The Development of Investor Relations
The term investor relations (IR) is a recent one, but many of the core tasks of IR have long histories. This book includes a history of IR because IR is a complex phenomenon that can only be understood historically and because no published history of IR currently exists.
Nine of the most significant influences behind the growth of IR since the mid-1970s are shown in Figure 2.1. It is worth analyzing these factors in detail since the origin of IR has not been well documented, and many of these trends are still in progress and continue to shape the practice of IR.
Figure 2.1 Nine key influences on the growth of IR
From the mid-1970s, the investor—corporation relationship became less passive from both sides. Investors became less tolerant of managerial failure, and managers soon became more sensitive to investor expectations. Investors were also more inclined to closely monitor companies following increased pressure from clients and regulators. The techniques of IR were developed by management teams from the late 1970s as a defense mechanism against shareholder activism. These techniques became commonplace in the early 1980s.
The relationship between firms and investors changed substantially following the “Big Bang” deregulation of the London Stock Exchange in 1986. This introduced telephone and electronic trading and abolished the fixing of commissions, which quickly eroded the “old boy network” in the London markets. With the demise of local relationships came the rapid domination of foreign investment banks. Trading became much easier, and the U.S. model of financial analysts was introduced to assist investors make investment decisions. The internationalization of the London Stock Exchange after 1986 was one aspect of the increasing diversity of investors; another aspect was the growth of “ethical” investment which was promoted by the growth of public sector and religious bodies investing pension fund assets in ordinary stock, but providing their asset managers with mandates that included ethical rules. The wider availability of short selling put extra pressure on management teams. The emergence of “dark pools” (mechanisms where investors can trade stock secretly without declaring trades to the market) also reduced managerial visibility of stock movements. This required management to put extra emphasis on regular meetings with investors to gather feedback. The growth in investor diversity, also includes the growth of hedge funds, activist funds, ethical funds, and foreign investors. In classical abstract economic analysis, all shareholders have the same requirements. In fact this is far from the case. Investors are already diverse, and the trend is toward greater diversity.
Also in the 1980s, increasing access to debt finance (especially the emergence of high yield “junk” bonds) created a new breed of aggressive “corporate raiders” who started to challenge the large conglomerate corporations. The hostile takeover boom of the 1980s resulted in hundreds of firms in the United Kingdom and United States being purchased in leveraged buyouts; many of the targets then being asset stripped. The incumbent management teams were usually replaced, and new teams installed. The increasing short-termism and nervousness of investors created a growing disparity between the lengthening time frame applicable to most board-level decisions, and the reducing investment time frame of most professional investors.
Shareholder primacy thinking reemerged in the late 1970s generally dated from Milton Friedman’s 1970 article, which was validated by Jenson & Mecking in 1976 and became mainstream in the 1980s. Several strands of this thinking emerged: in economics it emerged as “agency theory” (Jenson and Meckling, 1976; Fama 1980) and in investment it emerged as “shareholder value.” It was soon endorsed by leading chief executive officers (CEOs) most notably by Jack Welch in 1981. (Deakin, 2010). “Shareholder value” asserts that management owes their loyalty exclusively to the task of maximizing the firm’s value from a shareholder perspective, and the interests of other groups, if recognized at all, were to be subordinated to shareholder interests.
The popularity of agency theory was closely connected to the spread of performance-based pay, in the form of bonuses and stock options, as suggested by Jenson and Meckling in their 1976 article. Investors pressured remuneration committees into creating substantial stock-option packages for CEOs and chief financial officers (CFOs); tying managerial pay increases to stock market performance. The stock options succeeded in focusing the CEO and CFO on the stock price, but failed to align executives with shareholders. The fact that CEOs were being given the option to buy discounted shares with no danger of losing money made their position far different from that of investors (although quite similar to the position of fund managers who also enjoyed asymmetrical reward structures). Rather than resolving the agency problem, executive stock options merely pushed it one stage further along the investment chain.
