Renowned US economist Milton Friedman once famously declared that public companies exist solely to serve their shareholders. Last week, Friedman may have been rolling in his grave. The CEOs of the 192 largest public corporations in the US delivered a “statement of purpose” that each of their companies would no longer only look to maximize shareholder profits. Instead, they would deliver value to each of their business’s stakeholders including employees, customers, suppliers, and the communities they operate in with a view to create longer term value. The statement comes amid a global debate about the responsibilities of corporations at a time of large economic inequality. Critics of current corporate practices suggest many companies now put profits before the needs of workers and customers on issues as varied as pricing, outsourcing, data privacy, and inconsistent wage increases between the average worker and executives. It’s important to note: no one is suggesting that corporations shouldn’t work to generate profits for shareholders, rather should consider other factors in measuring their success.
Short-Termism Under the Regulatory Microscope
Investors, governments, policymakers, and regulators have been vocal in calling on companies to focus more on environmental, social, and governance (ESG) issues. However, beyond evolving ESG regulation, there has been a more targeted debate regarding “short-termism” at listed companies, asset managers, and pension funds, and insurers. The topic has captured the attention of the two largest global regulators (the US Securities and Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA), both of whom took up the issue this summer.
Short-termism refers to an excessive focus on short term results at the expense of longer-term interests. The recent scrutiny of short-termism derives from a general hypothesis that modern public markets and capitalism inevitably incentivizes behavior and financial engineering that boosts share prices in the short term at the expense of the longer-term strategic interests. One of the most obvious manifestations of short-termism is that public companies and asset managers may make decisions excessively based on how such decisions are affected by quarterly earnings reports and subsequent analyst commentary. Focusing quarter-to-quarter means companies and asset managers may pay less attention to longer term strategy, sustainability, and value creation. Regulators want to know if markets are unduly impacted or influenced by this focus on improving short-term price performance to the detriment of longer-term goals such as research and development or improved employee welfare.
While grappling with the same subject, ESMA and SEC have taken divergent paths in their assessments. ESMA issued a public consultation paper, while the SEC engaged in a few roundtable discussions and requested some expert opinions before forming their formal opinion. While different in approach, there are certain commonalities that could impact global asset managers, if the regulators choose to act on their assessments.
ESMA’s Consultation Paper
ESMA launched their public consultation in June through an online survey. The survey probed six distinct areas which produced four common themes:
- Investment strategy and horizon
- Disclosure of environmental, social, and governance (ESG) factors
- The role of fair value in better decision making
- Institutional investor engagement
- Investment manager and executive remuneration
- Use of credit default swaps (CDS) by investment funds
1. A Nuanced Area
Asset managers and industry bodies that responded to the consultation seemed to agree that short-termism is subjective. Managers continuously weigh how best to deliver liquidity and investment horizons fit for the needs and profiles of their end investors. Short-term, highly liquid products may result in higher turnover but that is normally a function of subscription and redemption activity, not a discretionary decision of the asset manager. High portfolio turnover results in higher transaction charges which erodes performance, so portfolio turnover is not necessarily an accurate measure of a short-term mind set. It is noted that the holding periods of fund investors has shortened in recent years (because more information is available and it’s easier to trade in and out electronically) and perhaps regulators should consider incentives for investors to remain invested in funds longer-term.
2. Unintended Regulatory Consequence Leading to Undue Short-Termism
Survey respondents also highlighted that quarterly corporate reporting aimed at increasing transparency to investors may also lead to excessive short-term investment behaviours, such as excessive trading in reaction to a profit warning or a windfall gain. Certain regulation might have the unintended consequence of favouring safer, short-term liquid assets at the expense of long-term asset, such as Solvency 2 which outlines balance sheet risk capital requirements. Recent EU Commission initiatives, such as the European Long Term Investment Fund and Pan European Pension Products (PEPP) are opportunities to change the investor mindset and foster a longer-term investment landscape in the EU. However, both regulatory and fiscal constraints remain for future growth of these structures.
