New risks, new rules
A panel discussion at Aberdeen’s London Investment Conference 2015 saw journalist Andrew Neil interview three Aberdeen fund managers on the role of corporate governance in their investment decision-making. In conversation with him were Devan Kaloo, head of equities, Graham McDonald, head of private equity and Neil Murray, head of global developed markets and LDI, fixed income
The role of asset managers
Opening the discussion, Andrew asked the panel: “In a complex investment world with many intermediaries, how much influence do you actually have in the management of the companies in which you invest?”
“As equity fund managers, we have a responsibility – and a vested interest – to ensure companies are being run in an appropriate manner,” commented Devan. “We have the ability to vote the shares that we own, thus directly influencing company management. More broadly, we can also help set the price of capital by disciplining companies through the sale or purchase of shares.
“As an example, if a company wants to make an ill-conceived acquisition and pay for it by shares, selling those ahead of the acquisition will push up the cost of the acquisition and make management think twice. Indeed, if the acquisition were material enough, shareholders could even vote against it. Alternatively, if a company demonstrates poor governance, we can change it for the better by enforcing our rights as shareholders, holding the board of directors to account and requiring the exit of management.”
Andrew noted that corporate governance in equities is relatively clear-cut as shareholders are owners of the companies in which they invest. He then asked what the role of governance is in fixed income.
“It is different to equities because we do not own the company as shareholders do,” said Neil. “Fixed income investors lend money to governments and companies. However, we have an important role in shaping governance policies because, with better governance and controls, comes a lower cost of borrowing. Fund managers may be able to influence companies to improve their governance standards but they rarely have the same influence with governments.”
Noting that the governance process for private equity at Aberdeen is slightly different because the investment is in funds rather than companies directly – meaning there is a level of intermediation – Graham explained: “It requires us to invest time and effort to understand each fund and its governance requirement.
“Quite often, we will sit on the advisory board of a fund that represents the limited partner who is invested in that fund. We aim to understand the dynamics of the general partner and their policies and governance standards. We have a separate operational due-diligence team who address compliance issues such as where the general partner is registered and other background checks.”
What does good governance look like?
Andrew then asked what factors the panellists look for in a company before investing client’s money.
“The quality of management is a key factor – how management has performed throughout various business cycles and how they have treated shareholders in the past,” commented Devan. “We also look at the other investors in the company, and the risks they may bring as fellow owners. There are other important business and financial metrics but the quality of a company’s people will ultimately determine the quality of its governance.”
Prior to the Investment Conference, Aberdeen carried out some bespoke governance research in which 85% of respondents said that asset managers should engage with the companies in which they invest client funds – both at the pre-investment due-diligence stage and at regular intervals subsequently. Andrew asked the panel if Aberdeen engages with companies in this way.
“Yes, we screen all companies before we invest to ensure they are managing their businesses prudently and are responsive to shareholders,” stated Devan. “Once we invest, our high level of due-diligence and monitoring continues because it is important that the company – and its board of directors in particular – are aware that we are doing this and hold them to account for their actions.”
A further finding from the research was that only 43% of respondents said their asset managers are effective at engaging with the companies in which they invest, with a considerable 37% indicating they are not. Andrew requested the panel’s reaction to this.
“As an industry, asset managers do not engage with companies sufficiently,” commented Devan. “Given that governance is labour-intensive, many asset managers outsource this work to third-party providers who often have a simple ‘tick-box’ approach. In order to influence the companies you invest in for the better, it is necessary to engage in those companies. Therefore, we carry out governance checks and speak to the board and management ourselves.
“An example of the rise of tick-box governance can increasingly be seen with regard to management remuneration, which in an effort to satisfy different interest groups has become increasingly complicated – so much so that it is difficult to evaluate if someone is doing a good or bad job relative to the pay they are receiving. Indeed, it can often prove too complicated – not just for shareholders to understand, but for the very employees it is ostensibly designed to incentivise. This is a warning sign to us.”
Andrew stated that many institutional investors are subject to regulations themselves, which has its own governance implications. He asked the panel how that matters. “Yes, many investors based around the world have their own requirements for environmental, social and governance investing,” said Neil. “We implement these requirements in our research and screening process by, for example, not lending to certain companies or sectors. This has an impact on companies’ cost of debt on a global basis.”
Graham added: “Investors in private equity are also becoming more selective in areas they do not want to fund – for example, avoiding companies or funds involved in ammunitions, nuclear weapons and alcohol production. There is now greater transparency around these issues so that pension fund trustees and other investors are able to make better-informed decisions. We are able to tailor fund vehicles to cater for these needs, rather than offering generic products.”
An increasingly intermediated world
Andrew then referred to a recent Economist article that stated: “Fund managers have to deal with an ever-growing group of intermediaries – from regulators to their own employees – and each group has its own interests to serve and rents to extract. No wonder fund managers usually fail to monitor individual companies.” He invited the panel to discuss this point.
“Yes, the world for fund managers is undoubtedly much more complicated in that there are more interest groups, from the regulator, to governments, to civil society, pushing for fund managers to get companies to do one thing or another,” commented Devan.
“Yet some things have not changed. It remains the responsibility of fund managers to help ensure that the companies they invest in are well-run. The governance process is more complicated than it used to be in that more people want to influence it but it is essential to ensure a good return on capital for investors. Good governance is not contrary to good returns.”
Andrew stated that it might be in the short term to which Devan responded: “Yes, but perhaps that has been the problem with the fund management industry. Our role should be to remind companies that the board and management are there to make a good return for all their shareholders first and foremost, but this should be done in a manner that focuses on the long-term sustainability of the company.”
Neil added: “There are several intermediate parties in fixed-income investing, including banks and regulators. Ultimately, a company has to give you your money back but there are many underlying issues a company must resolve – for example, how should companies treat its debtholders versus its shareholders, how much leverage should it use, and so on. If we are not completely happy with a company’s or a government’s actions, we will reassess the investment thesis.”