Mind the gap – London Business School Review
Activist investors are noisy investors. When they target a company and demand that it changes its ways, the investment world sits up and takes notice.
The intervention makes headlines. Having taken a signiﬁcant stake in its target, the activist will often seek a seat on the board. Other shareholders are confronted with questions about how the company now at the centre of attention has conducted its aﬀairs: is it run as well as it possibly can be; has it diversiﬁed too much; is its strategy the right one?
Julian Franks, Professor of Finance at London Business School, has looked at how – and to what extent – shareholders exert inﬂuence over the companies in which they hold a stake. He says: “Shareholder activists will typically hold a relatively large stake in a relatively small number of stocks. That’s one channel through which a group of shareholders can exert inﬂuence.”
But, as he points out, such activist interventions are not frequent. In the large majority of cases, “conventional” shareholders, such as pension funds and insurance groups, each with stakes in perhaps hundreds of quoted companies – keep their heads down. They are passive. If they ask a company to change its ways, they do so privately. Unlike the activist, the conventional shareholder does not, with a few exceptions, make a public fuss. And, as Franks points out, very often this shareholder will have only a small stake in the company in which it holds shares; typically between one and ﬁve per cent.
Hence, the argument goes, conventional shareholders have little inﬂuence over the companies in which they put their – or their clients’ – money. They lack real power and inﬂuence. They may have ownership, but they lack control.
So is this stereotype true or false?
Without doubt, there is a clear distinction to be drawn between activist shareholders on the one hand and conventional shareholders on the other. An activist is likely to have built up a substantial stake in each of its targets. “Furthermore,” says Franks, “there will be relatively few of those targets, so it can pour all its energies into inﬂuencing what they do. In contrast, it is unrealistic to expect an insurance group or pension fund with shares in hundreds of companies to involve itself with the aﬀairs of those companies with the same intensity.”
Nevertheless, there are clear signs that, over the past decade or so, conventional shareholders have become increasingly prepared to challenge what managements seek to do. “The atmosphere among conventional asset managers has become more active and conﬁdent,” says Franks.
“So far, these challenges have largely been in areas such as executive remuneration, social responsibility and board composition, so they are rather diﬀerent from activists’ interventions, which are likely to be more concerned with value creation and selling assets or putting a company into play.
“Such challenges by conventional shareholders are manifested in opposition or abstentions when they are asked to vote on such matters. But I would suggest that this represents an important step in the evolution of how conventional shareholders engage with companies. They have become more active.”
Together with Marco Becht of Solvay Brussels School and Hannes Wagner of Bocconi University in Milan, Franks studied the voting pattern of Standard Life Investments (SLI) over the period autumn 2003 to the end of 2015. The table opposite tells the story. Before the great ﬁ nancial crisis – in the ﬁ ve-plus years from autumn 2003 to the end of 2008 – SLI opposed the managements of companies in which it was invested in just 0.5 per cent of votes. In the seven years from the start of 2009, the proportion was 1.3 per cent. Abstentions also rose, from 1.0 per cent to 2.6 per cent.
Modest ﬁgures, perhaps, but they show a distinct trend. And Franks suggests that this increased robustness in facing up to companies’ managements may come to embrace a wider range of issues than in the past: “Today, the concern is directors’ remuneration. Tomorrow, it may be the question of strategic focus or whether a proposed takeover is a good idea.
“Is this merely misguided optimism? I don’t think so. We haven’t reached the end of the road on this. The gap between owners and managers has narrowed over recent years. That gap will be narrowed further still.”
Furthermore, there are diﬀ erent ways in which investors can nudge management into changing its ways if they feel unhappy about what it is doing. Unless an investor is going to keep quiet despite its misgivings, there are two options. It can complain and hope for improvement, or it can simply sell its shares. The choice is summed up in the phrase coined by the late economist and political philosopher, Albert Hirschman: voice or exit.
Franks says: “There are plenty of investment managers who insist that they prefer the option of ‘voice’. They are shareholders for the medium or long term.” If they feel uneasy about something a company’s management is doing or wants to do, they will try to inﬂuence what management does. This doesn’t necessarily mean emulating the role of the activist investor and calling publicly for change, but it does bring pressure on the management to re-examine the way the business is run.
But what if that engagement fails? Exit remains an option. And the very threat that an investor will sell its shares is likely to concentrate managements’ minds when considering how to respond to pressure for change.
Franks observes: “After all, if a signiﬁcant investor sells its shares following a failed attempt at engagement, that could be regarded by the wider investment community as a negative signal. Other people will see it and draw their own conclusions – perhaps that the company is not performing as well as it might, or its governance is poor.
“So although we might prefer that an asset manager engages with a company and is persistent in pushing for change, the fact that a failed engagement ends in exit is not necessarily of no value. The company’s management will be unable to ignore the signal the exit gives to other shareholders.”
All this must be seen in the context of a profound change in the shape of corporate ownership during the past 20 years. Over that time, the number of companies with a listing on the main UK stock market has more than halved, as illustrated in the graph above.
Furthermore, the pattern of ownership of the quoted companies has shifted. Franks notes: “Fifteen years ago, more than 40 per cent of quoted main market equities were held by domestic insurance companies and pension funds. No longer. I doubt the ﬁgure is now more than 10 per cent. These investors hold a greater share of their assets in ﬁxed-income investments. And there has been international diversiﬁcation – domestic investors hold more overseas and overseas investors hold more shares in the UK.”
So who have replaced these old-style domestic investors? Franks says: “Besides overseas shareholders, we have seen the rise of activist investors. Their increased visibility has perhaps oiled the wheels for conventional asset managers to become more active themselves.”
More important still, no one should ignore the private capital markets. Remember, the assets of companies such as Thames Water and the old British Airports Authority, which controlled most UK airports, are now held through the private capital markets. Companies such as these are not simply owned by private equity funds; some of their biggest shareholders are the very pension funds and insurance companies which used to have ownership through listed shares but which are now major investors via the private capital markets.
As Franks points out: “This is signiﬁcant. A privately owned company will typically have far fewer shareholders than a listed one. And if an investor is one of a clutch of, say, half a dozen shareholders in an enterprise, that investor is likely to be far more hands-on than if it were simply one of many thousands on a public stock exchange. Ownership and control will go hand in glove – or, at the very least, the gap between the two is signiﬁcantly reduced.”
Indeed, the rise of private equity may be a response to the so-called principal-agent problem, where the principals (shareholders) are unable to prevent the agents (managers) from doing things which are not in the best interests of investors. The principal-agent problem will be greatest where a company is owned by a vast number of widely dispersed shareholders. Taking a company private and thus putting its ownership in the hands of a handful of investors addresses that.