Introduction
With the significant increase in the participation of institutional investors in the ownership structure of listed companies in many countries, they started to have a considerable function in corporate governance. Increase in their participation in the ownership structure listed companies is observed for several decades. (The American Economic Review, 2013) The aim of this paper is to examine an important corporate governance mechanism: the role of institutional investors in firm’s performance. First, the essay presents a background of the creation of institutional investors mechanism. Then, the role and effectiveness of that group will be discussed, drawing on academic research findings and real life examples. It concludes, that institutional investors are active shareholders, developing decision links and stronger communication with their inventive companies.
Background
The financial crisis of the years 2007-2009 appeared some important omission in the area of corporate governance. These include the remuneration system for executives in financial institutions or weak position of supervisory boards, accompanied by the insufficient activity of invalidity of the shareholders – institutional investors. Reform of corporate governance should provide institutional investors with stronger than previously put forward as involvement in monitoring managers of portfolio companies (OECD, 2009). Institutional investors became major participants in the financial market, as a result, corporate governance in connection with the reform of the pension system and the severity of privatisation processes in many countries. Equity markets are increasingly dominated by institutions. Between 1900 and 1945, institutional investors controlled approximately 5% of the US stock market, however by 2009, that figure had risen to 67%. (Journal of Accounting and Economics, 2016). Activities, which institutional investors create, adds a positive value and contributes to the improvement of corporate governance and better results in their portfolio. Empirical analysis confirms that the role of institutional investors in corporate governance increases in companies, which reach worse economic performance, and which have a significant interest (Karpoff et al. 1996) and in companies where the structure of corporate governance is weak (Akyul, Carroll 2006). The research, conducted to date, has also shown that their activity has increased significantly in recent years, after the scandals involving, among others, such companies as Enron and WorldCom (Klein, 2006 Zur; Renneboob, Szilagyi 2008). Among the most frequently conducted research it represented analysing the impact of current activity of institutional investors on the company’s results measured mainly a change in the share price. Their results show that occurs above-average growth in the share price in a short period around the date of public disclosure of the activity of institutional investors (Black 1998; Gillan, Starks 1998; Karpoff 2001). Much attention is paid to check whether the active monitoring of institutional investors has an effect on the degree of relation between salaries executives with the results on a company performance (Hartzell, 2003 Starks, Almazan et al., 2005; Smith, Swan 2008).
INSTITUTIONAL INVESTORS VS SHORT_TERMISM
Institutional investors such as pension funds, mutual funds, life insurance companies, investment and unit trusts have a significant impact on the efficiency of corporate governance. Monitoring company management by influencing their decision making is carried on to bring into line shareholders and management interest. This issue is directly linked to the agency theory framework which presents a company as a network of contracts (trade agency) between individual participants including shareholders, managers and lenders. Separation of ownership and control, led to the ‘agency problems’ in the USA and UK. The system of corporate ownership rose problems between shareholders (principal) and company executives (agents), who do not inevitably decide in the best interest of principals (Jensen and Meckling, 1976) as company managers are often focused on their personal objectives such us higher bonuses rather than maximising long-term shareholders wealth, called ‘residual loss’ in the agency theory. This problem introduces shareholders with a want to control company management. Short-term investment pressure has arisen from the institutional investors, more interested in achieving quick profits than in development of investee companies. In 1990, an Economist article affirmed the obsession of investors with the short term (Journal of Corporate Finance, 2014). In recent years, the turnover of shares in the listed companies, has by far exceeded those of 1990. European Parliament stated in 2010 that current financial crisis had weakened the belief of institutional investors as accountable shareholders. Recent banking crises increased demand for institutional investors to evolve into long-term shareholders. They are supposed to pressurise the management of companies they invest in, to put into a practise long-term strategies.
The European Commission published The Green Paper on corporate governance, stating that in asset management contracts, short-term incentives seem to play an important role to asset managers’ short-termism and that could cause shareholders apathy. Interviews with assets managers conducted by the Commission revealed that there was significant support for reconstructing the disclosure of incentive structures for company managers (The European Commission, 2011). Balanced institutional investors, who by definition control their investments in the company over the long-run, are by far more likely to enhance from controlling management activities in order to diminish managerial short-termism and agency conflicts than would investors who are not favourable of the long run (Harvard Law School, 2013). The Harvard Business Review (2013) introduced a problem of short-ternism within institutional investors, showing the survey from early 2013 done by McKinsey and the Canada Pension Plan Investment Board (CPPIB). McKinsey Quarterly survey included more than 1000 board members around the world in order to assess their progress in taking a longer-term approach to running their companies. The results showed that 86% considered using a longer time horizon by institutional investors to make business decisions, would positively influence corporate performance in a several ways, for instance increasing innovation and strengthening financial returns. The final outcome of the survey was that institutional investors ‘expected their companies to generate greater earnings in the near term(…). They made it clear that they were often just channeling increased short-term pressures from investors, including institutional shareholders. It indicates that the most practical and effective method to move further is to alter the investment strategies and attitudes of the main players who form the cornerstone of the capitalist system: the big asset owners (The Harvard Business Review, 2003).
