”Cadbury chief slams investor groups for lack of openness.” This headline in the Financial Times of April 22 2005 demonstrates just how fragile the ceasefire in the war of words has become between UK companies and their shareholders. In a speech to an audience of investor relations executives, John Sunderland, chairman of Cadbury Schweppes and president of the CBI, the UK employer’s body, attacked institutional investors and hedge funds for short-termism and lack of transparency compared with listed companies.
In response, Anthony Watson, chief executive of Hermes Pensions Management, the UK’s most active institutional investor, wrote on April 27 that John Sunderland had posed some good questions. He further suggested that if all CBI company pension funds were to demand answers to the questions he had raised, then the behaviour of institutional investors would change, which would be to everyone’s benefit.
It is estimated that institutional investors based in the UK and internationally own just over 70 per cent of the shares of companies listed on the London Stock Exchange. Estimates for the US present a comparable figure of just over 60 per cent.
While there is no denying the importance of institutional investors, there is a growing difference in the investment community between long-term and short-term investors. The former are viewed as “renters” of stocks, whereas the latter are increasingly viewed, and are beginning to act, as “owners” of the companies in which they invest. Evidence for this trend includes the growing number of investors establishing corporate governance functions to engage more actively with their investee companies. This article will focus on longer-term institutional investors, such as pension funds, insurance companies and investment trusts, and will not consider short-term investors, such as hedge funds.
The responsibility of institutional investors
To whom do institutional investors owe responsibility? Well, assuming that you have a pension of some kind, it is to people like you and me. The workforce of companies and other organisations contribute part of their salary to their pension fund to provide benefits for the beneficiaries of the scheme.
The fund trustees appoint investment managers, normally institutional investors, to invest funds on behalf of the fund and its beneficiaries. They typically invest in the shares of listed companies, as history has shown these to be the optimal long-term investment. Where this circle breaks down is at the interface between the investment manager and the board of the companies in which they have invested.
If an institutional investor is unhappy with the performance of a company in which it has invested, then it may decide to sell the shares. However, it could be argued that this is irresponsible, as all the institution is doing is avoiding the problem and postponing the need to address the issues in the company. Until recently, it was not seen as the responsibility of the investor to engage with the company and seek to work with it for positive change, and this type of behaviour was perfectly acceptable. But today, things are changing - and largely as a result of the growth in active investment by institutional investors, or shareholder activism.
The trend for shareholder activism emerged in the US through the engagement of large institutional investors, such as the California State Pension Fund (Calpers), the teachers’ pension fund TIAA-Cref, and investment managers such as Lens, which was founded in 1991 by Robert Monks and Nell Minow. In the mid-1990s, the trend crossed the Atlantic to the UK. There, the leading active investor has been Hermes Pensions Management, which uses its Focus Funds to strengthen shareholder involvement in UK companies and, more recently, continental Europe and the Asia Pacific region.
In general, the issues about which active shareholders seek to engage companies can be summarised as the following: performance - both operating and in terms of total shareholder return; strategy; governance and communication, including board constitution; executive remuneration; capital structure; and risk management, including social, ethical and environmental issues. Most shareholder engagement activity takes place out of the glare of the media - one recent exception to this was, ironically, the deposing of Michael Green as the potential chairman of ITV, the UK television company, at the time of the merger between Carlton and Granada.
A frequently posed question is whether or not investor engagement increases shareholder value. There are numerous examples to support the view that companies with involved shareholders will tend to outperform. For example, if you had invested $1m in the Lens Fund in August 1992, then by August 1997 it would have been worth $3.2m, giving a compound return of 26 per cent per annum. By comparison, an equivalent investment in the Standard Poor’s Index would only have been worth $2.5m. A similar example concerns Calpers which, between 1987 and 1995, actively engaged with 53 underperforming companies in which it had invested. For the five years before engagement, the collective performance of the investee companies was 75 per cent below the Standard Poor’s Index and, for the five years after, it was 54 per cent above.
In the UK, Hermes’ original UK Focus Fund has outperformed the FTSE All Share Total Return Index by 4.5 per cent on an annualised basis since its inception in 1998, during a time of difficult stock market conditions. Further evidence to support the link between shareholder activism and performance comes from the growth of private equity funds, which are the ultimate form of institutional investor ownership. For the ten years to 2003, UK private equity funds outperformed the FTSE 100 by almost 10 per cent per annum.
The role of institutional investors
In recent years, UK regulators have shown growing interest in the role of institutional investors. The 2001 government-sponsored Myners Report concluded that there were a number of areas where decision-making could be improved. It recommended that institutional investors should:
Set out how they will discharge their responsibilities. Investors are required to create a document, which should be made publicly available, outlining their policy in a number of areas. This should cover how investee companies will be monitored; how the investor will require investees to comply with the Combined Code; how they will meet with a company’s board; how conflicts of interest will be addressed; how they will intervene; the type of circumstances when further action will be taken and details of what that action may be; and their policy on voting.
Monitor the performance of investee companies and establish, where necessary, a regular dialogue with them. Investors should try to identify problems at an early stage to minimise any loss of shareholder value. They should monitor companies regularly, either themselves or via contracted research providers, by considering the annual report and accounts, circulars and meeting resolutions. If necessary, they should instigate active dialogue with the company’s board, although they should avoid becoming “insiders”.
Intervene where necessary. Much of this has been covered under the discussion of shareholder activism above. The primary duty of institutional investors is to those on behalf of whom they invest, and they must act in their best interests. They should seek to intervene, possibly with other shareholders, when they have concerns about shareholder value.
Evaluate the impact of their activism. Institutional investors have a responsibility to evaluate the impact of their intervention - not all of it is welcomed by company boards.
nReport back to clients/beneficial owners. Transparency is an important feature of effective shareholder activism and institutional investors should communicate regularly with their clients. However, they should not be expected to make disclosures that might be counterproductive - sometimes confidentiality may be necessary to achieve the desired outcome.
The January 2003 Higgs Report further crystallised the role of UK institutional shareholders by encouraging them to take their responsibilities more seriously. The revised Combined Code on corporate governance contained two relevant recommendations: first, institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives and second, they have responsibility to make considered use of their vote.
In the US, the Centre for Financial Market Integrity published its Asset Manager Code of Professional Conduct at the end of April 2005. The Code sets out global ethical and professional standards for companies that manage clients’ assets, and its general principles are very similar to those of the Myners Report.
Sadly, few investors appear to have taken these recommendations to heart, with still only 40 per cent of UK institutional investors exercising their right to vote at both annual and extraordinary general meetings.
Future Trends
Over time, the relationship between corporate executives and institutional investors will become less strained. Throughout the history of corporate governance, there has always been a strong initial reaction to the introduction of new initiatives, followed by a cooling off period and gradual acceptance of the change.
As companies are already well regulated through the various recent codes, it is unlikely that there will be further additions to company regulations. However, it is a different situation for institutional investors. Given the ongoing pension problems in the UK and elsewhere, and the relative lack of interest from many investors in the roles and responsibilities described here, it is likely that they will continue to receive attention. If nothing else, the glare of the media may force them to take their responsibilities more seriously and, in the extreme, government may force them to be more transparent.
Murray Steele is a senior lecturer in strategic management at Cranfield School of Management. He is also a non-executive director or chairman of three companies, a pension fund trustee and a trustee of a large educational charity.
