Investor Engagement: Investors and Management Practice under Shareholder Value

INVESTOR ENGAGEMENT

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Investor Engagement Investors and Management Practice under Shareholder Value

RO D E R IC K MART IN PE T E R D. C A S S O N TA H IR M . N IS A R

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Great Clarendon Street, Oxford ox2 6 Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Published in the United States by Oxford University Press Inc., New York © Roderick Martin, Peter D. Casson, and Tahir M. Nisar 2007 The moral rights of the authors have been asserted Database right Oxford University Press (maker) First published 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Data available Typeset by SPI Publisher Services, Pondicherry, India Printed in Great Britain on acid-free paper by Biddles Ltd., King’s Lynn, Norfolk ISBN 978–0–19–920260–7 1 3 5 7 9 10 8 6 4 2

Preface This book examines the relations between investors and firms in the context of the rise of shareholder value. The rise of shareholder value has been a major change in capitalist economies since the 1980s. Shareholder value underpins both recent finance theory and much corporate practice. It has profound consequences for economic behaviour, and for society as a whole. Shareholder value gives priority to the interests of a single stakeholder, the shareholder, in the governance of the firm, rather than to balancing the interests of multiple stakeholders. In the confident words of Hansmann and Kraakman (2004: 33), ‘there is no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value’. The UK Department of Trade and Industry (DTI) presents ‘enlightened shareholder value’ as the cornerstone of company law reform. Shareholder value provides clarity of focus and rewards risk takers, generating an entrepreneurial business culture and enhancing international competitiveness. The rise of shareholder value has its roots in changing social and political values, most fundamentally the view that the allocation of economic benefits through competitive markets is both more efficient and fairer than their allocation through politics and administration. Governments and other interest groups, especially employee organizations, have adopted a largely defensive posture towards investors and shareholder value. In short, shareholder value is the dominant motif of a new form of capitalism, investor capitalism, which has supplanted traditional managerial capitalism, in the USA and to a degree elsewhere. The underlying assumption of the present book is that shareholder value leads, in many circumstances, to new relationships between investors and firms. This new relationship involves investors engaging more fully with the activities of the firms in which they invest than in the earlier period of ‘managerial’ capitalism. Investors are not simply the passive principals on whose behalf managers, as agents, act. The extent to which investors engage with the firms in which they invest differs among types of investors and among firms. Our main concern is with two categories of investors, institutional investors and private equity firms. Institutional investors are acquiring the characteristics of ‘universal owners’ (Hawley and Williams 1997), locked into their investments by the size and spread of their holdings. Where exit is difficult engagement is likely. As ‘universal owners’, large institutional investors, especially pension funds, have an interest in the overall long-term contribution

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of the firm to the national economy, not only in the firm’s short-term stock market performance. In a different but comparable manner, private equity firms are heavily engaged with the management of the companies in which they invest, particularly in the problematic aftermath of the dot-com boom. Such investors usually own large proportions of the shares of the companies in which they invest, giving their engagement substantial leverage. However, the rise of shareholder value and investor engagement has not led to a simple one-way relationship between investors and managers, in which investors decide and managers respond. The relationship is a more complex one of interdependence. Senior managers manage their relationships with investors, as they manage their relationships with other stakeholders— employees, customers, suppliers, and governments. However, senior managers have to pay special attention to investors, since losing investor confidence may lead to managerial crises and the loss of corporate control. Investors have shown themselves to be especially concerned with issues such as corporate restructuring and executive remuneration, as shown in the discussions of GlaxoSmithKline plc, J. Sainsbury plc, and The Bayer Group below. The book focuses primarily on Britain. However, the internationalization of capital flows has been a major trend in capitalist economies since the 1980s, especially amongst the USA, Britain, and Continental Europe, as well as in Asia. US funds have become significant investors in Britain and Germany, whilst British and European, especially German, investors have invested heavily in the USA. As the world’s largest economy—and only political superpower—the USA has influenced other economies more than the reverse, with US conceptions of corporate governance, based on shareholder value, acting as an international benchmark. The increasing emphasis on common international standards in corporate governance, in accounting procedures, and in good business practice reflects US conceptions. The influence of shareholder value has been especially strong in Britain. The book is divided into eight chapters. In the first chapter we outline the basic concepts of shareholder value and analyse the growth of shareholder value since the 1980s. The chapter views shareholder value as a special application of agency theory. The chapter also outlines the factors that have led to the dominance of shareholder value, showing that its rise was not inevitable, but reflected the specific historical circumstances of the 1980s. The second chapter turns to investor engagement specifically, outlining the conceptual framework used to analyse investor engagement and identifying a spectrum of approaches to engagement. The spectrum incorporates five approaches: indirect/laissez-faire, external, internal, negotiatory, and direct. Each approach involves distinctive means of disciplining managers, ranging from indirect methods of control (capital withdrawal and exit or threat of

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exit), through shareholder resolutions, non-executive director appointments, and persuasion, to direct methods of control (executive appointments). We also suggest areas of management practice where investors might be expected to play a significant role. In the third chapter, we examine the propensity of institutional investors to engage with the firms in which they invest. Different types of institutional investors have different propensities to engage, influenced by their regulatory environment, the size and distribution of their portfolios, their time horizons, and the financial incentives of fund managers, as well as by corporate performance. The focus is on the rationales for monitoring and intervention, highlighting the objections as well as the benefits. The argument is supported by detailed consideration of the case of USS Limited as a major pension fund. The fourth chapter examines how institutional investors engage with the companies in which they invest. We distinguish between routine and extraordinary engagement, showing the methods adopted for each mode. As monitoring and intervention lead to acute ‘free rider’ problems, with the costs born by the individual but the benefits distributed to the collective, establishing collaboration amongst investors concerned about the performance of a company is a priority. Organizations such as the Institutional Shareholders Committee are a means of managing such issues. The chapter includes a discussion of events at J. Sainsbury plc in 2004, as an example of institutional investors combining to oblige the company to reconsider its remuneration policy. The fifth chapter turns to private equity firms, the rationale for engagement, and the methods followed. The chapter presents case studies of seven private equity firms, showing how private equity firms relate to the companies in which they invest. The case studies are complemented by examples of portfolio companies in which the private equity firms have invested. Four of the case studies are of British firms, one German, and two American. The chapter documents the different contributions which private equity firms make to the companies in which they invest, beyond the provision of finance. Private equity firms provide access to commercial ‘savvy’ and international connections, as well as finance, to their portfolio companies. Private equity investors may involve themselves in areas of management practice traditionally considered as matters of concern to investors, such as corporate restructuring, mergers and acquisitions, executive compensation, and the role of share options, and in areas not usually considered as matters of concern to investors, such as innovation and employee skill development. The chapter concludes by analysing the cases in terms of the channels, forms, content, and outcomes of the engagement process. Managers seek to influence investors, just as investors monitor and engage with their investee companies. In the sixth chapter, we examine how

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managers manage their relations with investors. Managing investor relations is an increasingly important role for senior managers, involving direct and indirect methods of influencing capital markets. With their command of organizational resources and their in-depth knowledge of company operations and performance, managers are well placed to manage investors’ expectations and to secure investor support. The chapter outlines three elements in managing investors. The first is the board of directors, especially the role of nonexecutive directors. The second is the management of relations with actual or potential investors in the corporation. The third element is the management of relations with the investment community. The three elements overlap and are mutually supportive, and all require active management by senior management. However, conceptions of ‘best City practice’ limit the scope of managerial initiative. The relationship between managers and investors is one of interdependence, rather than control, by either side. Shareholder value has been greeted as ‘the end of history’ for corporate governance, with international convergence on ‘Anglo-Saxon’ conceptions of corporate governance and the basic institutional arrangements associated with shareholder value (Hansmann and Kraakman 2004). In the seventh chapter, we examine corporate governance in Germany, as a test case for international convergence. The chapter argues that current trends in Germany point to an enhanced stakeholder model rather than to a shareholder value model, although there has been a growth in support for shareholder value. The continuing strength of employee representation on supervisory boards and other factors colour the interpretation of shareholder value, even in companies which have adopted shareholder value rhetoric; the case of The Bayer Group, one of the exemplars of shareholder value in Germany, illustrates both change and continuity. The chapter argues that shareholder value depends on the institutional complementarity between corporate governance arrangements and other features of the business system of which it is a part, and that such complementarity between shareholder value and ‘coordinated market economies’ is absent (Hall and Soskice 2001). The first seven chapters are descriptive and analytical. The eighth concluding chapter adopts a normative standpoint, examining the justifications for shareholder value and investor engagement. There are both efficiency and equity justifications for shareholder value. With regard to efficiency, we argue that the shareholder value analysis exaggerates the weaknesses of internal control systems, overestimates the efficiency of capital markets as means of transferring resources from sectors of low value added to high value added, and attributes too much importance to the capital market and equity finance as a source of new investment. With regard to equity, shareholder value neglects the risks taken by other stakeholders, including the risks undertaken

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by employees who make firm-specific commitments in acquiring specific skills. The chapter also examines the justifications for shareholder engagement, showing that engagement to achieve enhanced shareholder value and conformity with ‘best City practice’ is non-controversial, but that engagement to achieve wider social objectives may seriously distort the company’s activities. The chapter concludes by arguing that the critical requirements for the further development of corporate governance are greater openness and the inclusion of a wider range of interests in corporate governance, not further enhancement of the protection accorded to shareholder interests. The growth of shareholder value has direct consequences for business decision-making. It also has profound consequences for society as a whole. Shareholder value is too important to be left to investors and managers, or even to economists and lawyers. In this book, we argue for an expansive conception of enlightened shareholder value, which reflects the view that the function of the firm is more than simply ‘to make shareholders richer’. This book originated in a project commissioned by DTI entitled Investors and Management Practice. The report, in two volumes (Literature Survey and Case Studies), was prepared by the three authors on behalf of the University of Southampton School of Management. We are very grateful to DTI for the opportunity to undertake the work on its behalf. However, the present book is very different from our initial work, covering a wider range of issues and adopting a very different approach; we doubt that DTI would wholly agree with the arguments developed in the last chapter. Our book examines relations between investors and managers—what we have termed investor engagement—in the broader context of the rise of shareholder value and related developments in the institutions of corporate governance. Institutions of corporate governance are, in turn, integrated into the overall structures of national business systems. Investor engagement is thus nested in specific institutional arrangements of corporate governance and specific forms of business system. With the attenuation of institutional research support in social sciences in British (and other) universities, and the Research Assessment Exerciseinduced preoccupation with publication in ‘international’ journals, writing a book of this kind has necessarily become a ‘labour of love’. Without David Musson’s encouragement in particular, and the interest of the Oxford University Press (OUP) in general, this project would have not been undertaken and this book would have not happened: we are very grateful for their continuing support. We are also very grateful to the three anonymous reviewers who have read our initial book proposal and whose comments and suggestions have crystallized our early thoughts. Also to Matthew Derbyshire and colleagues at OUP who have kept this book ‘on schedule’, throughout the writing (and

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the production) process. We are also very thankful to Professor Hugh Whittaker, formerly of Doshisha University (Kyoto, Japan), now of University of Auckland (New Zealand), for his willingness to review our work when in the process of moving from Japan to New Zealand. In addition, we are very appreciative of the University of Southampton School of Management, and of the Central European University Business School (Budapest, Hungary), where much of the research and writing has been undertaken. Roderick Martin is particularly thankful to Monash University Department of Management (Melbourne, Australia), specifically to Professor Julian Teicher, for gracious hospitality during sabbatical leave, and to Templeton College, University of Oxford, for appointment as Visiting Research Associate to facilitate this project. Roger Undy as well as Michael Earl and colleagues at Templeton College have been very welcoming hosts. Anamaria M. Cristescu-Martin has been our first, and most attentive, reader. For endless weeks of painstakingly detailed comments and suggestions, for elucidating countless obscure references, and for applying OUP’s 34-page long Notes to Authors to our 80–90,000 word long manuscript, we are most grateful to her. If this book is still not as ‘perfect’ as it could be, it is because the usual disclaimer about any eventual remaining errors is true in our case too. Roderick Martin Peter D. Casson Tahir M. Nisar

Contents List of Tables Notes on Authors Abbreviations

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1. Shareholder Value as Context for Investor Engagement 1.1. Introduction 1.2. The Theory of Shareholder Value 1.3. Preconditions for Efficient Capital Markets 1.4. The Rise of Shareholder Value Capitalism 1.5. Conclusion

1 1 6 8 11 17

2. Investor Engagement 2.1. Introduction 2.2. Conceptual Framework 2.3. Internal and External Contexts 2.4. Areas of Potential Investor Engagement 2.5. Conclusion

19 19 20 23 24 34

3. Institutional Investor Engagement Propensity 3.1. Introduction 3.2. Types of Institutional Investors 3.3. Rationale for Investor Engagement 3.4. Areas of Potential Institutional Investor Engagement 3.5. Conclusion

36 36 38 41 47 57

4. Forms of Institutional Investor Engagement 4.1. Introduction 4.2. Routine Institutional Investor Engagement 4.3. Extraordinary Institutional Investor Engagement 4.4. Conclusion

60 60 61 67 81

5. Private Equity Investor Engagement 5.1. Introduction 5.2. Private Equity Investment Arrangements 5.3. Case Studies 5.4. Conclusion

84 84 85 90 113

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6. Managing Investors 6.1. Introduction 6.2. Managing the Boards of Directors 6.3. Managing the Investors 6.4. Limitations on Managing Investors 6.5. Conclusion

120 120 122 129 132 137

7. Corporate Governance Convergence in International Perspective 7.1. Introduction 7.2. The Case for International Convergence 7.3. Liberal Market and Coordinated Market Economies: A Counterargument 7.4. Corporate Governance in Germany: Continuity or Change? 7.5. Restructuring the ‘Rhineland’ Way: The Bayer Group Case 7.6. International Convergence?

139 139 141 145 147 155 163

8. Shareholder Value, Investor Engagement, and Management Practice: a Normative Evaluation 8.1. Arguments for Shareholder Value 8.2. Arguments for Investor Engagement

169 170 181

References Author Index Subject Index

189 209 214

List of Tables 2.1. Investor engagement in corporate governance

22

5.1. Key private equity funding characteristics

86

5.2. Main private equity investor concerns

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7.1. Bayer divisional performance 2002–3

157

Notes on Authors Roderick Martin is a sociologist, with a long tradition of work in employment relations and industrial sociology. He is currently Professor of Management at the Central European University Business School (Budapest, Hungary). Previous books include The Sociology of Power (1977, Routledge and Kegan Paul), New Technology and Industrial Relations in Fleet Street (1981, Oxford University Press), Bargaining Power (1992, Oxford University Press), and Transforming Management in Central and Eastern Europe (1999, Oxford University Press). Peter D. Casson is senior lecturer in accounting at the University of Southampton School of Management, with a background in psychology as well as accounting. After working as a research psychologist he trained as an accountant, and is a Fellow of the Institute of Chartered Accountants in England and Wales. His research interests include issues related to senior executive and employee share participation schemes, and accounting for complex financial instruments, as well as corporate governance. Tahir M. Nisar is lecturer at the University of Southampton School of Management with a particular interest in the economics of labour management. His Ph.D. was from the LSE for a thesis on Voice, Value and Corporate Governance: A Study of the 1998 Workplace Employee Relations Survey. Recent papers have been concerned with the role of subjectivity in bonus plan payouts and with bonuses and investment in intangibles.

Abbreviations ABI

Association of British Insurers

AG

public limited company (Aktiengesellschaft (in German))

AGM

annual general meeting

AIM

Alternative Investment Market

BBB/BBB+

Egan-Jones Ratings Company credit ratings for institutional investors

BRD

Federal Republic of Germany (Bundesrepublik Deutschland (in German))

BV

limited liability company (Besloten Vennootschap (in Dutch))

BVCA

British Venture Capital Association

BVK

German Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungsgesellschaften (in German))

CalPERS

California Public Employee Retirement System

CEE

Central and Eastern Europe

CEO

chief executive officer

CFO

chief financial officer

CII

Council for Institutional Investors (in the USA)

CSR

corporate social responsibility

DAX

Deutsche Aktienindex (in German)

DDR

German Democratic Republic (Deutsche Demokratische Republik (in German))

DM

German mark (Deutsche Mark (in German))

DTI

Department of Trade and Industry

DVC

Deutsche Venture Capital

EC

European Commission

EGM

emergency general meeting

EIF

European Investment Fund

EPS

earnings per share

ESOP EU

employee share ownership programme European Union

EVA™

economic value added

FSA

Financial Services Authority (in the UK)

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Abbreviations

FSE

Frankfurt Stock Exchange

FTSE (Group)

British provider of stock market indices and associated data services

FTSE 100 Index

share index of the 100 largest companies listed on the London Stock Exchange

FTSE MID 250 Index

capitalization-weighted index of 250 companies listed on the London Stock Exchange

FTSE All-Share Index

capitalization-weighted index, comprised of companies listed on the London Stock Exchange

GAAP

Generally Accepted Accounting Principles

GDP

gross domestic product

GmbH/GesmbH

limited liability company (Gesellschaft mit beschränkter Haftung (in German))

GSK

GlaxoSmithKline plc

HRM

human resources management

HRSU

Human Reproductive Sciences Unit

IASB

International Accounting Standards Board

ICGN

International Corporate Governance Network

ICT

information and communication technology

IEBM

International Encyclopaedia of Business and Management

IFC

International Finance Corporation

IFRS

International Financial Reporting Standards

IIC

Institutional Investors’ Committee

IIGCC

Institutional Investors’ Group on Climate Change

ILO

International Labour Organization

IMA

Investment Management Association

IMF

International Monetary Fund

IPO

initial public offering

ISC

Institutional Shareholders’ Committee

IT

information technology

IVIS

Institutional Voting Information Service

LLC

limited liability company (in the USA)

LLP

limited liability partnership (in the USA)

LP

limited partnership (in the USA)

LSE

London Stock Exchange

MA

Master of Arts

Abbreviations

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MNC

multinational company/corporation

NAPF

National Association of Pension Funds

NM

German stock market equivalent to the LSE’s AIM and TechMARK, launched in 1997 to provide means for smaller companies, especially technology companies, to raise capital and list their shares (Neuer Markt (in German))

NYSE

New York Stock Exchange

OECD

Organization for Economic Co-operation and Development

OFEX (plc)

Off-Exchange; unregulated over-the-counter market in UK stock shares which specializes in small companies (later PLUS Markets Group plc)

OFTEL

Office of Telecommunications (later Office of Communications (OFCOM))

PATCO

Professional Air Traffic Controllers’ Union (in the USA)

PCI (Standard)

Peripheral Component Interconnect

PIRC

Pensions and Investment Research Consultants (in the UK)

R&D

research and development

RBU

Rothschild Bioscience Unit

RI

responsible investment

RNS

Reuters News Services

RPI

retail price index

SEC

Securities and Exchange Commission (in the USA)

SIM

subscriber identity module

SMI

small minority investment

S&P 500

list of 500 US corporations and stock market index, owned and maintained by Standard and Poor’s

TIAA-CREF

Teachers’ Insurance and Annuity Association-College Retirement Equities Fund (in the USA)

TSR

total shareholder return

TU

trade union

TUC

Trade Union Congress (in the UK)

UBS

Union Bank of Switzerland

USS

Universities’ Superannuation Scheme

VCT

venture capital trust

VW

Volkswagen AG

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1 Shareholder Value as Context for Investor Engagement 1.1. INTRODUCTION The significance of capital for the growth of the firm has been recognized in economics at least since the publication of the first edition of Adam Smith’s The Wealth of Nations in 1776. For Adam Smith, capital investment enabled the division of labour, increased productivity, and the growth of the firm (1976: Book 2). In Adam Smith’s more colourful and evocative prose (1976: 360): [c]apital may be employed in four different ways: either, first, in procuring the rude produce annually required for the use and consumption of the society; or, secondly, in manufacturing and preparing that rude produce for immediate use and consumption; or, thirdly, in transporting either the rude or manufactured produce from the places where they abound to those where they are wanted; or, lastly, in dividing particular portions of either into such small parcels as suit the occasional demands of those who want them. . . . [U]nless a capital was employed in furnishing rude produce to a certain degree of abundance, neither manufacturers nor trade of any kind could exist.

Yet management writers have historically paid only limited attention to the behaviour of the providers of capital, the investors—much less attention than that paid to the behaviour of either management or labour. Investors have been the largely invisible ghost in the capitalist machine. This lack of visibility is reflected in mainstream management texts, the canons of conventional management knowledge. For example, organizational behaviour texts, such as Buchanan and Huczynski’s (2004) or Mullins’ (1996) do not mention investors, whilst Ackroyd’s recent sociological study of industry (2002: 85–90) provides only a brief statement of the classic managerialist analysis of relations between investors and managers. Similarly, strategic management texts, such as G. Johnson, Scholes, and Whittington’s widely used Exploring Corporate Strategy (2005), now in its seventh edition, pay no attention to investors. At the same time, the extensive literature on financial markets and financial decisionmaking has been more concerned with developing models of markets than

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with the empirical analysis of concrete sociological and behavioural issues arising from the relations between investors and managers of the companies in which they invest, although the recent growth of behavioural finance is changing this situation (Shleifer 2000; Smart, Megginson, and Gitman 2004: 361–7). Historically, the major sociological research on the role of capital and the behaviour of investors has been by Marxists, beginning of course with Capital (1930) itself. Hilferding’s work Finance Capital: A Study of the Latest Phase of Capitalist Development, originally published in 1910 in German and republished in a new English edition in 1981, remains a classic study. In the same Marxist tradition, Zeitlin’s research (1974) in the USA in the 1970s examined the relationships between owners and managers, but from the perspective of class analysis rather than from the perspective of the theory of the firm. More recently, the French ‘regulation’ school (Boyer 2004; Aglietta and Reberioux 2005) has analysed ‘circuits of capital’. The British interdisciplinary social science journal Economy and Society published a special issue on ‘Shareholder Value and the Political Economy of Late Capitalism’ in 2000. But such research has not been incorporated into mainstream management thinking—neither Hilferding nor Zeitlin appears in the International Encyclopaedia of Business and Management (IEBM), whilst investors do not appears in the IEBM volume ‘Organizational Behaviour’. One justification for the neglect of the role of investors in the management literature has been the belief that managers rather than owners determine the destiny of firms—the investor is a ‘capitalist without function’, in Marxist terms (Dahrendorf 1959: 44). The dispersal of investors identified by Berle and Means in 1932 in their study of The Modern Corporation and Private Property resulted in the separation of ownership from control, with owners marginalized. Managers were seen as securely in control of the corporation (Berle and Means 1932): the position of ownership has changed from that of an active to that of a passive agent. In place of actual physical properties over which the owner could exercise discretion and for which he was responsible, the owner now holds a piece of paper representing a set of rights and expectations with respect to an enterprise. But over the enterprise and over the physical property—the instruments of production—in which he has an interest, the owner has little control. At the same time he bears no responsibility with respect to the enterprise or its physical property. It has often been said that the owner of a horse is responsible. If the horse lives he must feed it. If the horse dies he must bury it. No such responsibility attaches to a share of stock. The owner is practically powerless through his own efforts to affect the underlying property.

Dispersed shareholders had neither the incentive nor the capacity to monitor the performance of managers or to exercise control over them: exit rather

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than voice was the most effective way of responding to dissatisfaction. The period between the 1920s and the 1970s was the classic period of ‘managerial capitalism’ (Marris 1964). However, the issue of the relationship between investors and managers has been given a new urgency by the growth of a new form of capitalism associated with the ‘shareholder value’ approach to the corporate governance of the firm. The sharpened focus on shareholder value has been a major change in capitalist economies since the 1980s. The priority of shareholder value underpins both much recent finance theory, as the efficient capital market hypothesis, and much corporate practice. It has profound consequences for economic behaviour, and more broadly for society as a whole. Shareholder value involves managers giving priority to the interests of a single stakeholder, the investor, instead of seeking to balance the interests of multiple stakeholders, as in traditional theories of the firm, or to maximize managerial rewards, as in revisionist analyses (Marris 1964; Blair 1995; A. L. Friedman and Miles 2002). The succinct slogan of Mark Roe’s book, Strong Managers, Weak Owners (1994), is no longer appropriate. In the confident words of Hansmann and Kraakman (2004: 33), ‘there is no longer any serious competitor to the view that corporate law should principally strive to increase long-term shareholder value’. Similarly, ‘enlightened shareholder value’ has become the cornerstone of company law reform for New Labour government in the UK. For the Department of Trade and Industry (DTI), ‘enlightened shareholder value’ provides clarity of focus and a mechanism for rewarding risk takers, fostering innovation, and an entrepreneurial business culture. Froud et al. (2000: 104) gave the same weight to shareholder value, if with much less enthusiasm, in their analysis of ‘financialization’: ‘[t]he new forces of the capital market, via investment institutions and professional fund managers, are generally much more mobile and rapidly threatening [to managers] than the old forces of the product market via retailers and consumers’. In short, shareholder value is the dominant motif of a new form of capitalism, investor capitalism, which is supplanting traditional managerial capitalism in the USA and, to varying degrees, elsewhere (Useem 1996). In the academic management literature, the relations between investors and managers have become primarily the province of finance specialists and lawyers, under the rubric of corporate governance (see Clarke 2004 for a valuable five-volume collection of papers). Both groups have focused on the means required to develop efficient capital markets and to maximize shareholder value. Issues addressed include the best means of protecting the interests of minority shareholders, clarification of the role of the board of directors as the guardian of shareholder interests, and the effectiveness of alternative means of aligning the interests of senior managers with those of shareholders (LaPorta et al. 1999; Prendergast 1999; MacAvoy and Millstein 2004).

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This book addresses a broader range of issues, the overall behavioural and structural features of relations between investors and managers, not primarily market efficiencies, institutional arrangements, or corporate financial performance. Our orientation is thus sociological, rather than legal or financial. We view corporate governance as a means to an end: it is the institutionalized means for allocating authority and power within the enterprise. This parallels the conception of Gourevitch and Shinn (2005: 3), who view corporate governance as ‘the authority structure of a firm’. Our study focuses upon investors’ relations with the management of the firms in which they invest, investor engagement. Such investor engagement may occur in any market-based business system. However, the likelihood and forms of engagement are closely linked with the institutions of corporate governance and the business system of which they are a part. The corporate governance regime may encourage and facilitate, or discourage and hinder, investor engagement. Corporate governance regimes prioritizing shareholder value encourage and facilitate investor engagement. The special status of shareholders in shareholder value corporate governance regimes reinforces incentives and provides the rationale for investor engagement. Shareholder value legitimizes investor engagement, a legitimation endorsed by corporate management itself (Useem 1993). Shareholder value also generates metrics by which investors can monitor the performance of corporate management and evaluate the effectiveness of their own engagement, using measures such as economic value added (EVA™, net operating profits after tax minus the required rate of return on capital employed)—what Froud et al. (2000: 80–110) referred to as ‘financialization’. The rights, policies, and practices that support shareholder value provide a supportive context for investor engagement. On the other hand, stakeholder corporate governance regimes, in which the interests of employees, communities, the state, and customers are given weight, lack similar incentives or rationale for investor engagement. Corporate governance regimes, in turn, are linked to overall features of national business systems, as discussed in Chapter 7. Liberal market capitalist business systems provide a congenial ecology for the development of shareholder value corporate governance regimes, whilst coordinated market business systems do not. In short, investor engagement is nested in the institutions and practices of shareholder value corporate governance regimes and liberal market economies. Our underlying theme is that shareholder value and investor engagement do make a difference to firm behaviour. Investor relations emerged as a recognized management function in the 1980s. The heightened sensitivity of senior managers to investor expectations and the priority given to managing investor relations is one aspect of the new relationship, discussed in Chapter 6. A

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second aspect of the new relationship is the primary concern of this book, the closer engagement of many investors with the firms in which they invest. Investors are more than the passive principals on whose behalf managers, as agents, act. But the extent to which investors engage with the firms in which they invest differs amongst types of investors and amongst firms. The changing situation of institutional investors is increasing investor engagement, with institutional investors acquiring the characteristics of ‘universal owners’ (Hawley and Williams 1997), locked into their current investments by the size and spread of their holdings. Where exit is difficult, engagement is more likely. As universal owners, large institutional investors, especially pension funds, have a strong interest in the quality of corporate governance, in minimizing the negative externalities of corporate activities, and in the overall corporate contribution to the economies to which their beneficiaries belong. Moreover, private equity funds and venture capital funds are also likely to be heavily engaged with the management of the firms in which they invest, particularly in the aftermath of the collapse of the dot-com boom. Such investors usually possess special knowledge of the sector in which they are investing and own a large proportion of the shares of the companies in which they invest, giving their engagement substantial leverage, as discussed in Chapter 5. The influence of shareholder value philosophies differs amongst countries, with commitment to shareholder value more pronounced in the USA and Britain (the ‘Anglo-Saxon liberal market economies’, in Hall and Soskice’s 2001 classification) than in mainland Europe or in Japan. However, there are perceptions of a general trend towards the international adoption of shareholder value philosophies and their associated practices, even in Germany and Japan (Dore 2000). There are several reasons for this trend, including the major expansion in international capital flows amongst capitalist economies following the abolition of capital controls in the late 1970s (see Aglietta and Reberioux 2005). Firms headquartered outside the USA have increasingly listed on the New York Stock Exchange (NYSE), accepting NYSE stringent listing requirements. As the world’s largest economy—and only political superpower—the USA has influenced behaviour in other economies more than the reverse. Consequently, there has been increasing emphasis on common international forms of corporate governance, on standard accounting practices, and on shared conceptions of good business practice, heavily influenced by US conceptions. Chapter 1 outlines shareholder value thinking as the context for investor engagement and undertakes three tasks. First, following this Introduction (Section 1.1), Section 1.2 presents the basic tenets of shareholder value, as developed mainly in the 1980s and 1990s. Then, Section 1.3 outlines the institutional preconditions which the literature has identified as fostering

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the development of efficient capital markets to maximize shareholder value. Section 1.4 discusses the reasons for the growth of shareholder value from the 1980s, relating its growth to broader changes in the economic and political environment. Section 1.5 concludes with a brief summary. The chapter focuses on developments in the USA and Britain, where commitment to shareholder value has been strongest.

1.2. THE THEORY OF SHAREHOLDER VALUE Shareholder value corporate governance is a special application of agency theory. As Shleifer and Vishny (1997: 773) expressed it in their widely quoted A Survey of Corporate Governance, ‘corporate governance deals with the agency problem: the separation of management and finance. The fundamental question of corporate governance is how to assure financiers that they get a return on their financial investment’. In agency theory, principals engage agents to operate on their behalf. An ‘agency relationship [is] a contract under which one or more persons—the principal(s)—engage another person— the agent—to perform some service on their behalf that involves delegating some decision-making authority to the agent’ (Jensen 2000: 85–6). The contracts between principals/investors and agents/managers may be implicit or explicit. However, such contracts are necessarily incomplete, since managers are required to use their best business judgement to enhance shareholder value, including responding constructively to unforeseen circumstances. Managers therefore receive delegated authority from investors. Investors, or more frequently their agents, monitor corporate performance, directly and indirectly, through ‘reputational intermediaries’ (Coffee 2006), to ensure that managers act in the investors’ interests and maximize the return on the shareholders’ assets. The overall objective of maximizing shareholder value provides the basis for establishing performance metrics, which indicate how well the organization is performing to investors and other external audiences, as well as motivating managers. As one shareholder value booster (quoted in Useem 1993: 130) enthused, ‘“public companies are not in business to reward creditors, inspire devotion of their employees, win the favour of the communities in which they operate, or have the best plants or products. These are all means to an end—making shareholders richer”’. Agency theory provides the underlying theoretical rationale for shareholder value corporate governance. It rests ultimately upon a specific conception of the firm, in which the firm is viewed as a ‘nexus of treaties’ (Aoki, Gustafson, and Williamson 1990). According to Jensen (1998: 56), the corporate firm is ‘a legal fiction which serves as a nexus for contracting relationships and which is also characterised by the existence of divisible residual claims on the assets and cash

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flows of the organization’ (emphasis in original). The firm is a particular type of market, ‘the outcome of a complex equilibrium process’ (Jensen 1998: 57), involving interdependences and exchange relationships between the parties. Following Oliver Williamson (1971, in Williamson and Masten 1999), firms are viewed as means of managing transactions and controlling transaction costs when ‘market failure’ occurs. Constructing the institutions of shareholder value forms of corporate governance involves four elements directly relevant to investor engagement. The first element is defining and determining the interests of principals and their agents. As shown in Chapter 3, different types of investors and investors’ agents have different types of interests, which affect their propensity to engage with the firms in which they invest. The second element is establishing the mechanisms for monitoring the performance of agents and disciplining perceived malfeasance. The different forms of engagement, the means of monitoring performance, and the measures taken to remedy unsatisfactory performance also differ. The third element is the process of moulding the perceived interests of principals and agents, to establish congruence between them. Both investors and managers seek to secure acceptance of the legitimacy of their definitions of interests, as discussed in Chapter 6. The fourth element is providing incentives for agents to maximize performance in the pursuit of principals’ interests, for example through the development of share option schemes. In this conceptualization, relatively little attention is paid to the influence of corporate governance on the actual practices of management. In Williamsonian (1990) language, corporate governance is a means of protecting investors against moral hazard and minimizing the danger of senior managers pursuing ‘self-seeking with guile’. Shareholder value corporate governance arrangements may be institutionalized in different ways. However, the common feature is the establishment of a board of directors, usually combining senior corporate executives and external representatives of shareholders’ interests, responsible for overseeing and supervising company managers, to ensure that shareholder value is maximized. Within the board, non-executive directors seek to ensure that management focus on shareholder value is maintained, chairing major committees of the board, including the audit committee and the remuneration committee, responsible for determining senior management remuneration. In Britain, although not in the USA, the chairman of the board is usually a nonexecutive director. Board structures and processes are thus designed to ensure that senior executives act on behalf of the interests of their principals, not in their own interests. The priority of shareholder value is the foundation principle underlying the general theory of efficient capital markets, as developed in recent finance theory (Jensen and Meckling 1976; Jensen 1997). Capital markets are means of

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allocating resources from less to more profitable and thus more socially productive uses in a timely manner. According to Jensen (1997: 28), capital markets are more efficient in reallocating resources and reducing excess capacity than internal management decision-making and controls, and less disruptive than product markets: ‘[c]apital market and corporate control transactions such as the repurchase of stock (or the purchase of another company) for cash or debt creates exit of resources in a very direct way’. As an example, Jensen (1997: 28–9) cited the restructuring of the US oil industry in the 1980s: [w]hen Chevron acquired Gulf for $13.2 billion in cash and debt in 1984, the net assets devoted to the oil industry fell by $13.2 billion. . . . In the 1980s the oil industry had to shrink to accommodate the reduction in the quantity of oil demanded and the reduced rate of growth of demand. This meant paying out to shareholders its huge cash inflows, reducing exploration and development expenditures to bring reserves in line with reduced demands, and closing refining and distribution facilities.

Capital markets are efficient means of reallocating resources because they operate on transparent financial principles and are relatively immune from special interest influence by insiders, whether managers or employees, local communities, or politicians.

1.3. PRECONDITIONS FOR EFFICIENT CAPITAL MARKETS The shareholder value corporate governance regime provides the institutional framework for the effective operation of capital markets. The development of capital markets which efficiently maximize shareholder value depends on establishing the appropriate institutional, legal, and cultural preconditions which foster effective corporate governance systems and align the interests of senior managers with those of shareholders. According to Gilson (2000: 3), there is a ‘straightforward relationship’ between the ability of capital markets to operate effectively and corporate governance, with corporate governance functioning as ‘the corporation’s equity contract, the set of rules that determines the terms of the stockholders’ investment’.

1.3.1. Institutional Preconditions The first set of preconditions relates to the integrity of information, the availability of adequate accurate information on corporate performance, and the means available to evaluate it (Gilson 2000: 6): ‘[e]quity investment requires

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good corporate governance, and good corporate governance requires the capacity to make credible disclosure of financial results. In the absence of effective financial disclosure, a country’s capacity to support equity markets and, in turn, important kinds of industry, is compromised’. This involves timely access to accurate and credible information on corporate financial performance and enterprise strategies, as well as share price information. Effective corporate governance requires transparent accounting procedures, the preparation and presentation of financial statements according to generally accepted accounting standards, whose integrity is validated by independent auditors, and the application of full disclosure rules. Capital markets also require transparency regarding beneficial share ownership, to reduce the potential for market distorting trading by block holders or other major shareholders, especially problematic during merger and acquisition activity, as well as to restrict access to the private benefits of control. The role of information intermediaries—auditors, analysts, financial advisers, and business media commentators—is central. The independent auditor is the guarantor of information integrity. However, the independence of auditors is not always complete. The US corporate scandals of the late 1990s, including the collapse of Enron and WorldCom, arose from the failure of auditors, and subsequently other information intermediaries, to provide honest evaluations of corporate financial performance. Particularly severe problems arose when audit firms were associated with management consultancies, as with Arthur Andersen and Accenture/Andersen Consulting at Enron, especially where consultancy fees were considerably higher than audit fees (Coffee 2003, 2006; Windolf 2004). Market efficiency and equity require that information should be accessible to all potential investors. However, there were systematic failures by information gatekeepers and reputational intermediaries in the USA in the late 1990s which undermined the integrity of the information available (Coffee 2006). The close relationships which developed between corporations and financial analysts in the USA in the 1990s, and between both and financial journalists, made unbiased assessments difficult (Coffee 2006).

1.3.2. Legal Preconditions The first legal precondition for efficient capital markets is the protection of shareholder rights, especially the rights of minority shareholders. According to Black (2001: 783), ‘there are two essential prerequisites for strong public securities markets. A country’s laws and related institutions must give minority shareholders (1) good information about the value of a company’s business;

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and (2) confidence that the company’s insiders (its managers and controlling shareholders) won’t cheat investors . . . through “self-dealing” transactions . . . or outright theft’. Legal protection is required against self-dealing, either direct or indirect, whether by corporate management or by majority shareholders (Black 2001: 804). All non-controlling investors—large or small, shareholders or creditors—need their rights protecting. . . . Outside investors’ rights are generally protected through the enforcement of regulations and laws. . . . Protected shareholder rights include those to receive dividends on pro rata terms, to vote for directors, to participate in shareholders’ meetings, to subscribe to new issues of securities on the same terms as the insiders, to sue directors or the majority for suspected expropriation, to call extraordinary general meetings and so on. (LaPorta et al. 1999: 5–6)

Common law jurisdictions, such as in the USA and Britain, are seen as providing a firmer basis for developing equity markets than civil law jurisdictions, providing stronger protection for the interests of minority shareholders (LaPorta et al. 1997; LaPorta, Lopez-de-Silanes, and Shleifer 1998; Coffee 2001: 7). LaPorta et al. (1999: 11–12) suggested that common law jurisdictions provide more secure legal protection to shareholders than civil law jurisdictions because the judiciary has greater discretion in interpreting precedent in common law systems than in the more prescriptive regulatory environment of civil law systems. In common law systems, the judiciary is the protector of civil liberties, not the agent of state regulation. Explanations for the historical origins of different legal families are controversial and beyond the scope of this study. But the significance of legal family for the legal protection accorded to shareholders is clear (Gourevitch and Shinn 2005: 83–7). The second legal precondition is support for effective means of monitoring and supervising the performance of corporate management. This has two aspects. The first is the legal regulation of corporate procedures, especially relating to the responsibilities and role of the board of directors, including the oversight role of non-executive directors. The role of non-executive directors has been the subject of extensive debate in both Britain and the USA. Hence, successive British commissions on company law reform—Cadbury 1992; Hampel 1998; Myners 2001; Higgs 2003—discussed possible changes in the law relating to directors’ responsibilities and role, leading to revised company law legislation, currently (in May 2006) under parliamentary debate. Hitherto, reliance has been placed upon codes of practice, reinforced by the common law duty laid upon directors to act in the best interests of the company (P. Davies 2000). The performance of non-executive directors has been criticized from two directions. On the one hand, non-executive directors have been criticized for their perceived lack of independence, with substantial minorities

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of non-executives having links with corporate management (see Section 6.2). On the other hand, non-executive directors have been criticized for their lack of strategic awareness and for only limited involvement in the effective monitoring of managers. A particular concern has been with the role of nonexecutive directors on remuneration committees, where they have been seen as too compliant with senior management. The responsibilities of directors have been increasingly regulated, by law and by stock exchange rules, especially since the passage of the Sarbanes–Oxley Act in the USA in 2002. The second aspect is the legal regulation of information intermediaries, including disclosure and conflicts of interest (Coffee 2006).

1.3.3. Cultural Preconditions The major cultural precondition is the creation of an environment of high trust, especially contractual trust. Trust, the expectation that agreements made will be adhered to, is fundamental to effective economic relationships (Sako 1992; Khalil 2003). Trust may be personal, based on knowledge of the character of the individual parties, or contractual, based on the acceptance of written commitments, underwritten by third parties and the legal system. Personal and contractual trust coexist. However, personal trust is an unsatisfactory basis for the efficient operation of markets, since the distribution of personal information is partial and asymmetric. Efficient capital markets work with contractual trust rather than personal trust, reflecting the requirement for transparent and widely distributed information. The low levels of contractual trust are a major reason for the failure to develop effective capital markets in post-Soviet Russia, despite the high incentives provided by potentially very profitable resource-rich enterprises. The absence of trust undermines the potential for rule enforcement and gives rise to mafia-type means of enforcing compliance (Radaev 2002). Similarly, low levels of trust reinforce tendencies towards corruption, recognized by the World Bank as a major reason for the patchy development of equity markets in developing and post-socialist economies (Raiser 1998; Kornai and Rose-Ackerman 2004).

1.4. THE RISE OF SHAREHOLDER VALUE CAPITALISM The international dominance of shareholder value philosophies was not inevitable, but reflected specific historical circumstances. The rise of shareholder value was rooted in broad changes in social and political values, most

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fundamentally in the view that the allocation of economic rewards through competitive markets is both more efficient and fairer than their allocation through politics and administration (Dore 2000: 4–5). Shareholder value originated as a response to the declining profitability of US firms in the 1970s (Fligstein 2001). It grew beyond a financial market technicality to become a broadly based economic and social analysis, even a social movement for some (G. F. Davis and T. A. Thompson 1994). Indeed, Jensen (2000) spoke of a ‘third industrial revolution’ in his work extolling the efficiency of capital markets, whilst Froud et al. (2000: 85) referred to a ‘quasi-religious element of shareholder fundamentalism’. There are six major sets of reasons for the growth of shareholder value as the driving force of capitalist development. The first set of reasons is financial, the steps taken to revive US business profitability in the late 1970s. The second set of reasons is political and relates to changes in the political environment, with the political success of Mrs Thatcher in Britain and President Reagan in the USA. The triumph of Thatcherism in Britain and Reaganism in the USA led to an emphasis on market liberalism, with deregulated markets for capital as well as for products and labour, and fewer restrictions on business. The third set of reasons is economic and related to changes in the structure of the economy, including the changing position of labour. The emphasis on shareholders’ rights was made possible by, and reinforced, a change in the distribution of power in society, with the decline in the power of organized labour. Alongside growing income inequality and decline in the percentage of gross domestic product (GDP) allocated to labour, the growth of shareholder value reflected the reduced capacity of organized labour to define and to defend employees’ interests. The fourth set of reasons relates to comparative international economic performance and the poor performance of coordinated market economies in the 1990s. The relative decline of collectively oriented coordinated market economies, both in Continental Europe and in Japan, following on the earlier collapse of socialist economies, reinforced the attractiveness of liberal market shareholder-oriented capitalisms. Britain’s apparent success in creating flexible labour markets, reducing unemployment, and achieving faster growth than other European countries, without inflation, increased European respect for shareholder value and liberal market capitalism. The fifth set of reasons relates to the internationalization of capital flows, especially the internationalization of the portfolio investments of US mutual funds, and the fund managers’ pressures for acceptance of their interpretations of good corporate governance. The final set of reasons is academic, associated with the wider development of corporate finance as an academic specialism, and growing the popularity of rational social choice theory and institutional economics amongst American social scientists. In the 1990s, agency theories of

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the firm and institutional economics provided the most popular frameworks for analysing organizations, as in the widely quoted work of Oliver Williamson (1975, 1985) and subsequently John Roberts (2004). The fundamental origins of shareholder value lay in corporate responses to the ‘accumulation crisis’, to use the Marxist term, in the USA in the late 1970s, and the subsequent corporate restructuring through mergers and acquisitions. US corporations experienced a decline in profitability in the 1970s, following the 1973 oil crisis. Inflation led to high interest rates, and to low stock prices, with stock price levels falling below asset values. US manufacturing failed to match Japanese increases in productivity, and Japanese imports grew rapidly, especially of cars and consumer electronics. There was major excess capacity in manufacturing. The crisis was viewed as primarily a financial crisis, and financial measures were taken to resolve it. The measures taken involved rationalization, restructuring, downsizing, and mergers and acquisitions, as well as refinancing. The means to achieve this reorganization included both traditional and new forms of restructuring and financial engineering. Corporate strategies included divestment of non-core activities, to sharpen focus and to reduce the ‘diversification discount’ (J. Roberts1 2004); horizontal mergers and acquisitions, to eliminate spare capacity, reduce competition, and increase market share; stock repurchase, to increase share prices through reducing supply; and increased debt through the issue of high-yield bonds (junk bonds). Such strategies reflected the financial conception of the firm in a new era (Fligstein and Shin 2005). Financial reorganization was especially likely in firms with a chief executive officer (CEO) with a financial background and with institutional investors represented on the boards of directors (Fligstein 2001: 164). The financial engineering associated with the boom in merger and acquisition activity in the 1980s and the growth of shareholder value was facilitated by political changes. The deregulation agenda promoted by President Carter in the USA in the late 1970s was accelerated by President Reagan, including new merger guidelines issued by William Baxter in 1981, which relaxed the conditions under which mergers were subject to antitrust restraints. President Reagan’s reductions in corporation tax also encouraged corporate share acquisitions. The simultaneous programme of privatization, deregulation, and market liberalization undertaken by Mrs Thatcher’s Conservative government in Britain encouraged similar trends. The privatization of utilities, beginning on a large scale with British Telecom in 1984, was explicitly designed to broaden the basis of share ownership, with discounted prices and preferential allocations for individual shareholders, as well as to raise revenue and ‘roll back the state’ (Vickers and Yarrow 1988: 188–90; Riddell 1991: 87–112). Privatization led to a massive increase in the number of shareholders in Britain, a national

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opinion poll survey in April 1986 indicating that 14 per cent of the population, almost six million people owned shares (Vickers and Yarrow 1988: 189). The accelerated disposal of council houses (municipally owned property), was also designed to build a ‘property owning democracy’. Labour was incapable of mustering support for counter-definitions of corporate transformation. First, this weakness was partly due to changes in the structure of employment and in the labour market, which increased the organizational difficulties of labour, and partly to political changes. The decline in large-scale manufacturing, the growth of service sector employment, and the reductions in the size of firms (if not of corporations) created major difficulties in recruitment for trade unions (TUs) (Martin 1992: 173–7). Recruitment was more difficult in the new economy. TU membership declined, as retiring members were not replaced. Declining membership created organizational difficulties for TU leaders, as well as weakening their claims to define the legitimate interests of workers. Second, both Republican administrations in the USA and Conservative administrations in Britain followed antiunion policies. The strong stance taken by the Reagan administration against air traffic controllers in the 1981 strike, which eventually resulted in the destruction of the Professional Air Traffic Controllers’ Union (PATCO) marked a symbolic end to the New Deal consensus between capital and labour (Kochan and Katz 1988). In Britain, the 1984 coal miners’ strike, eventually broken by strong government action, marked a similar end to the post-war industrial relations system. Conservative governments passed a succession of increasingly restrictive laws on TU activity, beginning with the 1980 Employment Act (Dunn and Metcalf 1996). The decline of collective labour organization and collective bargaining and the growth of human resources management (HRM) echoed and reinforced market rhetoric. The publication in 1984 of the initial Harvard Business School volume on HRM (Beer et al. 1984) symbolized a transformation in the management of employees within the firm. Explicitly antiunion policies were increasingly common in the USA, if still rare in Britain. Employment relations came to be defined in terms of individual rather than collective relationships, with managerial conceptions of employment relations in individualized rather than collective terms coming to be endorsed by employees as well as managers. Human capital theory rather than collective bargaining came to form the basis for earnings differentials: earnings differentials were justified by the possession of different individual human capital endowments rather than differences in collective bargaining power, or even institutionally recognized skills (Lazear 1998). The language of human capital theory resonated with the language of maximizing shareholder value. Employees wished to optimize their returns on

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their investment in skills, just as investors wished to optimize their returns on their financial investments. The fourth set of reasons for the growth of shareholder value relates to differences in national economic performance. The US economy recovered from the Japanese threat in the early 1990s, leading to the long stock market and consumer boom between 1992 and 2001. US self-confidence returned, buttressed by the triumphalism associated with the collapse of communism and the perceived impending ‘end of history’ (Fukuyama 1992). The USA experienced significant increase in employment levels and acceleration in economic growth (Boyer 2004). At the same time the British economy revived, so that by 2000 the level of unemployment in Britain was substantially below that of its major European competitors. The achievements of the US and British economies were seen as reflecting the strengths of liberal market capitalism. In the 1990s, the German and French economies were perceived as failing, with higher unemployment and lower rates of economic growth than in the USA and Britain. Similarly, the continuing Japanese recession indicated the limitations of the Japanese form of coordinated welfare capitalism: failures in corporate governance, the absence of effective control rights for residual claimants, were believed to have led to the ‘widespread misallocation of capital that mired Japan in excess capacity and liquidity problems’ (Morck and Nakamura 2000: 1). The perceived dynamism of the US and British economies was linked specifically to the role of its venture capital markets. In the USA and, to a lesser extent, Britain, venture capital markets were seen as major enablers for the creation of dynamic new technology companies. Venture capital markets provided a means for financing innovation in ‘high technology’ industries, especially the information technology (IT) sector. The innovation ‘wave’ of the 1980s and 1990s was associated with entrepreneurial, risk-taking firms, creating a dynamic IT sector, financed by venture capitalists attracted by highpotential rewards. ‘Silicon Valley’ was viewed as the epitome of this process. The high profits associated with the rapidly expanding computer software industry, and the subsequent ‘dot-com’ Internet stocks boom, appeared to provide justification for the ideology of the risk-taking entrepreneur as hero, especially in the USA. Venture capital markets were absent or ill-developed in Germany or France. The success of the USA in reviving its innovation capability, especially in information and communication technologies, and the rapid expansion of Internet-based companies, led to a long stock market boom (Boyer 2004). New production concepts were developed in the USA, which claimed to combine the efficiency and cost effectiveness of just-in-time systems as developed in Japan with the flexibility of decentralized production

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systems—so called Wintelism, named after the chief executive of Nike (M. A. O’Sullivan 2001a: 221–4). High-value and high-visibility brand name firms based in the USA, such as Nike in footwear and Dell in computers, retained responsibility for product design and development, whilst manufacturing was outsourced to wherever production costs were lowest. The fifth set of reasons for the spread of shareholder value relates to the expansion in the flow of international capital, especially between the USA and Europe. The international flow of capital was a powerful means of transmitting commitment to shareholder value. Three aspects were especially important. First, US and British funds, both mutual funds and pension funds, increased their levels of investment overseas after 1980, with the liberalization of capital export controls. By 1999, US institutional investors’ assets overseas amounted to $19,279 billion, whilst UK institutional investors’ assets amounted to $3,264 billion; 51 per cent of US assets and 68 per cent of UK assets were held in equities (Gourevitch and Shinn 2005: 106). Japanese overseas investment, at $5,039 billion, was much less likely to be invested in equities, only 19 per cent (Gourevitch and Shinn 2005: 106). The level of foreign penetration, measured as the percentage of the total market capitalization of listed firms held by foreign investors, reached 36.1 per cent in France, 35.0 per cent in the UK, and 23.6 per cent in Germany in 2000 (Gourevitch and Shinn 2005: 105). The fund managers responsible for such investments had clear conceptions of good corporate governance, with an emphasis on transparency, the rights of minority shareholders, and the role of independent directors. Their conceptions were institutionalized in the metrics used by ratings agencies such as Standard and Poor’s to construct corporate governance indices. Second, fund managers exerted pressure for standardizing national reporting requirements and accounting procedures, in line with the requirements of the US Generally Accepted Accounting Principles (GAAP) or the International Accounting Standards Board (IASB). Third, non-US corporations which listed on NYSE were required to meet the associated listing requirements, including the expanded requirements introduced following the Enron scandals and the Sarbanes–Oxley Act 2002. The final set of reasons for the spread of shareholder value thinking is academic, the growth of corporate finance as an academic discipline and the widespread popularity of agency theories of social action, and institutional economics specifically, amongst American management scholars. Scholars such as Michael Jensen (1997, 1998, 2000), in a succession of papers beginning in the 1970s, played a major role in developing corporate finance, and linked its development with the efficient capital market hypothesis and shareholder value. Oliver Williamson’s work (1964, 1970, 1975, 1985) on transaction cost economics, beginning with the publication of The Economics of Discretionary

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Behavior: Managerial Objectives in a Theory of the Firm in 1964, proved highly influential in organizational analysis, leading to the development of institutional economics (Carroll and Teece 1999). This involved analysing organizational behaviour in terms of transaction cost economics, in which corporate structures are ultimately determined by the search for the best means of economizing on transaction costs. Economic activities are coordinated via markets, except in specific, limited circumstances, since lower transaction costs can be achieved through markets than through organization (or ‘hierarchy’). Coordination through organization occurs only when markets fail. There is an obvious congruence between the emphasis of institutional economics on economizing transaction costs through markets and the emphasis of financial economists on efficient capital markets. Williamson (1996: 173) himself identified the similarities: ‘TCE [transaction cost economics] and AT [agency theory] both work out of a managerial-discretion set up. They also adopt an efficient-contracting orientation to economic organisation. And both argue that the board of directors in the corporation arises endogenously’.

1.5. CONCLUSION This introductory chapter has outlined the major features of shareholder value thinking and provided a brief account of the factors which have contributed to its growth since the 1980s. Realizing shareholder value has always been a major preoccupation of senior managers in capitalist systems, as Marxists have long emphasized. However, between the 1920s and the 1970s, the wide dispersal of share ownership and the separation between ownership and control allowed senior corporate managers the discretion to accommodate a wide range of interests (most centrally their own), not only those of shareholders. The New Deal consensus in the USA, and Keynesian social democracy in Britain, underwrote conceptions of the firm which incorporated the interests of a wide range of stakeholders, including organized employees. Since the 1980s, beginning in the USA, senior managers have given higher priority to shareholder interests, with maximizing shareholder value becoming the dominant corporate objective. Linked to this objective, institutional and legal reforms aimed to create efficient capital markets. Measures taken to achieve this included company law reforms and administrative measures to enhance the protection of shareholders’ interests, to foster transparent corporate reporting systems, and to ease capital flows. The extent of the reforms designed to achieve these objectives differed amongst countries, but the direction of the changes was uniform.

