​Will AFM independent directors make a difference?  We look at a recent case study

The deadline for authorised fund managers (AFMs) to appoint independent directors is just over four months away on 30th September 2019.  In order to balance the interests of AFM investors and shareholders the FCA, in April 2018, implemented its proposal that all AFM boards should have a minimum of 25% independents. The recent spat over Woodford Investment Management’s transfer of £73m of unquoted assets from Woodford Equity Income Fund (WEIF) to Woodford Patient Capital Trust (WPCT) makes an interesting case study.  WEIF was a ‘forced’ seller in the sense that it needed to reduce its unquoted holdings to stay within the rules.  The deal was done at ‘fair value’, but sweetened for WPCT shareholders because WEIF paid 100% of nav for the WPCT shares they received in return for the assets as opposed to the approximately 20% discount in the market. WEIF, as an authorised open-ended investment company (ie. analogous to a fund but a corporate structure) is controlled by an authorised corporate director (ACD), Link Fund Solutions Limited, which receives a fee of up to 1% per annum for administering the company.  The ACD has six Directors, of which only one is non-executive and potentially independent.  WPCT is an investment trust falling under the usual corporate rules.  It has six independent directors. Both WEIF and WPCT’s investments are managed by Woodford IM, so the potential for a conflict of interest is clear.  Shareholders of both companies were concerned by the deal.  WEIF shareholders were worried that they were investing in WPCT shares at 20% higher price than they needed.  WPCT shareholders thought they might be being stuffed with stale WEIF assets at high prices. Our point here is not that the deal was bad for either company or that Woodford IM has behaved in any improper way.  The price may indeed have been a fair one, and the deal good for both WEIF and WPCT.  Our point is that neither company were able to provide shareholders with any real assurance that their Directors had looked after their interests.  After being pushed, WPCT’s chairman commented that “The Board sought advice from a range of parties and had the companies, which we already own and know well, independently valued.’  The ACD made no comment to WEIF shareholders but Woodford IM commented ‘The potential conflicts of interest have been thoroughly assessed and managed in terms of both sets of shareholders, not just by Woodford, but by all parties involved in the transaction.’  At Linchpin, we don’t think either of those comments add to anything more than unverifiable assurances.  They are not good enough. The question then arises whether independent Directors in place at WEIF or Woodford IM would have made any difference to WEIF shareholders.  On the evidence of WPCT, they might still have been fobbed off with a bland assurance.  But independent directors would at least bear some accountability for protecting shareholder interests and could be questioned at AGMs.  We view that as an improvement.  One final comment: we are aware that some AFMs are simply going to past executives to fill the new positions.  We rather doubt that they will be perceived as truly independent.  The need above all is for someone who can bridge the gap between investment and governance but with an independent mindset.  We can think of people who fit that description well.   To find out more, please click here.​

Upcoming events

Please find below a list of events that William and Mukesh are attending or speaking at: 2-3 May 2019 - Private & Public Pensions Conference - Pennyhill Park, Surrey - William is moderating a panel on listed vs. unlisted infrastructure strategies.  9 May 2019 - UK Pensions Seminar - Transforming Investment Outcomes - Today. Tomorrow. Together. - London - Mukesh is attending this seminar organised by Aberdeen Standard 13-15 May 2019 - PLSA Local Authority Conference 2019 - De Vere Cotswold Water Park Hotel, Gloucestershire - William is participating in a plenary on 'This house believes the LGPS should be required to build social housing and infrastructure for the good of the nation' at 16.20 on 14 May. 

