By Paola Perotti – CEO and Managing Partner, GO Investment Partners LLP
Shareholder engagement and activism continue to rise, prompted by institutional investors whose influence has grown in recent years and counterbalanced the impact of the shift from active to passive investing.
When BlackRock CEO Larry Finks writes to CEOs about BlackRock’s engagement priorities for the companies in which it has invested for 2019 and beyond, we know that shareholder engagement is on an inexorable rise.
Last July, the SEC announced a round table on the proxy process in the US. In his opening statement, chairman Jay Clayton noted that it had “seen a dramatic increase in the number of US companies reporting shareholder engagement, with 72 per cent of S&P 500 companies reporting engagement with shareholders in 2017, compared to just six per cent in 2010”.
Here in Europe, the revised European Union Shareholder Rights Directive (SRD II) came into force on 10 June 2019.
With rights come responsibilities. While the title of the directive continues to refer to shareholders’ rights, SRD II aims to promote effective stewardship and long-term investment objectives also by focussing on the responsibilities of the investment community. It sets new obligations for investors and asset managers, including a greater transparency about engagement policies (which now ‘should be publicly available online’), investment strategies and voting behaviour.
Companies will have to become accustomed to a higher level of engagement activity from investors but should not be unduly concerned. While some forms of shareholder engagement have degenerated into public mudslinging with disastrous consequences for all concerned, most shareholders have a genuine concern for the long-term interests of the companies in which they are invested. They want to ensure the long-term sustainability of the business by engaging constructively with management to improve the business. They want to work with investee companies to create positive and sustainable change.
When I reflect across the long engagement experience of GO Investment Partners, the firm I am honoured to lead, I am drawn to the conclusion that the main challenge shareholders face when they ask boards to justify governance practices or adopt new ones is unrealistic expectations. Too many engagements are driven by optimistic schedules. Change does not happen overnight – it takes time, hard work and dedicated effort from many individuals and groups. Patience and persistence are key.
So, as investors continue to increase their corporate engagement, what can they learn from companies and their managers about effecting change within organisations? As most readers of this publication will know, bringing about effective corporate change is a difficult and complex process, requiring herculean efforts, especially in larger organisations.
In this context, I thought it may be helpful to outline the main features exhibited by successful corporate changes in the hope that investors can derive key lessons or pointers for a more effective dialogue between us and companies.
Management Guru Peter Drucker defined ‘change leaders’ as those people and organisations that lead change rather than react to it. In his book, Management Challenges for the 21st Century, he argued that to thrive in the new millennium, managers cannot just adapt to change: they have to lead it. “Unless an organisation sees that its task is to lead change,” Drucker wrote, “that organisation – whether a business, a university, or a hospital – will not survive. In a period of rapid structural change, the only organisations that survive are the ‘change leaders’.”
Change starts at the top – change will not happen unless the leadership team recognises and is willing to discuss the issues that are preventing the attainment of specific corporate goals.
One of the most successful workplace changes ever is undoubtedly the transformation of IBM from a soon-to-be-obsolete producer of mainframe computers into the innovative AI-driven technology company that we know today. We all know the adage that ‘nobody gets fired for buying IBM’ – yet by the early Nineties, customers were choosing faster, smaller computers and droves of customers were abandoning the company. As future chairman and CEO Louis V. Gerstner, Jr. recounted: “The leadership of IBM was paralysed, unable to act on any prediction.”
In an interview with Fortune Magazine in July 1991, then CEO and chairman John F. Akers blamed IBM’s poor performance on the company being caught in an industry moving so fast and changing so much that nobody in it could adjust quickly enough. Yet he was hopeful that a revamped product range and better execution would turn its fortunes around. They did not and Mr Akers was asked to leave by the board soon after.
“One of the most successful workplace changes ever is undoubtedly the transformation of IBM from a soon-to-be-obsolete producer of mainframe computers into the innovative AI-driven technology company that we know today”
As he recounts in Who Says Elephants Can’t Dance? – an account of IBM’s historic turnaround – Louis Gerstner, who took over the running of IBM from John Akers, the firm had drawers full of supposedly visionary plans. Gerstner knew that unless IBM changed its business model soon, it had no future. He took the bold decision to refocus the company’s strategy on the services and the emerging e-business.
This leads us to our first key lesson for meaningful engagement:
1. Is the leadership of the company willing to consider alternative viewpoints? Have they got the temperament to turn into change leaders or appoint someone who is a change leader?
When engaging on topics of strategy or performance, it is generally best to start engaging at the C-suite level, particularly the CEO. No change will take place if the
CEO does not acknowledge that some aspects of the business could possibly be run differently.
