GEORGE KERSHAW, partner of the headhunting firm Trust Associates, which specialises in recruiting investment trust directors, explains what makes a good board member and why it matters so much.
What makes a good trust director?
George Kershaw: When trust boards approach us to help them identify new non-executive directors, they will usually have a formal or informal skills matrix. This will show us which specialist skills they would like to find in successful candidates to complement the existing skill base.
In addition, there are two important overlays.
The first is the character of candidates. Specialist skills can be hired in to cover particular issues. The non-executive director is expected to be able to put areas of specialisation into the broader context of the governance of the trust. To do this, he or she must be blessed with a wide breadth of view as well as good judgement and the charm to put across ideas and suggestions constructively. It is important that they are easy to work with.
We also observe that many successful candidates have impressive academic credentials. Sweeping generalities have many exceptions but it is probably fair to say that investment company directors require more cerebral excellence than entrepreneurial talent.
The second important overlay is diversity, in particular, gender diversity. When we started in 2002, only 6% of non-executive directors were women and a significant proportion of trusts had male-only boards. It happens that 30% of successful candidates appointed through ourselves have been women. That figure has been constant over many years, as well as more recent periods. The installed base of directors is indeed now rising towards that figure and has reached 22% as of July 2018.
Has the process by which they are chosen changed in recent years?
GK: Considerably more care and time is required of boards in appointing new non-executive directors than in years gone by. Much of this increase has followed from the introduction and refinement of governance codes. The Code of Corporate Governance (the Code) is advisory and relies on the principle of ‘comply or explain’, meaning that boards must give an explanation if they fail to follow the code’s guidelines. (This is in contrast to the Listing Rules that trusts agree to when they list their shares on the stock exchange, which are compulsory.)
Many boards have tended to opt for ‘explain’ rather than ‘comply’ to justify the continuation of their previous practices, but the increased focus on governance has meant that boards feel under increasing pressure to comply. The relevance of this to the process of new appointments is that the code enjoins boards to recruit new directors through open advertising or the use of search consultants (principle number 20 in the 2018 Code).
This has now been in place for several years and there are now very few boards which ignore this principle. In practice, very few boards opt to advertise new non-executive director searches as they do not have an HR department to process applications. One of the more obvious changes to the recruitment process has therefore been that search consultants are involved in the vast majority of appointments.
Many boards are more clear about which set of skills are required in the successful candidate as a result of two other governance-oriented practices which are increasingly commonplace: an ‘away day’, when all the directors can meet to discuss the progress of the trust without the distraction of normal board business, and a formal process of board evaluation which is now required at least once a year.
As the use of search consultants has increased, we notice that most boards now require more than one firm to pitch for the business. In the early days, it was much less common for consultants to be appointed through a competitive tender process.
Is the quality of directors higher than it was?
GK: The make up of boards has changed significantly in the 21st century, largely as a result of changes to the Code – in particular, the requirement to use headhunters and the encouragement to limit the terms of non-executive director to nine years. Shareholders, and their voting agencies, also more frequently vote against the reappointment of directors. Boards were accused, before these changes, of being ‘pale, male and stale’ and ‘clubby’.
There was a certain amount of justification to this comment. ‘Pale’ is still an accusation with some validity, although that is beginning to change as more non-gender diversity feeds into the areas from which candidates are selected. ‘Male’ is much less of an issue in even quite recent history as the installed base of women directors rises towards 30%. For search consultants, it remains quite a challenge as the percentage of women who have achieved senior positions is lagging so far behind the percentage of women appointed to boards.
Successful candidates have mostly achieved very senior status by the time they are likely to be considered for board positions. However, the percentage of women who occupy the senior roles in fund management, for example, is still only about 7%. In consequence, successful women can be in strong demand and some individuals can receive a large number of approaches. One impressive woman, who we were fortunate to put onto a board shortly after she retired from her executive career, subsequently received no fewer than 40 invitations to join boards as a non-executive director.
‘Stale’ is also much less of an issue now, largely because of the Code. The 2018 version of the Code, due to take effect in 2019, has clear language discouraging chairmen in particular from serving more than nine years. The use of headhunters has significantly increased the pool of potential candidates and reduced clubbiness. The average number of directorships per director has now fallen to 1.3. Interestingly, the figure for women is 1.6.
The use of search consultants has also tended to reduce the influence of their investment managers, who were frequently previously invited to act as search consultants. This, together with the more strongly worded Code and the increased propensity of shareholders (and their voting agencies) to vote against director re-appointments, has resulted in increased director independence from the investment manager.
Most observers would agree that these changes have resulted in higher quality directors who are paid more than they used to be and take their duties more seriously. It is also fair to point out that some investment managers have not welcomed these changes and accuse boards of focusing too much on corporate governance and not enough on encouraging, and assisting, the managers to produce good returns.
What in practice are the board’s most important functions?