The importance of the Fed's change of heart in January

Last autumn we were confidently predicting that US 10-year yields would go above 3% and, for a short while, they did.  Today they are at 2.5% and we are equally confident they are going lower.  What has changed? The short answer is the facts.  The US Federal Reserve’s change of heart in January was in our view much more than a simple move from a tightening pathway to a more neutral position.  We think it was an admission that QE is here to stay for the long-term and that interest rates are in today’s world not able to perform their traditional function as a policy tool.  If so, that means investors have to think radically differently going forwards. Perhaps, we should first ask why?  Our friends at CrossBorder Capital think the catalyst is the frailty of corporate bond markets and particularly at the bottom end of the investment grade credits – BBB.  Institutions and corporates have been looking for safer, and perhaps higher, returns for their cash than they can receive from banks.  One response has been to invest in money market-like funds, which in turn lend to different corporates via repurchase agreements (“repos”) in order to minimise risk.  However, these repos depend on the availability of collateral in the form of ‘safe’ assets such as short-term government bonds.   Quantitative tightening means the latter are in scarce supply, accentuated by demand from some central banks (eg. Bank of Japan) for their own QE programmes.  CrossBorder’s data suggests that the average net supply of ‘safe’ assets’ over the last six years has been roughly one third of the 2010-2012 period and it is increasingly concentrated in the United States. The implications are numerous.  In the bigger picture, the Fed will use its balance sheet rather than interest rates to steer the economy.  We call that QE4.  While it may not inflate asset prices in the way that QE1, 2 and 3 did, it does provide the equivalent of a Greenspan ‘put’ for investors.  The US bond curve is likely to fall, possibly in an extreme case to levels similar to Japan, though in practice we doubt that.  In turn that may propel equity valuations higher as investors seek return. Inflation is a tougher question.  The history of QEs 1, 2 and 3 was that consumer inflation did not take off.  Today the employment background is tighter and society is less cohesive.  Governments may decide that inflation is the lesser of various evils and be prepared to accommodate some.  Far be it from us to suggest that that would also help them inflate their indebtedness away. If we are wrong, the brunt is likely to be borne by those lower down the debt hierarchy – BBB grade, non-investment grade debt and equity holders.  It’s no secret that not all BBB rated credit is worthy of its rating but if collateral for repos becomes scarce or unavailable even companies with unimpaired credit could find themselves struggling to refinance their existing corporate debt.  That could trigger a much sharper funding crisis as (shades of 2008 GFC) rating agencies find themselves re-evaluating their ratings. We see the path of the next few months as critical.  It all depends on whether the central banks are watching the right balls.  If you’d like to discuss this in further depth, please give us a call on +44 20 3637 6341. 

Exclude or be a responsible investor? You can't be both

Responsible investment – ie. nudging (or more) investee companies towards sustainable business models - is at the heart of modern institutional share-ownership.  It relies on being a shareholder in a business, which is why many investors in the LGPS and elsewhere state in their investment policies that they prefer to engage rather than to exclude.  Shareholders who care are more likely to persuade companies to alter their behaviour than those who don’t. In contrast, charities tend to exclude companies whose activities are opposed to their own objectives, and campaigners put pressure on other investors to exclude sectors such as tobacco, armaments and fossil fuels.  The argument is that if demand for a share is lower, the price will fall, making it more expensive for the company to raise money through bond and equity markets (and incidentally sending executive share options into negative value). At Linchpin we see some significant inconsistency here.  If you don’t own alcohol shares, for example, how can you influence them to behave better?  If you don’t own oil shares, why would they listen to your views about climate change?  Are companies such as Sports Direct going to listen to non-shareholders? Reality is of course not black and white.  There are some activities which are generally beyond accepted social acceptance and sometimes banned by international conventions (eg. some kinds of munition manufacture).  Exclusion is hardly controversial here: the question should be why a listing authority permitted the company to list. For charities with a specific focus, there may well be justifiable concerns that donors will be put off.   Could an anti-tobacco charity hold a tobacco company?  We would still argue it will have more influence from the inside but the reputational risk argument may understandably carry more weight with its trustees. At Linchpin we are firm believers in investing responsibly and we would challenge those who exclude simply because it’s easier.  The effect of exclusion on companies is often to push them towards becoming private again.  They may then be out of sight but their behaviour won’t have changed.  We think responsible investment, and here we mean engagement, is both more likely to effect change and add value.  Compared to exclusion, that is win-win for investors. Our message for investors would be to consider carefully the reasons for any exclusions.  Find out how Linchpin can help you here.​

Lose-lose for equities?

Market trends this quarter resemble 2017: equities rising, suggesting good times ahead, and bond yields falling, predicting the opposite.  Even if the messages are more muted today, they can’t both be right.  Two years ago we commented that bonds have the better predictive record and that eventually equities would fall in line.  We would not claim to have been precisely right, as equity markets have recovered much of the ground lost at the end of 2018.  However, it’s certainly true that economic growth is flagging and investor risk appetite has fallen, according to data from our friends at CrossBorder Capital.  This time round the liquidity background is less bleak since the Federal Reserve changed tack in January, though the data shows most central banks are continuing tight monetary policy.  Despite this, low bond yields remain a key predictor of lower economic growth.  Our view is that high valuations continue to make equities vulnerable both to disappointing earnings growth and to a more general market setback.  We would back the message from bonds. Some will say that high valuations (and they are high – probably only topped in 1929, the dotcom bubble and 2018) are justified by lower bond yields.  Our view is that it’s a lose-lose situation for equity markets.  If we’re wrong about the fundamental background, bond yields will rise, putting pressure on equity valuations.  If we’re right, earnings will disappoint, with the same result. Find out more here.​