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The growth of shareholder value as the exclusive criterion for corporate performance had its roots in the accumulation crisis of US corporations in the late 1970s. The crisis led to a decline in the profitability of US corporations. The remedies for the crisis included extensive financial and organizational restructuring, with a massive expansion in the number and size of corporate mergers and acquisitions. The shareholder value form taken by the new means of financial engineering were encouraged by political changes, the success of liberal market reforms associated with President Reagan in the USA and Mrs Thatcher in Britain, and the weakness of labour. The poor economic performance of coordinated market economies, such as Germany and Japan in the 1990s, with slower growth and higher unemployment than in the USA and Britain, enhanced the international prestige of liberal market economies and further encouraged the international spread of shareholder value thinking. The flow of institutional investment, especially of US mutual and pension funds, provided a major channel through which shareholder value thinking was disseminated. Finally, the normative implications of shareholder maximization were consonant with the implications of both efficient capital market theory and institutional economics, which formed the dominant strand of organizational analysis in the USA in the 1990s, when US business schools provided the internationally accepted definition of advanced management thinking. Shareholder value involves a radical simplification in the conception of the firm. Yet it has widespread ramifications. At the least, it is a powerful legitimating rationale for management practice, providing a template against which practice may be evaluated. Substantively, it has formed the basis for much company law reform and corporate practice, especially regarding corporate governance and mergers and acquisitions. The remainder of this book examines investor engagement in detail, in the context of the growth of shareholder value. Drawing upon an extensive literature and case studies of institutional investors and private equity–venture capital funds, the book documents the shape of investor engagement and the impact which investors have upon management practice.

2 Investor Engagement 2.1. INTRODUCTION Defining investor engagement is not straightforward. At the minimum, the time investors spend on acquiring information about a particular company decision and vote is a form of investor engagement, as is any kind of proactive approach to company mismanagement. At the maximum, investor engagement involves active intervention in the development and implementation of corporate strategy. In this study, we define investor engagement as the use of residual control rights by investors to influence the management processes of a given portfolio company. In some instances, investors may also induce largescale changes in management processes across several companies through the symbolic targeting of one or more portfolio companies. All such actions may be viewed as aspects of the engagement process. Through the engagement process, investors seek to affect the strategic direction and performance of portfolio companies. Within our framework of the engagement process, investor activism, for example through shareholder resolutions, represents a specific approach (Romano 1993, 2001). The goals of engagement vary, from advancing specific shareholder interests to achieving broad social objectives. So, too, do the forms of engagement, which range from simple requests for information to hostile targeting of company personnel or key practices. Some investors begin their intervention with behind-the-scene influence and negotiation in private, cooperative meetings with company management (Byrne 1998; Pellet 1998); if this approach fails, they may next contact board members and company advisers (Useem 1996). Myners’ ‘Principle Six’ (2000) advocates an explicit activist engagement strategy addressing when the investor should intervene, with what approach, and how effectiveness should be measured. The British Combined Code on Corporate Governance (Financial Reporting Council 2006: 19–20) states that institutional investors should enter into dialogue with companies, and make ‘considered use’ of their votes. Going public with investor concerns is generally considered to be a last resort, as it signals to the market that company management is unwilling to respond to more cooperative attempts at resolving

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differences (Gillan and Starks 2000; Prevost and Rao 2000). These more public forms of engagement include proxy voting (Davey 1991), media campaigns (Rehfeld 1998), and shareholder proposals (Del Guercio and Hawkins 1999). Chapter 2 covers three issues. Following this Introduction (Section 2.1), our overall approach is presented in Section 2.2, which outlines the spectrum of engagement. Section 2.3 briefly outlines the changing contexts of management practice, inside and outside the firm, alongside the growth of shareholder value and investor engagement. In Section 2.4, we comment on the relation between investor characteristics and specific areas of management practice. Finally, Section 2.5 provides a brief summarizing conclusion.

2.2. CONCEPTUAL FRAMEWORK Investor engagement may be conceptualized within the principal–agent paradigm of corporate governance (see Section 1.2). Agency problems typically arise from asymmetric information and incomplete contracts, which permit agents to act according to their own rather than their principal’s interests. The conflicts of interest that arise in this relationship may be managed by investors through incentive contracts and monitoring, and through more intense processes of engagement. Engagement allows investors to influence key management practices to ensure optimum shareholder value. Such an investor engagement approach is more sensitive to the shortcomings of contracts and agency relationships than an arm’s length financial model. Conventional agency theory is concerned with aligning the interests of shareholders (the principal) and those of managers (the agents). Shareholder value results from managers’ actions, which shareholders are unable to monitor directly; their success is only evident ex post. Managers receive compensation according to their ‘effort’ and success. For shareholders, the major problem is to motivate managers to act in the best way to maximize shareholder value. However, shareholders are unable to ensure such maximization because of their limited monitoring capacity and lack of detailed information on management practice; it is impossible to specify fully the requirements of managerial contracts at senior strategic levels, because of the need for flexibility and the exercise of professional managerial judgement, and the amount of information available to investors and to managers inevitably differs. To remedy this deficiency, the conventional solution is to align the interests of shareholders and managers through share options and similar arrangements. However, this alignment remains fragile because of continuing differences in

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interest and information asymmetry. Accordingly, increased investor activity is required. Investor engagement is thus a means of enhancing the value of equity through remedying information asymmetry and other means. Within this framework, investor engagement contributes to maximizing shareholder wealth; engagement will improve management practice and thereby enhance company financial performance. The UK’s Modern Company Law for a Competitive Economy: Final Report (Myners 2001) advocated ‘enlightened shareholder value’, arguing that to maximize returns to shareholders, good managers must take the interests of a range of stakeholders into account. Investors can influence corporate governance in a variety of ways, including external control measures, internal governance measures, and measures relating to executive compensation which align incentives (Karpoff, Malatesta, and Walkling 1996; Chidambaran and Woidtke 1999). Engagement enables investors to exercise ‘voice’ and discipline management directly and flexibly. This contrasts with the traditional arm’s length finance paradigm of governance, in which investor influence over governance, and management practice more generally, is secured by the threat or exercise of ‘exit’ (Parkinson 1995). Engagement practices have grown rapidly since the 1980s. This growth has been accompanied by the emergence, initially in the USA and more recently in Britain, of funds which specifically seek to establish their ‘thorough’ credentials through engagement with companies to change their practices and performance. Unlike conventional arm’s length investors, activist investors use their ownership stakes to engage with companies which underperform, rather than divestment. Institutional investors, especially pension funds, increasingly fit the engagement model of investor relations. The Institutional Shareholders’ Committee (ISC 2005: 1) has replaced ‘investor activism’ with investor engagement, and several leading UK and US investors now routinely follow engagement strategies. But there are no agreed standards of engagement content, practice, reporting, or governance against which their effectiveness and quality may be assessed. We therefore develop (see Table 2.1) a spectrum of engagement practices, which fall between indirect and direct control, as means of disciplining management. Each type of investor engagement involves a specific mode of control over management. The first, traditional laissez-faire, or indirect, engagement is characteristic of arm’s length financial arrangements, in which investors concede strategic and operational control to corporate management, their agents: discipline is exercised by exit, threat of exit, or capital withdrawal. The second, external engagement, sees investors intervening to protect the workings of mechanisms of control through the capital market, without becoming involved in the internal operations of the firm: disciplinary action

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Table 2.1 Investor engagement in corporate governance Type Indirect/laissez-faire External Internal Negotiatory Direct

Description

Action

Management-led/‘let well alone’ Exit protection Influence board membership and independence Face-to-face dialogue Investor-led

Capital withdrawal; (threat of) exit Shareholder resolutions Non-executive appointments Persuasion; relational financing Executive appointments

is occasional, for example through shareholder resolutions. The third, internal engagement involves investors influencing the internal governance of the firm through the appointment of independent, non-executive members on the board of directors, leaving the board to carry out its responsibility to maximize shareholder value. The fourth, negotiatory engagement involves investors discussing strategic and, on occasion, operational matters with corporate management, with influence exercised through persuasion, reinforced by financial pressures, through relational financing (long-term funding arrangements, often arranged through banks and corporate network allies). Finally, investors may be dominant block holders, able to control management directly, through hiring and firing company management—direct engagement. Within this spectrum of investor engagement, shareholder resolutions which go to a vote, more common in the USA than in Britain, or threats to call an emergency general meeting, which can be seen as failures of monitoring and may damage the standing of companies with the market, are a small subset (Chidambaran and Woidtke 1999). Shareholder resolutions are definitive. Hence, negotiated settlements between shareholder activists and companies provide a more effective form of engagement than shareholder resolutions because they allow for greater flexibility. More extreme, and public, tactics may have significant, often negative, financial consequences (Strickland, Wiles, and Zenner 1996; Wahal 1996; Chidambaran and Woidtke 1999; Gillan and Starks 2000). The relative absence of shareholder resolutions in Britain does not mean that shareholders are necessarily passive. Beyond publicly observable events, such as shareholder resolutions, Holland (1998: 249) found less public relationships which he characterized as ‘long-term, private, programmed set[s] of regular interactions between financial institutions and companies in which implicit financial institution relationship influence was exercised’. Investor engagement seeks to prevent crises, not simply to respond to them. Investors typically use their leverage to negotiate or demand changes in management practice, with dialogue rather than the threat of replacement as the norm.

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2.3. INTERNAL AND EXTERNAL CONTEXTS Investors are not the only influence on management practice; investor engagement occurs within a wider framework of management processes. Regardless of shareholder value, managers respond to their perceptions of the external and internal contexts of the firm, in the light of the firm’s objectives and the interests, norms, values, and beliefs of the senior managers. Historically, product markets (especially the level of product market competition), labour markets (the demand for and supply of labour), the rate of scientific and technological change, political institutions and policies, and social and cultural values have been the major relevant features of the external environment considered by mainstream management researchers (see e.g. Pettigrew and Fenton 2000; Ackroyd 2002). Capital markets have not figured prominently in management research, although they are obviously central in finance and financial economics. The main features of the internal context of the firm examined in the literature have been the production process, including both physical and social technology, formal organizational structures and processes, especially the distribution of authority, formal and informal relations, both vertical and horizontal, as well as the interests and attitudes of non-managerial employees. In the 1990s, there were major changes in the external and internal contexts of firms that led to changes in management practice, alongside the growth of shareholder value. The major changes in the external context include: the fragmentation of product markets; the growth of competition, especially international competition; slack labour markets; a high rate of technological change, affecting both products and production processes; and changing political and cultural values, including emergent environmental concerns. Significant external contextual changes usually neglected by management researchers, but of long-term importance for investors, include demographic changes— increased life expectancy (in most countries), lower birth rates, diminishing average household size with increasing numbers of single-person households, and changing migration patterns. Such demographic changes affected the expectations of the clients of institutional investors and thus the behaviour of institutional investors. The major changes in the internal context include: the widespread use of IT in production processes, control systems, communication networks, and in the provision of services; changing organizational structures, with the decentralization of authority and reduction in hierarchy (but often with the ‘strategic isolation’ of senior managers, ill-informed of day-to-day operations); new forms of work organization; increased need for horizontal as well as vertical communications; and weakened collective organization amongst non-managerial employees, and its near elimination

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amongst managerial employees. Managers have responded to the new contexts with increased sophistication, involving new forms of competition and collaboration (internationalization, globalization, and strategic alliances), new approaches to production (‘diversified quality production’, ‘flexible specialization’, and ‘lean manufacturing’), as well as the development of new products and services. The unifying themes amongst management researchers are more rapid change, increased uncertainty, and greater risk. Although all changes in the external and internal contexts affect relations between investors and managers to some degree, some changes are more directly relevant than others. Amongst the most significant relevant factors in the external context are demographic changes, with pension funds under pressure to maintain revenue to service pension commitments. Political changes also affect relations between investors and managers, both directly, for example controversies over shareholders’ rights, and indirectly, for example political sensitivity to the concerns of voters such as pensioners. Changes in the internal context, especially the increased use of IT, also affect shareholder– manager relations, with greater access to information and faster capability in responding to information received. Our discussion of the investors’ role in company management recognizes both external and internal contexts affecting relations between investors and managers.

2.4. AREAS OF POTENTIAL INVESTOR ENGAGEMENT This section outlines the major characteristics of investors which influence their relations with managers, specifically investors’ time horizons and capacity to respond to economic uncertainty. We indicate the spheres of managerial concern and practice where investor engagement might be expected to exercise an influence—investment in intangibles, innovation, skill development, and corporate strategy, including senior management remuneration. Finally, we discuss the links between investor decision-making and employment relations, suggesting that in this sphere, investor influence is indirect.

2.4.1. Time Horizons Investors differ in their need for liquidity. Investors with longer investment time horizons tend to favour engagement more than those with shorter investment time horizons. For example, pension funds, both private and public, tend to have significantly predictable, long-term outflows to beneficiaries.

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This ability to have a measured assessment of their outflows gives them the flexibility to develop a long-term perspective on their investments (Monks and Minow 1996; Brown 1998). This may then translate into funds offering their portfolio firms the benefit of ‘patient’ capital (Porter 1992). Consequently, there will be potential for increased influence from these institutions (Gibson 1990; Millstein 1991; Black 1992). Unlike pension fund managers, mutual fund managers and bankers face beneficiaries who may redeem their shares at any time, resulting in such funds having a much shorter time horizon and a much greater liquidity requirement (Levinthal and Myatt 1994; Monks and Minow 1996). Mutual funds in particular experience high portfolio turnover, frequent sale of shares of underperforming firms, and use of the proceeds to buy shares of firms with arguably better prospects. Their shorter investment horizon means that they will need to rely on market forces rather than engagement as the means for improving fund performance. The investment time horizon of financial institutions will have a direct effect on management decisions about project selection. Research on incentives frequently observes a tendency amongst managers to focus on the shortterm and ignore the long-run implications of their actions (J. Roberts1 2004). The time horizons of managers may differ from those of investors, being shorter. To the extent that the stock price of the company reflects the capitalized value of future profits, actions that increase future profits make the company more valuable to investors, who can enjoy higher returns through future dividends or capital gains. Investors therefore may want managers to take actions that increase the long-term value of the company. But managers may be more concerned with securing short-term personal gains than maximizing the long-term value of the company, especially where management performance is measured by meeting quarterly budget targets. Managers may have an incentive to take decisions with adverse long-term consequences, especially when actions cannot be observed easily by owners. For example, managers may defer funding projects with long-term pay-off yields to improve the short-term ‘numbers’. Active investors, when seeking long-term returns, may engage with managers to mitigate an excessively short-term focus.

2.4.2. Economic Uncertainties Economic literature on company performance suggests that companies facing high levels of economic uncertainty are likely to use suboptimal management strategies to minimize risks (Lazear 1998). Highly volatile environments constrain managers to seek to insulate their companies from such environmental uncertainty. The capacity of managers to insulate their firms from volatility

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without suboptimal decision-making—for example, over research and development (R&D) investments—depends upon the capacity of firms to absorb negative externalities. This, in turn, requires ‘patient capital’. Pension funds with a ‘universal owner’ perspective have an incentive to encourage companies to absorb negative externalities. They do not punish companies for taking risks in production or service provision when there is an economic downturn, thus helping them to make more efficient trade-offs between risk and insurance over the long term. To the extent that investors are willing and able to filter out uncontrollable factors, thereby reducing the ‘noise’ element in their assessment of company performance, they will achieve a more efficient investment profile. Hence, investors with holdings in a broad crosssection of listed companies acquire experience in interpreting ‘noise’ and may encourage company managers to achieve a better assessment of risk and insurance needs. The broad holdings of pension funds and their conceptions of beneficiary long-term interests have encouraged them to take a wider view of the economy. Their priority is the prosperity of the whole economy, not the short-term gains which may be obtained through the operation of the market for corporate control. Specifically, such investors will show less interest in takeover bids that result in substantial gains for target shareholders, but that do not produce enhanced returns in the long run for shareholders in bidding companies, especially when they hold equity stakes in both sets of firms. Furthermore prudential investment standards require funds to diversify their holdings across the market as a whole, with ‘universal owners’ becoming locked into both the individual companies in which they hold stakes and the market as a whole. Responding to management failures by exit ceases to be an option. Lock-in forces universal investors to engage with management on a long-term basis to improve overall corporate performance.

2.4.3. Intangibles Much organizational value is derived from intangible factors such as organizational knowledge, customer satisfaction, product innovation, and employee morale, rather than from physical assets such as real estate or physical plant. However, understanding and measuring the role of intangible factors in value creation poses a formidable challenge. Lev and Zarowin (1999) argued that the non-recognition of intangibles on the balance sheet has caused a significant decline in the relevance and usefulness of accounting measures. Accounting rules devised for a bricks-and-mortar economy may be ill-suited to an economy in which many firms derive their competitive advantage from investment in intangibles. For example, under current accounting rules, R&D expenditure

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is disclosed as a line item in the income statement but is not allowed to be capitalized on the balance sheet in the USA (although some development expenditures may be capitalized under UK and international GAAP). Many other intangible investments are not even identified in financial statements. For example, investments which create brand value, increase the customer base, enhance a firm’s IT, or improve product and process design are not distinguished from operating expenditures. If expenditures on intangibles are not measured and identified separately, there will be little incentive for managers to appreciate their true value to the company. For example, the most significant long-term investment in intangible assets in the service sector may be in employee training in areas such as improved customer service. However, the evidence on training expenditures suggests that companies adopt an ad hoc approach to developing their intangible assets (Bishop 1997). Investors appreciating the long-term value of investments in intangible assets, such as training provision in customer service, may be expected to adopt a more strategic approach (Finegold and Soskice 1988).

2.4.4. Innovation More direct investor involvement in governance may engender a stronger internal commitment to both product and process innovation (Parthiban, Hitt, and Gimeno 2001). According to one strand of literature, firms in ‘AngloSaxon’ business systems tend to place more emphasis on narrow financial objectives than on broader objectives such as market share or the enhancement of intangible assets (Carr and Tomkins 1998). This focus, associated with liquid equity markets, may be conducive to radical product innovations by facilitating the flotation of high-growth firms, as in the IT and biotechnology industries. By contrast, firms in coordinated market economies secure and maintain competitive advantage via incremental innovation in production processes and through product enhancement. Therefore, their innovation strategies are more broadly based and encompass a wider range of product markets. Such differences in innovation strategies are likely to influence management decision-making in relation to R&D expenditures, training, and skill development. In addition, there may be better employee incentives relating to in-house training, longer job tenures, and lower employee turnover (Frick 1997). These factors promote stronger internal labour markets, reinforcing stable employment at firm level. Relational financing, long-term funding often raised from banks or other firms in the corporate network, provides better incentives for investment in skill development, as managers are less prone to cut investment in training when there are shortfalls in cash flow (see

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Chapter 7). In contrast, outside finance pressures have generally created deficiencies in skill formation in the USA and UK (Finegold and Soskice 1988). The pressures of financial institutions for maintaining share prices and dividends may result in senior managers starving R&D of resources required for investment and inhibiting investment in new process innovations (DTI 2003). Hence, stock market short-termism may inhibit investments in longterm projects which may involve high risk but also the potential for high reward. Evidence for the low levels of investment in industrial R&D by British companies compared with foreign competitors has been long-standing; levels of public expenditure are less unfavourable (Walker 1993; Jaumotte and Pain 2005). The role of investors in creating this situation is difficult to demonstrate. On the one hand, industrial managers cite the insistence of ‘the City’ in maintaining high levels of dividend distribution as a reason for the failure to invest in long-term R&D: unrealistic targets are set for growth of earnings and returns on assets, to support high share prices (Froud et al. 2000). On the other hand, several organizational features within industry itself contribute to the low level of investment in R&D: the low representation of scientists and engineers amongst senior managers, the disjuncture between publicly funded research and industrial development, the use of inappropriate measures of management performance, and so on. The impact of investors upon innovation is likely to differ amongst sectors. It was hypothesized (Casper and Whitley 2002; Visintin and Tylecote 2003) that the UK’s indirect (or laissez-faire) type of investor engagement in corporate governance (see Table 2.1) is especially appropriate for innovation in sectors where: (a) rapid changes in products may require firms to be allowed to fail—Schumpeter’s ‘creative destruction’(1950); (b) the assets providing competitive advantage are physical, rather than human; (c ) there is strong patent protection, inhibiting reverse engineering and imitation; (d) the rents from innovation are easy to appropriate (and preferably easy to assess). These characteristics are more likely to be found in high technology sectors, and in pharmaceuticals, than in mid-technology sectors such as motor vehicles. DTI’s innovation data supports this analysis, with UK research concentrated in pharmaceuticals, biotechnology, and the special case of the defence industry (DTI 2003). The indirect (or laissez-faire) type of investor engagement in corporate governance (see Table 2.1) also fits the classic ‘first generation’ model of new product development, with its scientific research → product design → engineering → manufacturing → marketing → sales sequencing, permitting the disaggregated appropriation of value at each stage. This approach to corporate governance is inappropriate where innovation requires a close link between new product development and the production process, as in the cumulative

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product and process innovations characteristic of Japanese office products and consumer electronics (Fruin 1997). The indirect (or laissez-faire) type of investor engagement in corporate governance (see Table 2.1) is also unhelpful when new product development requires overlapping and integrated systems, because of the difficulty of disaggregating rents (as well as the difficulty in monitoring complexity). Indirect laissez-faire systems of engagement encourage discontinuous innovation, more direct systems of engagement cumulative innovation.

2.4.5. Employee Skill Development Employee skill development and learning are linked closely with patterns of innovation. Institutional investors are not responsible for employee skill development, but it has been argued (Lazonick and M. A. O’Sullivan 2000) that indirect systems of investor engagement in corporate governance (see Table 2.1) foster forms of industrial organization which encourage the acquisition of narrow and concentrated skills sets, rather than diffuse and firmspecific core capabilities. The emphasis on high levels of specific capabilities is consistent with the requirements of innovation in high technology, ‘leadingedge’ sectors, as in software engineering. It is also consistent with high levels of mobility amongst firms, whether voluntary or because of the disappearance of firms through Schumpeter’s process of creative destruction (1950). However, narrow and concentrated skill sets are not congruent with cumulative innovation and organizational, rather than individual, learning. Incentives for the acquisition of diffuse and firm-specific core skills, rather than narrow and concentrated skills, depend upon employment security; without employment security, on both sides of the employment relationship, the incentive to acquire firm-specific skills is limited. The absence of such skills restricts the potential for cumulative innovation. Furthermore, reliance upon specific and concentrated skills reinforces functional segregation, stimulating professional commitment and learning at the expense of organizational commitment (Lazonick 2002). More engaged investors, such as those investing in private equity funds, are more directly involved in skill development policies in investee companies, as shown in Chapter 5.

2.4.6. Corporate Strategies There are three general elements in investors’ contribution to the development of corporate strategies. First, as board members, investors have the potential

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to adopt a ‘helicopter’ perspective, being less ‘partisan’ than internal directors with their specific institutional interests. This broader perspective helps in fostering collaboration amongst diverse groups in the organization, seeking to achieve consensus, or at least a working agreement, on ways of taking the company forward. Second, investors have the potential capability to develop criteria for monitoring performance and to build consensus amongst diverse groups on their relevance, based on their broad experience of comparable firms. Investor directors are well placed to undertake strategic audits. Finally, investors may play a central role in defining core corporate values, in addition to the formal roles prescribed by The Combined Code on Corporate Governance (Carr and Tomkins 1998). More specifically, investors’ influence on strategy may be expected in three areas: restructuring, mergers and acquisitions, and senior management appointments, including senior management remuneration. With regard to restructuring, investors have pressed for greater focus on core activities and for the rationalization of operations since the 1990s. This has involved continuous emphasis on reducing operating costs as a means of meeting market competition. Investors may develop views on best corporate restructuring. As shown in our study (see Section 5.3), The Carlyle Group has a clear preference for expanding the scope of outsourcing, whilst other investors may have a strong commitment to the development of in-house capabilities. Flexible management approaches might require that companies focus only on core capabilities (which exploit task complementarities), whilst the auxiliary operations are contracted out. This allows companies to make substantial savings on labour costs without necessarily compromising quality and customer service standards. Flexible management approaches may produce lower-level employee labour cost savings for shareholder benefit, and investors may therefore favour and promote them, by using their influence, as suggested in Section 5.3. Alternatively, companies may eschew outsourcing and concentrate on enhancing skills. The second area of investor influence is that of mergers and acquisitions. Takeovers, or threats of takeover, are perceived as the major means whereby financial markets ‘discipline’ management practice in the market for corporate control. Poor management is believed to result in declining share price, prompting remedial action by investors either through direct intervention or disposal. Shareholder discontent results in a graduated response, from informal pressure on management through to share disposal. The weakening of share prices encourages hostile bids. There has been extensive research on takeovers since the late 1970s, both in Britain and in the USA. UK takeover rules prioritize the interests of shareholders, with directors of target companies required to be passive or to stimulate auctions to increase shareholder rewards,

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not to act in the interests of other stakeholders. Deakin et al. (2002: 11–12) argued that the City Code, in articulating a strongly pro-shareholder position in the issue of management passivity, reflects the influence which institutional shareholders and City professionals have been able to bring to bear on the regulatory process. It is largely thanks to concerted shareholder pressure that poison pills and the more obvious kinds of takeover defence, such as ‘shark repellents’ and ‘flip overs’, have not been adopted to anything approaching the levels seen in the USA.

Overall, takeovers are believed to increase shareholder value, especially for shareholders in the target company—returns to shareholders in the bidding company are more uncertain. Franks and Mayer (2000: 6) concluded that, in the UK, ‘takeovers in general are good for shareholders, although most of the gains accrue to the target’. Alternative methods of calculation, based on a residual income approach, are less positive, Bild et al. (2002) concluding that ‘on average acquisitions destroy roughly 30 per cent of the acquirer’s preacquisition value’. There are direct and indirect behavioural consequences of takeovers and mergers. The most obvious change is in the composition of the board of directors. Board composition changed in 90 per cent of successful hostile bids and in 50 per cent of friendly takeovers (Deakin et al. 2002). A second change is the disposal of assets—a means of achieving greater corporate focus as well as providing resources to cover debt incurred in a takeover bid. A third change is the reduction in employment levels. For example, Deakin et al. (2002: 30) reported that job reductions followed in all of the fifteen hostile takeover bids investigated in their case study research. The primary indirect consequence of takeovers is the disciplining of management performance. There are, however, sceptics about the impact of takeovers on corporate performance. In accordance with market theory, poorly performing firms with perceived scope for performance improvement should be the targets for hostile takeover bids. However, Franks and Mayer (2000) concluded that in Britain there is only a very loose association between poor performance and takeovers. The third area of investor strategic concern is senior management appointments, especially the Chief Executive Officer (CEO). CEO appointments are the responsibility of the board’s nominating committee. This may be chaired by the chairman of the board or by a senior non-executive director; the involvement of the chairman is not always recommended since (s)he may be too closely identified with the outgoing CEO. Although there is no formal role for investors in CEO selection, it is commonplace for institutional investors to be involved informally, nominating committees sounding out institutional

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investors on the acceptability of potential candidates. Investors have network contacts which provide access to extensive information on potential candidates, including their personal as well as professional qualities (Kaplan 1995). The role of institutional investors in senior management personnel changes usually becomes evident only in times of crisis (as with the oil company Shell in 2004), when companies are seen to be failing. However, stock market credibility is a necessary requirement for CEO selection; the selection requires the ‘confidence’ of the market, and canvassing approval for candidates from institutions is likely. Khurana (2002) documented the role of Wall Street in CEO selection in the USA, where the external recruitment of ‘charismatic’ CEOs expanded in the 1990s, specifically linked to the need for organizations to demonstrate commitment to shareholder value. Institutional investors, working through non-executive directors, may exert significant influence on the dismissal of CEOs in poorly performing companies. Hence, Renneboog and Trojanowski (2003) concluded that the chances of the CEO of a poorly performing firm losing his or her job are 21.3 per cent in an outsider director-dominated board, compared with only 11.4 per cent in an insider management-dominated board. With regard to senior management remuneration, the literature is mostly informed by the principal–agent model. Incentive contracts are often employed to align managerial interests with those of shareholders, by tying the managers’ compensation to the performance of the firm (Prendergast 1999). Share ownership, share option schemes, and performance-related bonus payments are used in various combinations to motivate managers to make shareholder wealth-maximizing decisions. This framework has limitations. First, investors are not in a position to determine whether management actions are the most appropriate under the given circumstances, and therefore whether they are maximizing shareholder value (Murphy 1999). The second criticism is centred on the ‘effort’ variable. As Holmstrom (1992) pointed out, CEOs can choose from a wide range of actions. It is judgement, not ‘effort’, that investors are seeking. The problem is not to get CEOs to work harder, but rather to ensure that their interests are aligned with the interests of shareholders and that judgements are made in accord with that alignment. However, it remains unclear whether increases in financial incentives lead executives to work more effectively in the interest of shareholders (Bebchuk and J. Fried 2004). In the 1990s, the idea of executives’ share options solving the ‘agency problem’ gained widespread acceptance. There was thus a consensus that executive share options would give managers a powerful incentive to put the interests of shareholders first. However, share prices may deviate substantially from their fundamental value, with management helping this process along in the short term. There are circumstances where a firm’s share price might go up for

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reasons having little to do with CEO judgement, for example a fall in interest rates or a rise in commodity prices. However, if the firm outperforms the market as a whole, or an industry peer group, then rewards linked to share price may be justifiable from the investors’ perspective. Institutional investors have few objections to rewarding highly successful executives, but take exception to high levels of compensation paid for average and below average performance, and particularly to ‘rewards for failure’, as shown in Chapter 4.

2.4.7. Employment Relations The direct influence of institutional investors on management practice in employment relations is limited, with firm performance at the level of functional detail rarely being monitored. However, the indirect influence of institutional investors may be considerable. Gospel and Pendleton (2003: 565) identified six main ways in which investors influence management decisionmaking, with implications for employment relations: ‘(i) the balance of support given by management for the interests of labour and capital; (ii) the time-frame of managerial decision-making; (iii) the nature of business strategies; (iv) the importance ascribed to financial factors in decision-making; (v) the approach to securing managerial and employee commitment; and (vi) the degree of co-operation with other firms’ (see also Gospel and Pendleton 2005). The major areas in which shareholders’ interests impact on employment relations include job security, level of earnings, degree of reliance on financial incentives for increased commitment, and skill requirements—market evaluations may be sensitive to employment relations problems. Moreover, Capelli (2000: 88) argued that institutional investment trends in the 1990s stimulated ‘market-mediated’ employment relations: ‘[d]evelopments in financial markets, especially for publicly-traded companies, seek to make executives operate much more like stockholders. . . . Companies continue to shed operations that are not their core competence, turning to outsourcers to supply components or provide functions that had previously been handled inside’. Externalization involved reductions in internal headcount, and management focus on managing the supply chain. The need to reduce headcount at the behest of ‘the City’ was stressed by enterprise managers. Hence, managers in privatized Telecom complained that the stock market focused on headcount as the measure of corporate efficiency and led managers to prioritize manpower reductions, even where they led to declines in the quality of services (Beynon et al. 2002: 142). Pressure to reduce headcount led to changes in employment practices, including increased reliance on overtime. Mergers and acquisitions usually led to job losses, associated with improvements in

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company share prices (Deakin et al. 2001). More widely, it was also argued (Deakin et al. 2001: 19) that increased emphasis on shareholder value reduced the potential for partnership approaches between management and labour. The Tenswell case in Deakin et al.’s Cambridge study (2001: 23) showed the direct influence of shareholder (and debt holder) pressure leading to job losses and industrial relations conflict. However, other case study companies had institutional investors willing to take a long-term view of shareholder interests, allowing ‘partnership’ arrangements to continue. According to Gallie et al. (1998: ch. 10), pressure on labour costs in the 1980s and 1990s led to job losses, organizational restructuring, de-layering, decentralization, increased discretion and responsibility to lower-level employees, increased skills, and increased stress. However, there is no evidence that institutional investors directly sought such solutions to problems of reducing labour costs: enterprise management teams chose such approaches. In short, shareholder value did not require the destruction of partnership relationships between management and unions (see also Deakin et al. 2005). Corporate managers retained room to manoeuvre, which they chose to exercise in a labour cost reduction manner.

2.5. CONCLUSION This chapter has outlined the framework we have used for analysing relations between investors and management practice: investor engagement. We have defined investor engagement in terms of the overall approach followed by investors towards their portfolio companies, within which investor activism, as conventionally understood, is a small subset. We have characterized a spectrum of engagement, featuring five different patterns of investor practices and means of disciplining managers, ranging from indirect or laissez-faire to direct investor control. The higher levels of engagement are characteristic of some types of institutional investor, especially pension funds, and private equity funds. Investor engagement occurs within the context of other influences upon management practice, including product market competition and technological and internal organizational changes. Such contextual factors were outlined in Section 2.3. In Section 2.4, we have provided a brief general outline of the investor characteristics likely to influence investor approaches to engagement, especially time horizon, and indicated the spheres of management practice which might be expected to provide the focus for such engagement. These include the attitude towards investment in intangibles, the approach to innovation and skill development, and the formulation and

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development of corporate strategy, including the role and remuneration of the CEO. The influence of investors is often direct in the above areas. In other areas, such as employment relations, the influence is indirect. Investors, nationally and internationally, have become a major influence on corporate behaviour, an influence sanctioned and fostered by shareholder value. The following chapters analyse different aspects of this relationship. Chapters 3 and 4 focus primarily on institutional investors, whilst Chapter 5 focuses on private equity funds.

3 Institutional Investor Engagement Propensity 3.1. INTRODUCTION The pattern of shareholding in both the USA and the UK changed in the second part of the twentieth century, with the transition from ownership by individuals to institutional ownership, on behalf of individuals. R. C. Clark (1981) called this process ‘the four stages of capitalism’. The first two stages are those described by Berle and Means (1932), the first stage being nineteenth century capitalism, characterized by ‘promoter–investor–manager’, and the second being characterized by separate ownership and control, professional management, and diffused share ownership. The third stage of capitalism reached ‘young adulthood’ during the 1960s in the USA, and was characterized by separate ownership and management of investments, with further professionalization of investment management. This process of financial intermediation involved a separation of the suppliers of capital for investment from those who decided how that capital was to be invested. Finally, the separation of the supply of capital between those who have beneficial interests and those who decide on allocating savings is characteristic of the fourth stage of capitalism. Employee pension funds illustrate this stage most clearly: employees are the beneficiaries but decisions about saving are made by pension fund administrators and fund managers acting on their behalf. Drucker (1991: 144) noted that the twenty largest US pension funds owned approximately 10 per cent of the share capital of US-listed companies in the early 1990s; such ‘pension funds . . . have the responsibility to ensure performance and results in America’s largest and most important companies’. For Drucker, pension funds necessarily had to monitor and engage with the companies in which they invested, as guardians of the long-term interests of American pensioners. Useem (1996) viewed the move from ‘managerial capitalism’ to ‘investor capitalism’ as a consequence of the change in the pattern of share ownership. The move to ownership by institutions led to new investor–manager

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relationships: ‘[t]he developing relationships between investors and managers resemble neither markets nor organizations. Rather, they are emerging as enduring networks, a lattice of informal ties that come to guide a continuous two-way exchange of information and exercise of influence’ (Useem 1996: 6). Such networks can be maintained in various ways, ranging from relational styles of investing to routine information exchanges. The pattern of change in ownership in the UK followed the trend identified by R. C. Clark (1981), Drucker (1991), and G. L. Clark and Hebb (2004) for the USA. The Office for National Statistics (2005) reported that there was a decline in the proportion of shares held by UK individuals in listed companies, from 54.0 per cent in 1963 to 14.1 per cent at the end of 2004. The pattern of change was complex. First, there was a shift towards holdings by UK institutions. By 1993, UK individuals owned only 17.7 per cent of the shares of UK-listed companies, whilst UK institutions (excluding banks) held 61.4 per cent; of these, 31.7 per cent were held by UK pension funds. Most of the debate on UK shareholder activism is based on the view that there has been an increase in ownership by UK institutional investors. Second, however, whilst UK individual holdings had stabilized by 2004, holdings by UK institutions had fallen to 38.1 per cent, with UK pension funds holding only 15.7 per cent. This decline is mainly accounted for by the increased holdings of overseas investors. In 1963, overseas investors held only 7.0 per cent of UKlisted company shares. By 1993, this had increased to 16.3 per cent, doubling to 32.6 per cent in 2004. The Trades Union Congress (TUC 2005) noted: ‘[the] figures on share-ownership show that the proportion of UK equities held by domestic institutional investors is actually in long-term decline. In contrast overseas investors account for a steadily increasing slice of the ownership of UK companies. In addition the rise of hedge funds and, in combination, stocklending has also acted to dissipate institutional power’. The implications of the move to ownership by overseas investors have yet to be fully appreciated in the debates surrounding institutional share ownership and shareholder activism. Furthermore, whilst there has been a shift from ownership by individuals to ownership by institutions, individual institutions rarely hold a sizeable stake in a listed company. Goergen and Renneboog (2002) showed that, in a sample of FTSE 250 Index companies, the average ultimate voting block of the largest block holder was as low as 5.1 per cent for banks, 4.0 per cent for insurance firms, and 7.0 per cent for investment/pension funds. (The proportion of the share capital of the FTSE 100 Index companies held by institutional investors is likely to be much smaller.) For the USA, the average institutional holdings in individual companies are even smaller, the ‘median’ size of the largest block being below the minimum disclosure level of 5 per cent (Mayer 1999: 5).

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However, a coalition of the five largest block holders would have substantial voting power in most listed companies. Several authors saw the change from individual to institutional share ownership as heralding a new era of capitalism, in which institutional investors play an active role (Useem 1996). Institutional shareholders would use their ‘voice’ instead of simply ‘exiting’ from their investments in the event of becoming dissatisfied with a company. Factors which suggest that this exercise of ‘voice’ is a rational strategy for portfolio investors include the growth in passive investment strategies, the acknowledged benefits of diversification, and the negative impact of selling large blocks of shares on the market. Whilst these factors are widely accepted as reasons to intervene, there are also reasons for non-intervention (see Section 3.3). Despite substantial barriers to intervention, governments and other organizations are beginning to put pressure on institutional investors to engage with the companies in which they invest (e.g. Monks 2005). Hence, investor engagement propensity has to be considered against this background of diversity and complexity. Following this Introduction (Section 3.1), Section 3.2 discusses differences amongst institutional investors. Section 3.3 discusses the overall rationale for institutional investor engagement, as well as the factors which inhibit such engagement. In Section 3.4, we discuss the specific occasions for institutional investor engagement, including the emerging movement for corporate social responsibility (CSR). Finally, Section 3.5 is a summarizing conclusion which links institutional investor engagement to shareholder value.

3.2. TYPES OF INSTITUTIONAL INVESTORS Institutional investors are not a homogeneous group. The wide range of investors can be grouped in a variety of ways. One dimension is the extent to which the investor is regulated. For example, pension funds, insurance companies, unit trusts, open-ended investment companies, and investment trusts in the UK and mutual funds in the USA are regulated, whereas hedge funds and private equity funds are largely unregulated. Regulation defines the duties of the trustees, managers, etc., and restricts their investment strategies. The Trustee Act 2000 (HMSO 2000), for example, requires that trustees should have regard to the ‘standard investment criteria’. These include, in relation to a given trust, the need for diversification, as far as is appropriate to the circumstances of that trust. This requirement affects the general characteristics of investment portfolios, and restricts the choice of investment strategies. It

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may, for example, restrict or prohibit institutions from adopting positive and negative screening strategies for responsible investment (see Chapter 4). Other dimensions include: (a) whether the institution is a portfolio investor or a controlling shareholder; (b) whether the investment is held in a diversified portfolio or concentrated in a small number of selected companies; (c ) whether investors have short or long time horizons; (d) whether the target returns are defined in absolute terms, for example, the internal rate of return on the investment, or in relative terms, against a benchmark such as the performance of other institutions or a stock market index; and (e) the way in which the rewards of the fund managers are determined. The extent to which an investor has a controlling shareholding largely determines its engagement methods. The reasons why large or controlling investors may wish to engage are relatively straightforward, since they capture most, if not all, of the benefits of their intervention. The position of portfolio investors is more problematic. Despite the change from individual to institutional share ownership, each institution still generally owns only a small fraction of an individual company’s equity capital. Even the largest institutions usually own far less than 5 per cent of the equity shares of large listed companies (Mayer 1999). Whilst controlling shareholders can exert considerable pressure on a company, including changing its management, it is more difficult for portfolio investors with less than 5 per cent of the capital to exert such pressure effectively. Investors may concentrate their holdings on a selected type or group of companies or hold a diversified portfolio. Investors with diversified portfolios face a particularly wide range of problems with engagement. First, the costs of monitoring and, where required, intervening can be large due to the number of companies in the portfolio. Second, free rider problems are acute, with high transaction costs in acquiring and evaluating a wide range of information, and with the costs of intervention borne by the institution whilst the institution receives only a small proportion of the benefits. The overall monitoring costs for investors with restricted portfolios are less than the costs of investors with a diversified portfolio, whilst the returns from intervention in one company have a greater impact on the overall return on the portfolio. Focus funds, such as the Hermes Focus Funds, enhance their returns by investing in only a limited range of selected companies (see Section 3.3). The time horizon of the investor may be an important factor in determining the approach to engagement. The time horizon for many hedge funds is short, as they seek to exploit market anomalies. At the other extreme are pension funds, investing to meet obligations that fall many years ahead. However, the extent to which an investor with long-term commitments is in fact a long-term

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investor partly depends on the type of portfolio held. For example, institutions adopting a passive investment strategy, such as index tracking, must frequently rebalance their portfolios, since they cannot exclude companies which are significantly loaded on the index. Long-term investors with a more active investment strategy are not necessarily committed to long-term investment in a specific company. The performance of funds may be assessed in either relative or absolute terms. Fund performance is assessed traditionally by comparison with other funds. Hence, funds may be assessed in terms of their ranking in a set of funds, or the quartile or decile in which the performance of the fund is placed. For index-tracking funds, performance is measured against the index. Other funds may be assessed against an absolute measure. This is usually so for hedge funds and private equity funds, where target returns are often expressed in terms of internal rate of return. Finally, the way in which fund managers are rewarded may differ amongst funds. Traditionally, fund managers have been remunerated according to the value of the funds under their management, often through a percentage of their value. Hedge funds and private equity funds have incentive structures, allowing managers to participate in the profits. For example, the most widely used structure for private equity investments is the limited partnership, with general partners usually also senior managers. General partners receive a management fee, 1 to 3 per cent of the committed capital, together with a share of the partnership’s profits (see Section 3.3). How management fees are determined and allocated may therefore affect the incentives of investors to monitor and intervene in investee companies. Whilst it is possible to identify types of institutional investors, it is often difficult to determine who the relevant investor is for understanding investor engagement. For example, most pension funds use external fund managers. Even a large pension scheme, such as Universities’ Superannuation Scheme (USS), only manages a proportion of its funds in-house. Who is the relevant investor in such cases? Different participants in the investment process have different incentives. Although pension fund trustees usually have a long time horizon, the time horizons of fund managers may be short. Fund managers may adopt short-term horizons because of the pressures created by the regular, often quarterly, meetings with trustees (Myners 2001). Although trustees and their advisers report that managers would not usually be dismissed as a consequence of poor performance over one quarter, Myners (2001: 10) concluded: ‘[i]f clients are—as at present—extremely vague about the time horizons over which managers’ performance will be judged, managers will, perfectly rationally, assume that they could be dismissed after any quarter’s performance. This has the potential to encourage managers to adopt an investment

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approach which does not reflect either their clients’ wishes or their long-term interests’. The incentives for fund managers to intervene may therefore differ from those of pension fund trustees.

3.3. RATIONALE FOR INVESTOR ENGAGEMENT The rationale for engagement differs between portfolio investors and those with a large or controlling interest. The development of ‘investor capitalism’, to use Useem’s term (1996), has led to a focus on institutional investors as portfolio investors. Institutional investors may hold a high proportion of shares—in January 2006, institutional investors held 31.84 per cent of US shares (Damodaran 2006). But such investors usually hold only a small fraction of the equity of any one company. Other types of institutional investor may have larger, sometimes controlling interests, in investee companies. This type of investor includes focus funds, especially those with a relational style of investing, some activist hedge funds, and private equity firms. These two groups of investors have different motivations to monitor and engage with the companies in which they invest.

3.3.1. Portfolio Investors Investors who are not satisfied with a company’s performance may—following Hirschman’s terminology (1970)—choose between engaging with the company to bring about changes which will improve performance (‘voice’), not intervening whilst retaining the investment (‘loyalty’), or selling their shares in the company (‘exit’). Exit is usually the rational choice for an investor holding only a small stake in a company. Why, then, do some portfolio investors choose to intervene? Institutional investors have several reasons to adopt engagement strategies. First, investors may risk inadequate diversification if they sell their investment in a company. The costs of engagement are therefore offset by the benefits of continued diversification. Second, the growth in indexed funds has given institutions a strong incentive to seek to increase the value of the market as a whole by targeting, and intervening in, underperforming companies. In addition to the direct contribution to improving any one company’s performance, spillover effects enhance the performance of the market as a whole. Third, the need to counter the increased use of anti-takeover provisions by US companies has strongly encouraged investor intervention. Investors believed that they had an

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overwhelming interest in maintaining the unfettered operation of the market for corporate control, traditionally viewed as the main constraint on corporate management. Although institutional investors may have both the incentives and means to monitor and intervene in companies’ affairs, several factors militate against. The rationale for abstaining from engagement identified by Berle and Means (1932) continues to apply to institutional investors. The large size of institutional investor holdings should act as a partial correction to free rider problems. However, although the monetary value of shares held by an institutional investor in a company may be large, the proportion of the total equity held is likely to be small and the leverage limited, as shown above (see Section 3.1). The institutional investor is thus in a position similar to that of the individual in a diffusely held company: the investor pays the full costs of monitoring and intervening, when necessary, but gains only a fraction of the resulting benefit. Where costs are disproportionate to the expected benefits, the investor has limited incentive to monitor and intervene. Where institutional investors hold only a small fraction of the shares in any one company, they face the same free rider problems as individual investors; the transition from individual to institutional investors may modify free rider problems, but cannot eliminate them. In addition, competition amongst institutional investors, and their associated fund managers, to demonstrate superior performance, reduces the incentive to enhance the performance of a company whose shares are held by several institutional investors. (Unless, of course, a particular institutional fund is over-weighted and has a higher proportional gain from any benefits of intervention, which could result in its superior performance relative to that of other institutional funds.) Even in the absence of free rider problems, the capacity and ability of institutional investors, and of fund managers acting on their behalf, to monitor the companies in which they invest may be limited. The level of expenditure on monitoring is constrained by the level of management fee income. Even the most active institutional investors are believed to spend less than half a basis point on governance activities. Moreover, if institutional investors have little incentive to monitor the companies in which they invest, they have even less incentive to intervene in their affairs. First, the free rider problem is as valid for intervention as it is for monitoring. Second, the institution acts as agent for the beneficial owners of the assets in the fund; whilst the costs of intervention are frequently borne by fund managers, most of the benefits of intervention accrue to the beneficial owners. This is particularly the case where fund managers receive a fixed fee, irrespective of changes in the value of the funds under their management:

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[b]ut overall shareholders have been rather lax in engaging. The great problem for fund managers is that we are not paid to do it and it is a very expensive process. If you are going to do it properly—engage with companies and do more than just tick the boxes—it becomes very expensive to have good quality, reasonably senior people on board to do the job. (Ross Goobey quoted by Toyne 2003)

The institutional investors who engage with the companies in which they invest often subcontract this responsibility to their fund managers, without additional reward. Third, fund managers depend on investee companies for soft information about their affairs. Intervention may jeopardize access to this information. Fourth, market players may perceive intervention as indicating company problems, thus depressing the investee company’s share price. Finally, clients continually monitor the performance of fund managers. Consequently, fund managers have an incentive to focus on short-term performance measures; any benefits of intervention are likely to be obtained only in the long term. Institutional investors not only lack incentives to intervene in an investee company’s affairs, but intervention itself may create problems. An institution may need to increase its share holding, in order to acquire leverage to intervene effectively, but this would restrict the liquidity of the fund. Placing one of its employees on the board of directors would also reduce the liquidity of the fund, since insider trading rules may make it difficult for the institution to trade in the company’s shares, as well as result in conflicts of interest: the director’s fiduciary duty to the company may conflict with his or her duty to the investing institution. There may also be some pressures on institutional investors to avoid intervening in an investee company’s affairs. First, intervention may have negative political consequences if there is public concern about ‘interference’ with legitimate business decisions. Second, conflicts of interest may discourage intervention or voting against the adoption of certain management resolutions (Myners 2001: 91): ‘[f]und management firms may be keen to attract or to keep a contract to manage the pension of the company in question—or they may be part of a wider financial organisation, which wants, for example, the investment banking or insurance business of that company’. Fund managers do not wish to be known as ‘troublemakers’, as this may make it more difficult for them to attract new business (Myners 2001: 91). In this context, shareholder activism may restrict the ability of institutions to market their financial services: ‘[a]ll major institutions have significant conflicts of interest; all but public pension funds have incentives to keep corporate managers happy. For each, conflicts of interest will tilt the voting calculus to some extent away from maximizing share value’ (Black 1990: 606). In many investee companies, the

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finance directors are also trustees of the companies’ pension schemes, increasing the importance of fund managers maintaining good working relations with them. However, external pressures may encourage investor engagement. The British New Labour Government believes that institutional investors should be involved in the companies in which they invest. This approach originated in the Company Law Review Steering Group Final Report on Modern Company Law for a Competitive Economy, the Myners’ Report (2001). The Company Law Review Steering Group, established by DTI in 1998, concluded that two factors inhibited intervention by institutional investors: conflicts of interest and a failure to take their fiduciary responsibilities seriously. The Myners’ Report (2001: Paragraph 79) was ‘particularly concerned by the value lost to institutional investors through the reluctance of fund managers to actively engage with companies in which they had holdings, even where they had strong reservations about strategy, personnel or other potential causes of corporate underperformance’. One possible approach considered by government, directed at pension fund management, was to impose a statutory duty to intervene in investee companies, where this was in the best interests of the fund. The British regulatory framework requires and facilitates institutional investor engagement. This framework is enshrined in The Combined Code on Corporate Governance (Financial Reporting Council 2006), ISC’s Responsibilities of Institutional Shareholders and Agents: Statement of Principles (Institutional Shareholders’ Committee 2002), and in the Company Law Reform Bill (House of Commons 2006). The Combined Code on Corporate Governance (Financial Reporting Council 2006) requires institutional shareholders to: (a) make considered use of their votes; (b) enter into a dialogue with investee companies, where practicable, based on a mutual understanding of objectives; and (c ) give due weight to all relevant factors drawn to their attention when evaluating investee companies’ corporate governance arrangements. At the same time, The Combined Code on Corporate Governance requires investee companies to enter into a dialogue with institutional shareholders based on a mutual understanding of objectives. Similarly, ISC’s Responsibilities of Institutional Shareholders and Agents: Statement of Principles (2002), which outlines best institutional investor practice, identifies the responsibilities of institutional investors in respect of the companies in which they invest. In particular, institutional investors are required to: (a) set out their policies on how they will discharge their responsibilities; (b) monitor the performance of and establish, where necessary, a regular dialogue with investee companies; (c ) intervene, where necessary; (d) evaluate the impact of their engagement; and (e) report back to clients/beneficial owners. Finally, the New Labour Government’s view of the role of shareholders is reflected in its Company

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Law Reform Bill White Paper (DTI 2005b: 16): ‘[t]he Government believes that companies work best where the respective roles and responsibilities of directors and members or shareholders are clearly understood, where there is effective communication and engagement between directors and shareholders, and where there are efficient mechanisms for taking decisions critical to the running of the company’. This position was carried forward into the Company Law Reform Bill (House of Commons 2006), which followed the Company Law Reform Bill White Paper (DTI 2005b): ‘enhancing shareholder engagement and a long-term investment culture’ is one of the four key objectives of this piece of legislation (House of Commons 2006: 30). The views of institutional investors on good corporate governance are reflected in—and formed by—codes of best practice. These have been developed by individual institutions, industry bodies, other organizations such as stock exchanges, governments, and multinational bodies such as the Organisation for Economic Co-operation and Development (OECD). The codes of best practice reflect the views of the issuing organization, taking into account national institutional characteristics. In the UK, codes of best practice on corporate governance were developed initially within industry organizations, the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF), and by ISC. The ISC issued The Responsibilities of Institutional Shareholders in the UK in December 1991 and outlined its expectations regarding corporate governance between 1991 and 1993 in a series of statements of best practice. These covered five areas. (i) institutional investors had an obligation to exercise their influence in a responsible manner—in particular, they were encouraged to enter dialogue with investee companies; (ii) institutional investors should use their votes positively, to support boards of directors, ‘unless they have good reason for doing otherwise’; (iii) institutional investors were to take action to remedy any weaknesses perceived in the operation of boards of directors; (iv) whilst the remuneration of directors and senior managers was seen as a matter for the board and dealt with through an independent remuneration committee, ISC recommended that there should be adequate public disclosure of the principles used in determining the level of remuneration. Finally, ISC recommended how institutional investors should deal with takeover bids. The ISC statement on the role and duties of company directors matched that on institutional investors, and included the following recommendations: (a) a company’s articles of association should indicate the maximum number of directors and provide that, each year, a third of the directors are subject to retirement by rotation; (b) the roles of chairman of the board of directors and CEO should usually be separated; (c ) there should be sufficient independent non-executive directors to monitor the performance of executive directors; (d) service contracts should

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be approved by remuneration committees, with a majority of non-executive directors; (e) ‘rolling’ contracts should run for more than three years; and ( f ) details of any performance-linked remuneration schemes or share option incentive schemes should be given in the company’s annual report.

