Corporate finance under the microscope
A spate of high profile interventions by the authorities globally against everything from proposed mergers to share buybacks has led to suggestions of an anti-business bias in some quarters. The evidence, however, paints a different picture.
The spectacle is becoming familiar. Red-faced and sweating, corporate executives are grilled by politicians at a hastily-convened parliamentary or Senate hearing, demanding why the latest deal has gone wrong, or pension fund has imploded, or tax domicile was decided. Such hearings are a fairly new phenomenon, but they capture a certain public mood that has set in since the global financial crisis. In the last five years we have seen bankers, fund managers, media owners, global healthcare executives, tech companies and now retail titans, all being metaphorically flogged before the court of public opinion.
This undoubtedly makes good viewing, and might even win a few votes. But is it anything else? Is there really an anti-business bias; driven by governments, regulators and other authorities – in the UK and around the world – that is making it harder for companies to take risks and do business?
Holding to account
When trying to answer that question, consideration must first be given to the type of intervention. Instances of senior executives being called to defend their company’s actions in front of politicians, for example, are at the end of the spectrum, and typically only happen when serious failures in corporate governance have been acknowledged by those companies.
Such hearings can even lead to concrete actions. After senior executives at German carmaker Volkswagen appeared before the US Department of Justice in April over the emissions scandal that broke in late 2015, an agreement in principle was reached for the car manufacturer either to buy back the vehicles or fix them. In a suitably contrite statement, the company described the deal as “an important step on the road to making things right”. Subsequently, Volkswagen reached a $14.7 billion (£11.3 billion) settlement with the Department of Justice to compensate vehicle owners and invest in greener vehicle and pollution-reducing technology.
Abigail Herron, Director of Responsible Investment Strategy & Research at Aviva Investors, believes such hearings offer useful insight for investors on company culture and the calibre of management.
“Take, for instance, the performance of the former chairman of the Co-operative Bank at the Treasury Select Committee in 2013,” she says. “This was widely seen as a flashpoint where it was revealed how extensive the rot at the Co-operative Bank went.
“In the UK, there are live examples of the tension between governmental scrutiny and corporate governance, with a number of executives appearing before the Commons’ Business, Innovation and Skills Committee,” adds Herron. “These are highly-public forums that put the spotlight on poor corporate behaviour. I don’t view these as evidence of any anti-business bias – if they deter others, they will serve a useful purpose.”
Promoting better governance
In a similar context, state-backed initiatives to promote corporate governance can also play a valuable role. After the $1.7 billion accounting scandal at Japan’s Olympus was exposed in 2011, the Japanese authorities embarked on a transparency and corporate governance drive. If the number of accounting and other corporate scandals that have been brought out into the open since then are a guide, the initiative has been a success. The Financial Times reported on May 29 that the number of improper accounting cases hit an all-time high of 58 cases in 2015-16, citing figures from Tokyo Shoko Research,1 more than double the level in 2012.
While such scandals will do little to allay the concerns of international investors in the short term, the fact that corporate governance is a focus of the Japanese government and regulators is an important step in the right direction; as were the introduction of the Stewardship Code for Institutional Investors in 2014 and Corporate Governance Code in 2015 in the country.
The effectiveness of intervention in other areas, such as blocking mergers or proposals to halt share-buybacks, is more difficult to gauge, however. In a slowing economic environment, it is naturally more challenging for companies to increase their share price through boosting revenues and earnings. In 2015, the constituent members of the S&P 500 saw their earnings fall 15 per cent from 2014. It is not getting better. With the second-quarter earnings season approaching, researcher FactSet estimates a further five per cent decline in S&P 500 earnings over the previous quarter, or the first time since mid 2008 that US companies have suffered five consecutive quarters of falling earnings.
With earnings harder to come by, companies have turned to other avenues to boost their share prices. This includes recent multi-year highs for both US and European M&A, and a consistent trend in companies undertaking share buybacks. In Japan for instance, there have been almost as many companies announcing share buybacks in the first half of this year as for all 2015 combined. In the US, 2015 saw the greatest number of buybacks since before the crisis. Indeed, companies have spent almost $2 trillion on repurchasing shares since the beginning of 2013.
