TOWARDS A WIDER DEFINITION OF RESPONSIBLE INVESTMENT.

IS THERE A NEED FOR CHANGE?

Free-market philosophies have dominated the global economic agenda since the early 1980's. There is ample evidence that over this period performance of larger quoted enterprises has not improved to match the rhetoric of free-marketeers. The financial markets appeared for a period to have found the performance 'philosophers stone' but this has proved to be an illusion and the collapse of an unsustainable philosophy has brought chaos to the financial markets and to the 'real' economy.

PERSPECTIVES

1. The behaviour of many investors and top managers in the free-market economies has flown in the face of good evidence about the roots of high performance. Externally driven activism, growth by M&A, underinvestment in longer-term programmes, especially in technology industries, has had a particularly drastic effect on the UK economy, to the extent that Britain has been drained of intellectual capital and is no longer a participant in many advanced technologies.
2. The period of 'shareholder value' when it was believed that the alignment of managers' agendas with those of 'shareholders' has not produced superior performance, either in investment or in industry. The growth of speculative short-termism in the financial markets has damaged many companies.
3. There is strong evidence that pay has become divorced from performance as a result of a developing symbiotic relationship between quoted companies and investors. One impact of this is hugely growing disparities between the rewards of top players in the markets and in industry, causing increasing de-motivation amongst the wider working population. But pay is not the cause of performance problems - it is a consequence of false perspectives and a faulty ethical compass.
4. The US and UK have both suffered growing balance of trade deficits. In the UK, this is a result of an increasingly unbalanced economy, dependent to an unhealthy degree on domestic consumption, housing and the finance industry. The decline in exports from the technology and manufacturing has vastly outstripped increases in finance or services exports. This gap will prove to be increasingly difficult to fund.

THE BOTTOM LINE

There is a very strong case for a major revision of the values and behaviour of influential players in industry and in the financial markets. As the investment markets have become the dominant force, driving the industrial agenda and the behaviours of top managers, it seems likely that investors will need to take the lead in making changes.

This Paper argues that these changes will be more effective if the definition and scope of 'Responsible Investment' is widened to encompass the impact of investors on three constituencies:

• The 'objects of investment' - especially when these are larger companies. Investors need to recognise that companies are primarily human organisations that need consistent investment and respond badly to being treated as though they were bundles of assets
• Clients, especially the bulk of 'ordinary' shareholders such as pension fund members, householders, small savers and employees
• Society. The fiction that society does not exist or that the finance industries could behave as thought they were apart from the societies in which they lived has been blown apart as a malign fantasy. The full import of this may not yet have been realised - for example, the ability of the rich and powerful to shelter their wealth from taxes is not yet on mainstream political agendas - but it is very likely that it will be in the near future.

Therefore there is a strong case for a radical revision of the definition of responsible investment..........

RESPONSIBLE INVESTMENT

The investment industry as a part of Society

The Failures of Free-market Global finance

The root causes of the implosion of the global financial and banking systems lie deeper than sub-prime lending and the development of complex derivatives, which are simply symptoms of a deeper malaise.

Arguably the failure was driven by a set of much more complex factors, including:

• The creation of a strong sub-culture within the finance industries, fuelled by professional arrogance and oppressive social pressures on insiders. This included denial of the ability or right of outsiders to 'interfere' in the free actions of market players
• The abdication from a duty of care or any responsibility towards a wider Society - even denial of the existence of such an entity
• Adoption and promotion of philosophical and economic creeds that lauded the pursuit of individual gain unimpeded by external regulation. This included denigration of the role of governments or democratic institutions in the management of economic affairs
• The use of financial and political power to influence politicians, governments and the public agenda, especially in the 'Anglo-Saxon' economies

This phenomenon was most extreme in the UK and US. The Nordic countries, and the Netherlands, Spain, Japan and South East Asian nations together with China, pursued a range of different philosophies leading to different outcomes. It might be noted in passing that Spain, which pursued a policy of strong banking regulation, has been far less affected by the current crash, to the extent that Spanish banks are now in a position to pick up some of the pieces from collapsed US and UK institutions.

