Q4 2014 Stewardship and Managing Equity Interests for Our Clients
Old Mutual Global Investors manages money on behalf of its clients with the aim of generating returns to meet their financial aspirations. As part of that process, we regard using our powers as shareholders, particularly the ability to engage with companies on a range of issues, as a key tool for relevant equity funds. We are stewards of our clients’ interests and it is appropriate we report on that role. Our report is also consistent with fulfilling our obligations under the UK Stewardship Code 2012.
In these reports, it is generally our practice to remove identification of the companies with which we are engaging. Experience has taught us that undertaking discussions which may be sensitive, or delicate, in the glare of publicity is damaging. Publicity can cause a defensive reaction and entrenches views. We prefer to conduct a sensible dialogue with companies where, in the event of a change of policy, this can be adopted and not seen as a management climb down. It is part of the need to build an element of trust, permitting clear and occasionally frank communication and challenge.
Our voting policy document states that we control a wide range of equity interests. These range from short-term holdings, in which case it is not appropriate to vote, to derivatives (which cannot be voted on) to funds where the focus is on trading. Where our stewardship can be most effective, and where the bulk of our stewardship work will occur, is in long-only funds where the emphasis is on understanding and building a long-term investment and relationship with the company.
A sample of our activity for the October-December period of 2014 is set out below:
We arranged to meet the chair of a company. The company was recruiting a new finance director, so we thought it an opportune moment to discuss the recruitment, given the fact that in the presence of a dominant chief executive, a finance director would, we felt, need to be strong enough to provide a suitable counterbalance to the CEO.
The chair confirmed that he would be recruiting a CFO with experience, credibility and someone who would be able to challenge the CEO.
We also discussed the future of the business, including levels of research and development. Discussions included environmental issues surrounding the power consumption of the company’s products.
Performance and leadership
We continued to engage with a company regarding performance, the company’s strategy and implementation of that strategy. In addition to the senior executives, this has included discussions with the chair and the senior independent director.
This is a company where there has been some pressure on the company’s CEO as a result of the company’s underperformance. Our discussions have confirmed that all senior executives are aware that improvements are required. We also believe that the CEO is acutely conscious of the issues.
We met the chair of a company which had made a number of major changes to the governance structure of the company in recent years. The company had formerly been a partnership in financial services and carried something of that structure through to its listing as a public company. This included a large number of executive directors, together with limited independence on the board, compared to the vast majority of listed companies. Regulators and shareholders had pushed for an effective, more streamlined governance structure with lower risk.
Accordingly, the chair had initiated a process of change and the company now had a more conventional governance structure. A new management team was working to make the business more efficient and had already achieved some success. On the board, the company has recruited independent, capable non-executives.
The chair admitted the company had been weak on environmental and social issues but was working to address them.
We welcomed the changes that had been made and voiced support for the new management team. We discussed the changes that were occurring in the organisation and, consistent with meetings we have held previously with the executives, also discussed changes in key personnel.
Performance across the business
A company with which we have been in long running engagement on strategy and performance announced it would be recruiting a new chief executive. We have spoken with members of the board, including the chair of the company, and will continue to engage.
On performance, we have in particular drawn attention to underperformance by one division of the company relative to competitors. We are assured the company will address these issues: we will continue to monitor the company and encourage it to address its underperformance.
Pay. High Pay. Very High Pay. BG Group
BG Group announced in October that it would appoint Helge Lund as chief executive in March 2015. The company also announced the pay package for the new CEO and since the arrangement was not covered by the pay policy agreed at the company’s 2014 annual general meeting, an extraordinary general meeting would be held to approve the new package.
The package included a £1.5m base salary, fixed for five years; an annual bonus of potentially up to 200% of salary; an annual share award, released subject to performance, of shares worth six times salary at the time of grant; and an additional share award of £12m, released according to unspecified performance targets. (The company intended to include targets based on strategy, health and safety, culture and succession between 3 and 5 years from grant.)
Ahead of the EGM, the company received feedback from a number of larger shareholders that the package was unacceptable. The company therefore announced a revised package which was within the current (approved) pay policy, hence the requirement for a resolution at an EGM was avoided. The main change was that instead of a £12m joining award, Lund would instead receive a £10.6m share award, subject to “company performance conditions …. expected to comprise a combination of relative total shareholder return (TSR), cashflow and capital efficiency measures. Any changes made to the structure of the LTIP (long-term incentive plan) will remain within the company's remuneration policy and the company will consult further with shareholders before they are finalised.”
