Responsibility and Solidarity in Saving and the Profit and Loss Sharing (PLS) Concept

At a time when the revival of the debate on the Tobin tax is drawing attention to financial arbitration between the long and short term from the perspective of durable development, it is worth considering the ways in which loaned capital earns money. The second half of the last decade has highlighted the paradoxes of a low interest rate that encouraged the actuarial optimisation of leverage effects and, towards this end, the game of rationalisation and of exclusive concentration on profit by the shareholder.

The Profit and Loss Sharing (PLS) concept is an original way of paying for medium to long term first rank (priority or “senior”) debt. It is based on the sharing of hoped-for profits from a project or an investment, or indeed the losses made in the future, according to a contractual percentage, which is a function of the actual results of the period considered, charged at each term defined for the repayment of the principle. The enterprise and all the economic agents connected with it share a convergence of interest: the equitable sharing of its results to which they contribute. The PLS system favours a rather more efficient allocation or sharing of resources in the fabric of the economy.

1. The Saver: creditor of last resort

When a first rank creditor sees his investment as a form of solidarity with the performance of the enterprise, granting credit becomes a more responsible decision. It encourages a profound knowledge of the debtors so that their capacity to honour their commitments can be fully understood. Such behaviour is the antithesis of that of the anonymous public limited companies (sociétés anonymes de capitaux) which dominate the market economy. The latter, quoted or not, work for their shareholders with the obligation to satisfy their customers and the personnel who assure their continuation into the future.

It was in the context of the large value-added generated by the industrial revolution that the societies of mutual help were born, aimed at supporting agriculture, artisans and indeed the small enterprise, all of which were otherwise excluded from the banking system. The foundation of the cooperative banking sector begins around 1850 with the simultaneous initiatives of two Germans, Friedrich Wilhelm Raiffeisen (1818 – 1888), a Catholic and mayor of an agricultural district, and Herman Schulze Delizsch (1808 – 1883), a Protestant judge and liberal politician. The first created the earliest rural cooperative credit fund, pressurising the more well-to-do peasants to deposit their funds there in order to help the poorer ones. The second created credit associations (Vorschussvereine) which obtained their capital from the sums deposited by their members. The members were liable to the limit of their contribution, but the vicinity of the actors (each fund concerned only the village) was the guarantee that all loans would be honoured. The solidarity created by putting savings together in common also gave access to credit to those who showed themselves worthy of it, even if they did not have the financial standing required by the classic banking establishments.

These two great initiators who developed the networks of the Raiffeisenbanken and the Popular Banks of Germany (Volksbank) are at the origin of the powerful German cooperative mutual sector. Their experiences were taken up in France at the turn of the century. The French cooperative sector today includes the Caisses de Crédit agricole, the Banques Populaires, the Crédit Mutuel and, since January 1st 1999, the Caisse d’Epargnes.

The member is at the basis of all these institutions. Key to them is the democratic principle according to which one person has one vote. The managers are elected by the members who also even oversee their decisions and their access to the credit from which they can profit. The members manage in a mutually beneficial way the appropriation and distribution of the wealth produced, basing their decisions on positive values such as confidence in each other born of close association, and the creation of enterprises and new jobs.

2. The PLS Concept

The Profit and Loss Sharing concept applies mainly to medium or long term loans which finance assets or projects. It presupposes a debtor able, with or without external assistance, to calculate the results of his activities, before and after financial charges.

How does one define the object to be shared? The profit or loss shared is equivalent to the operating profit of activities before financial charges from which have been deducted the following two elements:

2. An essential provision for a reserve to allow the borrower to recover his equity (allocation for the provision for reserves)

3. The capital repayment of the loan falling due (allocation for provision for the capital repayment of the loan)

The Sharing Rate negotiated between borrower and lender is applied to the net outstanding amount. The portion of the profit (or loss) thus calculated which is due to the lender is then reported in the borrower’s Profit & Loss account as a financial charge (or an extraordinary item), while the above described countervailing provisions are simultaneously released. This mechanism has the advantages that:

· It relies very closely on the cash flow position of the enterprise (see table 1)

· It is relatively neutral from a fiscal point of view; financial charges thus calculated increase taxable profit (after allocations for depreciation and provision for risk).

