In the UK, there has been a vibrant debate on whether active engagement by fund managers with investee companies adds “value” in its widest sense. Drawing on comments made by asset managers at a recent conference, Pauline Skypala, FTfm editor, recently wrote: “It is not at all clear that greater engagement by fund managers will lead to better governed companies. There is no evidence that this is the case.” (Let’s be realistic about engagement, May 21)
In terms of broad impact, pressure by shareholders – including through engagement – over the preceding two decades has contributed to corporate governance improvements at UK companies. Boards of directors, for instance, are more independent and operate more professionally today than a generation ago. What is less clear is the extent to which such interventions have created “value” in terms of improved business performance.
In our view, deficiencies in value-adding engagement by fund managers (as distinct from asset owners) relate to the lack of intensive “stewardship” interactions with individual companies on strategy, leadership development and succession, and other matters that drive and sustain business success in the long-run. John Kay, in his review of the UK equity markets, points out that the “structure of the [investment] industry favours exit over voice and gives minimal incentives to stewardship”.
For stewardship engagement to take hold, fundamental changes are required. First, asset managers will be best positioned to engage seriously with investee companies if they hold relatively small portfolios. At many investment houses, fund managers have hundred of names in their portfolios, making it difficult to monitor – let alone engage deeply with – individual companies. One UK chairman complained to us that most asset managers lack in-depth understanding of holdings, thereby hampering robust shareholder-company dialogue.
By contrast, “focus” funds – including those that actively agitate for change – typically maintain concentrated portfolios (as few as a dozen core holdings in some instances).
Importantly, preliminary results from a London Business School study of 1,900 “interventions” globally (at listed companies) by “activist” investors indicate that such engagements delivered above-average rates of return.
Second, active engagement will be compelling to fund managers only if performance measures are sufficiently long-term as to permit stewardship efforts to “bear fruit” and ascertained qualitatively (causal relationship between engagement activities and subsequent company changes and outcomes) and quantitatively (firm and investment outperformance). While most pension funds and other clients still obsess over quarterly performance by their fund managers, others adopt a more sophisticated approach.
Third, to encourage robust engagement with investee companies, fund managers should be rewarded appropriately for outperformance. Correspondingly, engagement-related expenses – which can be substantial for certain interventions (particularly when legal, investment banking or other third-party assistance is required) – should be shared between the investment managers and the funds they manage. Presently, these costs are typically borne by the asset manager (ie, deducted from its management fee) rather than paid out of the fund. This structure creates a significant deterrent to effective engagement.
Without reforms along the lines outlined above, the “stewardship deficit” in the UK will not be closed.
Peter Butler is founder partner and chief executive and Simon Wong is partner at Governance for Owners