Sunday, 20 September 2015

Playing The Long Game

Short-termism, on the part of corporates and investors, is an issue that apparently will just not go away. The first wave of criticism seems to have broken in the early 1990s. Michael Porter's work on the subject is probably most famous, but also worth a read is the Century Foundation task-force report (which involved Robert Shiller). Around the same time, in the UK frustration and concern about short-term pressure from financial markets was expressed by many corporate leaders. This lead the then trade body for asset managers, IFMA, to commission a response from Paul Marsh (Short-termism On Trial) which, perhaps unsurprisingly, absolved investors of any responsibility and put the blame back on corporates.

Looking back on this period two things are worth noting. First, many corporate leaders were willing to speak out, and be openly critical of pressure from financial markets. Second, the types of proposals that were put forward by those looking at the subject were fairly significant structural changes, such as amending shareholder rights, changing the tax system or creating new types of investment vehicles (remember "relational investing" anyone?). I think if we look back on this period what we really see is corporates and grappling with the emerging relationship with institutional investors. Many were worried about their power being usurped and their priorities being set for them by a new, powerful set of external actors.

To take an example from the time, in 1990 Sir Hector Laing, then chair of United Biscuits and later Conservative peer, contributed an essay to an NAPF report entitled Creative Tension in which he compared the power of concentrated share ownership in the hands of a few institutional fund managers to the power of the trade unions that the Tories had seen off. He even warned that this concentration of power was an equivalent threat to the UK's economic performance.

If we wind forward a couple of decades, we find that short-termism is still being discussed as issue of concern. What is more, many would argue that the problem has got worse. The average holding period for shares has continued to drop, in part driven by the rise of high frequency trading which makes a mockery of the idea that much equity trading is based on an assessment of the prospects of the companies to which they relate. In addition there is concern about the extent of investment undertaken by companies in countries where financial markets play a significant role in corporate finance.

However, what we see - in general - is that corporate leaders speak out much less often than they did in the past, and that the policy solutions put forward are much less ambitious. Partly this is explained by corporates (for whatever reason) accepting the agenda of financial markets. I personally think Tony Golding nailed this in his book on the City:
Industrialists no longer make speeches about ‘short-termism’ because the rules of the game have changed. The 1990s saw the emergence of a New Industrial Compact between senior management and institutional investors. Today’s CEOs and FDs accept the process of regular dialogue, the mantra of shareholder value, target setting and performance appraisal as a fact of life… [T]he evidence points to the conclusion that managers have adjusted to institutional timescales rather than vice versa. What is clear, however, is that where once there was a mismatch, there is now an identity of interest.
And if you want to see an example of this New Industrial Compact in practice, remember that the bodies representing the interests of the big corporates on the one hand (CBI) and the big asset managers on the other (IMA) clearly collaborated in their submissions to a consultation undertaken by the government in 2011 on... err... short-termism.  

Alongside this has occurred the gradual codification of shareholder rights in various regulations, codes etc and the associated acceptance of a basic model in policy of how markets work and how problems are best dealt with. The elements of this model seem to me to be: a general scepticism about the efficacy of direct regulatory intervention (with the law of unintended consequences frequently invoked); a belief that market failure can be addressed by increased disclosure and empowerment of principals; and a belief that individuals respond to financial incentives in a relatively straightforward way that can be manipulated.

I think these factors combined help explain why, despite continued concern at the potential of short-term pressure from financial markets, recent proposed policy interventions seem well short of the scale required. For example, both Alfred Rappaport and Andrew Smithers have written very impressive books about the problems of short-term pressures in the current set up. Yet both, to me, have an heroic faith in the ability of tweaked financial incentives to tackle these forces. Or, in the investor world, look at the negative response that the Mercer/Generation research into potential 'loyalty' rewards for shareholders received from large shareholders themselves. A lot of people come to these issues with a lot of priors. We now have (at least) a second generation of people coming to these issues who take ideas like "equal treatment of shareholders" as well-established fundamental truths. This does not make for a very wide-ranging discussion of options.

In light of this it is very encouraging that some people are willing to think quite a bit differently. A recent addition to the small library you can assemble on short-termism is Playing The Long Game by Laurie Fitzjohn-Sykes. According to his bio, if I understand it correctly Laurie is an ex sell side analyst, which brings an interesting perspective, especially given John Kay's view on his former profession!

I won't beat around the bush - I like this book, and I say that as someone who has read a fair bit of material on these issues. First, some general comments. The book is short and well written, so if you are a newbie to this area you won't find yourself out of your depth, or giving up in the early pages of a monster. On the other hand, despite the path being pretty well trodden, I was pleasantly surprised to find Laurie references some papers etc that I haven't read, and which I will go and have a look at.

Now to the guts. From the outset he accepts the argument that short-termism is a problem, and cites in evidence factors such as low investment by corporates and levels of cash returned to shareholders, and argues that this a problem for all parties. Importantly, given what I've said above, he also states as  early as the first chapter that previous proposed reforms have been too small in scale. I won't summarise the commentary on the evolution of the current situation (such as the growth of institutional investors) save to highlight that he (rightly) skips over Drucker's "pension fund socialism" quickly. It's a beguiling idea that too much time has been wasted on, given that we know what came next. Socialism it wasn't.

