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Beyond profit

Q: What are your thoughts on current approaches to governance of infrastructure assets?

PH: We think there’s a gap. There’s a gap in current guidance for what constitutes best practice corporate governance for critical UK infrastructure. From our experience, there is a demonstrable gap between what is currently in the public domain as guidance and what we think could be beneficial for governance of infrastructure businesses that provide essential services.

Q: What would you see as the ideal model of governance?

PH: We invest clients’ money for 20-plus years and one thing we know for sure is things will change. Investors can’t ‘pre-legislate’ for these changes or micromanage them over this period of time. What you need to do is put in place a robust framework that is best able to manage inevitable change and ensure that the business can adapt and evolve over time, and that starts with fit-for-purpose governance. In terms of what that means in practice, we believe it starts with an appropriate separation and clear lines of responsibility between different stakeholders – shareholders and their rights, the board and their duties and obligations, and management and their responsibilities.

We want investee companies to attract best-in-class management that is empowered and appropriately incentivised and aligned with the performance of the business, which is not just about financial performance. We feel strongly that the board should constitute the primary forum for managing the company and we believe the board should act in the best interests of the company as a whole, taking into account broader stakeholder interests. Directors should be appointed based on merit and boards should have the appropriate diversity of skills and experience.

We believe that shareholders who attempt to micromanage businesses outside the boardroom risk importing a range of conflicts, can seriously undermine management credibility and therefore responsibility, and potentially create a dynamic where management effectively abdicates responsibilities.

Q: To what extent is this practice being carried out in the industry at the moment?

PH: You really need to first look at the current framework. There is no current best practice regime for privately owned infrastructure assets, even for those that would be FTSE 100 companies if owned on the listed market. There are existing guidelines such as the UK corporate governance code, which is really only applicable to listed companies, and the Walker Guidelines for Disclosure and Transparency, which focuses more on reporting than governance.

There are some specific governance principles for certain regulated utilities set by the likes of Ofwat and Ofgem, but there is nothing ubiquitous for a best practice regime for privately owned essential infrastructure assets. We think that the introduction of such guidance could be beneficial and help to articulate and align the objectives of government, private investors and the public, in turn improving the legitimacy of privately owned infrastructure businesses for all stakeholders.

It’s also important to look at the current legal framework. UK company law sets out directors’ duties very clearly, where a “director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members of a whole, and in doing so have regard (amongst other matters) to the consequences of any decision in the long-term, employees, suppliers, customers, reputation, community and the environment.” We feel that the current investment management practice adopted by many private owners often unintentionally dilutes consideration of other stakeholders’ interests and of other matters directors should have due regard to when fulfilling their duties.

Infrastructure assets provide essential services for the efficient and proper functioning of society, so there is a broader remit than just being an enterprise designed to maximise financial returns. In our view, there is a social contract between critical infrastructure businesses and broader stakeholders.

Consequently, we feel that an enhanced governance regime for essential infrastructure assets could provide a framework that promotes best practice with more emphasis on boards being mindful of broader stakeholder interests.

Q: Is this something your industry colleagues are on board with?

PH: Some are, certainly. We’ve had a very positive reaction from a range of stakeholders, including a number of the regulators and also some of the policy-setters and people who are actively involved in filling roles on boards and some fellow investors. Part of the challenge here is that ‘turkeys don’t vote for Christmas’. Some institutions have built their institutional framework around shareholder- appointed employee directors, where the rights and obligations of shareholders, and those of the board and management, are often conflated and not clearly defined. There are no bright lines that ensure appropriate accountability.

Our approach is designed to ensure a diversified, appropriately skilled and experienced board is duly empowered and that conflicts between shareholders’ interests and the company’s interests are minimised and where they do arise are managed appropriately.

A shareholder might be simply looking to maximise short-term profitability. Yet we have a business which is founded on a social contract and, as a result, has a social obligation to a much broader range of stakeholders. At times, we have found there are people who talk about good governance, but find it more challenging to relinquish some of the rights they already have to enable such governance frameworks to be adopted.

Q: How can this be changed in terms of day-to-day management?

PH: One of the features of UK critical infrastructure is it is typically large-scale, requiring a significant amount of capital to be invested, with the result being that there are often a significant number of shareholders invested in the larger, and arguably more critical, infrastructure businesses. Typically, each investor will have a right to appoint a director and some investors have marketed themselves to their clients on the basis that they deliver material incremental value through having direct governance rights through a shareholder-appointed director to the company. Whilst in principle this sounds appealing, in practice often the outcome is you’ll have a board which will have between eight and 10 directors who are all employees of the shareholders and most, if not all, will have a finance background. There is a risk of limited diversity, lack of appropriate challenge and a focus on short-term gains.

This approach can also result in blurred lines, where such nominated individuals may often be required to act in two capacities – as a company director and as a shareholder representative.

I think the other aspect is that there are time constraints where there may be an employee whose full-time job is to acquire assets, give marketing presentations and so on, so they may not be able to dedicate the time that’s required to ensure that the business is run properly.

That is why we adopt a different approach from most. Whilst we typically obtain governance rights that allow a shareholder-appointed director to the company, we look to appoint a suitably qualified and experienced non-executive director (who is not a full-time Hermes employee) to the Board. This appointment is only made after a suitable transition period for new investments and after we have undertaken a board skills matrix review to assess the best skill set for our appointed director to possess that is additive and complementary to the rest of the board. We believe this adds diversity, skills, experience and a purer focus on director duties and responsibilities.

Q: What has historically held back better governance practices?

PH: Historically, the infrastructure market has principally adopted the private equity model in terms of aggregating capital in collective investment vehicles and marketing itself to institutional investors, promising to maximise the value of an investment by being an active investor/owner of a business. However, investing in infrastructure is different from private equity. Private equity is typically about providing transitional capital designed to maximise revenues, reduce costs and exit the investment to maximise shareholder returns. In infrastructure investors are seeking to invest in assets that are inter-generational, that affect the environment and have the ability to impact society at large, almost always disproportionately the more disadvantaged elements of society.

It’s not about saying infrastructure investors don’t want an appropriate return. We certainly feel investors and our clients should earn a fair return for the risks they’ve taken, but it’s also about putting in place a framework that provides for the stewardship of these assets over the longer term and being a responsible investor that recognises how these assets are operated will affect the world in which our beneficiaries live. Particularly for assets that have between 50- and 100-year lives, we believe that thinking about all the stakeholders and their legitimate requirements and by doing the right thing will be beneficial to our investors. The mantra of being an ‘active owner to maximise profits’ is one I think the infrastructure market needs to mature away from. That’s not the only shareholder model. There are plenty of studies out there showing that if you are responsible owner of well-governed companies, you can actually get a better return.