When it comes to buybacks, some politicians in the US are also exploring ways to make them less attractive for companies, especially buyback programmes that are debt-funded. The concern among some policymakers is that companies’ fortunes are at risk from the interests of short-term speculators. Concern over short-termism was the motivation behind The Brokaw Act, unveiled in March 2016 by senators Tammy Baldwin of Wisconsin and Jeff Merkley of Oregon. The senators accuse activist funds of encouraging so-called “quarterly capitalism” that forces company executives to focus on next quarter’s earnings, instead of long-term investments and capital improvements.
Any changes to the treatment of buybacks is almost certainly not going to happen before the US general election in November, but it could be a live issue in 2017. Fears over short-termism are also shared by many investors, although it is questionable whether regulation is a more effective tool than stronger engagement by large shareholders.
“While buybacks may be a sensible strategy in the short-term, we do worry whether it is to the detriment of the longer-term prospects of businesses,” says Richard Saldanha, Global Equity Fund Manager at Aviva Investors. “Although it’s more than likely companies will continue to generate significant amounts of cash and debt markets will remain accessible, to generate sustainable long-term growth corporates will need to focus more on re-investing in their own businesses through capex. Ultimately, it is up to long-term shareholders and stewards of capital to ensure that companies are allocating capital in the most efficient way.”
One of the most hotly-debated issues in the corporate finance world at present is the treatment of tax inversions; especially in the wake of the US Treasury Department’s decision to clamp down on the practice in April. Inversions involve a large company merging with a smaller overseas partner and then relocating their headquarters to that country.
The Treasury’s intervention was widely believed to have been driven by a single deal – the proposed $160 billion tie-up between US pharmaceutical giant Pfizer and the Ireland-domiciled Allergan announced in November 2015 and abandoned in April. This would have seen Pfizer relocate its headquarters to Dublin and, if press reports are to be believed, reduce its tax bill by $35 billion.
In a statement, the US Treasury said: “Genuine cross-border mergers make the US economy stronger by enabling US companies to invest overseas and encouraging foreign investment to flow into the United States. But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of a parent entity to a low-tax jurisdiction simply to avoid US taxes.”
In a spikey response, the US Chamber of Commerce said: “There is nothing ‘patriotic’ about politicians bullying America’s job creators for legally trying to level the playing field. Instead of focusing on sound bites, Washington should do its job and comprehensively reform the tax code.”
The lobby group may get its wish. In its statement in April, the Treasury acknowledged that the “best way to address inversions is to reform our business tax system”.
Looking broadly at the issue of intervention, Giles Parkinson, Global Equities Fund Manager at Aviva Investors, does not believe the current scrutiny is unusual. “Whether we’re discussing share buybacks, mergers or tax inversions, it’s hard to argue that they are out of kilter with what we’ve seen previously,” he says. “Their popularity now is no greater than they were at the top of the previous cycles in 2007 or 2000. And as a corollary, the regulatory reaction to them is also no greater than it was in previous cycles.”
Rather than an anti-business bias, the shift – if there is one – is that the authorities in the US, continental Europe and the UK are moving in the direction of encouraging companies to use the corporate finance techniques at their disposal for growth and investment of the market as a whole – rather than their next quarterly share price moves.
1 Takata, Mitsubishi and Toa revelations raise fears that worse may follow, Financial Times, May 29, 2016
- Another five per cent slide in S&P 500 earnings is forecast for the second quarter over the previous one by industry experts - the first time US companies have suffered five consecutive quarters of falling earnings since mid-2008
- With earnings harder to come by, companies have turned to other avenues to boost their share prices. This includes a surge in share buybacks and recent multi-year highs for both US and European M&A
- The number of improper accounting cases involving Japanese companies hit a record high of 58 in 2015-16, more than double the level in 2012
- The fact that corporate governance is a focus of the Japanese government and regulators is an important step in the right direction
- Rather than an anti-business bias, the authorities in the US, UK and continental Europe are looking to encourage companies to use corporate finance for growth and investment – rather than their next quarterly share price moves