Aligning The Interests Of Executives, Shareholders And Investors.

Keith Skeoch – Speech Transcript
 Marketforce Future of Fund Management conference March 13 2013

Reaching Consensus: 
Aligning the interests of executives, shareholders and investors.

Good morning, what an interesting question, well in fact I think there are actually 2 big questions! In answering them I will try and build on Ed and Helena’s remarks by adding a long-term perspective.

The first is the age-old question about how to align the interests of the various stakeholders in an enterprise, in our case a modern fund management firm. How to co-ordinate harness and mitigate the base effects of self interested behaviour in what academics term, the principal - agent problem, has been the subject of debate for centuries. The first corporate-governance conversation that took place in 1609 between the investors and executives of the Dutch East India Company and was later first identified as an item for academic debate by Adam Smith in 1776 in the Wealth of Nations. Arguably one of the most meaningful governance conversations took place around 800 years ago and resulted in the signing of the Magna Carta in 1215.

The second big question -

how to achieve consensus is probably even more difficult to resolve than the first, partly because there are so many routes to consensus. King john famously had it forced upon him. Isaac le Maire, the investor in the Dutch East India Company resorted to the courts to have the company wound up and its assets returned to investors, and lost. So he and others had to find a way to exit and let new investors take their place. The answer was the creation of a new business model, the joint stock company, which has served investors, savers and economies pretty well for the last four hundred years. It was also the start of a perpetual conversation about the governance arrangements required to tame the wilder consequences of self -interest. The consensus on how to do this throughout the last four hundred years has been driven by a combination of economic necessity and theory.

Steven Medema in his excellent history “The Hesitant Hand” identifies three broad paradigms. The first driven by the nineteenth century classical economists emphasised a system of natural liberty harmonising self-interest and social interest, which allowed markets to operate without much intervention from the state. The second spanned much of the twentieth century as marginal and neoclassical economics recognised that there are some circumstances where markets do not co-ordinate diverging interests and government has a role as an efficient co-ordinating force. A backlash against this thinking came late in the twentieth century as economists from Chicago and Virginia started to dominate thinking with the view that self-interested behaviour can also impact the operation of Government, causing failures in markets and Government alike. Indeed the Pendulum swung so far in this direction that Harvard philosopher Michael Sandel named the paradigm the era of market triumphalism “without quite realising it, without ever deciding to do so, we drifted from having a market economy to being a market society”.

So what are the lessons from history for reaching a consensus about how we align the interests of all the stakeholders in a modern fund management firm. The first has to be recognising the paradigm you are operating in as Margaret Thatcher once remarked, “nothing is more obstinate than a fashionable consensus”. Which leads on to the second the time scales over which a consensus forms and persists, we are dealing with long run phenomena and it is very important to take an equally long run approach. Finally be careful about what you wish for and be mindful of the unintended consequences on behaviours and values, this must surely be a lesson that we have all learned from operating in Sandel’s market based society and a lesson we need to pass on to future generations. Mark Carney in a recent speech on Rebuilding Trust in Global Banking points out that “trust arrives on foot but leaves in a Ferrari” and made an impassioned plea for a re-discovery of core values.

So where are we and how should we try to apply these lessons?
The market society paradigm was of course brought to an abrupt end by the global financial crisis and while a new paradigm or at least the intellectual foundations for it, are not fully formed, it is reasonably clear that the pendulum is fast swinging back towards interventionism as a means of co-ordinating self and social interest. While in some quarters the tendency will be to resist change, the fact that the new paradigm has not fully formed provides an opportunity to influence its shape. One clear implication of this is that if, as an industry, we are to reach or influence any form of consensus an additional set of stakeholders needs to be added to our list – governments and regulators. Another that follows is that it isn’t just a question of arguing our case the industry and its participants need to demonstrate the right behaviours and earn the trust of our key stakeholders. Like it or not having the trust of the regulators, government and politicians has rocketed right to the top of the agenda. The bulk of the focus has been on bankers but it is clear that fund managers are increasingly coming into the frame, whether its payments for corporate access, the transparency of fund charges or the continued pressure to hold boards and remuneration committees to account.

Mark Carney, who in his role as Chairman of the G20’s Financial Stability Board and Governor elect of the Bank of England, is someone whose views will help mould the new paradigm. In the speech mentioned earlier he helpfully provided some insight into what regulators may be looking at. The responsibility for core values “begins with company boards and senior management. They need to define clearly the purpose of their organisations and promote a culture of ethical foundations throughout them. Employees need a broader sense of purpose grounded in strong connections with their clients and communities. To move to a world that once again values the future, bankers need to see themselves as custodians of their institutions improving them before passing them on to their successors”. Remove the word banker and insert fund manager and we have a sense of the challenge facing the industry.

So how do we measure up to Carney’s challenge? Actually as an industry we should be well placed in terms of broad purpose, connections with clients and communities.

The sense of purpose in a fund management company is relatively simple it’s the delivery of Investment Performance for clients, which in my shop we call the number one job. The basic building block for trust between a fund manager and a client is the delivery of the client’s desired level of investment performance. Trust is also reinforced by boosting the client’s confidence in the delivery mechanism that ensures that the delivery of said performance is both repeatable and sustainable over periods that are long enough to map with the client’s investment horizon. In the old world much of the debate surrounded the separation of α and β and the cost of the platforms used to deliver. This old world was characterised by a surfeit of assets driven by strong volume flows into the industry, rising markets, strong risk appetites. This perpetuated a fragmented industry where competition for market share was modest and returns for executives and shareholders alike were good.

