Tuesday, February 5, 2013

Barriers to Cooperation

Barriers to Cooperation

When it comes to matters of governance, most institutional investors cede their rights to management.  This state of affairs is true for investors in publicly traded equities, as well as the alternative categories such as private equity and real estate.  It’s only when things go wrong that investors attempt to assert their rights, and by then it is too late.  It’s in these adverse situations that investors need to band together, and yet in my experience, they seldom cooperate effectively.

Management makes sure that joint-action among investors is as difficult as possible.  In public equities, state corporate laws circumscribe investor collaboration, as well as access to shareholder lists.  In private equity and real estate, many managers use a divide and conquer strategy to control their investors. Sad to say, I advised numerous clients on how to cultivate certain key relationships when negotiating key elements of the investment contract or soliciting investors about amendments to partnership agreements.  The idea was to woo a few investors and then force the other investors to fall into line.  
The Numbers Don't Add Up (2008)

Needless to say, as an investor I often fell prey to this tactic.  When a partner approached me to be the “lead investor,” I was eager to engage.  They knew how to stroke my ego.  I never polled other investors or attempted to discern whom else the manager might be engaging.  I just went ahead and entered into the discussions. Once they’d reeled me, the manager used the agreement to corral other investors.

When performance flags or the manager starts losing key employees, investors finally take notice.  However, there’s not much investors can do, unless they’re invested in conventional stocks and bonds.   In those conventional settings, they can terminate the manager.  In the alternative asset classes, firing the manager or withholding additional capital is next to impossible to achieve.  Any decisive action requires a super-majority.  Getting 50% of the investors to act in concert is difficult; imagine organizing 75% or 80%.  In other words, the existing environment makes it very tough for investors to join together and exercise their rights as owners.

I wish investors would spend more of their time working in concert.  I think we’d achieve better returns, as fees would decline and managers would be held accountable.  Unfortunately, only a small number of investors take their ownership seriously, and even fewer work together.  As a result, the money managers remain firmly in control.

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