The willingness of investors to engage with, and challenge, management has grown since the 1970s for a number of reasons. One reason is the growth of activist investors. There are different types of activists, from the “moral activist” who tend to be public pension funds to the short-term investors, especially hedge funds who are willing to influence analysts and journalists to pressure management to change policy. Certain U.S. pension funds, most notably CalPERS, have set the example of enforcing high standards of corporate governance and ESG policies, and this example has been followed to a more limited degree by public pension funds such as Hermes in the United Kingdom. Another reason is the emergence of collective initiatives by investors which has facilitated collective action. For instance, the International Corporate Governance Network (ICGN), which was initially founded by pension funds in 1995, has now more than 300 members—mainly fund managers. Another reason is the growth of institutional ownership. Since the 1960s, much of the diffusion of ownership that Berle and Means (1932) identified as the source of the governance problem has been reversed, with the decline of private investment as a proportion of the stock market. Institutional ownership now accounts for over 80 percent of U.K. equities, with the top 10 firms alone accounting for 25 percent of the market (Gaved, 1997). This concentration and the illiquidity it sometimes implies, together with increased competition between investors, have arguably given the investors both the opportunity and the need to actively manage their relationships with companies. (Roberts et al, 2011)
Although analysts had been around in the United States since the 1920s, with the first research department created in 1926 (Groysberg and Healy, 2013), the Wall Street crash depressed the nascent industry. A very gentlemanly form of competition developed with very constrained competition between analysts, who were well recompensed out of the substantial negotiated commissions that stockbrokers were paid for transactions. This cosy pattern was gradually ended by the Securities and Exchange Commission in a series of commission cuts during the early 1970s and then terminated by the abolition of negotiated commission on 1st May 1975. The sell-side analyst in the United States now returned to the 1920s model of aggressive selling of stock. This pattern had an influence on the United Kingdom from the late 1970s as U.S. investment banks looked to expand overseas due to the fierce competition in the United States, and the sleepy London Stock Exchange was a natural target. The late 1970s saw a growth in analyst research and investor aggression in the United Kingdom. The IR society was formed in 1980 in the middle of this turmoil, following the growth of IR. The investor relations officer (IRO) quickly became a key executive at many listed firms, tasked with managing this new relationship with analysts and investors. The 1980s saw the aggressive “shake-out” of many British industries who were rapidly exposed to foreign competitors following the ending of the formerly rigorous exchange controls in 1979. Analysts who were CFA or MBA trained brought a new language learned in U.S. business schools. Many British firms had been carefully managed with employee consent, because of the sensitive industrial relations atmosphere in the United Kingdom. U.S. analysts and investors were intolerant of trade unions and evolutionary change. They rapidly assessed corporate strategy, managerial talent, and market position. CEOs and CFOs were forced to learn this language quickly, and IROs were tasked with developing these corporate stories, writing the management “commentary” that became a required part of annual reports, and meeting with analysts to provide them with the background knowledge about the business that they needed to write their reports. Analyst reports now became a key weapon in the competition between investment banks for clients and trading commissions. Reports became more frequent and more aggressive. Analysts needed to change their story on a company several times a year to generate new waves of transactions, and so analysts became more journalistic in their search for “angles” and “stories” and more prone to hyperbole. Analysts began to draw on a wider range of data to create their stories and pressed management for more disclosure.
