Institutional Investors: What Is Their Role as Owners of Public Companies?

There is a lot of buzz around the topic of institutional investor engagement in Asia.

A recent blog post on shareholder engagement highlights global trends in board–shareowner engagement. The blog post also raises an important question: Is engagement worth it from a corporate or investor point of view?

The Organisation for Economic Co-operation and Development (OECD) recently released a corporate governance working paper on “Institutional Investors as Owners: Who Are They and What Do They Do?” The paper has been written from a public policy perspective and considers the role of ownership engagement in effective capital allocation and monitoring of corporate performance. I found this paper fascinating and would like to summarize the contents for the benefit of readers.

Defining the role of institutional shareholders depends on whether the shareholders contribute capital, information, and monitoring, or whether they only contribute capital.

Institutional investors are a complex, heterogeneous group. The common characteristic is that institutional investors are not physical persons; instead they are legal entities.

Statistics noted in the OECD working paper show that the percentage of public equity held by physical persons has declined over the years. In the mid-1960s, physical persons held as much as 84% of all publicly listed stocks in the United States. Today they hold less than 40%. In the UK, the percentage has reduced from 54% to 11% in the last 50 years, and in Japan, only 18% of all public equity was held by physical persons in 2011.

Diversity and Complexity of Institutional Investors

Character, quality, and degree of institutional investor engagement across the globe vary widely because of the different categories of institutional investors and their business models. The OECD report authors have analyzed the complex landscape of institutional investors by bifurcating them as traditional (i.e., pension funds, investment funds including mutual funds, and insurance companies) and alternative (i.e., sovereign wealth funds, private equity, hedge funds, and exchange-traded funds).

Asset managers have been added as a separate class due to the rapid growth of outsourcing to asset managers, as reflected in the UK Stewardship Code. The report defines asset managers (as opposed to asset owners) as having the day-to-day responsibility of managing investments; they are not expected to invest in their own name but directly in their clients’ name and based on their clients’ investment policy. The report’s authors recognize that other categories like closed-end investment companies, proprietary trading desks of investment banks, foundations, and endowments could be added but have been conspicuously omitted due to lack of reliable data.

Growing Importance of Institutional Investors in the Investment Chain

The report says that the combined holdings of all institutions represented US $84.8 trillion as of 2011. Out of this, 38% (US $32 trillion) was held in the form of public equity. The traditional institutions held US $28 trillion in public equity, and alternative institutions held US $4.6 trillion in public equity.

Globally, asset management firms were estimated to have had about US $63 trillion under management at the end of 2011, according to a 2012 joint research report by Towers Watson and Pensions and Investments. The OECD report authors recognize that institutional investors increasingly invest in instruments offered by other institutional investors. Pension funds, for instance, invest in private equity, and insurance companies invest in mutual funds. Some of the asset managers are traditional or alternative institutional investors that manage their assets through a special asset management arm.

Key Findings of the OECD Report

• Equity ownership in its own right is not a determinant of ownership engagement.
• Investment chain is complex due to cross-investments among institutional investors, increased complexity in equity market structure and trade practices, and an increase in outsourcing of ownership and asset management functions.
• Ownership engagement plays an important role for effective capital allocation and the informed monitoring of corporate performance.
• Exercising shareholder rights (i.e., access to information, participation in key decisions concerning fundamental corporate changes, election of board of directors, etc.) is always associated with certain costs and requires adequate resources.
• Shareholders need to be distinguished by whether they contribute risk capital and monitor/provide information or whether they only contribute risk capital. The latter shareholder will not be interested in engaging with the company.

A number of features and choices define the institutional investor’s business model and its ability and willingness to serve as informed and engaged owners. These features and choices are then used to establish taxonomy for identifying different degrees of ownership engagement ranging from “no engagement” to “inside engagement.”

Determinants of Ownership Engagement

Source: Çelik, S. and M. Isaksson (2013), “Institutional Investors as Owners: Who Are They and What Do They Do?” OECD Corporate Governance Working Papers, No. 11, OECD Publishing.

Four Broad Categories of Ownership Engagement

1. No Engagement:  This category comprises institutions that do not monitor individual investee companies actively or do not actively engage in any dialogue with the management of investee companies.  One example would be institutional investors that are subject to engagement limitations or an outright prohibition to vote their shares.
2. Reactive Engagement: This relies on buying advice and voting services from external providers, such as proxy advisers, or may include reactions to engagement based on other active shareholders. One example would include mutual funds that are subject to legal requirements to vote their shares with the help of proxy advisers.
3. Alpha Engagement: This engagement level is associated with ownership engagement that seeks to support short- or long-term returns above market benchmarks. Both active hedge funds and private equity funds can be examples of alpha engagement.
4. Inside Engagement: This encompasses fundamental corporate analysis, direct voting of shares, and often assuming board responsibilities. One example would be a closed-end investment company like Berkshire Hathaway, which is the largest shareholder in Coca-Cola and is represented on the board of Coca-Cola by one of its directors.

The following conclusions were reached as a result of the working paper:

1. In order to understand the level of ownership engagement, we need to identify a whole range of different determinants.
2. Legal or regulatory requirements for voting may have little effect on ownership engagement if other and more dominant determinants for ownership engagement remain unchanged.
3. Institutions with the highest degree of engagement typically have no regulatory obligation with respect to the degree of their ownership engagement.

Do you agree?  We’re interested in hearing your views.

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