Experts

IRC Experts' Recommendations on the Conciliation and Long-term Court: How to get there?

At the beginning of 2019, the College of Experts of the Institut du Capitalisme Responsable (ICR) decided to produce analytical notes on strategic and fundamental themes related to responsible capitalism.

A multidisciplinary working group composed of some members of the College, led by the ICR, was then set up around the theme of balancing the short and long term for investors and companies.

After one year of work, about ten meetings and four plenary sessions with the College and the Board of Directors of the ICR, the working group published recommendations addressed to investors and companies, completed by an analytical note, in order to promote an enhanced dialogue.

by the IRC Board Experts members

Note: Companies vs investors, is it possible to reconcile short and long terms?

Balancing short and long term for investors and companies

As Georges Bernanos said: “We do not submit to the future, we make it.” 1 Short-term time horizons have always existed for both companies and investors; maximising short-term profit requirements, almost constant company finance benchmarking, calculations of the variable amount of compensation depending (generally) on stock market criteria, and high-frequency trading – all this to say: the financialisation of the economy – have emboldened a “short-termist” dictatorship. What is more, radical changes in the availability of information and the instant ability to share it worldwide, have largely increased the negative perception of “the short-term”, which has come to be considered as harmful for the economy in its omnipresence.

According to Milton Friedman’s doctrine from the 1970s, the manager of a company has “one and only one social responsibility towards its shareholders: to use its resources and engage in activities designed to increase its profits”2. This doctrine, which focuses on maximising profits for shareholders, seems to be questioned today. The growing expectations of civil society, in particular, are shaping the “new” role of companies: positively contributing to their ecosystem, being aware of the impacts of their activity on stakeholders (including employees, suppliers, customers, investors, subcontractors, NGOs, academics, etc.), being sincere in all of their actions and written materials, as well as including environmental, social, and societal issues in their strategies.

We can define short-termism as a situation in which certain company stakeholders – primarily investors, managers, and members of the Board of Directors – display a systematic, but sometimes contrived, preference for strategies providing quicker gains at the expense of long-term value creation. Short-termism as a whole must be viewed as a social process, in which a given behaviour is emboldened by the reaction of others3.

Despite the overwhelming consensus on the definition of short-termism, researchers are not able to agree on how to empirically illustrate the substandard nature of these decisions. The big question remains the same: how do we demonstrate whether short-term decisions are detrimental to long-term value creation? As, once a short-term decision is made, it is impossible by definition to ascertain what the effects of a different, long-term decision could have been.

In order to understand the situation, we asked ourselves the following question: if the “long-term” represents a performance factor, then why do some company stakeholders favour short-termism?

Is the long term a performance factor ?

According to several recent studies, the long-term represents a performance factor for companies. A McKinsey study 4 was carried out in 2017 on this subject: using a data set from over 600 companies in the United States over the 2001-2015 period, researchers created a Corporate Horizon Index based on 5 key factors: investment models, growth, quarterly management, quality, and profit management. This index made it possible to isolate companies qualified as “long-term” in order to gauge their performance : they exceeded that of “short-term” companies on both economic and financial indicators.

First of all, the study notes that the revenue of “long-term” companies increased cumulatively by on average 47%, with less volatility. Profits also increased by 36% on average, and economic profit by 81%. “Long-term” focused companies invested more than others: they spent almost 50% more than others on R&D over the 2001-2014 period and did not cut this budget during the financial crisis. Their spending in this area increased annually by 8.5% on average, compared to 3.7% for other companies. These “long-term” companies also demonstrated improved financial performance over time: on average, their market capitalisation increased by $7 billion, and the total return for their shareholders was 50% higher. They also created 12,000 additional jobs on average.

So, what key factors make these companies different? Numerous studies have confirmed that taking into account gender balance 5, diversity 6, and moreover environmental, social and corporate governance (ESG)  criterions 7 directly correlated to stock market performance and above-average results. It is thus essential to include extra-financial criteria both in corporate strategies and in investors’ investment decisions.

It should be noted that three-quarters  8 of the managers of European companies believe that overlooking sustainable development in their strategy will negatively affect their company’s ability to create value in the long term. While at the same time, more than three-quarters9 of investors say that ESG criteria are or are becoming increasingly important in their activities — almost two-thirds of investors claim their investment framework is in line with the Sustainable Development Goals (SDGs).

Why do some company stakeholders favour short-termism?

Several stakeholder categories can be identified within companies: employees, executive managers, managers or top executives, and the Board of Directors. By setting aside employees – who have an obvious interest in their company’s sustainability – several reasons resulting in a short-termist attitude within these categories of stakeholders can be identified.

First and foremost, it is surprising to note that according to a joint study by Focusing Capital on the Long Term Global and McKinsey, 40% of managers (Boards of Directors and Management Teams) label themselves as being among the main sources of short-term pressure. 87% of respondents stated feeling major pressure to demonstrate substantial financial performance within two years 10.

