Wednesday, 28 March 2012

Don’t shoot the pension fund managers!

By Professor Simon Deakin, Director, Corporate Governance Research Programme, ESRC funded Centre for Business Research, University of Cambridge.

Long-term investment in infrastructure needs a better policy mix

George Osborne's attempts to encourage British pension funds to invest more in infrastructure projects are to be applauded. Canadian and Australian pension funds have already invested heavily in infrastructure, but UK funds are still reluctant investors. Why?

British prime minister David Cameron tours Newton Heath rail depot. Getty images
British prime minister David Cameron tours Newton Heath rail depot. Getty images

Pension fund trustees have a fiduciary duty to get the best return for scheme members after taking due account of risk. Government cannot and should not dictate how or where and how these funds invest their assets. If government wants pension funds to engage with the long term needs of the UK economy, it must first understand the particular pressures they face as investors.

Pension funds must invest for the very long term because their beneficiaries, the scheme members, will be receiving their pensions decades after making their contributions. As investors, however, the pension schemes cannot just take the long view. They must balance risks and returns over the investment cycle, which in practice means taking advantage of liquidity when it is available and making the most of opportunities for profit taking when they arise. Thus it is implausible to believe that the interests of pension funds are automatically aligned with the public interest in sustainable infrastructure. The right incentives and structures need to be put in place to support infrastructure investment.

What can be done? We need to address both sides of the issue. On the one hand, an acceptable division of investment risk between pension funds and the government must be found. On the other, the risks associated with the organisation of large-scale infrastructure projects - so-called construction risk - need to be better understood and managed.

Let's take investment risk first. There is demand, on the part of pension schemes, for long-term investments which will provide a stable return. An asset class based on infrastructure investment may well provide part of the answer. Government would need to play a role in inflation-proofing and underwriting part of the financial risks. From the government's point of view, infrastructure bonds which operate in a manner similar to inflation-proofed gilts could be a feasible option, but not if they result in private investors just shifting long-run costs on to the public finances in the manner of PFI (‘moral hazard'). Getting this right, and avoiding the pitfalls of PFI, will require a high degree of transparency and trust on both sides in coming months if a viable solution is to be found.

M4 motorway near Bristol. Getty images
M4 motorway near Bristol. Getty images

Now let's consider construction risk. Pension funds argue that too many large construction projects don't deliver, pointing to cost overruns and delays in completion on projects like Wembley stadium and the Jubilee Line extension. For this reason, they are more enthusiastic about investing in so-called brownfield sites, involving the maintenance of existing infrastructure, than in building new capacity. Yet new capacity is precisely what is needed in areas such as energy, transport and waste management.

From the pension funds' point of view, the government could solve the problem of construction risk for them by simply underwriting potential losses. The difficulty with this is not just that the Treasury has limited capacity to take such an open-ended risk, but that to do so on an open ended basis would risk repeating the ‘moral hazard' problem associated with PFI.

At least part of the solution must lie in addressing construction risk at its source, in the way projects are managed. Enormous strides have been made in recent years in managing the risks of large infrastructure projects, with the construction of the Heathrow Terminal 5 building leading the way. Lessons from Terminal 5 and other successful projects have been embedded in the procurement process and contractual design of the construction of the 2012 Olympics site. The construction industry has been actively promoting good practice through modifications to the standard-form contracts used in infrastructure projects. The government has encouraged this process and needs to continue doing so.

A British Airways aircraft takes off from Terminal 5. Getty images
A British Airways aircraft takes off from Terminal 5. Getty images

Getting infrastructure investment right is therefore a twin-track process. The role of government is not to impose solutions on finance or industry, but to identify good practice and encourage information exchange and dialogue between the two sides. If the government sees its role in these terms there is every prospect of a workable set of solutions emerging.

The issue of infrastructure investment has wider lessons for economic governance in the UK. The question George Osborne needs to ask is: what can be done to encourage an investment regime that more effectively internalises the risks of complex projects, not just in infrastructure but more generally in innovative areas of manufacturing?

On the finance side, this means thinking about the way that pension funds are structured and governed, and about the role played by asset management firms and other market intermediaries in the investment process. Are the right structures and incentives in place for pension funds and their agents to represent the interests of scheme beneficiaries in stable returns which also bring wider benefits to the UK economy?

On the corporate side, some thought needs to be given to whether company law and associated regulatory measures, such as the Takeover Code, are sending boards of listed companies the right signals.  A legal and regulatory regime which is widely, if arguably incorrectly, interpreted as requiring listed companies to prioritise short-term shareholder value, is not compatible with the country's long-term investment needs. Are Britain's corporate governance arrangements, so long held up as an example to the world, part of the reason for the continuing decline in investment in R&D by UK firms, by comparison to our competitors, and for the presence of no more than a handful of globally successful British manufacturing companies when Germany and Japan have a dozen or more each?

