Could institutional investors have prevented the credit crisis?

Did a failure of active ownership contribute and if so, how can it be remedied?

Many years ago, in the wake of devastating urban riots, the UK Home Secretary of the time sought to deflect accusations that there were insufficient police forces to deal with the crisis. The important question, he said, was not “where were the police?” but “where were mum and dad?” His point was well made. In any crisis, the spotlight falls on the aftermath and too little attention is paid to those who might have prevented the crisis in the first place. In the financial services industry’s current predicament, the “mum and dad” in question are institutional investors. Sure, they enjoyed the boom that took Northern Rock’s share price to £12 and Lehman Brothers’ to $86. But did they ask tough questions about the sustainability of those profits and the strategies on which they rested? Colin Melvin, chief executive of Hermes Equity Ownership Service, part of Hermes Fund Managers with £35bn under management, said: “The fundamental problem is that large, long-term investors failed to act as good owners and invested in ways that undermined the system. Banks had owners – what were they doing?” The principles of good governance, which hold that managers and boards should be accountableto informed and active investors, have been under almost permanent debate in markets globally for two decades. And, in the UK, it is more than seven years since Paul Myners, the former Gartmore chief executive, published his government-sponsored report urging a greater commitment by pension funds to responsible ownership. Yet progress has been all but non-existent. In the UK, only a handful of large fund managers are genuinely committed to acting as engaged and active owners of companies, and the list of those managers is almost unchanged from a decade ago. Anita Skipper, corporate governance director at Aviva Investors, which manages £235bn, said: “Forty per cent of shareholders don’t even bother to vote and many of those who do simply support management.” This culture of absentee landlordism did not cause the financial crisis, but it did contribute to the failure of oversight that allowed banks to pursue their ill-advised lending spree unchecked. Reforming that culture will be difficult. Fund managers face few incentives to engage in responsible ownership – it is expensive to deliver, and most clients do not demand it.
Acting as a genuine owner across a portfolio of hundreds, maybe thousands, of stocks is a highly resource-intensive activity, requiring large teams of specialist staff. Michelle Edkins, managing director at Governance for Owners, a fund management and advisory firm, said: “A thorough governance programme, beyond merely voting, costs money.” But who pays? An investment strategy based on committed ownership may add value – at least, it helps prevent value destruction – but it is a long-term commitment and the benefits are hard to measure with any certainty. For fund management clients wanting concrete returns in the near term, ownership looks like a luxury they can ill afford. Whatever the reason, few pension funds insist that their managers commit to meaningful monitoring of and engagement with portfolio companies, and are prepared to pay extra for it. Edkins said: “Too many pension funds have loose or vague language about taking good governance seriously in their statement of investment principles, but they don’t put resources into it.” Skipper said: “If asked, fund managers tend to do what their clients ask them. Trustees don’t need to understand all the technical details but they need to ensure that their fund managers do.” But pension funds themselves argue that this explanation gets the problem the wrong way round. Daniel Summerfield, co-head of responsible investment at the Universities Superannuation Scheme, with approximately £28bn under management, said: “If fund managers think that governance is important and adds value, then they should be resourcing it properly without waiting for a specific mandate from their clients.” No fund manager waits for pension fund approval beforeappointing a pharmaceuticals analyst or buying economic research, so why should resourcing an ownership function be any different? Finger-pointing between fund managers and pension funds is only the symptom of the disease, however, and not the cause. The wider problem to be addressed is that the investment management industry is not structured in a way that encourages real ownership.Melvin said: “There is a long chain between an equity investment in a company and the ultimate beneficiary, featuring pension fund advisers, fund managers, custodians and brokers, among others. Even though the investment horizon for the beneficiary is very long-term – say, 30 years – each of those service providers in the chain has an incentive to generate short-term activity for their own gain.”

“Too many pension funds have loose or vague language about taking good governance seriously”

Reform is necessary to address these structural flaws. The relatively lowly status of pension fund trustees must be addressed as a priority. Melvin said: “Trustees are often part-time and only a minority are expert in financial matters. That means that advisers and service providers to the pension fund industry tend to be in control.”
Those outsiders have little incentive to commit to long-term ownership so long as fees can be earned from maximising short-term activity. But the fund management industry too needs to make adjustments, in particular abandoning its institutionalised view that governance is a tick-box, compliance-driven activity.

Edkins said: “Governance analysis doesn’t come naturally to most portfolio managers. It’s a different skill, but it is an essential element of the investment function. When governance goes wrong, there is a cost.” Summerfield said: “Corporate governance needs to be incorporated into investment decision-making processes much better than it is at present. There are still too many examples of the same company being visited by the governance and equities teams separately. Integration of these two areas of activity is vital.”The lack of an ownership culture in investment management, and the short-termism it breeds, has long been identified as a flaw in the Anglo-American system of capitalism. The failure in that system has been so profound that a concerted effort aimed at correcting that flaw can no longer seriously be resisted.
Kit Bingham is a corporate affairs director at The Communication Group
This article first appeared in Financial News and is reprinted with permission.