BEHAVIOURAL ASSUMPTIONS OF INSTITUTIONAL INVESTORS
The other most fundamental assumption of agency theory is the behavioural assumption of self-interest and associated emergence of agency costs as it is difficult and highly-priced for the principles to exercise control over agents (Eisenhardt, 1989). In the first document of good practices developed in the UK – in the Cadbury Report (1992), institutional investors were seen as a group, which bears the greatest responsibility to adapt to the principles of corporate governance. A similar position was represented in Greenbury report (1995), which emphasised that institutional investors should use their power and influence to ensure the implementation of good corporate governance practices in companies within their portfolio. Then, in the Hampel report (1998) found that the position and role of shareholders in corporate governance is largely dependent on the actions of institutional investors. In 2004, Myners Report expressed the expectation that institutional investors were more engaged in monitoring companies at their expense – especially those that reach a weak economic performance. The Combined Code (2003) encouraged them to various forms of activity. One of the rules states that institutional investors should establish a dialogue with the companies in order to better understand their business goals. In addition, they should apply the appropriate importance to assess the corporate governance practices of the company, especially to evaluate the structure and composition of the board of directors. Finally, the Stewardship Code published by Financial Reporting Council (FRC) in 2012, enhanced institutional investors to engagement with companies to help improve long-termism. It also encouraged them to ‘improve the efficient exercise of governance responsibilities by setting out good practise on engagement with investee companies to which the FRC believed institutional investors should aspire’. Monitoring corporate management is a potentially important governance mechanism (Almazan, 2004).
Attempts by shareholders and managers to audit company management arise agency costs and involve initiating activities which are expensive and time-consuming. Monitoring techniques help to resolve agency problems which involve incentive schemes, debt contracts and remuneration contracts for management. According to Andres Almazan (2003) ‘one area in which investors can actively monitor is in the assessment and rewarding of managerial performance, i.e., in the design of executive compensation’, which can evolve a greater understanding of the nature of agency problem between managers and shareholders. He adds then ‘The pay-for-performance sensitivity of managerial compensation is increasing in the ownership of monitoring shareholders and decreasing in the cost of monitoring’. It also indicates that the level of executive compensation is declining in the ownership of the monitoring shareholders and rising in their cost of monitoring. If institutional investors exercise their rights of ownership and engage in corporate governance in order to encourage managers of portfolio companies to activities enhancing value for shareholders, it defines them as active. Involvement of institutional investors in control of the company means that the group of agents (Company’s managerial staff) oversees another group of agents (Asset Managers institutional investors). They may have inadequate stimuli to oversee agents as they receive a small part of the benefits earned, thanks to the corporate supervision. In addition, they are afraid that their effort will benefit others. However in general, agents and principals must work together to make their impact on the company’s management team, which is cost effective.
CONCLUSION
Finally, institutional investors often prefer a quick opportunity to liquidate the assets (short-termism) over the controls on assets as a result of possible lawsuits from company management in the context of retaliatory actions. Accusations against them would be publicised in the media, which would contribute to the violation of their reputation. Fund managers try to avoid any situation that could expose them to the charge of failure to comply with the obligation to duly represent the interests of their clients (Sikes, 2014). It is recommended that to start moving the long-termism issue from the theoretical perspective to action, is with the members who provide the crucial power for capitalism – the world’s leading asset owners, corporate boards, and company executives. By welcoming the responsibility and opportunity to lead in the best interests of large asset owners, could be a high-powered strength for instituting well-balanced long-term capitalism that ultimately benefits everyone. To conclude, institutional investors are active shareholders, developing decision links and stronger communication with their inventive companies. They exercise their rights of ownership and engage in corporate governance activities enhancing value for shareholders. Institutional investors have become major participants in the financial market, having a significant impact on the efficiency of corporate governance by monitoring company management and influencing their decision making.