The definition of ‘interest’ (in English) is complex:
1. the feeling of wanting to know or learn about something or someone.
2. money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt.
3. the advantage or benefit of a person or group.
4. a stake or involvement in an undertaking, especially a financial one.
Depending on the interest that institutional investors serve, the specialists identified three types of institutional investors. The classification may be interesting for institutional investors, especially during their annual discussion on strategy, as real life may show a behavior that is not aligned with the disclosed strategy.
Institutional investors that have an agency behavior
Agency institutional investors describes the behavior of institutional investors engaging (or failing to engage) with portfolio companies so as to serve the wider financial or business interest of the corporate group of which they are a part rather than their end beneficiaries. Other example of for asset managers acting in ways which serve the interests of the company or investors that employs them (we will name them ‘principals’), rather than their clients. In case of agency investors, the financial interest of their principals may conflict with the interests of their shareholders generally speaking, beneficiaries, customers, and clients.
Agency behavior may manifest in a reluctance to challenge corporate management of portfolio companies in the hope of gaining further benefits from the principals.
As regards incentives, this type of investors might, for example, remunerate some of the employees for short-term objectives that are not related with market aligned key performance indicators. These practices would not provide any incentives to improve stewardship decisions and the result may be:
- greater passivity, or
- efforts to increase short-term financial returns.
Agency investors are effectively caught between corporate governance pressures to serve their own shareholders, and the contractual and fiduciary duties they owe to their clients and end beneficiaries. Whilst the latter may require actions to promote the interests of clients and their end beneficiaries, actions intended to improve short-term returns or reduce costs relative to competitors will hit internal targets and it is difficult to argue that they are not in the best financial interests of clients and beneficiaries.
Agency behavior may bring complications, as regulators may impose fines for breach of relevant regulations, including for example failure to manage conflicts of interest fairly.
Institutional investors with a trusteeship behavior
The ‘trusteeship’ behavior is described when the portfolio of investments (focused on one or more types that managers consider) will further the financial interests of their beneficiaries over an appropriate time frame. The investors may exhibit trusteeship behavior where they give mandates to managers which demand and assess performance over relatively long-time frames. The portfolio for a trustee behavior should consider
- sustainable long-term returns,
- the ESG factors in selecting investments and carrying out financial analysis
- voting policies which will be applied across the portfolio, and
- to engage with companies where this will produce better long-term financial returns than divestment.
The ownership behavior
The third type of behavior refers to the managers that are acting as real owners and pursuing the long-term success of the portfolio companies.
Whereas trusteeship behavior entails a focus on producing the best financial outcome for shareholders, clients, or beneficiaries across multiple assets in a portfolio, ownership behavior involves acting alone or in collaboration with other shareholders to produce the best long-term financial outcome for an individual portfolio company. The action delivers benefits for all shareholders in proportion to their shareholdings.
The ownership behavior will become less attractive as diversification inevitably moves the focus of both investors and managers away from the performance of individual companies and towards the performance of the portfolio as a whole.
The latest changes at the level of European legislation (for instance SRDII) lead to a trusteeship approach, as the rules requiring asset managers to be more transparent about implementation of their engagement policy and exercise of voting rights. The transparency may help investors to identify managers whose behavior is likely to be aligned with their own.
And now, what type of institutional investors do you think that are active on Romanian market and how they may influence the corporate governance in the near future?