How far should shareholder corporate governance go? For those who answer “All the way!” I offer these reflections on how far that really is.
My thinking along this line was stimulated by a visit from George Roberts, billionaire cofounder and principal of Kohlberg, Kravis & Roberts, the leading and largest US firm specializing in controlling corporate investments variously known as leveraged buyouts, management buyouts, and private equity investments.
Mr. Roberts spent two hours discussing KK&R’s governance practices with my class on Fiduciary and Venture Investing atStanfordLawSchool. I have taught this course for five years now, examining with my students the law and practice applicable to pension trustees, corporate directors, and fund managers. George Roberts’ visit put into clear focus the things that a controlling shareholder actually does to exercise that control.
As ICGN members know, these activities include not only presence on the board of directors of shareholder representatives, whose influence is commensurate with the majority interest they represent, but also active participation in formulating corporate decisions. This goes beyond approval of decisions presented to the board, or even selection among options presented to the board.
KK&R representatives actively participate in formulating the corporate budgetary plan and authorizations in advance of each fiscal year, reviewing drafts of the plan, participating in planning meetings, and making appropriate suggestions for revision. They also participate actively in formulating the compensation plan of executives. This participation focuses on tying compensation to realistic, or even ambitious, performance goals, so that it is only genuinely good performance which is rewarded. KK&R believes that really good performance, and only really good performance, should be rewarded, and well rewarded indeed. They want the executives’ interest focused on the shareholders’ interests, so that both executives and shareholders prosper together. Of course, the rewards to the KK&R executives participating in this process parallel those of the executives and shareholders.
While KK&R’s practices are now institutionalized, so that they can be explained to the pension trustees and other institutional investors who provide KK&R’s bankroll for investments, any controlling shareholder alert to protecting its interests might do the same. Indeed, in corporate situations where there is a dominant shareholder, that shareholder would be expected to participate in the same way.
KK&R’s services, of course, do not come free. They receive substantial management and incentive fees for locating companies susceptible to a controlling investment at an advantageous price; negotiating, financing, and carrying through the transaction; then monitoring and guiding the development of the investment in the manner just discussed; and finally identifying and carrying out an exit strategy to realize the resulting profits.
These aggressive, proactive initiatives go far beyond even the most ambitious institutional corporate governance programs carried out in theUnited Statesor elsewhere. Lacking the staff, expertise, and perhaps the thick-skinned aggressiveness required to carry out such a program themselves, pension plans and other institutions in effect employ KK&R as an intermediary to do so.
Few institutions wish themselves to own a direct, controlling interest in any corporation, so the acquisition and sale of such an interest is well beyond the scope of their investment objectives. In that respect, they never expect to become competitors of KK&R.
However, as a group, pension and other institutional investors already hold controlling votes in many corporations. The question raised in my class as a result of George Roberts’ visit is the following: Why do institutional investors not, as a group, exercise their control as do other controlling shareholders such as KK&R, by exercising a strong influence over the design of corporate budgets and compensation plans?
I will not hazard an answer to that question in this article, but I will suggest that until they do, shareholder corporate governance will not have gone “all the way.”
Few pension funds or other institutional investors have staff who would be confident of adding value by direct participation in the fundamental corporate decision making. Such staff, however, can be hired internally, or retained externally.
The expense of retaining expert staff for this function would be considerable, and it would be difficult for any one pension fund or institution to justify the expense to its own owners, especially since all shareholders would presumably benefit from its efforts,. However, a group of shareholders might retain an organization to perform these tasks, sharing the expense. Or, to the extent all shareholders benefit, it might be treated as a legitimate business expense of the controlled corporation.
Leo Tolstoy’s comment that “the best fertilizer is the footprint of the owner” made the point that absentee owners can’t expect the best results. In a corporate setting, does this mean that institutional investor representatives should be taking as active a part in corporate budgeting processes as KK&R?
A very serious argument could be made, and indeed has been well made in an article by Richard Koppes and Maureen L. Reilly, that the fiduciary duty of pension trustees and other fiduciaries requires them to be more than passive investors, especially when they finesse even the decision whether to buy or sell, through participation in an index fund. As owners, pension trustees and other fiduciaries have a duty to oversee the corporations they own.
The elements of a realistic program by a corporate owner to exercise that control are well illustrated by the practices of KK&R in managing the corporations they control, practices which have been favorably described in an article in the Harvard Business Review.
This is what it means for institutional investors to go all the way in corporate governance. I leave it to the membership of ICGN to decide whether and when, if ever, they should or will go “all the way.”