Sunday, 23 December 2007

Shareholder activism: theory and practice

Shareholder activism in theory ought to be a straightforward and commonly utilised strategy. If the owner of a public company thinks that it is being run in a way that destroys value (or threatens to) then they should engage with the management of the business to bring about change. Concerns about the threat to value might involve company strategy, corporate governance or even social or environmental concerns. But in theory it should be in the shareholders' self-interest to engage with management. Afterall, they are the owners, it is really their business.

In practice things are very different. For one, neither company management nor investors (again I'm talking fund managers here) seem to really consider the latter as 'owners' in any meaningful sense. They all pay lip service to the theory, but on a day-to-day basis it seems to be taken for granted that investors are principally traders rather than owners.

There are some rational explanations for this from the investor point of view. For example there is the 'free rider' issue. If a shareholder does engage with a given company, and as such prevents value destruction (or even creates value) than ALL shareholders gain by this, not just them. So, from a fund manager's point of view, why incur the cost of doing something that benefits your rivals.

If you think that line of thinking is problematic consider another one. For example, if a fund manager has concerns about a certain company they may well underweight it relative to that company's standing in a given index. If the manager is also underweight in that company relative to its peer group then it is actually in its short-term interest for the company to perform badly. It will hurt that fund manager's performance, but it will hurt their rivals more.

A more straightforward explanation is that it may simply be easier in the fund manager's mind to underweight or even sell out of a given company than engage with it.

There are of course exceptions. Investors like Hermes and Governance for Owners base their whole pitch to pension funds on the basis that they will engage, and on a serious basis. For example their focus funds will do the opposite of the process above and take an overweight position in a company that they believe has problems. By using the leverage of their increased stake they try to convince the management to change direction, alter the governance of the company etc. By doing so they aim to benefit from the value created by improving the company.

But most fund managers do not, in my opinion, operate anything like that. Although most managers now employ staff to work on corporate governance they typically seem to be quite separate from the portfolio managers. Their principal activity is voting shares, typically with a view to encouraging compliance with the Combined Code or comparable standards overseas. Now this is certainly an improvement from the situation in even the recent past where some fund managers did not vote at all. But simply pushing for compliance with a certain set of standards clearly has its limitations. It's a bit like a school inspector focusing on whether the right curriculum is being taught, rather than the quality of teachers, or the school's actual exam results (as misleading as such stats might be...).

This leads me to think that some fund managers undertake this activity because they think they need to be seen to be doing it, rather than because they genuinely believe it has value. They are traders who feel compelled to exhibit some basic signs of being interested in ownership. I'm not doubting the sincerity of people who work in the corporate governance teams of such investment houses, rather I wonder how seriously the leadership of such organisations take such issues.

As I have said before I think one of the reasons the ownership bit of shareholding malfunctions like this is because of the delegation of power from the ultimate investors (us, or our trustees) to professional fund managers. It is another version of the principal-agent problem. And I actually think that fund managers are doing pretty much what we are telling and paying them to do. The main message that they get from pension fund trustees is that performance is very important, and poor performance will result in them getting the sack. Corporate governance and social responsibility are very much an afterthought, and not considered at all by some trustees. In such a scenario it's not unreasonable that fund managers prioritise trading to deliver returns over engagement. Therefore until trustees change the signals that they send to their investment managers this situation will likely continue.

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