06 October 2009

UBS Corporate Governance Forum

The debate surrounding the response to the global financial crisis has to date focused on the failures of regulation and supervision.

Whilst this is a necessary discussion a similar debate needs to be opened in the institutional investment community about whether a fundamentally short-termist strategy is appropriate to service the liabilities of the nations savers and pension participants; why so much emphasis is based on quarterly performance, appraised relative to an index when the fundamental beneficiaries of those investments have liabilities that span lifetimes; why governance and good stewardship is marginalised.

We need to address the importance of good governance and its place in the investment decision-making process; to ask whether failures by owners, or their agents, were a contributory factor in causing the crisis. When companies fail it is reasonable to ask, “What were the owners doing?”

The source of the global financial crisis can be found in a number of places: alongside macro capital imbalances we had elements of pointless financial engineering, mis-selling of complex securities, poorly structured remuneration and deficient risk management.

The last two fall within the scope of corporate governance and investor stewardship.

For a long period inadequate governance practices went unchallenged and unchecked in the global banking sector. Employees, directors and even whole companies were not held to account until their performance collapsed and value was destroyed.

By that stage it was too late.

The Government has led the way in strengthening financial services regulation, but regulation can only do so much. Any basket of measures designed to mitigate a similar crisis arising again must include improved governance and investor engagement.

The financial services industry matches those who demand capital with those who can supply it.

This is not a straightforward exercise. In a simplified model individual savers those making provision for retirement entrust their money to institutional investors who appoint professional and experienced fund managers to make decisions on their behalf.

In reality much longer and more complex webs of principal/agent relationships connect the ultimate suppliers of capital with those who actually manage it on their behalf.

This delegation of responsibility exposes the ultimate beneficiary, for instance pension fund trustees, members and sponsors, to the principal/agent challenge of establishing suitably aligned interests.

In this connection I continue to observe that while savers and pension participants have liabilities and performance requirements for absolute investment returns (normally expressed in constant money value terms) that stretch over lifetimes, fund managers working on their behalf tend to focus on short-term index or peer benchmarked performance, where the metric is a ‘relative to others’ term.

Investors seem to appraise performance over durations far shorter than the equivalent liabilities. Fund managers compete for the right to manage client money and, if objectives are expressed in terms of short-term performance, they rationally respond to deliver a product that meets customer expectations (therein lying the route to their commercial prosperity).

This lack of consideration for the long-term can be seen in examples of portfolios being churned for little evident benefit; erosion of return by incurring non-value adding trades; holding underweight positions in securities judged to be over-valued in order to reduce portfolio tracking risk; portfolios which are over-diversified, with low conviction and incentive to take governance seriously; tolerance of flawed voting procedures; M&A activity approved despite limited evidence of value creation; lack of real interest in governance or oversight of remuneration practices; and poor control of corporate risk budgets and processes.

Many of these behaviours link specifically to the promotion of trading and liquidity, belief in market liquidity. Few appear to be linked to taking the longer view.

Moreover, investors’ emphasis on short-term return communicates itself to the thinking of business leaders who feel obligated to think and act short term – perhaps not as short as the perspective of fund managers, but shorter than many corporate leaders believe to be optimal. Fund managers, with noble exceptions, cannot be described as suppliers or owners of “patient capital”.

Nor do they appear to have much incentive, under existing predominant active long-only models, to take governance very seriously.

In turn the over-emphasis on benchmarked performance incentivises herd-like behaviours; managers can find themselves in the awkward situation where they feel obliged to hold positions they believe to be overvalued simply because they cannot afford to be contrarian, a situation visibly observed in the dot com boom.

Whether a fund manager is ‘right’ is judged over short durations (compared with liabilities) and relative to others. The easiest way of being ‘right’ is to avoid being ‘wrong’, and this is best achieved by replicating the decisions others have made, and disregarding serious judgements about trade-offs between absolute risk and absolute return.

The long-termist approach has been espoused by celebrated investors for decades but has been consistently ignored by the mainstream investment management industry.

For instance, there have been, in my judgement, three periods when Berkshire Hathaway’s commendable long-term absolute performance involved several years of sequential under-performance against main indices. In my experience, this would have seen UK pension fund trustees put Buffet’s appointment ‘under review’ at a minimum.

But Buffett’s record has shown the value of taking a longer view, accepting extended periods of relative under-performance as a fair price for avoiding extremes of market valuation or under-valuations; holding a concentrated, high conviction portfolio and taking a real interest in his companies, including in some cases taking Board seats.

The blame for the situation I describe in the UK should not be laid at the door of the fund management industry.

