The perceived divergence of priorities between bondholders and shareholders has led some to believe that these investors cannot engage with companies on the same issues. Some – remarkably - even question the legitimacy of bondholders (or other creditors) engaging with companies in the first place. However, given their financial stakes in a company, both types of investors not only have legitimate cause to engage, but also a professional duty to do so. So say, Mitch Reznick, Co-Head of Credit, and Dr. Hans Christoph-Hirt, Head of Hermes EOS, in We Can All Get Along, a new report dispelling myths surrounding joint company engagements between bondholders and long-term shareholders.
Writing in the paper, the authors argue that the difference in the payoff profile of equities and bonds is sometimes cited as a reason that bondholders focus less on long-term factors, while shareholders want to see growth. However, there are strategic issues which the pair highlight as being relevant to a company’s current and likely future health and value creation, including the management of ESG (environmental, social and governance) factors.
Arguing that although the cash flows from bonds held to maturity will not alter unless operating cash flows are substantially impaired, the authors highlight that unmitigated risks can weaken a company’s ability to fulfil its debt-service obligations. An increase in financial risk, can put pressure on share prices and, in turn, impact bondholders as the equity buffer is eroded. So, even if the cash flows remain intact, credit spreads on bonds widen and the prices of the instruments fall, impacting performance. Numerous studies – including several that Hermes has conducted or participated in – show that the integration of ESG analysis, combined with active engagement, can help improve performance and thus benefit multiple stakeholders1. It is therefore clear that poorly managed ESG factors can destroy value for both equity and bond investors, as evidenced dramatically by the financial impact of Carillion’s collapse in 2017, which was driven largely by strategic and governance failings2.
Mitch Reznick, Co-Head of Credit, said: “Bondholders – like shareholders – have a financial stake in the companies on whose balance sheet their debt resides, and the returns from both debt and equity instruments are ultimately linked to the performance of the underlying company. In cases of insolvency, bondholders typically have a stronger claim on the value of the company, providing an incentive to understand and help preserve its drivers of long-term performance. If companies want continued access to the debt markets on reasonable terms, they need to listen to what bondholders have to say about ESG risks and other influential factors.”
Dr. Hans Christoph-Hirt, Head of Hermes EOS, said: “We engage with companies, not the instruments through which our clients invest in them. Poorly managed ESG factors can destroy value for both equity and bond investors. This is why it makes sense to engage companies from the perspective of both the bond and the shareholders – both of whom have legitimate cause to engage – and seek a rounded dialogue. While there can be tensions on certain issues and occasional conflicts between these two perspectives, the focus of the engagement and its objectives will generally be the same.”
As discussed in the paper, the authors argue that the alignment of bond and shareholders’ interests is much stronger than generally assumed, particularly in the ESG sphere although there are situations where interests appear unaligned.
However, these areas of divergence are relatively rare and in the vast majority of situations, such as high dividends or excessive share buybacks, will be unsustainable. Yet damage will be felt as much by long-term shareholders as by bondholders. Both types of investors will benefit from demanding regular dividend payouts as it is an important discipline for management teams. Clear, stable, well-communicated financial policies imply transparency, reduce uncertainty and benefit all stakeholders.
Mitch Reznick, Co-Head of Credit, continued: “The debates about poison pills and dividends both highlight the same principle: greater accountability, efficiency and effectiveness is in the interests of both bondholders as well as shareholders. We do not see any benefit from having portfolio companies run by executives and boards that do not place the long-term sustainability of the business above all other demands – no matter how alluring it is to yield to the many voices seeking short-term gains.”
Dr. Hans Christoph-Hirt, Head of Hermes EOS, continued: “The financial stakes managed by bond and long-term shareholders provide them with the legitimacy – and, arguably, an obligation – to engage companies on ESG factors and other issues affecting long-term value creation. In the majority of circumstances, bond and shareholders have interests and priorities that are well aligned – particularly in the management of ESG factors. This is why we choose not to engage through the lens afforded by financial instruments. Instead, our broader perspective compels us to engage with companies for the benefit of all financial stakeholders, taking broader environmental, governance and societal objectives into account.”
1 See, for example: “ESG Shareholder Engagement and Downside Risk (Working Paper),” by Hoepner A., Oikonomou I., Sautner, Z., Starks, L.T., and X. Zhou, published in January 2018; “Active Ownership,” by Dimson, E., Karakas, O., and X. Li, published in 2015 by the Review of Financial Studies, 28(12), 3225-3268; “Activism on Corporate Social Responsibility,” by Barko, T., Cremers, M., and L. Renneboog, published in 2017 as an ECGI Working Paper No 509/2017; “How ESG Engagement Creates Value For Investors and Companies,” published in 2018 by the Principles for Responsible Investment; and “ESG’s Evolving Performance: First, Do No Harm,” by Renshaw, A. Ph.D., published in July 2018 by Axioma.
2 For an overview on the causes that led to Carillion’s collapse, see “Where did Carillion go wrong?”, published on 18 January 2018 in The Economist.