How can a focus on active stewardship restore trust?
Cases of corporate failure and short-comings litter the history books of stock markets around the world. The names Carillion, Lehman Brothers and Enron are as notable for the nature of their demise as they are for construction, banking or energy.
Pension funds and other investors in these companies have suffered heavy losses. But they are not the only ones. Corporate failure arguably has a greater impact on workers who are made redundant and suppliers who have their contracts terminated. The damage done to local communities can sometimes last for years, if not decades.
Yet much of the asset management industry operates on the basis that their interests are best served by ensuring profits are maximised. This fundamental premise needs challenging and a more thoughtful approach to creating sustainable value needs to be sought.
Rebooting corporate purpose needs to be accompanied by an upgrade to the stewardship practices of institutional investors.
This is why the Financial Reporting Council’s consultation on the stewardship code is welcome.
The first step to improving stewardship is to recognise that the legitimacy of asset managers hinges on what they deliver for savers. It is an acknowledgement that these people have a wider set of interests than just a financial return. It has to be right at the centre of the way we approach stewardship.
Secondly, the Environmental Social & Governance (ESG) factors that matter to savers need to be embedded right at the heart of the investment process that delivers the financial return. This applies for all asset classes , not just equities.
The third step in improving stewardship is perhaps the most challenging. Asset managers need to recognise that what is good for equity shareholders is not always in the interests of everyone who matters.
This is a big shift. Ever since the 1930s investors have believed that what is good for equity shareholders is also good for the corporation and other stakeholders. Shareholders have been granted an increasing number of rights to both monitor the riskiness of their investment and take actions to mitigate some of those risks.
This heroic assumption is the cornerstone of our corporate governance system. Unfortunately it is also unfit for purpose and the balance of interests needs readdressing.
More sophisticated financial markets mean that it is easier for institutional investors to hedge the riskiness of their equity stake potentially weakening the alignment with wealth creation. The capital structure of companies is morphing, reliance on equity issuance is declining while expectations about the impact of equity ownership on corporate behaviour continues to increase.
The nature of financial markets has created an environment where the value of a company, as defined by its share price, is made up of a multitude of views, many of which have no real interest in corporate success. Indeed it includes a community, in the form of short sellers with a primary objective centred on corporate failure. This most obviously does not lead towards better stewardship.
It is time to recognise that the alignment between equity ownership and the long-term health of the company has weakened. The nature of corporate liabilities are changing. What institutional investors actually own is the securities issued by a corporation, not their assets. That means that it makes sense for stewardship principles to be applied throughout the capital structure.
The outstanding debt of some companies is far greater than its equity market capitalisation. When corporate failure occurs some bonds are “bailed-in” and exchanged for new shares. It makes sense that the voice of bondholders is heard more loudly on matters of stewardship.
The restoration of trust in business is essential for it to exist and prosper in society. This requires companies to carefully consider why they do what they do and to reconsider their place in society.
As the provider of finance and resource, institutional investors have an increasingly important role to play through active stewardship. Engaging, probing, escalating concerns and holding boards to account is a growing and key part of our role. Corporate purpose is essential to value creation but must be more than a plaque in the reception area.
This article was published in the Financial Times on 20 February 2019.
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