Times they are a'changing

We’ve spent most of the last two years or so marking how tight the monetary environment is.  It is not just that the US Federal Reserve and to a lesser extent other central banks have until very recently been withdrawing liquidity, it is also how the private sector has been less willing, or able, to use or extend credit.  That has been behind our bearish stance on the market and also western economies. But times they are a’changing and, in Bob Dylan’s words, ‘the slow one now will later be fast’.  Most obviously, the Federal Reserve has changed course from its path of steady tightening to a more neutral position.  That can now be seen in the end February and early March data.  More discreetly, the ECB and Bank of England have become more accommodative while the PBOC, until now the loosest central bank, is tightening.  The reasons are not hard to seek: the US economy was previously, as we have said, heading for recession while Europe is drifting in the same direction.  We’d argue, as we did in our last blog, that Abenomics needs a reboot and we can expect significant policy action from Japan too. Though equity markets have risen in reaction, we’re not sure this can be maintained.  Valuations, at least in the US, remain extremely high by historic standards.  That doesn’t mean they will necessarily revert to the mean in the short term: that may have to wait until bond yields normalise.  However, equity investors are unlikely to get more than the yield (3% globally, a juicy 5% if dividends aren’t cut on FTSE 100) +1% or so growth.  There simply isn’t room for valuation expansion and there is significant room for valuation contractions if things go wrong. So times they are a’changing but our views on equities remain biased to the negative.  In the short term we prefer investments which are priced off bond yield curves.  In other words, we remain risk off.​

Does Abenomics need a reboot?

My favourite commentator on Japan, Peter Tasker, has written a blog asking whether it’s all about to go wrong for Japan.  His evidence is an interview on Reuters by the guru of Koichi Hamada suggesting that ‘the public is better off having prices fall, not rise…’ and that now is time for the next consumption tax rate rise.  If you don’t follow Japan, all you need to know about that is that previous ones have proven highly contentious. Hamada may just be accepting reality.  Nominal GDP growth in Japan has been negative again over the past two quarters and the country is also flirting with deflation anew.  As the employment participation rate (16-64 year olds) stands at 77%, his comments are consistent with what’s happening – if you are in employment, deflation is beneficial. The bigger point Peter makes is that Abenomics needs a reboot.  After six years the effects are fading, along with QE round the world.  Peter’s recipe is to cancel the consumption tax rise, to target bond issuance rather than the yield curve, and to wait patiently for tight employment to have its effect on inflation.  I’d add to that the boost that the Rugby 2019 World Cup and 2020 Olympics will give Japan.  And the stockmarket?  I’ve been lukewarm for the past 12 months and remain that way.  There’s scope for upside if some of Peter’s suggestions are followed.  And in the long-term there’s still plenty of good news on corporate governance, despite the Nissan/Ghosn furore.  However, I suspect some patience is required.  At home, corporations are still saving rather than spending, and abroad economies are slowing and the yen looks like strengthening.  Plus, of course, if the Bank of Japan were to target bond issuance, it might sell some of the equities it has purchased over the past nearly five years. ​

Is your organisation really smart?

I attended an interesting breakfast seminar at the consultants, Redington, last week about minimising mistakes. The starting point was that ‘stupid people don’t learn from their mistakes; smart people do; really smart people learn from other people’s mistakes’.  Two speakers, from KKR and 24 Asset Management, gave a short description of what they had done to make sure their organisations fell into the last category before a more general discussion.  Some of it is fairly obvious, at least to those of us who have been around for 30+ years: it is largely cultural and has to be led from the top; owning up to mistakes should be encouraged, not penalised, so long as the knowledge gained is shared; senior people should go out of their way to give time to dissenting views and always speak last at meetings; diversity of decision-makers is good; careful analysis both beforehand and afterwards (was the decision a good one?) is helpful. However, it is much easier said than done, particularly for younger organisations and staff.  The hard question came from the audience: if a junior employee makes a mistake which costs the business money, but owns up to it and shares the lessons learned with their colleagues, what do you do with their bonus?  Reduce it on the basis they made a mistake?  Leave it alone, on the basis that they behaved well?  Or increase it as a signal to encourage colleagues to learn from the mistake. One shared conclusion was that the behemoths among us, whether civil service or investment bank, don’t usually fall into the very smart category.​

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