The company added that the “revised package reduces the expected value of Mr Lund's initial share award from approximately £10 million to approximately £4.7 million.”
So, a victory for shareholders. Or is it?
A condition based on total shareholder return is made somewhat easier by the poor TSR performance of BG Group over the last year. Assuming that share prices reflect future expectations for a company, BG Group’s share price performance has reflected a gloomy outlook (the chart below shows share price performance for the year to 01 December 2014, against the comparator group the company has been using for the current share plan). If a new CEO comes up with a credible strategy and starts to successfully implement that strategy, the expectations for the company would respond accordingly and the company’s share price and TSR would bounce upwards. Since the TSR measure is based on comparative performance, BG Group’s TSR is starting from a low point with the likelihood that even a mediocre improvement in expectations will cause TSR performance to significantly exceed that of the competitors.
We would agree that cashflow and capital efficiency measures are, generally, highly desirable in a share plan. The actual measures used and the thresholds for those targets need to be carefully selected, however. The new CEO will be reviewing and changing the strategy. A risk is that new targets will act against a change of strategy that might be in the longer term interests of shareholders: For example, it may make sense to dispose of an asset that generates good capital returns, or cash flow, compared to the rest of the group. The outcome of a sale at a good price may be to reduce the group’s returns or cashflow in the shorter term and therefore reduce the potential rewards for the CEO, even though it is in the best interests of shareholders over the longer term.
Although the measures originally proposed for the share award were uncertain, unknown and not clearly linked to returns to shareholders, they may have permitted greater flexibility regarding strategy – and potentially greater flexibility to act in the best interests of long-term shareholders - than the existing pay policy would reward.
Building a relationship
In addition to meeting the executives (CFO and CEO) we met, separately, the senior independent director and the chair of a company providing food and beverages in which we control a material proportion of the shares. The company has listed only recently.
We had met the CEO and the senior independent director before, in connection with other companies.
Discussions with the directors included strategy, opportunities arising from implementation of the strategy and facilitating a mutual understanding of objectives and expectations.
We met the chair of a manufacturing company, following meetings with the company’s executives, regarding the company’s pension scheme. There is a case that a deficit on the pension scheme was being reduced at a pace which did not reflect economic reality – namely, the rapid funding of the pension scheme would place it, ultimately, in substantial surplus – and that the scheme funding was reducing the appropriate rewards for shareholders. The company explained that the current funding had been agreed with the regulator when the company, along with many others, faced some distress at the depths of the financial crisis. In return for some leeway at that point, the company was contributing to the pension scheme at a more rapid rate than the scheme really required.
It may appear unfair for shareholders to be questioning funding for the pension scheme. We would, ordinarily, agree. The pension scheme is a contractual commitment with the workforce and it is important the company meets its responsibilities. In the case of this particular company, the company had not only survived the credit crisis but provided a strong and improved covenant – it is a quality company which is investing in the future with a good product range and generating strong share price returns. A company with this level of performance deserves support from shareholders but it is only responsible for us, as investment managers, to ensure that clients earn an appropriate return from the investment. The balance at the moment appears skewed to the pension scheme.
The company noted our position and our questioning of the arrangement is something it can use in future discussions with the Pensions Regulator.
We do recognise that there are many examples of companies which have behaved poorly on pension schemes and we understand and support the role of the Pensions Regulator. It is important for long term sustainability of the companies which continue to have defined benefit pension schemes arrangements outstanding – or, in this case, a defined benefit pension scheme which continues to accrue benefits for the workforce – for those companies to be subject to challenge on the balance of financial interests.
Of course, if/when the scheme does move into a surplus it is highly unlikely that any surplus would be returned to the company and/or shareholders until the pension scheme has completed its work for all beneficiaries: with some pension scheme members barely 20 years old, it may be many decades before there might be a realistic prospect of that surplus being returned.
Long-term investment, long-term support
We met the chair of a property company in which one of our funds has maintained a long-term holding. Discussions included board succession; the recruitment process within the board and the company (including the need to address the limited number of women being recruited into the industry); the company’s objective of recycling capital into areas where returns are greatest; the extent of the company’s operations; the potential to share costs by entering into joint ventures; the need for capital discipline; gearing; that socially responsible activities should be embedded within the business; and, auditing.
We also noted we remained supportive of the management team.
