¹King's College London, London, UK

Correspondence: Gregory Jackson, Department of Management, King's College London, 150 Stamford Street, London SEI 9NH, UK. E-mail: gregory.2.jackson@kcl.ac.uk

Abstract

The article 'A New Finance Capitalism?' raises an important paradox. Institutional investors are growing in size and the concentration of their stakes gives them potential influence over managers. Yet we observe an unexpected absence of shareholder activism and voice on the part of institutional investors in contemporary America. Concentration occurs without commitment. This comment further explores some reasons why today's largest investors seem resigned to or even to benefit from their relative passivity and preference of exit over voice. These reasons include conflicts of interest, market failures, lack of organizational capabilities, use of informal voice, and dependence of markets for corporate control. Corporate governance scholars have surprisingly little evidence on these topics, which suggest an important agenda for future research.

The conventional historical understanding of US corporate governance involves a period of 'managerial capitalism' giving way to an era of 'investor capitalism'.¹ Managerial capitalism was characterized by a growing dispersion of ownership, resulting in a separation of ownership from control. Managers ruled the roost. However, the emergence of new institutional investors has led to a growing mediation of equity investment through professionally managed funds. Consequently, the argument goes that institutional investors have emerged who are potentially large enough to exert control and have sufficient incentives to actively monitor their investments (Useem, 1996). Of course, investors may still prefer to 'exit' by selling their shares if share prices are not doing well. But the investor capitalism hypothesis also relied upon the idea that pension funds or mutual funds were unable to exit. Their sheer size limited the liquidity of their stakes, so that selling would entail big losses. Also, the use of indexed funds as a way to spread risk means that these investors are unable to sell, even if a particular firm is underperforming.

In the article 'A New Finance Capitalism?', an important paradox is raised. Institutional investors seem to be growing in size and the concentration of their stakes gives them potential influence over managers. Yet we observe an unexpected absence of shareholder activism and voice on the part of institutional investors in contemporary America. Concentration occurs without commitment. In this comment, I will further explore some of the reasons why today's largest investors seem resigned to or even to be benefiting from their relative passivity and preference of exit over voice: conflicts of interest, market failures, lack of organizational capabilities, use of informal voice, and dependence of markets for corporate control. Corporate governance scholars have surprisingly little decisive evidence on these topics, which suggests an important research agenda.

The article develops its main argument through a historical juxtaposition of US finance capitalism of the turn of the Century J.P. Morgan variety with contemporary finance capitalism using the case of Fidelity Investments. This comparison is intuitively interesting, but how does it help us to understand today's financial capitalism? The central issue here seems to be whether ownership concentration occurs with or without control. Certainly, J.P. Morgan used ownership of large stakes and further use of voting trusts a means of control – Morgan gained seats on boards of directors, used these to broker or influence major transactions such as mergers, acquisitions and as recapitalizations, thereby reshaping the dynamics of markets and even whole industries (Chernow, 1991; Hannah, 2007). The populist reaction to these activities was at least one factor involved in the major wave of state intervention into US financial markets (Roe, 1994) and breaking up of the 'House of Morgan' through the 1933 Glass-Steagall Act.

Meanwhile, Fidelity is a very different animal. Founded in the 1940s, Fidelity grew by creating a portfolio of mutual funds and engaging in asset management. Large-scale growth came through the management of pension fund assets over the 1960s and IRA (Individual Retirement Accounts) investments from the 1970s onwards. The reasons for Fidelity taking a different stance toward corporate control than J.P. Morgan seem largely obvious. Mutual funds invest on behalf of their clients, and live in a world of regulation that makes it much more difficult to be a corporate 'insider' while also upholding fiduciary duties towards investors. Taking seats on the board or actively brokering transactions (let alone cartelizing markets) would involve serious conflicts of interest and likely invite legal sanction.

The more interesting and subtle issue is this. If Fidelity does accumulate concentrated ownership to some degree, why do they not at least seek to influence corporations in ways that improve their financial performance and hence serve their own financial interests? A number of possible explanations are considered in the paper, none of them mutually exclusive. First, one provocative explanation advanced by Davis and Kim (2007) shows that mutual funds adopt more pro-management stances in corporate governance to the degree they are dependent on other sorts of business from corporations, such as managing corporate pension funds. The more activist types of funds are those with the greatest independence from the corporate sector. In essence, the story here is a simple conflict of interest story, but a powerful one that certainly applies to Fidelity. Second, a further explanation may relate to more classic agency theory. Mutual funds have diverse portfolios and stand to gain only a portion of the value added through investing in shareholder activism, while other shareholders may be free riders. Information sharing and coordination of strategies among investors may be limited since such information may also give proprietary advantages in trading. Hence, market failure remains likely. Third, many institutional investors lack the organizational capacity to engage with a large portfolio of companies. Engagement is expensive, and funds often delegate management of particular portfolios to outside specialists. Likewise, institutional investors may rely on external service providers, like ISS, to rate companies or inform their corporate governance policies. Finally, even if institutional investors overcome conflicts of interest and market failures, shareholder activism remains likely to be of a quite generalized orientation. Institutional investors, such as the famous case of CALPERs, may advocate across-the-board guidelines, and have explicit policies for voting their shares in line with certain principles (Jacoby, 2007). However, the influence of those strategies on particular firms and maximizing returns on particular investments is relatively limited.