Fund managers are simply reacting rationally to the expectations and incentives placed upon them by their clients.

More accurately, the problem is that the long-term perspectives of the ultimate suppliers of capital are not featuring sufficiently in the investment decisions and approaches required from their agents.

If I am correct in my observations – and they are not new, as this debate has been taking place since well before I was first employed as a fund manager in the mid nineteen seventies – the answer must lie with pension trustees and other similar end investors revisiting the goals they set for their fund managers – including duration, tracking error and the relevance of goals expressed in relative as opposed to absolute terms.

End investors also need to ask whether they are comfortable with the care exercised over their individual investments by their agents – the processes of stewardship and governance.

I should add in parentheses here that these questions and some of my observations ironically apply with less force to the portfolio construction and engagement methods typically employed by private equity and some approaches to hedge fund management. Many do not apply or apply more subtly to pure indexers, activist specialists or the interesting new model of outsourcing governance to those with specialist skills.

Having addressed issues around agency risk and the appropriateness of portfolio goals, let me turn to governance.

Governance and engagement, or stewardship, is the means by which some of these problems should be addressed: better engagement by investors will help communicate the interests of investment beneficiaries to the ultimate decision makers. A stronger governance framework will help ensure that these considerations are at the heart of the investment decision-making process.

For shareholders, this is a real opportunity to add value through good governance.

A strong, effective, credible board openly and honestly engaging with shareholders will bring benefits to the company in terms of being granted access to wider sources of funding, a lower cost of capital, and greater commitment from long-term investors.

Engagement by fund management houses would be more welcomed by corporates if it was believed that the associated considerations of governance were at the heart of the investment decisions made by investors.

In reality, however, realising this value from stewardship is complicated.

The benefits of good governance are a public good and subject to the free rider problem. Initiating good governance procedures can be costly whilst the benefits will accrue to all shareholders (and in many cases creditors).

The free-rider effect creates an incentive to wait for someone else to engage and then free ride on their returns.

This is compounded by the fact that there is an asymmetry in the relative visibility of the costs and benefits of good governance.

The costs can be quantified and measured, whilst the benefits are more obscure and typically can be seen only in their absence.

It’s not easy to illustrate the value created by good governance although the value destroyed by bad governance can be more evident – as many investors in the world’s banks have experienced.

It is the failure to overcome these problems of agency mismanagement, inappropriate portfolio goals and the perceived free-rider barrier to becoming actively and constructively involved that has placed value at risk for participants at all levels, from institutional shareholders to individual savers.

To date, investors have not applied enough attention to the challenge of effective stewardship.

In the irrational exuberance of a bull market, it is easy to subordinate such considerations when short-term gains appear to be so easily obtained.

However, the aftershocks of the global financial crisis and the huge losses sustained provide a timely opportunity for pension trustees and others to ask some searching questions about how they should express their investment objectives to their fund managers and what they expect their fund managers to do to take full and proper care of their investments.

This is not an insignificant challenge. Overcoming it, however, would represent an important economic achievement

In the first instance this challenge can be met by reviewing the significance attached to governance within the corporate model of incumbent fund managers.

Governance departments in fund management organisations tend to be under-funded and under-recognised. Governance specialists, with one or two commendable exceptions, are not central to or senior in their own organisations.

They are not functionally embedded in the decision-making departments of fund management firms and all too often give the impression of being an afterthought or a gesture to political correctness.

I doubt if the governance budget in most mainstream active fund managers in the competitive sector exceeds 5% of the resource committed to stock selection – the latter adding little performance value for most investors employing traditional long-only approaches. This is at least true in terms of how performance is normally measured – another example of the paradox of how the professional money management industry has inverted resource allocation, devoting the greatest resource and professionalism to those decisions that are least important and vice versa; compare highly paid active long-only equity managers with lay trustees.

We rarely find governance agents with serious real world commercial experience in, for example, corporate strategy, business process management or human resource management; hence they tend to stick to box ticking and the use of insights and language that cannot always capture the complexity of problems.

It is not surprising that corporate executives express frustrations to me with the governance folk with whom they have to meet or confusion about the different messages they get from front-line fund managers on the one hand and their governance colleagues in the same firm on the other.

Can they be credible governance agents without relevant experience and organisational authority?

In my experience, corporate governance teams tend to spend a lot of their time at events and conferences speaking to their opposite numbers from their competitors. One has to ask how much time they spend speaking to their own Chief Executive or Chief Investment Officer?

How seriously are their views taken by fund manager colleagues when formulating investment views or constructing portfolios?

From the perspective of the investment firm’s operations, corporate governance is too frequently one step removed from the actual investment process – it is seen as a nice add-on to the core service of managing money, making investments and making money from doing it.