Those of us running fund management companies today face a different environment, assets are still plentiful but volume growth is almost non-existent as global flows into the industry have virtually stagnated over the last few years and are forecast to rise by not much more than 1%pa over the course of the next five years. Competition for this growth is fierce, McKinsey for instance calculate that anywhere between 60% and 100% of flows in the US are being captured by 10 asset management firms. Casey Quirk, another consultant also suggests that those that are winning are concentrated in delivering performance for clients through four strategies. High Alpha active management, cost efficient β, asset allocation expertise and solutions led distribution. It is certainly my experience that over the last five years there has been an increasing tendency to focus on outcome orientated and risk based delivery mechanisms for investment performance as clients seek to mitigate the impact on return of more volatile markets. The implied increase in the transparency and simplicity of the return outcome arguably should make it easier to align our sense of purpose with client interests. Libor plus 5% or an absolute return of 7.5% through a well- defined investment process are clear examples of what the client expects and is paying for.

Trust is earned not just by the delivery of investment performance but the manner in which is delivered. A recent survey of US advisors for the FT suggested that trustworthiness was the key to a strong reputation for asset managers and the best way to improve trust was to deliver consistent returns through a consistent investment process with a high level of transparency. This will become increasingly important where client demands are changing towards more outcome and risk orientated solutions where portfolio construction becomes every bit as important as the investment insight that generates α. While simplicity of and transparency of outcomes may help align interests, paradoxically the burden will be for increased sophistication in portfolio construction, which in turn will increase complexity in the manufacturing process. Consistent delivery of outcome orientated and risk based solutions is difficult and potentially expensive to deliver and it is critical in aligning ourselves with clients that we neither over promise nor over charge.

One means of ensuring that the share of costs and profits are aligned among stakeholders is to ensure that remuneration incentives in the business are in the right place. This is particularly important in a human capital business where the right balance needs to be struck between being able to attract the rare talent that generates and delivers both investment performance in difficult markets and the net return that is delivered to clients and savers. The simplest means of doing this is to ensure that compensation at fund management firms is directly related to clients, in a rigorous and measurable manner. Most modern firms have already shifted in this direction because clients especially large institutional ones demand it. At Standard Life Investments the bonus pot is determined not only by our financial performance but also the risk -adjusted performance we have delivered to clients. Individual fund manager bonuses depend on the money weighted average of the money they manage for clients and where relevant against the appropriate peer group. Even our LTIPs have an investment performance component. All of this makes good commercial sense because our clients want to see our skin in their game.

We have also become increasingly focussed, as part of our Stewardship responsibilities, on ensuring those at the top of an organisation, whose leadership helps define the culture and ethical foundations of a business, have wealth rather than annual income at risk. Compensation schemes that promote this not only align interests but also lengthen time horizons as well dealing very effectively with the payment for failure issue. Fund management executives that have their own wealth invested in their firm’s funds and directly exposed to business performance will suffer if clients and shareholders suffer. More importantly they will also have an interest in ensuring that good investment and business performance is sustained over the medium term rather than in any single year. Wealth held in this form by a fund management firm’s most senior executives should be a significant multiple of annual salary and schemes should facilitate the ability to build this ratio during their career. Clearly simplicity and transparency dictates that we should practice what we preach. The only fund investments I own are with Standard Life Investments, my holdings in Standard Life PLC are a matter of public record. Both combined are a large multiple of my salary and are a significant proportion of my overall wealth. As a result my financial well- being as well as that of my nearest are dearest is much more exposed to sustained performance over the medium term and aligned with both clients and shareholders.

In order to sustain this performance we need to deliver consistent investment performance, through consistent investment processes aligned with our differentiated investment philosophy, which provides the glue for the values that binds our people together with both each other and our clients. We also believe that fund management is a honourable profession where positive outcomes can have positive and beneficial impact on peoples’ lives through making a difference to their financial wealth and health. The connection with clients and our basic purpose as fund mangers should be both strong and aligned. If we can do all of this and deliver a profit that is good enough to both pay and grow dividends and reinvest in talent and technology in the business we will also keep its shareholders or owners happy

The way to build trust with broader community is the promotion of Stewardship, which should lie at the centre of financial and economic life and I would like to think might form the basis for the developing fourth paradigm. Asset gatherers are the Stewards of savers funds and need simple transparent and cost effective propositions to deliver returns that allow individuals to financially cope with life’s trials and tribulations. Investors are the stewards of the assets they manage and have fiduciary responsibilities to their clients about their ability to deliver a return to help meet savers needs. Companies and boards of directors are stewards of the capital they are allocated, the assets they acquire with it and the return delivered to investors and their ultimate clients savers. Finally the policymakers also need to recognise that they are Stewards of the economic and financial system and should take a long run approach to its health rather than looking for shorter run engineered fixes. Fund managers have been far too silent in promoting the broader role of stewardship and in playing their role in helping to shape the policy agenda for conduct and capital markets, we may not be systemically risky like the banks but we are systemically important in allocating capital on behalf of our clients. We need to find a stronger voice that speaks louder on behalf of our clients as we engage proactively with regulators governments and politicians.

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Generating a consensus on how to align interests among stakeholders is a puzzle society has been trying to solve for at least 400 years but by stimulating a debate we can hope to start and shape the issues around which a consensus about what needs to be done may form. Thank you for opportunity to make a contribution to the debate.