An alternative hypothesis is that institutional investors exert their influence largely through informal engagement, rather than formal exercise of control (see Pendleton and Gospel, 2005). A recent and innovative study of Hermes pension fund found significant returns to shareholder intervention, but equally stressed the largely informal character of such engagement (Becht et al., 2006). Even large shareholders like Hermes rarely have enough votes to openly challenge management, given that most investors will remain passive supporters of management apart from during exceptional crises. Investors may also eschew open public criticism of firms whose stock they own. Rather, institutional investors may prefer to operate behind the scenes through informal communication and personal access to top executives by virtue of their potential influence over share prices, if the investor chooses to sell. Here the threat of exit conditions voice. Indeed, studies of the influence of foreign institutional investors on stakeholder-oriented firms in countries like Japan demonstrate the importance of growing transparency and increasing dialogue of a largely informal nature (Ahmadjian, 2007). Even if the option of voice fails to change company behaviour, the salience of exit in the US or UK remains substantial due to the active market for corporate control. Institutional investors are likely to be able to sell their stakes to a takeover bidder at a substantial premium. Indeed, at the end of the day, institutional investors remain financially orientated rather than strategic investors and can only realize financial gain through exit over a relatively defined time horizon. Or as one fund manager of a leading UK institutional investor explains: The biggest stakes are mostly at 10 or 15% . You're talking the smaller companies, really. It would be very expensive to own 10% , 15% of a top 100 company.... I think the target size will depend on the conviction that we have. I mean, at the end of the day, it's always about value you think is within the company over the next what ... 2 or 3 years, or something like that, and if you're very convinced while you're there, by their strategy and their prospects, you would put more into it. (Interview, London, 25 March 2007)²

Of course, institutional investors may remain passive simply because managers adopt a pro-investor orientation and set of policies anyway. This argument runs inverse to Davis and Kim's (2007) argument: not investors are pro-management, but management is pro-investor.³ Shareholder value has become widely institutionalized as a guiding managerial principle, both in the legal regime or soft-law regulation (e.g. various corporate governance codes) and in the ideologies and incentives of managers themselves (Höpner and Jackson, 2006). By designing a legitimate account of their behaviour in terms of creating shareholder-value, managers around the world have succeeded in engineering a massive rise of executive salaries through stock options and other incentive-based payment schemes that, at least superficially, were advocated by investors and academic economists within the agency theory paradigm. Ultimately, institutional investors and managers may be complicit to remedy poor performance through an active market of takeovers, which often destroy shareholder value (Cosh et al., 2007) and yet give shareholders ample opportunity to exit from their investments with a nearly guaranteed premium.

The 'new financial capitalism' and its unique pattern of concentration with liquidity is not just an American phenomena. Table 1 shows the top 10 owners of equity in the UK, and demonstrates much the same pattern of dominant institutional investors and high share turnover among their portfolios. For example, Fidelity International in the UK churned 44% of their share portfolio in 2006, putting them among the most active traders. Yet eight of the top 10 investors traded over one-third of their portfolios per year, suggesting an average 3-year time horizon or shorter. Yet other financial systems in Europe seem less vulnerable to this pattern. Table 2 shows the top 10 German shareholders and their respective turnover. The list contains four institutional investors, but also a quasi-public bank and several corporations. Only three of these investors traded more than a third of their portfolios. The German system remains a mix of liquidity and greater commitment. However, the list is notable for the absence of the Big Three private banks (e.g. Deutsche Bank, Dresdner Bank, and Commerzbank) whose long-term blockholdings were once at the centre of the German corporate network (Höpner and Krempel, 2003).

Table 1 - The 10 biggest UK shareholders in 2006, by total equity assets.

Full table

Table 2 - The 10 biggest German shareholders in 2006, by total equity assets.

Full table

At a more theoretical level, understanding the significance of the 'new financial capitalism' and its corollary of 'shareholder value' management practices requires a more fine-grained and sociological perspective on the organization and networks of interdependence in the world of finance. Finance is undoubtedly exerting an ever-growing influence on corporate behaviour. Yet as the discussion above suggests, the nature of this influence can no longer be adequately understood through the simple dichotomy of ownership dispersion or concentration. The dynamics of 'financial capitalism' today are clearly more complex.⁴ Research on corporate governance must come to terms with the fact that various investors (e.g. banks, pension funds, individuals, insurance companies, hedge funds, private equity, etc.) possess different identities, interests, time horizons, and strategies (see discussion in Aguilera and Jackson, 2003). Not only do investors follow different strategies but these strategies interact with one another in complex ways that are insufficiently understood by prevailing dichotomies or unqualified reference to concepts such as private benefits, which arise in diverse ways.

The emergence of new types of investors, such as private equity investors and hedge funds, alongside institutional investors raises even deeper questions about corporate governance (De Cock et al., 2007). These actors often seek opportunities by speculating against market trends or betting on negative performance, sometimes using complex new financial instruments. Institutional investor strategies focused on growth and value may be confounded by the hedge fund speculation on losses or their disproportional influence on share price movements. Institutional investor engagement based on the 'public' world of corporate governance codes and rules is complicated by private equity investors who shift the rules of the game substantially to the 'private' domain of entrepreneurial authority – a strategy that often goes hand in hand with a reallocation of rights and obligations between equity holders and debt holders by increased financial leveraging and securitization of debt finance. All these dimensions may also become blurred through the web of delegation and outsourcing, wherein private equity and hedge funds are a growing share of institutional investors' own portfolios. This sort of non-unanimity of shareholder interests, in fact, challenges the notion of 'shareholder value' as a social construct to guide managerial decision making – meanwhile, we must ask value for which shareholders?

If the 'new financial capitalism' is here, the key to understanding its true nature will not be watching the attempts of large institutional investors to raise their voices at AGM meetings. Rather, in this financial capitalism, managers must cope with different shareholder 'values' driven by diverse strategies of company valuation and ways of amortizing investments to realize value. What seems for certain is that institutional investment will involve a complex dialectic where voice is intrinsically tied with exit, even for the most committed and powerful actors.