Why the fund management ownership model has failed

Something is wrong with capitalism. More specifically something has clearly failed in the Anglo-American model of capitalism in which shareholders, as owners of companies, are expected to exercise oversight and, where necessary, restraint. While the idea that shareholders as ‘owners’ is a theoretical cornerstone for much of the activity that takes place in the responsible investment world, recent experience does not offer confidence that this model is working effectively. In the UK, the House of Commons Treasury Select Committee’s inquiry into the banking crisis is generating a huge amount of material that could prove very useful as we try and find our way out of this mess. The written submissions from two of the leading institutional investor bodies – the Association of British Insurers (ABI) and the Investment Management Association (IMA) – provide some particularly interesting perspectives on the limitations of attempts to get shareholders to exercise ownership. For example, the ABI argues that the fragmented nature of share-ownership means that effective shareholder engagement is often hamstrung because some ‘owners’ aren’t very interested in governance, enabling companiesto ‘divide and rule’. A similar point was made last year by corporate governance veteran, Ira Millstein, senior partner at US law firm Weil, Gotshal & Manges. Meanwhile, the IMA argues that shareholders did try to influence the banks, both by selling their shares or, where this wasn’t possible, by engaging with management. Both types of intervention were ineffective, it argues. The IMA also makes the point that the effectiveness of engagement is inevitably limited during a credit bubble, as banks can raise funds easily and are less reliant on their shareholders. Perhaps the most telling comment from the IMA comes towards the end of its evidence: “In many instances it is now apparent that the boards and management of financial institutions failed to fully appreciate the risks on their balance sheets, thus, investment managers could not have been expected to either; this was not a problem which could have been avoided by better engagement. Managers compensate for such information asymmetries by diversifying portfolio construction.” This seems to be a fairly open admission that fund managers can’t play the oversight role very effectively (principally because of limits to their

knowledge). The best they can hope for is to avoid putting all their clients’ eggs in one basket. In fact, in addition to not spotting (or being able to spot) risks on balance sheets, it seems fairly clear that they didn’t notice or challenge the risks in remuneration. No UK-listed bank came anywhere close to losing the vote on its remuneration report, for example. And it’s even less likely that investors were probing below board-level remuneration. Part of the problem is clearly the wide variation in shareholder competence in identifying and addressing governance and related issues. As the ABI suggests, some investors simply don’t want to act like owners, whilst others do. We do not believe that all investors are blind to the importance of governance issues. There are certainly some in the market that resource activity in this area properly and appear to engage effectively. But they may not have the strength to bring about change by themselves. This is compounded by the typical relationship between fund manager and client. Many pension funds simply delegate responsibility for governance analysis and shareholder voting to their existing fund managers. Yet as Dr. Craig Mackenzie, senior lecturer at Edinburgh University Business School, has argued previously on Responsible Investor, such an approach rests on the mistaken assumption that fund managers will have competency in this area. Mackenzie said: “The most commercially successful pension fund equity managers tend not to implement active ownership effectively while the most effective active ownership managers tend not to win equity mandates.” Such a situation is perhaps not surprising. Pension funds are primarily interested in picking an asset manager who is best placed to manage a given mandate most effectively.Having picked the best manager for the job, funds then also give them responsibility for corporate governance. The problem, as highlighted above, is that these managers typically do not have strength in this area because they do not consider it core business. Indeed, some fund managers clearly believe corporate governance activity is simply a box that needs to be ticked in order to appear on client shortlists. The lack of serious commitment by some financial institutions to corporate governance analysis appears to be expressed in current market activity. A number of major institutions are cutting back their resources in the area of analysis of environmental, social and governance issues.

“No UK-listed bank came anywhere close to losing the vote on its remuneration report”

If confirmed, this trend presents a serious challenge to pension funds that believe that good corporate governance is an intrinsic part of good business and successful investment strategy. If they delegate responsibility for addressing governance issues to their fund managers, recent experience and current market activity suggests they may find they are not using their shareholder rights effectively.
There is a logical alternative. Just as pension funds seek to appoint fund managers best at managing a particular asset class, they can appoint a service provider best at addressing corporate governance and shareholder rights issues. Some may counter that governance analysis must be embedded in investment decisions. We agree, but it

clearly is not to date. Current market practice clearly demonstrates that many fund managers do not have the resources available to achieve this, assuming they have the commitment, and this doesn’t look likely to change any time soon. We believe that a separate voting and engagement service is the best option for pension funds that want to exercise ownership, but have no available internal resource. This change in pension fund behaviour alone, however, will not bring about a step change in our flawed ownership culture. We also need to see a real paradigm shift in the nature of governance analysis itself. To date shareholder engagement over governance issues has been characterised by an emphasis on compliance. In the UK we have seen the gradual evolution of the Combined Code as a set of best practice principles and companies have been slowly nudged towards compliance. This has been of real benefit for the market as a whole – companies and investors. The governance of the UK’s public companies was, until recently, widely admired. But, as the current crisis has amply demonstrated, simply running the slide-rule over companies to measure compliance against a set of guidelines will not take us very far. Compliance is a means not an end. Governance has to mean adding value to the relationship between shareholders and the companies they own. As owners, high standards ofgovernance must also require more effective management and risk control. This means that investors who do take governance seriously also need to have a much better handle on the business models of the companies they own. Albeit with the enormous benefit of hindsight, the warping of UK bank business models, through ratcheting up their leverage, seems fairly clear. This at least must give us hope that we can improve our analysis in the future, increasing predictive elements of our scrutiny. This necessitates the shift away from simple compliance-monitoring towards a much greater emphasis on risk; in particular company-specific risk, and business model. This will not come cheap, as this type of analysis is, in our experience, rare. Therefore it needs to be properly funded by investors. For pension funds, this analysis of the crisis is probably an unwelcome message: you need to spend more money. But the actual resources required, if the market moves in this direction in general, should be relatively modest, especially compared to the losses incurred because banks have not been properly stewarded by either their directors or their owners. Our fear is that if these kind of steps are not taken, then policymakers may consider less shareholder-friendly ‘solutions’ to the principal-agent problem. Without radical change, the listed company governance model may be on borrowed time.
Tom Powdrill is head of communications at Pensions Investment Research Consultants (PIRC)