US investment funds are increasingly confronting European management over corporate governance issues.
In February a New York-based fund, backed by the California Public Employees' Retirement System (Calpers), the largest US investment fund, made a dramatic public call to Anglo-Dutch oil company Royal Dutch/Shell, calling on it to alter its board structure and strengthen the role of its chief executive. The blindside, from Knight Vinke Asset Management, came after the oil giant admitted it had overstated oil and natural-gas reserves by one fifth. In less than a month, chairman Philip Watts and the head of exploration had resigned.
Certainly, Watts' departure cannot be attributed solely to Knight Vinke's attack, but the high-profile nature of the attack couldn't have helped the embattled head.
Large US investment funds have often initiated and maintained open communication with US companies in order to ensure management was aware of their viewpoint. In European companies, however, the voice of investment funds, especially US investment funds, has been weaker. Structural issues such as holding companies and certificates of ownership have impeded communication in some countries. Many of these US funds historically did not even bother to vote their shares as they had neither the understanding of the major issues at the company, nor the manpower to vote in each of the companies where they owned stakes.
Recent scandals, such as Enron, Ahold and Parmalat, however, have put funds under pressure to become more involved in their investments. In some countries, notably the Netherlands, new corporate governance rules will actually require all investment funds to vote their shares.
Funds such as Knight Vinke represent a new breed of investor. These so-called engagement or activist funds are becoming ever more prominent. An engagement fund is similar to a hedge fund in that it makes investments based on a perceived weakness in the company - in this case in the company's corporate governance policies. These funds hope to boost shareholder value by helping the company improve its corporate governance.
At a time when many IROs feel under fire from investors and regulators, and are already stretched thin dealing with the basic disclosure requirements and communicating with the company's largest shareholders, this new activism - particularly by smaller US funds - is not completely welcome. When these funds are not among the company's major shareholders, are there good reasons to spend time and resources addressing their concerns? Are there things IROs can do to make sure any interaction with the company and the fund is in the best interests of all shareholders?
Battle lines shift
Many of the large investment funds are engaging companies directly. In fact, some of the large US mutual and pension funds have strengthened their European presence and are taking a more active role, says Umberto Mosetti, a partner in the Milan office of pan-European investor advice group DĂ©minor. 'I am noticing some household names - mutual funds as well as pension funds - are becoming very vocal,' Mosetti says. 'Some of them are investing a lot in research and engaging, and are not afraid to express a critical voice when they feel shareholder rights are being threatened. If anything, the European offices are really taking the lead.'
The level of activism varies from country to country, as well as by industry. In France, US fund activism dates back to the early 1990s when many large US funds bought into former state-owned industries as they were privatized. 'In the last couple of years my client base has shifted from pension funds simply reacting to bad deals where shareholder rights were not respected, to hedge funds trying to promote value through strategic initiatives,' says Sophie L'Helias, a Paris-based attorney specializing in governance issues and shareholder initiatives.
Bringing in hired guns
In many instances the funds do not have the resources or manpower to engage with every one of their investments. Instead, they are hiring specialist firms to vote shares on their behalf, research the company and - if necessary - contact company managers to discuss points of concern.
In the past, when funds met with management during a roadshow, management would simply ask for and get the fund's proxy. Those times are now over, according to many, including Anne Louise van Lynden van Sandenburg, one of the founders of Investor Voice, a Netherlands-based shareholder engagement service set up in 2003. 'US pension funds have rarely voted over here,' says Van Lynden. 'By not voting, they haven't had a standpoint on important issues such as board members. Now funds are waking up and saying, Whoa, we have to vote our shares.'
The Institutional Shareholder Services (ISS) representative in Germany, Alexander Juschus, says Germany has not seen the same level of activism as other European countries, although there are signs more US funds are voting than previously. Structural issues in Germany often mean the rewards for shareholder activism are low. In one high-profile case in June 2003, investors tried to remove a board member of German airline Lufthansa, who, as the employee representative, was seen as having acted against shareholder interests by leading a strike. Despite the majority vote to condemn the board member's actions, he still could not be removed from the board as there was no provision for removing the employee representative.
One thing that has forced some investors to vote their shares, despite feeling their voice is not being heard, is that many large custodian banks stopped taking the proxies for their clients in 2001-2002. 'Suddenly US funds had to find other ways to vote,' says Juschus. At the most recent annual meeting of industrial conglomerate Siemens, however, Juschus says ISS delivered 'considerable' votes.
Funds can hire firms to vote their shares for them. ISS is one of the larger providers of this service in the US and has also established a network of consultants in most European countries. It votes at more than 22,000 shareholder meetings each year.
Large pension funds have also set up organizations that allow them to share responsibilities for voting. Two such groups are Pensions Investments Research Consultants (Pirc) in the UK and the Foundation for Corporate Governance Research for Pension Funds (SCGOP), a Netherlands-based group.
