Investors are quick to highlight the successes of their engagement with companies – and rightly so. But what happens when things don’t go so well? Here we talk through what happens when an engagement reaches the end of the road.
We run a UK smaller companies fund and take ESG factors into account in our investment decision-making. From a stewardship perspective, we’re often engaging directly with senior management or board directors. The quality of dialogue is high, and we can usually have an honest conversation with key decision-makers about where we see areas for improvement.
However, sub-optimal governance arrangements can also be a common feature when investing in smaller companies. It’s often a legacy of how the company operated prior to becoming a listed or quoted business. Two of the main problems we encounter are:
- Long-standing directors that have exceeded the recommended nine-year tenure. This risks an overly cosy culture developing, where directors no longer provide sufficient challenge.
- Boards that are very small. Whilst not looking for numbers for the sake of it, we prefer a larger board to bring in broad and varying perspectives on the company and its industry.
At one particular company in our smaller companies fund, we watched both of these problems combine. Over six years, we saw the board shrink in size and the level of independence diminish. Concerned by the increased governance risks, our fund manager began an engagement campaign that ended up spanning several years. He voiced his concerns to the company on many occasions and also raised the matter with the firm’s broker. In addition, we expressed our dissatisfaction by voting against the re-appointment of certain directors at the company AGM. Although the company acknowledged the validity of our view, they took no immediate action to remedy matters.
During this period, the company made an acquisition and, as a result, appointed a director of the acquired company to the board. While the new appointment did boost director numbers and (in the company’s view) improve board composition, from our perspective the matter was more nuanced and progress was too slow.
The new individual was not independent due to his existing relationship with the acquired company. He was also a sizeable shareholder. As such, the overall independence of the board declined. At this point, our fund manager scaled back the holding of the company in the fund, so as to reduce exposure to the increased governance risk.
Further conversations with management followed post-acquisition and it became clear that the company did not intend to make any more changes to the board’s composition in the near future. Nor did it see the additional governance risks that come with a board that is majority non-independent. We often hear companies say that a director acts independently and challenges management even if, on paper, they are deemed non-independent. As investors, such assertions are impossible to verify and therefore provide an insufficient basis on which to base or change our views.
In any case, our engagement reached the end of the road. We knew that any further effort to persuade would be pointless. When an engagement fails, we have to decide whether the status quo is tolerable. Sometimes we can agree to disagree with the company. Sometimes an engagement shifts our own view, especially on governance where there can be compelling reasons why the company has departed from the usual norms.
In this instance, however, our fund manager decided that the status quo was not a good outcome for our clients and we took the rare step of divesting from the company.
To be clear, the investment performed satisfactorily over the years and there is nothing to suggest that the governance risks are anything but risks at this stage. Ultimately though, we are here to serve our clients. If we can achieve the same returns but with lower risk by investing elsewhere, then that’s what we are obligated to do.
Although the engagement did not achieve its original aim, it still proved to be valuable nevertheless. It gave us clarity and insight into management’s thinking and, in the end, it informed our investment decision-making.
