HOW TO DEAL WITH AN INCREASINGLY ESG-SENSITIVE AND MORE IR-IMMUNE INVESTOR LANDSCAPE

The institutional investor landscape around the globe has changed significantly over recent decades. One phenomenon witnessed over the last several years is the trend to a larger ownership by passive institutional investors in issuers of all market capitalisations and across almost all jurisdictions. At the same time shareholder activism by actively-managed institutional investors has experienced a new peak, with several campaigns breaking the news and considerably more campaigns being fought out behind the scenes.

Often the most passive investors from an investment management perspective have become the most active investors on corporate governance issues and transactions. In addition to the considerably increased ownership of passively-managed funds, investors generally have now become more “ESG-sensitive”.

The question is now: How to engage with them?

Educated and alert investor relations officers or company secretaries will have noticed the news of the largest passive fund managers announcing seemingly ever increasing inflows of funds over the last couple of years. BlackRock, the world’s largest money manager, recently announced record inflows into its passive products, while its active arm saw redemptions. In February, The Vanguard Group, a purely passive fund manager, disclosed it had reached 4 trillion USD assets under management for the first time in history, with inflows into its products of 322 billion USD only in 2016 alone. In January of this year, investors poured more than 40 billion USD into US-listed ETF’s alone, exceeding the average monthly inflow of 26 billion USD by far.

Seen from a baseline of December 2008, passive reported investments have significantly outgrown active investments on a relative scale in almost every European market, except Italy. This includes growth in France by 130 percentage points, in Germany and the Netherlands by about 170 percentage points and in the UK by 50 percentage points. Overall, in the European markets, disclosed passive holdings have outgrown actively managed holdings by 62 percentage points.

While on an absolute basis active fund managers remain significantly larger than their passive counterparts, this development poses a problem for many issuers. The set of investors issuers can share their story with, whose investment decisions they can influence to some degree, is truly shrinking in percentage terms, even if strong performance increases the size of the pie. Furthermore, Ipreo has heard anecdotal comments from “active” managers that confirm a move to a more passive strategy once they outperform their benchmarks in the early quarters of the year, leaving an even larger part of the pie being benchmark driven.

For some issuers, passive institutional money already accounts for more than 30-40% or their free float. In Germany’s main DAX index, according to a recent Ipreo study one investment group alone - BlackRock - accounts for 10% of the entire DAX free float, and 6% of all shares outstanding. Similar numbers can be found in developed markets as France, Switzerland, and the UK, as well as parts of Asia where names as BlackRock, Vanguard or Dimensional Fund Advisors often come up as top holders. Additionally, many international pension and retirement funds have decided to allocate and outsource the investment discretion of their funds to managers following passive benchmark strategies (usually for risk management purpose), while they keep the voting discretion in-house. This is reflective of an increasing importance of corporate governance in asset management and a heightened ESG sensitivity of all investors – which makes passive holders often the most active ones when it comes to voting or engagement.

INCREASED ESG SENSITIVITY

Supported by regulatory directives as well as private and industry initiatives as the UNPRI, institutional investors have recently begun to ramp up their corporate governance efforts by building out and hiring expert corporate governance teams. Investors see this process as revenue-generating -- not only to become better corporate citizens but also to enhance their risk management practices and boost their performance. Instead of voting with their feet, active managers now often rely on internal governance guidelines and an engagement process to improve corporate behaviour with a focus on governance, compensation, and capital raising-related items, as well as ensuring independent and qualified boards. Hence, we have seen a record level of dissent around shareholder meetings in Europe and Asia, a record high of shareholder activism, and increasing engagement of traditional institutional investors to change corporate behaviour.

One important thing to note is that we are now dealing with more than just a few investors who want to cause trouble. We are dealing with the vast majority of traditional and alternative investors, who effectively use corporate governance as an entry point to increase value. Pure-play activist investors can only be successful if they get the support of the traditional investors globally. Many activist funds, such as Knight Vinke, were funded partly with seed money provided by prominent pension funds, hence it makes sense that traditional investors have less intention to vote against activist proposals if value creating suggestions are made. And many traditional investors, active and passive, supported active ownership campaigns in the last years, just as the main proxy advisors ISS and Glass Lewis were supported activist proposals globally.