Secondly, short-termism can result from the use of biased evaluation methods for investment projects – methods based solely on financial data – which then lead to an underestimation of extra-financial benefits (e.g. training, reputation, etc.) 11. The potentially erroneous understanding of extra-financial benefits and risks can also influence this type of decision. The predominantly financial view of companies and shareholder returns has participated to the rise and spread of MBA training. Indeed, the heightened expansion of the concept of “shareholder capitalism” since the 1980s has intensified investors’ focus on quarterly performance and on the maximisation of short-term shareholder returns through dividends and buyouts.

It is also necessary to take into account the objectives and ambitions that are specific these categories of stakeholders, including financial incentives and time horizons in particular. Opportunists have been able to reject long-term investment projects in order to fixate on more profitable short-term alternatives, thus allowing them to maximise their objectives.  Executive compensation policies have too frequently favoured short-term financial returns, which also matched the personal interests of managers with high turnover rates. These financial incentives blend with an assortment of psychological pressures that encourage managers to favour the short-term, such as a need to quickly prove themselves in order to establish or maintain their reputation, or even a natural preference for investments with immediate returns rather than risky projects with distant profits.

Investors are the second category of stakeholders that, according to numerous studies, are responsible for short-termism. They make up a varied and disparate population, including institutional investors, asset managers, asset owners, hedge funds, private equity, activist shareholder, traders, individual shareholders, and employee shareholders, that interacts both with itself and other financial stakeholders in the market, such as financial and extra-financial rating agencies, merchant banks, financial analysts, etc. Some investors are able to encourage managers to artificially inflate performance indicators or modify the company’s strategy with a view to encouraging short-termism; others, however, promote investments in future growth mechanisms and support the market value of companies with modest immediate profitability but major potential.

All of these stakeholders pursue investment strategies with wildly different objectives. These multifaceted expectations hike the pressure on the company. One can generally observe several common factors: a greater or lesser aversion to risk; a preference for short-term due to pressure on management companies from certain asset owners to steadily outperform the market; a (still limited) inclusion of extra-financial factors that create value in the long term; earnings indexed according to short-term financial targets; the dilution of responsibility in investment decisions due to an excess of intermediary influencers.

However, an array of other factors that explain current managers’ inclination to favouring the short-term should not be overlooked. We must note the major pressure of a highly competitive and increasingly unpredictable market. Competition is therefore cited by 51% of managers 10 as a determining factor in the need to demonstrate short-term financial performance. The digital revolution, the energy transition, the risk of uberisation, and geopolitical risks, to name but a few, are all reasons that compel managers to constantly reassess their strategy. Their responsiveness is crucial to their survival in a world that has become increasingly uncertain.

Conclusion

Short termism – as discussed in this document – is not an isolated phenomenon that only investors or companies can be held responsible for. It reflects more generally the complex and interdependent interactions of numerous stakeholders with varied interests and means of action. They prop each other up and self-fuel a negative momentum: competitive environments, short-term reporting, and a continuous flow of information all incite companies to establish short-term objectives and indicators, and to reward short-term decisions, abandoning long-term opportunities. In response, investors and the market also react within a short-term time horizon, and vice versa.  

However, it must be noted that the short-term cannot be neglected, as it is necessary in order to adapt to a world being run in so-called VUCA mode: Volatility, Uncertainty, Complexity, Ambiguity But its dominance is not compatible with the sustainability requirements of today’s companies. It must therefore be returned to its rightful place: that of a management indicator, an adaptability and agility variable for the company with regard to future challenges.

The short-term does not obstruct the long-term, but is a necessary condition for constant progress. Being able to anticipate a company’s future challenges –demographic and social changes, environmental challenges, major technological developments, artificial intelligence, and economic developments – means harnessing all of the company’s potential, in particular through the use of intangible assets.

The systemic nature of short termism calls for a holistic approach, with new processes to steer principal stakeholders towards more long-term objectives. Management represents a powerful lever for change within companies, with its role being to anticipate and thus enable short-term management with a consistent long-term time horizon.

Combining overall performance and positive externalities requires a stable reconciliation of individual and collective interests, company and society, short and long-term time horizons, while also bolstering collective responsibility throughout the investment chain.

by the Board Experts members

So... Can we count on you? Open Letter to Larry Fink, CEO of BlackRock, by our Board Experts members

In your annual letter sent to the directors of companies in which BlackRock has invested, you challenge them on how substantial their efforts are and on how they promote their support for sustainable growth and profitability. We would like to thank you on behalf of the Institute for Responsible Capitalism, which brings together the directors of very large global companies, leading investors, academics and advisory bodies, on the one hand, and operates in close collaboration with public authorities, on the other.  

Generally speaking, in France, just like in other global economic powers, the main listed companies have significantly moved in this direction in recent years, under pressure from the regulators, civil society, consumers, activists and investors, as shown by a number of particularly significant indicators.

For instance, 80% of SBF 120 companies in France have incorporated at least one CSR criterion into the annual variable salary for their corporate officers[1] in 2019. On average (still within this index), the proportion of long-term indexed variable salary has risen above 50%. The number of reports included which combine the same level of financial performance and social, societal and environmental challenges has increased fourfold since 2016. Almost half of these reports devote a chapter to value sharing.