Along with other critics, he sees the introduction of short-term share-based management compensation (managerial heroin I think Buffett called it?) as a driver of the short-termism that has arisen in the system. He also shares the view of Rappaport and others that analysis based on short-term financial results is also part of the problem, given the uncertainty attached to looking further into the future. Because management know more than investors, but are incentivised to keep the share price up, they can choose paths that achieve this even if they believe this nay not deliver long-term success. And the whole process is turbo-charged because the "investors" are typically asset managers who themselves face business risk as a result of the pressure for short-term from clients like pension funds.

Turning to alternatives, Laurie provides a pretty even-handed brief review of the other models, or varieties of capitalism if you prefer! The arguments here are familiar to most - arrangements like block-holding and different governance structures (co-determination etc) can allow companies to take a longer term perspective, but also makes them less flexible. Interestingly, he also uses examples of tech companies with controlling founder shareholders. These can often be *horrible* from a mainstream corp gov perspective, but would they have been able to develop the way they have with a regime more friendly to minority shareholders. But he also makes the point that this may not be sustainable or desirable over the long term.

This section is also where I have the greatest disagreement with Laurie, since he is critical of a shift towards a stakeholder model. His arguments are principally that this would put too much power with management, and would be difficult to implement. I don't want to take up too much of a review setting out my own thoughts but I have some quick responses to this. I believe employee representation plus ownership / profit-sharing should be introduced because: employees generally contribute more and take higher risk than shareholders; they are better placed and better motivated to monitor management than shareholders; I think shareholder value can be created without it being an operational objective / codified in company law etc. More generally, if we look at firm structure as an issue of political economy, rather than just economic efficiency /market failure, I think there is a compelling case for employees to have a greater stake, particularly as this might help tackle inequality. But here endeth the lesson....!

So finally come the solutions. Here, in line with his earlier comments, Laurie goes for a range of policies tackling different aspects. He is sceptical of the value of greater board independence on its own to improve governance, or of board reforms to tackle short-termism. He suggests instead that directors be encouraged (financially) to speed more time on their duties, and that they could have greater poet to commission external advice. But he is clear this isn't a big part of the solution.

On exec pay, he first proposes the classic combo of greater disclosure and greater shareholder power which has not been much of a success to date. But he also suggests a penal tax rate of 80% for directors' earnings over a certain level (say £500k) unless this in invested in the company's own shares for 10 years. And he proposes directors' pension contributions be locked up in the company too. For reasons I won't rehearse I'm sceptical about the potential for much behavioural change from exec pay reform, but at least we get some radicalism here.

Turning to investors, he proposes the creation of a tax advantaged savings vehicle that would have to hold shares for a minimum average of 3 years. The suggestion is to make this attractive using a corporate tax reform rebate, which I will come back to later. The idea is that by reducing turnover this would force fund managers to take a long term view, rather than chasing quarterlies and dividends. Again, the detail needs to looked at, but I'm attracted to the willingness to make a structural change.

Where I don't agree is Laurie's suggestion that this menu of reforms be made attractive to companies and investors by offering corporation tax rebates. Full disclosure: I've just spent two days at a union conference on tax avoidance and I am worried by the race to the bottom on corporate tax rates, so I'm very resistant to the idea of further "base erosion" (especially given the impact on developing countries who rely disproportionately on corporate taxes). But there is no reason this couldn't be tweaked, if only presentationally. Perhaps one option is that the default is the new set-up, but with corporates able to pay more to opt out?

Finally, he also makes recommendations for the improvement of third-party financial analysis. These are aimed at the scaling up of researcher providers, distancing research from investment banks, and making the research available widely. An interesting idea here is that that institutional investors be subject to a research levy, based on AUM. I can see this would be controversial, but it would perhaps tackle the problems caused by current research allocations by asset managers. As an aside I wonder if Laurie has looked at the experience of the Enhanced Analytics Initiative which also tried to achieve change in the type of research provided by changing the way research budgets are allocated. This had an ESG slant, but was aiming at ensuring long-term thematic issues were properly covered. Unfortunately, I'm not sure it worked.

To draw things to a close, I'm not on the same page as Laurie on some points, and I would certainly favour a shift in stakeholder representation and voice within companies. As I said earlier this is partly because these are deeply political issues and therefore I don't think should be considered solely in terms of market efficiency, but that's a debate for another day. But I am impressed with his willingness to put forward a broad range of proposals that should be introduced together.

Whatever disagreements I might have with the specifics this more likely to achieve change than many ideas that come from within the system and seem to envisage that only what is reported (disclosure) and how people are paid are worth looking at. In addition, with the idea of an alternative regime into which companies andinvestors could opt, Laurie shares some important common ground with Colin Mayer's ideas in Firm Commitment (which is closer to my own personal views). If there are some broad outlines emerging they may be these: variations of the corporate form - even within markets - can and should be encouraged; and it is OK to make trade offs between liquidity, rights and reward provided that participants are able to choose, rather than being forced down one path.

Perhaps, we can see the early signs of escaping the unchallenged assumptions that have prevented meaningful debate this highly important area for years.

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