Actively engaging with equity
Joseph Mariathasan explores the niche investment area of activist funds, which seek returns through the application of a private equity level of engagement to a select number of listed companies
Karl Marx is not the economist whose views most fund managers would claim to follow. But if you ever visit his grave at the once fashionable Victorian cemetery in Highgate, North London, you will see the epitaph inscribed beneath his bust: "The Philosophers have only interpreted the world in various ways; the point, however, is to change it."
Some fund managers have taken this axiom very much to heart, and in their interactions with the companies they follow, seek not just to interpret the information they get, but to fundamentally change the companies themselves.
At one extreme, this can be the aggressive activism shown by hedge funds such as The Children's Investment Fund Management (TCI) and Knight Vinke. TCI as a major shareholder of the Deutsche Borse managed to force the resignation of the CEO when he refused to abandon his efforts to take over the London Stock Exchange. Knight Vinke, with only a very small holding in HSBC, attempted to garner largescale shareholder support last year with the backing of US pension fund CalPERS to force HSBC to have a strategic review of its global banking operations, claiming it was undervalued by up to 50%. A very public campaign that included published letters to the board attracted a number of column inches from the press, subjecting the board to a great deal of pressure to take their demands seriously, even though the actual stake held by the activist was relatively minor.
At another level, shareholder activism has been tied in with the general debate on corporate governance and the necessity for fund managers to exercise active voting. For most fund managers, this has been a chore that adds little to their ability to outperform their peers and arguably detracts from it by the amount of resources it consumes, leading to the development of engagement overlay providers -- specialist providers who do not manage the underlying investment, but provide voting and engagement services to asset owners.
This is a development that leads Raj Thamotheram, director, responsible investment at Axa Investment Managers, to ask: "Underpinning this debate is the integration of material ESG issues into the investment decision-making process -- is it the goal or is it not? The question is: are such providers a necessary evolutionary step to active ownership becoming a core feature of mainstream fund management work? Or should clients demand that fund managers deliver what they are paid to do -- which includes active stewardship of the investments they make on clients' behalf."Ê
The problem, of course, is that a fund manager that has 50 or more stocks in a portfolio -- and the figure can be well over 100 stocks in many actively managed portfolios, can scarcely hope to devote resources to actively engaging with the boards on corporate governance issues which will have little eventual impact on their own fund's performance.
Active engagement
There are, however, a few investment managers who have gone down the road of actively engaging with companies in what they perceive as a cooperative manner, to achieve outperformance that can be measured and rewarded. Hermes in the UK was the first to adopt this approach, working with Robert Monks, the founder of the US firm Lens and seen by many as the godfather of the whole corporate governance movement. The Hermes team subsequently left to found Governance for Owners (GO), which its managing director, Robin Hindle Fisher, describes as very different in style from the aggressive activism practised by hedge funds, explaining: "We like confidential and constructive relationships with boards. We don't think that it is right for shareholders to dictate policy to companies. That is the role of the boards."
With just nine stocks in their pan-European strategy, their philosophy is very much that of a private equity investor. Hindle Fisher explained: "We hold 1% to 10% stakes in companies that are fundamentally sound but have a valuation gap between the current share price and the long term valuation. In Europe, there are still a lot of opportunities to identify companies with unfocused strategies, management issues or balance sheet weaknesses that lead to shares trading well below intrinsic value. We do a huge amount of fundamental analysis, including meeting with management, and work out firstly, is there a valuation opportunity? Secondly, are there some specific issues that are leading to a discount? And finally, is there an implementation plan that is Ôdoable' and that would address the causes of the valuation anomaly?"
To get into that close a relationship with management can take time. Hindle Fisher continued: "Our holding period is typically three years but the first six to 18 months may be spent just in building up relationships with the board and management. Sometimes, management may be reluctant to have discussions with us, but through a combination of our own executives and the high profile advisory board that we have, we succeed in building relationships with the companies. These relationships are based on the credibility we have with boards and management teams and that in turn is based on the understanding we have of businesses and the advice that we are able to give companies. When this works well, having GO as a shareholder is like having a free McKinsey."
Performance
Does this sort of action actually work? A recent study by the London Business School on the Hermes approach does seem to show evidence that it did for Hermes, with the study concluding that the outperformance seen was due to engagement with management rather than stock picking.
Henderson has recently launched a fund that takes this kind of approach one step further by working with PricewaterhouseCoopers to launch what they call a Pan European Active Engagement Fund. John Havranek, head of engagement funds at Henderson, sees what they are doing as something more than just a governance fund. Again, with just a small number of investments -- the target is ten -- the strategy is to see a substantial and measurable change arising from the engagement process.
He stated: "What we are finding is that influence is not based on ownership, but on the level of understanding and engagement. Through a deep understanding of a business, we can act as a catalyst."