3.3.2. Large (and Controlling) Shareholders In contrast to portfolio investors, who hold only a small percentage of an investee company’s equity, some investors hold large, and possibly controlling, stakes in the companies in which they invest. Three types of investors fall into this category: private equity funds, activist hedge funds, and focus funds. The incentives to engage with investee companies differ amongst these types. The managers of private equity funds and hedge funds share in the returns generated from the funds’ assets (see Chapter 5 for private equity funds). To reflect this incentive, private equity firms usually adopt limited partnership structures, consisting of general partners, who are usually responsible for managing the partnership’s investments, and limited partners, who are the main investors (see Burgel 2000; Peacock and Cooper 2000; Myners 2001). General partners usually receive 1–3 per cent of the committed capital in management fees, together with a share of the partnership’s profits, referred to as carried interest. This share of the partnership’s profits is the core of the incentive structure, and is typically set at 20 per cent of the net profit of the partnership. Early agreements usually calculated profit on individual investments; more recent agreements generally calculate profit based on the return on the partnership’s portfolio. Many partnership contracts include a hurdle rate, which may be a pure hurdle rate, where profits in excess of the hurdle are shared between limited and general partners, or a catch-up hurdle rate where limited partners have preferential access to profits below the hurdle (Burgel 2000). Focus funds such as Hermes in the UK invest a large portion of their funds in relatively few companies, aiming to outperform the main indices. One particular type of focus funds invests in companies perceived to be underperforming and then uses relational investment strategies to improve their performance. Lens Investment Management LLC founded by Robert Monks and Nell Minow in 1991 illustrates this approach in the USA—its investments outperformed the S&P 500 index over the period from its inception to its closure in 2000 (Lens Investment Management LLP 2006). Hermes Focus Funds adopted a similar approach—invest, engage, and then divest—in the UK. Their strategy was to invest in underperforming companies, where Hermes Focus Funds expected to engage successfully and achieve an improvement on

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the then current share price value of at least 20 per cent. Hermes Focus Funds invested in only forty-one companies between the beginning of 1999 and the end of 2004 (Becht, Franks, and Mayer 2006). The incentives of large and controlling shareholders to engage with the companies in which they invest are different from those of portfolio investors. First, the size of their holdings allows them to capture more of the financial benefits of intervention than portfolio investors do. Hence, there is a greater likelihood that these benefits exceed the costs of shareholder engagement. Second, the size of their holdings also provides them with the leverage to influence the managements of investee companies. This is particularly true where the shareholdings are not only large but also controlling. Finally, the incentive structure often allows not only beneficial holders but also fund managers to receive the financial benefits of intervention. 3.4. AREAS OF POTENTIAL INSTITUTIONAL INVESTOR ENGAGEMENT A variety of specific institutional investor concerns may lead to investor engagement. First, poor company performance (Section 3.4.1), particularly as reflected by share price decline, frequently triggers engagement. Second, corporate governance (Section 3.4.2) concerns may also lead to institutional investor engagement. Good corporate governance practices and structures are viewed as associated with superior company performance or, at least, as protection against poor company performance. Third, CSR (see Section 3.4.3) issues are becoming priorities for some institutional investors. Some institutional funds include only ‘ethical’ investments (positive screening) or exclude those regarded as unethical (negative screening). Other institutional funds, with portfolios diversified to the extent that positive and negative screenings are no longer possible, engage with investee companies to promote CSR. Fourth, strategic issues—such as senior executive remuneration (see Section 3.4.4) and corporate strategy (see Section 3.4.5)—may prompt institutional investors to engage. In particular, activist hedge funds engage in acquisitions and disposals, company financial structures, and overall strategies. The propensity to engage, and the likely success of engagement, is mediated by ownership structure. In particular, it is more difficult for institutional investors to engage with portfolio companies where there is a high level of insider share ownership than it is to engage with portfolio companies where there is a low level of insider share ownership. It is also difficult for institutional investors to engage with portfolio companies where a large shareholder,

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for example a family block holder, can determine the outcome of intervention. Hence, in the J. Sainsbury plc case (see Section 4.4.2) the shares owned by the family were voted differently from those of institutional investors in favour of change. The votes on the resolution to approve the Directors’ Remuneration Report for the year to 27 March 2004 were 865,151,050 votes (71.4 per cent) for, and 346,566,638 votes (28.6 per cent) against, with the majority based largely on the votes of the family. Of the 865 million shares voted in favour of the resolution, it is thought that about 680 million were owned by the Sainsbury family (The Guardian 2004b)—the resolution would have been rejected without them. The engagement incentives for institutional investors are thus small when outcomes are likely to be determined by family block holders anyway. [However, even voting defeat may result in change: Peter Montagnon, head of investments at ABI, was reported to have claimed that the Sainsbury vote was ‘a clear mandate to the incoming chairman to put the remuneration policies and process right and do whatever it takes to put it right’ (ibid.). His reported claims were subsequently met.] This link between propensity to engage and ownership structure is generally supported by findings in the empirical literature. Bizjak and Marquette (1998) and Carleton, Nelson, and Weisbach (1998) found lower levels of insider than of institutional ownership in targeted companies, although Karpoff, Malatesta, and Walkling (1996) did not find these levels statistically significant. Karpoff, Malatesta, and Walkling (1996) and Bizjak and Marquette (1998) also reported higher concentrations of institutional than of insider ownership in targeted companies, but Carleton, Nelson, and Weisbach (1998) failed to find such a difference.

3.4.1. Company Performance Poor company performance, which may be reflected directly in the company results or indirectly in the share price, is the main trigger for extraordinary institutional engagement. A portfolio company performing poorly relative to the sector, a sector performing poorly relative to the market, or indeed the fund performing badly compared with its peer group usually triggers actions by funds and/or fund managers. The Universities’ Superannuation Scheme (USS), for example, seeks to understand the reason for poor performance, either through the fund manager and/or broker, and/or through meetings with the portfolio company, before acting more energetically. The view that extraordinary actions by institutional investors are triggered by poor company performance is generally supported by findings reported in the, mainly US, literature. Studies of the characteristics of portfolio companies

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targeted by institutional investors listed one or more of the following: (a) share price performance in the pre-targeting period; (b) accounting measures of performance in the pre-targeting period; and (c ) ownership structure. Opler and Sokobin (1997) found that companies selected for the Council of Institutional Investors (CII) focus list exhibited poor share price performance relative to the S&P 500 and relative to other firms in the same industry, and matched companies in the period prior to their inclusion in the list. Similarly, M. P. Smith (1996) found negative returns in the pre-targeting period in a study of California Public Employee Retirement System (CalPERS)-targeted companies. Wahal (1996) too found that companies underperformed the market in the two years prior to targeting, but also that they came from industries which themselves underperformed the market. Finally, Bizjak and Marquette (1998) found that companies with institutional investor proposals to rescind poison pills had a significantly lower three-year abnormal return relative to a value-weighted index. On the other hand, Karpoff, Malatesta, and Walkling (1996) and Carleton, Nelson, and Weisbach (1998) did not find differences in pre-targeting performance in a study of Teachers’ Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF)targeted companies. Several different accounting measures have been used to identify performance differences prior to targeting. Karpoff, Malatesta, and Walkling (1996) found that companies receiving proposals had lower market-to-book ratios, operating returns to sales, and recent sales growth than control companies. Bizjak and Marquette (1998), using operating cash flow as a performance measure, found evidence of poorer performance in targeted firms. However, Opler and Sokobin (1997), also using this measure, did not find much evidence of poorer performance prior to inclusion in the CII focus list. Wahal (1996) showed that targeted companies had lower return on assets for two years and one year prior to targeting. The general picture that emerges is of targeted firms having poor pretargeting performance, measured both in terms of share price performance and using accounting measures. (Differences in sample and time period selections may account for differences in findings.) However, engagement criteria differ amongst institutional investors, and they may also change over time. For example, Carleton, Nelson, and Weisbach (1998: 1338) noted that, for US institutional investors, ‘the criteria for targeting [intervention] vary dramatically with institutions. Some institutions, such as the Colorado Public Employees Retirement System, have targeted firms based solely on performance, whilst others, such as TIAA-CREF, target firms based on specific governance objectives. Other activist pension funds (for example, CalPERS) have used a combination of governance issues and

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performance measures in their targeting criteria’. In addition, poor performance in combination with other factors may lead to institutional investor engagement. Hebb (2004) noted that many recent corporate scandals, such as Enron, WorldCom, Parmalat, and Hollinger International, involved companies that had strong company performance but low transparency, and that activist institutional investors believe that there is a link between the two. She also noted that poor performance on its own was not sufficient to generate action by institutional investors: many appeared willing to maintain investments in poorly performing investee companies which exhibited high levels of transparency. In the UK, the institutional investors’ action against J. Sainsbury plc targeted both company performance and corporate governance issues (see Section 4.4.2).

3.4.2. Corporate Governance Thomas and Cotter’s study (2005) of the US 2002, 2003, and 2004 proxy seasons reported that about 41 per cent of shareholder proposals relate to corporate governance issues, both external and internal. Most of the resolutions falling in the external corporate control/governance area concern redemption, poison pills, and the repeal of classified boards. Poison pills and classified boards are viewed as inhibiting the market for corporate control, making takeovers more difficult, and reducing shareholder value. An alternative view is that, on the contrary, by having to pay more rather than less to acquire the company, bidders will increase shareholder value (Comment and Schwert 1995). Coles and Hesterly (2000) suggested a negative abnormal return where a company with an independent director minority announces a poison pill/classified board provision, but a positive abnormal return where a company with an independent director majority did so. The impact of poison pill/classified board provisions on shareholder value is therefore mediated by the internal corporate control/governance characteristics of the company. Internal corporate control/governance issues usually concern board structure, composition, and processes. The most frequent issues for shareholder proposals relate to independent board chairmen, cumulative voting, and the independence of the board and board committees. UK investors have similar concerns to their US counterparts, although cumulative voting has not been considered in the UK. Despite institutional investor concern with internal corporate governance, there is little evidence that the adoption of best corporate governance practices will necessarily lead to superior company performance. Dalton et al. (1998) and Hermalin and Weisbach (2003) suggested that there is no relationship

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between company performance and: (a) board balance between independent and other directors; and (b) separation of the positions of CEO and chairman of the board of directors. The absence of significant statistical relationships between company performance and board composition and structure may not, however, mean that there are no relationships between company performance and board characteristics, since board characteristics may be viewed as endogenously determined (Hermalin and Weisbach 2003). For example, poor company performance is likely to lead to pressures to increase the independence of the board of directors, or to separate the positions of CEO and chairman. This suggests that institutional investors may regard good corporate governance practices as a protection against poor company performance, rather than as a means of ensuring good performance. This is consistent with the view that changes in board structure follow poor performance. It is also consistent with the view that the role of the board of directors is to monitor management actions and act in situations of potential conflict of interest between managers and company, and to abstain from intervening in ongoing operations when the firm is performing adequately.

3.4.3. Corporate Social Responsibility The range of legitimate institutional investor interests is widening, with the growth of the CSR movement, and engagement is increasingly focused on social and environment issues. The way in which the UK Government views corporate governance also reflects these issues. The New Labour Government sees institutional investors as a means of holding corporations to social as well as economic obligations. An expanded conception of corporate responsibility is thus enshrined in The Company Law Reform Bill (DTI 2005a: 69: Clause 156) which requires directors to ‘promote the success of the company for the benefit of its members as a whole’, and to have regard for: (a) the likely consequences of any decision in the long term; (b) the interests of the company’s employees; (c ) the need to foster the company’s business relationships with suppliers, customers and others; (d) the impact of the company’s operations on the community and the environment; (e) the desirability of the company maintaining a reputation for high standards of business conduct; and ( f ) the need to act fairly as between members of the company.

The Company Law Reform Bill incorporates the principle of ‘enlightened shareholder value’. The concept of CSR is not new. Vogel (2005) described an early phase of CSR developing in the USA following a US court decision in 1954 that the management of Standard Oil of New Jersey had discretion to make a gift to

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the engineering school at Princeton University. By the 1960s, many large companies set aside a proportion of their profits for philanthropic purposes, often by means of a foundation. Vogel (2005) noted that, although there was peer pressure for companies to become more philanthropic, it was not assumed that less philanthropic companies would be less profitable. The growth of corporate philanthropy was not unchallenged. In 1970, Milton Friedman (p. 1) questioned the place of social responsibility in business: [t]he businessmen believe that they are defending free enterprise when they declaim that business is not concerned ‘merely’ with profit but also with promoting desirable ‘social’ ends; that business has a ‘social conscience’ and takes seriously its responsibilities for providing employment, eliminating discrimination, avoiding pollution and whatever else may be the catchwords of the contemporary crop of reformers. In fact they are, or would be if they or anyone else took them seriously, preaching pure and unadulterated socialism.

He argued that managers had a direct responsibility to the owners of the business, and that this generally meant that they ‘will make as much money as possible while conforming to the basic rules of society’. Social responsibility was justified only when it contributed to the benefit of the company’s owners, if necessary long-term, for example in improving the educational standards of potential employees. The conception of social responsibility as a means of enhancing the long-term interests of the corporation underlies what Vogel (2005) called ‘the new world of CSR: doing good to do well’. CSR is now associated with company performance, with socially responsible companies being viewed as more profitable than the others, in the long run. Ethical or responsible investment has developed alongside the utilitarian conception of CSR. Ethical investment had its origins in the church, in both the USA and the UK, with the desire to integrate Christian beliefs with responsible management of the church’s financial assets. The general approach to responsible investment by churches in the UK has been based on exclusion, for example avoiding investment in companies engaged in armaments, alcohol, and gambling. Friends Provident Stewardship Fund was the first ethical fund to be offered to the public in the UK. Launched in 1984 by Friends Provident, an insurance company established on Quaker values, the fund excludes companies in certain sectors, mainly armaments, alcohol, and gambling, and includes shares in companies on an ethical list. A number of other financial institutions followed Friends Provident and introduced ethical funds. At the end of 1999, the ethical mutual funds market was estimated at over $6,390 million in the UK, and $153,000 million in the USA (Bauer, Koedijk, and Otten 2002: 18).

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The main strategies adopted by ethical funds were positive and negative screening. A third strategy has emerged more recently, involving engagement with companies on ethical, social, and environmental issues (IMA 2005b). Ethical issues include bribery, corruption, and responsible marketing of products and services. Social issues include human rights, community relations, health and safety at the workplace, and issues in the management of the supply chain, for example, the employment practices of suppliers. Environmental issues include climate change, the use of resources, and biodiversity. This strategy now covers a wide range of institutional investors, including pension funds, insurance companies, and a variety of pooled investment vehicles. The growth in shareholder activism on social and environmental issues reflects both economic and moral concerns. Economically, the perceived benefits of diversification within investment portfolios, and the recent requirements of trustees to consider these in their management of funds on behalf of beneficiaries, restrict the scope for using positive and/or negative screening of investments. To reconcile the goals of responsible investment and diversification, institutional shareholders may engage with the companies in which they invest, rather than exclude them from their portfolios. Hawley and Williams (2000, 2002) explained investor engagement on social and environmental issues in terms of the concepts of ‘fiduciary capitalism’ and ‘universal owner’. ‘Fiduciary capitalism’ describes the third stage of corporate capitalism, in which share ownership is concentrated in the hands of fiduciary institutions such as pension funds and mutual funds (R. C. Clark 1981). ‘Fiduciary capitalism’ represents more than a simple change in the way in which shares are held. Institutional shareholders have different incentives and behaviour patterns from those of individual investors and, as ‘universal owners’, depend on the performance of the economy as a whole rather than on the performance of each individual company in the portfolio. The interests of ‘universal owners’ such as USS extend beyond macroeconomic policy issues to include regulatory concerns and the provision of public goods such as health care and education. According to its Statement of Investment Principles (USS 2006: 2), the USS objective is ‘to maximise the long-term investment return on the assets having regard to the liabilities of the scheme and the desirability of maintaining stable contribution rates’. The securities component of the fund is managed by a number of discretionary specialist managers and index tracking, and enhanced index tracking, managers; the property portfolio is managed internally. The appropriate distribution of assets within USS is UK equities 40 per cent, overseas equities 40 per cent, fixed interest 10 per cent, and property 10 per cent. The approximate allocation of the securities portfolio is 55 per cent internally

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managed balanced funds, 15 per cent index tracking/enhanced index tracking funds, and 30 per cent externally managed specialist funds. Generally no more than 4 per cent of the assets can be invested in any one company, and USS may not hold more than 10 per cent of the market capitalization of any one company without prior authority from the chairman of the investment committee. USS seeks to follow a long-term enlightened shareholder value conception of the role of the institutional investor, and aims to be ‘an active and responsible long-term shareholder of companies and markets in which it invests’ (USS 2006: 7). It believes that encouraging responsible corporate behaviour protects and enhances the value of its investments. More specifically, USS (2006: 7) requires its fund managers ‘to pay appropriate regard to relevant corporate governance, social, ethical and environmental considerations in the selection, retention and realisation of all fund investments’. The USS management committee reviews and, where appropriate, updates its corporate governance and social, ethical, and environmental policies, to ensure that they are consistent with good institutional investor practice. In return, fund managers (both internal and external) have to use their influence to promote good practice in the companies in which they invest and the markets in which they are significantly exposed. They also have to monitor the companies in which they invest, or in which they are likely to invest, on corporate governance and social, ethical, and environmental issues. Where this is likely to be effective, they have to further collaborate with other institutional investors to encourage company managers to address these issues appropriately. Finally, as a part of the engagement strategy with companies, USS uses its voting rights ‘in a prioritised, value-adding and informed manner’ (USS 2006: 7). In addition, USS has a responsible investment strategy, supported by a team of three specialists. This is based on engagement rather than screening, and is thus consistent with USS being a ‘universal owner’: [o]ur strategy is based on active engagement with the companies whose shares we hold. This involves dialogue about acceptable standards of corporate governance, environmental, ethical and social performance. This dialogue is professionally planned and when needed, robust. Engagement also involves work to shape the context in which company-specific discussions take place. . . . Apart from the moral issues involved, proper assessment of the reputational impact of the company’s performance on these wider fronts is increasingly material to investment considerations. (USS 2004)

Under this strategy, and in collaboration with other institutional shareholders, USS develops corporate governance policies for UK and US companies;

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engages with oil and gas companies on a variety of social and environmental issues; and ensures that companies operating in Myanmar are fully aware of the risks involved and comply with best practice. Two such collaborative USS projects, one on climate change and one on the health care crisis in emerging markets and the role of pharmaceutical companies, illustrate the link between shareholder value, institutional investor engagement, and CSR. The project on the health care crisis in emerging markets and the role of pharmaceutical companies involves several institutional investors. Its objective is ‘to encourage the [pharmaceutical] sector to address the risks associated with public health crisis in poor countries/emerging markets and to raise awareness amongst the sector’s investors/analysts of the importance of this debate about affordable access’ (Pharmaceutical Shareowners’ Group not dated). The pharmaceutical sector business model, which is based on patents to protect investments in risky R&D projects, and the long-term performance of pharmaceutical companies would be under threat if governments, for example, were to weaken the patent protection in emerging markets or impose price caps on pharmaceutical products. The project on climate change is even larger and more ambitious. USS (2004) identified its status as a ‘universal owner’ and the long-term needs of its pension beneficiaries as reasons for institutional investor concern with climate change. According to the report on climate change commissioned by USS (G. T. Davies 2003: 5), if climate change threatens economic development, and especially if there are many or significant impacts, it will also therefore be likely to undermine the ability of pension funds and other institutional investors to fulfil their aims, so it is in their interests to see that risks associated with climate change are minimized. Whilst this responsibility is widely shared, institutional investors are uniquely suited to take particular actions.

3.4.4. Senior Executive Remuneration Institutional investors are less concerned with the actual amounts paid to senior executives and more with the structure of the remuneration package and the relationship between this and company performance. Share-based schemes, especially share option schemes, are an area of particular concern. In the UK, ABI (2005) issued guidance on share-based schemes to companies which seek to limit the dilution of existing shareholders’ interests and, as far as schemes for senior executives and directors are concerned, to ensure that effective performance conditions are included in the scheme structure. ‘Share incentive schemes should emphasise the importance of linking remuneration to performance, limits on dilution and individual participation, and a structure that effectively aligns the long term interests of management with

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those of shareholders, having due regard to the cost of the schemes, which should be disclosed’. (ABI 2005:) Institutional investors may exert influence and control over such schemes through their voting rights. The J. Sainsbury plc case (see Section 4.4.2) illustrates the importance of the link between senior executive remuneration and company performance as a trigger for institutional shareholder activism.

3.4.5. Corporate Strategy Institutional investors may engage with portfolio companies to bring about changes in their corporate strategy, especially in their acquisition and disposal polices, their capital structures, and the way they finance their assets. Institutional investors’ role in corporate strategy is largely invisible, an aspect of the continuous routine engagement process (see Section 4.2). However, internal conflicts between institutional investors and senior executives may result in public, visible influence. For example, the proposed takeover of the London Stock Exchange (LSE) by Deutsche Börse at the end of 2004 was opposed by a group of institutional investors who regarded the acquisition as a form of corporate empire building rather than an attempt to enhance shareholder value. The Children’s Investment Fund Management, a Londonbased hedge fund which held more than 5 per cent of Deutsche Börse’s shares, indicated that it thought the takeover would destroy shareholder value and recommended that Deutsche Börse buyback some of its own shares instead. The takeover was blocked by The Children’s Investment Fund Management and other institutional investors, and the Deutsche Börse Chairman and CEO were removed (Cohen 2005; Stevenson 2005). Institutional investors may also change the way in which companies are financed. In particular, they may wish companies with strong cash flows to increase their gearing and buyback shares. Jensen’s free cash flow theory (1986) offers a partial explanation: the managers of companies with free cash flow, that is cash flow in excess of that required to fund projects with positive net present values, have incentives to grow the companies beyond their optimal sizes. Although managers could promise to pay the free cash flow out to shareholders, such promises are nonbinding. However, if part of the share capital is replaced by debt, managers are bound to meet the interest payments, thereby reducing the cash flows available for discretionary use by managers. To increase earnings per share (EPS) is another possible reason for replacing part of the equity by debt, although this may not lead to a change in the value of the company (Dobbs and Rehm 2005).

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3.5. CONCLUSION Institutional investors are not a homogeneous group. Some exist in a regulated environment, whilst others are largely unregulated. Regulation can affect the type of portfolio an investor holds, and the investment strategies it adopts. For example, regulated investors may be required to hold broad portfolios which, should they wish to be ‘responsible investors’, restricts their use of positive and/or negative screening. Other factors further differentiate institutional investors: (a) whether the proportion of the issued share capital of the investee company held by investor is low or high; (b) whether the investor’s assets are in a diversified portfolio of companies or concentrated in a small number of companies; (c ) whether the investor’s time horizon is short or long; (d) whether the investor aims to achieve absolute returns or better returns than its peers; and (e) the way in which the rewards of the fund managers are determined. These characteristics determine both the incentives of institutional shareholders to monitor and engage with the companies in which they invest, and the issues on which they engage. When attempting to understand the institutional investors’ incentives for engagement, and the issues on which engagement focuses, there are often problems in determining the identity of the relevant actor as some, or all, of the institutional investors’ assets may be managed by others. For example, part of a pension fund’s assets may be managed by fund managers and the remainder may be invested in hedge funds and/or private equity funds. Should the analysis focus on the beneficial owners or on those managing the assets on behalf of the beneficiaries? Unless the beneficial owners establish incentives to align their interests with those of the managers of their assets, the relevant actors are probably the asset managers. Complex agency problems may thus arise. Institutional investors’ reasons to become involved with the companies in which they invest were considered in this chapter against this complex background. Institutional investors with large, and possibly controlling, interests have incentives to engage because they receive a major proportion of any benefits of engagement. Also, because of the size of their stakes in investee companies, intervention can be relatively straightforward. This does not apply to portfolio investors, who usually own a very small proportion of any one company’s equity. Many have seen the shift from shares being held by individuals to shares being held by institutions as signalling an era of shareholder dominance. However, institutional portfolio investors are often in very much the same position as individuals, since they rarely hold more than a very small fraction of a company’s share capital. The rational strategy for such an investor would often be either ‘exit’ or ‘loyalty’. Nevertheless, institutional portfolio

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investors have been increasingly adopting ‘voice’. This is because many of them adopt passive investment strategies, which make ‘exit’ problematic, and also because there may be a spillover of action against one company to other companies in their portfolios. Against these reasons for intervention, it is possible to identify several reasons why intervention is not desirable, including costs and potential conflicts of interest. Institutional investors engage with investee companies to promote change, mainly when companies are perceived to be underperforming, when they have poor corporate governance structures, or for ethical, social, or environmental reasons. Engagement with underperforming companies can be viewed as being motivated by concern with the destruction of shareholder value. In a similar way, engagement with companies to improve their corporate governance structures may also be motivated by shareholder value since better corporate governance may be viewed as leading to improved company performance or, more convincingly, as a protection against poor performance. As pressure for changes in corporate governance usually follows a decline in shareholder value, it would seem that institutional investors’ primary concern is with performance, directly or indirectly. Finally, CSR is now associated in part of the management literature with company performance, and pressure to improve ethical, social, and environmental practices can also be seen to be linked to concerns about shareholder value. Shareholder value and the institutional development of mechanisms of capital investment have given great potential influence to institutional investors and to fund managers acting on their behalf. This chapter has described the propensity of institutional investors to engage with the companies in which they invest. We have concentrated on pension funds, as the institutional investors with the longest time horizons and the highest propensity to engage. Pension fund trustees are required to manage the assets under their responsibility with ‘the degree of diligence that an ordinary prudent man would take, if he were minded to make an investment for the benefit of other people, for whom he felt morally bound to provide’, to quote DTI’s Consultation Paper on Encouraging Shareholder Activism (2001: 12). Such guidance leaves wide scope for discretion to trustees and fund managers—diligence, prudence, and moral obligation do not provide precise guidance for investor decisionmaking. In the absence of more precise requirements, the British Government feels that institutional investors have been too hesitant to engage with the companies in which they invest, citing ‘a broader culture of non-intervention’ amongst fund managers (DTI 2001: 5). The British Government is therefore minded to strengthen the requirements on pension trustees, leading to more forceful pressure on fund managers to engage with the companies in which they invest, in the pursuit of ‘enlightened shareholder value’. Some writers

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(e.g. Williams and Conley 2004) have advocated investor engagement to realize a broad conception of enlightened shareholder value, especially appropriate for pension funds with long-term commitments to their beneficiaries. Some pension funds, such as USS, have endorsed such conceptions. However, fund managers are generally reluctant to transform their culture and/or to undertake activities which they see as under-rewarded. It is perhaps not surprising that discussion of investor engagement, in the context of company law reform, has been protracted, with proposals debated in the late 1990s still not enacted.

4 Forms of Institutional Investor Engagement 4.1. INTRODUCTION Institutional investor engagement is routinized in corporate practice, with meetings amongst investors, fund managers, and senior executives as part of the annual corporate calendar. Engagement intensifies when investors become concerned about company performance, whether for economic reasons (e.g. share price performance, profitability, or trends in market share), for corporate governance failures (e.g. over managing CEO succession), or for specific deficiencies in management practice (e.g. excessively generous senior management remuneration packages). The actual form taken is likely to differ between routine engagement and extraordinary engagement (Stapledon 1996). Shareholder value legitimizes investor engagement for both institutional investors and corporate management, and structures the interpretive framework used in their relations. The routine forms of engagement are important because they institutionalize this interpretive framework, rather than because they constitute means of exercising direct institutional investor power over corporate management. Institutional investors and corporate managers share the expectation that investors should be satisfied with corporate performance, an expectation reinforced by inter-organizational and organizational routines. However, institutional investors’ expectations may be disappointed, and relations between investors and corporate management may become strained, leading to extraordinary engagement. Such engagement may take the form of direct action by investors or their agents, either individually or, more likely, collectively to remedy institutional investors’ concerns. Following this short Introduction (Section 4.1), Sections 4.2 and 4.3 examine routine and extraordinary institutional investor engagement respectively. Chapter 4 concludes with a brief summary in Section 4.4.

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4.2. ROUTINE INSTITUTIONAL INVESTOR ENGAGEMENT Institutional investors routinely engage with the companies in which they invest. They monitor investee companies through desk research, using a variety of information sources including market information, company financial reports, and analysts’ reports. Rating agencies, such as Standard and Poor’s, and the business media, especially the Financial Times in Britain and the Wall Street Journal in the USA, provide supplementary information. In addition, institutional investors usually meet with the senior management, normally the CEO and chief financial officer (CFO), at least once a year; they expect senior managers to make themselves available as required, an expectation usually met. Institutional investors usually vote on resolutions, in the large majority of cases supporting management proposals. In addition, through their routine meetings with investee companies, institutional investors and their representatives influence management in specific aspects of their strategy and management practices.

4.2.1. Meetings Historically, the arm’s length market relationship between institutional investors and the companies in which they invest did not require extensive contact. Since capital mobility and financial markets were the means of maximizing shareholder value and disciplining corporate management, laissezfaire and distance were appropriate. This separation was reinforced by ‘corporate arrogance’ on both sides (Joint City/Industry Working Group 1995). However, the development of shareholder value was associated with a change in both parties: greater interest by institutional investors and their agents, less arrogance and more accessibility by corporate management. By the mid1990s, an increasing number of institutional investors were holding meetings with UK companies, anxious to keep them informed of company developments and to seek support for their long-term strategies. Directors of listed companies came to regard meetings with institutional investors as central to managing relations with capital markets. As well as meetings with institutional investors, companies address the needs of brokers’ analysts, who play a role in the pricing of securities within the market, and act as sources of information for institutional investors. The process itself has become institutionalized with the growth of investor relations departments within large companies. Routine investor engagement takes place in the UK within the regulatory context of The Combined Code on Corporate Governance (Financial Reporting

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Council 2006) and ISC’s The Responsibilities of Institutional Shareholders and Agents: Statement of Principles (2002), which provide an outline of ‘best City practice’. The Combined Code on Corporate Governance (Financial Reporting Council 2006) expects institutional shareholders and investee companies to enter into a dialogue based on ‘the mutual understanding of objectives’ (see Section 3.3.1). The Responsibilities of Institutional Shareholders and Agents: Statement of Principles (ISC 2002) advises institutional investors and their agents to make public their policies on engagement. These are required to outline the procedures for monitoring investee companies and the rules for meetings with senior management. Institutional shareholders who have concerns about an investee company, and who do not intend to sell their shares, should let the board of directors know their concerns. ISC (2002) also indicates that investee companies should not provide institutional investors, without their consent, with information which could affect their share trading ability. The investment fund managers’ UBS Global Asset Management UK Limited (UBS 2002: 1) statement on responsible investment reflects the ISC advice: On behalf of our clients, we aim to be supportive, long-term shareholders. We seek to develop both a long-term relationship and an understanding of mutual objectives and concerns with the companies in which we invest. We do this through regular meetings. These meetings are held between our investment team of analysts and portfolio managers and, typically, the company’s chief executive and finance director. In any given year we would normally expect to have over 5,000 such meetings globally. These meetings enable us to have discussions with company management about corporate strategy and objectives and to make an assessment of management performance. They also allow us to monitor a particular company’s development over time and assess progress against our expectations as investors. They also give us an opportunity to outline what our expectations are and to explain our views on important issues.

An Investment Management Association (IMA 2005b) survey of thirty-three fund managers reported that twenty-six of them met every investee company at least once a year, with twelve of them meeting every investee company at least twice a year. Six of the remaining fund managers met the majority of investee companies at least once a year, with the remaining fund manager only meeting companies in which his or her firm held at least 5 per cent of their share capital. According to the Joint City/Industry Working Group (1995), ‘[t]he model company gives an annual presentation to institutional investors and brokers’ analysts. This presentation forms the back-drop to other meetings between the company and its investors. It covers management’s vision, long-term corporate objectives, and the company’s strategy and operations

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for each important market and business segment’. J. Sainsbury plc’s Annual Report 2006 reflects this ideal: There is regular dialogue with institutional investors who, along with buyside and sellside analysts, are invited to presentations by the Company immediately after the announcement of the Company’s interim and full year results. They are also invited to participate in conference calls following the announcement of the Company’s trading statements. The content of these presentations and conference calls are webcast and are posted on the Company’s website (www.j-sainsbury.co.uk/investors) so as to be available to all investors. The Company also held a presentation on the anticipated impact of International Financial Reporting Standards in April 2005. In July, the Operating Board hosted a visit to the Canley store and Hams Hall distribution centre for investors and analysts. Makinson Cowell provide investor relations consultancy services to the Company and reported to the Board on the views of institutional investors. Non-Executive Directors also receive regular market reports and broker updates from the Company’s Investor Relations department.

The meetings between fund managers and corporate management are an important component of the process by which information about companies is transferred to the market and becomes incorporated into company share prices. They allow fund managers to understand company strategy and assess company management, including their ability to achieve this strategy (Barker 1998: 251). Such routinized meetings reinforce shareholder value expectations, on both sides, as well as providing for the transmission of information. They also allow fund managers to make personal judgements of the integrity of company management, and of the quality of information, especially ‘soft’ information, which they provide. According to survey findings (Barker et al. 2004: 1), ‘fund managers meetings with senior management are their most important source of information’, with institutions favouring ‘regular, private one-to-one meetings with corporates above all other means of corporate communication’. Such meetings also allow financial institutions to judge the extent of their own influence. Buy- and sell-side analysts are also involved in this process. Analysts, who may be present alongside fund managers at meetings with company management, act as information intermediaries. Their reports and recommendations to investors, including fund mangers, have an impact on company share prices. Institutional investors mould corporate values along shareholder value lines at these meetings. Joint meetings on company performance, strategy, and management underscore company managers’ internalization of the interests of financial institutions, aligning company policies and structures with the

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needs of institutional investors (Holland 1998). Preparing for such joint meetings (J. Roberts2 et al. 2004: 9–10) involves corporate managers in seeking to anticipate investor wants and then carefully constructing the presentation of the corporate self so as to play to these wants and appear responsive—to make the company attractive to the targeted investor. In the knowledge of meetings to come the interests of the investor are in this way internalised in advance and made to ‘play spontaneously’ upon the minds of directors. But the concern here goes beyond a scripting of the messages about company strategy to a concern with the presentation of the qualities of the messengers and their relationship.

As part of the ongoing ‘exchange’ relationship, financial institutions transfer to investee companies innovations and new management practices that come to their attention through their contact network.

4.2.2. Voting Equity share issues by US and UK companies usually have one vote per share. UK and US institutional investors are unhappy with the concept of variable voting rights for different classes of equity shares. However, this attitude is not universal. For example, although they usually have one vote per share, some listed Canadian companies have dual-class share structures, with one class of shares having multiple voting rights (McDermott and Farrell 2004). Similar multiple-class share structures exist in Germany. Such arrangements may, of course, give shareholders carrying multiple voting rights control over a company, even without holding an overall majority of shares. The national regulatory framework determines the matters on which shareholder approval is required. For companies incorporated in the UK and listed on LSE, shareholder approval is required on matters including changes to their names and constitutions; the allotment, issue, and repurchase of shares; the appointment, reappointment, and removal of directors and auditors; the declaration of dividends; and transactions involving the acquisition or disposal of assets that represent a significant proportion of the companies’ net assets. Similar provisions apply to US-listed companies. The UK Combined Code on Corporate Governance (Financial Reporting Council 2006) stresses that institutional shareholders ‘have a responsibility to make considered use of their votes’. ISC’s Responsibilities of Institutional Shareholders and Agents: Statement of Principles (2002) provides guidance to institutional investors on how they should exercise their voting rights when they vote against, or abstain on, resolutions proposed by management, or when they support management on a contentious issue (see Section 4.2.5).

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The exercise of voting rights by institutional investors, even in countries with one vote per share, is far from straightforward due to the complex relationship between the beneficial owners of shares and their registered owners, and to the increasing practice of stock lending (Section 4.2.4).

4.2.3. Shareholdings Institutional arrangements for investment and custody of shares may lead to difficulties in exercising voting rights (Stapledon 1996; Myners 2004). Pension fund trustees usually appoint one or more fund managers to manage all or part of their funds’ assets. The custodian fund managers in turn hold these assets in a bare trust, with shares frequently registered in the name of a nominee company of the custodian fund managers. Although, in exercising voting rights, they are obliged to follow the directions of the pension fund trustees, or those of their representatives, custodian fund managers are the registered holders of the shares and as such receive notices of annual general meetings (AGMs), voting-related documents, etc. Pension fund trustees differ in their voting policies for investments held in managed funds (Stapledon 1996). They may delegate the voting rights to fund managers. Or they may retain their voting rights, obliging fund managers either to obtain approval for voting the shares or to follow the directions of the pension fund trustees. They may also delegate voting rights to fund managers but require that the pension fund trustees be consulted on contentious issues. Such institutional arrangements for shareholding may create difficulties. First, forwarding notices and documents received from portfolio companies to the fund trustees may cause delays. Second, further delays may occur either where fund managers are required to obtain approval for exercising voting rights or where they have to consult with pension fund trustees. Third, who should be regarded as the relevant investor, where fund trustees delegate their voting rights to fund managers?

4.2.4. Stock Lending Stock lending is a transaction where there is an absolute transfer of the title to a security together with an irrevocable agreement to return an equivalent security. Most stock lending is done by custodians and few beneficial owners lend the shares themselves. Not all beneficial owners, however, are aware that there is a transfer of voting rights, from lender to borrower, when they lend their shares (Myners 2004). Stock lending facilitates financial market liquidity and provides a source of income for institutional investors. Many institutional

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investors are involved in stock lending. In a recent survey (Linstock Limited 2004) of thirty-nine financial institutions belonging to the International Corporate Governance Network, thirty-two reported that they had lent stock. Of these, two-thirds had lent more than 10 per cent of their portfolio, and only 70 per cent had made provisions for the recall of shares which would allow the beneficial owners to exercise their voting rights. The majority of beneficial owners not knowing when their shares are lent further complicates the issue. The growth in the practice of stock lending may reduce the power of institutional investors, who hold voting rights in exchange for bearing residual risks (TUC 2005). There is also some evidence that stock lending may lead to share ‘over voting’, with beneficial and registered owners voting the same shares (Partnoy 2006).

4.2.5. Exercising Voting Rights A survey of twenty-seven fund managers revealed that most UK fund managers exercise all their voting rights on shares in UK companies (IMA 2005b). The survey showed that 1. the fund managers held investments in between 165 and 1,750 companies, with an average of 716 companies; 2. they could have voted on between 708 and 5,380 resolutions, with an average of 4,050 resolutions; 3. on average, they either voted, or else consciously abstained, on 94 per cent of the resolutions they could have voted on; and 4. on average, they voted 94.8 per cent for and 3.0 per cent against and abstained from 2.2 per cent of the resolutions on which they either voted or consciously abstained. The majority of fund managers will always advise the board of directors in advance of either consciously abstaining or voting against a resolution, and nearly all the others will do so on most occasions. The large number of companies within investment portfolios, together with the large number of resolutions that can be voted on, potentially means that institutional investors have to expend considerable resources. However, the problem is mitigated through information intermediaries and voting proxy agencies, as is the case with the USS. The shares held in both internally and externally managed funds are voted in accordance with USS wishes. ‘Manifest’, a voting proxy specialist, uses a USS voting template to manage USS voting of shares

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in UK companies. Resolutions which are in line with USS voting policies are supported and resolutions which are not are referred to USS for consideration. A resolution which is inconsistent with USS voting policies may nevertheless receive support. Manifest minimizes operational voting problems, screens resolutions, and frees time to focus on contentious issues.

4.3. EXTRAORDINARY INSTITUTIONAL INVESTOR ENGAGEMENT Relationship breakdown between institutional investor and investee company, for example over perceived company underperformance, triggers extraordinary engagement. Controlling shareholders can replace the company management; for portfolio investors, however, the problem is more difficult to resolve. The actions institutional investors may take range from company monitoring and letter writing to meeting with the company management, proposing resolutions, requisitioning extraordinary general meetings (EGMs), and intervening jointly with other shareholders (ISC 2002). The extent of the institutional investor control over the investee company determines the actions institutional investors actually take. Chapter 5 discusses private equity firms who can exert control over the companies in which they invest through majority shareholder or major block holder voting rights. This section discusses portfolio investors who hold small fractions of company equity shares and who, consequently, are able to exert only limited influence individually. The levels of control and influence available to private equity firms are generally not available to portfolio investors. ISC’s Responsibilities of Institutional Shareholders and Agents: Statement of Principles (2002: 4) sets out the overall approach to engagement by UK institutional investors: [i]f boards do not respond constructively when institutional shareholders and/or agents intervene, then institutional shareholders and/or agents will consider on a caseby-case basis whether to escalate their action, for example, by: — holding additional meetings with management specifically to discuss concerns; — expressing concern through the company’s advisers; — meeting with the Chairman, senior independent director, or with all independent directors; — intervening jointly with other institutions on particular issues; — making a public statement in advance of the AGM or an EGM; — submitting resolutions at shareholders’ meetings; and — requisitioning an EGM, possibly to change the board.

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Engagement with investee companies usually takes place in private, and it is only when the situation is not resolved that the concerns of institutional investors become public. In UBS Global Asset Management UK Limited’s case (UBS 2002: 2), for example, [i]f a company consistently fails to meet our expectations, we seek to institute a change in company strategy and, as an ultimate sanction, in the management. In the first instance, this is likely to be through discussions with the chairman or other senior non-executives. However, we regard any such action as representing a breakdown in our longer-term relationship with the company and it is only likely to be pursued when performance has been extremely poor or the board has consistently ignored what we believe to be the legitimate concerns of shareholders. We acknowledge that such direct intervention is invariably high profile and runs the risk of adverse publicity which may aggravate the situation. Hence, where possible, we endeavour to keep our discussions with the company or their advisers confidential while an issue is ‘current’.

The Survey of Fund Managers’ Engagement with Companies (IMA 2005b) gave an indication of the scale of engagement through the communications and meetings of fifteen fund managers for the quarter to 30 June 2004. These fund managers had, on average, seventy-five additional communications, including sixty-three meetings, with senior executives—the actual range was from 292 additional communications, including 210 meetings, to three additional meetings. The fund managers also met with independent directors and company advisers. On average, they had eleven meetings with independent directors, with a range from thirty-two meetings with the independent directors of twenty-five companies to one meeting. The fund managers tended to express their concerns to managers through company advisers. Of the twelve fund managers who provided this information, there were on average six instances involving six companies over the three-month period. These instances were generally confined to three fund managers. Portfolio investors may of course engage in additional joint action with other institutional investors.

4.3.1. Shareholder Resolutions and EGMs Institutional investors can change, or influence, investee companies by submitting resolutions for voting by shareholders. The form this process takes depends on the regulatory framework of the country, or state, where the portfolio company is listed. Different rules on submitting resolutions apply in the USA and UK. Many of the resolutions proposed by US shareholders, for example, are precatory rather than binding on the management.

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Company law in the UK provides that, subject to certain conditions, shareholders can requisition an EGM to consider a resolution, often for the removal of directors and the appointment of new ones. Requisitioning an EGM is a rare occurrence, but the threat of requisitioning an EGM is frequently used to coerce company management to change in the direction recommended by shareholders. A shareholder in a US company is entitled to submit a proposal that the company, and/or its board, should take a certain course of action if the shareholder has owned, for at least a year, voting shares either with a market value of at least $2,000 or representing 1 per cent of the company’s shares (Securities and Exchange Commission Rule 14a-8(c)(7), in M. A. O’Sullivan 2001a: 178). The shareholder is limited to one proposal per shareholders’ meeting, delivered to the company 120 days before the date it releases the proxy statement to shareholders. The company can reject such a proposal, for example because it deals with matters relating to the company’s ordinary business or to an election to the membership of the company’s board of directors. Thomas and Cotter’s classification (2005) of the issues which initiate shareholder resolutions is representative of the relevant literature: 1. auditor independence, which initiates proposals which would limit, or prevent, the provision of consulting services by external auditors; 2. compensation, which initiates proposals on the award and accounting treatment of share options; 3. internal corporate governance, which initiates proposals for an independent chairman, increased board independence, and the adoption of cumulative voting; 4. external corporate governance, which initiates proposals to redeem or vote on poison pills, to repeal classified boards, and on the elimination of supermajority provisions; 5. environmental and social issues, which initiate proposals on genetic engineering and climate change; and 6. other social responsibility issues, which initiate proposals to adopt International Labour Organization standards and report political donations. The majority of proposals in the USA concern issues relating to takeover defences, in particular repeal of classified boards and elimination of poison pills, executive compensation, and board, especially chairman, independence (Thomas and Cotter 2005 and also Karpoff, Malatesta, and Walkling 1996; Wahal 1996; Del Guercio and Hawkins 1999; Gillan and Starks 2000). The topics addressed by shareholder proposals changed over time. An examination

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of shareholder resolutions between 1988 and 1998 revealed that some issues persisted over a relatively long period of time, some emerged over time, whilst others ‘waxed and waned’ (Graves, Rehbein, and Waddock 2001). For example, the number of proposals concerning human rights remained fairly constant over the ten-year period, those regarding South Africa were the most frequent between 1988 and 1992 but disappeared after 1996, whilst those relating to labour rights emerged over the ten-year period. Shareholders may propose resolutions in order to put pressure on management, and withdraw the proposals if management agrees to the shareholders’ resolutions. The withdrawal of proposals indicates strength in negotiating with management. Proposals are more likely to be withdrawn following management acceptance if they are sponsored by institutional investors or by coordinated groups (Chidambaran and Woidtke 1999). Several studies examined the factors influencing voting outcome (Karpoff, Malatesta, and Walkling 1996). Wahal (1996) found that there was a significantly higher level of support for proposals related to takeover defences than for proposals concerned with governance issues. The ownership structure of the targeted company also influenced voting outcome. L. A. Gordon and Pound (1993) reported that voting depended on the distribution of ownership amongst insiders, institutions, outside block holders, and outside directors who were block holders, with institutional investors being more successful where insider ownership was limited. Bethel and Gillan (2002) found that votes cast in favour of management were reduced by the presence of institutional shareholders. Finally, Wahal (1996) reported differences depending on which particular institutional investor targeted the company. TIAA-CREF’s (an activist US institutional investor) correspondence with various targeted companies showed the negotiation processes which take place between financial institutions and investee companies over governance issues (Carleton, Nelson, and Weisbach 1998). TIAA-CREF has been involved in corporate governance activism through the filing of proxy resolutions since the 1987 proxy season. TIAA-CREF’s stated policy has been to select targets each year amongst investee companies where TIAA-CREF has a substantial position, where institutional investors hold a large proportion of their shares, and which do not follow TIAA-CREF-endorsed corporate governance procedures. TIAA-CREF is generally able to reach agreements with the companies it targets (Carleton, Nelson, and Weisbach 1998). Of the forty-five companies contacted between 1992 and 1996, thirty-two (71 per cent) reached an agreement prior to voting the TIAA-CREF proxy resolution; thirteen (29 per cent) resisted and had the TIAA-CREF resolution voted. Ultimately, TIAA-CREF reached agreements with forty-two of the forty-three companies which were not acquired during the course of negotiations (97.7 per cent),

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a high per centage despite one instance of majority vote only. The investee companies implemented the changes requested by TIAA-CREF in most cases. All seven companies targeted for confidential voting instituted confidential voting. At least twelve of the sixteen companies targeted on blank check preferred stock as an anti-takeover device passed resolutions limiting its use. Of the eighteen companies which were not acquired during negotiations targeted for board diversity, seventeen placed new women or minorities on their board by June 1997. Compared with the USA, there are few shareholder resolutions in the UK. None of the fund managers surveyed by IMA (2005b) tabled a shareholders’ resolution in 2003 or 2004. This may be at least partly explained by the UK company law provisions on shareholder resolutions. First, a resolution can only be proposed if the shareholders, either individually or collectively, own at least 5 per cent of the company voting rights or if there are at least one hundred shareholders who have on average at least £100 of nominal capital per shareholder. This means that shareholders would usually have to come together to meet the 5 per cent requirement, and this in turn could potentially raise issues about concert parties. Second, although shareholders can require companies to circulate notices of resolutions proposed for consideration at AGMs, and statements with respect to the resolutions, the costs of circulation currently fall on shareholders. However, UK company law allows shareholders holding at least 10 per cent of a company’s voting share capital to requisition its directors to call an EGM: ‘shareholders in the UK are much better positioned [than those in the USA] to express their voice thanks to both the legal independence of the pension funds themselves, and the residual power they have to call an EGM with 10 per cent of the share capital’ (Ross Goobey quoted in Owen, Kirchmaier, and Grant 2004). The shareholders calling for an EGM, the requisitionists, must state the objects of the meeting, and the company’s directors must call a meeting within twenty-one days of receiving the shareholders’ notice. The meeting must take place within twenty-eight days from the notice convening the meeting. If the company’s directors fail to convene a meeting within twenty-one days, the requisitionists may convene one themselves. Shareholders rarely requisition an EGM, because it can be costly and can damage a company’s reputation and shareholder value, and shareholder activists rarely have to resort to this ‘nuclear option’. The majority of fund managers will only requisition an EGM in extreme circumstances, and none of the IMA (2005b) respondents had requisitioned an EGM in 2003 or 2004. However, the threat of requisitioning an EGM may be more widely used, making directors more receptive than they would otherwise be to shareholder proposals (Owen, Kirchmaier, and Grant 2004).

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The issues which arise when calling an EGM are well illustrated in the case of SkyePharma plc. In January 2006, three institutional shareholders, led by North Atlantic Value LLP, requisitioned the board of directors of SkyePharma plc to call an EGM to consider, and vote on, a resolution to remove the incumbent Executive Chairman from office and appoint their nominee in his place (SkyePharma plc 2006a). SkyePharma plc is a UK-listed pharmaceutical company specializing in drug-delivery technologies which improve drug effectiveness and safety. Its income derives from the reimbursement of development costs and milestone payments for the drugs which the Company is formulating for clients, from royalties or revenue sharing on sales of marketed drugs, and from margins on drug manufacture. The Company’s performance and its share price after listing on the market in May 1996 were disappointing. Towards the end of 2005, there were further problems. In November 2005, the Company announced that as a result of an unsolicited approach from another company, the Board of Directors had decided to review all its strategic options, including the sale of the Company as a whole. Although the Company received several expressions of interest, both for the Company as a whole and for its individual assets, it did not receive a firm offer by the January deadline. The Company also failed to find a partner to develop its asthma-treatment drug. Finally, the Company announced that its CEO Michael Ashton would be retiring on reaching the age of 60 and that Executive Chairman Ian Gowrie-Smith and some of the non-executive directors would also be stepping down in 2006. SkyePharma’s non-executive directors met with a number of institutional shareholders to discuss the appointment of a new CEO and the Company’s strategy: ‘[i]nvestors [gave] SkyePharma just weeks to sort out its management team, or face a coup to oust Ian Gowrie-Smith, chairman and founder of the drug reformulation group’ (Financial Times 2006). North Atlantic Value, Morley Fund Management, and Insight Investment Management held approximately 13 per cent of SkyePharma’s voting share capital in January 2006. Christopher Mills, CEO at North Atlantic Value (as well as Chief Investment Officer at J. O. Hambro Investment Management) had a history of shareholder activism: North Atlantic Value described itself as ‘an entity through which all activist investment in publicly quoted securities and private equity investments are carried out’ (North Atlantic Value LLP 2004). The press releases indicated four reasons for North Atlantic Value wanting to appoint Bob Thian as executive chairman. First, the decline in shareholder value: SkyePharma share price dropped from 75.0 pence in May 1996 to 40.5 pence on 28 February 2006, a fall of 46 per cent. Second, the Company’s operating performance had been poor. The Company never achieved ‘sustainable profitability’, although its directors had made promises about performance—they were accused of ‘over promising and under delivering’.

