By Cydney Posner
Here is an interesting paper from the Millstein Center (courtesy of the corporatecounsel.net blog) that examines the role of institutional investors in corporate governance. In the wake of the financial crisis in 2008, legislators and regulators devolved more power to corporate shareholders as a "check" on the seemingly unbridled risk-taking in which some corporations engaged and on the excessive compensation granted to corporate executives by boards of directors. Measures such as say on pay and proxy access each involved efforts to transfer to shareholders more power over corporate governance matters. Institutional investors, such as pension funds, mutual funds, insurance companies, hedge funds and endowments of non-profit entities like universities and foundations, own a substantial percentage of U.S. corporations, as high as 70% of the largest 1,000 companies in 2009. The study asks –but does not even attempt to answer – questions regarding whether these institutional shareholders are really up to the challenge of playing the type of stewardship role that was envisioned by these legislative and regulatory changes or whether these efforts may have been misguided: "a big bet that investor institutions can and will exercise rights responsibly, and that such behavior will make markets more sustainable, less prone to error, and more in sync with the interests of capital providers." At the end of the day, the paper makes the case that we need to have as much understanding of investor entities as we do about issuers and implicitly asks whether institutional shareholders are part of the problem or part of the solution?
In 2007, the year before the financial crisis, institutional investors owned the following percentages of the largest corporations: top 250 (71.8%); top 500 (75.3%); and top 1000 (76.4%). As the concentration of institutional investor ownership has increased, the average holding period has decreased dramatically; for NYSE-listed companies, the period was about seven years in the 1970s and is now about seven to nine months.
The study cites some interesting prior academic findings:
- One study found a "statistically meaningful negative correlation between defined contribution (DC) assets and support for shareholder resolutions"; that is, the greater the dependency of the fund adviser "upon the DC channel for asset management business, the less likely the fund family will be to support shareholder-sponsored governance resolutions."
- Investors with a short-term focus are more frequently associated with mergers and acquisitions that "allow managers to proceed with value-reducing acquisitions or to bargain for personal benefits (e.g. job security, empire building) at the expense of shareholder return."
- "Acquirers with short-term shareholders prior to the merger are found to underperform significantly (by as much as -0.7% monthly, or -8% per year, over a holding period of three years), compared with acquirers with long-term shareholders."
- Capital available for long-term investing by pension funds, endowments/foundations, life insurers, sovereign wealth funds and family offices (but not typical defined contribution savings vehicles such as mutual funds) is actually limited by a series of constraints.
- Skewed compensation schemes, risk measures that penalize managers who favor long-term investments, and career considerations can affect investment goals and behavior.
- "Short-termism is both statistically and economically significant in capital markets…..This is a market failure. It would tend to result in investment being too low and in long-duration projects suffering disproportionately. This might include projects with high-build or sunk costs, including infrastructure and high-tech investments."
- Studies focusing on the impact of long-term investment by sovereign wealth funds (SWFs) on share price returns arrive at different results. Some papers show short-term price jumps; however, other studies show that they are not long-lasting. One theory is that the market rewards these stocks out of a belief that SWFs can play an important role as owners to encourage performance. However, one study showed that SWFs "shy away from assertive monitoring for fear of political resistance. So the expectation that SWFs are responsible stewards may be inflated."
- Funds identified as short term in investment outlook appear to be associated with corporations downsizing R&D budgets to meet earnings objectives.
- A March 2011 study contended that "confusion, outdated assumptions and suboptimal governance practices have distorted interpretation and implementation of fiduciary duty practices among institutional investors. Such consequences have caused value losses to beneficiaries and harmful short-term behavior among portfolio companies, in the view of the report's authors."
