In Hermes’ view good management and good governance are synonymous. It is difficult to imagine a well managed company that has poor governance. All the evidence is that well governed companies do better and are more highly valued by the market. Furthermore, the improvement and the market’s appreciation of that improvement as the governance improves can be identified.
It is clear that many companies have travelled a long way in recent years – a point the president of the Confederation of British Industry (CBI) John Sunderland made in his speech earlier this year, in which he also attacked institutions for short-termism and not putting their own house in order.
If this is the case, then why are things not better? The simple answer is that the chain of accountability, although now much better, is far from perfect. Ownership and control has been split for centuries, as Adam Smith noted in the 18th century. Governance is about bringing them back together again.
Ownership, as principal, rests with the pension fund members, insurance policy holders and retail savers but control rests with two sets of agents – the fund managers as allocators of capital and boards as users of that capital: two agents for the same principal, who should be working together to enhance the interest of that principal. There has been good progress over the last 15 years but it is far from over.
Because of its historic position, Hermes is in two ways a useful example of the role which the investor should play in discharging his duties to the ultimate beneficiaries of the capital. First, we are owned by the UK’s largest pension fund, the British Telecom Pension Scheme with assets in excess of £30bn (e44bn) so we can speak as the ultimate owner not as an externally mandated delegate of the trustees’ investment authority.
Second, most of that money is invested in index matching portfolios. As a result, we have no opportunity or ability to sell.
The only way in which we can enhance value (or prevent it being destroyed) within these index matching portfolios is to discharge our ownership obligations and actively engage with boards and management where is it appropriate to do so.
Problems arise in many situations when traders in shares overwhelm those who act as owners of the company. Then share prices will overreact in both directions as views on value will differ. There are occasions when shares should be sold. But in doing so the vendor is not abdicating his ownership rights and obligations. He is simply passing them on to the purchaser of the shares who should deal with them and for exactly the same reasons as the previous owner.
However, if on long-term holdings these rights and obligations are not undertaken, accusations of short-termism are justified.
It is wrong to only blame the hedge funds. They are a diverse group with many different investment strategies. The Deutsche Börse/LSE situation was one example which shows they can act as responsible and involved investors.
Accusations of short-termism reflect a misalignment between the interests of investing institutions and those of their clients. For investment houses, relative performance is key to the amount of funds they manage and therefore their returns to their shareholders, directors and employees. They are less focused on client performance, and the obligations of pension funds to meet their liabilities.
It is this disconnection between what the corporate board sees and what the institution does that produces the problem to which many have referred. The share price of UK PLC, the market, should be seen as a long-term reflection of corporate performance, with value creation as the only justification required for shareholder involvement in discharging their obligations.
The Hermes Principles outline what we require of companies – specifically a definition of the strategic purpose of the company, backed up by the obligation on a board to define its cost of capital and how it hopes to create a surplus over that cost as well as dealing with the communication, social and environmental issues.
Our governance efforts are directed to meet the current actuarially determined funding obligations in the pension scheme, which requires a nominal return from equities of 7-8% per annum, compounded for 25 years.
In return, boards can expect from us a consistent clear dialogue with a shared understanding of objectives, a reduction of the agency problem and in particular, unless we have lost confidence in the board, support in hostile take-over situations and of course in capital raising.
The CBI’s Sunderland had a number of complaints about fund managers including the orientation of the sell side to servicing short-term traders and investment banks’ own trading desks which account for a very high percentage of daily volume.
We do operate in a market and people are entitled to buy and sell. What creates the vacuum is where this activity becomes too dominant and there is is a failure by too many institutions to recognise their ownership obligations. Share trades should not be a distraction from allocators and users of capital getting on with the real business of creating wealth.
In terms of remuneration, Hermes declares the remuneration of its boards, although there is no obligation to do so. This gives us that natural human trade-off in our dealings with company boards. Others should consider doing this.
We often get complaints about the transparency of institutions’ decision making, who is doing it and what it is based on. In particular, how do the governance activities fit with the portfolio decisions? This is not an easy task as no one size fits all. I have written to the chairmen of all the companies in the FTSE All Share to invite them if they had any complaints or queries to contact me directly. So far no-one has.
In terms of transparency, we always tell the company beforehand if we are minded to vote against any resolution and why. It should be discussed not just come out of the blue.
Transparency of ownership is a complicated issue, which could be improved so that both company and institution are clear on how much is owned at any one time. But any call for differential voting rights to be applied to different types of holders would be a backward step.
Institutions should always make sure that they get any stock they have lent back in time for a vote – especially if it affects the outcome of takeover bids. In our view beneficial owners of contracts for differences should have the same disclosure requirements as they do on shares held directly.
In conclusion, I agree with Sunderland that the management and governance of investing institutions need to undergo further reform. What is required is for those involved to look at how things can be done better in a market environment. The combined code is an excellent and flexible framework. Further regulation or legislation is certainly not required.
But with the central problem of short-termism, nothing is going to change until the institution’s customers insist on change. Only that will close the misalignment between the interests of investing institutions and those of their clients. And the means to make this happen are in the hands of companies’ board directors.
First, companies should use the Operating and Financial Review to set the agenda, define the long-term strategy and identify the success drivers of the business.
Second, corporate boards themselves influence great swathes of the investment industry through their corporate pension funds. These boards should seek the assurance from the trustees that the investment managers they appoint exercise their ownership obligations as well as they can.
As a first step, they should demand that the investing institutions sign up to the Institutional Shareholder Committee’s Code. And institutions need to demonstrate that they really concentrate on the long term and discharge their ownership obligations accordingly. There should also be a role for investment consultants, but trustees must be prepared to pay.
We have moved a long way in this debate but the requirement is still there for both boards and investment institutions to go the extra mile for the ultimate beneficiaries to get what they need from their savings. And this will only happen if they both recognise that they are in it together.