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Third, investors’ funds had been diluted by frequent calls for further equity funding on a non-pre-emptive basis, leading to a diminution of shareholder value. Fourth, wasteful expenditure including: (a) the lease of the Manhattan property owned by Gowrie-Smith; (b) expensive offices overlooking Green Park in central London, for the Executive Chairman and other executives; and (c ) the acquisition of companies which appeared to add little value or in which SkyePharma directors had a personal interest or served as board members. The Board of Directors refuted the charges and claimed that calling an EGM reduced shareholder value. Between requisitioning and holding the EGM, several changes took place. On 23 January, Gowrie-Smith resigned, reportedly to bring the controversy to an end and avoid the ‘expense and distraction’ of an EGM (SkyePharma plc 2006b). The Board of Directors met on 1 February and Dr Jerry Karabelas, a non-Executive Director since November 2000, was appointed nonExecutive Chairman. On 6 February, the Company appointed new chief executive and chief operating officers. Karabelas hoped that these changes would dissuade the requisitionists. For them, however, the new Executive Chairman was associated with a period of major destruction of shareholder value. The Company’s Nomination Committee met with Thian and discussed the possibility of a non-executive directorship. This he was unwilling to accept. (The Board of Directors was to argue later against his appointment as Executive Chairman as being contrary to the non-executive chairmanship principle and on grounds of no ‘recent relevant experience in the pharmaceutical industry’.) The EGM took place on 9 March and considered Thian’s appointment as Executive Chairman: the resolution was defeated by a majority of 28.5 million shares. In terms of votes cast, 53 per cent were against and 47 per cent were for, and in terms of numbers of voting shareholders, 23 per cent voted for and 77 per cent against: ‘[t]he EGM is now behind us. We can now get on with running the business for the benefit of all shareholders’ said Karabelas (SkyePharma plc 2006c ). On 14 March, SkyePharma reached an agreement with two of the dissatisfied institutional investors, Morley Fund Management and Insight Investment Management—two new independent non-executive directors were to be appointed: [a]lthough SkyePharma strives to maintain the highest standards of corporate governance, there is always room for improvement. We have noted the level of dissatisfaction about certain issues among a significant body of shareholders. We are happy to have reached agreement over a process that allows us to address these concerns to the satisfaction of all. We can now concentrate on the primary task of execution of the Company’s new corporate strategy, which we believe will benefit all shareholders. (SkyePharma plc 2006d)

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4.3.2. Joint Institutional Investor Engagement Institutional investors usually carry out extraordinary engagement jointly with other institutional investors. Joint engagement enhances effectiveness, reduces free rider problems, diminishes the costs of any one institutional investor, and increases leverage over corporate management, by increasing the size of holdings and the number of votes (Dresner 2002). Hence, most institutional investors are willing to engage jointly (IMA 2005a). As UBS Global Asset Management UK Limited (UBS 2002: 2) expressed it, ‘[w]e believe the effectiveness [of institutional investor engagement] is considerably increased when we find common ground with other shareholders. . . . We are willing to work with collective bodies, such as NAPF Case Committees, or collaborate with other major shareholder groups if we believe this will increase the chances of success’. Similarly, USS actively did so, initiating the Institutional Investors’ Group on Climate Change (IIGCC) as a ‘forum for collaboration between pension funds and other institutional investors on issues related to climate change’, aiming ‘to promote a better understanding of the implications of climate change amongst its members and other institutional investors’, and ‘to encourage companies and markets in which its members invest to address any material risks and opportunities to their businesses associated with climate change’ (IIGCC 2003: 2). Twenty-three members had joined IIGCC by the end of 2003. Joint institutional investor engagement may be indirect (through industry bodies such as NAPF and/or the ABI in the UK) and/or direct (through meetings, common statements, and letters and, within concert party constraints, through voting) (Stapledon 1996). Concerns about a particular portfolio company may lead to an institutional investor seeking to collaborate with other institutional investors in the same company and to loose, temporary coalitions—this is exactly what happened in the case of Patientline plc. Patientline plc is a UK-listed company which provides hospital telephone and television services. It was floated on the Alternative Investment Market (AIM) in March 2001 and was moved to the main market in 2003. The company made losses every year following flotation, and by February 2006 the shares were trading at around 20 per cent of their price on flotation in 2001. Following complaints from patients and their relatives over the cost of Patientline hospital telephone services, the company was subject to investigation by the Office of Telecommunications (OFTEL), the telecommunications regulator. Against this background, Shore Capital, an investment bank, announced its intention to requisition an EGM in order to remove Derek Lewis, the Company’s Executive Chairman. Shore Capital had already obtained

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the support of other institutional shareholders, holding nearly 50 per cent of the Company’s voting shares in total. The statement issued by Shore Capital through the stock exchange the following day included a copy of the letter to Patientline shareholders. This highlighted the significant fall in share price, fall in revenue per terminal, terminals not functioning and so not generating revenue, management failure to accept responsibility for problems faced by the Company, unplanned increases in borrowing requirements, loss of customer confidence, and the high turnover of chief executives and finance directors, with ‘a dramatic loss of investor confidence’ (The Independent 2006). Shore Capital suggested that the current CEO, Per Jonsson, and management team understood that change was necessary, but that incumbent Executive Chairman, Derek Lewis, was not the appropriate person to lead this change. Shore Capital proposed Barclay Douglas, one of its directors, instead. Shore Capital indicated that it held 17.0 per cent of Patientline voting share capital, and that it had irrevocable commitments from other institutional investors holding a further 10.8 per cent of the shares. On the same day, Patientline announced that Per Jonsson had left the company and had been replaced by Colin Babb (LSE 2006). The Company also issued an energetic defence (Patientline 2006). [Later that month, in compliance with its obligations under the Listing Agreement, the Company announced that Colin Babb had been an executive director of a company which went into administration in 2001 and of one which was placed in administration in 2005 (see also Research Recommendations Electronic Voting 2006).] Several collective organizations institutionalize collaboration amongst institutional investors. ABI, NAPF, and the Pensions and Investment Research Consultants (PIRC) are the major industry bodies which provide mechanisms for coordinated institutional investor action in the UK. ABI and NAPF established investor protection committees in the 1930s and 1960s respectively. PIRC was established in 1986 by a consortium of local authority pension funds. ISC, acting as an umbrella organization, represents the main mechanism for collaboration amongst institutional investors. ISC was established in April 1973, following the recommendations of a Bank of England working party setup ‘to examine and report upon a possible structure and method of operation of a central organization through which institutional investors, in collaboration with those concerned, would stimulate action to improve efficiency in industrial and commercial companies where this was judged necessary’ (Wilson 1980: 253, quoted in Owen 2001: 9). Initially, ISC comprised the Association of Investment Trust Companies, the Association of Unit Trust Managers, and NAPF, with ABI agreeing to cooperate in individual cases, but not as a full member. ISC was to function through case committees, made up

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of members of the constituent organizations, possibly assisted by outsiders. There were to be no public ISC statements: [t]he ISC works through so-called ‘case’ committees which investigate members’ complaints. Any fund manager who does not feel happy about the way a particular company is being run brings his grumbles to the notice of the relevant case committee. This then confidentially circulates all its members to find out the extent of institutional shareholdings in the company and to canvass other managers’ views. Quiet, behindthe-scenes pressure is put upon the company to make changes. (Reading 1975)

Case committees were not a new concept: they had for some time been an important mechanism through which concerned institutional investors engaged with company managers. ABI had established case committees, with representatives of the insurance companies with the largest stakes in a company, for many years, and NAPF had used case committees, with representatives from pension funds. ISC intervened rarely. The Wilson Committee to Review the Functioning of Financial Institutions (Wilson 1980) reported that up to the end of 1979 the ISC had dealt with thirty-seven cases. Of these, seven led to formal case committees, nineteen were thought more appropriate for independent action, and eleven had either ‘already gone too far for anything to be done or were resolved in some other way, for example by the company concerned becoming the subject of a successful take-over bid’ (Wilson 1980: Paragraph 912). ISC activity increased in the early 1980s when economic pressures forced companies to enter a period of restructuring, and ‘the committee in its heyday was dealing with four or five cases at a time of companies in difficulty’ (Financial Times 1990). However, the Committee’s activity decreased in the mid-1980s, with swelling company profits and share prices and declining incidence of management failure. Commenting generally on intervention through the use of case committees, the Wilson Committee (Wilson 1980: Paragraph 913) reported that, although they were effective in some cases, in others the intervention was either too late or inadequate: The institutions are still to some extent feeling their way, which may inhibit them from intervening at an early enough stage, and a company’s troubles may be inherently difficult to resolve. The managements of companies in difficulty are usually well aware of their problems and are frequently subject to a plethora of advice. What they usually lack are solutions, which the institutions are not typically well equipped to provide. Nor is the bringing in of outside advice or the replacement of senior management necessarily an answer. Satisfactory alternatives are not easy to find, especially if the company is in severe difficulty. The institutions may not themselves always agree on the best line of action—they are not as monolithic as the habit of talking about them

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in the plural might suggest. Finally they might meet management resistance and may be handicapped by their desire to operate in private so as to avoid the risk of making a bad situation worse through publicity.

The problems highlighted in the Wilson Report continued to affect institutional investors’ attempts to intervene in an investee company in difficulty. Some of these were addressed, or evaded, nearly a decade later by new ISC Chairman, Donald Brydon, of Barclays de Zoete Wedd, and Chairman of NAPF’s Investment Committee. On taking up his appointment in October 1988, he identified the main issues facing ISC: ‘the remuneration of top executives, employee share schemes, accounting methods, disclosure of shareholdings, the conduct of takeover bids and pre-emptive rights issues’ (Financial Times 1988). Brydon reformed the Committee by widening its membership, to include merchant bankers, and by developing ISC as a forum through which institutional investors could become engaged with investee companies on issues of corporate governance. The Committee was to retain its ‘core responsibility’ of dealing with management failure, but Brydon wanted ISC to support the activities of the investment protection committees of its constituent members. In particular, where there was concern about a company’s strategy, he wanted ISC to develop alternative business plans using the expertise of its own members and, where appropriate, outside consultants: ‘[i]t is not for shareholders to tell a company how to run itself. But it is their role to present a company they are concerned about with alternatives and to get its reaction. The response of management would be the best clue as to whether it was going to take the company forward successfully or not’ (Financial Times 1990). In order to develop this enhanced role, ISC recruited a Secretary-General, Maurice Epstein. However, with the appointment of its next Chairman, Michael Sandland, in 1991, the ISC’s direction changed again: the Committee became once again concerned with general issues and less concerned with particular companies. This led to Epstein’s resignation: ‘the committee is taking a less interventionist role in corporate affairs than he had expected when recruited during the previous chairmanship’ (The Independent 1991). The balance between involvement in general policy debates and intervention in specific company problems continues to change. ABI, NAPF, and PIRC advise their members on share voting issues. ABI’s Institutional Voting Information Service, for example, reviews information from UK companies for compliance with best corporate governance practice, and provides colour-coded recommendations for each resolution put before company general meetings: (a) blue if the resolution is consistent with ABI guidelines and current best corporate governance practice; (b) amber if the resolution does not appear to be in compliance with ABI guidelines and

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current best corporate governance practice—depending on the outcome of discussions with the company, the colour may change to red or green; (c ) red if either the resolution does not comply with ABI guidelines or is inconsistent with current best corporate governance practice, and also if a decision was taken to abstain or oppose a resolution after consultation with a significant proportion of ABI members; and (d) green if, after discussions with the company, the resolution is deemed consistent with ABI guidelines and current best corporate governance practice, and also if a decision was taken to support a resolution after consultation with a significant proportion of ABI members. PIRC generates detailed reports on corporate governance issues on each company within the FTSE All-Share Index. These include analyses of the board structure and levels and structures of directors’ remuneration and service contracts of each company, and indicate the extent of compliance with The Combined Code on Corporate Governance principles. PIRC also provides share voting recommendations, based on its own policies or those of the institutional shareholders, as well as voting proxy services. Unlike shareholder resolutions and EGMs, the joint form of institutional investor engagement is widely used by institutional investors: all the respondents to the IMA’s Survey of Fund Managers’ Engagement with Companies (2005b) had been involved in joint intervention during the year to 30 June 2004. During the nine months to 31 March 2004, fund managers had been involved in joint intervention on seven occasions, on average, involving approximately the same number of companies. There was considerable variation, though, with one fund manager being involved in joint engagement on fifteen separate occasions, whilst two took part in only one such instance. The institutional investors’ handling of J. Sainsbury plc in 2004 is an example both of joint engagement and of superiority of joint over individual engagement. In 2004, institutional investors became concerned with the Company’s poor overall performance: J. Sainsbury plc was failing to meet market expectations and was losing market share. Institutional investors were also concerned about specific policy aspects, in particular the details of the impending payments to the retiring Chairman and CEO Sir Peter Davis. The institutional shareholders judged as overgenerous the payments proposed for Sir Peter (who resigned at the beginning of July 2004) under the Share Award Plan 2003 (The Observer 2004). ABI issued a ‘red top’ warning on the resolution and NAPF and PIRC advised institutional investors to vote against the resolution to approve the Board of Directors’ Remuneration Report for the 52 weeks to 27 March 2004 at the AGM on 12 July 2004. Against a background of declining corporate performance and disregard for ‘best City practice’, the detailed account below shows the interaction amongst institutional investors.

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Earlier in the year, in February 2004, institutional investors had already reacted negatively to the Company’s announcement of the appointment of Sir Ian Prosser as Deputy-Chairman and Chairman elect. Their opposition led to Sir Ian failing to take up the posts. Institutional investors were particularly critical of the performance indicators established for Sir Peter, believing them to be too soft: Sir Peter was to be allocated 300,000 shares provided that he ‘used his best endeavours’ to procure acceptable Chief-Executive and Deputy-Chairman replacements (The Observer 2004). The Board of Directors’ Remuneration Committee recommended that 864,000 of the 1,000,000 shares available to Sir Peter should be awarded conditionally as follows: (a) 110,000 shares (out of a maximum of 150,000) in respect of business transformation targets; (b) 75,000 (out of 150,000) in respect of the appointments of a new Chief Executive and Deputy-Chairman; and (c ) 679,000 (out of 700,000) in respect of the Group’s underlying pre-tax profit. Institutional investors were also disappointed by the Company’s continued poor financial performance: the Company reported a fall of 2.9 per cent in underlying pre-tax profit, to £675 million. Institutional shareholders thus demanded that the board of directors hold back most of the award (The Business 2004), amongst rumours that ABI and NAPF would shortly recommend their members to abstain or vote against the Remuneration Report at the Company’s AGM on 12 July, and that PIRC had already made this recommendation. Lord Levene, the Company’s senior independent director, sought to reach an agreement: ‘[i]f Lord Levene doesn’t manage a face-saving deal over the next two days, most UK institutions are going to vote against [the Remuneration Report]. After the Sir Ian Prosser affair, the Sainsbury’s board urgently needs to re-establish some credibility with investors’ [an institutional investor, quoted in Financial Times (2004a)]. According to Financial Times (2004a): [w]hen Sir Peter’s bonus scheme was unveiled in March last year, investors were evidently told two things: that the undisclosed profit targets that would trigger this award (and another one that may be payable in a year’s time) were tough; and that the Sainsbury family, which holds 38 per cent of the equity, had already approved the deal. The former assertion was so much rubbish. Sir Peter is getting most of his potential pay-out, even though Sainsbury’s performance relative to its peers was poor last year; even though he presided over the Prosser fiasco; and even though the board had the discretion to vary the pay-out. This is as tough as a melted tub of Sainsbury’s ice-cream.

The Financial Times journalist also commented that there was an impression that the Sainsbury family tended ‘to go along with whatever the board decides’.

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Institutional investor confidence declined even further on 1 July 2004 when the Company issued a Trading Statement warning that underlying profit before tax for 2004–5 would be ‘significantly below consensus market forecasts with the majority of the impact expected in the first half ’ (J. Sainsbury plc 2004a). Two credit-rating agencies, Moody’s and Standard and Poor’s, put the Company’s rating under review for a possible downgrade, and a third, Fitch, actually downgraded the Company’s senior unsecured debt from BBB+ to BBB (Financial Times 2004c ). The announcement that Sir Peter had resigned, and that Philip Hampton had been appointed Chairman, did not reduce institutional investor hostility towards the Company. Further reports (Financial News 2004) stated that ABI had been demanding that Sir Peter return a substantial proportion of his bonus to the Company, with one institutional shareholder saying that investors ‘would be looking for 100% because performance targets were not met’. Hostility to the award of the share bonus generalized into concern about overall remuneration policies. Peter Montagnon (Financial Times 2004b), the head of investment affairs at ABI, indicated serious levels of institutional shareholder concern with executive remuneration: ‘[t]here is a risk of the entire system of remuneration falling into disrepute. We cannot afford for that to happen if we are to continue to attract and reward talent in running listed companies’. He was also reported (Financial Times 2004b) as indicating that, although shareholders had been advised by the Company that the performance targets for bonuses would be ‘stretching and demanding’, this was far from the case. NAPF met with Keith Butler-Wheelhouse, Chairman of J. Sainsbury plc’s Remuneration Committee, and—in an attempt to bring shareholders ‘back on side’—the Company suggested on 1 July that the awards to Sir Peter would not be included in the Remuneration Report on which shareholders were due to vote. A spokesperson for J. Sainsbury plc reportedly (The Daily Telegraph 2004) said that the Company had indeed considered this possibility, but then decided against it. Consequently, NAPF recommended its members to vote against the resolution. The Company management’s next market move was a news release on 8 July: ‘[t]he Board of J Sainsbury plc has reconsidered the Remuneration Report insofar as it relates to Sir Peter Davis in the light of institutional shareholder objections to his remuneration arrangements, the recent trading update and Sir Peter Davis stepping down as Chairman and as a director of the Company’. This went on to explain that the Company’s decision to award Sir Peter 864,000 out of a possible total of 1,000,000 shares for 2003–4 was based on advice from Towers Perrin, professional remuneration consultants. However, on 30 June 2004, the new CEO, Justin King, had stated at a special

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Board of Directors meeting that the original recommendation by the Remuneration Committee could no longer be supported, in view of his assessment of the Company’s overall situation. The Board of Directors considered putting an amended resolution to the impending AGM, which would have excluded matters relating to Sir Peter, but gave up on advice from the Company’s lawyers and the mixed response from shareholder representative bodies. It proposed instead to submit the original Remuneration Report to the AGM, but not to implement the recommendations in relation to Sir Peter (RNS 2004). The outcome of the AGM was made even more uncertain by the decision of Judith Portrait to abstain from voting on the Remuneration Report—as trustee of various settlements, including charitable trusts and the blind trust for Lord Sainsbury of Turville, she controlled the voting rights of 23 per cent of the Company’s shares. Portrait reportedly (The Guardian 2004a) recognized that Sir Peter’s bonus payment had become a matter of principle and that ‘the only mature stance as a major shareholder is to abstain’. The news release (The Guardian 2004a) also suggested that she thought that a vote in favour of the resolution would be interpreted as ‘tacit support for an unpopular payment and evidence of a dysfunctional family ownership’. The Remuneration Report was accepted, but only by a narrow majority. Moreover, institutional shareholders exacted a high price from the Board of Directors for failing to improve the Company’s performance and for disregarding ‘best City practice’ in its remuneration policy. By 2006, with the appointments of a new senior executive team and new non-executive directors, the composition of the Board of Directors was completely different from that of 2000.

4.4. CONCLUSION This chapter has distinguished between two main forms of institutional investor engagement, routine and extraordinary. Routine engagement ranges from day-to-day monitoring of companies through, for example, their share prices, analysts’ and companies’ reports, and press comments to meetings with management and voting on resolutions. With extraordinary engagement, institutional investors attempt to change the policies and practices of the companies in which they invest, often in response to poor company performance. Routine meetings between investors and managers serve to foster shared interpretive frameworks. Such frameworks are based on common endorsement of the major principles of shareholder value. Routine meetings not only provide institutional investors with an opportunity to understand better the strategies of the companies in which they invest, and the qualities of

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their management, but they also condition management and management practices. Management attention becomes naturally focused on shareholders’ concerns. Furthermore, through their interactions with company management, institutional investors may encourage the transfer of ‘best’ management practices amongst companies, often amongst companies operating in the same business sector. Institutional investors also express their views through voting on resolutions, usually proposed by company management. They usually support such resolutions, and when they do not do so justifying to the company management their reasons for voting against, or actively abstaining. Extraordinary engagement occurs when investors are dissatisfied with company management, whether over financial performance or governance issues. Institutional investors holding large, perhaps controlling, stakes in a company can affect change by replacing the company’s management. This is not the case with portfolio investors who have to use other methods of engagement to affect change. Institutional shareholders can act on their own to bring about change, or they can act jointly with other investors. The analysis of correspondence between TIAA-CREF and the companies which it targeted showed that a large activist investor acting alone could achieve its objectives through contact with companies. Institutional shareholders write to companies and meet with their managements and, often more importantly, with their chairmen and non-executive directors. In addition to ‘jawboning’, US shareholders can propose proxy resolutions. However, shareholder resolutions, if adopted, tend to be precatory rather than mandatory, with uncertain outcome. Because of differences in company law, it is more difficult for individual institutions to propose resolutions to be considered at AGMs of UK companies. Institutional investors engage more effectively when acting collectively rather than individually, whether seeking to influence individual companies or seeking support for overall policy objectives. By acting in collaboration, institutional investors share the costs of engagement, eliminate free rider problems, and—through increasing the proportion of shares controlled—acquire enhanced leverage. Lack of unity allows targeted managements to play one investor off against another, reducing the effectiveness of engagement. Collaboration may be ad hoc, targeting a specific company—for actions of which investors disapprove, or continuing—reflecting long-term anxiety about company performance. Leverage may be exercised informally—through contacts with company directors, or formally—through threatening to requisition an EGM or, rarely, by actually requisitioning an EGM. Collaboration may also be focused on specific long-term social and environmental issues, and institutionalized by specific groups such as IIGCC initiated by USS. Long-term collaboration amongst institutional investors is institutionalized through ISC, an umbrella organization representing IMA and the Association

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of Investment Trust Companies, as well as ABI and NAPF. The industry bodies seek to advance industry interests along two main pathways. First, ISC seeks to develop an industry consensus on best practice, and to secure Government support for its views, for example over company law reform. In this way, ISC acts as a public/private interest pressure group. The industry favours selfregulation and ‘comply or explain’ practice rather than direct primary legislation (see J. Roberts2, Sanderson, and Seidl 2006). The industry associations also seek to ‘police’ company compliance with ‘best City practice’. Second, ISC and NAPF operate through investor protection committees or, in NAPF, case committees, to report on companies giving ‘cause for concern’—on performance grounds, or for apparently failing to comply with The Combined Code on Corporate Governance—most frequently on remuneration issues. Institutional investor influence operating via ISC and other bodies has been largely effective in securing the development of public policies, and codes of practice, congenial to the industry. However, ISC’s and industry’s private modes of operation make it impossible to assess whether it has been successful in mobilizing and channelling institutional investor influence to improve individual company performance.

5 Private Equity Investor Engagement 5.1. INTRODUCTION In Chapters 3 and 4, we examined relationships between institutional investors and the companies in which they invest. We now turn our attention to private equity firms and private equity fund engagement with investee companies. We examine seven private equity firms, as well as related portfolio companies. Four of these private equity firms are British (Amadeus Capital Partners Limited, Merlin Biosciences Limited, Sitka Limited, and 3i Group plc), one is German (TechnoStart GmbH), and two are American (Kleiner, Perkins, Caufield and Byers LP and The Carlyle Group LLC). They cover a wide range of funds: large diverse funds are represented by 3i Group plc and The Carlyle Group LLC, large specialist funds by Kleiner, Perkins, Caufield, and Byers LP, medium-sized specialist funds by Amadeus Capital Partners Limited and Merlin Biosciences Limited, and small specialist funds by Sitka Limited and TechnoStart GmbH. Despite differences in nationality and size, private equity funds share common features, as the subsequent analysis demonstrates. Investors in private equity funds expect high rates of return in exchange for high levels of risk. Private equity firms differ in their approach to achieving such returns. High returns may be secured by pursuing an active trading policy and by careful selection of companies in which to invest. However, we focus on private equity firms which secure high returns through active post-investment involvement in portfolio companies. In the case of startup investee companies, private equity firms act as both scouts, who identify companies with potential, and coaches, who assist companies in realizing that potential (Baum and Silverman 2003). The approach they adopt and the resources they devote to post-investment monitoring and intervention further differentiates amongst private equity firms. Elango et al. (1995) identified three levels of involvement: ‘inactive’, mainly confined to attending board of directors meetings, ‘active advice-giver’, and ‘hands-on’. Similarly, Macmillan, Kulow, and Khoylian (1989) found three clusters of involvement: ‘laissez-faire’, ‘moderate’, and ‘close tracker’. In our own terminology, we are concerned here with the three more intense forms of engagement—internal, negotiatory, and

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direct (see Section 2.2). In short, using the industry’s own terminology, some funds are ‘hands-on’, whilst others are ‘hands-off ’ [British Venture Capital Association (BVCA) 2002]. We concern ourselves primarily with ‘hands-on’ funds. Private equity firms which adopt a hands-on, active approach to managing their investments become involved as business partners in portfolio companies, through representation on the board of directors: either an executive of the private equity firm or an external consultant is appointed director. They monitor portfolio companies through reviewing management accounts and board minutes, for example, and share in decision-making regarding strategic issues such as purchases of major capital items, acquisitions and disposals, changes in strategic direction, appointments of directors and auditors, and changes in capital structure. High levels of engagement can help portfolio companies in many ways, through advice and support, assistance in developing corporate culture and creating strategic alliances, as well as with exercising corporate governance. They can also spur innovation. However, private equity firms are rarely involved in the day-to-day operations of portfolio companies (BVCA 2002). Chapter 5 is structured into four sections. Following this short Introduction (Section 5.1), Section 5.2 discusses ways in which private equity firms structure their funds, focusing particularly on staged funding, as well as on issues of specific concern to private equity firms. Section 5.3 presents cases of private equity funds and associated portfolio companies, and analyses investment strategies and the ways these influence management in investee companies. The concluding Section 5.4 discusses the conditions which enable private equity funds to influence corporate management successfully.

5.2. PRIVATE EQUITY INVESTMENT ARRANGEMENTS Private equity investments are structured to provide means whereby private equity managers, acting on behalf of private equity investors, monitor and control investments, whilst also maintaining strong incentives for portfolio company managements, through private equity fund structures. Staged funding, contingent on company and management performance, is a major means of influencing investee companies. Two methods of staging funds, ‘milestone financing’ and ‘round financing’, are commonly used, especially with start-up portfolio companies (Cuny and Talmor 2003). ‘Milestone financing’ involves private equity firms providing funds subject to investee companies meeting

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Private Equity Investor Engagement Table 5.1 Key private equity funding characteristics (n = 30) Characteristic

Explanation

Frequency (%)

Investment type

Milestone funding Round/full funding

64 36

Milestone contractual conditions

Capital structure: liquidation preferred equity Board of directors composition Senior staff recruitment Executive stock options Annual budget approval

68 80 43 36 61

Trading Flotation or IPO

70 30

Exit strategy

specified criteria. ‘Round financing’ entails investee companies requesting additional funding. Staged funding provides private equity firms with an abandonment option, as well as monitoring and control opportunities, whilst offering incentives for portfolio company managements. Private equity fund managers provided details of 30 private equity deals, 64 per cent of which used milestone funding, whilst the rest opted for round and/or full funding. Table 5.1 (key private equity funding characteristics) summarizes their main characteristics, based on term sheets. Private equity financing involves the separation of rights over cash flow, including net assets in the event of liquidation, from voting, board membership, and other forms of control (Kaplan and Strömberg 2000, 2001). This allows private equity firms to both retain control rights, which allow fund managers to intervene when portfolio company managements fail to meet agreed targets, and provide incentives. Convertible preferred shares give private equity firms claims over assets superior to those held by portfolio company managements: their value usually equals that of the original private equity investment (Kaplan and Strömberg 2000). In addition, cumulative dividends can sometimes further strengthen the private equity firms’ liquidation rights (Kaplan and Strömberg 2000). Redemption provisions, or put options, which allow private equity firms to redeem securities after a defined period, may also strengthen private equity firm claims. Indeed, 68 per cent of the private equity deals in Table 5.1 involved liquidation preferred equity. Liquidation preferred equity has two advantages. First, investment risks are lower than for ordinary shares, because the private equity claims over portfolio company profits and assets are superior. Second, investee company management incentives are higher than otherwise, because the value of their securities depends on residual profits and assets (after meeting convertible preferred shareholder

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Table 5.2 Main private equity investor concerns (%, n = 30) Concern area Performance measurement Innovation policy Management processes Strategic discussions Employee recruitment and retention Outsourcing Marketing Executive stock options/incentives

Frequency 79 73 71 64 64 58 40 32

claims). Portfolio company managements frequently own significant equity shares, with returns on share ownership representing a potentially sizeable component of total management compensation (Fenn, Liang, and Prowse 1995). The inclusion of an equity earn-out, which allows portfolio company managements to increase their holdings if certain performance conditions are met, may heighten incentives. The early stages of engagement are critically important. The nature and extent of external expertise varies with the private equity firm’s resources and the portfolio company’s specific needs. To run investee companies, private equity firms may install their own operationally experienced managements, or may employ managers from other companies. They may also use thirdparty consulting firms to assist in developing and implementing investee company strategies. Private equity firms establish term sheets involving strategic plans with reporting metrics to track progress. The term sheets can cover a wide range of issues, such as property rights, capital investment, governance, and compensation. Currently, as outlined in Table 5.2 (main private equity investor concerns), term sheets commonly set forth the portfolio company’s valuation and capital structure, the composition of its board of directors, the vesting schedule for its management’s stock options and the size of the employee stock option pool, as well as the registration rights for its investors if and when the company launches a public offering. They may also include a number of key management decisions. The private equity firms we examined typically operate in two broad investment areas, technology and health care. Traditionally, private equity investors have sought to incorporate protective provisions in their contracts with portfolio companies, for example the right to approve major corporate decisions such as payment of dividends, sale of additional securities, or sale or liquidation of the company. Following the collapse of the Internet share

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bubble in 2002, the range of protection measures was extensively revised, in private equity investors’ favour. Investors now commonly insist on incorporating provisions which were previously the sole prerogative of portfolio company managements: annual budget and new approval, licencing of intellectual property rights, and even hiring and firing decisions. Hence, in the wake of the high technology market slump, private equity firms such as 3i Group plc began exerting much more leverage on financing arrangements. Terms previously seen only in very high-risk or last-ditch financings began emerging across the board. Private equity investors also began insisting on mandatory cumulative dividends and drag-along rights (a rather draconian measure which allows minority private equity investors to force the sale of a portfolio company, irrespective of opposition from its management). Private equity investor concerns fall broadly into three categories. First, board of directors activity, with private equity investors playing a crucial role, especially in relation to corporate strategy and including performance measurement. Second, new product development and innovation, whose potential attracted private equity investors’ attention in the first place. Third, specific operational aspects, usually where the private equity investor has a particular perspective. Private equity investors exercise the most obvious and direct influence over investee companies through board membership. General partners may be directors, and/or they may nominate outsiders as directors of portfolio companies. Sometimes, private equity firms may even dominate the boards of directors of investee companies. This is contingent on portfolio company performance, with poor performance leading to large private equity firm representation and possibly to loss of portfolio company management voting control. Kaplan and Strömberg (2000) revealed that private equity firms had control in 26 per cent of cases, portfolio companies had control in only 12 per cent, and in the remaining 62 per cent neither the private equity firm nor the portfolio company had control. Investee companies in this study had overall control in the majority of cases, although private equity firms maintained representation on each board of directors. On average, boards had just over six directors. Boards of directors fulfil three categories of functional activities: (a) networking activities—forming links between the company and its external environment and securing critical resources; (b) monitoring activities—dealing with internal governance issues, monitoring company performance, and providing mechanisms to align the interests of management with shareholders; and (c ) strategy-making activities—contributing to the company’s strategic decision-making processes (Goodstein, Gautum, and Boeker 1994). The term sheet analysis illustrates private equity investors’ role in two of these

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three categories: monitoring company performance and developing strategy; networking activities are more matters of practice than formal agreement. Mentioned in 79 per cent of agreements, monitoring activities occupied a central place. They were concerned with establishing appropriate management procedures, especially in relation to meeting the criteria agreed in staged funding arrangements. Strategy-making activities were explicitly covered in 64 per cent of agreements, as well as being discussed routinely at board of directors meetings. The nature and scope of innovation in start-up and growth companies were a major private equity investor interest. Private equity firms gave advice or provided/arranged expertise on innovation or R&D in 73 per cent of cases. The case studies in Section 5.3 indicate a number of ways in which private equity firms influence innovation and R&D activities in their portfolio companies. Finally, private equity investors may seek to influence areas, for example marketing, which traditionally fall within the portfolio company’s operational domain as well as decisions, such as mergers and acquisitions, conventionally regarded as strategic. Hence, reflecting this expansive conception of the private equity investors’ role, the investment criteria adopted by 3i included the potential for adding value to portfolio companies by offering advice, continuing assistance in developing new products and services, recruiting key personnel, and providing introductions to potential customers, strategic partners, financiers, and investment bankers. In addition, private equity firms may be involved in outsourcing decisions—58 per cent of the term sheets studied had an outsourcing component. The Carlyle Group LLC was especially active in promoting outsourcing, part of a general drive to maintain focus in portfolio company operations. The formal terms of the initial agreements between private equity firms and investee companies only provide a framework for engagement. From an engagement perspective, ongoing monitoring of company performance and continuing provision of advice and assistance are more important. Private equity firms can monitor and exert control over portfolio companies through covenants which give them the right to inspect accounting and other company records, receive timely accounting and operating information, and sanction certain decisions (Fenn, Liang, and Prowse 1995). In line with these covenants, the boards of directors of portfolio companies monitor financial and operational performance and evaluate portfolio company strategies and product market opportunities in order to develop the new ventures’ strategies and meet the changing circumstances (Wijbenga et al. 2003). All private equity firms in our study undertook desk-based monitoring, involving portfolio company accounts and project reports. In addition, general partners usually

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met with portfolio company managements at least once a month to provide advice and raise issues of concern. Some had done so even before they invested in these portfolio companies, as part of their general research function, whilst for others it was part of the review meeting following the regular presentation of financial results. All private equity funds were represented at meetings of portfolio company boards of directors, held between five and eight times a year. Similarly, all portfolio companies reported frequent interactions with private equity fund managers, by telephone or in writing. The outline of formal arrangements understates the level of private equity investor involvement in portfolio companies. The majority of private equity funds researched integrated engagement in the overall investment process—the resources deployed in engagement could not be isolated even if, due to the specialist knowledge required, particular individuals took responsibility for particular engagement aspects.

5.3. CASE STUDIES The case study evidence further illustrates private equity investor engagement with the companies in which they invest. We outline the company background, investment strategy, and engagement practices, and we present an example of associated investee company for each of the seven private equity investors we studied. The case studies are based on interviews with private equity fund and portfolio company managers, supplemented by desk research, including company literature, acquired directly and via the Internet, and press reports. The degree of detail included in each case study varies, reflecting differences in access to information. The main areas covered for private equity firms were company background, investment strategy, engagement approach, formal and informal interaction with portfolio companies, and degree of influence over portfolio companies. For investee companies, we examined private equity firm influence on: strategy and performance, including overall strategy, acquisitions and disposals, new product development, and operational performance; and general management issues such as employee recruitment, compensation, marketing activities, and outsourcing. The key issue we address is the extent to which private equity investors play an active role in investee companies, in addition to their obvious financial role. The literature on private equity firms identifies several dimensions of engagement, such as monitoring, corporate governance, as well as advice and support. Private equity investors not only supply capital but also proffer expertise and advice, in addition to facilitating information exchange and

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dialogue amongst a network of portfolio companies. In addition to securing investment, investee companies also use private equity firm reputation and access to a network of relationships—with customers, suppliers, investment bankers, and other important stakeholders. All seven private equity firms we studied nominated non-executive directors. Similarly, all seven of them established advisory boards of industry experts, to which portfolio companies had access via fund managers. In some circumstances, private equity firms collaborated with one another formally, via syndicates, or informally—an approach more common amongst small specialist funds than amongst large general funds. Private equity firms operating in technology sectors established specialist ‘affiliate’ funds for industry experts, as a means of securing their support for portfolio companies as well as a means of raising finance. The seven private equity firms were managed by partners with scientific and technological backgrounds, as well as business experience, with large general funds increasingly tending towards sector specialization, alongside specialist technology and health care funds.

5.3.1. Amadeus Capital Partners Limited Based in Cambridge, Amadeus Capital Partners Limited is a private equity firm specializing in high technology investments in Europe. It was established in 1997 by three partners, who combined technological backgrounds with financial experience. The CEO had previously worked at Apax, where she had acquired extensive experience in advising early-stage high technology portfolio companies with their skill development and utilization. A metallurgist by training, she moved into management via an MA in Public and Private Management at Yale University. She had been chair of BVCA and a member of the DTI Technology Strategy Board. One of the other two partners had a background in physics, before becoming co-founder of Acorn Computer Group and Vice President of Research at Olivetti. He was a serial entrepreneur, involved in establishing more than twenty technology companies, and a leading participant in the ‘Silicon Fen’ effect. The third partner had worked with more than 30 early-stage companies, providing financial and strategic input. Amadeus Capital Partners is committed to long-term time horizons. The firm’s only cash exit at the time of the fieldwork was Entropic, which was sold to Microsoft in autumn 2004. It subsequently saw two portfolio companies float, the first being Lastminute.com, in which Amadeus Capital Partners held a small stake. The initial public offering (IPO) of the second, Orchestream, was nine times oversubscribed, raising £49 million and valuing the company,

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which develops policy management software to ensure quality of service over Internet protocol networks, at £185 million. Amadeus Capital Partners advises on the investment of £288 million, raised through three funds. The Firm raised its first fund, Amadeus I, in 1997; its second, Amadeus II, in 2000; and its third, Amadeus Mobile Seed Fund in the mobile telecommunications sector, in 2001. Amadeus Capital Partners invested in wired and wireless, including broadband, companies. Its investments also covered e-infrastructures, comprising software or software components enabling Internet activity. Holdings in this sector included Mediasurface, a web content management and software company, and Altio, an Internet enabling company. Its investments in e-commerce included Lastminute.com, NMTV, Think Natural, and Worldpop.com. Amadeus Capital Partners sought to link its investment strategy to its knowledge strengths, leveraging resources with expertise. Hence, it invests in small early-stage developments, often too small—sometimes only three or four people—to merit the name ‘company’. As a means of developing its networks, the Firm established a £2.5 million ‘invitation-only’ side fund for IT leaders. The side fund incorporated these ‘key influentials’ into the extended Amadeus Capital Partners network, familiarizing them with the Firm’s portfolio companies. Side fund investors acted as intermediaries between start-ups and sources of technical and management knowledge. They were often industry leaders, ‘helpful in getting the phone answered’, the CEO explained. ‘Side funds like this are one of the classic features of US venture funds—it’s an idea we picked up in Silicon Valley.’ The network was further extended through its advisory board, which included external business experts as well as investor representatives. Amadeus set out with the intention of emulating ‘Silicon Valley’ venture capital practice through its closely collaborative approach, with private equity investors assisting in building portfolio companies by means of side funds and advisory boards, providing an extensive international network of contacts. The Firm aims to nurture its portfolio companies through direct management support and the use of its global network of technology investors and leaders. Management support takes the form of helping portfolio companies with their operational performance, as well as providing market networking support through its advisory boards and side funds. Amadeus Capital Partners believes that its collaborative approach, in terms both of syndication and in its dealings with portfolio companies, is one of the Firm’s distinguishing features. According to its CEO, ‘[the Firm] tends to form a partnership with investees that is more collaborative than confrontational—this is not to say that we can’t be tough at times. But it is better to concentrate on making the entire

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pie bigger than on squabbling to the nearest millimetre about the size of your own particular slice’. Amadeus Capital Partners’ engagement practices included non-executive appointments, strategic audits, participation in discussions on innovation and product launch (Cambridge Silicon Radio), advice on marketing (PacketFront), and on outsourcing (Southampton Photonics). The Firm did not involve itself in employee recruitment issues, nor in share options. Plastic Logic Limited is one of the potentially significant portfolio companies in which Amadeus Capital Partners invested; the Company develops plastic electronics technology. Richard Friend, Cavendish Professor of Physics, and colleagues founded Plastic Logic in November 2000, working in partnership with Dow Chemicals and Seiko-Epson of Japan. The Company was a spinout from the Cavendish Laboratory at the University of Cambridge, building on over ten years of fundamental research. Plastic Logic is a successor to Cambridge Display Technology Limited formed ten years earlier to commercialize light-emitting plastic materials based on research carried out by Friend. The Company claims competitive advantage in its success in combining the right plastic materials with a viable manufacturing process. Unlike hard silicon chips, plastic chips can be printed on film rolls which can then be applied to clothing, curved surfaces such as bottles, and large displays. Plastic Logic partners include leading chemical and printing companies. Other semiconductor companies, including Royal Philips Electronics and Intel, pursue or invest in similar research. Plastic semiconductors have already been demonstrated in single transistors and integrated circuits. The attraction is not performance, because electron mobility in plastic is inferior to electron mobility in silicon. But systems which do not require critical performance benefit from the lowercost production of electronics printed onto packaging or incorporated within plastic casings. Such technology could, for example, make it possible for packaged goods to communicate with point-of-sale terminals without being removed from a shopping cart. With the active support of its investors, Plastic Logic hopes to become a world leader in providing solutions for printing active electronic circuits. Headquartered in state-of-the-art facilities on the Cambridge Science Park, the Company received investment of over £15 million from a range of private equity and other investors, including from Amadeus Capital Partners. The Firm’s involvement was particularly close, reflecting the ‘Silicon Fen’ factor, and the close links between Plastic Logic and Hermann Hauser, an Amadeus Capital Partners founder and director who had previously worked at the Cavendish Laboratory. Hauser subsequently became a non-Executive Director of Plastic Logic, and particularly encouraged the Company to strengthen its management team by recruiting new personnel and putting in place a product

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commercialization strategy at the earliest possible opportunity. Amadeus Capital Partners made £2 million available to Plastic Logic for new application technologies such as active-matrix drives for mobile telephone and large displays. Alongside Amadeus Capital Partners, current investors in Plastic Logic include Dow Venture Capital Group and Cambridge Research and Innovation. Dow Venture Capital worked particularly closely with Plastic Logic. Dow Chemicals contributed semiconductor polymer technology, based primarily on its proprietary polyfluorene chemistry, working with Plastic Logic to develop new semiconductor material technology. According to Friend, collaboration with Dow Chemicals during academic research led to subsequent commercial cooperation. ‘Clearly we value Dow’s materials expertise and financial resources. However, what’s as important is that their Venture Capital Group are pretty savvy. The Dow Venture Capital team have been very responsive in providing general commercial advice and assistance.’ Dow Venture Capital helped Plastic Logic exploit its intellectual property rights, whilst Bank of America Equity Partners provided the Company with market data and other product demand-related information.

5.3.2. Merlin Biosciences Limited Sir Christopher Evans founded Merlin Biosciences Limited in 1996, as an advisory firm specializing in equity investments in European life science companies. Sir Christopher also founded Chiroscience (subsequently merged with Celltech), Celsis, and Enzymatix. In 1997, Merlin Biosciences established its first fund to provide seed capital for UK biotechnology companies, which have since grown into major European biotechnology players. In 2000, the Firm began investing in more developed companies throughout Europe through its second fund. By 2006, Merlin Biosciences advised three funds with a total capital of C450 million and thirty-five portfolio companies. Merlin Biosciences won the Investor GP Capital All-stars award for ‘Venture Capital Fund of the Year’, based on criteria such as track record for innovative fund-raising, quality of investments and exits, and reputation for adding value to portfolio companies and for working closely with the early-stage investment community. The Merlin Biosciences partners had worked together for several years, and were themselves investors in the Firm’s private equity funds. With sixteen professional staff, Merlin Biosciences staffed each investment with a team of professionals, including at least one partner with day-to-day involvement in the management of the investment. Merlin Biosciences’ sectoral focus enabled it to bring its resources to bear quickly on major matters affecting

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portfolio companies. Merlin Biosciences partners normally sat on the boards of their portfolio companies, and through their international business connections often introduced new partners, customers, and suppliers who helped the young businesses to develop new markets. Merlin Biosciences sought to influence rather than control, usually taking a minority shareholding. Like Amadeus Capital Partners, Merlin Biosciences’ engagement philosophy was to be an active supporter of its portfolio companies. Merlin Biosciences Fund I raised C62 million in 1997. It was the first major seed fund for UK biotechnology companies, with a planned retention period for each investment of five to seven years. Fund I attracted commitments from a range of North European investors, with pension and life funds from the UK, Germany, Benelux, and Scandinavia as its primary sources of capital. It also targeted private equity investors, particularly funds looking for an allocation in life sciences but lacking specific in-house bioscience capability. Merlin Biosciences purposely did not target US investors because it was ‘small for most people’s standards’, with a final target of C200 million. Fund I targeted the bioscience equity gap which was perceived to exist for mid-stage life science companies. Its typical portfolio companies were two to four years old, and had reached ‘proof of principle’ stage, with products in late preclinical or clinical trial phases. Fund I was invested primarily in biotechnology companies (88 per cent), with a small holding (12 per cent) in medical devices. Merlin Biosciences Fund II raised C247 million and targeted unquoted pan-European mid-stage and late-stage biotechnology companies, with a bias towards marketable drugs. Its intended hold period for each investment was four to five years. The average investment size was between C7 and C10 million per company—relatively small amounts because there was normally more than one round of financing per company. The average investment in earlystage companies was smaller than that for mid- and late-stage companies, around C3 million. Fund II’s portfolio comprised 21 biotechnology companies and two medical device companies. The Merlin Biosciences team founded 14 bioscience companies and floated two on the LSE, Chiroscience and Celsis International: Chiroscience became part of Celltec, which in turn merged in 2005 with UCB, a pharmaceutical multinational based in Belgium. Merlin Biosciences Fund III had made eleven investments by 2006, being established as a pan-European ‘value’ fund in 2004. The Firm built up a network of international alliances. In 2001, Merlin Biosciences entered into a strategic collaboration with German life science advisory group, BioConnect, based in Frankfurt and Munich. The Firm acquired a significant stake in it, and also entered into an advisory investment

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agreement to support its wider investment activities in Continental Europe, particularly in German-speaking Europe. As part of the agreement, Merlin Biosciences’ director Mark Clement was appointed Chairman of BioConnect. Merlin Biosciences continued to grow through merger, with the head of Rothschild Bioscience Unit (RBU), together with other key individuals from the RBU team, joining the Firm. It also took over the management contract for the £57 million International Biotechnology Trust, an investment trust specializing in mid-stage biotechnology companies, formerly managed by RBU. Merlin Biosciences also assumed responsibility for the RBU’s Australian $43 million (£18 million) Australian Bioscience Trust and its Canadian $40 million (£25 million) Canadian Bioscience Trust. By bringing together Merlin Biosciences and the RBU funds and teams, Merlin Biosciences acquired the capacity to fund companies from test-tube stage to flotation. Merlin Biosciences followed a wide range of investment practices. It nominated non-executive directors, established an affiliate fund, and developed syndication arrangements. It frequently participated in discussions on strategy, including product development, competitor analysis (Eurogene, Microscience), and in strategic audits (Microscience). It became involved in human resource issues, including employee recruitment and management development. It did not provide guidance on stock options, outsourcing, or marketing campaigns. The Edinburgh-based pharmaceutical company, Ardana plc, was one of Merlin Biosciences’ portfolio companies. The Company was established in 2000 to take advantage of the reproductive health market, estimated to be worth £10.2 billion per year. At the time of the fieldwork, the Company was private, but in 2005 it was listed on LSE, raising £22 million on its launch. Ardana is an emerging pharmaceutical company focused on reproductive health, aiming to become a leading source of clinical and commercial innovation. The Company initially targeted commercializing research carried out by the Medical Research Council’s Human Reproductive Sciences Unit (HRSU) in Edinburgh. HRSU has been at the forefront of research in the human reproductive system for over thirty years, being one of four international academic centres of excellence in human reproductive biology. Ardana established an exclusive relationship with HRSU early, acquiring the right to assess and the exclusive option to licence or assign all existing unencumbered intellectual property and patent applications arising in the course of HRSU research. Through HRSU, Ardana gained an early-stage product portfolio and clinical development resources. HRSU employed 100 staff with an annual budget of £3.8 million. It benefited from a close relationship with the Department of Obstetrics and Gynaecology, University of Edinburgh, and was a partner in the Contraceptive Development Network. These relationships gave Ardana ready

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access to specialized clinical expertise, reproductive tissues, and patients. In 2004, HRSU moved to a custom-built £39 million institute. Between its inception and 2004, Ardana raised £43.4 million in four funding rounds. Alongside Merlin Biosciences, Ardana’s major investors included Deutsche Venture Capital, 3i Bioscience Investment Trust, and Mitsubishi. In October 2001, Ardana raised £13.3 million from a group of prominent international private equity investors in its first full round of fund-raising, led by Merlin Biosciences. The group included ABN-AMRO Capital (the Netherlands), 3i (the UK), Mitsubishi (Japan), and Green Highlander (the USA), alongside further funding from Ardana’s founding venture capital firm, Medical Venture Council. This funding was used to accelerate in-house research projects and to support a number of strategic initiatives for the acquisition, in-licencing, and co-marketing of reproductive health products. In July 2003, Ardana raised £20 million from a group of prominent international private equity investors in its second full round of fund-raising, including funding from Merlin Biosciences Fund II. The financing round was led by Techno Venture Management of Munich, Germany, with other participants including ISIS Equity Partners, and existing Ardana shareholders (Merlin Biosciences Fund II, MVM, ABN-AMRO Capital, 3i, and Green Highlander). This round of funds allowed the Company to establish more joint ventures and acquisitions, grow its core competencies, and introduce new areas. In May 2004, Ardana raised £9 million in an extension to its existing financing, Merlin Biosciences increasing its commitment further. The extension received strong support from existing and new investors. The new investors were Deutsche Venture Capital and Albany Venture Managers. Other existing investors, MVM International Life Sciences Fund and ABN-AMRO Participates, also increased their investment. Following the new investment, the Company appointed a new CEO and a new CFO, as well as strengthening its board of directors. Finally, the Company launched an IPO in 2005, with Nomura International as lead manager. Ardana offered 16,400,000 shares at 128 pence, raising £21 million gross, approximately £18 million net, of expenses. By September 2006, the shares had drifted slightly lower, trading at around 124 pence. As well as providing finance, Merlin Biosciences and other investors gave advice, and warnings, on Ardana’s activities. Merlin Biosciences provided additional funds for in-house research for product development. Deutsche Venture Capital, Albany Venture Managers, and 3i Bioscience Investment Trust provided additional funds for new professional appointments. Investors, including Merlin Biosciences, engaged in internal debate over the Company’s acquisition strategy. In order to secure a later stage and near market product pipeline to complement the HRSU research programmes, Ardana executed a series of licencing agreements and acquisitions. Ardana’s investors queried the

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rationale for acquisition, especially relating to europeptides, a prostate cancer drug in the second phase of development. The CEO remarked: we prepared a detailed business plan about the potential contributions of the acquired company to our strategic positioning. We’re in a business which requires new additions of capabilities on a regular basis; sometimes we can provide it ourselves, but, on some other occasions, we’ve to look outwards. Acquisitions of companies and licencing arrangements with a number of other players is a strategy we have to follow if we want to succeed. This is something we keep reminding our investors.

Merlin Biosciences was difficult to convince. The CEO adopted a conciliatory stance: ‘[w]e understand the concerns of investors in our present strategy of acquisition. The benefits from acquisitions aren’t always clear, it takes time to demonstrate the benefits of synergy’. Ardana’s success in developing an attractive product range prompted its private equity investors to press for its IPO. This was subsequently undertaken. The publicly quoted Company retained the strategy it had followed as a private company. It retained its focus on human reproductive health, sought to retain the value of its intellectual property by in-licencing and by building a sales and marketing infrastructure, and sought to strengthen its drugs pipeline by acquisitions. By 2006, the Company had launched one product in the UK (Striant™), one product had received marketing approval in several European countries, and three products had established clinical proof of concept. Ardana reported an operating loss of £10 million in 2005–6, and recognized that it would operate at a loss for several years.

5.3.3. Sitka Limited Sitka Limited was set up in May 1999 as a specialist private equity and advisory firm focusing on the health care sector. In 2005, Sitka became part of the private equity firm Noble Fund Managers, the third in its stable of private equity investment vehicles. Since its inception, Sitka has supported a range of early-stage health care companies preparing to come to the private equity market. Deals include Celtipharm, a European business-to-business e-commerce portal for pharmacies, FA Technology, a French media company, BioAlliance, a biotech company, and eCare, an online service promoting well-being at work. Sitka initially started by advising international fund managers on private equity finance for medium-size investment opportunities in Continental Europe, before developing into an active investor as well as adviser. The Firm concentrated on the French and Italian markets, its French co-founder and director having previously worked in Paris for Schroders Ventures Europe,

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before moving to London. The Firm believed that the French and Italian markets were underdeveloped for private equity, especially in the mid-market sector. According to Sitka, many Latin companies would need private equity investment over the next decade, but most lack basic information about the workings of the private equity market. Its team is relatively small, with six directors, including four non-executive directors, and a small core of professional staff; Chairman Gillian Nott OBE previously managed BP’s venture capital portfolio and was a director of the Financial Services Authority. In February 2001, Sitka launched its first fund, Sitka Health Fund Venture Capital Trust (VCT). The Fund invested in UK-based companies seeking between £300,000 and £1 million in investment, and potentially making available larger sums when co-investing with major investors. Areas of particular interest to the Fund included medical devices, diagnostics, pharmaceutical product portfolios, drug discovery technologies, instrumentation and reagents, health care services, and e-commerce health ventures. The Fund invested in companies at different stages of development, ranging from earlystage through development funding to investments in companies undertaking new share issues on OFEX or AIM. Sitka listed the attractions of the sector as: growing demand for products and services from an ageing population; rising National Health Service expenditure; universities increasingly looking to exploit their intellectual property; scientific innovation; and the continuing priority of health spending for both governments and individuals. Its Fund aimed to create a balanced portfolio of growth companies in the health sector. Of its eleven investments in 2004, four were early-stage, five at development stage, and two AIM-listed. The holdings were a mix of companies using technology to discover drugs, companies producing diagnostic equipment and devices, as well as service providers. In 2005, the Company had £7.1 million invested in 15 companies in the health care sector, including six AIM-listed companies, the largest investment being £600,000 in the private company Digital Healthcare, a software company specializing in the analysis of digital images from clinical photography. According to Sitka, the benefits of investing in the health industry were grossly underestimated: ‘if you invest £100 into the sector, on average you can expect a return of around £160 after four to six years—and that’s before tax relief. With relief at 40 per cent, you could almost triple your money, which is equivalent to an annual return of 20 per cent’. According to one investment analyst, ‘Sitka has a strong team with a wealth of knowledge, but all VCTs are high-risk because of the nature of the companies they are investing in and, because Sitka is heavily exposed to a single sector, that adds extra risk’. But the Firm argued that ‘investors who “play safe” by pouring money into AIM and generalist VCTs were wasting a great opportunity. We are not an AIM tracker

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fund, like some VCTs. We’re looking for much higher, proper venture capital returns. Also, as a specialist, we get to see the best stuff first, long before the companies approach generalist VCTs.’ Although small, Sitka claimed to follow a ‘hands-on’ approach to its investments. The firm nominated non-executive directors. It also established an Affiliate Fund and syndication relationships, and created an expert Advisory Board. Where required, it assisted in carrying out strategic audits, as at the French pharmaceutical firm Celtipharm. The firm participated in portfolio company discussions on particular issues of management concern, for example product development (Vectura), market share, and competitor analysis (Celtipharm and BioAlliance). Finally, the firm assisted in the recruitment of skilled technologists (Molecular SkinCare Limited). Sitka did not play a role in stock options or in outsourcing. Molecular SkinCare Limited was typical of the companies in which Sitka invested. Molecular SkinCare was a spin-out company from the University of Sheffield Medical School. The Company combined the scientific research capabilities of University of Sheffield researchers with those of clinical researchers to establish a biotechnology company aiming to develop a proprietary therapeutic pipeline in dermatology. The Company focused on psoriasis and eczema. Before setting up Molecular SkinCare, its founders had worked together for a number of years in dermatology. Sitka was instrumental in bringing together the laboratory research of Dr Ward, Dr Tazi-Ahnini (Senior Science Director), and Professor Gordon Duff (Chairman) and the clinical dermatology expertise of Dr Cork (Medical Director). A Sitka director was a member of the Molecular SkinCare Board of Directors. The Company raised £1.2 million in 2002, through a first round of venture capital financing led by Sitka, with additional investments by Cambridge Research and Innovation and Catalyst Biomedica, as well as by the University of Sheffield’s own investment arm. The Company was subsequently taken over in 2005 by York Pharma, a pharmaceutical company specializing in dermatology. The University of Sheffield realized holdings, but Sitka retained an investment of £500,000. In September 2005, Molecular SkinCare reported shareholder funds of £11,096,598 and a loss on the six-month trading period of £3,096,316.

