factories or inventory, now about 75% of it lies in intangibles - patents, copyrights, staff creativity, trade secrets, know-how, reputation, brand names, customer relationships, and the ability to manage them all.

It is a truism of the world that the scarcest resource commands an outsize share of the returns, because those who control it can force the holders of the more common resources to bid against each other.

If finance capital is scarce, the financiers rule. But in a world in which finance capital is plentiful and creative capital less so, the financiers get to bid for the privilege of going into business with the creatives, and sharing the returns from their intangible capital.

This shift in power is resisted because it does not accord with the 19th century model of the corporation, in which the financiers are the principals and all others are their subordinates and agents, and because the finance capitalists are not too keen on the shift. In fact, much of the work of the government that is undermining the efficiency of the public markets can be viewed as an effort to retard this change, to maintain the dominance of the finance capital over creative capital.

The private equity firms' fat pay-offs and occasional ostentation on a Veblenian scale make them good targets, but their real sin is to be leaders and symbols of the shift. They earn their returns by identifying the opportunities for superior deployment of capital and by revamping the internal structure of the companies they take over so as to empower and reward the creativity of the managers and employees, collecting a handling fee along the way for their own intellectual contributions.

Granted, this picture can be over-idealized. As is true of all such market shifts, not every private equity firm is the real deal. There is considerable froth and hype, as the headlines of the past few weeks attest. Not many private equity firms really understand their role in the great scheme of things, and most will probably fail to outperform the public markets. That's show biz.

But it is hard to refute a strong suspicion that a good part of the opposition to giving capital gains treatment to the earnings of the private equity types is psychological. These people are supposed to be employees, not principals, and only on the latter should the tax gods smile. These people are uppity. The proposals are the tax code equivalent of medieval sumptuary laws, which prohibited dressing above one's station.

http://www.tcsdaily.com/article.aspx?id=080707C