The Mittelstand Way to Social Impact

Social finance is often promoted as a new phenomenon, but before the 1970s it was not unusual for finance to have a social dimension and a longer-term perspective, according to Robert Wardrop, research fellow in sociology and finance at Cambridge Judge Business School.

Up to the 1970s, Wardrop told attendees of a Centre for Social Impact conference, the prevailing wisdom was that the unchecked interests of shareholders could be damaging to a business, and therefore a key job of managers was to balance the interests of all stakeholders. In 1946, for example, management theorist Peter Drucker wrote that a corporation's social function was as important as its economic function. 

In 1970, however, American economist Milton Friedman argued that because shareholders own the corporation and employ its managers, the primary responsibility of managers is to act in the interest of shareholders. The only social responsibility of business, he said, is to increase profits. 

Friedman’s influential remarks signaled an ideological shift towards maximizing shareholder value. Then, in the 1980s, pension regulation in the U.S. opened the door to investment in junk-grade funds, increasing the pressure to deliver short-term returns. “During this period,” Wardrop noted, “CSR (corporate social responsibility) got hived off from day-to-day business.”

In New York, if you cheat someone in business, you move. In Germany, if you move to another valley, your past follows you. These are real social sanctions.

Much of German industry, however, never got the memo. The governance culture there, particularly in Germany’s medium-sized family-controlled Mittelstand firms, remains focused on long-term shareholder value. “These are owners looking at 20- to 30-year timelines,” said Wardrop. “It’s about value. And they never move. In New York, if you cheat someone in business, you move. In Germany, if you move to another valley, your past follows you. These are real social sanctions.” 

Wardrop has conducted a number of studies of these companies. He has benchmarked institutional trust in Germany, for example, and found that the only group to maintain positive trust since the 2008 financial crisis were Mittelstand firms. 

These companies have used the trust they’ve acquired to weather the credit crunch, Wardrop said. The contrast is particularly stark between the UK and Germany. While British firms in recent years struggled to secure any investment capital, Mittelstand firms raised more than seven billion euros in mini-bonds since 2009. Wardrop cited one case where British and German investors were asked what interest rate they would suggest for the same bond offering from a Mittelstand firm. The German investors were willing to lend at lower interest rates because they had a deeper understanding of the firm’s owners and how they were likely to treat creditors if the firm got into financial difficulties.

“They’re not social impact firms but firms with social impact,” said Wardrop. “Thousands and thousands of individuals are buying bonds because they’re observing the behaviour of these firms in their communities. Bond investors in these companies define them not in terms of size or profitability or sector. It’s entirely about how they’re governed.”

The lesson for North America, Wardrop said, is that whole-scale change will only come about if “we attack the ownership governance that’s driving the short-term return horizon.” The investment community will also need to develop a new measure of financial return that captures management’s commitment to creating long-term value. 

“The trust numbers for Mittelstand firms didn’t budge because to save their businesses during the trough of the financial crisis, the owners dug into their pockets to retain labour and to pay debt obligations. This notion of highest return is risk-adjusted and part of that risk is assuming the behaviour of the underlying equity owner under stress. Credit markets capture zero of that today. In the future, credit modeling will have to pull in some approximation of future stress events and how that will impact on the investment.”

— Alan Morantz