Business model complexity grew in the 1980s for a number of reasons. More managers and analysts were receiving business school training with the growth of the MBA and “Executive MBA” and the growing demand for financial qualifications, ACA and CFA being preferred. Managers were now able to implement the latest thinking, and the spread of ideas was facilitated by the growth in international business publishing. Asian, European, and American business ideas now found easy acceptance (encouraged by the increasingly international market for top executive talent). Peters and Waterman (1982) started a new trend, a business book that preached universal principles, had a research foundation, and used popular language. Airport lounge bookstores now become libraries disseminating business knowledge that could be digested within a two-hour plane trip. “Business models” became increasingly relevant to corporate success, with consultants offering corporate redesign involving contracting out, divisionalization, and downsizing. All business functions were now expected to offer flexibility, efficiency, strategic contribution and measurable value. Distribution became “logistics,” and HRM became “strategic HRM,” as departments competed for professional status and a seat at the board table. The increasing complexity of business meant that analysts and investors spent more time analyzing firms and analyst reports became more like consultancy reports. IROs had to learn the latest concepts in strategy and management since analysts would compare firms against each other and highlight any firms that weren’t adopting the latest thinking.
“Voluntary disclosure” became an important part of competing for capital in the 1970s and 1980s due to the growth of “intangible” value, the emergence of greater business model diversity, and the declining usefulness of financial statements for investment decision-making (Lev and Zarowin, 1999). This extra information imposed a double burden on firms; the information had to be not only collected and reported but analysts often required talking through the information by the firm, since much of the new disclosure was technical and industry specific. Since the 1970s, it has been commonplace to note the growing limitation of accounting information in firm valuation, due to the increasing importance of nonfinancial assets (Gazdar, 2007) such as reputation and human resources which explain the difference between book value and market value. The most extreme examples include firms like Apple, Microsoft, and Coca-Cola, whose verifiable assets may represent less than 10 percent of the market value of the firm. This leaves accountants struggling to account for the value of the firm, and other methods of evaluation have evolved to plug the gap between book value and market value.
Finally, growing pressure from regulators, including increased regulation of corporate decision-making after the creation of the Financial Reporting Council (FRC) in 1990 and the publication of the Cadbury Report in 1992, started the industry of “corporate governance” analysis. One of the most effective changes effected by regulators has been the crackdown on “creative accounting” techniques developed by corporations in the 1980s. Creative accounting has two aims: the inflation of profits, for short-term share price improvement, which must generally end in disaster, and the leveling of profits, known as “income smoothing,” which is a way of making financial results less erratic then they would usually be to satisfy the market’s unreasonable demand for ever increasing profits. Revenue and profit are given special status by the market as indicators of corporate well-being, far beyond their actual ability to represent this. Analysts and investors have unrealistic expectations about the predictability and stability of profit. Even small falls in profit for a period can result in a severe stock price penalty, since profit is used as a signal of corporate health. Because corporate executives are aware of the market’s focus on profit and revenue, they go to great lengths to protect these figures from deterioration, involving complex accounting and budgeting procedures, the reclassification of assets and activities, and transfers between different corporate entities. Abraham J. Brilof, professor of accounting at the City University of New York, was an early critic of creative accounting and inept auditing, writing articles since the late 1960s, and publishing an influential book, Unaccountable Accounting, in 1972, and four years later publishing The Truth About Corporate Accounting. Much of what Brilof urged was finally accomplished in SOX. Terry Smith’s famous book published in 1992 revealed the extent of the abuse of accounting standards, and initiated a response by the United Kingdom’s FRC to make standards less flexible, as well as making analysts and investors more careful when reading financial statements. Since the scope for creative accounting began to reduce, the other way of managing expectations—“guidance”—became more important. The art of guidance is one of the key skills of the IRO, and so IR grows in importance as creative accounting has become more restricted, as accounting standards have become more precise, as investors have grown less tolerant of it, and as prosecuting authorities have become more vigorous. The growth of regulation alongside increasing penalties (both fines and stock price effects) for misconduct meant that a specialist compliance resource was needed, and IR took on this role.
This brief history has shown how modern IR is the product of a long period of development. Two things seem clear: first, that IR is here to stay, but, second, that IR will keep evolving as the two disciplines that it relies on evolve—the practice of investment and the practice of corporate management. It is essential that IROs who desire long careers keep closely in touch with both of these constantly developing fields.