Also posted on FT's Economists' Forum

Tuesday, 20 March 2012

Kay needs to replace “shareholder value” with “corporate value”

By Professor Simon Deakin, director, Corporate Governance Research Programme, Centre for Business Research, University of Cambridge

John Kay's interim report finds that equity markets are failing in their primary tasks, which he identifies as enhancing the long-term growth of listed companies and providing savers with an appropriately high, risk-adjusted return on their investments. The failure lies, he suggests, in the way that market actors are currently incentivised. If asset managers are assessed on a quarterly or biannual basis, it is not surprising that they apply benchmarks based on the short-run performance of the firms they invest in.

Corporate managers, on the other hand, believe that they have a legal duty to maximise short-term shareholder value, and act accordingly. Kay rightly suggests that this view is mistaken as a matter of law but, again, it is no surprise that directors and managers think in these terms, given the way that shareholders are routinely described as the 'owners' of the firms they invest in. Disclosure rules add to the problem, in particular those requiring quarterly reporting of corporate results. Lawyers will recognise that shareholders are the owners of their shares, not the company, and that they have no right to manage the firm, having delegated this power to the board, but these subtleties are clearly being lost in translation.

What can be done?

It is not just a question of getting across a more accurate understanding of the legal structure of the company limited by share capital. The idea that managers should run listed companies in such a way as to maximise share prices is deeply embedded in UK corporate governance practice. It is reflected in the way top managers are remunerated, through bonuses and options linked to share price movements, and in the way that company performance is benchmarked, through metrics such as earnings per share and return on equity. Kay takes aim at some of these practices which, he points out, do not just privilege the short-term, but also tend to discourage large-scale capital investment by companies.

Kay also reports suggestions that there are elements in the regulatory framework beyond company law which favour corporate restructuring and deal-making over long-term growth, notably the City Code on Takeovers and Mergers. While the Takeover Panel's view that the principal aim of the Code is to protect minority shareholders is undoubtedly correct, it is no less clearly the case that its main effect is to facilitate hostile takeovers of UK-listed companies by denying boards the room for manoeuvre that they would have in virtually every other developed economy.

How should these concerns be addressed?

The final report will have to set out a plausible agenda for regulatory reform if it is to be more than a well intentioned review of existing practices. There are some practical changes Kay could suggest such as making clarifying the legal duty of the board to have regard to the long-term interests of the company under section 172 of the Companies Act 2006 and making clear that this duty takes priority over the terms of the Takeover Code. But going forward, Kay also needs to give a clearer account of the philosophy that would guide reform.

Kay argues that shareholders should act as 'stewards' of the companies they invest in. This is fine as far as it goes, and may chime with the ambitions of some pension fund trustees and asset managers to support investment in innovative manufacturing and infrastructure. However, the final report needs to recognise that there are numerous instances in which the interests of shareholders simply do not coincide with the wider public interest in maintaining a sustainable and competitive corporate sector in the UK.

The restructuring of British enterprise through hostile takeover bids, hedge fund activism and private equity over the past three decades was not just the consequence of decisions taken by capital market intermediaries acting without regard to the interests of their shareholder 'principals'. Institutional investors were highly critical of listed companies which did not prioritise shareholder value, and pressed for a greater role for independent directors on boards as a way of getting their views across. There is more than anecdotal evidence that some of the deals involving the restructuring of companies with a core role in the British economy, from the takeover of BAA by Ferrovial through to RBS's bid for ABN Amro, were driven by a combination of pressure from boards and shareholders for quick returns, with considerations of corporate strategy pushed to the margins.

It is naive to see hostile takeovers, private equity and hedge fund activism as addressing problems of 'failed' companies. Much more often, these forms of investment simply extract value from companies for the benefit of investors and intermediaries, at a direct cost to workers (who lose jobs and protected terms and conditions of employment), customers (who experience a deterioration in the quality of products and services) and the taxpayer (who foot the bill through tax reliefs on corporate leverage).

What has brought us to this point?

Since the early 1980s, company law and corporate governance regulation have given shareholders many more rights to 'hold management to account'. Kay recognises that trading in the secondary market for shares does not bring in new capital for firms, but he justifies shareholder influence on the grounds that investors can exercise effective oversight over firms' capital allocation decisions and over their governance. This is implausible.

In today's liquid capital markets, shareholders are for the most part transitory owners who have no lasting connection to the firms whose traded securities they hold. The question we should be asking is why law and regulation have ceded such large influence to this group. It is partly intellectual fashion, a misguided belief in the informational efficiency of liquid capital markets. It is also down to intense lobbying by the market intermediaries (the asset management firms, legal advisers and investment banks) who benefit most from current arrangements.

John Kay is on the right path in arguing for a long-term approach to investment decisions, but too optimistic in believing that shareholders will always act as enlightened owners.

We need to replace shareholder value with corporate value as the objective of management and take a detailed look at corporate governance regulation and practice with this guiding principle in mind. If this means sidelining the Takeover Code and subordinating it to the wider goal of a reformed company law in promoting sustainable enterprise, so be it. This is the kind of hard choice we will have to make if we want capital markets to make a real contribution to prosperity and growth.

Also posted on FT's Economists' Forum

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