Responsible Investing in a Time of Crisis

18 May, 2020 08:41
source: Grow the Pie

Singularity Financial Hong Kong May 18, 2020 – what does it mean to be a responsible investor in a time of crisis?

About this author: Alex Edmans (@aedmans) is Professor of Finance at London Business School and Academic Director of the Centre for Corporate Governance. He is also the author of “Grow the Pie: How Great Companies Deliver Both Purpose and Profit”. This post is republished with permission from the Grow the Pie blog.

In my first article in this series, “Responsible Business in a Time of Crisis”, I suggested business leaders ask themselves “What’s in my hand?”  In other words, what resources does my company have that I can use – through thinking innovatively and creatively – to serve wider society?

Similarly, I believe the starting point for a responsible investor is to ask “What’s in my hand?”  And the answer is a lot of things.  Investors have the ability to call the shots, the ability to buy and sell, and their relationships with other investors.  Let’s look at these in turn:

The Ability to Call the Shots (Engagement)

One powerful resource in investors’ hands is the ability to call the shots through voting.  Legally, it’s only investors – not stakeholders such as employees, customers, or environmental representatives – who get to vote on director elections and executive pay in countries such as the UK and US.

And the ability to vote spills over into the ability to call the shots in many other ways.  Investors can engage with companies through private meetings.  Often this engagement is collaborative – providing suggestions to management, or acting as an external sounding board.  Now managers need not agree with investors’ suggestions.  They may simply have different views on how the company should be run.  But, sometimes, management may disagree out of concern for themselves rather than the firm.  They may refuse to invest in workers, as doing so will prevent them hitting their short-term bonus hurdles.  Or they may resist scrapping an unprofitable investment because it was their own pet project.  Thus, having votes in their hand is powerful as investors can take action if management is intransigent.

This concept of “shareholder primacy” – that shareholders, and only shareholders, have the vote – is controversial.  There are concerns that they use this vote to pressure executives to split the pie differently – focus on short-term profit at the expense of wider society.  These concerns have been used to justify calls to reduce shareholder rights.  Rigorous evidence actually shows that shareholder engagement generally grows the pie, improving social value as well as profit.  But, often this evidence is ignored – potentially because the story that investors pillage companies to line their own pockets is more compelling and thus readily accepted (an example of confirmation bias).

So now is the time for investors to step up.  To show that they use their rights to create long-term value for all of society.  How can they do so? By emphasising to companies that they’ll be evaluating management on how their responses to the crisis affect wider society, rather than short-term financials.  Now serving society will mean different things in different companies, so there’s no one-size-fits-all approach.  Some companies can continue to pay their employees during the crisis; others can’t without jeopardising their viability.  Some can give in-kind donations; others’ products aren’t directly related to the crisis.  (See my companion article on responsible business in the crisis for examples of actions companies have taken).  It’s not investors’ prerogative to micro-manage every step of the journey.  But it is their prerogative to guide the destination, which is long-term social value.  And their outside perspective can bring to management’s attention some second-order effects that they miss due to having to focus on the first-order effects of the crisis – for example, increased demand for home-delivered goods may worsen working conditions in warehouses.

Relatedly, investors should stress their willingness to bear their share of a shrinking pie – accept lower short-term profits – to reduce the burden that stakeholders have to bear.  Where appropriate, this may mean telling management they support cutting the dividend or cancelling a previously-announced share repurchase, to free up cash to be used for other stakeholders.  (A companion article explains how, contrary to popular belief, payouts to shareholders don’t actually benefit shareholders in a crisis).  Or that they’re willing to contribute to a capital raise, if there’s a clear justification for what this capital will be used for.

And similarly investors can step back from other topics that they might have been engaging on before the crisis.  For example, many investors were correctly encouraging companies to reform executive pay away from financial bonuses and towards long-term equity.  But, in the current crisis, companies have far more urgent priorities, and stepping back from less urgent engagements will free up management time.

Why should investors use “what’s in their hand” in this way? For three reasons:

1. Investing in stakeholders typically benefits shareholders in the long term.  A supermarket may reserve special opening hours for the elderly and vulnerable out of a genuine desire to prioritise them, but as a by-product it benefits from greater customer loyalty and employee engagement.  Indeed, evidence shows that serving society ultimately benefits investors in the long-term.

