Frustrated with sell-side analysts’ failure to screen companies for governance risks, a consortium of European funds with over $460 billion in assets recently announced a plan to steer 5 percent of commissions to brokers who includes such analysis of intangibles into their research.
The program, officially dubbed the “Enhanced Analytic Initiative,” is considered an industry first, and experts say the move could significantly impact public companies by elevating the profile of “soft” metrics—like governance ratings and corporate social responsibility profiles. And the funds behind the EAI expect that the move will not only be adopted by other asset managers, but that it will increase both the quality and transparency of research.
Thamotheram
“We want to liberate their intelligence,” says Raj Thamotheram, senior advisor at the U.K.’s Universities Superannuation Scheme. The other initial funds behind the initiative include PGGM in the Netherlands, Germany’s Allianz Dresdner PMC, and France’s BNP Paribas Asset Management. In addition, two funds recently joined the initiative, including Generation Investment Management, a new investment management firm led by David Blood, the former CEO of Goldman Sachs Asset Management, and Al Gore, former Vice President of the United States.
According to Thamotheram, recent global corporate scandals failed to make it on the radar screen of analysts supposedly covering CRS and governance issues. “Just look at the case of Vioxx,” he says. “The news about its side effects has been in the public domain for some time, but you weren't seeing the concern about those side effects reflected in what sell-side analysts were saying or even what many governance and social responsibility specialists were reporting.”
As a result, Thamotheram and others see the EAI as a critical mechanism for assessing risks within funds’ portfolios more effectively. “Getting the market to price risk more accurately is what we need to do so we can make better decisions,” he says.
Lots Of Talk, Fragmented Results
Of course, efforts have been under way for years to make both governance and social responsibility key issues that need to be considered and factored into the recommendations made by analysts globally. As Enron and other disasters have come to light, efforts to launch widely-accepted corporate governance ratings have been launched by firms such as Institutional Shareholder Services, which has developed its “Corporate Governance Quotient,” and GovernanceMetrics International, which offers its “GMI Ratings.”
Separately, both ratings agencies Moody’s Investors Service and S&P have vowed to incorporate governance and social responsibility into their own recommendations.
However, most of these efforts have become mired in arguments over the value of “qualitative” versus “quantitative” indicators and—at least in the case of ISS—conflicts of interest about how the firm is compensated as it releases its ratings.
EVALUATING PERFORMANCE
In late November, the EAI members outlined five baseline criteria that would be utilized to evaluate broker performance:
The comprehensiveness of the range of extra-financial issues analysed;
The ability of brokers to make company-specific assessments which permit comparison between companies;
Whether there is integration of the results of both financial and extra-financial analysis;
Whether brokers have succeeded in providing the research universe required to match the broad investable universes of the members;
The responsiveness of the service especially given the front-loaded commitments of the EAI members.
Borremans
“What’s unique is that there is no such thing out there today like this,” says Eric Borremans, head of sustainability research at BNP Paribas. “To date the sell-side has been producing bits and pieces of research but it hasn’t been systematic; it has been more ad hoc. That’s why we’ve joined forces, to provide research more systematically.”
Of note is the fact that the fund will compensate analysts who scrutinize governance and CRS metrics at public companies. “They’re putting cash behind it, and that’s significant,” says Stephen Davis, president of governance consultancy Davis Global Advisors. According to Davis, who writes a monthly column for Compliance Week, and who first identified the Enhanced Analytic Initiative in his weekly “Global Proxy Watch” newsletter, the funds are trying to shake up the marketplace. “I think they’re pushing the envelope in a direction that eventually will be used by everyone,” he says.
Ratings Agencies: Wait And See
Dallas
Ratings agency executives say they’re intrigued by the initiative. “It’s a very interesting idea and speaks to what we’re trying to work on,” says George Dallas, managing director, practice leader, governance services at S&P in London. “We’ve seen stuff crop up in different shapes and forms; I can’t say I’ve seen anything quite like it before.”
Bertsch
Ken Bertsch, senior vice president and director of corporate governance at Moody’s Investors Service, agrees that the program is unique. “I haven’t heard of anything set up this way,” says Bertsch, the former director of corporate governance at TIAA-CREF. “The buy-side folks are the real consumers, so this is great.”
Though enthusiastic about the opportunities and implications of the program, ratings agency executives also acknowledge that it’s too early to ascertain whether it will be successful. “We’ll see how it takes shape,” says Dallas at S&P. “It triggers just as many questions as it does definitive responses.”
Bertsch at Moody’s also acknowledges that the challenge—namely, getting funds to focus on the long-term investment cycle—is significant. “It’s not an easy problem,” he notes. That being said, Bertsch likes the funds’ chances. “It sounds like a cooperative program,” he says. “It’s all for the good, to try to focus on the longer term.”
A Desire To Grow
Executives at the four funds say they’re eager to have other asset managers join the initiative, and have been courting them aggressively; notably absent from the list of initial backers are any North American funds. “We’re open-minded in terms of participation, [and] by no means closed,” says Borremans at BNP Paribas, “and we have a strong desire to grow.”
But adding additional funds is the easy part; getting the desired research promises to remain problematic.
“Getting the quality of the research we want and the commitment to producing it will be a challenge,” acknowledges Borremans. “By definition brokers approach this in different ways. What we want is less standardized than financial reporting and more sector-specific than traditional financial analysis across the board. Balance sheets are in the same format; this is not.”
Davis
Stephen Davis agrees. “Portfolio managers have been most comfortable with stats; governance analysis, on the other hand, has been sort of a narrative,” he says.
That being said, the funds are determined not to tell the analysts how to do their jobs.
“It's key that we not tell analysts what is material because they know, or at least should know, their companies inside out,” says Thamotheram. Instead, he wants to empower them to determine and track which metrics are most critical. “We want to fund analysts who capture and report on what makes durable investment returns and helps us manage absolute risks,” he says. “We want to stimulate competition among bankers about how to hear what is the best, most insightful research or research service they can think of, and we want them to think of the least-conflicted research service,” he adds.
As a carrot—in addition to the 5 percent—Thamotheram says the funds don’t intend to restrict access to their research, giving it wider currency. But as a stick, he says the initiative will dump partners who don’t produce the kind of research they want.
“We’re paying for what we want,” he says, adding that the funds will actively monitor and evaluate the research. “We’re making our criteria specific and we’re going to evaluate the baseline and make our commission allocations for 2005 fees,” he says. “We’ll retain our ability to reward brokers based on our judgment.”
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