5.3.4. 3i Group plc 3i Group plc was created by a syndicate of UK banks in 1945, at the end of the Second World War, to invest in the UK industry: the banks sold off their stakes in 1987. The Firm listed on LSE in 1994 and remains the largest

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British private equity firm. In 2005–6, the Firm managed a total portfolio of £4,139 million. 3i carries out four lines of business: buyouts, growth capital, venture capital, and small minority investments (SMIs), a division covering smaller and older investments due to be phased out. The largest business line is buyouts (£1,465 million), focusing on the mid-market, the smallest SMIs, at £564 million. In 2005–6, the return on capital was £831 million, representing 22.5 per cent return on opening shareholder funds. 3i invests in all financing stages of industrial, consumer goods, and financial companies. Unlike more narrowly focused ten to twenty person partnerships popular in ‘Silicon Valley’, the Firm has 300 investment professionals (more than 900 employees in all), with offices throughout Europe (ten), the USA (in ‘Silicon Valley’ and in Waltham, Massachusetts, close to Boston), and Asia, including a recently opened office in Shanghai. 3i’s size and international relationship network provide the capacity to integrate local and global business developments. The Firm remains British, with 78.8 per cent of its shareholders based in Britain, 9.4 per cent in Continental Europe, and 10.0 per cent in the USA. However, the Firm is increasingly international. Although nearly two-thirds of its portfolio was invested in Britain in 2003, by 2005 over half 3i’s assets were outside the UK, and 63 per cent of investment in 2005–6 was overseas. Ninety per cent by value of the Firm’s investment was in Europe in 2005–6. 3i’s recent history reflects overall market trends, especially technology market trends. In 2003, the Firm suffered a valuation drop in its portfolio of £1.2 billion, and a negative return of £935 million or 23.7 per cent of shareholders’ funds. The Firm wrote £75 million off its early-stage and technology portfolios. 3i blamed market movements for the loss of £800 million. Despite the losses, the Firm maintained its enthusiasm for technology businesses, and performance improved in 2004, leading to very strong financial performance by 2005–6 as the market improved, especially for realizations in the buyout division. The Firm is strongly committed to shareholder value: in the CEO’s words to the 2006 AGM, ‘we remain determined to accelerate the development of 3i to deliver further shareholder value’. Clear targets for return on investments are established, with allowances for risk and volatility: 20 per cent for buyouts, 20 per cent for growth capital, and 25 per cent for private equity, with the recognition of higher volatility. Resources are increasingly devoted to private equity activities, with an increase in late-stage investments, and to investment in Asia and the USA. 3i’s investment strategy is increasingly focused, with larger investments in fewer companies. Between 2001 and 2006, the number of companies in 3i’s portfolio dropped from 2,759 to 1,087; between 2002 and 2006, the number of new investments dropped from 291 to 58 (3i Group

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2006: 9). The Firm is seeking to consolidate its holdings, planning to realize its investments in the SMI sector, mainly small, older UK investments in the near future. 3i seeks to build a successful partnership between investors, entrepreneurs, and management. The Firm’s investment criteria include the potential to add value to the portfolio company by offering advice, assistance in developing new products and services, recruitment of key personnel and introduction to potential customers, strategic partners, financiers, and investment bankers. The usual investment period is three to seven years. 3i is committed to nurturing its portfolio companies in many ways. One of the most important is the access made available to 3i’s global network of investors and advisers. Due to its long history of investing in high technology companies, 3i is well connected with technology investors internationally, and able to call on the intellectual capital of academics and industry specialists. The VCT operates through sector groups, with special strength in oil, gas and power, media, and health care. The Firm’s network is formalized through its Advisory Board and affiliate fund, and maintained informally through special corporate events. As other private equity firms, 3i nominates non-executive directors of portfolio companies. 3i (3i Group 2006: 14) claims to work closely with each company we invest in to create a route map to becoming a scaleable, successful business. We are a selective, active investor and we sit on the boards of the majority of companies in which we invest. We work in partnership with our investee management teams to add value by utilising 3i’s global network of relationships. Through these relationships, we will often introduce new partners, customers and suppliers, and because our network is international, we can help young businesses to bridge the gap to new markets.

3i played an active role in Ardana Limited (see Section 5.3.2).

5.3.5. TechnoStart GmbH Operating from near Stuttgart in South-West Germany, TechnoStart GmbH focuses on seed and early-stage technology companies: its slogan is ‘we invest in great companies at a time when they are still small’. It manages more than C100 million in three different funds, Beteiligungsfonds, Ventures I, and Ventures II. There are three main groups of investors in the three funds managed or advised by TechnoStart: blue-chip financial institutions, corporate investors, and selected private individuals. TechnoStart was set up as an investment adviser and manager of private equity funds in 1990. In 1991, it started to invest in TechnoStart Beteiligungsfonds, a first-time seed fund. In 1998, following its successful exit from the Firm’s first biotechnology seed investment

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in MorphoSys, TechnoStart transformed itself into a private equity firm. By 2004, TechnoStart had a staff of twelve, mainly with a scientific background. Since 1998, TechnoStart has offered strategic, financial, and management support at the seed stage, and also assisted companies through the full venture cycle. Nevertheless, the Firm clearly focuses on early-stage investments, contributing in only a few cases to later rounds of financing outside its own portfolio and in up to three rounds within its own portfolio. TechnoStart invests a minimum of C600,000 in the seed phase, keeping money aside for future investment rounds. About 70 per cent of the capital for investment comes from institutional investors like Switzerland’s Partners Group, technology private equity group 3i, and the European Investment Fund (EIF). Business angels, individual investors, and Dow Chemicals contribute the rest. TechnoStart provides a vehicle whereby general funds can invest in highly specialized areas, relying upon expert professional advice. The Firm closed its second fund, TechnoStart Ventures I, at C41 million. Investors included TBG, EIF, Technologie Holding, and Dow Chemicals. The Fund also raised capital from private individuals. Institutional investors provided 50 per cent of the second closing total and corporate sources 8 per cent, whilst the balance of 42 per cent was drawn from private individuals. In 2006, the Fund’s portfolio comprised companies in three sectors: seven companies in life sciences, including two in genomics (Febit Biotec in automated genomics and Graffinity Technologies in chemical genomics); four companies in new materials, including ItN Nanovation AG in nanomaterials and Oxford Biomaterials in biomaterials; and five companies in applied physics, including Novaled, organic light emitting diode technology, and TF Instruments, precision ultrasonics in fluids. In 2002, TechnoStart began a new Technology Radar Screening Programme, aimed at using private equity to actively source ‘blue sky’ technologies and turn scientific explorations into commercial opportunities. With its money and support, these academic projects would form the nucleus for further development, usually as start-up companies. After having proved that the technology works on a laboratory scale, further funding is used to explore the full commercial potential of the now validated technology platform. TechnoStart believed that there was huge potential in German and European academic institutes waiting to be unlocked. The Firm was specifically looking for ‘cross-over’ themes which had been neglected by academic institutes (‘too industry-oriented’) or corporate R&D laboratories (‘too blue sky’). The novel-spinning technology company Spinox (renamed Oxford Biomaterials in 2005) was the Programme’s first project. The Company was a spin-off from the University of Oxford via Isis Innovation, the University’s technology transfer company. It was set up by the Department of Zoology in the field

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of bio-mimetic spinning of spider silk. According to Isis Innovation, ‘high performance fibres are amazingly tough and may eventually out-compete oil based polymer fibres, and illustrate how future materials can be based on sustainable, non-polluting processes. . . . Natural spinning processes are highly energy efficient and do not require high temperatures, strongly acidic solutions or toxic organic solvents’. The Company, funded jointly by TechnoStart and Isis Innovation, aims to copy spiders’ ability to spin silks, the materials being used for sutures or woven materials for surgical implants, protective clothing, and in sports equipment. TechnoStart is normally represented on the advisory or supervisory boards of its portfolio companies; it also helps to identify and recruit additional members with relevant experience and competence. The Firm has also established its own Advisory Board to assist portfolio companies as well as itself. The Firm is involved in establishing an organization structure and developing portfolio companies’ financial strategies, and contributes to all aspects of future development, including staff recruitment, business development, and marketing. At least one of its members becomes almost fully dedicated to any one portfolio company, and organizes further input from other TechnoStart team members. However, TechnoStart stresses that the Firm acts as coentrepreneur: the Firm is not the entrepreneur, and it is the entrepreneur who is ultimately responsible for top-quality performance. TechnoStart emphasizes its scientific and technological credentials, as a means of differentiating its investment and engagement strategies. This proved helpful in establishing credibility with advanced academic researchers. ItN Nanovation AG is such an example. ItN Nanovation AG is a company developing nanoparticles for ceramic products to be used in ovens or in water purification installations, amongst other applications. TechnoStart arranged C3.8 million funding for this Saarbruecken-based Company. One of the Company’s partners recalled that ItN Nanovation had contacted about 25 private equity firms in the year they spent trying to raise the initial round of funding: ‘TechnoStart was the only one to take some of our nanoparticles with them and examine them under an electron microscope. The impression you get when you talk with VCs is that the only thing they are interested in is money. TechnoStart looked more deeply into things’. The Firm’s other defining characteristic is that it offers both money and guidance; according to its own management, ‘scientists don’t necessarily have the training to manage people, to write patents, to find markets or to find other applications for their technology’. The Firm’s strategic expertise was very helpful in the area of patents, according to ItN Nanovation: TechnoStart set up workshops with patent lawyers to help the Company identify the most appropriate approach to patenting. Importantly, the Company patented the

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technology, not just the product. By 2006, the Company held over 30 patents, with significant licencing income. ItN Nanovation was taken public via an IPO on the Frankfurt Stock Exchange (FSE) in July 2006, raising C27.6 million. Major financing came from German institutional shareholders (68.6 per cent), with foreign institutional shareholders receiving 23.9 per cent, and private investors, including managers, employees, and family and friends receiving 7.5 per cent. By 2006, the Company had grown to 60 employees. ItN Nanovation reported an operating loss in 2006, due to expenditure on R&D and increasing personnel in sales and marketing, but anticipated moving into breaking even at the operating level in the fourth quarter of 2007.

5.3.6. Kleiner, Perkins, Caufield and Byers LP Kleiner, Perkins, Caufield and Byers LP was set up in 1972 by Eugene Kleiner to invest in the IT industry. From its foundation, the Firm aimed to provide operating advice and resources as well as capital investment. The Firm helped launch such notable firms as Sun Microsystems, Genentech, and Compaq. Headquartered on Silicon Valley’s Sand Hill Road in Menlo Park, the Firm is surrounded by many other major private equity firms, including Mayfield Fund, Sequoia Capital, Accel Partners, Benchmark Capital, and New Enterprise Associates. Currently, the Firm comprises ten partners. Of the four founding partners, only Frank Caufield remains active in the Firm. A graduate of the United States Military Academy and Harvard Business School, Caufield came from Oak Grove Ventures, another Menlo Park firm. Caufield sits on the Board of Directors of Quantum, Wyse Technology, VeriFone, America Online, and Quickturn. John Doerr, another major partner, has been behind start-ups such as Netscape, @Home, and Amazon.com, as well as several other companies. Doerr worked in sales at Intel and co-founded a chip company before becoming a venture capitalist. Doerr is a graduate of Rice University and Harvard Business School. Cynthia Healy, mainly responsible for investment in biotechnology and pharmaceuticals, holds a Ph.D. in pharmacology from New York Medical College. Another partner, Vinod Khosla, co-founded Sun Microsystems. Other general partners have had executive roles in technology companies such as Sun Microsystems, Microsoft, and Symantec. The Firm recruits professionals with a technology background, preferably with experience in innovative companies. With $1.5 billion in investment capital under management, the Firm offers finance to ventures at all levels of maturity, from seed through to third-stage financing. However, its stated specialty is early-stage financing for technology

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companies. Specifically, the Firm’s portfolio divides into two primary areas: information sciences and life sciences. In information sciences, the portfolio breaks down into five sections: Internet, enterprise software, consumer media, communications, and semiconductors. In life sciences, investment is geared towards companies in three groups: medical devices and diagnostics, drug discovery and therapeutics, and health care services and informatics. The Firm structures its investments into a framework of initiatives, several partners collaborating in an embryonic area, and seeks to pursue three or four initiatives at any one time. Sometimes they succeed, as with communications, telecommunications, and fibre optics; on other occasions they fail, as with pen computing. The Firm claims to subscribe to ‘keiretsu’, a Japanese concept referring to networks of organizations bound together by mutual obligations and contacts: ‘keiretsu’ is an enhanced form of networking. Entrepreneurs gain access to its portfolio of companies and associations with global business leaders. These relationships are the foundations for strategic alliances, partnership opportunities, and the sharing of insights to help build new ventures faster, broader, and with less risk. For Kleiner, Perkins, Caufield and Byers, Internet-based technologies have provided a major opportunity to forge such a network, with Netscape and Google at its centre. ‘Keiretsu’ reinforces the Firm’s ability to leverage the local insights of its investment professionals. The Firm claims to facilitate inter-organizational cooperation amongst its network of portfolio companies by ‘brokering’ strategically important information. As evidence, Kleiner, Perkins, Caufield and Byers claims that there are over 100 strategic alliances amongst its portfolio companies. However, the Firm’s experience also demonstrates the limits of such an approach. For example, its attempt to bring together Excite and @Home in a merger failed. Inspired by ‘keiretsu’ philosophy, the Firm brought the two firms together. It was the merger of a failing portal company with a broadband service provider that was far from profitable. The Firm envisioned the combined company as a step up for both struggling entities. Instead, the deal alienated its customer base as well as its supplier and investor communities. Kleiner, Perkins, Caufield and Byers follows a thorough engagement approach. It specifically claims that entrepreneurs ‘don’t need investors, they need coaches’. In addition to the common practices of nominating nonexecutive directors and establishing an affiliate fund and advisory board, it participates in discussions of a wide range of strategic issues with portfolio companies such as Amazon and Netscape. These include corporate strategy and marketing, senior executive recruitment, the use of stock options, and outsourcing.

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The Firm’s investments include Kodiak Networks Incorporated, an IT company providing advanced voice services designed to accelerate wireless communications. The Company operates in partnership with manufacturers of handsets, operating system providers, and subscriber identity module (SIM) card vendors. Kevin Compton, employed by the Firm since 1990, sits as an experienced executive on the Kodiak Networks Board of Directors. With a background in telecommunications, Compton served on several private company boards of directors on the Firm’s behalf, including KnowNow, Volterra, and Intersperse, and led the partnership in several others. As an indication of the close relationships between private equity investors and specialized, high technology companies, the six member Board of Directors of Kodiak Networks included three representatives of private equity firms. Similar arrangements existed in other Kleiner, Perkins, Caufield and Byers portfolio companies. The Firm and its investee companies were part of a dense network of private equity investors and IT organizations in Silicon Valley.

5.3.7. The Carlyle Group LLC Established in 1987, The Carlyle Group LLC (named after the New York hotel in which its early meetings were held) is one of the world’s largest and most controversial private equity firms, with more than $18.3 billion under management. It claims to generate extraordinary returns for its investors by employing a conservative, proven, and disciplined approach. The Carlyle Group invests in buyouts, real estate, leveraged finance, and ventures in Asia, Europe, and North America. Its partners invest their own funds, as well as manage the investments of others; they have committed more than $900 million of their own capital to its funds. The Firm is a private partnership, owned by a group of individuals, most of whom are managing directors, and one institution, CalPERS, which owns 5.5 per cent. The Firm is based in Washington, DC and has offices in 14 countries, with more than 500 employees. The Carlyle Group has recruited high-profile, politically connected general partners, including the former Secretary of Defence Frank Carlucci, former Secretary of State James Baker III, former budget director Richard Darman, and foreign leaders, including former British Prime Minister John Major. Dayto-day management of the organization is conducted by its three co-founders and managing directors, William E. Conway, Jr., Daniel A. D’Aniello, and David M. Rubenstein, under the chairmanship of Louis V. Gerstner. The Carlyle Group has more than 80 managing directors and nearly 300 investment professionals. The large staff enables the Firm to carry out in-house many

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of the roles other private equity firms contract out, including accounting oversight, deal sourcing, and due diligence, and various back-office duties. The Firm has built a large leveraged buyout activity by targeting investment opportunities in sectors where business and government intersect. It capitalizes on a network of influential friends and advisers to find deals not generally available through normal channels. The Firm’s specific niche in the early stages was in aerospace and defence. In a period of airline bankruptcies and post-Cold War defence downsizing, the Firm acquired the defence electronics businesses of companies, including General Dynamics and Magnavox Electronic Systems, very cheaply. The Carlyle Group broadened its investment scope beyond aerospace and defence to include sectors such as IT, telecommunications, and environmental remediation (industries for safer environment). All these industries involve significant regulatory oversight. In addition to its $1.4 billion domestic corporate buyout fund, the Firm also raised a $220 million venture capital fund designed predominantly to look at telecommunications, biotechnology, health care, and IT deals in the Washington, DC area. Through regional investment funds, the Firm took advantage of government privatization and corporate restructuring opportunities in Europe and Asia. The investments of its network of 250 global limited partners in 50 different countries account for roughly half of its total funds. The Carlyle Group played a particularly prominent role in the growth of public to private deals. Venture capitalists argue that taking companies from public to private enables them to make the necessary management changes more effectively. The company can focus on maximizing value without the need to spend time with City analysts or show sensitivity to the business media. Private status makes it possible to implement management changes rapidly, enabling a sharper focus on cash generation by, for example, acting quickly to reduce dangerous build-ups of stock and introducing heavy markdowns, generating cash through accelerating inventory turnover. Such manoeuvres are more difficult for quoted companies, whose like-for-like and margin numbers come under regular close scrutiny, with big markdowns viewed negatively by the City. Given its size, professional orientation, and wide scale of operations, The Carlyle Group has substantial resources to devote to contractual and communications relations with its portfolio companies. The Firm’s term sheets set forth in minute detail the portfolio company’s valuation and capital structure, the composition of its board of directors, the vesting schedule for its management’s stock options, and the size of the employee stock option pool, as well as the registration rights for its investors if and when the company launches a public offering. The Carlyle Group nominates non-executive directors, and expects them to take a leading role in ensuring that portfolio companies

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meet the requirements established in term sheets. The contact between The Carlyle Group and its investee companies is especially deep when the Firm is seeking to bring about strategic change, for example through increased use of outsourcing. The German company Edscha AG and the US company Blackboard Incorporated are two companies in which The Carlyle Group played a major role. They illustrate how private equity firms can influence the development of very different types of firms, in very different circumstances. Edscha AG is an example of a long-established German firm operating in a very competitive manufacturing sector—motor vehicles; Blackboard Incorporated is an example of a US high technology company exploiting the rapidly growing international market for educational technology.

5.3.7.1. Edscha AG Edscha AG was founded in 1870 in Remscheid, Bavaria by Edouard Scharwachter, whose shortened name became the company name. It was originally a manufacturer of hinges, locks, and other fittings for horse-drawn carriages. The Company developed into a major manufacturer and supplier of components for the truck and car industry. The Company remained in family control until the 1990s, the founder’s great nephew acting as Managing Director from 1941 until 1990. In 1994, Edscha redefined its corporate strategy, closing unprofitable locations and internationalizing production. In 1997, a management buyout occurred, with the shares purchased by the then managing director and private investors, led by The Carlyle Group. The Company was subsequently floated on FSE. Following further corporate restructuring, the Company was taken private in 2004. The major shareholders were The Carlyle Group, with a controlling interest, and the Edscha senior management. The Company was reorganized into four divisions: Hinge Systems, Convertible Roof Systems, Driver Controls, and Vehicle Development. With 31 production sites worldwide, the ‘company way’ involves a clear overall strategy: ‘globalization, reduction in the number of suppliers, extension of the range of products from components to create modules and systems, and outsourcing of production and development’. The most recent development (2006) is the creation of a wholly-owned subsidiary in China, Edscha Automotive Technology (Shanghai). The Carlyle Group played a major role in the transformation of a classic German ‘mittlestande’ firm into a car components multinational through a public to private transaction. This influence was reflected in changes at board of directors level, in corporate strategy, and in particular areas of practice. The current Board of Directors is small, and both the CEO and CFO had

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previously worked for The Carlyle Group. The Company’s financial restructuring reflected the influence of the Firm, with its strong commitment to public-to-private transformations. This influence was also evident in corporate practice, both in the development of the overall strategy (‘Mobility 2005’) and in the adoption of particular practices, especially in the supply chain management area. Edscha was best known as Europe’s largest automotive hinge maker, but its expansion into convertible roofs led to its acquisition by The Carlyle Group. The Firm bought its stake from PCI Edscha Partners, Deutsche Beteiligungs, and Flint Echo. To take Edscha private, the Firm created a holding company, EdCar. The Carlyle Group currently holds 77 per cent of Edscha’s equity, with four members of Edscha’s management board holding the remaining 23 per cent. The Firm accelerated Edscha’s international expansion, and eventually may take the Company public again when financial markets are favourable. The Carlyle Group intended to partner with the company on a long-term basis. The deal also confirms the importance of private equity consortia in the automotive industry. The Carlyle Group had already established a pattern of international holdings in the automotive sector, for example, the Firm owning the Honsel Group, a German supplier of aluminium castings. As part of its consolidation strategy, the Firm integrated the strategic management functions of Honsel into another venture, AMCAN Consolidated Technologies, a Canadian producer of automotive light-metal precision components. The Firm stimulated the development of a comprehensive strategy review. This resulted in a package of measures, called ‘Mobility 2005’, introduced to adapt Edscha in a flexible manner to compete successfully in the highly competitive automotive components market. The Carlyle Group was apprehensive about Edscha’s ability to maintain its competitive advantage and therefore saw ‘Mobility 2005’ as a way forward to focus the Company strategy. In the 2004–5 financial year, Edscha failed to reach its sales and earnings targets. By adopting the measures contained in ‘Mobility 2005’, Edscha expected to recover its flexibility and live up to its ‘best in class’ claim. Important elements of the programme were rigorous exploitation of potential for savings in purchasing and through outsourcing, capacity adjustments, concentration of capacity at low-cost locations, reduction of overhead and personnel costs, and control of investment. A key element of the package was streamlining the supply chain. As a supplier to the automotive industry, Edscha’s operating fields included car body products, convertible top systems, and sliding canvas tops for trucks. For the highly competitive automotive components industry, characterized by major annual price reductions, it was necessary for Edscha to introduce a strictly customer-oriented organization. Services desired by customers had

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to be fulfilled rapidly, on time, in top quality, and at market-oriented prices. Edscha’s own supply chain was unreliable—a purchased part otherwise always available went suddenly out-of-stock, or a capacity bottleneck previously undetected came up. It also appeared that the newly acquired companies did not integrate fully with Edscha’s existing procedures and practices. In one of the board of directors meetings, The Carlyle Group representative took up the issue, with the consequence that the management decided to re-evaluate its existing supply chain practices. With the target of firmly anchoring process orientation across the entire organization, a project was launched in cooperation with Swisslog Supply Chain Consulting Division, which was actively supported by The Carlyle Group representative throughout its implementation. Order centres were installed in relevant Edscha plants, assuming responsibility for planning and controlling the production process—inventory, volume, schedule effectiveness, and shorter throughput times—using Swisslog’s WAY Supply Chain Simulation. This phase was followed by business process reengineering, extending into improvement in data quality, and training of employees in the use of WAY simulation and new business processes. From December 2005, all production at the works in Remscheid was planned and controlled by the order centre, eliminating planning errors. All manufacturing tasks, including controlling information for the work groups, are now tested for capacity and material availability. Employees at Edscha can now meet deadlines, since bottlenecks are detected during the simulation and can be eliminated before they actually occur, using appropriate measures. Other performance improvements claimed included a 50 per cent reduction in inventory, guaranteed just-in-time delivery, and 95 per cent improvement in schedule effectiveness without buffer stocks. Moreover, the Company claimed that the new organization has had a positive effect on the corporate culture and the ongoing improvement process.

5.3.7.2. Blackboard Incorporated Blackboard Incorporated is an online education company which provides elearning tools for teaching and learning over the Internet. Blackboard provides what it terms ‘universal learning solutions’, a long-term strategy for educators to host single-course websites with Blackboard.com, multiple-course websites with Blackboard CourseInfo, and entire online campuses with Blackboard Campus. Blackboard customers include hundreds of prominent institutions, including Arizona State University, Cornell University, Georgetown University, and The College of William and Mary in the USA and the University of Southampton in the UK. Blackboard Campus is the first enterprise-grade system (a system which provides online multiple educational facilities such as

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teaching, assessment, and feedback) for supporting the academic activities of an entire college or university. Students, educators, and visitors to an online campus powered by Blackboard Campus have access to an interactive and customized online learning environment which provides continuous access to academic programmes and other aspects of campus life. Blackboard has already undertaken a successful IPO. It is also continuing to raise new equity finance. Strategic investors from the first round of financing included America Online, Dell Computer, Pearson, Internet Capital Group, Novak-Biddle Venture Partners, Kaplan Incorporated, Aurora Funds, and Merrill Lynch Kecalp, as well as The Carlyle Group. A leading executive in education technology and e-learning, Matthew Pittinsky co-founded Blackboard with a mission to use the Internet as a means of providing a flexible environment for teaching and learning. With 2,700 client institutions, 415 staff, 4 acquisitions, and more than $100 million in investment financing, Blackboard is a leading international provider of e-education systems. As Chairman, Pittinsky leads Blackboard’s corporate and product strategy, including its merger and acquisition plans, from an educator’s perspective. He also serves as Blackboard’s chief spokesperson to the academic and financial communities and leads the Company’s internal communications and culture-building activities. Pittinsky based Blackboard’s original business plan on research he conducted whilst a student at Harvard Graduate School of Education. Prior to co-founding Blackboard, he worked as a consultant in KPMG Consulting’s Higher Education practice. Blackboard expanded its product range from a platform for offering online courses to a complete enterprise portal, including assessment, student feedback, and so on. The service currently allows individuals connected with a campus to pull up a personalized screen which gives access, subject to security procedures, to online components of courses and email, and to information in administrative systems (fees due, grades, schedules, etc.), academic resources, and a number of information modules from campus affiliations and selected news and ecommerce organizations. Whilst initially devised for the USA, the company is increasing its international marketing. The Carlyle Group is a major investor in Blackboard. In addition to finance, the Firm provides continuing help and support. This support includes finding global suppliers, deal structuring, and general management support such as with the recruitment of technical workers. As an example of investor influence on strategy, to consolidate Blackboards’s market position, The Carlyle Group proposed a partnership between Blackboard and Prometheus. The Prometheus course management system was designed in 1997 at George Washington University (Washington, DC) and was currently used by 65 post-secondary institutions, including Rochester

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Institute of Technology and Wharton School at the University of Pennsylvania. Blackboard funded the acquisition through a combination of debt and equity, acquiring significant new resources in ‘talent, technology and a blue-chip client base’, according to Pittinsky. The alliance served the product and skill development needs of Blackboard. For example, Prometheus is a community source software, allowing clients to customize code in an open environment. Blackboard is an open architecture system. The merger facilitated system extension and better customization, thus allowing the company to secure long-term benefits. The Carlyle Group recognized these potential pay-offs and supported the acquisition. The Carlyle Group also encouraged Blackboard to develop partnerships to facilitate international expansion. Blackboard entered into partnership with Welocalize to implement an enterprise-wide globalization plan related to the Blackboard learning system. The Company claims that the partnership will enable educational institutions internationally to tailor e-learning to their local pedagogical approaches. The Firm was also instrumental in initiating negotiations between Blackboard and other companies. The Company also formed a strategic licensing agreement with NextEd, a multinational provider of web-based education hosting and delivery solutions. Under the terms of the agreement, NextEd licenses the Blackboard Campus software platform for use across its international server network, deployed to reach students in Asia-Pacific, Europe, and Africa.

5.4. CONCLUSION Chapter 5 has examined the relations between private equity investors and the companies in which they invest. The private equity firms we studied were of very different sizes, with very different levels of resources available for deployment via engagement with investee companies. For example, The Carlyle Group had far more resources available, both in money and in personnel, than smaller funds such as Merlin Biosciences. The sizes of portfolio companies varied widely, from historic multinationals such as Edscha to new small high technology university or research institute spin-outs such as Plastic Logic and Ardana respectively. Nevertheless, patterns of influence may be discerned. Even smaller funds, such as Merlin Biosciences and Sitka, possessed resources of skill and expertise, as well as finance, which were able to support investor engagement. Private equity investor engagement may be analysed into four elements, adapting the conventional pattern of communication studies: channels, form, content, and outcome. Hence channels may be formal or informal, direct or

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indirect. Form may differ, ranging from requirements, as in the mandatory elements in term sheets, through recommendations, to advice, often given informally on a day-to-day basis. Content also varies, reflecting the particular concerns of private equity investors and specific contexts of intervention. Three main sets of concerns were evident in our case studies. The first major set of concerns involved the boards of directors, and board-level decisions, especially overall strategy, particularly acquisitions. The second major set of concerns related to innovation and new product development, since high potential rewards from innovation were the major justification for venture capital involvement in the first place. Such concerns were especially evident in high-risk sectors such as pharmaceuticals. The third set of concerns related to portfolio companies’ management of their operations, including their management of human resources and supply chains. Finally, outcomes differed. Term sheet requirements were likely to be met, but recommendations and/or advice may be accepted and acted upon, accepted and not implemented, modified, or rejected. Private equity investor engagement was multichannel. Some engagement involved formal channels of communications, for example term sheet schedule requirements. The involvement of private equity investor representatives in portfolio company boards of directors also involved formal channels. In other contexts, engagement involved informal channels, including email, telephone, and personal meetings. The extent of the informal communication depended upon private equity investor resources and the issues involved. 3i and The Carlyle Group had the resources to support involvement in intensive communications, formal and informal, whilst Sitka did not—The Carlyle Group’s portfolio companies were subject to particular scrutiny. The case studies indicated intensive interaction over acquisitions, as in the Ardana case. The form of intervention differed, ranging from requirements to recommendations and advice. Recommendations and advice were important, since portfolio companies often lacked the breadth of experience and contacts that venture capital investors provided. Even the most distinguished researchers, with the most potentially rewarding technologies, such as Plastic Logic, recognized the need for the commercial ‘savvy’ that their venture capital investors supplied. With regard to content, private equity investor intervention related to three main areas, as just suggested. The first area is the board of directors, and the board’s role (see also Busenitz, Fiet, and Moesel 2004). Investors were represented on the boards of directors of all portfolio companies. As board members they performed three major roles: developing strategy, monitoring management processes, and providing networking support. First, investors played a critical role in developing the overall strategy of portfolio companies, especially in relation to acquisitions. The most fundamental transformation is

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changing the control structure of the portfolio company; The Carlyle Group was instrumental in taking the German company Edscha private. Cautious about management acquisition plans, private equity investors played a major role in the consideration of acquisitions in Ardana. Second, private equity investors were concerned with establishing adequate procedures for monitoring corporate performance. The most frequently mentioned category of activity in term sheets was performance measurement, mentioned in 79 per cent of term sheets. Such issues were, of course, especially critical for staged funding. Concern with monitoring performance extended beyond financial measures, for example benchmarking market performance against competitors. Third, private equity investors, both via the board of directors and by other means, provided links to the wider investor community, increasing access to expertise as well as to finance. The Carlyle Group was especially active in using its networking resources to assist its portfolio companies, both Edscha and Blackboard profiting substantially. Kleiner, Perkins, Caufield and Byers institutionalized its networking role through the development of ‘keiretsu’. Through establishing side funds and expert advisory boards, smaller funds played a similar networking role. The second set of issues of concern related to innovation and new product development. The driving force for innovation came from the portfolio companies themselves, the reason for their creation. Plastic Logic, for example, arose out of long-term high-level academic research, Ardana was building upon advanced research in reproductive medicine. However, private equity investors could enable portfolio companies to be more effective in their innovation by drawing attention to possibilities, by providing expert assistance in assessing possibilities, and by providing earmarked funds for investment in particularly promising licencing opportunities. TechnoStart provided support and expertise to develop academic projects into start-up companies. After finding that the technology worked on a laboratory scale, further funding was used to support exploring the full commercial potential of the now validated technology platform. TechnoStart developed its own Technology Radar Screening Programme approach—a skill development strategy—to identify potentially useful inventions in the academic sector. It further provided support and expertise to help develop these projects as start-up companies. Investors could also provide contacts with related researchers and resources, as the Dow Venture Capital Group did for Plastic Logic. The third set of private equity investor concerns was operational, the provision of advice and assistance in specific areas of management. The precise concern differed amongst private equity investors, depending upon their own resources and expertise, and amongst portfolio companies, depending upon the particular issues they faced. Portfolio companies tended to be weak in

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marketing, a first area of concern, and private equity investors provided marketing support. HRM was a second area of concern. Recruitment and retention of professional staff was a particular area of concern, mentioned in 64 per cent of term sheets. Examples in our case studies included Amadeus Capital Partners providing earmarked funds for recruitment, Plastic Logic offering the possibility of pre-IPO stock options as a recruitment incentive for professional technologists. Obtaining private equity was associated with a significant increase in the likelihood of adopting a stock option/bonus plan (e.g. TechnoStart offered stock options with increased investor activity), in addition to recruiting new staff. In many instances, the goal was to institute substantial and focused performance incentives—usually a system of rewards equalling 15–20 per cent of the total equity. In some cases, share ownership plans covered the whole organization, but in most cases incentives were targeted at leading executives. Training also played a significant role in some investee companies, for example in the private equity company Sovereign’s concern with the training programmes for Care UK, a health care services company. Private equity firms thus influenced the skill acquisition strategies of portfolio companies through recruitment (e.g. making sure the portfolio company had expert individuals in key positions), retention strategies (e.g. employee share options and other incentive schemes), and teambuilding (e.g. training programmes). At the same time, there is limited evidence of general partners assisting with operational issues, and it was impractical for general partners to be involved in day-to-day management. The evidence thus indicates that portfolio companies received considerable help from their private equity investors in building their internal organization, specifically in skill development, including building operational teams, introducing new management practices such as inventory systems, or helping create new management capabilities such as expertise in patent registration. The leadership at the very top of the organization was also influenced by private equity funds, the CEO having the central role in building up a company. To begin with, company founders naturally took the leadership positions in their own companies. Whilst founders may be very suited for initial phases, not all founders could make the transition from entrepreneur to manager. Our case studies suggested that as companies grow, they tend to bring in outsiders for the positions of CEO and/or CFO (hence, Ardana and Plastic Logic appointed a new CEO and respectively CFO in the second round of venture capital financing). New CEOs and/or CFOs were installed in 33 per cent of the deals studied. The final element is the outcome of the intervention. The relationship between private equity firms and their portfolio companies was one of interdependence. Private equity firms sought high levels of financial returns on their

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investments, reflecting the level of risk; as the private equity firm Sitka emphasized, its private equity funds aimed at higher returns than index matching. Private equity firms also targeted their investments, usually in areas relating to their specific expertise, providing the motivation and capacity for engagement. Private equity firms such as Merlin Biosciences, as well as much larger funds such as 3i and The Carlyle Group, possessed, or had access to, wideranging technological as well as financial resources. Reciprocally, portfolio companies sought expert advice and support, as well as funding, from their private equity partners. Portfolio companies sought finance for their initiatives, preferably from round rather than staged funding, since staged funding limited managerial discretion. However, portfolio companies also sought skills, experience, contacts, and commercial ‘savvy’ from their investors. Even the most distinguished researchers recognized that they needed the commercial assistance available from their investors. Hence, Plastic Logic relied heavily upon Dow Venture Capital in developing the Company’s potentially groundbreaking approach to combining plastics with electronics. Similarly, Ardana required pharmaceutical industry experience, provided by the members of its board of directors, to link the distinguished research at HRSU with potential commercialization. Private equity firms provided the link between university research and commercial opportunity. The relationship between private equity firms and their portfolio companies was thus more than a market relationship, based on investment and return on investment; it was a partnership based on shared risks, as both private equity investors and portfolio companies recognized. The role of private equity firms thus extends beyond that of traditional financial intermediaries: private equity investors can play a pivotal role in the development of the companies they finance. The ‘strategic fit’ between private equity investors and investee companies is a key enabler of engagement, that is the match between investors’ capabilities/skills and the needs of investees. As Milgrom and J. Roberts1 (1992) emphasized, the ‘fit’ between strategy and resources and environment is a key component of corporate strategy. In particular, strategic focus and organizational structure affect the processing of ‘soft’ information, which is at the core of financial intermediation: financial judgement is not only a question of numbers. Private equity fund partners can help their portfolio companies in many ways, including with professionalizing the management team, giving advice and support, creating strategic alliances, or involving themselves in the governance of the corporation. How does the strategic fit of the private equity firm, in terms of organizational focus and human capital, affect its involvement with the companies it finances? There are two main conclusions. First, engagement style is strongly related to the private equity firm’s own strategy and focus. Private equity firms

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investing in one particular specialized area (e.g. biosciences) are significantly more capable of becoming usefully involved with their portfolio companies than general funds. Similarly, firms which specialize their investment activities exclusively in specific types of deals, such as venture capital deals, are more capable of providing relevant resources for engagement. Second, the skills and experience (the human capital endowments) of fund partners and managers are relevant; general private equity partners with scientific and technological training and prior business experience are significantly more involved with the companies they finance than generalist financial intermediaries. All funds in our study placed a strong emphasis on their professional staff having scientific backgrounds, relevant to the sector specialization, and prior business experience. Being a specialized private equity firm strongly favours an active engagement style. Merlin Biosciences and Sitka specialize in health-related businesses, whilst Kleiner, Perkins, Caufield and Byers focuses on the IT sector. The more activist firms deal on average with three portfolio companies in a particular sector at a time, whilst the industry practice is six. Firms which focus on one particular sectoral activity and firms which focus on financing relatively few companies per partner are in a position to provide more governance and support to their companies. More diversified venture capital firms such as 3i have designated sector specialists, or domain experts, to vet proposals regardless of geographical location. This approach may miss out on the strengths of local networks, which only local offices can provide, but local networks have difficulty in providing the depth of specialized expertise. Knowledge-based firms, such as financial intermediaries, create value in very different ways from the manufacturing model. In traditional manufacturing firms, such as major car manufacturers, the major strategic trade-off is between differentiation and cost, achieving a balance amongst quality, product variety, and production cost. For knowledge firms the trade-off is between the depth of specialization in particular areas, which can only be acquired over a period of time, and scope, the range of problems which can be taken on. For example, Kleiner, Perkins, Caufield and Byers limited its investment to a few specific areas like high technology industry. Similarly, Amadeus Capital Partners concentrated only on bioscience projects, whilst TechnoStart’s main focus was technology transfer from academic institutions. Following similar trade-offs consistently creates specialization, adding to the value of existing intellectual capital and building reputation. Despite its small size and operating in a high-risk area, Sitka believed that focus and specialization was the best approach. Sitka’s investment strategy relied heavily on its partners’ knowledge and skill.

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The move towards specialization and sectoral focus has not always been popular with fund managers, brought up to concentrate on entrepreneurial deal-making. Private equity firms have had to confront organizational legacies stemming from their original individual or regional approach to investing. For example, in 3i there was an attitude that ‘this is my fiefdom’ amongst fund managers, resulting in an approach towards exclusivity and pursuit of individual self-interest. To ensure that new investments made strategic sense for 3i, the Firm designated sector specialists, or domain experts, to vet proposals regardless of origin. Large general purpose private equity funds, such as 3i and The Carlyle Group, are moving in the direction of sector specialization. Sector specialization means understanding the business issues prevalent in a particular sector well, and knowing key people in the field. Competitive advantage will be built on this expertise because of the nuance and contextual detail needed for screening quality projects. To this end, the large private equity firms are building up specializations in areas like biosciences and media, as well as traditional sectors such as retailing, to capitalize on new business ideas in those fields. Private equity funding is only a small segment of the capital market, even in countries with a developed venture capital culture such as Britain and the USA. However, it is disproportionately important, providing resources for high-risk investments that may form the basis for long-term economic growth; they are a major means of stimulating and managing the turbulent process of ‘creative destruction’ which Schumpeter (1950) saw as the basis for economic development. Private equity investment provided the initial impetus for the dynamic growth of the IT sector in the USA in the 1980s and 1990s, whilst both the IT and pharmaceuticals sectors continue to attract riskoriented investors; biotechnology and nanotechnology firms are also becoming increasingly attractive for such investors. Private equity firms which act as ‘coaches’ provide the means whereby ‘cutting edge’ researchers can acquire the commercial ‘savvy’ and skills to develop projects into, eventually, products. As the experience of pharmaceutical firms Ardana and Molecular SkinCare indicated, this may be a long road. However, as Blackboard demonstrated, it may be a highly rewarding one.

6 Investor Management 6.1. INTRODUCTION The relationship between investors and managers is two-way: managers seek to influence investors just as investors seek to engage with managers. Senior managers are highly sensitive to the wishes of investors, even when they are not actively seeking to raise capital. The performance of the firm’s share price is a powerful, and obvious, index of management performance: the share price is a running commentary on corporate managerial performance, giving highly visible expression to the rhetoric of shareholder value. Managers need to ‘manage’ investors in large corporations, where institutional investors and fund managers may influence corporate restructuring and merger and acquisition activity directly or indirectly, through share price changes. The demerger movement in the 1990s was a direct response by corporate managers to the stock market discount on conglomerate firms (J. Roberts1 2004: 224–5). Managers are also required to respond to investors’ definitions of ‘good corporate governance’, for example in the 1990s reshaping boards of directors to meet changing conceptions of the roles and responsibilities of non-executive directors. Managers are also sharply aware of the influence of investors on the professional careers of senior management personnel, especially on the turnover of chief executives. Failure to maintain what investors regard as an acceptable share price may lead to the CEO’s loss of office, although the mechanisms whereby that result is achieved appear to vary with the business system (Khurana 2002: 87; Renneboog and Trojanowski 2003). In the USA and Britain, the requirements for an effective CEO include maintenance of a high reputation ‘on the Street’ in New York or with the City in London (Khurana 2002). The need for managers to be sensitive to investors is equally evident in new firms with venture capital investors, with the detailed engagement practices identified in Chapter 5. Managers seek to manage their relations with investors just as they seek to manage their relations with other stakeholders. In managing investor relations, senior management objectives are both institutional and personal. The main institutional objective is maintaining corporate independence, indicated

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in the priority given to anti-takeover measures, as was the case especially in the USA in the early 1990s: the battery of anti-takeover devices, including ‘poison pills’ and ‘golden parachutes’ as defensive stratagems, highlights senior corporate management commitment to institutional independence. Maintaining corporate independence is the fundamental principle of corporate management, since corporate independence is the foundation for achieving other objectives: it is rare for incumbent senior management to encourage takeover of their own firm, without significant ‘sweeteners’ such as favourable treatment in the new entity (Clarke 2004). Senior management is also concerned to maintain control, or at least major influence, over major strategic decisions, an integral part of its corporate professional role. Personal objectives include enhancement, or at least retention, of personal corporate position, level of financial reward, and the self-enhancing perquisites of the senior management role. Overall, senior managers have strong personal as well as professional incentives to seek to entrench their control of the corporation (Walsh and Seward 2004). From the investor perspective, even sceptics of agency theory recognize that investors have strong incentives to monitor corporate management closely, to align corporate strategy and operations with shareholder interests, to reduce the chances of malfeasance, and to control corporate excess. The major threats to corporate management control in the present phase of Anglo-American capitalism come from investors, rather than TUs or political parties. Corporate management depends upon investors for resources, external support, and legitimation, whilst investors depend upon managers’ business judgement to achieve their objectives. In seeking to manage investors, senior managers possess four major types of resources: material, legal, cultural, and intellectual. The first major type of resource is material, the direct control of corporate assets, including financial assets, subject to auditor oversight. Of course, corporate management has influence on the level of directors’ own rewards. Relevant material resources also include the control of the corporate communications system, internal and external, which provides a ready means for disseminating information and mobilizing support. They also include the day-to-day management of the institutional support for the board of directors. The second major resource is the legal protection of managerial authority. This is expressed clearly in the US ‘business judgement’ rule, whereby boards of directors and corporate management are held legally accountable for self-dealing and dishonesty, but not for errors of commercial judgement (Kaufman, Zacharias, and Karson 1995; Blair and Stout 1999). Managers are legally protected against corporate financial losses and commercial errors, provided that they acted in good faith and used honest judgement (Kauffman, Zacharias, and Karson 1995). The presumption of ‘innocent until proven guilty’ reinforces the position of

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corporate management, the controllers of organizational information flows. Thirdly, this legal protection is supported by both state authorities and the broader culture, which endorse corporate managerial authority. The fourth major resource is knowledge and understanding. Managers generally have deeper knowledge and understanding of corporate affairs than investors or their agents, and are able to deploy that greater knowledge in cases of disagreement. The position of senior management thus remains much stronger, materially and legally as well as politically and institutionally, than implied by advocates of shareholder value. There are three major strands in corporate management’s approach to managing investors. The first is managing the board of directors, the de jure controllers of corporate assets on behalf of shareholders. The second is the management of relations with investors who have actually invested in the corporation, or are potential investors in the corporation. The third strand is the management of the capital market and the capital market’s perception of the corporation. The three elements overlap and are mutually supportive, and all three require active senior management engagement. To develop the theme of managers managing investors, the chapter is organized into five sections. Following this Introduction (Section 6.1), in Section 6.2 we briefly examine issues involved in the management of the board of directors, insofar as they relate to the board’s role in representing investors. Much further research is needed in this aspect of corporate governance, where relations are especially opaque and research access is problematic, even for well-connected scholars (see e.g. Holland 2002; MacAvoy and Millstein 2004). In Section 6.3, we examine the process of managing investors and the means adopted to manage market perceptions, including the management of expectations. In Section 6.4, we indicate the limits of management autonomy, using case studies of J. Sainsbury plc and GlaxoSmithKline plc (GSK) to illustrate how managers may disappoint the expectations of the capital market and fail to manage relations with investors successfully. In Section 6.5, we return to the overall issue of investor engagement under shareholder value from the senior managers’ perspective.

6.2. MANAGING THE BOARDS OF DIRECTORS The boards of directors are the de jure controllers of the corporation and its assets. Employees, including senior managers, are the servants of the corporation, as represented by the board. Managing the board is therefore a central task for senior corporate managers, especially the CEO. There are

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major differences between boards of directors in Britain and the USA, and even greater differences between boards in Britain and the USA and other countries. However, the relations between managers and investors as reflected in developments at board level are critical in all systems, since they concern the fundamental control and direction of the corporation. The discussion below focuses on Britain and the USA, with only limited reference to the situation elsewhere, which is discussed in detail in Chapter 7. The board of directors is the central focus of corporate power in Britain and the USA (Pettigrew and McNulty 1995; Maitlis 2004). In both countries, the board is formally responsible to shareholders and subject to annual reelection at the AGM. Board members are not necessarily shareholders themselves, but act in the interests of all shareholders. In Britain, The Combined Code on Corporate Governance states that non-executive directors should not receive share options, since holding share options might prejudice the directors’ independence (Financial Reporting Council 2006: 11). However, some major companies, including GSK, introduce an element of share allocations and share options in the remuneration of non-executive directors as well as corporate management, despite the opposition of The Combined Code on Corporate Governance to the practice. The terms of reference for directors and their responsibilities are matters for the corporations themselves, but in both Britain and the USA, company law lays down specific requirements, enforced via regulatory agencies [Securities and Exchange Commission (SEC) in the USA, Financial Services Authority in the UK] and, for listed companies, stock exchange rules. Where companies do not follow recommended practices, they are required to explain the deviation. In both countries, the board comprises a combination of executive and non-executive directors, the balance between these categories differing amongst firms, with more efficient firms having a larger role for nonexecutives (Dalton et al. 1998: 270; Hermalin and Weisbach 2003). However, there is external pressure from politicians and business reformers in both Britain and the USA for the proportion of non-executive directors to be increased and their role expanded (Lorsch and MacIver 1989; Higgs 2003). Indeed, US reformers have advocated boards composed exclusively of external directors (Black 1992; Bainbridge 1993; Dalton et al. 1998). Non-executive directors play a central role, especially in monitoring the performance of the CEO. In the USA, boards dominated by outside directors are more active in removing CEOs of failing corporations than boards dominated by insider directors (Hermalin and Weisbach 2003: 8). Moves to increase the responsibility and authority of non-executive directors were already underway in the 1990s (MacAvoy and Millstein 2004). But the corporate scandals of Enron, WorldCom, and others in the USA were perceived as showing the failure

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of non-executive directors to fulfil their monitoring role effectively and as reflecting the dominance of corporate management over boards of directors, requiring further reinforcement of the independence and influence of nonexecutive directors (MacAvoy and Millstein 2004). The relations between the CEO and the board, especially the chairman of the board, are especially important. The chairman of the board acts as a major link between the corporation and the investment community, interpreting the corporation’s strategy to the investment community and the investment community’s expectations to the board. In 3i, for example, the Chairman is formally charged with ensuring ‘effective communication with shareholders’ (3i 2006: 46). The chairman is expected to play an active role in monitoring the performance of the CEO and in managing CEO succession, whether voluntary or involuntary. In the UK, following the recommendations of the Cadbury Committee in 1992 and successor committees on corporate governance (Hampel 1998; Myners 2000; Higgs 2003) as well as The Combined Code on Corporate Governance (Financial Reporting Council 2006), the role of the chairman of the board of directors has been separated from that of the CEO: the chairman is responsible for managing the board whilst the CEO manages the company. According to The Combined Code on Corporate Governance (Financial Reporting Council 2006: 4), ‘[t]here should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision’. The Grant Thornton UK LLP (2003: 8) survey of Corporate Governance in Practice showed that 91.9 per cent of FTSE 100 Index companies had separated the two roles, and 89.2 per cent of the FTSE MID 250 Index. In the USA, the roles of CEO and chairman of the board continue to be combined, despite pressures from reformers for the two roles to be separated. Corporate CEOs have strongly resisted pressure for their role to be redefined. Hence, the Business Round Table (BRT 1997: 13) concluded that ‘most corporations will continue to choose, and be well served by, unifying the positions of chairman and CEO. Such a structure provides a single leader with a single vision for the company and most Business Roundtable members believe it results in a more effective organization’. Non-executive board members are part time, in the UK spending on average ten hours per week on board business; ten board meetings a year is the norm for major listed companies (Deakin and Hughes 1999: Table 1). Nonexecutive directors are expected to have extensive business contacts and reputations with the business community, playing a major boundary-spanning role (Filatotchev and Bishop 2001: 4). Hence, non-executive directors

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are likely to have more than one directorship: the average number of outside directorships held by non-executive directors of the 175 largest quoted companies in the UK in 1995 was 1.27 (M. O’Sullivan 2000), whilst Filatotchev and Bishop (2001: 18) reported a much higher figure of five for non-executive directors in their IPO sample. For the USA, Shivdasani and Yermack (1999) reported two additional directorships for Fortune500 non-executive directors in 1994–6. For example, GSK Chairman, Sir Christopher Hogg, had been a highly successful CEO of the textiles and paints conglomerate Courtaulds, where he was responsible for the early demerger of its textiles operations. As well as chairing GSK, he chaired Reuters, the information and communications corporation. His successor as chairman in 2004 was Sir Christopher Gent, the former CEO of Vodaphone. Other members of the GSK Board in 2004 were also heavily involved in City affairs: Sir Ian Prosser, former Chairman of the hotel group Six Continents, was the senior non-Executive Director, Sir Peter Job (formerly Reuters), Sir Robert Wilson (Chairman of British Gas and Rio Tinto), and Mr Crispin Davies (Reed-Elsevier, Guinness). The boards of other major corporations, such as Vodaphone, drew from the same, rather small, pool of former senior corporate managers. The GSK Board was well acquainted with City practices, and well qualified to convey City opinions. Such external board members ‘provide access to valued resources and information as well as facilitate interfirm commitments’ (Dalton et al. 1998: 273). But the wide range of commitments and connections that made them attractive as directors representative of shareholder interests and guarantors of the company’s good practice to the City, meant that they relied heavily upon corporate management for knowledge of the firm and the sector. The time available for developing understanding of the organization and monitoring corporate management was inevitably limited. Board members represent both the interests of the company as an institution and those of shareholders as a group, with the balance between their two lines of responsibilities being the subject of controversy. According to the stakeholder view, safeguarding the interests of the corporation as an entity requires the board to act independently of both investors and corporate management. Hence, in Blair and Stout’s model (1999: 250), the board is a ‘mediating hierarchy’, a means of resolving conflicts that emerge in ‘team production’, Blair and Stout’s reformulation of the concept of the corporation. According to more conventional views of shareholder value, the primary responsibility of the board is of course to investors. Critical to both interpretations of the role is board independence. According to the OECD (2004: 12) Principles of Corporate Governance, ‘the board should be able to exercise objective judgement on corporate affairs independent from management, controlling shareholders and others in a special position to influence the company’. According to the UK

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Combined Code on Corporate Governance (Financial Reporting Council 1998: Paragraph A3.4), ‘a non-executive director is considered independent when the board determines that the director is independent in character and judgement, and there are no relationships or circumstances which could affect, or appear to affect, the director’s judgement’: relevant relationships include former employment, ‘material business relationship’, family ties, representation of a significant shareholder. The Combined Code on Corporate Governance’s wording was revised in 2006, but not materially changed (Financial Reporting Council 2006: 6–7). As Hermalin and Weisbach (2003: 12) commented, ‘probably the most important factor determining a board’s effectiveness is its independence from the CEO’. Whether the board is seen as a mediator between stakeholders or as a servant of investors, lack of independence undermines the legitimacy and acceptability of the board’s judgements, externally and internally. However, the level of board independence from corporate management is questionable. In both the UK and the USA, research has indicated that non-executive directors are likely to have had some connection with the senior management team prior to their election as directors and to have only a limited degree of independence. For example, Udueni (1998: 6, 16) concluded that ‘less than 20% of the outside directors are truly independent’, based on an analysis of 184 large UK industrial firms for 1995–6. Likewise in the USA, where the CEO exercises a major influence over the selection of nonexecutive directors (Khurana 2002). British chairmen and finance directors claimed that ‘independence of mind’ was more important than meeting the formal independence criteria established by The Combined Code on Corporate Governance (Moxey 2004: 10)—a somewhat subjective and potentially selfserving criterion for assessment. Moreover, even the most independent nonexecutive director is more likely to share the norms, values, and assumptions of the senior management group than of any other group in the ‘production team’. The executive members of the board of directors operate as members of the senior management team, led by the CEO. There are several ways in which the senior management team may manage the board: through influencing its composition, through its institutional arrangements, and through its mode of operation. The first is through influencing its composition. In both Britain and the USA, shareholders vote on the election of directors, according to the size of their shareholdings. However, there are limitations on the nominations of candidates for election as directors. The nominating procedure is carried out by the existing board— in the UK usually through a nominating committee consisting mainly, or exclusively, of non-executive directors, as recommended by The Combined Code on Corporate Governance (Grant Thornton UK LLP 2003). However, the process is heavily influenced by corporate management, and the number

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of nominations usually matches the number of vacancies. The CEO plays an especially important role in the selection of board members (Shivdasani and Yermack 1999). Moreover, corporate management takes the initiative in seeking potential candidates for board membership, although the board itself is responsible for its own membership subject to election by the shareholders’ AGM. The selection process for non-executive directors is highly informal. As the Higgs Report (Higgs 2003: 39) noted, ‘almost half of the non-executive directors surveyed for the review were recruited to their role through personal contacts or friendships. Only 4 per cent had had a formal interview, and only 1 per cent had obtained their job through answering an advertisement. This situation was widely criticized in responses to consultation, and I accept that it can lead to an overly familiar atmosphere in the board room’. The electoral process is managed by corporate management, or subcontracted to a professional communications firm such as, in Britain, the Electoral Reform Society. Information about candidates is circulated by management. There is little scope for shareholders to secure the election of a director against the wishes of corporate management. Instead, shareholders nominally possess a power of veto over the nominations presented by the existing board. However, this veto power is ‘the nuclear option’ and is very rarely used—rejecting board nominees indicates a corporation in crisis. Nevertheless, the threat to vote against directors nominated by the incumbent board is very powerful, and has been used by major institutional investors, as in the election of GSK directors in 2003. Corporate management thus controls the board’s electoral process, but may be subject to shareholder rebellion if shareholder wishes are too blatantly ignored, especially when ignoring investors’ known wishes is associated with perceived self-dealing, for example with overgenerous remuneration arrangements, especially in poorly performing companies. The second way in which corporate management may manage the board is through influencing the size and structure of the board and its committee structure. The size of the board may be related to its function, with a broad distinction between representative and ‘management’ boards. Where boards are intentionally representative, as in dual supervisory/management board structures, the supervisory board is likely to be large, as in Germany, where it has twenty members, or Japan, where boards such as Toyota’s are even larger than in Germany. However, British and US boards have a managerial rather than representative role, being responsible for developing corporate strategy and overseeing financial performance rather than representing different stakeholder interests—they are intended to be ‘efficient’ rather than ‘dignified’ institutions, to use Bagehot’s classic constitutional distinction. Accordingly, British and US boards are small, with reformers recommending no more than eight members, composed almost exclusively of external non-executives, on

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the grounds that larger boards are inefficient. ‘Firms with higher proportions of outside directors and smaller boards tend to make arguably better— or at least different—decisions concerning acquisitions, poison pills, executive compensation, and CEO replacement, ceteris paribus’ (Hermalin and Weisbach 2003: 2). Boards also differ in the extent to which they are supported by an institutional infrastructure of committees. Both in Britain and in the USA, there are increasingly precise prescriptions of the ways in which boards should operate, especially on the role of non-executive directors, from regulatory authorities and stock exchanges. In the UK, The Combined Code on Corporate Governance (Financial Reporting Council 2006) provides clear and extensive guidelines on corporate governance. Non-executive directors are required to chair the remunerations committee, and The Combined Code on Corporate Governance recommends that the remuneration committee should consist exclusively of non-executive directors. According to the Grant Thornton UK LLP (2003: 16) survey, 88.9 per cent of FTSE 100 Index companies and 79.2 per cent of FTSE MID 250 Index companies complied with this recommendation. Similarly in the USA, board substructures have been extended and the role of non-executive directors enhanced, for example with the appointment of lead directors (Holmstrom and Kaplan 2003: 16). The mechanics of managing the board differ according to the size and structure of the board. As with the election of directors, the size and structure of the board and its committees are the formal responsibility of the board itself, but the incentives for initiative lie primarily with senior corporate management. Senior management also influence the operations of the board. The CEO is a major participant in board discussions, whether he is chairman of the board or not. The board is responsible for determining its own operations, although specific activities are required by legislation, or The Combined Code on Corporate Governance in Britain or SEC in the USA, including the annual approval of the accounts and the creation of a remuneration committee chaired by a non-executive director. In both Britain and the USA, non-executive directors are recommended to meet as a group at least once a year, without the presence of executive directors and, in the USA, without the presence of the chairman. Other activities are more discretionary, and subject to the initiatives of the senior management team. For example, firms may organize special education sessions for board members, focusing on specific issues that the senior management team regard as currently important, such as the status of the drugs pipeline in a pharmaceutical company (e.g. GSK) or the development of corporate human resources in an investment fund (e.g. 3i Group plc). The papers for board meetings are prepared by the senior management team, giving corporate management access to control of the board agenda,

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and administrative support is provided in-house. Corporate management’s control over the day-to-day operations of the board provides a major means of channelling support for its policies and interests. The first stage in corporate management’s strategy for managing investors is thus managing the board, as the major link between the corporation and the investment community. The senior management team possess many advantages in this process. The board of directors is elected by the company’s shareholders at the AGM, and the responsibility for elections, as for other board activities, rests with the board itself. But the elections are usually noncompetitive, with the number of candidates presented for election by the board matching the number of vacancies. In the UK, ‘opposition’ candidates may be nominated by shareholders holding 5 per cent of total voting rights or 100 members each holding £100 paid-up capital. However, the procedure is very rarely used and there is little possibility of shareholders securing the election of a director against the wishes of the incumbent board. The conduct of the election is the responsibility of the board, usually under the guidance of the chairman, but with the implementation via the senior management team. The senior management team also has considerable influence on the structure of the board and its committees, and on its modus operandi.