GK: The role of directors of investment companies has changed over the years. If you travel back far enough in time, investment company boards met monthly to make changes to the trust’s portfolio as they thought fit. The role of the manager was to implement the changes which the board had decided upon and to deal with the administration of the company. The key skill of the directors was therefore experience of fund management. These trusts were almost all ‘self-managed’. Over several decades, this has changed markedly in both respects.
There are only a small number of self-managed investment trusts where the investment management company is owned by the shareholders of the investment trust. Alliance Trust is the largest such example today. The board of such a trust is therefore responsible for the running of the company through the executives of that company. The board is ultimately responsible for all issues such as the remuneration of the senior executives and corporate acquisitions and disposals.
The vast majority of trusts, however, have no employees and deal only with third-party organisations. The role of the boards of such companies is to represent the interests of their shareholders who also are their customers (unlike most PLCs). Most directors of investment trusts would agree that the most important function of the boards of these companies is to check that the portfolio of the trust is run in accordance with the mandate which has been explained to shareholders and that it is run as well and as cost effectively as is possible.
Where the performance of any of the third-party suppliers is deficient, it is the board’s role to assess the alternatives and, if necessary, to cancel their existing contract and to select an alternative supplier.
Many boards nowadays will have an ‘away day’ to address these high-level responsibilities as well to consider any significant changes that they should consider in terms of mandate or investment manager or, indeed, whether they should consider winding up the trust and returning the proceeds to shareholders.
If we look at the board’s functions through the eyes of a search consultant, we can focus on the skills criteria that we are instructed to use. In each case, boards are after individuals who know which questions to ask and are able to understand whether the answers are satisfactory. The criterion which arises most is experience of fund management; not perhaps surprising as these are investment trusts. Boards are after an understanding of what the selected fund manager is trying to achieve and, ultimately, whether they are doing it well enough. Should the board need to interview alternative managers, experience of fund management is essential.
The next criterion which arises frequently is a requirement for an accounting qualification, normally in the case of a search for an audit chair. While not a Code requirement, most boards do now require the chair of audit to have such a qualification. This might easily be added to one of the other skillsets which the board has identified as being desirable, such as investment management as per above.
Less frequent, but still quite common, is some experience of marketing. One of the ways of minimising the discount of share price to net asset value is to ensure that the shares of the trust are being well marketed.
An understanding of the technical aspects of investment trusts is also quite a frequent criterion. This has become more valued as the range of tools available to trust boards has increased.
For example, boards now have considerable powers to influence the level of discount at which the share price stands to the NAV. Discount control mechanisms (DCMs) are now commonplace and varied.
Where can boards go wrong?
GK: Unfortunately there are many examples of boards which have failed to use these powers wisely. A typical example is of one trust which invested globally. It had had a share buyback programme in place which had kept the discount at less than 10%. The chairmanship changed as a matter of course and after his departure the board lacked both technical investment trust knowledge and anyone with marketing experience. The buyback program was abandoned without putting anything else in its place.
Predictably the discount widened and that prompted a hedge fund to pick up a significant holding in the shares at a discount of 15%. The board then reversed its decision and brought back the hedge fund’s holding at a discount of 5%. The hedge fund consequently made a profit at the expense of shareholders and questions were rightly asked about the quality of corporate governance. Other international trusts have made similar mistakes, which all stem from a failure to understand why the discount was so large and how to address the problem in a way which benefited the current shareholders.
There are many examples of boards which have made unwise decisions because they did not have appropriate experience. One notable example occurred when the board of an investment trust with a mandate to invest in Japan, despairing of the Japanese market’s continual weakness, switched the investment manager and gave the mandate to a company running hedge funds.
This might have been a smart move, but for two factors. The first was that the switch was made just as the Japanese market rose by nearly 10%. The new manager had hedged the portfolio against further falls. Shareholders therefore were both sorely disappointed and surprised that they had gained nothing from the rise in the market.
The second was a serious lapse of good governance by the board. They had failed to canvass the views of shareholders. Had they done so, they would have known that most shareholders held the shares because they wanted some limited exposure to the Japanese market. It was not the role of the board in this instance to take a view about whether Japan was a good place to invest without asking shareholders and explaining very clearly how they had changed the mandate of the trust.
It is not surprising that the consequence was that the board was replaced on a shareholder vote and the trust was liquidated. These examples are now quite rare because directors take their duties more seriously and the standard of corporate governance has significantly improved across the board. Investors who buy shares in investment trusts are entitled to think that the board is acting in their interest and should rightly be held to account if they are not, as increasingly they are.
GEORGE KERSHAW co-founded Trust Associates in 2002 and focuses principally on finding non-executive directors for investment companies, as well as a variety of other projects, including research into shareholder attitudes, share buybacks and corporate governance. He led the CSFB investment trust team from 1996 to 2000.