Change the system
The connections between the basic models of corporate financing and their potential for creating societal as well as private wealth needs exploring. Currently the focus of initiatives about the regulation of PE and hedge funds focuses on the two Ts: transparency and tax.
Peter Linthwaite, director of the British Private Equity and Venture Capital Association, which represents hundreds of private equity firms, acknowledges that there is 'a wider base of people with a legitimate interest' in the industry and 'there will be more people than just the investors and employees who will want to know about how these companies are run'.22 Faced with potential regulation, his association has convened a group to develop a voluntary code to promote transparency in the industry. Chaired by Sir David Walker, former chairman of Morgan Stanley, the group's ten members include industry leaders such as David Blitzer, senior managing director of Blackstone, and Lord Hollick, a partner at Kohlberg Kravis Roberts (KKR).
Transparent behaviour can still be problem behaviour. Bill Stein, writing in the New York Times, focused on the question of taxation. 'Long ago, I had a European history teacher named Mrs Enright. She explained to me that one of the causes of the French Revolution was the sad truth that the aristocracy was not taxed at all, while the workers and burghers were taxed highly. Is this our future?'23 Stein argued that the US must 'make the tax on private equity and hedge funds approximate the treatment of other highly paid people-or it can continue down the road to the Bastille'. In the UK, some PE managers told the Treasury they would support tax rises on carried interest, the share of profits that account for most of dealmakers' pay.
Some commentators, particularly in the US, vociferously disagree. 'What we don't need is government intervention to restrain a model that genuinely creates wealth in a world that needs wealth creation. What we will, and should, see is a greater requirement for transparency and accountability in how the sector goes about its business,' argued Mallen Baker in May. However, given that the pressures from financial markets are often pointed to by corporate leaders as barriers to more effective corporate contributions to sustainable development, it seems too early to argue against government intervention, especially when it is government that has shaped the rules and trading environment that have given birth to these innovative financial practices in the first place. The techniques of highly leveraged buy-outs and short-selling are so problematic for long-term corporate planning that by using such instruments hedge funds and private equity could be cannibalising capitalism, eating it up from within.
Currently it is the institutional investors who pay the price, as they have to invest across the whole market to reduce their risks, and so they buy the heavily indebted stocks when they are sold back onto the stock market by PE firms. Yet about half of the $1.1 trillion under management by PE comes from such institutions, including esteemed US pension groups such as CalPERS and even university endowment funds and central banks. Even within existing regulations on fiduciary duty this practice could be challenged. Because, if the value of the whole portfolio of investments is taken into account, not just the performance of individual equities and instruments, then by pumping up a system that costs their portfolio as a whole, through funding PE, trustees could be in contravention of their fiduciary duty. Yet they face a prisoner's dilemma: if they stay out of PE and hedge funds, their wider portfolios will still suffer while they miss out on the short-term earnings from these financial players. So although the ITUC are examining the possibility of blocking member pension funds from investing in buy-outs firms that engage in activities detrimental to workers' rights,24 a broader international response will be required. Interestingly, some institutional investors in the UN Principles for Responsible Investment (UNPRI) initiative have established a working group on private equity.
This situation suggests that institutional investors should take greater leadership in considering the kind of financial system that is supportive of their members' interests and work towards that. Therefore, not only do such institutions need to establish what forms of hedging and PE might be compatible with long-term value creation and the broader interests of their members, but develop an understanding of the kind of global financial system that will deliver that goal. The implication might be a new public policy agenda from investors seeking to promote more patient and accountable capital. With this understanding the pressures from the European Commission on the Swedish government to remove 'preferential treatment' of investors with long-standing share ownership could be seen as against their interests.
As we reflect on the responsibilities of financial institutions it would be useful to consider how understanding of the responsibilities of non-financial corporations has developed since 1990s, in the West. There has been a shift away from an agenda where business managers sought to satisfy themselves that they were being smarter about managing their social and environmental impacts for financial returns, or in agreement with their own ethical preferences, towards an understanding that as managers of powerful organisations they needed to be more accountable to those they affected. This is a matter of principle, underpinned by notions of equality, dignity and fair play: stakeholders should be respected. This same shift in thinking has not occurred in the realm of responsible finance. Instead, six broad types of approach can now be seen. One approach is to buy into a narrow range of stocks that are preferred for a mixture of financial and ethical reasons, such as clean technology funds. Another approach has been to invest across the board, but screen out those companies in sectors you don't like, such as tobacco or armaments. A third approach has been to buy into those stocks that are the best performing of their class on ethical issues that concern you. A fourth approach has been to engage with companies you have stocks in to seek improvement in their performance on ethical issues, within the framework of what's financially material, such as some of the members of the UNPRI. A new approach is emerging, whereby investors seek to engage companies on the basis of a broader understanding of what is material to the performance of the portfolio as a whole, what James Gifford of the UNPRI calls 'portfolio wide materiality'. Lastly, some institutional investors recognise that their members have concerns beyond the financial, and so they want to uphold certain traditions and values. The question of the accountability of the owners, and finding a new accord between financial property rights and duties, defined as capital accountability by one of these authors in a UN publication in 2004, has not been discussed in responsible investment circles.25 Indeed, most regulatory innovations in recent years have helped make capital less patient and accountable.
The lack of engagement on either regulatory issues or matters of their own accountability by financial institutions could be a result of the lack of informed pressure coming from civil society. NGOs have focused much of their effort-for example, through BankTrack, a network that tracks the impact of the private financial sector on sustainability26-on either project finance, which is only about 1% of global finance, or on ranking the high-street banks' incorporation of social and environmental issues into their wider lending practices. The problematic practices of the financial services in areas such as currency speculation, offshore trusts, short-selling and leveraged buy-outs have not been engaged by most mainstream NGOs. There could be two reasons for this. First is the brain drain from NGOs into the worlds of socially responsible investment and corporate social responsibility management or consulting. Many of the leading people in responsible finance, such as Nick Robins, Rob Lake, Raj Thamotheram and Steve Waygood, left NGOs. Second is the institutionalisation of NGOs, so they become less innovative and more risk-averse over time. It is more of a challenge to make the case to your membership for why, for instance, currency speculation should be curbed to promote sustainable development than why a fence should be put around a forest to protect a bird. Given climate change, driven by dynamics of global finance, the latter may be increasingly futile, but it's still an easier communications option, which makes it an easier fundraising message. The rapid changes in finance mean there is an urgent need for a reversal of that brain drain, and for people from the business side to join with NGOs, unions and others who are interested in addressing the root causes of corporate social irresponsibility.