6.3. MANAGING THE INVESTORS Managing investors involves managing relations with actual and potential investors in the company, and managing overall relations with the investment community. The first is the responsibility of the investor relations department, the second is an additional aspect of the overall corporate public relations function, including relations with the media. We are concerned here with the first, whilst recognizing the importance of the second. In the USA and the UK, investor relations were professionalized in the 1980s (Useem 1993: 132; Marston 1996; Investor Relations Society 2005). From its beginnings, the objective of corporate investor relations was to assist in the recruitment, retention, and enhancement of the quality of investors. The focus was on sell-side analysts, responsible for advice on, and management of, the funds of major institutional investors. Such analysts became increasingly important in the 1990s, especially in the USA, their number more than doubling, to over 4,000, between 1980 and 1998 (Khurana 2002: 76). Investor management was approached in the same way as managing other markets. Market assessments involved comparing corporate shareholders with the shareholder lists of other corporations in the same sector, for example in the proportion and

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distribution of institutional investor holdings and the location of individual investors. A similar process of professionalization occurred in Britain, with the establishment of the Investor Relations Society in 1980, with the vision of ‘promoting excellence in investor relations and enhancing corporate value through effective communications’; in 2005, it had almost 700 members (Investor Relations Society 2005). Typical investor relations departments comprised three or four professionals, with a budget of £500,000 (Investor Relations Society 2004). The role of investor relations departments was, as The Financial Times observed, ‘to manage analysts’ expectations and prevent unwanted stock market turbulence’ (Financial Times 2005a). Senior management sought to influence stock analysts and major investors both directly and indirectly. Directly, managers organized one-on-one discussions between senior executives and major investors (see Section 4.2.1). In the UK, the meetings between corporate managers and fund managers and senior managers of institutional investors are formal, with the CEO, chairman and finance director present, often linked to the presentation of interim and yearend results. ‘For any company there is a hierarchy of investors and, to some extent, analysts, in terms of size and influence. The largest investors can usually ask to see any of the company directors they choose, and nearly always the chief executive, chairman and finance director will be present’ (Stiles and Taylor 2002: 90). Larger investors are wined and dined, smaller investors dealt with over the telephone or even handled by the public relations department. According to one chief executive (quoted in Stiles and Taylor 2002: 90–1), reflecting on the management of investor relations: We used to be a fairly secretive company, primarily because we are operating in a very competitive market. But we realized that we were treated with something like suspicion in the City. We wanted to raise money to fund an acquisition and we knew that if we didn’t open up more, we would have trouble finding capital easily. We arranged a series of meetings, with shareholders, analysts, journalists, to describe our strategy and how we do things. It went down very well, and our meetings are now much more regular, either over lunch or at set piece occasions.

Many companies, such as GSK, claim to follow The Combined Code on Corporate Governance and to carry out a ‘dialogue’ with investors on the company’s objectives, plans, and performance on a routine basis. In the case of GSK, financial results were formerly published quarterly, usually with halfyearly and annual presentations to shareholders, but the frequency of publication was reduced in 2004. Regular presentations on the results are made to institutional investors, analysts, and the media in London and New York, and frequent presentations are made to specialized conferences, both to the investor and medical communities. Teleconferences are held in connection

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with the publication of financial results and made available on the corporate website, which includes a special page on investor relations. In addition, ad hoc presentations are arranged on key topics, such as a special presentation on the company’s drug pipeline in December 2003. Two major operating principles appear to govern management’s approach to managing relations with investors. The first is the principle of ‘no surprises’. Management recognizes the importance of avoiding surprises for investors, whether abrupt changes in corporate strategy or changes in personnel, especially executive departures. Private discussions are held with major investors to avoid surprises, especially when these are expected to have potentially negative effects on the company’s share price. Fund managers, especially those following ‘relationship’ investment principles, expect such consultation (Holland 2002). Fund managers’ credibility and professional standing are undermined if the investors whose funds they are managing become aware of corporate developments before they do. The second principle is closely related to the first, the importance of managing expectations. Investor expectations are determined partly by external factors, especially the performance of benchmark comparators, and partly by the corporation’s own commitments and previous performance. Matching investors’ expectations could be achieved through managing investors’ expectations as well as through achieving enhanced corporate performance—a strategy long familiar to managers in centrally planned economies. According to Graham, Harvey, and Rajgopal’s survey (2005: 5) of CFOs in the USA, ‘the two most important benchmarks [used by CFOs] are quarterly earnings for the same quarter last year and the analyst consensus estimates. . . . Managers are willing to make small or moderate sacrifices in economic value to meet the earnings expectations of analysts and investors to avoid the severe market reaction for under-delivering’. Meeting market expectations, preferably through smooth earnings growth, is perceived as the best means of projecting corporate competence. Predictions of financial performance may be managed, with expectations pitched low in some circumstances to enable market expectations to be exceeded—including even profit warnings. In July 2006, GSK raised its full year target for earnings growth from 10 to 12 per cent, but analysts had hoped for 15 per cent and GSK shares lost 23 pence on the announcement; its Chief Operating Officer explained GSK’s approach: ‘We have a history of giving conservative guidance, which we have always exceeded or matched. We don’t like to disappoint and I think a 20% upgrade to 12% is pretty good’ (Guardian 2006). But managing expectations through ‘smoothing’ and manipulating measures of financial performance could degenerate into market manipulation, as in the late 1990s US corporate scandals, when Enron’s creative accounting led to the fabrication of earnings (Coffee 2006). Managing expectations is particularly important in

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pharmaceuticals, where information on future drug developments is critical to market evaluation, but highly uncertain. GSK managed the release of information regarding drugs under development or in the pipeline as part of its long-term marketing to the investment community. The increased importance of institutional investors created a new situation for corporate management concerned to manage investors. The widely dispersed investors documented in the analysis of Berle and Means (1932) required little management, with investors having little leverage on the capital market or the corporation. Investor invisibility allowed managers effective autonomy. The growth of institutional investors appeared to represent a greater threat to management autonomy, making a reality of shareholder ownership, with greater concentration of shareholder power. Senior managers faced greater capital resource dependence. This dependence was reinforced by the ideology of shareholder value. However, as Blair and Stout (1999: 252) commented, ‘shareholders’ rights and powers over directors in publicly held companies are remarkably limited both in theory and in practice, and as a result directors of public firms enjoy an extraordinary degree of discretion to pursue other agendas and to favor other constituencies, especially management, at shareholders’ expense’. Corporate management retained significant room for manoeuvre and resources for managing their environment. The development of professionalized capital fund management, with specialized sell-side and buy-side analysts, information intermediaries, public relations consultants, and publicists as well as business journalists created a culture oriented towards capital market operations within which corporate executives could operate comfortably (Coffee 2006). In the USA, there was a symbiotic relationship amongst the charismatic CEO, financial analysts, and the business media, geared to depicting the business leader as cultural hero (Khurana 2002). (With a small number of exceptions—Sir Richard Branson, Lord Browne—business leaders did not achieve the same iconic status in Britain.) The questionable accounting practices of Enron, WorldCom, and other US corporations in the late 1990s indicate the wide scope for managing investors available to corporate executives, despite the rhetoric of shareholder value (Coffee 2006). Corporate managers proved capable of managing institutional investors, at least in the short run.

6.4. LIMITATIONS ON MANAGING INVESTORS Previous sections have shown how corporate management managed investors, and the ways in which management could retain its influence despite the increased concentration of investment via institutional investors, and the

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growth of shareholder value ideologies. However, there were limits to management’s room for manoeuvre. Corporate managers were increasingly constrained by expectations of ‘good corporate governance’, as defined by successive reforming committees both in Britain and in the USA. Investors cited ‘best City practice’ in Britain as the benchmark for corporate governance. Moreover, the British government encouraged investor activism, especially by pension funds, as a means of realizing ‘enlightened shareholder value’. New Labour Government proposals for company law reform are geared to enhancing shareholder engagement and activism to achieve this (Financial Times 2005b). In defining the general duties of directors, Lord Sainsbury (Parliamentary Under-Secretary of State, DTI) (House of Lords 2006: Column 184) stated that directors ‘must, in promoting the success of the company, have regard to factors such as the long term consequences of business decisions and the impact of the company’s activities on employees, the community and the environment’. The issues of excessive executive remuneration and rewards for failure raised investor concerns and indicated the limits of corporate management autonomy. In this section, we outline two case studies which indicate the conflicts that arise when companies breach what major investors regard as ‘best City practice’ and companies fail to manage market expectations: the excessive payments made to Sir Peter Davis by Sainsbury in 2004 and the over-generous remuneration proposals by GSK in 2003. Conflicts between senior corporate management and institutional investors were evident at J. Sainsbury plc, the UK food retailer, as outlined more fully (see Section 4.3). They indicated the limits of corporate management influence over investors. The payments, which were recommended by the Board’s Remuneration Committee and approved by the Board, were generally considered by shareholders to be excessive. Corporate management claimed that the size of the award to the outgoing Chief Executive Sir Peter Davis under the share bonus scheme was justified by the Company’s performance and the effectiveness of the Chairman in securing the appointment of a new Chief Executive and a Deputy-Chairman who was to be Chairman designate. However, institutional shareholders regarded the financial performance of the Company as disappointing and they opposed the appointment of the person selected as Deputy-Chairman, leading to his failing to take up the post. In line with New Labour’s commitment to enhancing investor influence, changes in UK Company Law in 2002 required quoted companies to include a remuneration report in their annual report, and for the remuneration report to be approved at the company’s AGM. The new regulations were issued in response to government concerns about the level of remuneration to directors, and applied to all quoted companies in respect of financial years ending on

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or after 31 December 2002. Sainsbury’s institutional shareholders were concerned with what they judged to be excessively generous payments made to Sir Peter under a ‘Share Award Plan 2003’. They were also unhappy with the nominated successor Sir Ian Prosser’s previous track record. In response to the criticism from institutional shareholders and the press, Sir Ian renounced the job. In addition to the debacle over his appointment, the Company did not perform well in 2003–4, with a fall of 2.9 per cent in underlying pre-tax profit to £675 million. Despite Sir Peter’s failure to secure an acceptable successor, the Remuneration Committee recommended that 864,000 of the 1 million shares potentially available to the outgoing CEO be awarded conditionally. After considerable unfavourable publicity, the Remuneration Report which incorporated the payments to Sir Peter was only narrowly accepted at the company’s AGM in 2004, the size of the negative vote reflecting the deep anxieties of institutional investors. The problems faced by Sainsbury senior management in 2003–4 indicate the limits to corporate management influence. Corporate management was able to persuade the Board to adopt a remuneration policy that conflicted with the known expectations of major institutional investors. However, two related factors prevented the policy from being implemented. The first was the continuing poor performance of the Company, reflected in the continuing market share decline and in its poor profit performance. Indeed, Sir Peter was leaving because of his failure to turn the company round, his successor, Justin King, being brought in as a ‘young Turk’ to rescue the situation. The second was the failure to take account of shareholders’ expectations regarding remuneration policy. Investors did not query the level of remuneration, but the inadequacy of the conditions set for achieving it, both in terms of the ‘soft’ conditions (succession planning) and in terms of the financial performance. The controversy over Sir Peter’s remuneration weakened the credibility of the Sainsbury Board with investors, forcing Sir Peter to give up his prospective appointment as Chairman on standing down as CEO and subsequent Board changes. Shortly after the conflict over Sir Peter’s payments, the Chairman of the Remuneration Committee resigned, and the Senior Non-Executive Director Lord Levene came to the end of his term of office. By 2006, the composition of the Sainsbury’s Board was completely transformed, alongside a major turnover in senior management. Similar problems arising from the failure to follow ‘best City practice’ occurred at GSK in 2003–4. In 2003, the GSK Board radically revised its remuneration policy for senior executives, with the stated intention of aligning the interests of senior management more closely with those of investors. There was a major increase in the importance of the bonus and performancerelated elements in remuneration, designed to focus management attention on

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shareholder value. However, the scheme backfired, due to what institutional investors regarded as the excessively generous treatment of the CEO and, to a lesser extent, the CFO, and the proposal was rejected. The Board’s proposed changes were presented as bringing the Company’s practice into line with US practice. The key principle articulated by the Remuneration Committee was establishing comparability with global pharmaceutical companies, whilst providing a remuneration system which secured, retained, and motivated ‘key talent in a very competitive market place. . . . UK shareholder guidelines would be followed to the maximum extent consistent with the needs of the business and the company would maintain a regular dialogue with shareholders’ (GSK 2003: 45). The global pharmaceutical companies used for comparison comprised eight US companies (including the world’s largest, Pfizer), two Swiss, two French, one Japanese, one German, and one other British company, AstraZeneca. Senior executive remuneration comprised three major elements: basic pay, bonus pay, and share allocations and options. Basic pay, the least important element, was the median salary for the global pharmaceutical comparator group. The annual bonus was to be based on performance: no bonus to be payable if the performance was 96 per cent of the target performance, with upper limits to bonuses of 100–200 per cent of basic salary, 200 per cent being the upper limit for the CEO. ‘Bonus awards for 2003 reflected the Committee’s belief that the company produced superior results during the year, after taking account of factors outside the control of management, notably exchange rate changes and the launch of generic competition to Paxil in the USA’ (GSK 2003: 46). In addition, executives received share awards and share options, based on performance compared with the 14 comparator pharmaceutical companies (not, as previously, with the performance of the FTSE 100 Index). Performance was measured by total shareholder return (TSR), vesting 35 per cent if median TSR, 100 per cent if in the top two. The wider share option scheme for senior executives was based on EPS, with 100 per cent allocation if EPS equalled Retail Price Index (RPI) plus 5 per cent. If performance targets were not met after three years, performance would be re-measured after four years. In addition, ‘[t]o align the interests of executives with shareholders, executives [we]re required to maintain significant holdings of shares in GSK’ (GSK 2003: 46). The number of shares to be held varied according to position: CEO four times base salary, other Executive Directors three times base salary; 700 top executives the equivalent to base salary. The contractual notice period for the CEO was reduced from two to one year, with entitlement to one year’s annual salary and one year’s on target bonus. Shareholders regarded the level of remuneration as excessively generous. They also believed that the level of payments to be made to CEO J. P. Garnier in the event of his resignation was unacceptable, being estimated at up to

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£22 million (Murray-West and Barrow 2003). The Report of the Remuneration Committee was rejected at the 2003 AGM by 50.72 per cent of votes to 49.28 per cent, with both institutional and individual shareholders voting against the report. Even before the AGM, the Board Chairman Sir Christopher Hogg had written rather defensively to shareholders regarding the Report. ABI criticized GSK for ‘significant breaches’ of ‘best City practice’ on remuneration, whilst NAPF urged members to abstain on the re-election of the incumbent CEO and CFO as directors. Although the negative vote was not legally binding, the Remuneration Committee Report was withdrawn. Subsequently, the share options for the CEO were rearranged and the terms regarding his termination were revised, but the total remuneration package eventually approved at the 2004 AGM still provided for very generous annual remuneration, at £2.8 million. Investors were thus able to have a significant influence on the level of executive remuneration, but corporate management achieved its objective in moving towards a US level and system of remuneration. The GSK corporate management severely mishandled remuneration issues in 2003, resulting in the very exceptional rejection of the Report of the Remuneration Committee. Unfavourable press publicity focused on the level of CEO remuneration. The level of remuneration was excessive, especially for executives close to retirement age and unlikely to be targets for poaching, one of the justifications given by the Remuneration Committee for the high level of remuneration. The share option schemes justified as aligning the interests of executives with those of shareholders were, in practice, further means of increasing executive remuneration, since the performance targets were not demanding. The Chairman claimed that the performance targets were ‘challenging’. But this was not plausible, especially with the exclusion of factors for which management could not be held responsible, such as exchange rate fluctuations. Moreover, the targets set were below those set for other major corporations. For example, the target of a return on capital of the RPI plus 5 per cent (during a period of slow growth in the RPI) was significantly lower than the RPI plus 15 per cent demanded by Vodaphone’s target EPS. However, corporate management succeeded in moving the company significantly towards US practice. The global companies with which GSK compared itself, both in terms of overall performance and in the specifics of remuneration policy, were primarily US companies. The Chairman and CEO J. P. Garnier acted as a charismatic American CEO, the dominant influence on the Board. These brief accounts of developments at Sainsbury and GSK show the limits of management ability to manage investors, and the limitations on their autonomy from investors. In both companies, management proposals

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on remuneration were challenged successfully at the AGM, with opposition mobilized by institutional investors through their collective organizations, ABI, NAPF, and PIRC Ltd. In both companies, management presented remuneration proposals which were regarded as excessively generous, especially in the context of lax performance targets established for qualifying for share options; opposition centred on the weakness of the conditions more than on the level of rewards. In both companies, the Board was obliged to act defensively, even shamefacedly. The Government and reformer pressure on corporate managements to amend corporate governance practices to meet external expectations increased gradually throughout the 1990s, and senior management accommodated to many changes without difficulty: many changes did not seriously constrain management autonomy. However, the external pressure on excessively generous share options arrangements in badly performing companies was rapid, and in the short run effective.

6.5. CONCLUSION In this chapter, we have examined relations between investors and managers from the perspective of senior managers. We have been concerned with the room to manoeuvre available to senior managers within the context of the rise of shareholder value. How far did management become constrained by investors? We have argued that management retains significant autonomy, and is more than the passive agent of the investor as principal. The relationship between managers and investors is one of mutual interdependence, in which investors possess resources required by managers, capital, and market reputation, and managers possess resources required by investors, skills in the mobilization of productive assets, and knowledge. In this respect, our analysis adopts a resource-dependency approach to corporate governance. The level of management dependence on investors is linked to corporate capital requirements and the availability of capital. Management autonomy is facilitated by capital abundance and weakened by capital scarcity. As Robert Freeland (2001: 297) showed in his major study of General Motors, slack capital resources undermined the ability of shareholders to veto management proposals. The second major resource controlled by investors, and thus source of corporate management dependence, is market reputation. Market reputation is the foundation for career success at senior corporate level. However, market reputation is a frangible commodity, difficult to sustain. Investors are dependent upon corporate management for transforming inert into active capital. The relationship between the two groups differs in different circumstances and is

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influenced by the power of the parties as well as of other stakeholders in the corporation. From the management perspective, investors are major stakeholders, who need to be managed, like any other stakeholder. Even before the rise of shareholder value, corporate managers were sensitive to investors’ views, since investors were a major influence on market reputation. However, managers saw—and continue to see—investors as providers of a resource, required for the operations of the company, not as owners to whom managers owe a fiduciary loyalty. Shareholder value provided a rhetoric and a mode of legitimation, but rarely a direct influence on management behaviour. According to Hendry et al. (2004: 17), ‘most of the managers interviewed shifted between two characterizations of their investors, as financial traders, serving their own clients, and as resource providers, or suppliers of capital’. Investors were not perceived as owners, with ultimate control over corporate assets: ‘[managers] talked of the need to maintain good relationships and keep shareholders on side, of the importance of managing expectations and controlling the flow of information, of the value of broadening the shareholder base, and of working to keep options open and maintain a freedom of manoeuvre’ (Hendry et al. 2004: 17). However, the day-to-day working assumptions about investors expressed by managers underestimate the significance of investors for their own actions. The expectations of fund managers, and the market generally, provide the framework within which senior management is required to operate. These expectations could be interpreted and managed, but not ignored. Market expectations are linked primarily to corporate performance in the same quarter of the previous year, with a small improvement. As one chemical industry manager expressed it, ‘ “[w]e feel that we are required to increase earnings every quarter. There’s no question about it. We begin to fuss about it in the last month of the quarter, and we really start to look at the earnings to make sure that we can make up versus last year, to the extent that we use some reserves and things like that to ensure growth” ’ (quoted in Useem 1993: 143). Provided that expectations are met, the capital market influence remains largely invisible. However, failure to meet expectations may result in increasing fund manager intervention, culminating in senior management dismissal— ‘with highly rewarded chief executives who perform badly we ensure they go much quicker now than they used to a few years ago’ (a fund manager quoted in Holland 2002). Moreover, an over obvious disregard for ‘best City practice’, especially regarding executive remuneration and share options in badly performing companies, could result in concerted shareholder action. Managers are thus able to manage investors, but only within limits set by investors’ expectations.

7 Corporate Governance Convergence in International Perspective 7.1. INTRODUCTION Previous chapters have examined in detail how investor engagement operates under shareholder value regimes in Britain and the USA, paradigm ‘AngloSaxon’ ‘liberal market’ business systems (Hall and Soskice 2001). The perspective widens in this chapter, to consider how far shareholder value, and investor engagement, are becoming the standard form of corporate governance in advanced coordinated market economies. Several scholars recently argued that corporate governance regimes are converging, with growing acceptance of shareholder value. Most strongly, Hansmann and Kraakman (2004) hailed enthusiastically ‘the end of history for corporate law’, with the triumph of shareholder value. Similarly, Coffee (1999: 20) argued: [w]hether through the integration of markets, the harmonization of standards across markets, or the migration of firms to foreign markets (chiefly in the US or the UK) a substantial degree of convergence seems predictable. This is so for a variety of reasons that ultimately rest on both the need for many firms to grow in scale in order to exploit global markets and the desire of public shareholders for a credible commitment from these firms that they will not be exploited.

An alternative view is that there is only limited evidence for convergence and that corporate governance institutions remain diverse, reflecting the logic of the national business systems of which they are a part; they are resilient against international trends (Aguilera and Jackson 2003; Clarke 2004). For example, coordinated market capitalisms, such as Germany, operate according to their own system logics, attach less importance to shareholder value and have different mechanisms for investor engagement. From this perspective, corporate governance arrangements, including the priority of shareholder value and the extent and form of investor engagement, vary with national economic, political, and social environments, including legal and institutional arrangements. An even more sceptical view of convergence was expressed by Joerg et al. (2005: 23) who argued that ‘there is actually little evidence that

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shareholder value maximization is the principal corporate target, regardless of the legal country of incorporation’. This chapter addresses the issue of convergence in corporate governance arrangements. There are different methodologies for assessing convergence. One methodology involves comparing specific corporate governance arrangements against a model of shareholder value corporate governance. Following this approach, LaPorta et al. (1999) assessed corporate governance regimes against a model of ‘best practice’ shareholder value corporate governance arrangements. The shareholder value measures are linked to national economic, social, and political features, especially legal institutions, in largescale international comparative surveys. However, such large-scale quantitative analyses provide more purchase on the inter-relationships between formal institutional arrangements than on understanding corporate action. Our own research into investor–management relations has focused more on corporate practice than on institutional arrangements. Consistent with this focus—and the Popperian logic of falsifiability—we have adopted a more nuanced, if more limited, handicraft methodology to discuss the convergence thesis, namely critical case analysis. This involves focusing on the strongest case for a given thesis; if the strongest case falls the hypothesis falls. This chapter therefore examines recent developments in corporate governance in Germany, as a test case for international convergence in corporate governance. Germany is an appropriate test case for the convergence thesis for economic, political, and institutional reasons. Economically, it is an open, developed industrial economy, closely integrated into the international trading system. In 1993, Germany accounted for a larger share of world visible exports than Japan with double its population, and about four times the per capita contribution of the USA: Germany contributed 10.1 per cent of world total visible exports, Japan 9.6 per cent, the USA 12.3 per cent, and the UK 4.8 per cent (Streeck 1997: 33). ‘West German trade and current account balances, expressed in per cent of GDP, exceeded those of Japan, and presented a stark contrast to the chronically definitarian Anglo-Saxon economies’ (Streeck 1997: 33). German economy has been highly successful for long periods of time. It is heavily reliant on international trade, with high levels of exports of manufactured goods. It has increasing inward and outward flows of international capital, with growing capital investment in Germany by US and British portfolio funds, as well as German investment abroad. It has become increasingly involved in cross-border mergers, with, for example, the creation of Daimler-Chrysler AG in motor vehicles and the German–French firm Aventis in pharmaceuticals, as well as the British Vodaphone purchase of German Mannesman. The integration of Germany into the international economy provides strong economic grounds for expecting convergence. Politically,

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successive German governments, especially Social-Democrat governments, have sought to increase the flexibility of economic enterprise performance and the openness of the German economy to ‘Anglo-Saxon’ practices (Lütz 2000: 20; Höpner 2003). German managers are increasingly exposed to the culture of shareholder value through attending US and British business schools and through working for American and British corporations. At the same time, German institutions and the legal system, including corporate governance arrangements, have followed the civil code principles of Continental European states and developed in very different ways from the USA and Britain. The chapter contains six sections. Following this Introduction (Section 7.1), Section 7.2 outlines the major arguments for the convergence of corporate governance regimes. Section 7.3 outlines the major features of the models of liberal market and coordinated market capitalisms, as developed by Hall and Soskice (2001), as a means of highlighting the relation between corporate governance and business systems. Section 7.4 outlines the major features of relations between investors and management in Germany, leading to a detailed case study of the Bayer Group in Section 7.5. Section 7.6 returns to re-examining the issue of convergence, indicating the limitations of the convergence thesis and outlining an alternative ‘organizational ecology’ approach.

7.2. THE CASE FOR INTERNATIONAL CONVERGENCE Hansmann and Kraakman (2004: 35) outlined a strong version of the case for convergence. They identified a ‘growing consensus’ amongst ‘academic, business and government elites in leading jurisdictions’ on the major characteristics of the dominant model, ‘the standard shareholder oriented model’. The major features of the model were perceived to be: ultimate control over the corporation in the hands of shareholders; corporate managers charged with the obligation to manage the corporation in the interests of its shareholders; the interests of other corporate constituencies, such as creditors, employees, suppliers, and customers protected by contractual and regulatory means rather than through participation in corporate governance; strong protection of non-controlling shareholders from exploitation at the hands of controlling shareholders; and the interests of the publicly traded corporation’s shareholders measured by the market value of their shares in the firm (Hansmann and Kraakman 2004: 35). ‘Normative convergence’ on the standard shareholder value model is expected to lead to ‘substantial convergence’ (Hansmann and Kraakman 2004: 36) and the eventual ‘end of history for corporate law’. The

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pressures seen as leading towards such convergence were primarily the evident failure of alternative models (manager-, labour-, or state-oriented), global competition, and the growing influence of shareholder groups, both directly and indirectly, through fund managers. Other scholars developed a weaker form of the convergence argument, in which functional convergence coexists with continuing institutional divergence: ‘functional not formal convergence’ (Gilson 2004: 137). Convergence in corporate governance was viewed as an aspect of the latetwentieth century globalization, with economic, political, and institutional forces leading in the same direction. The major economic forces include the international flow of portfolio investment funds, and increasing capital market integration with the rapid growth in international capital flows from the 1980s on. The major political influence is the role of the USA, both directly and indirectly, through its influence upon international financial institutions, especially the International Monetary Fund (IMF) and the World Bank. The major institutional influences are the stock exchange listing requirements and related listing strategies of major corporations, and the activities of specialized accounting bodies concerned to establish international accounting standards, such as IASB and GAAP. International capital flows, especially amongst advanced market economies, increased rapidly after 1980, with capital as the most mobile factor of production (Obstfeld and Taylor 2005). The growth was due to both supply and demand factors. On the supply side, the financialization of pension commitments in both the USA and Britain created a substantial flow of funds seeking investment opportunities. The collapse of the Bretton Woods financial system and abolition of exchange controls in the UK in the late 1970s made such capital available internationally (Obstfeld and Taylor 2005: 27). On the demand side, intensifying international competition required continuing investment in mature industries, whilst the emergence of information technology (IT) led to large capital requirements in new sectors. Commentators saw a new ‘Kondratieff wave’ or technological paradigm, the fifth, involving a new industrial revolution (Freeman 1982; Kaplinsky 1984). In the 1990s, the fall of socialism in Central and Eastern Europe (CEE), the collapse of the Soviet Union, and the development of China as an emerging market, as well as the gradual opening of India to foreign capital, stimulated further requirements for capital investment. Capital providers expected investor protection according to US or West European standards, or required higher returns to cover investment risk. US investors, and fund managers operating on their behalf, expected firms in which they invested to accept the principles of shareholder value. This globalization of capital flows provided the structural foundation for convergence in corporate governance arrangements.

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International investors and corporate managers both favoured convergence in corporate governance arrangements. Standardization economized on monitoring and information costs. Fund managers sought transparent, comparable financial information as the basis for investment decision-making, and reliable guarantees of investor property rights. Transparency and secure property rights were an integral part of the standard shareholder-oriented business model. Similar corporate governance regimes reduced the monitoring costs, including information costs, for investors. Integration, or standardization, also increased investor confidence in capital markets, reducing perceived risks and increasing the credibility of guarantees on the return from their investments. Corporate senior management also saw many major advantages in convergence in corporate governance arrangements; economy in monitoring and in information, as well as easier internal management and control. Managers also had an interest in maximizing the availability of potential sources of capital, facilitated by the integration of capital markets and standardized regimes of corporate governance. Political influences pointed in the same direction, towards integration of capital markets and standardization around a shareholder value model within a global system. The political influence of the USA, both directly and indirectly through IMF and the World Bank, was used to leverage support for the standard shareholder value model. In the early 1990s, US Aid funded management education and training programmes which incorporated shareholder value philosophies for managers in former socialist states. In the late 1990s, IMF and the World Bank required Asian economies to adopt US-style corporate governance as part of their reform packages (Gilson 2004: 131). Britain’s political influence was also used to encourage the adoption of corporate reforms, along shareholder value lines, both in Europe and in developing countries, for example through support for the privatization techniques promulgated by the Adam Smith Institute (a free-enterprise ‘think tank’ and consultancy), under foreign aid programmes. Institutional factors which helped to disseminate the standard model included the work of international institutions, especially IMF and the World Bank, the EU, the European Bank for Reconstruction and Development, OECD, and specialized business agencies such as the European Corporate Governance Network. At national level, the World Bank and IMF jointly funded ‘Corporate Governance Country Assessments’ (e.g. 2005, on Romania), measuring national corporate governance arrangements against OECD Principles of Corporate Governance. At company level, rating agencies such as Standard and Poor’s measured the quality of enterprise corporate governance arrangements against shareholder value criteria; such ratings affected the cost of capital. Steps towards the international standardization of financial

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reporting also reflected ‘Anglo-Saxon’ conceptions of financial transparency. Although there are differences in detail (and in ultimate philosophy) between the requirements of GAAP and those of IASB, the former being based upon rules and the latter on principles, the practical requirements are broadly similar. ‘The Big Four’ accounting firms, as well as major international management consultancies, also acted as means of transmitting shareholder value conceptions of corporate governance. The listing requirements of major stock exchanges, especially New York and London, were major sources of convergence. The number of international companies registering on the NYSE increased sharply in the 1990s, including major German corporations. Between 1992 and 1998, the number of foreign companies listing on NYSE more than tripled, from 119 to 361 (although the largest number of international corporations listing was from non-US North America) (Coffee 1999: 69). As of 31 December 2005, 453 non-US companies were listed on the NYSE, valued at $7.1 trillion (NYSE 2006). This included 195 European companies, the largest number being UK companies (sixty-two), followed by the Netherlands (twenty-nine); Germany had seventeen listed. The reasons for listing were less to secure access to American capital, since access could be achieved in less costly ways, and more to indicate commitment to high corporate governance standards to possible international investors. Although non-US corporations did not have to fulfil all the regulatory requirements set for US corporations, the standards were sufficiently high to provide credibility for international investors, whilst the barriers against delisting were substantial. Corporate governance regimes differ in the extent to which they satisfy the interests of investors and corporate managers. However, once given regimes have been identified as successful in meeting the needs of investors and managers, the forces of efficiency and competitive advantage, as well as imitation and institutional isomorphism, operate for corporate governance regimes, as for other areas of economic life (DiMaggio and Powell 1983). It has been argued (see discussion in Gilson 2004) that efficient corporate governance regimes drive out inefficient ones, given international capital mobility and freedom of corporate registration. However, the process of convergence is not the functionalist process of the efficient automatically driving out the inefficient, but reflects the strategies of senior corporate managers, responding to economic, political, and institutional pressures. Economic, political, and institutional factors were thus leading to convergence in corporate governance regimes. The type of regime on which business systems were converging involved arrangements favourable to shareholder value and competitive equity capital markets. The structural foundation for convergence was the flow of international capital. Investors’ and investment

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fund managers’ expectations defined the range of acceptable forms of corporate governance.

7.3. LIBERAL MARKET AND COORDINATED MARKET ECONOMIES: A COUNTERARGUMENT Liberal market economies provide a congenial ecology for shareholder value. The major characteristics of liberal market business systems are congruent with the major principles of shareholder value corporate governance regimes. In liberal market economies (Hall and Soskice 2001: 8): firms co-ordinate their activities primarily via hierarchies and competitive market arrangements. . . . Market relationships are characterized by the arms-length exchange of goods or services in a context of competition and formal contracting. In response to the price signals generated by such markets, the actors adjust their willingness to supply and demand goods or services, often on the basis of the marginal calculations stressed by neoclassical economics.

Firms in liberal market economies give priority to profitability, to maintain share prices and avoid threats of takeover, rather than to firm growth, or market share, or employment security. Systems of financial control and corporate governance are characterized as ‘outsider’, ‘arm’s length’. Such outsider systems foster innovation through facilitating the creation of new firms and increasing the agility of existing firms in responding to changes in product markets and technology. The financial system, modes of technology transfer, labour markets, and education and training systems complement one another in a more or less integrated business system. Hence, the financial system is based on ‘free market competition’ taking place on level-playing fields, publicly accessible information, and open market access. Capital markets are competitive, deregulated, and liquid, with high transaction turnover. Labour markets are flexible, with ease of hiring and firing, with flexible wages sensitive to external market rates, and no legally required employee representation or co-determination. The education system provides for investment in general skills (literacy, numeracy), with professional training as the responsibility of the individual. Liberal market economies provide the most appropriate system for radical innovation. Capital markets provide the resources for investment in new products and services, including venture capital attracted by high-risk premiums. Technology transfer occurs through inter-organizational competition and restructuring, with high levels of mobility of capital and labour,

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within a framework of antimonopoly and antitrust legislation. The absence of employee ‘lock-in’—or ‘property rights’—through participation, limited salary incrementation, and the availability of labour market institutions to facilitate labour mobility enable labour to move easily to new firms. The absence of employment seniority rules enables senior management to redeploy labour within the firm. Strong managerial prerogatives enable managers to reorganize production processes. Innovation is especially facilitated in sectors characterized by novelty, appropriability, and visibility (Tylecote et al. 2002: 2)—IT, medical engineering, and pharmaceuticals. The ecology of coordinated market economies is less congenial for the development of shareholder value than the ecology of liberal market capitalism. Coordination and cooperation, as well as competition, provide the basis for relations amongst institutions, between economic organizations and the state, and amongst economic organizations themselves. Hall and Soskice (2001: 28) identified Germany as the exemplar of a coordinated market economy. Coordinated market economies involve a high level of cooperation amongst firms, often legally supported and buttressed by state administrative involvement. Banks play a more central and capital markets a less central role than in liberal market economies. The corporate governance system facilitates long-term relationship financing, primarily via bank debt, based upon reputational monitoring rather than publicly assessable information. Sector-level industry collaboration supports industrywide standard setting and technology transfer. At firm level, the rule-governed industrial relations system provides for employee cooperation and wage moderation, with high priority given to employment security. Historically, Germany has been a ‘stakeholder’ rather than a ‘shareholder’ economy. The industrial relations system is inclusive, through co-determination, and rule-based rather than individualized and market-mediated. Co-determination provides an institutional mechanism for consensual decision-making, giving weight to employment security as well as profitability. Education and training systems are built upon cooperation between educational institutions and firms at sector level, facilitating human capital investment in firms. The education system provides close linkage between general and in-company training and skills development, whilst employment security reinforces employee commitment, based on sunk costs in firm-specific training. The central focus is on company needs, as defined within consensual co-determination institutions, not competitive advantage as defined by senior management. Such company needs are satisfied through collaboration, as well as competition, with other firms in the same sector. Coordinated market economies discourage both shareholder value and investor engagement, our direct concern, for four major reasons. First, legitimizing the interests of multiple stakeholders reduces the incentives for any

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single stakeholder to invest resources in monitoring corporate performance, given the costs of monitoring and free rider problems. Second, in coordinated market economies, senior managers act as mediators between potentially conflicting economic and political interests. Managerial decision-making becomes opaque, increasing the difficulties, as well as the costs, of investor monitoring. Third, reputational monitoring is difficult for investors outside the golden circle, since it depends upon implicit as well as explicit knowledge. Fourth, the existence of block holders or private control groups (such as families, community networks, or private foundations) reduces the incentives, and the capabilities, of other investors to monitor corporate managers, especially where the interests of minority shareholders are weakly protected by law. In such circumstances, it is unsurprising that banks perform the monitoring role performed by stock markets in liberal market economies. Comparison between liberal market economies and coordinated market economies indicates the significance of ‘institutional complementarities’ (Milgrom and J. Roberts1 1992) and organizational ecology for the development of shareholder value. There is a congenial ecology between liberal market economies and shareholder value and a hostile or at least unsympathetic ecology between shareholder value and coordinated market economies. It is not inevitable that liberal market economies would adopt shareholder value philosophies, nor that coordinated market economies would reject them—but such outcomes are likely. Against this background, Section 7.4 of this chapter examines recent trends in investor–management relations in Germany. Germany is analysed as the paradigm exemplar of coordinated market economy, with strong institutions and historically high levels of economic performance. If the German economy restructures to meet the requirements of shareholder value, it is likely that other, especially weaker, coordinated market economies will develop in a similar direction.

7.4. CORPORATE GOVERNANCE IN GERMANY: CONTINUITY OR CHANGE? The prestige of the German model of a coordinated market economy weakened in the 1990s, with wavering German economic performance. German reunification resulted in high economic costs, with the incorporation of the German Democratic Republic (DDR) into the Federal Republic (BRD) at West German mark parity and BRD levels of social welfare. In the 1990s, the German political elite believed that Germany was being left behind

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economically, and failing to capitalize on the growth of IT; Germany was perceived as lacking entrepreneurship skills (Höpner 2003). The opening of new investment opportunities in the former DDR and in former socialist economies in CEE provided an opportunity for German employers to ‘break free’ from the German social welfare model and to experiment with new approaches to labour management (Hyman 1996). The rise in unemployment, even in areas of the former BRD, led to concern that workers were ‘pricing themselves out of jobs’, especially with high social wages. Raising productivity required increased labour market flexibility. The internationalization of German management, with increasing numbers attending US business schools and working in and with US companies, and growing foreign investment widened exposure to shareholder value thinking. Weakening German economic performance and the growing internationalization of German business thus increased pressure for the liberalization of the German economy and for greater flexibility in the deployment of capital as well as labour. This involved encouraging equity-based capital markets, including venture capital markets. The lower rate of economic growth in Germany than in the USA, or even in the UK, in the late 1990s, led to suggestions that improving German economic performance required a more ‘Anglo-Saxon’ market-orientated approach to relations between investors and managers (e.g. Höpner 2003). The liberalization of international capital markets and ‘the greater readiness of hitherto “national” capital to seek the most profitable opportunities for both accessing and investing capital wherever this may be in the world’ led to pressure for change (Lane 2005: 118). German banks, especially Deutsche Bank, the largest, reinterpreted their role, with more emphasis on investment banking and less on lending, especially lending to German corporations. Intensified product market competition, leading to increased capital concentration, pointed in the same direction (Lane 2005: 119). The third pressure was increasing German exposure to ‘Anglo-Saxon’ cultural influences, through education and employment in British and American multinationals. Further, the European Commission sought to liberalize German capital markets, as part of the creation of a European capital market. International investment in Germany was accompanied by increased German investment outside Germany, especially in the USA and in CEE, symbolized in the internationalization of Deutsche Bank’s activities (Deutsche Bank 2004). According to one view, the traditional close relationship between investors and managers via major banks in the coordinated German economy is weakening, with the overall weakening of coordination within the economy. Hence, Lane (2005: 79) argued that ‘convergence is, indeed, occurring. . . . [Convergence] means one sided adaptation of the “coordinated market economy” model to that of the “liberal market economy”’. Although she

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saw little evidence of direct investment fund influence over corporate management, Lane (2005: 92) noticed widespread changes influenced by shareholder value thinking: Concern with the movement of company share price . . . motivates managers to introduce various strategy changes, welcomed and rewarded by capital market actors[:] . . . introduction of sometimes ambitious targets for growth in turnover and profits[;] . . . changes in organization to enable better control of performance by both top management and capital market actors, as well as to facilitate spinning out and/or listing of organizational subunits[;] . . . introduction of share options or equivalent schemes to align managerial incentives with those of investors[;] . . . introduction of reward systems for employees tied to the company’s or business unit’s performance.

The degree of weakening in the traditional system, its origins, and its likely outcome remain controversial. Evidence for the decline in coordination includes the reduction in bank share ownership, the reduced role of bankers on company supervisory boards, the dissolution of cross shareholding amongst industrial groups, and increasing emphasis upon shareholder value in senior management statements. In his study of the forty largest German companies, Martin Höpner (2001: 2) traced an increasing shareholder value orientation, measured by changes in corporate communications, top management remuneration, and the overall orientation towards the goal of profitability. However, evidence on the growth of shareholder value is conflicting (for a review, see Goergen, Manjon, and Renneboog 2004). The pattern of share ownership remains very different from Britain and the USA. The main categories of investors in Germany are, in descending order of importance, holding and industrial companies, individuals and families, and banks and public authorities (Goergen, Manjon, and Renneboog 2004: 10). About 80 per cent of direct equity stakes in stock exchange-listed firms are held by other firms, industrial firms, holding companies, investment firms, and financial firms (Goergen, Manjon, and Renneboog 2004: 10). Banks have greater importance than their direct share ownership suggests, since they exercise proxy votes on behalf of the shares deposited with them. Banks retain an active engagement with the management of German firms not evident elsewhere. Vitols (2004: 11) concluded that ‘on the whole the German financial system can be characterized as bank-based. In some cases structural change has only been quite gradual, whereas in other cases there has been a return to historical norms after a sharp change during the bubble years’. At the end of 2002, the banking system accounted for 73 per cent of financial liabilities, whilst other financial services, including investment funds, accounted for only 10 per cent (Vitols 2004: 12). Although stock market capitalization rose sharply between 1995

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and 2000, to over 60 per cent of GDP, by the end of 2002 it had declined to 31 per cent, its level of the early 1990s. The Neuer Markt, the Frankfurtbased alternative investment stock exchange, was established in 1997, with a substantial number of IPOs going to market between 1997 and 2002, mainly in the high technology, Internet, and software sectors. However, the bubble burst in 2002, there were no IPOs in Germany in 2003, and the Neuer Markt was declared a failure by the FSE and closed later the same year (Franzke, Grohs, and Laux 2004). Following detailed research on the German software industry, Engelhardt (2004: iii) concluded that ‘German venture capital for the most part was not able to establish successful entrepreneurial companies on the Silicon Valley model. Nor were they able to create a successful German variant of venture capital involvement in more traditional companies’. Overall, then, the German financial management system remains ‘insider’ rather than ‘outsider’, without the wide dispersal of shareholders and the separation between owners and managers characteristic of liberal market regimes, especially as analysed in agency theory. In Germany, ‘the bank prevails over the stock exchange’ (Albert 1997: section 2.4). The influence of the market is smaller than in liberal market economies, with high levels of block holding and the interests of investors typically mediated through banks. Banks have a dual role, as creditors as well as investors or the major representatives of investors: the interests of banks as creditors takes priority over the interests of banks as investors (Elsas and Krahnen 2004). The special relationships amongst investors, lenders, and senior managers are channelled usually through bank representation on supervisory boards. The relationship between banks and corporate managers is especially close in medium-sized enterprises, where regional savings banks frequently adopt the role of corporate ‘hausbank’ (Lütz 2000: 9–10). The monitoring of corporate performance is based on specific knowledge and reputation, not on publicly available information: unlike in Williamsonian theory, asymmetric knowledge is not regarded as a system weakness. The central role of banks in the German financial system, and the limited role of the capital market, may be explained by both supply and demand factors. On the supply side, Germany lacks large-scale private pension funds. The state pension is financed out of current taxation, in effect as a pay-as-yougo system, at more generous levels than ‘Anglo-Saxon’ state pensions. Moreover, occupational pension funds are invested in corporations, rather than via portfolio funds (Manow 2001). As in other countries with relatively low levels of income inequality, German savers have a propensity to place savings in low risk investments, even if with low returns (Vitols 2004: 16–18). Economies with relatively low levels of income inequality—and therefore large numbers of middle income savers—are more likely to favour low risk investments, such

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as bank savings, compared with countries with high levels of income inequality, such as the USA and Britain, where high levels of discretionary income at elite levels encourage investment in high-risk investments such as securities. German investors are risk averse, having experienced catastrophic inflation in recent history. On the demand side, companies continue to rely heavily upon internally generated funds, bank debt, and credit rather than equity market financing. The proportion of company financial liabilities represented by stocks declined from 47.6 per cent in 1999 to 24.0 per cent in 2002. Even in high-risk sectors such as biotechnology, successful German companies have been those concentrating upon ‘platform technologies’, funded by bank loans, rather than focusing on higher-risk therapeutics (Casper, Lehrer, and Soskice 1999). The relationship between investors and corporate management in Germany thus remains very different from the relationship in Britain and the USA. The role of financial markets is also very different in Germany from the USA or Britain. The level of stock market capitalization is lower than the capitalization of the smaller UK economy. The role of private ownership is greater, with a higher proportion of equity held directly in private hands, instead of indirectly via institutions, than in Britain or the USA. Corporate ownership is more highly concentrated in Germany than in the USA, with the mean percentage of shares owned by the five largest shareholders 41.5 per cent in Germany, compared with 25.4 per cent in the USA (Ehrentreich and Schmidt 1999: 14). Block holder power has been used in association with management control, rather than to advance specific shareholder interests, as envisaged by shareholder engagement in the ‘Anglo-Saxon’ sense. Extensive mutual cross shareholdings also help create barriers against external competition for corporate control, resulting in an inactive market for corporate control. The limitations on external competition in the market for corporate control are reinforced by the role of the supervisory board, where employee representatives are strongly opposed to measures reducing employment security—in effect, legally supported in-house white knights. Senior managers are concerned with the broadly defined needs of the company, including its public interest responsibilities, rather than exclusively with the firm’s competitive market performance (Streeck 2001). Broad conceptions of corporate interest are incorporated into management decision-making via the firm’s supervisory board, which includes representatives of employees (by law) as well as of local communities, other enterprises, and creditors. Close working relationships between banks and corporations, mutual interlocking shareholdings amongst corporations, concentrated shareholdings, reputational monitoring, sectoral cooperation, and consensus decisionmaking at the firm level result in a ‘conservative’ financial regime. Exit from

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unprofitable investments is difficult. Owners are reluctant to surrender their control, whilst employment security and the protection of employees’ interests are institutionalized in the supervisory board (Goergen and Renneboog 2003). The system discourages direct private investment in equities, especially direct investment by dispersed shareholders, lacking the knowledge to evaluate reputations in an informed manner, consolidating block holder influence. The system also discourages flexibility in responding to changes in product and labour markets. Ehrentreich and Schmidt (1999: 23) concluded ‘that the German system should provide a better long-term oriented environment to the management’ [of innovation] than the British or US systems. This assessment rests on the priority given to long-term company needs by ‘patient capital’. In particular, the structure of ownership and the corporate governance arrangements historically fostered firm strategies of diversified quality production, using skilled, flexible labour and cumulative innovation based upon developing employees with firm- and industry-specific skills. The inclusiveness of German firms fostered the ‘productionist’ approach amongst middle-sized firms which gave dominance to German firms in sectors such as machine tools, printing, and food machinery manufacture. More generally, the inclusive approach encouraged acceptance of flexibility, both in work organization and in employment conditions—what Dore (1988) termed ‘flexible rigidities’. The German pattern of corporate control, the structure of enterprise governance, and the industrial relations system supported a productionist orientation appropriate for sectors in which rents from innovation were difficult to appropriate (or even apportion). A traditional weakness of German financial markets has been the limited supply of venture capital. As Gerke (1998, quoted in Ehrentreich and Schmidt 1999: 21) concluded, ‘“in financing small companies and especially in setting up companies, there is an extensive market failure due to inadequate market transparency and information asymmetry”’. However, the German Venture Capital Association (BVK) claimed that adequate capital was available, not all available funds being placed, but that venture capital funders lacked confidence in the management of new ventures. This lack of confidence was also evident in the failure of the Neuer Markt (Franzke, Grohs, and Laux 2004; Tykvova and Walz 2004). In addition to traditional German financial caution, two factors contributed to limited investment in new ventures. First, venture capital firms were often subsidiaries of major banks, managed by present or former bank employees, and operating within a conservative banking culture. Secondly, the mode of exit from portfolio firms was usually more via buy back or trade sales, rather than the potentially much more profitable IPO (Ehrentreich and Schmidt 1999: 21–2).