If the CEO is not willing to listen, then engage with board members. Independent directors will benefit from hearing what their shareholders think about the company, and investors will benefit from hearing the board’s perspective on governance and strategic issues and how this relates to the board’s decisions and actions. Some of your viewpoints will resonate with the board. If they do not, a shareholder will still get an important insight on how the leadership of the company thinks about their business.
However, even the most change- committed board cannot change an organisation alone. They will need to convince key people within the organisation that change is necessary and enlist their help.
One of the first actions taken by Samuel J. Palmisano who succeeded Gerstener as IBM chairman and CEO in March 2002 was to dismantle the corporate executive committee of IBM and replace it with a number of teams organised around strategy, technology and operations that were supportive of the changes he wanted to implement.
In 2006, Indra Nooyi was elected CEO of PepsiCo and she wanted to re-orient PepsiCo’s product offering towards more health-oriented lines. One of her first steps was to reorganise PepsiCo into three business units and to refresh and galvanise its global leadership team by emphasising its role in positioning the new business structure for future growth.
2. Gradually widen your sphere of influence within the company’s management
Once a dialogue with the CEO and the board has been initiated, a shareholder should seek to widen their sphere of influence to other members of management – planting a seed that, hopefully will grow through internal discussions and reflections. The more company insiders know about your plans, the more they will start to coalesce into an idea that cannot be cast aside without due consideration.
“Sometimes not even management knows exactly where the future will lie. Asking the right question is more important than getting the right answer”
You do not necessarily need a clear strategy to initiate a dialogue about change. Shareholders need not put forward strategy plans for the companies in which they are invested. Sometimes not even management knows exactly where the future will lie. Asking the right question is more important than getting the right answer.
In his first letter as chairman of IBM in 2002, Palmisano soberly reflected that ‘right now, we have as many questions as answers, and more a sense of where we must go as a company than a clear path to get there” but he was determined to make IBM a truly great company “a great partner, investment and employer – for our generation and for our times”.
Again, when Sergio Marchionne took over the running of an ailing Fiat in 2004, he was not thinking that he would merge it with Chrysler within four years, but he knew that he somehow had to restructure Fiat’s uneconomic plants and globalise its product offering.
3. You do not need to have a solution for every engagement issue you want to raise before you start engaging with a company
As a shareholder, it is not realistic for you to expect to know your portfolio companies as an insider knows them. But you can draw on your accumulated knowledge and experience to highlight areas that do not look right (e.g. a business not currently returning its cost of capital or the lack of a specific skill or competence within the existing board). Ask the right question. Ground your observations in facts and common sense.
I am impressed by the manner in which my colleagues at Governance for Owners Japan approach this specific spect of engagement. They will point out inefficiencies in the strategic make-up of a business, perhaps by showing how peers have addressed a similar issue or challenge. They encourage rather than instruct and they know they must be patient.
4. Change takes time – learn to be patient!
It is not unusual for some investors to ask for conglomerates to be split into smaller units or for some activities to be sold. As a former investment banker, I know that these corporate actions take time.
In March 2018, Prudential announced it would demerge its UK operations and list them as M&G Prudential. At the time, Prudential stated that the demerger may not happen until late 2019 or early 2020 as Prudential first needed to carry out a number of steps, including the completion of the UK annuity portfolio sale, the transfer of the Hong Kong business and seeking to minimise costs associated with the demerger. If you assume the board spent a minimum of 18 to 24 months assessing the feasibility of a demerger, it will have taken at least three to four years from origination to final execution.
To refresh a board, you need to assess what additional competences are needed and then find the right person to fit the position – 12 to 18 months to find the right person for the job is by no means exceptional.
We investors need to learn the value of patience and appreciate the complexity of some of the requests we make of companies.
5. Be prepared to revise your original thesis
When a shareholder starts engaging with a company, they will formulate a hypothesis of how the company could improve, based on the information available at the time. Through dialogue with the company, it may surface that the original hypothesis was based on wrong assumptions. Be prepared to accept that your initial analysis was faulty or incomplete.
In the early 2000s, I was invested in a Swiss manufacturing company and one of the main tenets of the engagement was that they were to divest of a pumps business that, at the time, was not returning its cost of capital. Through repeated interaction with the company’s management, it became increasingly clear to us that the business had a strong strategic rationale for remaining in the company and the reason for the unsatisfactory returns was a gap in its pump size range, which encouraged clients to buy elsewhere. The Swiss company needed to fill that gap to be meaningful to its clients. We were the first in line to congratulate the company on its announcement of a small acquisition that completed its product line.
As has been said before, engagement is an art, not a science and there is no magic formula that we can apply. Shareholder engagement is all about dialogue and successful dialogue requires a genuine commitment on both parties to understand each other’s position.
In conclusion, the most successful engagements I can think of are those which have morphed over time and ended up as an amalgamation of the shareholders’ and the management’s position. Parties working together with one goal in mind – the long-term sustainability of the company they have committed to.