What significance can we give to this sharing? The constitution of the reserve is imperative in order to be able to share any future unexpected loss. The reserve is the symbol of the reciprocal solidarity which the concept of sharing profits and losses creates between the lender and the debtor. It is closely linked to the obligation that the members imposed on mutual aid societies to constitute guarantee funds with the profits generated by the activities they financed.

A loan financed on the PLS model cannot be assimilated to equity. A debt remunerated with PLS is paid off at each maturity date and with that, all rights of the lender over the borrower cease. The sharing of losses allows the criteria of exactability to be maintained for a current liability with at least one year’s maturity. Termination of business remains possible when assets are no longer sufficient to honour passive liabilities.

When the creditor assumes a part of the loss, this means, for this part, the extinction of the loan by an unconditional, immediate and automatic write off of the debt, as provided for within the loan agreement. This is the counterpart of the guarantee, with the same characteristics, for the creditor to participate in the return to or better fortune of the activity financed.

From the beginning, within the framework of the PLS system, the possibility to have to restore the credit of the debtor is envisaged. The debt written off, transformed into equity of the borrower, is like a gift from the lender to the borrower which has a distributive value. The granting of a new loan remains however subject to conditions.

3. Comparison of the PLS concept with classic lending: Simulation results

For the simulation, let us take an activity organised around the acquisition of equipment for 1 million euros, depreciable on a fiscally linear basis over 10 years and financed by a loan (50%) and by equity (50%). The credit extended, of 10 years duration equal to that of the equipment, is repaid linearly from the first year and remunerated using the PLS system. Activity costs are equal to 50% of the revenues expected for the first year. Adding funds to the reserve to allow the lender to reconstitute his equity during the duration of the credit is imperative and prior to the debt service. The remuneration of the loan is tax-deductible.

Three scenarios are simulated, each one with a classic loan, remunerated respectively by an interest rate of 5.25% and 6.25%, then with a loan remunerated on the PLS model, distinguishing in this second case between a rate of sharing equal to 30% or 15%:

· The project goes as planned, without any exceptional results;

· Turnover has been overvalued from the beginning by the figure of 20%;

· The activity undergoes a second unforeseeable shock in the fifth year with the entry of a competitor onto the market, leading to the diminution of revenue by 25%.

In the case of the classic loan, and all other things being equal over the 10 years of activity, an increase of the interest rate of 100 base points:

· Reduces the profit-earning capacity of the borrower’s equity in the first case;

· Increases the equity loss of the entrepreneur in the second case;

· Speeds up the termination of business by one year in the third case.

The constitution of the reserve slows down the arrival of the point in time at which termination of business is necessary but does not significantly change the results. It also hurts the entrepreneur who can save nothing of his investment.

In the case of the loan based on the PLS concept, and all other things being equal over the 10 years of activity:

· The activity is free of all influence from the change in interest rate and the latter does not interfere in the sharing out of wealth created between the creditor and debtor;

· Whatever case is envisaged, the proportions to be shared out remain the same;

· In the second case, the activity takes a knock and subsequently continues with a low profit-earning capacity;

· In the third case, the debtor, more involved than the creditor, can proceed to strategic arbitration in a more serene context than that of the termination of business.

The effects of the unforeseen shocks resulting from errors of anticipation, or from a highly competitive context, or indeed from a case of force majeure, are absorbed to different degrees.

The sharing rate is negotiated in the universe of competition as a function of all the components of risk (cost structure of the activity, secured future turnover, durability of asset life. . .) that influence the duration of the loan, and which may have a large range of appreciation. As a high percentage favours the creditor in the case of making a profit, so it penalises him in a loss situation. The appropriating of an excessive part of the product of the activity financed increases his risk if bad events get the upper hand.

The role of the creditor with his prior rank does not confer on him the vocation to transform himself implicitly into a shareholder since the latter is looking for leverage to make his equity funds more profitable.

4. The heart of the issue for the PLS concept: the creation and conservation of values

Structuring the passive side of the balance sheet of the enterprise by having recourse to a classic loan remunerated on the basis of an exogenous interest rate authorises the shareholder or the creditor to appropriate the wealth created inequitably, to the detriment of the enterprise and its other partners, clients and employees. Paradoxically, low interest rates, able to stimulate economic growth, have generated policies knowingly orchestrated to over-pay equity, well-beyond any relation to risk.