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The direction of changes in the German system, towards greater priority to shareholders, what Lütz (2000) termed ‘negotiated shareholder value’, is evident (Dore 2000: 176–81). However, the extent and speed of the change are not yet clear, nor is the impact on management practice. There remain major differences between Germany and the USA and Britain, leading Goergen, Manjon, and Renneboog to conclude in 2004 (p. 3) that ‘the differences [between the German and the “Anglo-Saxon” systems] are important enough as to claim that the “stereotypical view” [of the German system] is still a valid paradigm’. Analysis of changes at sector and firm level indicates the balance of contrary influences, and their impact on management practice. Jürgens (2002) analysed the impact of shareholder capitalism on the German car industry, providing a nuanced assessment of the extent and impact of corporate governance changes. He concluded that shareholder sovereignty holds less sway in Germany than in the USA. Companies retained an inclusive, relational, productionist, ‘work-holder’ orientation. This was supported by detailed examination of Volkswagen AG (VW) which showed that the company retained its traditional focus, maintaining employment levels, doing little outsourcing, not moving outside the automobile industry, and maintaining R&D and educational expenditures. However, VW is an unusual company, with 20 per cent of shares held by the State of Lower Saxony. Moreover, even in VW there was increased focus on meeting financial targets: return on capital in the 9–10 per cent range; return on sales 4.7 per cent rising to 6.5 per cent by 2005; and investments in physical assets paid out of cash flow with a cap at DM6 billion (Jürgens 2002: 22). Financial incentives were introduced, including stock options, heavily biased towards senior management. The main Board heavily criticized its subsidiary Audi for its failure to achieve its 6.5 per cent return-on-sales target (Jüggens 2002: 37). VW remained anxious that it was exposed to potential takeover, with its low capitalization/assets ratio and increasing EU questioning of the legal protection provided by the ‘VW Act’ (German Parliament 1960) and of the Lower Saxony Government’s 20 per cent holding. The pressures for VW to adopt a more ‘Anglo-Saxon’ approach accelerated in 2003, with increasing product market difficulties. At the time of writing, VW has only retained its financial independence by securing equity capital investment and senior management leadership from Porsche. In sum, investors are acquiring increased influence in the German corporate governance regime. Sensitivity to share price changes has increased: ‘profit and growth’, to quote the Siemens slogan for 2003, rather than growth and profit. Banks, including Deutsche Bank, are changing their roles, with increased emphasis on investment banking and less on lending, and adopting a less activist role in enterprise management. Inter-firm linkages are weakening. Share options are being introduced to provide additional incentives

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for mangers, if without the surrounding extravagant rhetoric of alignment with shareholder value adopted in the USA and Britain. Increased German exposure to US influences, with increased investment flows in both directions, with greater involvement by German managers in US-style management education, with major German–US mergers such as Daimler-Benz-Chrysler, and with major German companies such as Bayer following Daimler-Benz’s 1993 example and listing on NYSE. However, some of the evidence suggesting a trend towards ‘Anglo-Saxon’ style relations between investors and corporate management has proved short-lived. The growth in the venture capital market proved temporary, associated with the dot-com bubble of the late 1990s, rather than permanent. The growth in IPOs between 1997 and 2002 collapsed, and the Neuer Markt in Frankfurt closed in 2003. The Vodaphone takeover of Mannesmann was not followed by a flurry of further foreign takeovers, although the level of foreign investment remained high. The German two-tier system of supervisory boards and boards of management and co-determination survive (Boyer 2005). Major German companies remain more firmly embedded in German national capitalism than British companies do in Britain. Even the most ‘shareholder-friendly’ major German corporation, Bayer, had no international members on either its Supervisory or its Management Board in 2004, despite having over 85 per cent of its sales outside Germany (Höpner 2001; Bayer Group 2004). Banks retain a central role in monitoring corporate performance and in exercising supervisory influence; for example, banks remain heavily represented on the Bayer, and other, Supervisory Boards. Internally generated funds and bank credit remain the major sources of funds for new investment. Although German companies are increasingly global, for example in pharmaceuticals, they remain embedded in their national or even local economic system (in Bayer’s case Leverkusen) (see also Lane and Probert 2003). The level of stock market capitalization remains low, there is no German equivalent to the role of pension funds as ‘universal investors’ because of different pension arrangements, with much higher state benefits, whilst labour retains influence both politically and at the level of the enterprise through co-determination arrangements. This analysis suggests that the scope for convergence between coordinated market and liberal market corporate governance regimes, around the standard shareholder value model, may be limited. Institutional factors, especially the role of banks and the strength of co-determination arrangements, limit the flexibility available to German employers, leading Vitols (2003: 1) to speak of an ‘augmented stakeholder coalition’ in Germany. However, the outcome of the contradictory influences may be that German global corporations seek to stand aside from the national business system of which they are a part, reducing the coherence of the business system. Hence, German multinational

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corporations (MNCs) with substantial US investors may adopt an ‘AngloSaxon’ corporate governance regime, especially if listed on NYSE. The corporate governance structures established by Daimler-Chrysler AG indicate how the contrary requirements of the German and US business systems may be reconciled. Although registered in Germany, and maintaining its two-tier Supervisory and Management Board structure, Daimler-Chrysler AG adopted many of the practices associated with shareholder value, including the rhetoric of shareholder interests and the alignment of management and shareholder interests through the adoption of share options for senior managers. Major German MNCs continued to list on NYSE, despite the increasingly stringent corporate governance requirements which followed the introduction of the Sarbanes–Oxley Act in 2002. The growth of shareholder value thinking in German MNCs may thus lead to a split between international and national capital within Germany, with major MNCs adopting shareholder value, whilst medium-sized German companies continue to maintain traditional stakeholder conceptions of the firm and close relations with their house banks. There is thus conflicting evidence about changes in the system of corporate governance in Germany, and hence about the changing relationship between investors and management practice. To indicate the changing relations between investors and managers in Germany, the following section provides a case study of the major chemicals and pharmaceuticals company Bayer. In Höpner’s study of corporate governance in Germany (2001: 39, 40), Bayer was identified as the most shareholder-oriented major German company in the late 1990s, with a strong emphasis on profitability and a close linkage between managerial remuneration and profitability. Section 7.5 therefore examines the situation at Bayer in 2003–4.

7.5. RESTRUCTURING THE ‘RHINELAND’ WAY: THE BAYER GROUP CASE Founded in the late-nineteenth century, the Bayer Group remains a central player in the German chemical industry. Alongside Hoechst GmbH and BASF AG, it represented the core of the German chemical and pharmaceutical industry, surviving turbulent political transformations. In the 1990s, Bayer identified explicitly with the traditional Rhineland philosophy of stakeholder capitalism, leading Sigurt Vitols to assert in August 2002 (p. 12) that Bayer was ‘staying the course with the Rhineland model’, despite the appointment of a CEO, Manfred Schneider, with a finance rather than the usual scientific

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background as early as 1992. As late as 2002, Bayer affirmed its commitment to remaining an integrated chemical-pharmaceutical company, with a four pillar strategy, strongly resisting pressure from foreign (and some German) investors for the Company to be split up, in accordance with shareholder value thinking. Industrial relations were built upon creating consensus amongst all stakeholders, including employees. Pay differentials between managers and other employees changed little in the 1990s (Vitols 2002: 13). However, the pressure for hiving off and restructuring the Corporation accelerated sharply with the deterioration in Bayer’s financial performance in 2003. The Group made the first loss in its history in 2003, when it lost C1.4 billion. The shares reached a low of C10.28 on 17 March 2003 (after a peak in 2002 of C40.80). The Company’s difficulties reflected both the overall difficulties of the German economy and specific problems in the sectors in which Bayer operated. Like all German companies, Bayer suffered from sluggish domestic German demand and difficult export markets because of the strength of the euro, especially against the dollar. Intense competition in the chemicals sector, especially the bulk chemicals sector, and the imminent patent expiry of its best selling drug Cipro/Ciprobay in the USA, exacerbated the overall difficulties. The Company was obliged to undertake major restructuring in response to pressure from shareholders, including divestments and demergers, to create a new, more focused structure for the Group. The restructuring processes involved, including rationalization and demergers, were similar to those which took place earlier in the restructuring of British manufacturing, including in the chemical industry, although the institutional arrangements and processes of implementation were very different. The following paragraphs outline this process in detail. Bayer’s overall performance declined sharply in 2003. The operational performance declined, with a reduction in net sales from C29,624 million in 2002 to C28,567 million in 2003, a decline of 3.6 per cent (Bayer Group 2004). (Net sales had peaked at C30,971 million in 2000.) However, the financial results showed an even steeper deterioration. The overall operating results showed a decline from a surplus of C1,610 million in 2002 to a deficit of C1,203 million in 2003. An overall pre-tax profit of C956 million in 2002 had become a loss of C1,994 million in 2003. (As recently as 2000, Bayer had made a pretax surplus of C2,990 million.) Net cash flow declined by 26.1 per cent, from C4,458 million in 2002 to C3,293 million in 2003. Despite the Chairman’s commitment to maintaining the value of shareholders’ stock, stockholders equity declined from C15,335 million in 2002 to C12,213 million in 2003, a decline of 20.4 per cent. Despite the heavy losses, Bayer maintained dividend payments, at C0.5 per share, compared with C0.9 per share in 2002, a decline of 44.4 per cent.

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Table 7.1 Bayer divisional performance 2002–3 (million £s) Sales (£m)

Bayer HealthCare Bayer CropScience Bayer Polymers Bayer Chemicals

Change (%)

2002

2003

9,372 4,697 10,423 4,322

8,871 5,764 9,897 3,400

−5.3 22.7 −5.0 −21.3

Net cash flow (£m) 2002

2003

1,575 1,212 1,167 590

782 1,165 1,042 199

Change (%)

−50.3 −3.9 −10.7 −66.3

Source: Bayer Group (2002, 2003, 2004).

The Bayer Group comprised four divisions in 2003: Bayer HealthCare, Bayer CropScience, Bayer Polymers, and Bayer Chemicals. The major segments of Bayer HealthCare were pharmaceuticals, biological products, consumer care, diagnostics, and animal health. Bayer Polymers covered plastics, rubber, polyurethanes, coatings, and fibres. The CropScience and Chemicals divisions comprised only one segment each. The four divisions all performed worse in 2003 than in 2002, although the extent of the decline varied. (CropScience’s growth was due to acquisition.) Table 7.1 (Bayer divisional performance 2002–3) summarizes the performance of the four divisions in 2002 and 2003. The Bayer Group is heavily export oriented. Sales outside Germany amounted to 86.4 per cent of total sales in 2002 and 85.8 per cent in 2003, up from 81.6 per cent a decade earlier. Performance in 2003 was badly affected by the Iraq War and the initial impact upon business confidence, especially in the USA, its major market. In addition, special factors affected the performance of all four divisions. In Bayer HealthCare, the sale of its plasma business and the legal costs associated with the US Federal Government’s investigation into price fixing in pharmaceutical products, as well as the decline in sales of its two best selling drugs, reinforced the effects of unfavourable dollar/euro exchange rate. In CropScience, sales increased largely because of the acquisition of Aventis CropScience, but were also negatively affected by exchange rate movements. The position of Bayer Polymers was weakened by increasing energy costs, the relocation of major customers to Asia, and overcapacity in the industry, as well as by negative exchange rate movements. In the Chemicals division, overcapacity, increased competition from Asian suppliers, consolidation in customer industries, and adverse exchange rate movements led to sustained pressure on margins. This resulted in impairment losses in the division of C476 million. The long-term competitive environment in which Bayer operated

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was becoming more difficult, even if the negative currency movements could be hedged or regarded as transient. To deal with these problems, Bayer undertook a major restructuring and refocusing, the largest in the Company’s history. The Bayer Group split into two companies. The restructured Bayer Group concentrates on three areas— health care (Bayer HealthCare), nutrition (Bayer CropScience), and high technology materials (Bayer Material Science). The Chemicals business (except for two companies, H. C. Starck and Wolff Walsrode) was combined with a third of the Polymers business to form a new company, Lanxess, to be floated on FSE no later than 2005. Companies which did not fit into the corporate restructuring were to be divested. The strategy was to create two focused businesses, consistent with shareholder value philosophy, with different business models, in place of a single diversified Bayer Group; the four pillar strategy was abandoned. ‘While Bayer’s future core portfolio comprises research intensive growth businesses, the portfolio of Lanxess consists mostly of cost driven businesses operating in more mature markets’ (Bayer Group 2003: 1). The Company claimed that the future Bayer Group would concentrate on sectors with high-growth potential, based on innovation and R&D, especially in the health care sector. The company also aimed to develop further in Asia, especially in China, in materials science, although its historic centre of gravity had been in Germany and the USA. The strategic refocusing was designed specifically to facilitate the development of the health care businesses. Hence, 52 per cent of the Bayer Group’s R&D budget was spent in the Bayer HealthCare division (C1,249 million), although it represented under a third of the Company’s turnover. The specific areas targeted were infectious diseases, cardiovascular risk management, urology, and oncology. Bayer aimed to become one of the top three suppliers in all health care businesses except pharmaceuticals. In pharmaceuticals, the Company (Bayer Group 2003: 3) aimed to concentrate on a limited range of drugs, becoming a major medium-sized pharmaceutical supplier: ‘[i]n the future we will focus more closely on our competences and experience in the consumer oriented over the counter medicines, diagnostic self-testing and companion animal businesses’. Bayer HealthCare had a small number of very successful drugs (Cipro/Ciprobay, Adalat, Aspirin, and Avalox) and had just successfully launched an anti-impotence drug, Livitra, already selling well in the USA. However, it did not have the breadth of research capability of the largest global pharmaceutical companies such as GSK. Moreover, Bayer’s financial performance in pharmaceuticals was weakened by the costs of a legal case brought by Pfizer Incorporated over patent infringement, as well as the costs of contesting price fixing claims, and the expiry of the Company’s patent over its best selling drug in the USA, Cipro/Ciprobay. Bayer’s

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strategy for health care included building closer linkages with US generic producers, indicating a more cautious approach than GSK’s. North America was the major market for pharmaceuticals, accounting for C2,154 million out of C4,745 million turnover and was regarded as the major area for expansion. Bayer anticipated that restructuring would take time to improve financial performance. In its 2003 Annual Report (Bayer Group 2003), it stated its expectation that market conditions would be difficult in 2004, and that sales in the health care sector would be lower in 2004 than they had been in 2003 (mainly because of declining sales in the USA). In other sectors, the Group expected sales to be restricted by severe competition, especially in the Lanxess activities, but that the financial performance would improve through cost containment and lower depreciation and amortization. Bayer’s performance inevitably led to difficulties in its relations with investors in 2003. The Group’s share price declined; in a declining market, Bayer shares declined more than the index overall. The share price was at a peak of C22.42 in January 2003, before declining to a low point of C10.28 on 17 March, before rising to C23.58 in December 2003, following the announcement of the restructuring plan. The Company undertook very active management of its investor relations. Overall, 200 separate meetings were held with individual investors and analysts, and nine investor conferences and seventeen road shows were organized in Germany and overseas, including Britain. The Company made extensive use of the Internet, with a special investor relations website (http://www.investor.bayer.com), including an interactive analysis tool. Investor relations meetings were broadcast live on the Internet and material was published concurrently on the website. The Company claimed to have boosted institutional and private investor confidence through a programme of one-on-one meetings and road shows. This confidence was reinforced by the decision to provide a dividend of C0.50, a yield of 2.2 per cent on the year-end price, despite the heavy losses. The market responded favourably to the measures taken by the Company, with a rise in the share price by the end of the year. By the end of 2005, Bayer had made major progress: its shares stood 50.7 per cent higher than a year earlier, compared with an increase in the DAX of 27.1 per cent. Lanxess was carved out in January 2005, and operated at a small loss in 2005. Bayer thus faced major product market pressures after 2000, with strong competition in its traditional areas and difficulties in potential growth areas. The resulting weak financial performance generated shareholder pressure for strategic realignment. The strategic solutions adopted echoed those adopted earlier by US and British companies. Bayer’s strategy of divestment, restructuring, and refocusing followed traditional ‘Anglo-Saxon’ principles. However,

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the major institutional differences between Germany and Britain and the USA affected the ways in which ‘Anglo-Saxon’ principles were followed through in practice. Such institutional differences did not affect the overall shape of the strategy. However, they did colour the details of the strategy’s implementation, including financial policies. Bayer followed explicitly conservative financial policies. The Group sought to safeguard short- and medium-term liquidity, at minimum financial cost. In contrast to the financial decentralization encouraged by the shareholder value model, with reorganization into financially self-contained units, as at VW, financial decisions were centralized at Bayer Group level; ‘systematic centralization plays a key role in Bayer AG’s capital procurement and risk management’ (Bayer Group 2004: 41). The reductions in debt and the carving out of major business operations were ‘specifically designed to increase our financial scope to support earnings-oriented growth in the future’ (Bayer Group 2004: 41). The strategic focus was explicitly placed on earnings growth, and there was no specific mention of shareholder value. Divestments reflected shareholder value conceptions, whilst the continuing financial centralization reflected traditional financial conservatism. Bayer possessed the customary German two-tier structure of Supervisory Board and Board of Management. The Company operated according to the revised German Corporate Governance Code (Government Commission of the German Corporate Governance Code 2002), with a small number of explicit marginal exceptions; the revised Code was more shareholder friendly than its predecessor (Krahnen and Schmidt 2004: Part III). The Bayer Supervisory Board comprised twenty members, half elected by shareholders and half elected by employees. The Supervisory Board provided links to a wide range of German institutions, and included representatives from major firms and, especially, German banks. In 2003, Dr Manfred Schneider, Chairman of the Bayer Supervisory Board was also Chairman of the Supervisory Board of Linde AG and a member of the Supervisory Boards of Allianz AG, DaimlerChrysler AG, Metro AG, RWE AG, and TVI AG. The Supervisory Board also included a Deutsche Bank senior executive, Dr Josef Ackermann, Chairman of the Supervisory Board of Commerzbank AG, Frankfurt, the Chairman of Bankhaus Lazard, Berlin, and a member of the Board of Management of Allianz AG, Munich. The Company was thus closely linked to major German financial institutions via the Supervisory Board, and not directly linked to international financial institutions. Bayer was closely embedded in German national capitalism, but not institutionally linked to international capital. The Supervisory Board also included a number of prominent trade union officials, as well as current employees of the company. The Supervisory Board was responsible for overseeing the work of the Management Board,

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including developing the new strategy and restructuring the company to carry the strategy through. The responsibility for defining corporate strategy, setting the overall budget, allocating corporate resources, and developing management personnel lay with the Board of Management. The Board was explicitly committed to ‘serving the interests of the entire enterprise and achieving a sustained increase in corporate value’ (Bayer Group 2003: Corporate Governance: 4). The Management Board informed the Supervisory Board of its decisions and sought its advice, but was not required to accept advice, except in legally specified areas such as labour shedding. The Chairman of the Management Board is the German equivalent of the Anglo-American CEO, but the responsibility was defined as ‘co-ordinating the principles of corporate policy’ (Bayer Group 2003: Corporate Governance: 4); the German CEO was not expected to be Khurana’s ‘corporate savior’ (2002). In 2003, the Management Board comprised four members, all full-time senior executives—Werner Wenning, Chairman, Klaus Kuhn, CropScience, Dr Udo Oels, Chemicals, and Dr Richard Pott, HealthCare. Following shareholder value practice, Bayer launched a stock compensation programme in 2000. The programme comprised three strands, targeted at different levels of employee: a Stock Option programme for members of the Management Board and other Group executives; a Stock Incentive programme for other senior managers; and a Stock Participation programme for other employees. To be eligible for the programmes, employees were required to place their Bayer AG shares in a special deposit account. Under the Stock Option programme, the Company determined the number of shares each participant could deposit, on an individual basis; the participant received additionally one, two, or three share options for each share deposited, according to individual performance. The shares deposited were blocked for three years, followed by a two-year period in which the participant could exercise option rights, provided that the performance criteria had been met. The cash payment to be received for the shares depended on the absolute and relative performance of Bayer AG stock, although the criteria were not prespecified. If the criteria were not met, no payment was to be made. As at 31 December 2003, no options were exercisable, although stock options were granted (10,950 to the Chairman, 6,450 to other members of the Management Board). Bayer had thus moved in an Anglo-American direction regarding share options, but at a modest level, with restrictions on their realization and with no explicit reference to alignment with shareholder interests. The composition of the Supervisory Board ensured that employee interests received greater priority than in Anglo-American corporations. This was reflected in the frequent references to multiple stakeholders, rather than

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exclusive reference to shareholders. One reflection of this concern was the importance accorded to maintaining employment. Despite the Company’s financial performance, employee numbers declined slowly. Employment grew from 116,900 in 2001 to 122,600 in 2002, before declining to 115,400 in 2003, a decline of 5.87 per cent. The Company continued to concentrate employment in Europe, where 70,600 employees were located in 2003. Although details are not available on employees’ earnings, it is noteworthy that senior managers’ salaries and directors’ allowances were significantly lower than similar salaries and fees in US or British companies, such as GSK. The salary of the Management Board Chairman was C1,597,000, whilst the salaries of other Management Board members were C900,000. The Chairman of the Supervisory Board received C88,500, whilst other members received either C29,500 or C36,875. The institutional structures and working relationships of the Bayer Group differed substantially from those of comparable British companies such as GSK. The legally constituted two-tier Board structure led to consideration of the interests of a wider range of stakeholders than in British companies. Employee representation ensured a high priority for job security. The representation of banks and insurance companies on the Supervisory Board reflected their central role in corporate financing and their active engagement in the monitoring of corporate performance. However, there are signs of trends towards Anglo-American practices. The development of stock option schemes reflected corporate interest in widening senior management incentives, and in aligning senior management and shareholder interests. Moreover, as a company listed on NYSE, as well as LSE, Bayer was required to comply with ‘Anglo-Saxon’ listing requirements. Hence, the company was obliged to make detailed changes to its corporate governance arrangements to comply with the Sarbanes–Oxley Act 2002, with the objectives of increasing protection for shareholder rights, especially minority shareholders, and of improving financial transparency. Bayer experienced major difficulties in its major product markets, with increasing competition in bulk chemicals and polymers, high energy prices, and patchy performance in potentially high-growth sectors such as health care. In response to major losses and declining share price, Bayer undertook major restructuring, including divestments and demerging, and the acceptance of major financial impairments. Bayer became recognized as one of the most shareholder-oriented German companies. However, it pursued such policies within the framework of traditional German institutional arrangements, including co-determination structures, and traditional arrangements with banks. The Bayer case illustrates the ability of German firms to respond to serious market dislocation whilst retaining traditional

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structures. Many ‘Anglo-Saxon’ practices were introduced at Bayer, including stock options and increased income inequality, but with specific German touches—little use had been made of the Stock Option schemes by 2004 and the level of directors’ remuneration remained low by British and American standards.

7.6. INTERNATIONAL CONVERGENCE? Several scholars (Coffee 1999; Hansmann and Kraakman 2004; Lane 2005) argued that there is an international trend towards convergence in corporate governance regimes. The trend is towards ‘Anglo-Saxon’ corporate governance models, in which the maximization of shareholder value is the touchstone of corporate performance. Globalization, the international integration of product and capital markets, leads to pressures for the integration, or at least standardization, of corporate governance regimes. Regulatory competition and isomorphic imitation reinforce the effects of corporate competitiveness. There are two variants of the convergence argument. One view sees the convergence as substantive, in intention if not yet in accomplishment, with the development of similar legal frameworks and institutions of corporate governance. Shareholders’ rights, the means of protecting shareholders’ rights, especially those of minority shareholders, and the responsibilities of boards of directors are becoming standardized. A weaker version of the convergence thesis sees a functional, but not necessarily formal, convergence amongst corporate governance regimes, with different institutional arrangements achieving similar objectives. Hence, efficient capital markets may require the protection of minority shareholder interests, but there may be different but equally effective ways of achieving the same objective; functional convergence and institutional diversity could coexist (Gilson 2004). Other scholars argued that there is little sign of convergence. Extensive comparative research, especially in Europe, suggests that corporate governance regimes retain their national distinctiveness. According to Clarke (2004: 23), ‘despite the pressures towards adopting Anglo-Saxon modes of corporate governance, the divergences in both the policy and practice of corporate governance in Europe have thus far resisted any move towards European standards’. The ‘political’ approach adopted by Gourevitch and Shinn (2005) showed similar scepticism about convergence. Our analysis of Germany as a ‘critical case’ indicates some of the complexities of corporate governance changes and their impact on management practice. On the one hand, there are significant indications of increases in

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shareholder influence. US and British funds have made major investments in Germany, and have exerted pressure to adopt ‘Anglo-Saxon’ practices. German state policies have exerted influence in the same direction. On the other hand, the impact on management practice has been attenuated by the survival of distinctive features of the German business system, including inter-firm linkages, the role of banks, and the importance of co-determination institutions. German corporations, especially the ‘mittelstand’ (German small and medium enterprises), remain embedded in the German business system, and continue to reflect German expectations, even when following ‘Anglo-Saxon’ type restructuring strategies. Our conclusions reflect the growing scepticism about the imminent international dominance of shareholder value. Early proponents of convergence have increasingly recognized the importance of national differences in relation to the impact of legal regimes upon corporate governance (LaPorta et al. 1999). This increased recognition is associated with a growth in sociological and political conceptions of corporate governance and, perhaps, a weakening of support for economic models (see, e.g. Aguilera and Jackson 2003: 448). The importance of sensitivity to institutional particularities and to the embededness of corporate governance is evident even from comparison between the two systems most frequently identified as similar, the American and the British. Despite the broad similarity, there remain major differences between the British and American business systems and between their associated corporate governance regimes. Legal norms and business practices are broadly similar. This similarity is reinforced by the substantial flow of capital from the USA to Britain, and from Britain to the USA, enjoining common practices, for example in accounting standards. Intimate Anglo-American working relationships are evident in the GSK case discussed in Chapter 6. However, there are important differences between the British and the American business systems with significant implications for corporate governance and the relations between investors and managers. First, the level of stock market capitalization relative to GDP is much higher in Britain than in the USA, implying greater potential for investor influence in Britain than in the USA. Second, institutional share ownership is much more concentrated in Britain than in the USA, encouraging much closer ties between leading shareholders or their representatives and corporate management. The concentration of financial and corporate senior management in London reinforces this close association (reflected, e.g. in the network linkages of non-executive directors). Third, there is a higher proportion of shares held by pension funds, whose managers are more assertive about shareholder rights than other groups of investors, in Britain than in the USA. The larger number of defined benefit— rather than defined contribution and money purchase—pension schemes in

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Britain than in the USA may reinforce this tendency towards pension fund assertiveness. Fourth, UK institutional investors have a much higher proportion of their investments in equities than US institutional investors. Fifth, the US restrictions on banking activities, especially interstate banking, have no equivalent in Britain (Roe 1994). The US Federal Constitution, with its protection of the States’ rights interests, and deep antitrust feelings, equally has no British equivalent. Finally, British securities legislation is less elaborated than US legislation, especially since the Sarbanes–Oxley Act of 2002. The inhibitions on investor engagement are therefore fewer in Britain than in the USA. There are also differences in corporate governance arrangements. The most important differences relate to the role of the CEO. The role of the CEO in the corporation remains more dominant in the USA than in Britain, despite the reaction against ‘charismatic’ CEOs following Enron and other corporate scandals. The continuing US practice of combining the roles of CEO and chairman of the board contrasts with the British expectation (if not quite requirement), enshrined in The Combined Code on Corporate Governance (Financial Reporting Council 2006) recommendations, that the two roles should be separated. Moreover, norms regarding levels of senior management remuneration and stock option arrangements appear to be more restrictive in Britain than in the USA. Despite the pressures towards convergence, there remains significant international diversity in business systems, in corporate governance, and in the circumstances under which investors engage with the firms in which they invest. As Millstein (2004: 264) commented in his balanced summary of converging and diverging trends in corporate governance: ‘[c]orporate governance will, because of custom and culture, vary across firms and circumstances, and, more broadly, among nations, albeit around a core of certain universal needs of capital’. The problem is to define this core. Although the issue of convergence is central to recent research on corporate governance, there is little agreement on exactly what is converging or on the mechanisms of convergence. In particular, it is necessary to distinguish between pressures for the international integration of capital markets and pressures for the standardization of international corporate governance regimes: it is possible to envisage a high degree of capital market integration without the standardization of corporate governance arrangements. The popularity of China as a destination for capital investment has not been inhibited by the absence of shareholder value corporate governance arrangements (Nolan 2001: 29–30). The integration of capital markets may involve different types of corporate governance regimes and may occur without institutional standardization—even if idiosyncratic corporate governance arrangements may attract risk premia or insurance arrangements. Similarly,

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the standardization of corporate governance arrangements may occur without capital market integration, through institutional isomorphism. The argument here is that the degree of convergence depends heavily upon the relationship between the corporation and other elements in the business system, upon the pattern of ‘institutional complementarities’ (Milgrom and J. Roberts1 1992). Competitive equity capital markets, shareholder value, investor engagement, and their legal and institutional supports develop more easily in congruent business systems—liberal market economies—than in coordinated market economies. In tracing the underlying features of this congruence, two are especially important. The first is the distribution of wealth and power in society. The second is the scope of market relationships. The system of corporate governance reflects and reinforces the overall distribution of power in society. Control over corporate assets is a fundamental source of power in society, whether through share ownership, managerial authority, private influence, or collective organization; the corporation is the cornerstone of capitalist economies. There is an unsurprisingly close link between the distributions of power and wealth and institutions of corporate governance. For example, in highly unequal societies share ownership is concentrated, and firms are subject to close control by majority shareholders, block holders, family groupings, or through differentiated share categories. The pressures for protecting minority shareholders and transparency in financial reporting are likely to be weak. Hence, in Italy, the continuing close control of Italian corporations weakens pressure for transparent financial reporting (Melis 2000). In more egalitarian societies, with wider distribution of wealth and share ownership, whether directly or indirectly, through institutional funds, the pressures for the protection of minority shareholders and for financial transparency are greater. This analysis links shareholder value to changes in the structures of capitalism. The distribution of wealth, including capital, may be integrated with the distribution of direct economic power, in which capital investment and corporate control are closely associated, as in systems in which there is closed control of the corporation. As Gilson (2005: 5) commented, ‘excluding the United States and the United Kingdom, the worldwide corporate governance landscape has a single monolithic feature: control of publicly traded corporations is typically lodged in a single individual, family or group’. Hence, in Italy, family control of the corporation is achieved through overlapping investment and managerial control. Such overlap may exist even in liberal market economies, in family firms subject to closed ownership arrangements. In such systems, there is little need for mechanisms to ensure that senior managers attend to shareholders’ interests. Maximizing shareholder value may

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be of limited concern, because of the ‘private’ benefits of control. On the other hand, the distribution of capital may be disassociated from the distribution of corporate power, in societies in which the distribution of capital is widely dispersed, either directly in the form of shareholdings or indirectly in the form of pension entitlements. The issue of shareholder value becomes relevant in such societies. The likely extent of convergence of systems of corporate governance is thus set by differences in social class formations. Where capital is associated with corporate control through closed systems of ownership there is little incentive for shareholder value philosophies. There is thus little likelihood of ‘Anglo-Saxon’ shareholder value in countries such as Italy. There are strong sociological, not only legal, reasons for the limited potential for corporate governance reforms in societies such as Italy. Where power is diffused and capital widely distributed, the separation of ownership and control arises, resulting in potential conflicts of interest and the need for the legal protection of shareholders’ rights. The second area of institutional complementarity is the scope of market relationships. Business systems differ in the extent to which relationships are governed by market principles. Goods, labour, and capital may be allocated on the basis of political, bureaucratic, or personal relationships, as well as via markets. The supremacy of markets as means for allocating resources is a cultural value, with strong support on efficiency and equity grounds, not an empirically verified universal functional requirement. Historically, imperialist regimes have subordinated market principles to the requirements of maintaining military power and political control (Lavelle 2004). Similarly, nationalist and racialist regimes have restricted the operation of market principles. More recently, before 1989, socialist states in Europe distributed goods on the basis of political criteria, not very efficiently. The contributions of politically motivated industrial policies to the development of the Japanese economy in the 1960s and 1970s, and to the emergence of the South Asian tiger economies in the 1980s (Amsden 2001), are more positive examples of mixed principles of resource allocation. Shareholder value and competitive capital markets are congruent with institutional arrangements in business systems committed to the wide application of market principles, the liberal market economies. They are less congruent with business systems coordinated politically, bureaucratically, or through personal relationships. Such systems, however, have been more common historically than business systems constructed on market principles. The limits to convergence are set by the need for institutional complementarity. Shareholder value corporate governance regimes are unlikely in societies with highly inegalitarian distributions of power and wealth. They are also unlikely in societies with continued reliance upon political, bureaucratic,

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and personal relations in allocating resources. Such business systems are widespread. Shareholder value systems are likely in business systems with relatively equal distribution of wealth and power and with an emphasis on the widespread application of market principles in the allocation of resources. These are features of liberal market economies and ‘Anglo-Saxon’ business systems; they are not features of all market capitalist societies, much less societies that do not even claim to be capitalist. The potential for the convergence of corporate governance regimes is thus limited by the restricted distribution of complementary institutions and the social systems in which they are embedded— convergence in corporate governance is far from a historical inevitability.

8 Shareholder Value, Investor Engagement, and Management Practice: a Normative Evaluation This book has examined investor engagement in the context of the growth of shareholder value philosophy. We have outlined the varying objectives of different investors, the forms of investor engagement, and their consequences for relations between investors and managers and for management practice. During the period of ‘managerial capitalism’, in the USA roughly from the 1920s to the 1970s, widely dispersed shareholders had little capacity to monitor or influence corporate management effectively. Since the 1980s, shareholder value has given both rationale and incentive for investor engagement, by prioritizing the maximization of shareholder returns. The consolidation of shareholdings into large blocks controlled by institutional investors and their fund managers has appeared to make effective monitoring and influence a practical possibility. Moreover, the influence of private equity fund investors on their portfolio companies is direct and extensive, as shown in Chapter 5. Previous chapters have been descriptive and analytic. This chapter is different, turning to normative issues. In this chapter, we examine two issues: respectively, the arguments for shareholder value (Section 8.1) and for investor engagement (Section 8.2). In the first section, we examine the arguments for shareholder value. There are two types of arguments for shareholder value. The first is economic and concerns the relationship between shareholder value and economic performance, evaluating the expectation that shareholder value maximizes corporate performance and therefore collective welfare. The second is social and political, claiming that shareholder value is necessary to compensate investors for their acceptance of unsecured risks. In the second part of this chapter, we focus specifically on the arguments for investor engagement.

170 Shareholder Value, Investor Engagement, and Management Practice 8.1. ARGUMENTS FOR SHAREHOLDER VALUE According to the International Finance Corporation (IFC) (2006), part of the World Bank Group, the case for shareholder value corporate governance is ‘irresistible’: ‘[a] commitment to good corporate governance—well defined shareholder rights, a solid control environment, high levels of transparency and disclosure, and an empowered board of directors—make a company both more attractive to investors and lenders, and more profitable’. Amongst other data, IFC quoted the McKinsey (2002) Survey of Global Investor Opinion, showing that institutional investors are willing to pay a good governance premium of 30 per cent in Eastern Europe and Africa and 22 per cent in Asia and Latin America. In less risky environments, the good governance premium was lower, 8 per cent. Firms with good corporate governance secured cheaper debt, and in general outperformed their competitors. The econometric evidence discussed earlier (see Section 3.4.2) indicated the possible value of (a reputation for) good corporate governance for market performance. In short, share price market data suggests that there is a premium for good corporate governance, the value of the premium being higher in countries with high political risks. Shareholder value thus results in higher corporate returns. However, evaluation of the efficiency justifications for shareholder value requires a more fundamental analysis. There are five main justifications for the view that shareholder value is the most efficient form of corporate governance. The first justification is the perceived inadequacy of internal means of corporate control. Reliance upon internal means of control allows corporate management, and in some circumstances other internal stakeholders, to pursue their own interests, even at the expense of investors. The inadequacy of internal controls leads to the need for external mechanisms to monitor and control corporate management, primarily through the institutions of corporate governance. The second justification is the efficiency of capital markets as means for resource allocation, a means of transferring resources from areas of low returns on capital investment to areas of higher returns. The third justification is the role of the capital market in sourcing new capital investment. The fourth justification is the role of the capital market, especially the venture capital– private equity capital markets, in providing investment capital for high-risk ventures. The fifth justification is the value of share options as a mechanism for motivating corporate managers. The first justification for shareholder value and investor engagement is the evident failure of internal means of control. According to Jensen (1997: 27):

Shareholder Value, Investor Engagement, and Management Practice 171 substantial data support the proposition that the internal control systems of publicly held corporations have generally failed to cause managers to maximize efficiency and value. More persuasive than the formal statistical evidence is the fact that few firms ever restructure themselves or engage in a major strategic redirection without a crisis either in the capital markets, the legal/political or regulatory system, or the product/factor markets.

Corporate executives have strong incentives for ‘entrenchment’ and easily accessible means for realizing the private benefits of control (Shleifer and Vishny 1997: 742; Walsh and Seward 2004: 69). Such conclusions are consistent with transaction cost economics theories of the firm, in which ‘a self interest seeking assumption that makes allowance for guile’ is a major behavioural component (Williamson 1990: 11). The rational self-interest of managers, readily available opportunities for managerial aggrandizement, and the costs of monitoring by investors, as well as inertia, cause internal controls to decay. However, the assumption that internal controls necessarily fail is unfounded. This blanket judgement neglects variations in the values of corporate management, some of whom are more prone to the unfettered pursuit of self-interest than others. Not all managers act opportunistically in their private interests, although the assumption that they will do so may encourage such an approach. Managerial values vary, for example according to religious beliefs, and organizational cultures, as well as countervailing institutional pressures, such as union organization, may constrain managerial excess. Indeed, stewardship theory, as developed by Donaldson and others, posits a very strong positive conception of management values (J. H. Davis, Schoorman, and Donaldson 1997). The negative blanket assessment of internal controls also fails to reflect variations in the success of different forms of internal control. For example, the multi-divisional M form of corporate structure, initially developed by DuPont and General Motors in the 1920s, allowed central management to control the corporation through the budgetary process, with considerable success between the 1920s and the 1950s (Freeland 2001). Similarly, quasi-market internal structural arrangements and intra-management competition may successfully prevent the exploitation of the corporation by private interests, without the creation of shareholder value institutions. Countervailing power may operate within management, as well as between management and investors. In short, internal controls can work. The second efficiency justification for shareholder value is its effectiveness as a means of transferring resources from inefficient, or at least unprofitable,

172 Shareholder Value, Investor Engagement, and Management Practice sectors to more efficient or profitable sectors. At the macro level, capital markets and the contest for corporate control result in the reallocation of resources from less to more profitable and efficient users. Corporate reorganization through mergers, acquisitions, divestments, and restructuring are the means (and plant closures and job losses are the transitional costs) of achieving economic flexibility, the carrying through of the process of ‘creative destruction’ which Schumpeter (1950) saw as necessary for technological progress and economic growth. Hence, for example, in Jensen’s analysis (1997: 28) of the growth of shareholder value in the USA, excess capacity in the American tire industry in the 1980s led to takeovers and restructuring, with 37 tire plants closed between 1977 and 1987 and a decline of over 40 per cent in employment in the sector: ‘[t]he pattern in the US tire industry is repeated elsewhere among the crown jewels of American business’. Merger and acquisitions activity in the USA in the 1980s was seen as a necessary—and highly successful—response to the declining productivity and profitability of American industry in the 1970s. Oil price rises and Japanese competition made such reallocation necessary. The positive stock market returns of companies involved in merger and acquisition activity were interpreted by Jensen and other finance researchers as indications of the positive contribution of such corporate restructuring to economic growth and overall social welfare. However, the evidence for the overall positive contribution of merger and acquisition activity to shareholder value and performance enhancement is controversial (for reviews, see Andrade, Mitchell, and Stafford 2001; Tichy 2002; also Section 2.4.6). Franks and Mayer (2000: 6) concluded that ‘there are substantial gains to shareholders from takeovers but virtually all the gains accrue to the target’. Despite rhetoric and ideology, it is questionable whether underperforming companies are the primary targets for merger and acquisition. Franks and Mayer (2000: 8) argued that in Britain ‘the targets of hostile takeovers do not show evidence of past poor performance. Targets look to be average, or slightly below average, performers in comparison with other quoted companies’. In the USA, there is more evidence of underperformance leading to hostile acquisition (Franks and Mayer 2000: 8–9). Mergers and acquisitions lead to improved stock market returns, at least for the target company, but the effects on long-term value creation are more doubtful (see Section 2.4.6). There are four major grounds for questioning the special effectiveness of capital markets as a means of bringing about economic restructuring. First, capital markets may be more efficient in allocating resources away from unprofitable uses than in assessing and building new capacity. Following the principles of bounded rationality, the costs of assessing the profitability of

Shareholder Value, Investor Engagement, and Management Practice 173 existing activities are lower than the costs of assessing the potential profitability of future activities, since there are higher levels of uncertainty, higher levels of risk, and higher information costs in assessing the future than the past or present. Judging the past, including past errors, is easier than assessing the future. Second, resources diverted from industries with excess capacity may be channelled into different but equally unproductive uses, such as conspicuous consumption or military expenditure, replacing ploughshares with swords. Third, the analysis neglects the role of herding in stock market decisions. The movement of capital from wasteful to productive uses via the market for corporate control and corporate restructuring assumes rational capital market behaviour. However, the market’s herd instinct may lead to erratic investment patterns, as with the growth of investment in Internet stocks in the USA in the 1990s which led to the dot-com boom and subsequent slump, herding fuelling speculation and exaggerating volatility (Singh et al. 2005: 6–10). The growth of index-tracking funds and the mechanics of fund managers’ reward systems tied to performance against the index may further accentuate herding tendencies (Coffee 2002: 17–18). Moreover, the herd is more likely to be running the last race, not the next one. Finally, differences in perspectives, limitations in information, and high monitoring costs restrict the market’s capacity for evaluating innovation potential. Limited technological knowledge and difficulties in evaluating the comparative efficiencies of production processes restrict the market capacity to judge the value of investments in process innovation. To the extent that firms rely upon securing capital via equity investment, investment is more likely to be skewed to firms demonstrating high levels of product innovation than to firms investing in process innovation. Ceteris paribus, under shareholder value, the market is more likely to invest in high rather than medium technologies, in pharmaceuticals rather than cars. The justification for viewing the market for corporate control as an efficient mechanism for allocating resources from less to more valuable (or at least more profitable) activities is therefore questionable. There are alternative external means of monitoring performance, preventing the entrenchment of management interests and reallocating resources amongst sectors. Alternative methods include political regulation and the operation of product and factor market constraints. The advocates of shareholder value argue that capital markets are more efficient than other external agencies because they are more economically rational than political actors and more timely than product or factor markets (Jensen 1997: 26–7). We are sceptical of this conclusion. The economic and social costs of restructuring may be regarded as an inevitable consequence of economic change, independent of the means for carrying through such changes, whether capital markets, product market competition,

174 Shareholder Value, Investor Engagement, and Management Practice or political decision-making. The reallocation of resources amongst sectors is socially and economically disruptive, whether the process is undertaken via the capital market, factor markets, or political decision-making. The third efficiency justification for shareholder value is the role of the capital market in sourcing capital for new economic activities. The overall role of the equity market is to channel investment into profitable productive activities, as Adam Smith (1976) noted. However, it is easy to exaggerate the economic significance of equity investment. The extent to which firms rely upon the equity market, debt, bonds, or retained earnings differs amongst countries and amongst sectors. Firms seek to minimize control costs in securing finance for new investment, leading to a pecking order of funding preferences, with retained earnings being the preferred mode of funding, followed by debt (Myers and Majluf 1984; Leary and M. R. Roberts 2004). Even in capital market-oriented systems, such as Britain and the USA, the major source of capital for new investment is retained earnings (Corbett and Jenkinson 1996). The preference for retained earnings followed by debt and bonds, rather than equity, is especially strong in countries where relationship banking is the norm. Even in Britain, for investments in R&D, firms prefer debt to equity, except for firms with very high levels of expenditure on R&D, such as pharmaceuticals. ‘In aggregate, the UK and US stock markets contribute virtually nothing to total sources of finance of industry’ (Mayer 1999: 1). Share issues are more frequently used to fund acquisitions and mergers than for investment in new production facilities: ‘the stock market has primarily been a mechanism for the transfer of existing claims on real resources rather than a channel for funds to facilitate new investment in the corporate economy’ (M. A. O’Sullivan 2001b: 34). There are of course specific contributions. The venture capital market is a major source of capital for new firm creation, even if only a small proportion of total capitalization. The fourth efficiency justification for shareholder value is its encouragement to investment in high-risk new ventures. The venture capital market provides capital for investment in new sectors, such as IT and biotechnology, as well as in innovative service organizations. High returns and significant control rights are the rewards for undertaking high-risk investments. Venture capital–private equity funds acquire particular control rights and are heavily engaged in the development of the companies in which they invest, as shown in Chapter 5. Venture capital investment contracts typically provide for investor exit strategies after five or ten years, safeguarding investors’ commitments whilst reassuring entrepreneurs of their eventual return to control. The prospect of large financial rewards, safeguarded by control mechanisms protecting against downside risks, encourages investment in high-risk businesses and new firm development amongst both investors and potential

Shareholder Value, Investor Engagement, and Management Practice 175 entrepreneurs. The prospect of large potential rewards from high technology ‘spin-out’ companies has encouraged academic researchers to focus on the possible market value of their research. The venture capital market fosters innovation, especially in sectors where innovations are clearly identifiable and the returns to innovation easy to appropriate. Venture capital markets are especially effective in biotechnology and pharmaceuticals, where strong patent protection (at least in the USA, the major market) ensures that firms can appropriate the rents from innovation. However, capital markets are less efficient means of financing innovation where innovations are difficult to isolate and identify and returns difficult to appropriate, for example where patent protection is weak. Moreover, the frequency of legal challenges in pharmaceuticals and the de facto erosion of national patent protection by governments as well as competitors indicate the fragility of patent protection (see also Jaumotte and Pain 2005). The impact of shareholder value on process innovation is less positive. Shareholders have a natural preference for profit distribution rather than earnings retention, a preference reinforced when academics reinterpret earnings retention as a licence for managerial extravagance. Lazonick and M. A. O’Sullivan (2000: 70) argued that the major requirements for innovation are knowledge and money, and that knowledge and money are more likely to be available in firms oriented towards internal controls and the internal allocation of resources than in firms oriented towards external, market controls: ‘[i]n combination, financial commitment, organisational integration, and strategic control support organizational control in contrast to market control over the critical inputs to the innovation process’. Internal focus and internal funding are associated with investment in process as well as product innovation, frequently involving incremental changes in production processes, an aspect of learning by doing. Toshiba’s development of plain paper copiers is a classic example of this process, involving close links between plant-level organization, process innovation, and new product development (Fruin 1997). The benefits of such innovations are more difficult to appropriate, or sometimes even to identify, than product innovations, and are likely to escape the attention of capital markets. Process innovations are especially significant in medium technology enterprises, such as car manufacture, rather than high technology enterprises, especially where quality of manufacture is a source of competitive advantage. The double-edged impact of competitive equity markets is evident in the development of the US computer industry. On the one hand, the US computer industry was highly successful in the 1980s and 1990s in launching new products in IT, with ‘Silicon Valley’ as the ‘entrepreneurial seedbed’ for new companies creating software and, to a lesser extent, hardware for

176 Shareholder Value, Investor Engagement, and Management Practice Internet companies (Chandler 2001: 233). Venture capitalists, including Kleiner, Perkins, Caufield, and Byers, as discussed in Chapter 5, played a central role in this development. On the other hand, US equity-financed IT companies were single sector companies which dominated specific niches, but did not build large-scale manufacturing capacity to exploit the advantages acquired by being first mover. This contrasted with the earlier route to international dominance of consumer electronics by Japanese companies, and the route to continuing challenges to US computing dominance by Japanese computer manufacturers. The rise to international dominance by the Japanese consumer electronics industry was due to long-term capital accumulation and the learning capabilities of major Japanese firms such as Mitsubishi Electrical, Fujitsu, and Toshiba, which had their roots in the electrical and telecommunications industries established before the First World War. Such firms had grown into consumer electronics from related sectors, cumulatively developing their learning capability. This pattern of growth through diversification into related sectors over an extended period was financed by retained earnings and debt financing, not by raising funds in the capital market. This long-term, expansive growth contrasted with the narrower, sector-specific and focused development of the US industry. Hence, ‘the multi-sectored, multi-industry enterprises have more of the organizational capabilities and income to commercialize products of new technologies and to enhance products of existing technologies than do the single sector enterprises’ (Chandler 2001: 236). The competitive capital market mechanisms which encouraged rapid product innovation discouraged as potentially wasteful the capital accumulation which fostered cumulative learning, incremental innovation, related diversification, and growth in market share. The fifth strand in the efficiency justification for shareholder value relates to the role of incentives. The anticipation of future benefits from profit distribution or capital appreciation is, of course, the initial incentive for investors. The allocation of control rights to investors is the means of protecting investors against the expropriation or misappropriation of their resources by managers (Shleifer and Vishny 1997: 750). However, control rights are an inadequate basis in themselves for protecting investors’ interests, because of the incomplete character of investor–manager contracts, and the operational need for managerial autonomy and judgement. Shareholders therefore need to align the incentives of senior managers with those of investors. Without external monitoring and alignment of investor and corporate management interests, managers’ incentives may be distorted, with the extravagant mismanagement, even expropriation, of corporate resources through institutional empire building, excessive staffing, and overgenerous compensation schemes. Managers have strong incentives to prioritize corporate growth, even at the

Shareholder Value, Investor Engagement, and Management Practice 177 expense of profitability (Marris 1964). Share options, ‘contingent long term incentive contracts ex ante’ (Shleifer and Vishny 1997: 744), are the usual means of aligning managerial incentives with shareholders’ interests. Empirical research confirms that, overall, share options do contribute to aligning managerial incentives with shareholders’ interests, although they do not completely resolve agency problems, as Shleifer and Vishny admitted (1997: 745). Senior management share options, like bonus schemes, are sticky downwards, rewarding success in meeting targets but rarely penalizing failure; the downside risks for senior managers are small. The modus operandi of share option schemes usually allow managers to benefit from increases in share prices which derive from favourable macro-economic circumstances or product demand changes (such as raw material or energy price rises), whilst guarding against the negative consequences of unfavourable environmental changes, such as exchange rate fluctuations. Moreover, the wide discretion available to senior managers in developing share option schemes, and the loose constraints often imposed by remuneration committees, may result in self-dealing and overgenerous option arrangements, even if the ‘misdating’ of option entitlements is only a minority practice (Bebchuk and J. Fried 2004; also J. N. Gordon 2006: 108–110). It is not surprising that much of the initiative for the development of share option schemes came from managers rather than from shareholders. The finance literature has focused on the complexities of share option schemes, consistent with its preoccupation with problems of agency. However, the interests of investors and senior managers are relatively similar, as wealthy high-income earners, except in the specialized world of principal– agent theory. More problematic is the impact of shareholder value and share option schemes on the incentives of other stakeholders in the firm. Prioritizing the interests of investors and focusing on the incentives of senior managers inevitably marginalizes the interests of other stakeholders, especially employees, with obvious negative effects on their incentives. One mechanism for aligning employees’ incentives with those of investors is through the adoption of employee share ownership programmes (ESOPs) or similar programmes, fostering an investor orientation amongst employees (Blair, Kruse, and Blasi 2000). However, the scale of ESOPs is much smaller than the scale of share options, their coverage more limited, and their levels of reward far less generous. Their incentive effects are therefore limited. Providing incentives for employees to commit to the corporation and to invest in the development of their own human capital may be important, particularly for firms operating in knowledge-intensive sectors of the economy, but its importance is rarely recognized by senior management. Moreover, customers and clients may be discouraged by the approach of firms that so explicitly give higher priority to the interests of others.

178 Shareholder Value, Investor Engagement, and Management Practice The primary concern of shareholder value is with issues of distribution, with the efficient control and equitable distribution of corporate assets and income streams, within the framework of agency theory. This focus on issues of distribution inevitably neglects production concerns. This neglect has negative, rather than benign, consequences for the firm. Giving priority to minimizing transaction costs leads to difficulties in developing production systems which involve high levels of integration, and with a focus on organizational learning, including the transmission of implicit knowledge (Nonaka and Takeuchi 1995; Teece 2000). Integration may involve increasing transaction costs, with complex and even redundant linkages which foster understanding and organizational learning throughout the production system, rather than skill acquisition and learning targeted at specific objectives. Effective integration may involve increased communication costs, including communication redundancy, to provide for organizational learning and innovative responses to unanticipated external changes. Japanese success in manufacturing rests on such organizational learning and the close integration of product development and manufacturing, as Fujimoto (1999) showed in his studies of Toyota. Effective integration involves investment in developing employee skill levels, not only the strict application of engineering principles and cost–benefit analysis. As Lazonick and M. A. O’Sullivan (2000: 91) argued, ‘the key to understanding the influence of functional integration on innovation and international competitive advantage is the integration of product and process development and the skill base strategy that such integration entails’. The fluidity of capital markets enabled the rapid development of new, high technology sectors and revitalized established sectors. However, O’Sullivan (2001a) argued that the relationship between investors and managers in the USA does not provide a good environment for the development of the organizational learning and cumulative innovation seen as requirements for competitive ‘middle technology’ companies. The emphasis on shareholder value led to ‘downsize and distribute’ rather than ‘retain and reinvest’ practices. The theories of principal–agent gave too much attention to issues of entitlement and distribution and too little attention to production and, especially, innovation. Moreover, the success of ‘Wintelism’—new production systems based on combining central control of design and branding with outsourcing of production to specialized component producers—did not provide the basis for sustainable prosperity. Design innovations could seep to competitors, component producers could evolve ‘downstream’, and consumer brand loyalty could prove fickle. The negative implications of applying shareholder value logic for productive efficiency are especially evident in organizations seeking to develop highperformance work teams. High-performance work teams require high levels

Shareholder Value, Investor Engagement, and Management Practice 179 of trust, with team members relying on one another to operate flexibly and to use their initiative and intelligence to contribute to innovation, as well as to respond constructively to unpredictable environmental changes. However, prioritizing measures to control self-dealing inevitably corrodes trust and fosters a low-trust dynamic, in which management attempts at control foster the behaviours management is seeking to avoid, such as ‘self seeking with guile’ (to use Williamsonian language) as well as organizational ‘misbehaviour’ and outright resistance (Fox 1974; Williamson 1990; Ackroyd and P. Thompson 1999). Many modern production systems require the teamwork and flexibility fostered by the high-trust dynamic, which is difficult to reconcile with the transaction cost-minimization focus fostered by shareholder value. The limitations of the efficiency justifications for shareholder value reflect problems with its basic underlying assumptions. There are two sets of questionable assumptions. The first set relates to the conception of the firm. The second set relates to the psychology of economic actors. Theories of shareholder value operate with a specific conception of the firm, as a network of ego–alter relationships analysed in terms of ends–means linkages—the firm is conceptualized as a ‘nexus of treaties’ (Aoki, Gustafson, and Williamson 1990). Hence, according to Jensen (1998: 56), the corporation is ‘a legal fiction which serves as a nexus for contracting relationships and which is also characterized by the existence of divisible residual claims on the assets and cash flows of the organization’ (emphasis in original). The firm is a particular type of market, ‘the outcome of a complex equilibrium process’ (Jensen 1998: 57) involving interdependence and exchange relationships amongst the parties. This deconstruction of the firm into networks of principal–agent relations represents an under-theorized conception of the firm, neglecting the significance of institutions as social constructs—an ‘under-socialized’ conception of the firm. The firm has an independent corporate existence, not capable of decomposition into a nexus of treaties. This is recognized in the legal status, the legal personality, of the corporation. Corporate assets are held by the collectivity as a social organization, independently of the interests or wishes of individual shareholders: ‘[assets] are now owned by the company alone’ (Mitchell, O’Donnell, and Ramsay 2005: 14). As Kay and Silberston (2004: 51) expressed it, ‘the organic model of corporate behaviour—which gives to the corporation life independent from its shareholders—describes the actual behaviour of large companies and their managers far better than does the principal–agent perspective, and . . . this is as true in Britain and the United States as it is in Japan’. Indeed, the Japanese conception of ‘the new community firm’ does not even include the shareholder as a member of the community (Inagami and Whittaker 2005: 19). The board of directors is the legal guardian of corporate assets, whose legal obligations include acting as stewards on

180 Shareholder Value, Investor Engagement, and Management Practice behalf of the company, not only as representatives of the shareholder interest. Indeed, Blair and Stout (1999: 293) went as far as arguing that, in the USA, ‘case law makes clear that directors owe their fiduciary duties primarily to the corporation itself ’ (emphasis in original). The dual nature of directors’ obligations, to the corporation as an entity and to the shareholders of the corporation, is reflected in US legal conceptions. The business judgement rule protects corporate management and limits the scope of shareholders’ legitimate concerns. This duality and the good business judgement defence have been repeatedly underlined in the decisions of the Delaware Supreme Court, the jurisdiction in which the majority of major US corporations are registered. The second set of assumptions relates to the motivations of economic actors. As in transaction cost economics, agency theory operates on the assumption of agent opportunism. There is an inherent conflict of interest between principal and agent, which principals seek to manage. As J. Roberts1 (2004: 127) expressed it in The Modern Firm, ‘what is crucial is that, other things being equal, at the margin the agent prefers to provide less of the action taken on the principal’s behalf whilst the principal prefers more. In particular, the agent is assumed to prefer working less than would be efficient from the point of view of maximizing the total benefits produced minus the costs of his action’. As agents, corporate management are motivated to behave opportunistically, contrary to the interests of their principals. Where continuous monitoring and sanctioning by principals is impossible and contracts are incomplete, as in relations between investors and managers, special incentives are required to transcend the agent’s propensity for self-seeking. The ‘relentless application of calculative economic reasoning’ (Williamson 1993: 453) may generate interesting models and researchable hypotheses, as Williamson claimed, but has negative behavioural consequences when used as a basis for management action. The assumptions about motivation echo a long-standing tradition in management thinking, well summarized in Douglas McGregor’s ‘Theory X’ (1960): self-interest is the only reason for action, and monitoring and control, or at least insurance, is necessary to deal with the risk of malfeasance. However, operating according to the assumptions of ‘Theory X’ fosters mistrust and generates a low-trust dynamic, in which measures to counter the costs of anticipated malfeasance accelerate the decline in trust, as Fox (1974) demonstrated in his classic sociological study, Beyond Contract: Work, Power and Trust Relations. The low-trust dynamic involves a cycle of increasing control, psychological withdrawal, lack of cooperation, and competitiveness amongst individuals. Attempts to control malfeasance thus result in a self-fulfiling prophesy. In line with expectancy theory, anticipating treachery is likely to produce treachery.

