Know Your Register

Not all shareholders are created equal — Management should seek to understand shareholder perspectives — Preference should be given to those with aligned incentives.

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KNOW YOUR REGISTER

A shareholder register is, by definition, a list of owners. But in reality, based on today’s market participants, a shareholder register is a list of business models.

Each type of investor runs a different fund structure, earns fees a different way, and invests with a different time horizon. Those differences, far more than any stated intention or investment philosophy, determine what each will ask of management.

In our last paper, we argued that management should stop listening to most of their shareholders. Today we’ll examine who is talking to management and whether they are worth listening to.

The Passive Majority

Over the past decades, passive investing has grown to be the dominant force in public markets. Passive funds now hold more than half of fund assets in the US.¹

As shareholders, passive investors make poor owners. Most of the time they are simply absent from ownership decisions. When they do engage, the results can be worse: voting preferences are set as policy at a national level, by governance teams covering thousands of companies, and have little to do with the specific business.

Beyond voting, passive holders are also useless in a crisis. Index funds typically do not participate in equity raises, one of the few reasons a business has for being public in the first place. A holder that cannot distinguish one company from thousands in an index and is structurally constrained from providing meaningful support in times of crisis should not have a say in the boardroom.

The Pod Shops

Hedge funds and pod shops earn performance fees on annual results, and their analysts are paid on even shorter cycles. Their incentive is to extract as much value from a business as possible within their fee-earning window.

None of this is illegitimate, but it is a business model that has nothing to do with long-term equity returns. This misalignment of incentives means these funds push businesses to prioritize short-term returns over long-term compounding. Employees and management are ill-served by strategies that only create value for a few months, but are detrimental in the long run.

The Shrinking Active Middle

Traditional active managers are the shareholders management most wants: engaged, informed, and nominally long-term. But even alleged long-term investors are no longer long-term.

As flows migrate to passive, active funds are closing at an alarming rate, and a portfolio manager facing redemptions must sell whether the manager wants to or not. The PM's conviction may be real, but is overridden by fund outflows.

The stellar performance of passive indexes is having a subtle impact on the time horizon of remaining active managers. With the passive option constantly dangling in front of allocators, the ability to stick with a manager through times of underperformance is dwindling. This forces active managers into performance chasing over shorter windows, regardless of their stated time horizon.

 The Ultra-Long-Term

Surprisingly, even patient capital can be a dangerous advisor. Aggressive, leverage-fueled buyback programs take years to translate into shareholder upside, and the holders who push for them are precisely those with the ability to wait and stomach the risk along the way.

But shareholders can diversify in a way a businesses cannot. An investor pushing for high-risk buybacks can run that strategy across twenty positions; if one or two fail, the portfolio still wins.

The employees and management of the failed business hold exactly one position. A risk that is rational for a diversified portfolio can be a risk the business simply should not take.

Liquidation Lovers

Deep value investors appear on the register in times of crisis, buying large stakes at depressed prices, and they are rarely shy.

Here the cost basis is everything. An investor who paid a fraction of liquidation value may favor liquidation over business preservation. Liquidation promises an exceptional return on the investor's capital, but a truncated future for everyone else involved. Liquidation is almost never in the interest of employees, customers, or management, except in the most extreme circumstances.

Know Your Shareholders

The register, read properly, is not a constituency to be polled. It is a map of conflicting incentives, fee structures, time horizons, redemption risks, and cost bases.

Management teams that map their shareholders this way will find the question "what do our shareholders want?" dissolves into a better one: "which shareholders should I listen to?" Shareholders worthy of a seat at the table must have the incentives, business structure, and investment horizon that align with the business's strategy and goals. 

Notes:

1. Investment Company Institute