But funds still have to know how to vote, and for that a certain amount of research is needed. That's where firms like Investor Voice step in to research the companies and their corporate governance practices - to help the funds know how to vote on key issues.
Creating a battle plan
Given the increased role many funds want to play in the corporate governance of their investments, IROs are often caught in the crossfire. On the one hand, the company's largest investors and management do not want to highlight potential corporate governance issues, even when they acknowledge them. But the IRO increasingly has to answer questions about the independence of the board or executive compensation.
Before an IRO can offer answers on such key questions, or formulate a plan for resolving conflicts, the company has to know what the answer is. 'The first thing any company must do is have a clear policy position,' says Sarah Marsland, head of investor relations at London-based communications consultancy Financial Dynamics. 'This is more difficult than it sounds as often there are many departments involved.'
As in almost every area of investor relations, clear, direct and truthful communication is also important. Although the fund may not be a top investor, avoiding a conversation on the issues it raises only serves to justify the fund's concerns.
'Companies need to be well briefed about the individual approaches and areas of interest of each investor; they also need to be willing to communicate directly with them,' adds Marsland.
Usually, complaints about voting rights don't come as a surprise to the company. Other issues, however, might. In this case, the IRO does not have a chance to be prepared, but can certainly react quickly to get everyone inside management up to speed on the investor's concerns.
'Make sure the CEO and CFO understand the issues so they can assess the risk of responding or not responding to investors' demands,' warns L'Helias. 'Regardless of whether the IR person informs the CEO of the issue raised, the lack of responsiveness to demands could exacerbate tensions.
Sometimes investor proposals don't cost the company a significant amount and it's a win-win situation for both the company and shareholders. Other times, responding to investor concerns can be costly. That is why properly assessing the risk is so important, L'Helias adds.
Communication breakdown
In many cases, these funds will go public with their concerns only if communication breaks down or if their issues are not being addressed at a fast-enough pace. Often, negotiations are friendly and constructive, as both parties have the best interests of the company in mind. With mounting feeling that more open corporate governance leads to improved share values, there's little harm in meeting to discuss issues, according to the experts.
IROs can be ahead of the curve simply by being aware of the dramatic changes afoot and by being an advocate inside the company for more communication and openness with investors, says Mosetti. 'In some European companies, IR managers still have to realize that although they work for a company, they are really the link between the investor community and the corporation,' he points out. 'They can play an extremely important, beneficial role both in society and within the company. Sometimes it is the job of the IR manager to remind the CEO that there is an owner - a community of investors.'
In the ten years L'Helias has been approaching companies on behalf of investors, she's seen improvements in companies' openness. 'In the past, CEOs didn't really talk to investors,' she notes. 'And IROs didn't always understand or take investor concerns seriously. But CEOs have become more communicative and the general level of professionalism and responsiveness among IROs has increased.'
Having ignored too many warning signs in the past, investors are increasingly less willing to excuse lapses in open communication from companies. 'Parmalat had the most closed and provincial approach to small investors of any large company,' says Mosetti. 'Investors believed it was just a provincial way of doing business, but it was fraud. The lesson of Parmalat is that small investors should not give companies the benefit of the doubt. They should react negatively to those companies that do not have enough independent board members, or that do have an opaque structure. More often than not, this is a clear indication of a problem.'
From hedge funds to engagement funds
Engagement funds and hedge funds are taking an even more activist role. The conventional wisdom is that they are short-term investors, not interested in the financial health of the firm - but often their interests are aligned with those of other independent investors. They enter into a company where they perceive a potential for gain and they try to actively change the situation.
'Funds are beginning to more aggressively evaluate investment based on corporate governance,' says Ann Louise van Lynden van Sandenburg, founder of shareholder engagement service Investor Voice. 'Often there is a crisis that brings this to life. They say, Wait a minute, this is a good business - if these issues are repaired, then this is a good company.'
But companies often fear or ignore these types of investor by saying they are not among their top investors. Shell says it has not even responded to Knight Vinke's concerns, for instance. 'We are still in the process of meeting with our top 50 shareholders and some of the top 50-100 shareholders. Knight Vinke is not one of them,' says Bart van der Steenstraten of Shell's IR department. 'We haven't made an official response, but in talks with our shareholders we have made it clear we are listening to shareholder concerns. Those who want to let us know their views can, but we have 1 mn shareholders between all of the companies, and we cannot meet with and listen to every one of them.'
Engagement funds and hedge funds may not be a company's top investors, but they can have disproportionate power, especially if they team up with other minority shareholders. Also, the publicity, highlighting potential problems and making the firm appear unresponsive, cannot be good for the company's image. 'Hedge funds may be speculators, but often they are right,' says Umberto Mosetti of DĂ©minor.