He went on to give an example: "One investment is with a £2bn turnover manufacturing company. What is apparent is that they do not have a proper understanding of their profitability and pricing and as a result, whilst having a large market share, their margins are significantly below their competitors. We are helping them with this."
Clearly PWC's involvement in such activities is crucial and this sort of collaboration is probably unique, with PWC being remunerated in part through performance fees charged by the fund according to Havranek.
Havranek sees their approach as essentially engagement rather than aggressive activism, but they and other activist funds do have to tread carefully in the public marketplace to ensure that they do not cross the line between engagement and insider dealing. The FSA, in a note issued in May 2007, made it clear that whilst a fund manager could build a stake based on the "advantage of their own expert analysis of otherwise publicly available information", they might reach different conclusions if other participants also come to trade on the basis of another participant's strategy. There is clearly scope for abuse if activists hold positions in a company and others jump in on the back of rumours of changes such as a break up.
Havranek explained: "We engage with businesses and make recommendations or suggestions based on our own analysis and experience. We certainly don't want to be in a concert party, but we do talk to other investors as a matter of maintaining transparency."
But perhaps the deepest criticism of activist intervention of this type are the arguments marshalled by commentators such as Arjuna Sittambalam who argue that corporate governance activism can stifle enterprise and damage investment returns. Sittampalam's argument in his 2004 book Corporate Governance Activism -- Desirable Doctrine or Damaging Dogma? is that instead of pressurising for change, fund managers should stick to selling the stocks they dislike, whilst company management should be left to get on with their jobs, something that in most cases they are better equipped to do than a fund manager. Moreover, it is the existence of accountable and independent boards that should be taking the role of ensuring that management do not cause the company's decline through mismanagement.
The debate over the role and benefits of shareholder activism is likely to run and run, and ultimately, will also be dependent on the other checks and balances inherent in the local financial environment that can still differ significantly between the developed economies. As Hindle Fisher pointed out: "The rights and powers of shareholders in the US are very much weaker than in the UK, so an activist shareholder has to take a very much more aggressive approach to influence the boards and CEOs who can ignore them if they want to."
What may be clearer is that taking some of the private equity disciplines and applying them to selected listed companies may be able to produce substantial benefits. However, with such a high level of engagement with a small number of small and mid cap stocks, the capacity constraints for an activist manager such as Governance for Owners and Henderson are important. Hindle Fisher sees his firm as being able to manage Û2bn to Û2.5bn. At these levels, activist funds may be profitable for their investors, but they are hardly like to change the world.
Some fund managers have taken this axiom very much to heart, and in their interactions with the companies they follow, seek not just to interpret the information they get, but to fundamentally change the companies themselves.
At one extreme, this can be the aggressive activism shown by hedge funds such as The Children's Investment Fund Management (TCI) and Knight Vinke. TCI as a major shareholder of the Deutsche Borse managed to force the resignation of the CEO when he refused to abandon his efforts to take over the London Stock Exchange. Knight Vinke, with only a very small holding in HSBC, attempted to garner largescale shareholder support last year with the backing of US pension fund CalPERS to force HSBC to have a strategic review of its global banking operations, claiming it was undervalued by up to 50%. A very public campaign that included published letters to the board attracted a number of column inches from the press, subjecting the board to a great deal of pressure to take their demands seriously, even though the actual stake held by the activist was relatively minor.
At another level, shareholder activism has been tied in with the general debate on corporate governance and the necessity for fund managers to exercise active voting. For most fund managers, this has been a chore that adds little to their ability to outperform their peers and arguably detracts from it by the amount of resources it consumes, leading to the development of engagement overlay providers -- specialist providers who do not manage the underlying investment, but provide voting and engagement services to asset owners.
This is a development that leads Raj Thamotheram, director, responsible investment at Axa Investment Managers, to ask: "Underpinning this debate is the integration of material ESG issues into the investment decision-making process -- is it the goal or is it not? The question is: are such providers a necessary evolutionary step to active ownership becoming a core feature of mainstream fund management work? Or should clients demand that fund managers deliver what they are paid to do -- which includes active stewardship of the investments they make on clients' behalf."Ê
The problem, of course, is that a fund manager that has 50 or more stocks in a portfolio -- and the figure can be well over 100 stocks in many actively managed portfolios, can scarcely hope to devote resources to actively engaging with the boards on corporate governance issues which will have little eventual impact on their own fund's performance.
