Smarter investor
Published : July 2008
Investor activism seems to be hitting the headlines harder than usual. Is it about poor returns in unsettling times or something more fundamental? Ruari McCallion tries a bit
of speculation
Luqman Arnold has called for the break-up of Swiss bank UBS into various constituent parts. One may agree that he has a point; losing the odd billion or so on currency speculation may be unfortunate, but to take a $37 billion sub-prime mortgage related write-down in less than a year seems like carelessness, to misquote Oscar Wilde. On the other side of the coin, or perhaps in a different wallet, is Stuart Rose of Marks & Spencer. He is widely credited with having rescued the company from decline, but the question of whether he should then have combined the roles of chairman and chief executive has raised some eyebrows among the investing community, to say the least. Only a shareholders meeting that can ultimately unseat Rose from one, other or both of those roles and whether the shareholders will allow their gratitude at M&S’ turnaround to overcome their concerns remains to be seen, but the investing community has been changing over the past 20 years and appears to be less inclined to accept ‘a quiet word behind the scenes’ as the means to resolution.
Active investment is nothing new. Slater Walker in the 1960s made its reputation through detailed analysis prior to taking stakes in undervalued companies and exerting pressure on boards. Every fund manager who seeks or claims to pursue a return ‘above the FTSE average’ will have to be active, to a greater or lesser degree. What has attracted more attention lately is the perception that shareholders are seeking greater influence on corporate strategy. Of course, if everything’s going swimmingly, there will be few concerns to voice and even fewer ears to listen to them. So are the signs of more active involvement indicative of greater nervousness in unsettled times?
“Not necessarily,” said Barry O’Brien, of international law firm Freshfields Bruckhaus Deringer LLP. “To be fair, the UK and Europe are significantly behind the USA in terms of shareholder activism. It isn’t an everyday occurrence; in the UK, you can put that down to the fact that we have well-established pressure groups like the ABI [Association of British Investors]. We also have a time-honoured tradition of large institutional shareholders, like Standard Life, Schroeders and others, who have been able to exercise influence on a regular basis without resorting to more overt activism.”
Donald Stewart of Faegre & Benson LLP, argues that the changed ownership profile of major companies has been very influential. “According to Andy Brough of Schroeders, 15 years ago 80 per cent of the FTSE100 was owned by institutions; it’s now 20 to 30 per cent. A huge amount is owned by hedge funds and they are the very definition of active investors,” he said. Hedge funds are very much out for themselves and seek to exploit small shifts in value – whether in currencies, commodities or shares – and leverage them to their benefit. Institutional investors tended to hold over the longer-term – very long, in the case of dividend-hungry pension funds. If something happened they didn’t like, they’d simply sell their shares. Hedge funds are different.
“They are interested in as much return as possible in as short a time as possible,” Stewart continued. “They aren’t really interested in the long-term health of companies. It’s a different investing audience and a lot more volatile, which leads to more volatility in stock prices. The very large companies probably don’t notice that much difference; it’s a phenomenon in the middle market more than the top.” The active investor may not be as interested in the traditional niceties, even with established structures.
“There are ways for shareholders to express their concerns and it doesn’t fall under the heading of activism as such,” said O’Brien. “It isn’t the old ‘behind the scenes’ chat in the golf club stuff, more that there are well-established protocols and more formality. Companies hold regular meetings with important shareholders, which are properly convened, with minutes taken. Most of the main UK and European institutions have investment relations teams whose job it is to scrutinise the performance of investee companies and ensure they’re up to scratch.”
The arrival of hedge funds is a relatively recent phenomenon. As their concern is purely financial return and their horizons are very short-term, they could be characterised as behaving like selfish teenagers, making a fuss if they don’t get their own way, regardless of the broader interest. But to view them in that way is to miss a fundamental point about business and investment.
“You have to start with the premise that directors have to act in the best interests of their companies, which means the best interest of their shareholders,” said Stewart. But there’s an inherent dilemma in that situation. “What is in the best interests of shareholders? To maximise cash now or to squirrel it away for the longer-term? The law does not require directors to make the biggest short-term gains if it’s not in the longer-term interest of the business, so you can get a pretty high octane mix of different objectives. Companies are more likely to look at longer-term fixes than short-term investors.” The phrases ‘long-term’ and ‘short-term’ now take on different meanings, too. The average venture capital horizon of three to five years – short in most people’s view – is approaching eternity in the eyes of hedge funds. So are hedge fund objectives potentially damaging to company interests, and should they be allowed to behave in that way?
“They have no obligation regarding the interests of the companies they invest in – their interest is their own,” Stewart replied. “The issue is really how the managers of companies manage the expectations and interests of the whole body of shareholders.” The other influence is the latest Companies Act in the UK, which codified an obligation on companies to take into account the interests of employees and the broader community – ‘stakeholders ’, in the current parlance – as well as shareholders alone. But that’s not as big a change as it may have appeared.
“The new Companies Act didn’t change much in terms of the law – directors were always obliged to take into account the interests of creditors, employees and the wider community, but their primary obligation remains to shareholders,” Stewart continued. “They’re still stuck with the reality that investors will sell shares if they don’t like what’s going on. They may not say anything or vote against resolutions at meetings – they simply vote with their feet and sell. If enough people do it, the share price falls.”
Successive governments in the UK have actually encouraged more shareholder involvement and that does include new provisions in the Companies Act, under ‘derivative actions’. Investors have the direct right of action against directors if they are viewed as being in breach of their duties. That’s a situation that has long been in place in the USA, where a share price moving in the wrong direction can give rise to class actions and a flood of litigation. Stewart expects to see more, not less, of that in the UK, and that isn’t necessarily a good thing.
“It doesn’t do me and my clients any favours when we’re trying to raise money – and money is short in the current climate. Where investors can have a free go at directors if they feel so inclined, people become more reluctant to become directors of public companies,” he said.
But there are positives; investors don’t have to buy 50 per cent of the shares in order to get the board changed. The appalling apathy of institutional investors has allowed drift or, even worse, poor business practices being allowed to fester because no-one holds the board to account. Change there is to be welcomed and if investors feel obliged to engage more actively, it should – repeat, should – result in a better-run company. However, there’s a very big but – and it’s been seen in the shape of the sub-prime mortgage fallout.
“The pressures on banks to keep up with competitors was intense,” said O’Brien. “None of them would have taken the view that they were exposing the company to the subsequent storm and it would be very surprising if anyone could put forward the proposition that they would invest in the short term in something with longer-term dangers.”
But they did, nonetheless, and those who argued against either the rush to equities when P/E ratios were stratospheric, or into securitised high-risk mortgages on historically unprecedented earnings multiples, tended to lose their jobs.
Investor activism is very much a two-edged sword. In theory, it involves shareholders more in the companies they own and should lead to better governance. In practice, as with many good intentions, there are unforeseen consequences that are less welcome. And once the genie – in the shape of powerful investors interested only in the short-term – is out of the bottle, it’s difficult to put it back in. The high-profile, well-resourced active investor is here to stay. END