Issue: September 2012 / November 2012


Short-termism targeted

How to start winning back investors’ trust and confidence. UK report should resonate in SA.

Kay...packs a punch

Music to the ears of King III and the Code for Responsible Investing in SA (CRISA) is the final report of the Kay Review. Commissioned by the UK Business, Innovation & Skills ministry, and chaired by economist John Kay, it supports with firm recommendations the ways to attack the short-termism that blight equity markets and mock corporate sustainability. Old-fashioned concepts of ‘fiduciary’ and ‘stewardship’, preached more than practised, are brought back to the fold.

The 40 000-word report sets out to determine how well equity markets are achieving their core purposes of enhancing company performance and enabling savers to benefit from activity in these businesses. Not at all well, it finds, in that relatively few companies use the new-issue market to raise funds for new investment.

Central is the systemic problem of short-termism. It’s been caused principally by the decline of trust and the misalignment of incentives throughout the extended equity-investment chain. An upshot is the “hyperactive behaviour” of executives whose corporate strategy focuses on restructuring, financial re-engineering or mergers and acquisitions “at the expense of developing the operational capabilities of the business”.

Kay’s brief was confined to the UK. The relevance is far broader, not least to SA. There as here, it’s to be addressed not merely by voluntary codes but by governments, regulators and participants along the entire chain from company directors to asset managers, from financial advisors to pension-fund trustees.

No single reform will provide the solution, says Kay, but when implemented together “we believe our recommendations will help to deliver the improvements to equity markets necessary to support sustainable long-term value creation”.

The proposals are in the category of motherhood and apple pie. They are refined and restated because sight of them has been lost in the avarice of transactional avalanches. Recommendations aim to “restore trust and confidence in the investment chain by the application of fiduciary standards of care by all those who manage and advise on the investments of others”.

How to do this? Diminish the current role of trading cultures. Rectify the disincentives and barriers to engagement by asset managers with investee companies. Broaden the existing concept of stewardship. Encourage asset managers to hold more concentrated portfolios judged on the basis of long-term absolute performance. Shift regulatory philosophy to support market structures which create appropriate incentives, as opposed to countering inappropriate incentives through detailed rules of conduct. Tackle misaligned incentives in the remuneration practices of company executives and asset managers, and improve the disclosure of investment costs.

Critically too, the report comes out against “excessively frequent reporting” because it adds to pressures for short-term decision making: “Undue reliance on information disclosure has led to the provision of large quantities of data, much of which is of little value to users.”

Competition between asset managers on the basis of relative performance is inherently a zero-sum game, Kay argues. At the heart of short-termism is the conflict between the business model of asset managers with the interests of companies and their investors: “The asset-management industry can benefit its customers (savers), taken as a whole, only to the extent that its activities improve the performance of investee companies.”

Specific recommendations include:

  • A more expansive form of stewardship, focusing on strategic issues as well as corporate governance, that promote long-term decision making;
  • Collective engagement by institutional investors in companies;
  • Consultation by companies with major long-term investors over major board appointments;
  • Disengagement by companies from the process of managing short-term earnings expectations and announcements;
  • Scrap companies’ mandatory quarterly reports;
  • Strongly encourage high quality, succinct narrative reporting by companies;
  • Asset managers should make full disclosure of all costs, including actual or estimated transaction costs, and performance fees charged to a fund;
  • Review the legal concept of ‘fiduciary duty’, in the investment context, to address uncertainties and misunderstandings on the part of trustees and their advisers;
  • Company directors’ remuneration should relate to sustainable long-term business performance, with incentives provided only in the form of company shares held at least until after the executive has retired from the business;
  • Asset managers’ remuneration should be similarly restructured to align their interests with the interests and timescales of their clients. Pay should not be related to short-term performance but to a long-term incentive provided in the form of an interest in the fund held at least until the manager is no longer responsible for that fund.

Some of it is radical stuff, not easy to implement. But it is a blueprint for reforms that the UK legislators and regulators look keen to introduce. Several are already in the SA cauldron via King III and CRISA, not to mention National Treasury and the Financial Services Board. Now they’re given the additional impetus and imprimatur of Kay.