The art of engagement
The financial crisis saw institutional investors accused of taking their stewardship responsibilities too lightly or behaving like absentee landlords.
In the UK, this influenced the development of the Stewardship Code, which gave investors an explicit responsibility to express their views to company management directly where necessary, and not just through their general meeting voting choices.
At the same time, membership of the Principles for Responsible Investment, whose framework is encouraging investors to behave as active owners, has continued to grow.
“These trends were reflected in the so-called Shareholder Spring of 2012, where UK investors voted down management proposals at general meetings in unprecedented numbers, setting the mood for increased direct engagement,” says Stephen Cohen, CEO of activist investor Governance for Owners.
“Investors are increasingly realising that stewardship and engagement need to be part and parcel of their investment process and companies, recognising that investors are becoming more active, will want to pre-empt any issues of concern prior to an AGM, for example,” adds Daniel Summerfield, co-head of responsible investment at the UK’s Universities Superannuation Scheme (USS).
As USS’ portfolio has become increasingly diverse and global in nature, the number of overseas companies it engages with has increased. But most pension funds, unlike USS, outsource investment management to external service providers, although they may retain oversight of their stewardship activities such as voting and engagement.
In its integrated ESG approach, the responsible investment team at USS works closely with its portfolio managers and uses a number of models to identify companies where engagement could be beneficial. But Summerfield says that companies also increasingly approach the pension fund because they want the perspective of a long-term asset owner.
The various steps of engagement depend on the issue concerning the company and its sector. “Normally we would seek high level access, ideally board level access, with executives, non-executives and outside directors at the top of the company,” says Colin Melvin, chief executive at Hermes Equity Ownership Services (EOS). “If you seek contact at a lower level, it might be rather futile. At Hermes, we track these engagements relative to formal milestones, where we raise the issue with a company, the company acknowledges the problem and brings in a plan to deal with the problem so that we can assess our progress and report upon it.”
Investors start an engagement process by writing a letter to company trying to engage it in a dialogue. If that does not work, they may take direct action by submitting a shareholder Resolution. This is more common in the US because shareholder proposals are permitted in federal law. State laws also permit them.
“The shareholder resolution and process in Europe is mainly one that only permits shareholders to submit resolutions that are specifically in opposition to matters that are on the agenda for a shareholder meeting,” says John Wilcox, chairman at the corporate governance advisory firm Sodali, which works for companies only. “It is a different process from the US where a shareholder resolution gets submitted well before the agenda for an AGM is published.”
Alternatively, shareholders, including some Californian pension funds, may fund value investors or put money into hedge funds that are activists or other change agents.
“It is rarer for institutions to try to get a seat on the board of directors of a company or to oppose director elections but it is becoming more frequent,” adds Wilcox. “Increasingly they also withhold votes for directors on policy grounds and that is in part what proxy advisory firms are doing as well. As a final step they might take a company to court. The use of media has also become an important tool for activists, even for more conservative shareholder groups that want to effect change.”
Limited resources mean that even large institutional investors must focus engagement efforts – for example, by prioritising their largest holdings or companies or sectors with environmental or social issues of particular concern or markets where minority shareholder rights need specific attention or by selecting companies with the greatest scope to add value through activism.
For Summerfield, quality is more important than quantity. “If we are going to carry out engagement effectively with a company, we obviously have to be very informed about its performance, its strategy and everything connected to the company’s sector,” he says. “We would much rather do fewer engagements but do them well and in an informed manner.”
Summerfield says for engagements to be effective, they ought to be confidential and undertaken behind closed doors.
“This is a fundamental difference between the UK and, for example, the US where it seems to be much more in the public domain,” Summerfield continues. “For us, if an engagement appears on the front page of a newspaper it has failed.”
Sometimes USS undertakes engagements collaboratively with other investors. Summerfield says this amplifies the voice of investors and ensures that their concerns will be taken more seriously. “Where we have a specific governance concern, collaboration with like-minded investors can work well,” he says. “If an issue is more bespoke or activist in nature and specific to a particular company, engagements tend to take place on a one-on-one basis.”
The mistakes investors commonly make are waiting until it is late in the game to start engaging or adopting a compliance mentality, which looks only at whether companies have the right structures in place.
Says Wilcox: “In general, companies do not want to see engagement that is looking for short-term gain or some immediate profit at the expense of long-term value creation or any kind of change that puts the company’s long-term strategy at risk. At the same time, company management want to eliminate any misperceptions about the company.
“Another goal of management is to simply avoid activism. Engagement with shareholders is likely to prevent activism from occurring. Ultimately companies should think about bringing shareholders into the corporate family but that will take time, as there is a long history of adversarial relations between companies and shareholders, particularly in the US.”
The UK Investor Stewardship Working Party published its 20:20 Stewardship report in 2012. The report aimed to provide a framework to help achieve better investor stewardship and identified some common shortcomings in the approach of investors to meetings with companies, at least in the eyes of company managers and officers. These included an insufficient depth of knowledge of the company, a lack of continuity in relationships, a lack of a clear agenda or purpose for meetings with companies, a lack of feedback following meetings and a lack of internal consistency between the approach of portfolio managers and ESG specialists.
But can an engagement process actually translate into financial gains? Academic views on whether activism increases value are split. According to Wilcox, this is because it is difficult to come up with a methodology than can isolate the variables and do a definitive study.
“For a basic stewardship type of engagement looking at governance change or concerns it is sometimes very difficult to identify causal effect with the share price,” says Summerfield. “In some aspects it is more like a pre-emptive risk management approach, ensuring that good governance is in place to oversee management and their decision-making effectively. But in the more active, event-driven type of engagement with the aim, for example, of changing management or strategy, a clearer link to share price and the company’s performance can sometimes be identified.”
Occasionally companies may not respond to minority shareholders’ attempt at dialogue, says Cohen, particularly if the company has a large and dispersed shareholder base or one or more large shareholders dominate the company’s ownership structure.
USS has occasionally sold its holding in companies due to lack of access to boards of directors or failing to see any progress in engagement. “If the company’s board is reluctant to engage with investors it may be an indication that the board is not overseeing the company and the management in the interests of its investors,” says Summerfield. “It does raise a very real red flag if engagement fails to take place between the owners of the company and those appointed to represent their interests on the board.”
In the US, lawyers and other advisers will routinely warn companies not to get into the dialogue or have extra disclosure and explanations about their decisions because these may exceed disclosure requirements and involve insider information or selective disclosure. “But the attitude to treat shareholders as the enemy rather than as owners of the company and capital providers is changing,” says Wilcox.