Some of these countries have adopted different forms of market capitalism, which might be characterised as Social Market philosophies. In these models, the power of the Market as an instrument for wealth creation is fully recognised, but the activities of markets are consensually managed to ensure that they do not damage the interests of other societal stakeholders.

Towards different Values

It can be argued that the current crises provide an opportunity to deeply reconsider the roles and actions of the investment industry and indeed this process has already been in train for some time through the medium of the various movements for responsible investment.

It is worth spelling out some ideas and drivers that might spur change and improvement. Here is an outline of ideas that might lead to beneficial improvements:

Opportunity for constructive re- assessment of responsible investment

The current disasters should provide an opportunity for leaders in the investment industries to review the bases of their legitimacy.

A constructive train of thought might be as follows:

• The continued power of the investment industries to act as they wish will be at least temporarily constrained by government involvement and also by increasingly negative public sentiment
• This provides and opportunity for the industry to consider what voluntary actions might be taken to improve its contributions to the wider society and thus improve its legitimacy as a positive contributor. Failure to take the initiative will inevitably lead to strong external control sooner or later
• It has been accepted in certain quarters in the industry that investors have a duty of care towards the environment. The time is also ripe for a fundamental review of the nature of its duties of care towards its entire client base (not just the richer parts) and towards the objects of its investments, in particular industrial and commercial enterprises. Clear acceptance of a 'triangle of duty' towards the objects of investment, clients and the environment would form the centrepiece for a strong case that the investment industry is a responsible and productive player in the wider society.

NEW DIMENSIONS FOR RESPONSIBLE INVESTMENT

Investment Horizons

There has been constant comment about short-termism in the investment industry. Much of this comment is justified, given the growth of speculative investment practices such as 'shorting'. Private Equity managers and their supporters argue that they take a 'long-term' perspective, expecting to exit their investments in four to five years. Without commenting on the longer-term effects of 'asset- thinning' and high leverage, it is indicative of the mind-sets of many in the investment industry that five years is seen as long term.

The time it takes from idea to product for most complex technologies can range from five to ten years - if the 'experience effect', the root of high productivity, is added in, then natural timescales for larger and complex businesses stretch much further than five years. On another dimension, effective sustainable change in larger enterprises, which in essence are complex socio-political entities, may take from seven to ten years. For example, it is still doubtful whether the change process led by Sir Stuart Rose in M&S has really taken root. One of his predecessors, like George W. Bush, proclaimed 'mission accomplished' after two years, only to see the superficial improvements crumble to dust. If companies are to be constructively manage their ways through economic difficulties or invest for sustainable success, they need time to do it. Equally, responsible investors need to be able to recognise strategic 'vital signs' and differentiate between ill-founded and potentially high returning long-term strategies.

Therefore, responsible investors should, like Buffett, lead the way in pushing for acceptance of much longer time horizons.

Wider and deeper strategic skills

The investment industry seems to have become obsessed with metrics, quantification and benchmarking. Most financial and economic numerically-based information is likely to represent an extremely small slice of reality. Furthermore, most reported financial data passes through several filters on its way to its recipients, thus rendering its validity as a portrayal of reality suspect. Added to this is the fact that financial reporting is likely to be of historic data. Thus the tendency of many investors to place great importance on historic numbers is akin to driving by a distorted rear-view mirror.

The problem is - many investors are thoroughly versed in reading numbers but have neither the experience or the training required to understand the complexities of the interactions between organisations and their markets.

Letting go of the need to benchmark and create indices for everything would be a first step in moving towards a more skilful approach to selecting and supporting the objects of investment. Warren Buffett Is deeply interested in the business model, customer franchise, competitive positioning and the quality and values of leadership of the companies in which he invests. The number-crunchers of the investment industry need to learn how to make judgments about the longer term prospects of companies based on a mix of 'hard' and 'soft' factors. This is especially important, as historic numbers are an extremely poor way of making judgments about the longer term performance prospects of companies.

Duty of Care

Towards the Objects of investment

It has been seen that there is a high (some 80% over 20 years) rate of attrition and failure amongst companies in that most scrutinised of stock markets, the FTSE 100. The same effect seems to apply to CEO tenure in FTSE 100 companies.