2. Not every action to serve society will feedback into investor returns.  But, shareholder welfare consists of more than just shareholder returns.  A company’s shareholders – citizens saving for retirement, or institutions investing on their behalf – care about quality of life, not wealth.  They don’t want companies to maximise – even long-run profits – if this leads to structural employment, the collapse of businesses and thus decline in competition, or further deaths.

3. If, even in a massive social crisis, investors don’t use their shots to ensure companies serve wider society, then no-one will trust them do so in normal times.  So their rights may be taken away from them through changes in legislation.  Or, the legitimacy of the active management industry will be threatened and savers may move to index funds.

The Ability to Buy and Sell

A second resource in investors’ hands is the ability to buy and sell shares.  They can sell much faster than employees can quit their jobs, leading some commentators to argue that investors will inevitably have more short-term perspectives than workers.  So we need to restrict their rights if we want companies to focus more on the long-term.

This seemingly intuitive argument fundamentally confuses two things: the horizon of an investor with his orientation.  An investor can be selling in the short-term, but based on long-term factors, which is what we mean by his orientation.  An investor might exit a company despite it hitting its profit target, because it’s done so by extracting from society.  While there have been many positive responses to the crisis, there have also been some disappointing ones, e.g. Sports Direct requiring their employees to come to work even after the UK government banning all non-essential travel.  Such companies should be held to account.

The distinction between horizon and orientation is important.  I’ve heard calls that “now is the time for investors to get behind British business and not sell”.  But, this does not mean supporting companies unconditionally (see here for an excellent article by the Schroders CEO on this point).  Investors should indeed show loyalty to companies that miss profit targets if they’re prioritising social value.  But they should hold executive to account if they’re acting myopically, or being complacent and not thinking innovatively about how to use the vast resources they’ve been entrusted with to serve society.  Indeed, just as the power to vote against gives teeth to engagement, so does the power to sell.

And investors can only buy shares (supporting companies who have been unjustifiably sold) or contribute to capital raises if they have freed up funds through selling others.  Investors’ expertise is capital allocation.  This function is arguably even more important in a crisis than in good times, and should not be hindered by misguided interpretations of loyalty.

Relationships With Other Investors

In my companion article on responsible business, I highlighted that a key resource that a company has is its relationship with other companies – which it can use, for example, to redeploy its employees to other firms.  Similarly, a key resource that an investor has is its relationships with other investors.  One challenges with engagement is that an individual investor may have too small a stake to have a meaningful impact.  Collectively engaging with other investors, e.g. at AGMs, through joint private letters to companies, and through frameworks such as the Investor Forum and the UN PRI Collaboration Platform, can be particularly powerful.

Public letters should not be ruled out, but the assumption that public letters are more powerful than private ones may not hold.  Companies may doubt the sincerity of public letters claiming that investors are happy to receive lower dividends, wondering whether they have written this to win public approval.  One of the key scepticisms about responsible business and investing is that grand statements are made but not followed through.  A joint, private letter may be more sincere – just as a private reference on a former colleague is more credible than a public recommendation on LinkedIn.

Questions to Guide Engagement

What questions can investors ask management to (i) discern which companies are truly pursuing social value and (ii) challenge and hold companies to account?  The organisation Blueprint for Better Business has eight suggested questions to identify which companies are purpose-led in normal times.  For the current crisis, particularly insightful is a list of questions suggested by Morgan Stanley’s Sustainability Equity Research Team, because of how specific and probing they are. A few examples are as follows:

1. If employees have been temporarily furloughed, have they been given transparency around the length of leave? What benefits and support are available to them during their furlough?

2. What efforts are being taken to ensure that employees remain engaged? If working conditions have changed, what steps have been taken to ensure employees can remain productive and efficient?

3. If demand snaps back, how quickly can the workforce be re-staffed?

4. What actions has the company taken to support customers who may be facing financial challenges as a result of COVID-19 disruption?

5. Has the company made any extraordinary efforts in providing additional support to the community during the crisis?

These questions get to the heart of some of the most tricky issues that businesses have to wrestle with.  For example, #3 highlights the need to remain commercial, by ensuring that a business is well-placed to recover when the crisis attenuates.  #2 emphasises how, even though remote working is possible due to technology, employee engagement and mental health remain key challenges.  Investors might come up with their own lists of questions to help them use what’s in their hand – their ability to call the shots, their ability to buy and sell, and their relationships with other investors – to ensure that companies pursue long-term social value at this difficult time.

(This post is republished with permission from the Grow the Pie blog.)