Active engagement
There are, however, a few investment managers who have gone down the road of actively engaging with companies in what they perceive as a cooperative manner, to achieve outperformance that can be measured and rewarded. Hermes in the UK was the first to adopt this approach, working with Robert Monks, the founder of the US firm Lens and seen by many as the godfather of the whole corporate governance movement. The Hermes team subsequently left to found Governance for Owners (GO), which its managing director, Robin Hindle Fisher, describes as very different in style from the aggressive activism practised by hedge funds, explaining: "We like confidential and constructive relationships with boards. We don't think that it is right for shareholders to dictate policy to companies. That is the role of the boards."
With just nine stocks in their pan-European strategy, their philosophy is very much that of a private equity investor. Hindle Fisher explained: "We hold 1% to 10% stakes in companies that are fundamentally sound but have a valuation gap between the current share price and the long term valuation. In Europe, there are still a lot of opportunities to identify companies with unfocused strategies, management issues or balance sheet weaknesses that lead to shares trading well below intrinsic value. We do a huge amount of fundamental analysis, including meeting with management, and work out firstly, is there a valuation opportunity? Secondly, are there some specific issues that are leading to a discount? And finally, is there an implementation plan that is Ôdoable' and that would address the causes of the valuation anomaly?"
To get into that close a relationship with management can take time. Hindle Fisher continued: "Our holding period is typically three years but the first six to 18 months may be spent just in building up relationships with the board and management. Sometimes, management may be reluctant to have discussions with us, but through a combination of our own executives and the high profile advisory board that we have, we succeed in building relationships with the companies. These relationships are based on the credibility we have with boards and management teams and that in turn is based on the understanding we have of businesses and the advice that we are able to give companies. When this works well, having GO as a shareholder is like having a free McKinsey."
Performance
Does this sort of action actually work? A recent study by the London Business School on the Hermes approach does seem to show evidence that it did for Hermes, with the study concluding that the outperformance seen was due to engagement with management rather than stock picking.
Henderson has recently launched a fund that takes this kind of approach one step further by working with PricewaterhouseCoopers to launch what they call a Pan European Active Engagement Fund. John Havranek, head of engagement funds at Henderson, sees what they are doing as something more than just a governance fund. Again, with just a small number of investments -- the target is ten -- the strategy is to see a substantial and measurable change arising from the engagement process.
He stated: "What we are finding is that influence is not based on ownership, but on the level of understanding and engagement. Through a deep understanding of a business, we can act as a catalyst."
He went on to give an example: "One investment is with a £2bn turnover manufacturing company. What is apparent is that they do not have a proper understanding of their profitability and pricing and as a result, whilst having a large market share, their margins are significantly below their competitors. We are helping them with this."
Clearly PWC's involvement in such activities is crucial and this sort of collaboration is probably unique, with PWC being remunerated in part through performance fees charged by the fund according to Havranek.
Havranek sees their approach as essentially engagement rather than aggressive activism, but they and other activist funds do have to tread carefully in the public marketplace to ensure that they do not cross the line between engagement and insider dealing. The FSA, in a note issued in May 2007, made it clear that whilst a fund manager could build a stake based on the "advantage of their own expert analysis of otherwise publicly available information", they might reach different conclusions if other participants also come to trade on the basis of another participant's strategy. There is clearly scope for abuse if activists hold positions in a company and others jump in on the back of rumours of changes such as a break up.
Havranek explained: "We engage with businesses and make recommendations or suggestions based on our own analysis and experience. We certainly don't want to be in a concert party, but we do talk to other investors as a matter of maintaining transparency."
But perhaps the deepest criticism of activist intervention of this type are the arguments marshalled by commentators such as Arjuna Sittambalam who argue that corporate governance activism can stifle enterprise and damage investment returns. Sittampalam's argument in his 2004 book Corporate Governance Activism -- Desirable Doctrine or Damaging Dogma? is that instead of pressurising for change, fund managers should stick to selling the stocks they dislike, whilst company management should be left to get on with their jobs, something that in most cases they are better equipped to do than a fund manager. Moreover, it is the existence of accountable and independent boards that should be taking the role of ensuring that management do not cause the company's decline through mismanagement.
The debate over the role and benefits of shareholder activism is likely to run and run, and ultimately, will also be dependent on the other checks and balances inherent in the local financial environment that can still differ significantly between the developed economies. As Hindle Fisher pointed out: "The rights and powers of shareholders in the US are very much weaker than in the UK, so an activist shareholder has to take a very much more aggressive approach to influence the boards and CEOs who can ignore them if they want to."
What may be clearer is that taking some of the private equity disciplines and applying them to selected listed companies may be able to produce substantial benefits. However, with such a high level of engagement with a small number of small and mid cap stocks, the capacity constraints for an activist manager such as Governance for Owners and Henderson are important. Hindle Fisher sees his firm as being able to manage Û2bn to Û2.5bn. At these levels, activist funds may be profitable for their investors, but they are hardly like to change the world.
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