At this stage, predominantly large-cap companies with an international ownership structure see more proactive institutional investors in the ESG sector. They send out questionnaires, drill down on financial reports, scrutinize compensation practices, push for independent board structures, and introduce limits for capital measures. Consequently, issuers have to increase their efforts and communication when dealing with shareholders and their advisors in order to reduce risk and maintain a constructive dialogue.

HOW TO DEAL WITH INCREASED ESG SENSITIVITY

According to Ipreo intelligence, more than 50% of the largest institutional investors globally show either a Medium or High ESG sensitivity. Investors in these categories have expressed their ESG focus through adoption of ESG policies, formation of responsible ESG teams, active voting, and consistent engagement practices. In other words, more than half of the institutional investors, irrespective of their geography, investment style or turnover ratio, now have a clear focus on ESG criteria. They evaluate issuer benchmarks and compare them to peers, region, sector and industry – putting the onus on issuers to report effectively and show progress.

Among ESG policy components, more than two-thirds of investors have an internal proxy voting policy, while more than 50% have an engagement policy. This is driven in large part by the view that shareholders are stewards of assets and are accountable to their beneficiaries.

Any investor that takes ESG integration seriously will have an interest in engaging with issuers, and both for voting decision as well as investment decision purposes. For firms such as BlackRock, the ESG team sits with the portfolio managers, and there is constant interaction both internally as well as externally with issuers. Many of the largest asset managers have an ESG practice already implemented into their portfolio selection and asset management, hence this also offers an opportunity for issuers who take ESG seriously to become active and meet a “new” stakeholder group, the corporate governance teams of institutional investors and retirement funds.

Issuers should not be afraid of engagement: an active investor aims at a long-term profit maximisation and should generally have its interests aligned with the company. A survey by the Deutsche Aktieninstitut DAI some years ago supports this assessment and showed that 85% of the German issuers value an active dialogue with their shareholders. Furthermore, feedback from these meetings with governance teams often will be an eye-opener for IR, management, and board members, as they will get a different view on their companies and the drivers for investment and engagement. Lastly, it also helps to identify weaknesses and important trends early and get a chance to improve on governance matters, which often are also the main entry point by active shareholders and activists. Larry Fink, BlackRock’s CEO, stated numerous times in meetings with issuers, as well as publicly, that BlackRock does support activist investors that focus on long term value creation9, even those focusing on sustainability issues. Through active engagement from the issuer side, one client recently found out that one of their key investors, index-giant State Street Global Advisors, now intends to vote against companies that do not have female directors.

BEST PRACTICE PRINCIPLES FOR ENGAGEMENT

As engagement and voting strategies apply to most of the investors, issuers need to be aware of the best practice principles to engage from their side.

?? Understand your shareholder base on a portfolio level, to assess the risks and governance sensitivities of your beneficial owners

?? Widen your stakeholder network and engage early with the fund managers and governance teams of both active and passive investors, and their proxy advisors, before the final agenda of the AGM is solidified

?? Engage with the right people inside the company to answer the concerns of your investors and do not hesitate to include board members, lead independent director, and chairman of a committee when necessary. Often, this is even demanded by investors or their local governance code, so be proactive

?? Governance and the presentation of the items that will be voted on should always be a point of the engagement agenda for the meeting. Provide explanatory notes to accompany the notice of meeting

?? Disclosure and reporting needs to be provided alongside share plans in order to explain how they will be used explicitly for executive directors

?? Balance your discussion with the compliance view - a good explanation for a practice not totally in line with “good governance” is always better than a biased or obfuscating answer delivered for compliance purposes

?? If there is a new member to be elected, he/she should make a quick presentation of him/herself

?? Do not disregard concerns by some of your investors just because those concerns are not shared by the main proxy advisors (ISS/GL). Often, those concerns will become those of major proxy advisors, and of institutional investors and activists in the years to come; issues often progress from the voting guidelines of issuers to those

?? Be holistic: ESG policies should be part of a larger story and embedded into your long-term strategy

?? If possible, translate the financial impact of your ESG policy to give materiality to the challenges you are facing

?? Be transparent: Provide all necessary information to your shareholders (e.g. CVs of board members, attended board meetings, all remuneration criteria)

Remember, the level of ESG sensitivity varies from one institution to another; identifying the ESG sensitivity of your shareholder base will help you assess your ESG attractiveness and to improve the efficiency of your sustainability message.

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