Shareholder Value, Investor Engagement, and Management Practice 181 The justification for shareholder value rests more heavily on efficiency than on equity considerations. The equity justification for shareholder value derives from the unsecured status of the investor’s contribution to the corporation. Shareholders’ returns are not protected by contract, unlike the returns of other stakeholders, such as employees and creditors. Shareholders are residual claimants and bear the risks of the corporation’s losses, and therefore merit prioritization in the allocation of rewards. Moreover, as residual claimants, shareholders have the strongest incentive to optimize the performance of the corporation, since their rewards depend directly on the size of the residual. However, stressing the risks of shareholders over the risks of other stakeholders downplays the significance of the risks of other stakeholders. The returns of bondholders are also sensitive to the performance of the firm. Moreover, employees may also have made investments in acquiring knowledge and skills specifically relevant to the firm, with no guarantee of return. There are thus flaws in both the efficiency and the equity justifications for shareholder value. With regard to efficiency, the shareholder value analysis exaggerates the weaknesses of internal control systems, overestimates the efficiency of the capital market as a means of transferring resources from sectors of low value added to sectors of high value added, and attributes too much importance to the capital market and equity finance as a source of new capital investment, even for high-risk ventures. Shareholder value advocates are also sanguine in their assessment of share options as a means of aligning the interests of managers with those of shareholders, since share options are a means of increasing the rewards of managers as much as a means of aligning managers’ and shareholders’ interests. With regard to the equity justification for shareholder value, highlighting the role of shareholders as the sole bearers of unsecured risks neglects the risks experienced by other stakeholders, especially employees.

8.2. ARGUMENTS FOR INVESTOR ENGAGEMENT In this book, we have sought to describe investor engagement, its motivation, its forms, and its effects on management practice in the context of shareholder value. In this concluding section, we comment on investor engagement as a normative value. What are the justifications for investor engagement? What direction should the reform of corporate governance take regarding investor engagement? There are three major categories of justifications for investor engagement. The first, the most common and least controversial, is investor engagement as

182 Shareholder Value, Investor Engagement, and Management Practice a means of enhancing shareholder value. Investor engagement is a means of advancing investors’ interests and of maximizing shareholder returns, alongside other policies and practices such as mandatory codes of practice in corporate governance, transparent corporate reporting, standardized accounting procedures, and strong legal protection for shareholders’ property rights. There is consensus in shareholder value regimes on the appropriateness of investor engagement as a means of maximizing shareholder returns, directly or indirectly. The origins of shareholder activism in the USA, associated especially with CalPERS, lay in this form of investor engagement. CalPERS’ shareholder activism involved sponsoring shareholder resolutions against corporate anti-takeover devices, supporting shareholder resolutions on corporate board restructuring. Corporate governance reform has been primarily concerned with this form of investor engagement, as a means of protecting shareholder interests and enhancing shareholder value. The major objective has been to prevent the expropriation or misappropriation of investors’ assets by corporate management. Corporate law reform has been targeted at the protection of private property rights. International comparative research has suggested the greater success of common law jurisdictions than of civil law jurisdictions in supporting private property rights, leading to enhanced interest in the dynamics of common law jurisdictions (e.g. LaPorta et al. 1999). The major strategies for preventing management expropriation include strengthening the authority of independent directors on company boards, ensuring timely, transparent accounting information, and developing an informed critical business media (e.g. MacAvoy and Millstein 2004). Investor engagement is a significant means for carrying such strategies through at corporate level. The major difficulty perceived in pursuing such objectives through investor engagement is the free rider problem. As Shleifer and Vishny (1997: 741) commented, ‘the free rider problem faced by individual investors makes it uninteresting for them to learn about the firms they have financed, or even to participate in the governance’. The costs of investor engagement in time and money are particular, whilst the benefits of engagement are universal, the improvement of corporate governance. However, mechanisms exist for sharing the costs of engagement, with collective action through organizations such as NAPF or ISC as well as through ad hoc arrangements. Moreover, some of the costs of the monitoring required to support investor engagement are covered by public interest organizations and the business media, as well as regulatory bodies; the Wall Street Journal played a significant role in highlighting corporate scandal at Enron. The costs and practical difficulties arising from the free rider problem can easily be exaggerated.

Shareholder Value, Investor Engagement, and Management Practice 183 The second category of justifications for investor engagement is that of securing corporate conformity with ‘best City practice’. This involves going beyond the specific objective of maximizing shareholder value in the individual corporation to using investor engagement as a means of ensuring compliance with collective norms of behaviour. Such ‘best City practice’ may go beyond following the formal codes of practice or complying with stock exchange listing rules. From this perspective, investor engagement is a means of upholding the norms of good corporate behaviour. The norms include opposition to corporate tactics designed to restrict competition for corporate control, such as multi-class share structures, support for genuinely independent non-executive directors, and limitations on the remuneration levels of senior executives, especially in badly performing firms. Previous chapters have included examples of investors mobilizing to ensure compliance with ‘best City practice’, as with the opposition to remuneration practices at J. Sainsbury plc and GSK in 2003 and 2004. Investor engagement may also be used to transfer best practice internationally, for example through the transfer of venture capital practices from ‘Silicon Valley’ to Britain, as illustrated in Chapter 5. At a normative level, such investor engagement is not controversial, although previous chapters have indicated the practical difficulties involved in its realization. The third type of justifications for investor engagement is its use as a means for achieving broad economic and social objectives, including CSR. The specific justification for investor engagement in relation to broad economic and social objectives derives from investors’ responsibilities as ‘universal owners’. As universal owners, institutional investors, especially pension funds, have responsibilities for the long-term welfare of their beneficiaries, and concern for the negative externalities of the actions of the firms in which they invest. The USS case study in Chapter 3 shows investor recognition of this responsibility. This obligation is reinforced by market factors, the difficulty of universal owners disinvesting without having a negative impact on share prices. The force of this justification for investor engagement is enhanced by the absence of alternative influences on corporate management, with the weakening of collective employee organization, and the defensive ideological stance of public authorities towards business interests. The global CSR movement is seeking to push corporate practice towards such broader conceptions of corporate responsibility (Aguilera and Cuervo-Cazurra 2004). In this framework, investor engagement may be justified as an extension of enlightened shareholder value. The broader issues raised include environmental concerns and global climate change, as well as sector-specific issues such as low-price drugs for developing countries in pharmaceuticals, or discrimination issues, such as hiring practices for minorities. However, the use of investor engagement as a means of achieving such social objectives seriously undermines

184 Shareholder Value, Investor Engagement, and Management Practice the shareholder value model. It blurs the clarity of corporate objectives: one investor’s enlightened self-interest might be another investor’s irresponsible extravagance. Moreover, the adoption of broader objectives may undermine the collective unity of investors’ organizations, reducing their effectiveness in seeking to influence corporate management. Different institutional investors have different views on social and political issues, even where they agree on maintaining ‘best City practice’. In the USA, the courts have restricted the scope of investor activism and reinforced corporate management by regarding one of the major social issues of concern, minority hiring practices, as covered by the principles of the ‘good business judgement’ rule and therefore the responsibility of corporate management, outside the range of legitimate investor interest. Following their analysis of S&P 500 firms, Hillman and Keim (2001: 135) concluded that ‘participating in social issues beyond the direct stakeholders may adversely affect a firm’s ability to create shareholder wealth’. In conclusion, we view investor engagement in a broader political context. The institutions of corporate governance are political as well as economic. Investor engagement has political as well as economic significance, as the New Labour Government has recognized in its proposals for company law reform in the UK. Both Britain and the USA identify themselves as open, pluralist societies, in which groups compete to seek to achieve their objectives under the law, within the economic as well as the political system. This implies at least two conditions directly relevant to corporate governance. The first condition is transparency: group interests and the means used to achieve them should be visible. The second condition, more contentious and even more difficult to achieve, is that there should be a rough balance between groups in their capacities to realize their objectives. The first condition is not met in relations between investors and corporate managers. The process of investor engagement is currently far from open. The interactions amongst investors, their agents, trust fund managers, and corporate management are usually private, with other groups becoming aware only when relations break down. Hence, both investors and corporate managers regard frank, open discussions at shareholders’ AGMs as signs of failure in the management of investor relations. In such circumstances, the board has failed to meet its objective of ‘no surprises’. Institutional investors’ instructions to their collective organizations are usually confidential, as is the advice given by investors’ associations to their members. The New Labour Government, through DTI, has advocated that institutional investors should publicly declare their stance on shareholder resolutions placed on the AGM agendas of the companies in which they invest. However, despite support from many institutional investors, the policy has been strongly opposed by other investors and corporate managers, as being damaging to commercial relationships as

Shareholder Value, Investor Engagement, and Management Practice 185 well as being costly. The issue is currently under consideration in parliamentary discussions of The Company Law Reform Bill (House of Commons 2006). Greater transparency in the relations between investors and corporate managers would enhance the credibility of corporate accountability. The second condition is that there should be a rough balance between groups in their ability to achieve their objectives. The conception of a balanced plurality of interests within the corporation is alien to shareholder value. In shareholder value thinking, the corporation is considered as a unity, seeking to maximize shareholder value; a plurality of interests leads to conflict and reduces corporate efficiency. However, we have argued that the shareholder value conception of the firm is inadequate, neglecting the significance of the corporation as a social institution. We argue for the return to an older, pluralist stakeholder conception of the firm. The stakeholder approach to corporate governance gives weight to a wider range of equity considerations than shareholder value, whilst also maintaining that stakeholder forms of corporate governance can contribute to efficiency. The stakeholder conception of corporate governance views the corporation as a plurality of interests— employees, local communities, customers, clients, creditors, and the state, as well as investors—with legitimate interests in the conduct of the corporation. Different stakeholders have sometimes complementary and sometimes conflicting interests, resulting in different inter-group coalitions (Gourevitch and Shinn 2005). For stakeholder theorists, the prioritization of shareholder value involves an inequitable neglect of the interests of other stakeholders in the firm. In traditional stakeholder conceptions of the firm, the role of management is to balance the interests of different groups of stakeholders, if usually with a pronounced bias in favour of investors, as well as their own interests. In Britain, the high water mark of stakeholder conceptions of corporate governance was the Bullock Commission’s proposals for employee representation on boards of directors in 1977, a recommendation not adopted by the UK government and very strongly opposed by business (Elliott 1978). The revival of similar proposals would receive equally strong opposition from UK business leaders, although major British companies have successfully accommodated the much less threatening development of works’ councils required under the EU Directive (Marginson and Sisson 2004). The stakeholder conception of corporate governance was conventional wisdom in Britain and the USA in the late 1970s. However, the conception subsequently lost favour, with the rise of shareholder value, as outlined in Chapter 1. The equity justification for recognizing the interests of multiple stakeholders is that several stakeholders, not only investors, make firm-specific and only partially transferable commitments to the corporation. All such stakeholders could justifiably expect recognition of, and compensation for, the

186 Shareholder Value, Investor Engagement, and Management Practice risks involved in making such commitments. In particular, employees make long-term firm-specific commitments, through the investment of time and effort in acquiring skills that may be transferable to only a limited extent (Blair 1995). The efficient development of the firm’s productive capacities requires employees to invest in acquiring such skills. Moreover, for employees, as for managers, participation in the ownership of the firm is an incentive for corporate commitment, as recognized in the development of ESOPs. Although stakeholder analyses have paid most attention to employees, other groups may be recognized as possessing legitimate interests, where they are affected by corporate actions. Hence, local authorities may have a legitimate interest, for example, regarding schemes for urban redevelopment. Stakeholder conceptions of corporate governance have been recently discredited in Britain and the USA. Shareholder value has been seen as the basis for a more efficient and competitive form of corporate governance, for reasons discussed earlier (see Chapter 1). The international expansion of shareholder value conceptions has been seen as inevitable, the result of the greater functionality of shareholder value corporate governance regimes for developing economically competitive firms, as well as due to the isomorphic transfer of institutional forms. However, we have argued that the evidence justifying shareholder value on efficiency grounds is questionable, whilst the arguments justifying shareholder value on equity grounds are one-sided. The international expansion of shareholder value results from specific historical conditions and circumstances; it is not the outcome of the inevitable evolution of economic systems. The shareholder value model’s effectiveness depends on institutional complementarity between the model and the business system of which it is a part. Liberal market capitalisms provide a congenial ecology for shareholder value, whilst coordinated market regimes do not, as shown in Chapter 7. National contexts, including institutional arrangements, such as political and legal systems, and social structures, such as the class structure, as well as economic formations, set limits to the scope for expansion of shareholder value systems of corporate governance. Like John Armour and his Cambridge colleagues (Armour, Deakin, and Konzelmann 2003), we believe that it is premature to announce the ‘end of history’ for alternative forms of corporate governance (Hansmann and Kraakman 2004). Although stakeholder conceptions of corporate governance have been in retreat in ‘Anglo-Saxon’ economies since the 1980s, they remain important within a broader European context. The concept of ‘social partnership’, fundamental to EU thinking on employment relations and enshrined in the 1991 Treaty of Maastricht Social Policy Protocol and the 1997 Treaty of Amsterdam, reflects stakeholder conceptions of the firm, only partly diluted subsequently by shareholder value thinking; policymaking on such issues remains subject

Shareholder Value, Investor Engagement, and Management Practice 187 to intense debate, for example in the EU-funded European Foundation for the Improvement in Living and Working Conditions. The EU social partnership framework involves the state, employers’ organizations, and TUs in industry-level tripartite structures, concerned with industry-level issues, whilst employee representation is institutionalized at the level of the firm through works’ councils. Stakeholder conceptions of corporate governance, heavily influenced by German and Scandinavian experience, thus remain relevant even in the UK, as a result of EU legislation on international firms. Hence, under the 1994 EU Directive on European Works’ Councils, companies operating in more than one EU country and employing over 2,000 employees are required to establish works’ councils, although with far smaller responsibilities than under German or Scandinavian co-determination legislation (Marginson and Sisson 2004). Our argument is that there are significant equity gains from traditional stakeholder conceptions, whilst the efficiency disadvantages have been exaggerated; German and Scandinavian manufacturing enterprises have been notably more successful in international markets than British ones. The power and influence of different stakeholders in the corporation depend on the external context, including the macro-economy and product and labour markets, as well as the institutions of corporate governance. Firms, as well as governments, require flexibility to respond to changing circumstances. But institutional protection—‘flexible rigidities’ (Dore 1988)— may be required to prevent the interests of weaker groups from being swept away. The influence of shareholders as owners, employers, and employers’ organizations is currently dominant, buttressed by shareholder value corporate governance arrangements in Britain and the USA. The dominant ‘distributional coalition’ (to use Gourevitch and Shinn’s 2005 term) is between owners and corporate management. However, other distributional coalitions are feasible, such as between employees and managers against owners, rather than managers and owners against employees. The likelihood of such a coalition depends on political as well as economic conditions. Indeed, Austrian and Scandinavian corporatist models resulted from a distributional coalition between managers and employees (Gourevitch and Shinn’s 2005: 153–4). In different historical circumstances, institutional protection may be required for shareholders’ interests even in Britain and the USA. For example, shareholders may face expropriation by an alliance between managers (perhaps supported by block holders) and employees, under the guise of protecting national strategic interests. Moreover, it is not in the interests of dominant coalitions to sweep the losers from the field (especially if the game is to be repeated). A rapprochement between shareholder value and stakeholder conceptions, a ‘third way’, is achievable within the framework of ‘enlightened shareholder value’ (Williams and Conley 2004). In this rapprochement, shareholder

188 Shareholder Value, Investor Engagement, and Management Practice engagement has a central role to play, alongside the engagement of other stakeholders. To achieve this, the overall direction of corporate governance reform should be to increase transparency and to widen the range of groups involved in corporate governance, not to strengthen property rights, nor to increase commitment to ‘best City practice’, nor even to broaden the range of objectives sought through investor engagement. Taking corporate governance in this direction has echoes of traditional stakeholder conceptions; but it points to the future, as well as to the past.

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Author Index 3i Group 101–102, 189 ABI (Association of British Insurers) 55, 56, 189 Ackroyd, S. 1, 23, 179, 189 Aglietta, M. 2, 5, 189 Aguilera, R. V. 139, 164, 183, 189 Albert, M. 150, 189 Amsden, A. H. 167, 189 Andrade, G. 172, 189 Aoki, M. 6, 179, 189, 207 Armour, J. 186, 189 Ashenfelter, O. 202 Bainbridge, S. M. 123, 189 Barca, F. 196 Barker, R. G. 63, 189, 197, 204 Barrow, B. 136, 202 Bauer, R. 52, 189 Baum, A. C. 84, 189 Bayer Group 154, 156, 157, 158, 159, 160, 161, 189, 190 Beardwell, I. J. 193 Bebchuk, L. 32, 177, 190 Becht, M. 47, 190, 196 Beer, M. 14, 190 Berle, A. A. 2, 36, 42, 132, 190 Bethel, J. E. 70, 190 Beynon, H. 33, 190 Bild, M. 31, 190 Bishop, J. H. 27, 190 Bishop, K. 124, 125, 194 Bizjak, J. M. 48, 49, 190 Black, B. S. 9, 10, 25, 43, 123, 190 Blair, M. M. 3, 121, 125, 132, 177, 180, 186, 190, 191 Blasi, J. R. 177, 190 Boeker, W. 88, 196 Boyer, R. 2, 15, 154, 190 Brown, C. 25, 190 BRT (Business Round Table) 124, 191 Buchanan, D. 1, 191 Burgel, O. 46, 191 Busenitz, L. W. 114, 191 Business, The 79, 205 BVCA (British Venture Capital Association) 85, 191 Byrne, J. A. 19, 191

Cadbury, A. 10, 124, 191 Camejo, P. 197 Capelli, P. 33, 191 Card, D. 202 Carleton, W. 48, 49, 70, 191 Carr, C. 27, 30, 191 Carroll, R. 17, 191 Casper, S. 28, 151, 191 Chandler, A. D. 176, 191 Cheng, Y. 195 Chidambaran, N. K. 21, 22, 70, 191 Clark, G. L. 37, 191 Clark, R. C. 36, 37, 53, 191 Clarke, T. 3, 121, 139, 163, 192, 199, 201, 207 Coffee, Jr., J. C. 6, 9, 10, 11, 131, 132, 139, 144, 163, 173, 192 Cohen, L. 56, 192 Coles, J. W. 50, 192 Comment, R. 50, 192 Conley, J. M. 58–59, 187, 207 Cooper, S. 46, 203 Corbett, J. 174, 192 Cosh, A. 190 Cotter, J. F. 50, 69, 206 Crouch, C. 205 Cuervo-Cazurra, A. 183, 189 Cuny, C. J. 85, 192 Dahrendorf, R. 2, 192 Daily, C. M. 192 Daily Telegraph, The 80, 206 Dalton, D. R. 50, 123, 125, 192 Damodaran, A. 41, 192 Davey, P. J. 20, 192 Davies, G. 55, 192 Davies, P. 10, 192 Davis, G. F. 12, 192 Davis, J. H. 171, 193 De Hoyos, R. 205 Deakin, S. 31, 34, 124, 186, 189, 193 Del Guercio, D. 20, 69, 193 Deutsche Bank 148, 193 DiMaggio, P. 144, 193 Dobbs, R. 56, 193 Donaldson, L. 171, 193 Dore, R. 5, 12, 152, 153, 187, 193 Dresner, S. 74, 193

210

Author Index

Drucker, P. F. 36, 37, 193 DTI (Department of Trade and Industry) 28, 45, 51, 58, 193 Dunn, S. 14, 193 Ehrentreich, N. 151, 152, 193 Elango, B. 84, 194 Elliott, J. 185, 194 Ellstrand, A. E. 192 Elsas, R. 150, 194 Engelhardt, L. 150, 194 Farrell, S. 64, 201 Fenn, G. W. 87, 89, 194 Fenton, E. M. 23, 203 Fiet, J. O. 114, 191 Filatotchev, I. 124, 125, 194 Financial News 80, 194 Financial Times 72, 76, 77, 79, 80, 130, 133, 195 Financial Reporting Council 19, 44, 62, 64, 123, 124, 126, 128, 165, 194 Finegold, D. 27, 28, 194 Fligstein, N. 12, 13, 194 Fox, A. 179, 180, 194 Franks, J. 31, 47, 172, 190, 194 Franzke, S. 150, 152, 194 Freeland, R. F. 137, 171, 194 Freeman, C. 142, 194 Frick, B. 27, 194 Fried, J. 32, 177, 190 Fried, V. H. 194 Friedman, A. L. 3, 195 Friedman, M. 52, 195 Froud, J. A. 3, 4, 12, 28, 195 Fruin, W. M. 29, 175, 195 Fujimoto, T. 178, 195 Fukuyama, F. 15, 195 Gallie, D. 34, 195 Gautum, K. 88, 196 Gerke, W. 152, 195 German Parliament 153, 195 Gibson, W. D. 25, 195 Gillan, S. L. 20, 22, 69, 70, 190, 195 Gilson, R. J. 8, 142, 143, 144, 163, 166, 195 Gimeno, J. 27, 203 Gitman, L. J. 2, 205 Glen, J. 205 Goergen, M. 37, 149, 152, 153, 196 Goodstein, J. 88, 196 Gordon, J. N. 177, 195, 196, 197 Gordon, L. A. 70, 196

Gospel, H. 33, 196 Gourevitch, P. A. 4, 10, 16, 163, 185, 187, 196 Government Commission of the German Corporate Governance Code 160, 196 Graham, J. R. 131, 196 Grandori, A. 208 Grant, J. 71, 203 Grant Thornton UK LLP 124, 126, 128, 196 Graves, S. 70, 196 Grimshaw, D. 190 Grohs, S. 150, 152, 194 GSK (GlaxoSmithKline plc) 135, 196 Guardian, The 48, 81, 131, 206 Guest, P. 190 Gustafson, B. 6, 179, 189, 207 Hall, P. A. viii, 5, 139, 141, 145, 146, 196 Hampel, R. 10, 124, 196 Handa, H. 195 Hansmann, H. v, viii, 3, 139, 141, 163, 186, 197 Harvey, C. R. 131, 196 Haslam, C. 195 Hawkins, J. 20, 69, 193 Hawley, J. P. v, 5, 53, 197 Hebb, T. 37, 50, 191, 197 Hendry, J. 138, 189, 197, 204 Hermalin, B. E. 50, 51, 123, 126, 128, 197 Hesterly, W. S. 50, 192 Higgs, D. 10, 123, 124, 127, 197 Hilferding, R. 2, 197 Hillman, A. J. 184, 197 Hirschman, A. O. 41, 197 Hisrich, R. D. 194 Hitt, M. A. 27, 203 HMSO (Her Majesty’s Stationery Office) 38, 197 Hobbs, R. 193 Holland, J. 22, 64, 122, 131, 138, 197 Holmstrom, B. 32, 128, 197 Höpner, M. 141, 148, 149, 154, 155, 198 Hopt, K. J. 195 House of Commons 44, 45, 185, 198 House of Lords 133, 198 Huczynski, A. 1, 191 Hughes, A. 124, 193 Hyman, R. 148, 198 IFC (International Finance Corporation) 170, 198 IIGCC (Institutional Investors’ Group on Climate Change) 74, 198

Author Index IMA (Investment Management Association) 53, 62, 66, 68, 71, 74, 78, 198 Inagami, T. 179, 198 Independent, The 75, 77, 206 Investor Relations Society 129, 130, 198 ISC (Institutional Shareholders’ Committee) 21, 44, 45, 62, 64, 67, 198 J. Sainsbury plc 63, 80, 198 Jackson, G. 139, 164, 189 Jaumotte, F. 28, 175, 199 Jenkinson, T. 174, 192 Jensen, M. C. 6, 7, 8, 12, 16, 56, 170, 172, 173, 179, 199 Joerg, P. 139, 199 Johal, S. 195 Johnson, G. 1, 199 Johnson, J. L. 192 Joint City/Industry Working Group 61, 62, 199 Jürgens, U. 153, 199 Kaplan, S. N. 32, 86, 88, 128, 197, 199 Kaplinsky, R. 142, 199 Karson, M. 121, 199 Katz, H. C. 14, 200 Kaufman, A. 121, 199 Kay, J. 179, 199 Keim, G. D. 184, 197 Khalil, E. L. 11, 199 Khoylian, R. 84, 201 Khurana, R. 32, 120, 126, 129, 132, 161, 200 Kirchmaier, T. 71, 203 Kochan, T. A. 14, 190, 191, 200 Koedijk, K. 52, 189 Konzelmann, S. J. 186, 189, 193 Kornai, J. 11, 200 Kotkin, S. 204 Kraakman, R. v, viii, 3, 139, 141, 163, 186, 197 Krahnen, J. P. 150, 160, 194, 200 Kruse, D. L. 177, 190 Kulow, D. M. 84, 201 Lane, C. 148, 149, 154, 163, 200 LaPorta, R. 3, 10, 140, 164, 182, 200 Laux, C. 150, 152, 194 Lavelle, K. C. 167, 200 Lawrence, P. 190 Lazear, E. 14, 25, 200 Lazonick, W. 29, 175, 178, 200 Leary, M. T. 174, 200 Lehrer, M. 151, 191

211

Lens Investment Management LLC 46, 200 Lev, B. 26, 200 Levinthal, D. 25, 200 Liang, N. 87, 89, 194 Linstock Limited 66, 200 Loderer, C. 199 Lopez-de-Silanes, F. 10, 200 Lorsch, J. 123, 201 LSE (London Stock Exchange plc) 75, 201 Lütz, C. 141, 150, 153, 201 MacAvoy, P. W. 3, 122, 123, 124, 182, 201 McDermott, R. 64, 201 McGregor, D. 180, 201 MacIver, E. 123, 201 McKinsey & Company 170, 201 Macmillan, I. C. 84, 201 McNulty, T. 123, 203 Maitlis, S. 123, 201 Majluf, N. 174, 202 Malatesta, P. H. 21, 48, 49, 69, 70, 199 Manjon, M. C. 149, 153, 196 Manow, P. 150, 201 Marginson, P. 185, 187, 201 Marquette, C. J. 48, 49, 190 Marris, R. 3, 177, 201 Marston, C. 129, 201 Martin, R. 14, 201 Marx, K. 2, 13, 17, 201 Masten, S. E. 7, 208 Mayer, C. 31, 37, 39, 47, 172, 174, 190, 194, 201 Means, G. C. 2, 36, 42, 132, 190 Meckling, W. H. 7, 199 Megginson, W. L. 2, 205 Melis, A. 166, 201 Metcalf, D. 14, 193 Miles, S. 3, 195 Milgrom, P. 117, 147, 166, 201 Mills, D. Q. 190 Millstein, I. M. 3, 25, 122, 123, 124, 165, 182, 201 Minow, N. 25, 46, 202 Mitchell, M. 172, 189 Mitchell, R. 179, 202 Moen, E. 200 Moesel, D. D. 114, 191 Monks, R. A. G. 25, 38, 202 Morck, R. 15, 202 Morgan, G. 200 Moxey, P. 126, 202 Mullins, L. J. 1, 202 Murphy, K. 32, 202

212

Author Index

Murray-West, R. 136, 202 Myatt, J. 25, 200 Myers, S. C. 174, 202 Myners, P. 10, 19, 21, 40, 43, 44, 46, 65, 124, 202 Nakamura, M. 15, 202 Nash, D. 193 Nelson, J. 48, 49, 191 Nelson, R. 207 Nolan, P. 165, 202 Nonaka, I. 178, 202 North Atlantic Value LLP 72, 202 NYSE (New York Stock Exchange) 144, 202 Observer, The 78, 79, 206 Obstfeld, M. 142, 202 O’Donnell, A. 179, 202 OECD (Organisation for Economic Co-operation and Development) 125, 202 Office for National Statistics 37, 203 Opler, T. C. 49, 203 O’Sullivan, M. 125, 203 O’Sullivan, M. A. 16, 29, 69, 174, 175, 178, 200, 203 Otten, R. 52, 189 Owen, G. 71, 75, 203 Pain, N. 28, 175, 199 Parkinson, J. E. 21, 203 Parthiban, D. 27, 203 Partnoy, F. 66, 203 Patientline 75, 203 Peacock, I. 46, 203 Pellet, J. 19, 203 Pendleton, A. 33, 196 Pettigrew, A. 23, 123, 203 Pharmaceutical Shareowners’ Group 55, 203 Polonchek, A. 194 Porter, M. E. 25, 203 Postma, T. J. B. 207 Pound, J. 70, 196 Powell, W. W. 144, 193 Prendergast, C. 3, 32, 203 Prevost, A. K. 20, 203 Probert, J. 154, 200 Prowse, S. 87, 89, 194 Radaev, V. 11, 204 Raiser, M. 11, 204 Rajgopal, S. 131, 196

Ramirez, P. 206 Ramsay, I. 179, 202 Rao, R. P. 20, 203 Reading, B. 76, 204 Reberioux, A. 2, 5, 189 Rees, W. 203 Rehbein, K. 70, 196 Rehfeld, B. 20, 204 Rehm, W. 56, 193 Renneboog, L. 32, 37, 120, 149, 152, 153, 196, 204 Research Recommendations Electronic Voting 75, 204 Riddell, P. 13, 204 Roberts1, J. 13, 25, 117, 120, 147, 166, 180, 201, 204 Roberts2, J. 64, 83, 189, 197 Roberts, M. R. 174, 200 Roe, M. J. 3, 165, 195, 197, 204 Rose-Ackerman, S. 11, 200 Roth, L. 199 Rubery, J. 190 Runsten, M. 190 Sajo, A. 204 Sako, M. 11, 204 Sametz, A. W. 201 Sanderson, P. 83, 189, 197, 204 Scheikh, S. 203 Schmidt, R. H. 151, 152, 160, 193, 194, 200 Scholes, K. 1, 199 Schoorman, F. D. 171, 193 Schumpeter, J. A. 28, 29, 119, 172, 204 Schwert, G. W. 50, 192 Seidl, D. 83, 204 Seward, J. K. 121, 171, 207 Shin, T. J. 13, 194 Shinn, J. 4, 10, 16, 163, 185, 187, 196 Shivdasani, A. 125, 127, 204 Shleifer, A. 2, 6, 10, 171, 176, 177, 182, 200, 204 Silberston, Z. A. 179, 199 Silverman, B. S. 84, 189 Singh, A. 173, 205 Sisson, K. 185, 187, 201 SkyePharma plc 72, 73, 205 Slinger, G. 193 Smart, S. B. 2, 205 Smith, A. 1, 174, 205 Smith, M. P. 49, 205 Sokobin, J. 49, 203 Solomon, A. 206 Solomon, J. 206

Author Index Soskice, D. viii, 5, 27, 28, 139, 141, 145, 146, 151, 191, 194, 196 Spector, B. 190 Stafford, E. 172, 189 Stapledon, G. P. 60, 65, 74, 205 Starks, L. T. 20, 22, 69, 195 Stevenson, R. 56, 205 Stiles, P. 130, 205 Stout, L. 121, 125, 132, 180, 190 Streeck, W. 140, 151, 205 Strickland, D. 22, 205 Strömberg, P. 86, 88, 199 Takeuchi, H. 178, 202 Talmor, E. 85, 192 Taylor, A. M. 142, 202 Taylor, B. 130, 205 Teece, D. J. 17, 178, 191, 205 Thomas, R. S. 50, 69, 206 Thompson, P. 179, 189 Thompson, T. A. 12, 192 Tichy, G. 172, 206 Tomkins, C. 27, 30, 191 Tomlinson, M. 195 Toyne, P. 43, 206 Trojanowski, G. 32, 120, 204 TUC (Trade Union Congress) 37, 66, 206 Tykvova, T. 152, 206 Tylecote, A. 28, 146, 206, 207 UBS (UBS Global Asset Management UK Limited) 62, 68, 74, 206 Udueni, H. 126, 206 Useem, M. 3, 4, 6, 19, 36, 37, 38, 41, 129, 138, 206 USS (Universities’ Superannuation Scheme) 53, 54, 55, 206 van Witteloostuijn, A. 207 Vickers, J. 13, 14, 206 Vishny, R. W. 6, 171, 176, 177, 182, 200, 205 Visintin, F. 28, 207

213

Vitols, S. 149, 150, 154, 155, 207 Vogel, D. 51, 52, 207 Waddock, S. 70, 196 Waelchi, V. 199 Wahal, S. 22, 49, 69, 70, 207 Walker, W. 28, 207 Walkling, R. A. 21, 48, 49, 69, 70, 199 Walsh, J. P. 121, 171, 207 Walton, R. 190 Walz, U. 152, 206 Ward, K. 190 Wein, L. 197 Weisbach, M. S. 48, 49, 50, 51, 70, 123, 126, 128, 191, 197 Weisse, B. 205 White, M. 195 Whitley, R. 28, 191, 200 Whittaker, D. H. 179, 198 Whittington, R. 1, 199 Wijbenga, F. H. 89, 207 Wijkander, H. 197 Wiles, K. W. 22, 205 Wilkinson, F. 193 Williams, A. T. v, 5, 53, 197 Williams, C. A. 59–60, 187, 207 Williams, K. 195 Williamson, O. E. 6, 7, 13, 16, 17, 150, 171, 179, 180, 189, 207, 208 Wilson, H. 75, 76, 77, 208 Windolf, P. 9, 208 Woidtke, T. 21, 22, 70, 191 Wymeersch, E. 195 Yarrow, G. 13, 14, 206 Yermack, D. 125, 127, 204 Zacharias, L. 121, 199 Zammit, A. 205 Zarowin, P. 26, 200 Zeitlin, M. 2, 208 Zenner, M. 22, 205 Zwart, P. S. 207

Subject Index 3i Group plc 84, 100–2, 114, 117, 118, 119 accounting procedures 9, 16 accumulation crisis (in the USA) 13, 18 activist hedge funds 41, 46, 47 activist pension funds 49 advisory boards 91, 92, 115 affiliate funds 91 agency theories 6, 12, 16, 17, 20, 150, 177, 178, 180 Alternative Investment Market (AIM) 74, 99, 100 Amadeus Capital Partners Limited 84, 91–4, 118 analysts 9, 61, 62, 63, 108, 129–30, 131, 132, 159 annual general meetings (AGMs) 65, 67, 71, 81, 82, 101, 123, 127, 129, 133, 137, 184 anti-takeover provisions 41, 71, 121, 182 applied physics 103 Ardana plc 96–8, 102, 114, 115, 116, 117 initial public offering (IPO) 96 Association of British Insurers (ABI) 45, 55, 74, 75, 76, 77–8, 83, 136, 137 auditor independence 9, 69 Aventis 140, 157 BASF AG 155 Bayer Group 154, 155–63 Board of Management 160, 161 financial policies 160 beneficial share ownership 9, 36, 42, 57, 65–6 ‘best City practice’ 62, 81, 83, 133, 134, 136, 138, 183, 184, 188 biotechnology 27, 28, 94–5, 102, 119, 151, 174, 175 Blackboard Incorporated 111–13, 119 block holders 9, 22, 37–8, 70, 147, 150, 151, 152, 166, 187 boards of directors 3, 7, 10, 17, 22, 29, 31, 43, 45, 50–1, 66, 85, 87, 88–9, 90, 108, 114–15, 120, 122–9, 133, 170, 179–80, 185 chairmen 7, 31, 45, 51, 124, 128, 130, 165 composition 31, 50–1, 88, 126–7, 161, 179

independence 10, 50, 51, 69, 124, 125–6 membership, see boards of directors composition structure 7, 50, 51, 124, 127–8, 155, 160, 162 bonds 13, 174 bounded rationality 172–3 bribery 53 business judgement rule 121, 180, 184 business media 9, 61, 108, 132, 182 Business Round Table (in the USA) 124 business systems 4, 27, 120, 139, 144–5, 154, 155, 164–5, 166–8, 186 California Public Employee Retirement System (CalPERS) 49, 107, 182 capital 1, 2, 3, 16–17, 22, 36, 137 capital markets 3, 6–8, 9, 11–12, 15, 17, 23, 122, 132, 138, 143, 144–6, 148, 163, 165–7, 170–3, 175, 178 integration 143, 165–6 ‘capitalist without function’ 2 Carlyle Group, The 30, 84, 89, 107–13, 114, 115, 117, 119 Carter, Jimmy 13 chemical industry 156–7 chief executive officers (CEOs) 13, 31–2, 33, 45, 51, 61, 62, 116, 120, 121, 122, 123, 124, 126, 127, 128, 129, 130, 132, 134, 135, 136, 137, 138, 143, 146, 155, 161, 164, 165, 177 chief financial officers (CFOs) 61, 62, 116, 130, 131, 135 China 142, 165 civil law 10, 182 classified boards repeal 50, 69 climate change 53, 55, 69, 74, 183 codes of (best) practice 10, 45, 83, 182, 183 co-determination 145, 146, 154, 162, 164, 187 Combined Code on Corporate Governance, The 19, 30, 44, 61–2, 64, 78, 83, 123, 124, 126, 128, 165 common law 10, 182 Company Law Reform Bill 44, 45, 51, 185 Company Law Review Steering Group 44 ‘comply or explain’ 83, 123

Subject Index computer industry 175–6 conservative governments 13, 14 consumer electronics 13, 29, 176 control rights 15, 19, 86, 174, 176 controlling shareholders 10, 39, 47, 125, 141 coordinated market business systems, see coordinated market economies coordinated market capitalisms, see coordinated market economies coordinated market economies 4, 12, 18, 27, 139, 146–7, 148–9, 154, 166, 167, 186 coordinated market regimes, see coordinated market economies corporate finance 12, 16 corporate governance 1–188 convergence 139–68 standardization 143, 163, 165–6 corporate law 3, 139, 141, 182 corporate scandals 9, 16, 50, 123, 131, 165, 182 corporate social responsibility (CSR) 38, 47, 51, 52, 55, 58, 183–4 corporate strategy 19, 24, 56, 62, 73, 88–9, 106, 109, 117, 121, 124, 127, 129, 131, 149, 156, 158–61 corporate management, see boards of directors; chief executive officers (CEOs); and chief financial officers (CFOs) corruption 11, 53 Council of Institutional Investors (in the USA) 49 ‘creative destruction’ 28, 29, 119, 172 cross shareholding 149, 151, 164 custody of shares 65 Daimler-Chrysler AG 140, 154, 155 Davis, Sir Peter 78, 79, 80–1, 133–4, debt 8, 13, 31, 34, 56, 146, 151, 160, 170, 174, 176 Dell 16 demerger 120, 156 demographic change 23, 24 Department of Trade and Industry (DTI) 3, 184 deregulation 13 dermatology 100 Deutsche Bank (DB) 148, 153, 160 Deutsche Börse 56 disclosure 9, 170 dispersed capital 2, 132, 152, 167, 169 dispersed investors, see dispersed capital dispersed shareholders, see dispersed capital

215

‘distributional coalition’ 187 diversification 38, 41, 53, 176 ‘diversification discount’ 13 diversified portfolio 39, 57 dot-com boom 5, 15, 154, 173 dot-com bubble, see dot-com boom Dow Venture Capital Group 94, 115, 117 earnings 14, 28, 33, 131, 138 economic value added (EVATM ) 4 Edscha AG 109–11 efficient capital market hypothesis 3, 7, 8–11, 171–3 e-learning 112 emergency general meetings (EGMs) 10, 67, 68, 69, 71, 72, 73, 74, 78, 82 employees: representation 145, 185, 187 share ownership programmes (ESOPs) 177, 186 skills, see skill development employment: levels 15, 18, 27, 31, 148, 153, 162, 172 relations 14, 33–4, 186 security 29, 145, 146, 151, 152, see job security ‘enlightened shareholder value’ 3, 21, 51, 54, 58–9, 133, 187–8 Enron 9, 123, 131 environmental remediation 108 ethical investment 47, 52 European Bank for Reconstruction and Development 143 European Corporate Governance Network 143 European Union (EU) 143, 185–7 exit 2, 5, 21, 22, 26, 38, 41, 57, 58, 86, 151–2, 174 extraordinary engagement 48, 60, 67–81, 82 family block holders 48, 166 ‘fiduciary capitalism’ 53 finance directors 43, 75, 126 Financial Services Authority 123 Financial Times 61 ‘financialization’ 3, 4 firms: external context 23, 24, 187 internal context 23, 24 Fitch 80 flexibility 15, 20, 25, 141, 148, 152, 154, 172, 179, 187 focus funds 39, 41, 46–7 food machinery 152

216

Subject Index

France 15, 16, 98, 99 Frankfurt Stock Exchange (FSE) 105, 109, 150 free rider problems 39, 42, 74, 82, 182 Friends Provident Stewardship Fund 52 Fujitsu 176 functional convergence 142, 163 funds: managers 3, 12, 16, 25, 36, 39, 40, 41, 42, 43, 44, 47, 48, 54, 57, 58, 59, 62, 63, 65, 66, 68, 71, 76, 78, 86, 90, 91, 119, 120, 130, 131, 138, 142, 143, 169, 173, 184 performance 25, 40, 43 Garnier, J. P. 135, 136 General Motors 137, 171 Generally Accepted Accounting Principles (GAAP) 16, 27, 142, 144 Gent, Sir Christopher 125 Germany 5, 15, 16, 18, 64, 127, 139, 140–1, 144, 146, 147–63, 164 banks 146, 147, 148, 149–50, 151, 153, 154, 155, 160, 162, 164 regional savings banks 150 reunification 147 venture capital market 148, 152, 154 GlaxoSmithKline (GSK) 122, 123, 125, 127, 128, 130, 131, 132, 133, 134–6, 162, 183 Remuneration Committee 136 good governance premium 170 health care 55, 87, 98, 99, 102, 158, 159, 162 herding 173 Hermes 39, 46–7 high performance work teams 178 high technology 15, 28, 29, 88, 91, 102, 107, 109, 118, 150, 175, 178 Hoechst GmbH 155 Hogg, Sir Christopher 125, 136 human capital 14, 117–18, 146, 177 human resources management (HRM) 14, 116 human rights 53, 70 incentives 4, 7, 20, 21, 25–6, 27, 32, 40–1, 42, 43, 46, 47, 48, 53, 56, 57, 85, 86, 87, 116, 146, 149, 153, 162, 169, 171, 176–7, 180–1, 186 income inequality 12, 150–1 index tracking 40, 53–4, 173 indexed funds 41 information asymmetry 21, 152

information flows 122 information intermediaries 9, 63, 66, 132 information technology (IT) 15, 23, 24, 27, 92, 105, 107, 108, 119, 142, 146, 148, 174, 175, 176 initial public offerings (IPOs) 86, 91, 97–8, 105, 112, 116, 125, 150, 152, 154 innovation 3, 15, 27–9, 64, 85, 89, 114, 115, 145, 146, 152, 173, 175–6, 178, 179 insider share ownership 47, 48, 70 institutional complementarities 147, 166–8 institutional economics 12–13, 16–17, 18 institutional investors 5, 16, 37–8, 42–3, 49, 56, 61, 132 coordinated groups 70, see institutional investors joint engagement coordination 70, 74, 75, 78 joint engagement 74–81 Institutional Investors’ Group on Climate Change (IIGCC) 74, 82 Institutional Shareholders’ Committee (ISC) 21, 44–5, 62, 64, 67, 75–7, 82–3, 182 intangibles 26–7 internal labour market 27 internal means of control 170–1 International Accounting Standards Board (IASB) 16, 142, 144 international capital flows 5, 12, 16, 142 International Finance Corporation (IFC) 170 International Monetary Fund (IMF) 142, 143 Internet 15, 87–8, 106, 111, 150, 176 Investment Management Association (IMA) 62, 78, 82 investors: activism 19, 21, 34, 133, 184, see shareholder activism capitalism 3, 36, 41 engagement 1–188 spectrum 20–2, 34 relations departments 61, 129–30 Investor Relations Society 130 Isis Innovation 103–4 isomorphism 144, 163, 166, 186 Italy 98, 99, 166, 167 ItN Nanovation 103, 104–5 J. Sainsbury plc 48, 63, 78–81, 133–4, 183 Remuneration Committee 79–81, 133–6 Remuneration Report 48, 78, 79, 80, 81, 134

Subject Index Japan 12, 13, 15, 16, 29, 127, 140, 172, 176, 178, 179 new community firm 179 job security 29, 33, 145, 146, 151, 162 ‘keiretsu’ 106 Kleiner, Perkins, Caufield, and Byers LP 84, 105–7 knowledge-based firms value creation 118 Kodiak Networks Incorporated 107 labour 12, 14, 18, 23, 27, 30, 33–4, 142, 145–6, 148, 152, 154, 167, 187 Lanxess 158, 159 Lens Investment Management LLP 46 liberal market capitalisms, see liberal market economies liberal market economies 4, 5, 12, 15, 18, 139, 141, 145–8, 154, 166, 167–8, 186 life sciences 94–5, 103, 106 lock-in 26, 146 London Stock Exchange (LSE) 56, 64, 95, 96, 100, 144, 162 loyalty 41, 57 M form, see multi-divisional form of organization machine tools 152 management: objectives 120–1 remuneration, see senior executive remuneration managerial authority 121–2 managerial capitalism 3, 36, 169 managerial values 126, 171 managing expectations 131, 138 Mannesman 140, 154 market principles 167–8 market reputation (of executives) 137–8 mergers and acquisitions 9, 13, 18, 30, 31, 33–4, 89, 120, 172, 174 Merlin Biosciences Limited 84, 94–8, 113, 117 milestone financing 85, 86 minority shareholders 3, 9, 10, 16, 147, 162, 166 Mitsubishi Electrical 176 Molecular SkinCare Limited 100, 119 monitoring 4, 7, 10, 11, 20, 22, 29, 30, 39, 40, 42, 43, 44, 45, 61, 62, 67, 84, 85, 86, 88, 89, 90, 114, 115, 124, 125, 143, 146, 147, 150, 162, 169, 170, 171, 173, 176, 180, 182

217

Moody’s 80 moral hazard 7 multi-divisional form of organization 171 mutual funds 12, 16, 25, 38, 53 Myanmar 55 National Association of Pension Funds (NAPF) 45, 74, 75, 76, 77, 78, 79, 80, 83, 136, 137, 182 negative screening 39, 47, 53, 57 Neuer Markt 150, 152, 154 New Labour Government 3, 44, 51, 133, 184 new materials 103 New York Stock Exchange (NYSE) 5, 16, 144, 154, 155, 162 nexus of treaties, the firm as a 6, 179 Nike 16 ‘no surprises’ 131, 184 non-executive directors 7, 10–11, 22, 31, 32, 45, 46, 63, 72, 82, 91, 93, 96, 100, 102, 108, 120, 123–4, 125, 126–7, 128, 164, 183 normative convergence 141 Organisation for Economic Co-operation and Development (OECD) 45, 143 organizational learning 29, 175–6, 178 outsourcing 16, 30, 87, 89, 109, 110, 178 overseas investors 16, 37, see also international capital flows owners 2 ownership structure 47–8, 49, 70 partnership approach between management and labour 34, see also social partnership patent protection 28, 55, 175 Patientline 74–5 pattern of share ownership 36–8, 149, 151 pattern of shareholding, see pattern of share ownership pecking order of financing preferences 174 pension funds 5, 16, 18, 21, 24, 26, 34, 36, 37, 38, 39, 40, 43–4, 53, 57, 58–9, 65, 71, 74, 75, 76, 133, 150, 154, 164–5, 183 management 44 pensions 142, 150, 154 Pensions and Investment Research Consultants (PIRC) 75, 77–8, 79, 137 Pfizer 158 pharmaceuticals 28, 55, 72, 114, 119, 128, 132, 135, 146, 154, 155, 156, 157, 158–9, 173, 174, 175

218

Subject Index

Plastic Logic 93–4, 113, 114, 115, 116, 117 poison pills 31, 49, 50, 69, 121, 128 political environment 12, 139 political parties 121 positive screening 39, 47, 53, 57 power 4, 12, 166–8 principals–agents 6, 7, 20, 32, 177, 178, 179, 180 printing machinery 152 private benefits of control 9, 167, 171 private equity 1–188 channels 113, 114 content 113 financing 86–7 forms 113 funds 5, 29, 38, 40, 46, 57, 84–119 investor engagement 84–119 operational concerns 115–16 outcomes 113, 116–17 partners 118 privatization 13, 143 process innovation 27, 28, 29, 173, 175 product innovation 26, 27, 173, 175, 176 proxy seasons 50, 70 proxy voting 20, 70, 78, 66–7, 149 public to private deals 108 Reagan, Ronald 12, 13, 14, 18 redemption 50 regulated investors 38, 57 relationship financing 146 remuneration committees 7, 11, 45, 46, 128, 177 reproductive health 96–8 reputational intermediaries 6, 9 research and development (R&D) 26, 27, 28, 55, 89, 103, 153, 158, 174 residual claimants 15, 181 residual control rights 19 resource allocation principles 167, 170 resource dependency approach 137 Responsibilities of Institutional Shareholders and Agents: Statement of Principles 44, 45, 62, 64, 67 responsible marketing 53 restructuring 8, 13, 18, 30, 145, 158, 159, 161, 162, 164, 172–4 retained earnings 174, 176 risk 24, 25, 26, 28, 66, 86, 143, 150, 151, 165, 169, 170, 173, 174, 177, 181 round financing 85, 86 routine investor engagement 60, 61, 81–2 Russia 11

Sainsbury, Lord 81, 133 Sarbanes–Oxley Act (2002) 11, 16, 155, 162, 165 Schneider, Manfred 155, 160 Securities and Exchange Commission 69, 123 senior executive remuneration 7, 30, 32, 47, 56, 80, 127, 133, 135–6, 138, 149, 165 senior management, see boards of directors; chief executive officers (CEOs); chief financial officers (CFOs) shares: buyback 56 options 7, 20, 32–3, 46, 55–6, 69, 116, 123, 135, 136, 137, 138, 149, 153–4, 155, 161, 162, 163, 165, 170, 177, 181 prices 28, 30, 32, 33, 43, 47, 48, 49, 63, 72, 81, 120, 131, 145, 149, 153, 159, 170, 177, 183 repurchase, see stock repurchase shareholders: activism 19, 21, 34, 37, 43, 53, 70, 72, 133, 182, 184 proposals 20, 49, 50, 61, 69–71 resolutions 19, 20, 22, 43, 50, 61, 64, 66–7, 68–71, 77–8, 182, 184 rights 9–10, 162, 164, 170, 182 shareholder value 1–188 legitimation 4, 60, 121, 138 shareholdings 36–9, 47, 65, 126, 169 Shore Capital 74–5 Sitka Limited 84, 98–100, 113, 114, 117, 118 skills: development 24, 27, 29, 116, 146, 178, 181 formation 28 requirements 33 SkyePharma plc 72–3 social choice theory 12 social class 2, 167 social partnership 186–7 soft information 43, 63, 117 Spinox (later Oxford Biomaterials) 103–4 staged funding 85, 86, 89, 115, 117 stakeholders 3, 4, 17, 21, 31, 91, 120, 125, 126, 127, 138, 146, 147, 154, 155, 156, 161, 162, 170, 177, 181, 185–8 Standard and Poor’s 16, 61, 80, 143 standard investment criteria 38 stewardship theory 171 stock market capitalization 149, 151, 164 stocks: lending 65–6 options, see share options repurchase 8, 13, 64

Subject Index strategic fit 117 strategic management 1 substantial convergence 141, 163 supervisory boards 127, 149, 150, 151, 152, 154, 160–1, 162 takeovers 26, 30, 31, 45, 56, 69, 70, 77, 121, 145, 153, 154, 172 defences 31, 64, 69, 70 Teachers’ Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF) 49, 70–1, 82 technological paradigm 142 TechnoStart GmbH 84, 102–5, 115, 116, 118 telecommunications 108, 176 term sheets 86, 87, 88, 89, 108–9, 115, 116 Thatcher, Margaret 12, 13, 18 time horizons (investors) 24–5, 34, 39–40, 57, 58, 152 (managers), see time-frame of managerial decision-making time-frame of managerial decision-making 33 tire industry 172 Toshiba 175. 176 Toyota 127, 178 trade unions (TUs) 14, 121, 187 organization 171 training 27, 145, 146 transaction costs 7, 16–17, 39, 171, 178, 179, 180 transparency 9, 16, 50, 144, 152, 162, 166, 170, 184–5, 188

trust 11, 179, 180 trustees 38, 40–1, 43, 53, 58, 65 UBS Global Asset Management UK Limited 62, 68, 74 UK 1–188 unemployment, see employment levels universal owners 5, 26, 53, 54, 55, 183 Universities’ Superannuation Scheme (USS) 40, 48, 53–5, 59, 66–7, 74, 183 USA 1–188 oil industry 8, 55 venture capital 1–188, see private equity funds, see venture capital markets markets 5, 15, 119, 145, 148, 150, 152, 170, 174, 175, 183 Vodaphone 125, 136, 140, 154 voice 3, 21, 38, 41, 58 Volkswagen AG (VW) 153, 160 voting rights 54, 64–7, 71, 129 voting shares 69, 71, 72 Wall Street Journal, The 61, 182 Wilson Committee 76–7 Wintelism 15, 178 Works’ Councils 187 works’ councils 185 World Bank 11, 142, 143 WorldCom 9, 50, 123 York Pharma 100

219