The interest rate exacerbates conflicts between the short and long term and interferes in the arbitration between the factors of capital and labour at the heart of the enterprise, by reason of:

1. Rigidity of the debt service when revenues from the activity may be declining;

2. The dual nature of capital remuneration (interest and dividends).

Interest and salary rates vary inversely and are in opposition: the relative cost of the factors of production is defined as the ratio of the cost of labour to that of capital (w/i), which means that the interest rate, according to its fluctuations, raises or lowers the value of a job even though the job itself remains the same. The enterprise must constantly react even though the interest rate does not give any indication as to the historic indication of its evolution (generally speaking); an organisation which is no longer worth anything today could become worth something again tomorrow. The PLS model fits in with the natural movement of history, the transition from one technological state to another being stimulated only by the desire to innovate.

In giving de facto priority to the salaries of those who contribute to the determination of the performance of the activity, the PLS concept gives priority to the remuneration of human labour as opposed of that of capital. By creating an equitable convergence of interests between all the partners of the enterprise around the sharing of profits as compensation for the acceptance of the risk of loss, the PLS concept suppresses the dichotomy between the spheres of the real and financial economies.

· It synchronises the duration of a loan with that of the object financed and puts aside all quibbling over the opportunity and the cost of debt write-off;

· It allows the financing of new projects that are characterised by both weak profitability and low risk and which could be otherwise excluded from the economy (the case of agriculture).

· With the leverage effect moving only in the same direction as economic profitability, certain activities, challenged by a shock or by results that are lower than expected, remain viable. Debts and the activities financed both retain a value that constantly fluctuates as a function of one variable: their internal rate of return (IRR).

· It seeks, by means of specialised vehicles managed by financial intermediaries, responsible and solidaristic saving that does not wish to invest in capital risk (junior debt, equity) but would accept taking the risk on first ranking loans (senior debt) with a repayment schedule.

To organise, in a protective and independent legal environment, perfect flexibility of the remuneration for loaned capital based only on the endogenous profitability of the enterprise, should be an attractive argument. Since each enterprise is a link in the structure of the economic and social fabric, it is possible to think that the PLS concept would favour convergence towards a properly evaluated full employment.

But how can capital owners, creditors, shareholders or individual entrepreneurs be motivated? Entrepreneurs trade off their present salary against the return they could get from their activity. The shareholders, for their part, consider at a given instant the interest rate “without risk” when proceeding to invest. Both of them, facing the economic risks they take on, should be interested in independence for their enterprise or of their investment in relation to uncertain developments in the interest rate. The saver, lender of last resort, needs to be convinced, unconscious as he is of the global price he pays for his aversion to risk: inflation, unemployment and fiscal pressure.

Those who practise solidarity in saving and who would invest indirectly via an intermediate vehicle in loans remunerated with the PLS system, legitimately expect that these investments will be followed up and managed. But their involvement must remain limited so as not to be accused of de facto managing themselves the enterprises financed. To this end, there are several instruments available to them: the quality of the lender and manager of the loan portfolio, the checks carried out by auditors, the periodic appraisals by rating agencies, the possibility to require the entrepreneur to appoint an external consultant to assist in management. Putting all these actors into a competitive situation constitutes the most effective tool. It encourages transparency of information and the definition of the most profitable strategy for each enterprise financed. Finally, the saver has a double decision-making power:

· To withdraw from the intermediate vehicle

· As a member, to choose the manager, to renew periodically his mandate or to dismiss him.

Table 1: Simulation of profit and loss account and cash flow balance* 

Amount of loan: 100% Repayment terms: 5*20 Sharing percentage: 20% 

Conclusion

The PLS concept validates the intuition of Friedrich Wilhelm Raiffeisen according to which compensating for or mastering economic cycles depends on sociality, solidarity and responsibility in saving, requiring periodic, exhaustive and truthful information, capable of giving the saver confidence in the activities he finances.

The adoption of the PLS concept depends on the free choice of the actors participating in the life of the enterprise. Contrary to the postulate of classical economics, all economic agents save as a precaution, whatever is the level of expected revenue. A stable economic and financial environment, which is less speculative, is therefore more reassuring. This is the squaring of the circle at the origin of the age-long debate over the legitimacy of a rate of interest.

Table 2a: Classic Financing, with interest rate 5.25% and 6.25% 

Table 2b: PLS Financing / obligatory reserve fund / rate of sharing: 30% and 15%