- A 2010 study concluded that, "despite calls on institutional investors to step up dialogue with portfolio companies, ‘modern investment management practices and characteristics—such as financial arrangements that promote trading, excessive portfolio diversification, lengthening share ownership chain, misguided interpretation of fiduciary duty, and flawed business model and governance approach of passive funds—make genuine stewardship challenging for institutional investors.' "
A February 2009 roundtable of practitioners convened by the Millstein Center identified eight problems leading to a failure by institutional investors to exercise sufficient vigilance as owners, including the following:
- Short-term thinking finds expression in the way many institutions structure compensation arrangements for portfolio managers, with incentives based on time periods that encourage trading, rather than stewardship;
- Many institutions lack transparency around their own governance, policies and operations;
- Oversight bodies at institutions are typically not optimally composed, with common shortfalls in skills, leadership and clout;
- Within funds there are silos of fund managers and governance staff who may not communicate or interact with each other when developing portfolio company analyses or communicating with such companies;
- Fund investments are usually highly fragmented, with fractional holdings across thousands of stocks, making it less advantageous for any one fund to perform careful monitoring, sponsor sustained engagement or mount needed intervention at companies harboring material environmental, social and governance risks; and
- Funds allocate limited and often insufficient resources to engagement.
The authors suggest that much further analysis is required to address these concerns and to develop ideals of institutional investor stewardship:
- Should institutional investors be required or advised to adhere to concepts similar to public company governance and disclosure rules? How should "best governance practices" for institutional investors be defined?
- How effective are current concepts of fiduciary duties for institutional investors? Do they lead to a "lemming standard," with trustees judged by actions of other trustees, a standard that the authors suggest has "led to short-term strategies with deleterious effects. Similarly, the duty of loyalty, it is argued, has been diluted by the complexities of modern-day investing, by the use of consultants and extended investment chains, and inadequate management of conflict-of-interest policies."
- If, as is often argued, institutional investors "put pressure on portfolio company boards of directors and business leaders to take commercially risky or otherwise imprudent actions (e.g. assume undue legal or environmental risk) in order to achieve short-term share price increases," what is the cause of that behavior? Is it the result of linking institutional investor compensation to peer competition or indices measured within short time frames?
- How do you define the types of issuer behavior that should be encouraged or discouraged? For example, what "is ‘good' investee company concern about creating long-term sustainable value and what is ‘bad' investee complacency and unwillingness to adapt to changing realities? These questions go to the heart of the purpose of the corporation, the appropriate goals of investors and the very nature of our public markets…."
- What elements of issuer performance should concern institutional investors who wish to play a role as investor stewards? For example, what financial and nonfinancial metrics should be used to measure commercial performance? What metrics should be used to evaluate financial performance, if institutions take into account risk management and promotion of performance with integrity and sustainability?
- How effective have SOX, Dodd-Frank and other governance legislation been?
- What should be the role of the proxy advisory firms? Do they exert too much influence? Do they measure issues that are important to long-term company performance? Do they have conflicts of interest?
- How is the institutional investor stewardship role different from the role of the board of directors? Presumably, the role would be less "intense" than the role of directors in corporate oversight and strategic direction.
- Does investor stewardship involve engagement with the board of directors or the CEO and business leadership or both? Should the engagement be limited to "approve/disapprove" or should it involve more detailed consultation, advice and involvement in specific business decisions or strategies?
- Can institutional investors that follow momentum or mechanical or short-term trading strategies, play a stewardship role and help the board and the CEO choose and recalibrate a longer-term strategy where appropriate?
Interestingly, the U.K. has actually implemented a Stewardship Code (adopted by the quasi-regulatory Financial Reporting Council), which "requires institutional investors (including insurance, pension, trust and other funds) to explain how they will conduct their stewardship functions, including such issues as: how they will deal with conflicts of interest, monitor investee companies, escalate engagement with investee companies; when institutional investors should act in concert; and periodically report on stewardship. Per U.K. practice, institutional investors can abide by the code even if they opt out of recommendations so long as they explain why they do not/ should not apply to them." It remains to be seen whether similar authorities in the U.S. will feel the need to follow suit.