Conversely, there is much evidence that well-managed companies can remain vital and successful over very long timescales and that managers do not 'lose it' after 5 years in post. Much, but not all, of the attrition in the FTSE can be attributed to a cluster of factors:

• Inconsistent and relatively low rates of investment compared to foreign competitors
• Excessive returns to investors, at the cost of investment in Capex and R&D
• The selection of active and transactional, rather than management-led, organic strategies
• Investor actions to remove managers or break up/sell whole companies or their parts

Responsible investors might be expected to take time to understand the fundamentals of the industries, the strengths and weaknesses of the managers and organisations, the nature of the technologies, strategies and competencies of the companies in which they invest. Over time, as a relationship and familiarity grow, a trusting relationship can develop between investors and companies. From this trust a mutual duty of care can grow between them.

Towards clients and the wider community

Too much attention has been paid by the industry to the needs of the super-rich and establishing tax shelters. Too often the mass of shareholders (small savers, pension fund members, borrowers, mortgage holders) have been subject to neglect or exploitation.

The banking and investment industries will need to moderate their behaviour towards the needs of the bulk of the population.

The concept of responsible investment therefore needs to encompass not just the good of the physical environment, but also the health and wellbeing of the community at large.

Currently, the industry is starting from a position where it suffers from gross mistrust, even contempt from the wider society. If it cannot overcome this, the industry and its customers will suffer equally.

From an internally-referenced to a more balanced orientation

The investment industries are essentially internally referenced. Indications of this are:

• Herd behaviour, tending towards seeking safety through following the crowd, even when the popular strategies are completely dysfunctional
• Resistance to external intervention, even from democratically elected institutions.
• Internal fixing of rewards
• Adherence to fixed ideas and concepts, hostility, disinterest or resistance to evidence, research and ideas coming from different perspectives.
• 'Move on and forget tomorrow' orientation, thus inhibiting learning

The industry needs to become much more receptive to influences from the outside, to re-consider the skills and experience needed and to encourage a significant infusion of new blood drawn from outside the ranks of finance, accounting and banking.

The book "The Corporation", by Joel Bakan used the interesting device of regarding the corporation as an individual and creating a psychological profile. Readers can see a similar profile for the investment industry prepared by a clinical psychologist who worked for several years in investment banks.

Complete re-orientation of reward philosophies

The investment industry has a serious responsibility for its own rewards, as there is no objective external oversight of its policy and practice. In effect, players in the industry can reward themselves almost as they please. This has resulted in practices that by external standards are ludicrous, even more so now, given the massive destruction of value caused by the excesses of the banking industry.

But, more to the point for this paper, the investment industry has been granted de facto powers of governance over quoted companies by virtue of the withdrawal of government from this role. This has resulted in some of the effects described in other parts of this paper - in particular a massive increase in top managers' pay that has been virtually unconnected with improvements in real longer-term performance.

Given the heightened sensitivity of the public to pay levels in the investment industry and the involvement of government, at least temporarily in ownership, together with enhanced roles for the regulatory agencies, it is an appropriate time to consider what changes in reward philosophy might encourage beneficial changes in behaviour, for example:.

• (Financial) transactions which attract bonus to have specified outcome goals - the time horizons to be appropriate to the nature of the deal, eg M&A, at least three years
• Variable pay to be realised for the longer term value created by an activity. For example, no pay for merely consummating a takeover, rather longer term reward for the value created by the transaction after an appropriate period
• Longer-term orientation, with variable pay deferred until the actual outcomes of transactions are known
• Fixed pay to be a far greater proportion of the total pay package, far less leveraged pay for achieving short term
• Base pay for employees and directors to be sufficient to enable them to lead their normal lives without bonuses

Final Thought

The problems of pay and performance in industry cannot be laid at the doors of bad individuals. They are systemic and derive from the relationships that have developed between the top managers of quoted companies and institutional investors. Until this closed system of relationships is opened to objective scrutiny and the issues are addressed from both sides of the system, the performance problems that have beset the UK economy particularly will not be alleviated.