What role should asset managers play in supporting the long-term growth of publicly listed companies in the UK equity market?
This query raised more questions than answers at a recent continuing education event organized by the CFA Society of the UK (CFA UK) in London on 17 May 2012. The event was held against the backdrop of the “The Kay Review of UK Equity Markets and Long-Term Decision Making,” commissioned last year by the British business secretary to address how well the equity market supports the long-term growth of publicly listed companies and enables investors to participate in that growth.
The event featured: economist John Kay, who is leading the Kay Review; Colin McLean, FSIP, managing director of SVM Asset Management and an incoming member of CFA Institute’s Board of Governors; Deborah Gilshan, FCIS, corporate governance counsel at Railpen Investments; and Natalie WinterFrost, CFA, client director at Aberdeen Asset Management.
The discussion, which was conducted under the Chatham House Rule, was lively and interactive with those attending doing nearly as much talking as the speakers. While the discussion was specific to the United Kingdom, it raised issues that are relevant for many other countries. Here are some highlights.
First, the role of equity market in raising capital for UK businesses is relatively limited. As pointed out by CFA UK in its response to the Kay Review, there are more than 4 million businesses in the United Kingdom, and 2.6 million of those are companies. Listed companies, numbering about 9,950, comprise a small proportion, and even within this, few are raising additional equity capital. As one participant noted, equity has become more of a way of getting money out of rather than putting it in a listed company. This reality is quite different from the text book view that the equity market helps companies raise capital to finance long-term growth.
Second, there is growing belief that the equity market better serves the interests of intermediaries — such as asset managers — rather than those of listed companies and savers. As the interim report of the Kay Review also notes, “While the growth of financial intermediation has many positive aspects, intermediation is not an end in itself, and the rewards of intermediation can ultimately be justified only by the contribution such activity makes to economic activity outside the financial sector.” One participant said that the theme of the responses to the Kay Review so far also seems to be that “the system isn’t working terribly well and it is not our fault,” implying that what is needed is structural reform of the equity market in the interest of its customers — listed companies and savers.
Third, performance incentives for management of listed companies can be quite complex and aren’t necessarily aligned with long-term value creation. Performance-related executive compensation in the FTSE 100 (UKX:IND) companies is often driven by earnings per share, absolute total shareholder return, relative total shareholder return, or a combinations thereof. Instead of long-term value creation, these measures are likely to encourage leveraging and gaming in the short term. Economic profit could be a better measure than these as it takes into account cost of capital, but how to determine the cost of capital to arrive at economic profit is much less clear. Models such as the capital asset pricing model (CAPM) make unrealistic assumptions and can be, “more misleading than helpful,” in the words of one participant, in estimating the cost of equity. Some investment practitioners use the output of such models uncritically probably because they prefer quantitative analysis over qualitative analysis.
Fourth, engagement is integral to the stewardship expected from asset managers, but for asset managers to engage more with the companies in which they invest, the clients of asset managers need to be convinced of the merit, assuming there is merit, in engagement. There is increasing research that suggests good corporate governance has a bearing on performance, and corporate governance issues should be integrated into investment decision making. However, engagement suffers from free riding, and there is perhaps not as much research on the value of engagement by asset managers. Engagement may be good for the companies and savers in the long term, but the clients of asset managers are not necessarily interested in governance-driven engagement by asset managers.
Fifth, in aggregate, seeking alpha is similar to a zero-sum game. Active managers are incentivized to do something individually that does not make sense collectively. There is a mismatch between the business models of asset managers and the interests of listed companies and savers. This mismatch also helps explain why the asset managers see engagement as low, if at all present, on their list of priorities.
The final report of the Kay Review is expected in July this year. It will be interesting to see what recommendations it puts forth for structural reform to better align the incentives of asset managers and the interests of savers and listed companies.
The Royal Stock Exchange illustration from Shutterstock.