Finally, more than one in four companies in the CAC 40 have published a raison d’être, an initiative which you recommended in your letter on 17 January 2019 and is set out in the Law on Company Growth and Development (the “Loi Pacte”), which was approved this year. As you can see, our French companies are steadfastly and definitively committed to respecting all of their stakeholders (customers, investors, employees, suppliers, partners and civil society). The changes to the salary structure for our directors are a reflection of this paradigm shift in particular.

Admittedly, as you already mentioned in your letter from January, it has been a challenging period. “Companies are grappling with a financial environment in which the economy is coming to the end of its cycle, with increased volatility in particular, which could mean that priority is given to short-term yields, at the expense of long-term growth.” The global picture is worsening year by year, and political and economic instability is continuing to increase. At the same time, demographic, technological, geopolitical, commercial, social, and industrial changes are continuing to unfold more quickly.

We are also grappling with a paradox. On the one hand, we have a real threat to our “Earth” capital (which is still called living capital in a broad sense), which also includes social and societal challenges; on the other hand, we have an unprecedented abundance of liquidity, our financial capital. There are vast resources, yet vast needs too. We have reached a critical point. Discussions on the future of capitalism are now raising the issue of collective responsibility for economic and financial players. Against this backdrop, the College of Experts for the Institute for Responsible Capitalism has spearheaded work to explore ways of promoting far more widespread investment in assets and companies which help to regenerate our living capital.

Members of the College of Experts believe that investment decisions by management companies must align with the horizon for asset owners’[2] commitments, which are often long-term, in the interests of their end beneficiaries and savers in particular. We strongly believe that this involves urgently and radically transforming investment policies and managers’ financial incentives. These salary policies must line up with the horizon for their investments.

If not, the planet will begin to deteriorate more quickly and we will all share joint responsibility for it.

Both asset managers and companies have also experienced many encouraging changes.

The more than 2,300 investors who have signed up to the PRI, committing to incorporating ESG criteria into their investment decisions, now account for 86,300 billion dollars’ worth of assets under management. Investors from the Climate Action 100+ Coalition, which account for 35,000 billion dollars’ worth of assets under management, have secured commitment from the largest greenhouse gas emitters to improve their climate performance and ensure transparency in their emissions. These efforts have secured substantial climate commitments from major companies, such as Shell, Glencore, PetroChina and even Volkswagen[3].

However, we still have not reached anywhere near the level of commitment required to deal with the situation. Thus far, during roadshows, too many companies have been saying very little, or investors have not even been asking them questions about issues of responsibility. However, at the same time, investors have been complaining that companies are not providing ESG information or that it is of poor quality. This is evidence that deeper integration between extra-financial and financial aspects has still not happened, meaning that performances rewarded or penalised by financial markets are still essentially only siloed financial performances.

In order to support engaged companies, managers and asset owners must strengthen their involvement by increasing their level of stringency and transparency over the environmental social/societal impact of their investment decisions. There have also been many advances in Europe in this area.

For instance, Article 173 of the 2015 law on the energy transition requires the largest investors to be transparent about how they incorporate climate risk and, more generally, environmental, social and governance (ESG) risks into their management.

Another possible example is the Shareholder Rights Directive II (SRDII, Directive (EU) 2017/828), which has just been transposed and emphasises the commitment by investors to play a role in improving companies’ financial and non-financial performances, and to improve the alignment of investors’ interests in order to support longer-term investment strategies. Finally, we have to mention the European Commission’s action plan for sustainable finance, which sets out to redirect capital flows towards a more sustainable economy.

Mr Fink, we need to harness the power of all the asset managers in order to take over from companies, public authorities and (not to mention, of course), the driving force representing our citizens, savers, which trust you with adopting practices which, in the long term, foster sustainable growth and profitability.

BlackRock manages 7,000 billion dollars’ worth of assets, making it the global leader on its market, with just under 10% of global assets under management. As a result, it can be argued that the world is relying on your ability to align your investment policies and their ability to take into account the crucial issues facing our planet. During this period of great uncertainty and major anxiety, your leadership will be vital.

We would like to encourage you to implement our recommendations relating to greater transparency and stringency in extra-financial criteria (ESG criteria, in particular) in investment decisions, and relating to giving them greater prominence in these decisions. We would encourage you to start aligning investment decisions, the horizon for your financial commitments and your voting policy for general meetings more quickly. We would recommend that you explain how investors’ salaries line up with their investments more clearly.

Finally, we would like to invite all of the largest asset owners and asset managers in France and across the world to join us in this movement. We would like to see you get involved in these discussions with us. 

Can we count on you?

The members of the College of Experts

Institut du Capitalisme Responsable

---

[1] Analysis of directors’ salaries: what are the trends for 2019? – Deloitte

[2] Asset owners are represented by (national, corporate and public) pension funds, insurance companies, sovereign funds, family offices and more.

[3] Climate Action 100+, https://climateaction100.files.wordpress.com/2019/10/progressreport2019.pdf