3. Corporate Stewardship
Asset managers commented that corporate engagement, by way of proxy voting and direct access, is the most efficient way of mitigating any potential sources of undue short-termism at investable companies. There are swathes of research to show that active investor engagement is said to both improve investment performance and the societal impact of corporations. The Shareholder Rights Directive (SRD II) aims to further promote engagement of asset managers with the companies in which they invest in order to sustain and enhance long term value to clients, and many managers already believe they do.
Asset manager remuneration is highly regulated in the EU through UCITS and AIFMD provisions. General corporate executive remuneration is a lot less regulated. Many hope that SRD II may give shareholders, including asset managers, greater opportunity to influence better executive renumeration practices at listed companies such as a shifting away from linking variable remuneration solely to the value of short-term stock price.
The SEC Review
The issue of short-termism is equally as prevalent in the US and in July the SEC hosted a roundtable for investors, issuers, and other market experts on short-termism.
Interestingly, there were two very evident schools of thought displayed at the roundtable. The first suggested that the issue of short-termism has been somewhat conflated in importance and that even if it exists in the US market, it’s counter balanced by those with the equal and opposite view on long-termism and as part of a well-functioning public market. Activist hedge funds came under specific criticism, in addition to short selling, leveraged buyouts leaving companies heavily indebted, undue share buybacks from cash reserves, and high frequency trading. However, other contributors believe that listed companies, asset managers, and asset owners have indeed become too focused on short-term fluctuations in asset price to the detriment of long-term investors value creation. They argued retail investors are forced to trade-off between long termism and a liquidity imperative.
The final strand of the debate focused on the shift of more US companies choosing to be privately held. Some argue the pros of listing are outweighed by such high levels of transparency and shareholder reporting obligations which can take resources from strategic goals of a publicly held firm. SEC Chairman Jay Clayton has previously expressed concern that too many companies are becoming privately held, limiting access to these growth investment opportunities from US retail investors.
The roundtable also emphasised the complexity and high degree of resources required for quarterly corporate reporting in the US. The practical operational difficulties and resource intensity of filing SEC Form 10-Qs every quarter was specifically flagged as an area where reporting companies feel the benefits of such regular transparency are not worth the effort. They argued that most investors don’t read the detailed reports, and instead look to earnings releases and profit warnings. They requested the SEC to consider allowing less frequent and less detailed reporting for listed companies.
Such cost benefit analysis is a recurring theme within asset management as the reporting burden has continued to rise in recent years. It also forms part of regulators’ thinking as we’re in the midst of a global regulatory recalibration. Robust yet flexible regulatory reporting capabilities are increasingly important for cross border asset managers seeking to satisfy the exacting reporting demands of their regulators and investors. Working with the right data and reporting service provider has never been so important.
The Long and Short of it
With retirement funding gaps globally continuing to widen, the “hunt for yield” grows more competitive. This is reinforcing the notion that investors with longer-term liabilities might need to match these obligations with more “patient capital” (less liquid asset classes which will yield higher returns over the lifecycle of the investment). However, allowing retail investors access to less liquid asset classes must always be measured against liquidity requirements for this investor segment.
For the asset management industry, how to balance the demands these competing priorities appropriately is of top of mind. Mixing liquidity requirements with returns from longer time horizon assets is the key. Many asset managers are extending their product offerings to include intraday liquidity of ETFs or illiquid asset exposures such as private equity or real estate. We expect this trend is likely to continue. It will also add oxygen to an already vibrant regulatory discussion about appropriate retail investor protections if they are to access higher yielding but less liquid asset strategies. Recent liquidity concerns in retail investment funds such as the Woodford liquidity issue could cause regulators to pause for thought, even if it is evident that on a practical level the only way to bridge the funding gap is to allow access to such exposures more broadly.