The peripheral nature of governance within many fund management firms reflects the prevailing view among fund managers or portfolio constructors in the same firm – “we don’t do governance… it is a nuisance and a distraction… whenever we get involved we come to regret it… we don’t have the skills or the appetite… it is easier to sell… we only have governance people to satisfy the interests of a small number of our clients… most of our clients evidence very little interest in governance or stewardship… they don’t ask about what we are doing to improve companies in which we invest… they just monitor how we perform over quarterly periods as against an index or other managers”.

In light of the value put at risk by bad governance one has to ask why such a low priority is placed on governance?

If only a small part of the human and financial capital that was dedicated over recent years to an alphabet of derivatives and other forms of financial engineering had been diverted to overcoming the problems of bad governance, many of the market’s recent problems could have been averted.

I make this observation with the benefit of what is now an all-too-intimate awareness of what was going on at the heart of some of our banks immediately before the crisis.

In this connection I question the absence of an organisation in the UK that speaks solely on behalf of institutional investors without a commercial interest, as opposed to a tangential activity of trade associations.

The most appropriate arena for this to take place would surely be an industry-wide institute operating with close ties to the academic institutions also engaging in the debate. I have in mind something similar to the Council of Institutional Investors. But no such organisation exists in the UK.

Such a body would focus exclusively on promoting understanding and best practices in stewardship and good governance, unfettered by any other loyalties or priorities.

To date the only significant effort to address this challenge was the creation of the Institutional Shareholders Committee Forum.

This is composed of various constituent member bodies including the ABI, AIC, IMA and NAPF.

The terms of reference for the ISC are to provide a conduit through which members can share views and, where appropriate, co-ordinate activities on any matter likely to affect the interests of investing institutions in their role as investors.

However, in practical terms the ISC has struggled to deliver tangible results.

This should not come as a surprise.

The forum is a coordinating mechanism for trade bodies who themselves operate primarily to promote the interests of their own industries – there is no one organisation in the UK that speaks solely and exclusively on behalf of institutional investors without commercial benefit as an overriding goal. This, in my view, is a deficiency.

To compound this disconnect, the ISC is a loose collection of trade associations rather than member firms, and as such is two degrees removed from the operational nexus of the industry.

The committee has rarely met and has not evolved. It is controlled by industry trade bodies; it has no budget or permanent secretariat.

Trade bodies clearly and correctly operate primarily in the interests of their own fee-paying members. This may or may not accord with the interests of end investors but it is a fact of life that parties selling services to others for gain are not necessarily always going to have entirely shared interests with their clients.

The recent financial crisis is evidence enough that bad governance, compounded by ineffective oversight, can and will de-stabilise the financial system and destroy value. This should provide enough of an incentive for all parties concerned to address the problem.

There is a real opportunity for gain if we can secure a cultural shift in the priority and resource attributed to governance and stewardship.

We need to create a world in which considerations of governance are framed and measured in terms of risk – risk identification; risk management; risk mitigation; getting properly rewarded for risk.

There is a broad responsibility for bringing this situation about. But, in my view, primary responsibility to encourage and incentivise good outcomes must lie with beneficial owners.

To the extent that some of these problems constitute a market failure the government has a responsibility to act, and indeed has already done so.

Sir David Walker’s review and recommendations on governance in the banking sector will report next month. Sir David has rightly focussed on stewardship in addition to governance processes within corporations.

His interim report has recommended far-reaching changes to strengthen board challenge and shareholder oversight, to improve the quality and independence of risk management.

Beneficial investors should support Walker. He is working for their benefit.

In parallel, the FRC is reviewing the Combined Code and considering which of Walker’s preliminary recommendations might have wider application beyond the banking sector.

The FSA is implementing remuneration principles, which will ensure that banking remuneration practices can never again contribute in the way they did to excessive and unmanaged risk.

Government will ensure that shareholders have the information necessary to fulfil their duties in challenging boards about risk appetites and remuneration. But shareholders must then respond to the challenge of making good use of these ‘further and better particulars’.

Regulators can limit risky activities by making them much less profitable by requiring significantly increased capital or, in extreme circumstances, varying a bank’s permissions to engage in certain activities.

The FSA will use these powers, if necessary, to improve the resilience of the system.

However, the government alone cannot solve the problem.

Investors and their agents need to recognise the issue and acknowledge the value they put at risk by failing to rise to the challenge of being good and effective owners.

They need to work together to bring about a new enlightenment in governance and stewardship, placing it at the heart of capital allocations and efficient, effective and accountable investment decisions.