The company announced discussions were being held for an offer to be made for the company at a nil-premium to the closing share price. Generally, a takeover would be expected to generate a material premium to the closing share price.
The company was family-controlled. . We met with the directors who told us that the family had reached the stage where it wished to sell its interests and had little appetite to grow the company beyond its current size, meaning that the whole business was effectively for sale. We argued that the proposed price significantly undervalued the business, especially when taking into account the prices paid for similar businesses recently, and the potential growth we saw in the business.
The family was, however, determined to sell, disagreeing with our views on valuation. The price at which the company was subsequently sold was therefore disappointing.
Following a series of disappointing revelations concerning the pay arrangements of the CEO of a company, we arranged to speak to the chair and the senior independent director of the company. The company has a North American-focus and, accordingly, US-style pay packages - larger than and a different structure to those in the UK. Notwithstanding the difference of US and UK style pay, however, the pay appeared to reflect sub-optimal corporate governance procedures.
Our discussion with both directors was reassuring. Both relatively recent recruits to the board, they were aware of the problems and were working to address them. This included a review of all the pay arrangements and an expectation that the company would consult leading shareholders ahead of the company’s next AGM. The directors also displayed knowledge of other potential governance weaknesses we had identified and were addressing those issues.
There remains work to do but, having made contact, both the directors and the board are aware of the interest of shareholders in removing governance weaknesses and supporting successful development of the company.
A company consulted shareholders, including OMGI, on proposed changes to the pay arrangements for senior executives at the company. The proposals included a significant rise in the salary of the CEO. This was justified on the basis that the CEO, on appointment a few years ago, had been paid below the going rate in the expectation his salary would rise once he had acted to turn the company around. The company considers that that scenario has now been achieved.
Other proposed changes to executive pay included the use of different performance targets.
We met the chairman of the company and the chairman of the company’s remuneration committee to discuss the proposed changes. On changes to the performance targets, the company was moving towards earnings based targets from return on capital measures in order to address the flaw of return on capital measures, namely that they may discourage investment. The board intended that returns must exceed the weighted average cost of capital but would not want to constantly increase the level of return that must be achieved, instead achieving growth of the business through increasing earnings and the dividend. We had sympathy with this argument: whilst we are often concerned that earnings targets increase the incentive for an executive team to undertake acquisitions, we accept that the board is using a realistic cost-of-capital threshold and, indeed, trust the board to be robust on the need for a minimum level of return.
Following that discussion with the independent board members, we remained unconvinced that the salary rise was justified. Accordingly, it was agreed we would speak to the board’s remuneration adviser. We did so. Whilst there is always an element of subjectivity in the selection of peer groups against which to compare salary levels, it appears that the company is justified, in this case, in increasing the salary level taking account of the circumstances of the company at the time of the CEO’s appointment and subsequent performance. Further, given the arguments in favour of the increase, an objection would only be justified if the CEO was not suitable to hold that position. That is not our view.
In October, the UK Investor Forum was launched. The Forum arises from recommendations in John Kay’s report on the equity markets. The Forum is intended to be a mechanism to allow investors to work together more effectively than hitherto on UK companies where there is a perception that the company‘s strategy and/or some other aspect of the company is failing. The Forum is also intended to permit litigation-shy and publicity-shy US and sovereign wealth funds to work more closely – or simply to work at all – with UK investors.
Speeches from the investment fund industry made clear that, amongst other things, the Forum might help the UK economy in that there would be earlier identification and resolution of UK companies that might otherwise fail and/or underperform materially. That is an objective with which OMGI wholeheartedly agrees. Accordingly, we have had meetings with representatives of the Forum and we anticipate we will fully participate.
The launch event was attended by, amongst others, the UK’s Secretary of State for Business, Innovation and Skills, the Rt Hon Dr Vince Cable MP. Towards the end of the launch, Dr Cable was asked what two things he hoped would be the outcome of the Forum. He replied, a cut in executive pay and a reduction in UK takeover activity. It was somewhat disappointing that the top two takeaways did not include recognition of the ambition of the Forum to (amongst other things) act to improve the UK economy.
Old Mutual Global Investors is currently implementing voting across its funds consistent with our policy guidelines as set out at. We intend to vote on all applicable holdings during early 2015. We will revise and update our statement of compliance with the UK Stewardship Code to reflect our new practice accordingly.
Head of UK Stewardship and Governance