Big shareholders call the shots again as the City's old go-to guys go nowhere fast

Public equity is asserting itself against private equity and the waning power of banks. Executives should be afraid, finds Richard Northedge
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The Independent Online

In the jungle of the City, there is a new king. The big beasts of the banking world are wounded and the equity fund managers are now reasserting their power.

It was share owners who killed the bid for British Energy. It was equity investors who rescued Bradford & Bingley. And it is shareholders who are gearing up to impose corporate governance standards on business – not least on boardroom pay.

The banks have lost their clout in the investment world. Now shareholders are again setting the agenda and, having won the banks' crown, the equity fund managers are preparing for their biggest prize: demanding change at their former rivals for power.

Even though markets have fallen, equity funds are less battered than the banks. As Peter Montagnon, head of investment affairs at the Association of British Insurers (ABI), says: "Equity holders have the money."

The banks' power has weakened as their balance sheets have crumbled. This month the big five UK banks have reported a fall in half-year pre-tax profits totalling more than £11bn, with Royal Bank of Scotland plunging £691m into the red. They have had to raise over £20bn of new capital due to their bad lending.

By contrast, life insurers are prospering, with Standard Life lifting its six-month profits by 51 per cent last week and raising its dividend when many banks are cutting.

When shares last plunged six years ago, life firms, the country's biggest equity investors, were forced by regulators to sell shares at the bottom of the market to lower their risk. It left them weakened while the banks were launching the lending boom that made them the kings of the City. And using bank borrowing, highly geared private equity funds could outpace conventional shares.

But with that funding now turned off, public equity is asserting itself against private equity. Holders of shares in quoted groups are again calling the shots – as was demonstrated when fund managers at Invesco and Prudential vetoed the £12bn bid by French utility group EDF for British Energy. The banks and the Government rescued the power company in 2002 at the expense of equity holders; this time the boot was on the other foot.

Investors are now preparing to exploit their strength by demanding higher corporate governance standards from the companies in which they hold shares. Mark Burgess, head of equities at Legal & General, whose £300bn of assets makes it the UK's largest FTSE 100 investor, recently led the opposition to Marks & Spencer's decision to make chief executive Sir Stuart Rose chairman as well.

"We were right to question that appointment," says Mr Burgess. He points out that with M&S's sales falling, it needs a full-time chief executive.

As a growing number of companies report falling profits and sales amid the economic slowdown, institutional shareholders believe boardroom practices must be improved. One issue high on the agenda is pay. Companies are being told that the high rewards tolerated when profits were rising are unacceptable if returns fall. Bonus schemes, in particular, are being monitored and directors can expect opposition to their remuneration reports if the big shareholders think them undeserved.

Institutions are also prepared to fight against cuts in dividends. "We do not want to see directors paying themselves more while paying shareholders less," warns one fund manager.

There is a concern that companies are using falling share prices to justify dividend reductions. "It means that besides losing our capital, we lose our income," the manager adds. "Dividends are supposed to smooth out the business cycle and companies should think carefully of the consequences before cutting."

At Legal & General, Mr Burgess says: "The recent difficulties faced by large established UK businesses have served to undermine shareholder confidence. People have begun asking, who is ultimately responsible for administering sound corporate governance? And have they been asleep on the job?"

Mr Montagnon at the ABI emphasises the power of equity investors, stating: "It's important institutional shareholders are part of the solution. They have the money and the long-term interest and they have the rights.

"Equity holders are the ones with votes. Bond holders have an interest in getting their money back but they don't have the levers."

But if equity investors are preparing to exert their power over business in general, they see the banks as a prime target and blame them for the trouble in the markets and the economy.

They point out with satisfaction that City institutions and foreign funds provided the banks with essential new capital through rights issues or other share sales. And there is special glee at their role in refinancing Bradford & Bingley. The ABI and the funds it represents protested vigorously when the private equity fund TPG was invited to buy 23 per cent of the mortgage bank without the shares being offered to existing investors. Yet when TPG withdrew, traditional investors such as Standard Life, Prudential and Legal & General immediately stepped in at the request of regulators.

Equity investors point out that in the last banking crisis, the big banks launched lifeboats to save the small funds; this time it is the funds that are launching the boats to save the banks.

There is still concern, though, about what happened to Northern Rock – and what may happen in future when banks hit trouble. The ABI protested last week at the Government's conversion into ordinary equity of £400m of preference shares, pushing holders' claims to the back of the creditors' queue. And there is now concern at the proposed new Bank of England powers for dealing with other banks facing problems. The ABI is worried existing shareholders will lose the pre-emption rights that ensure they are offered new shares first.

Mr Montagnon says: "The equity holders have to be part of the solution, not part of the problem, and they will be more likely to do it if their rights of pre-emption are preserved."

Shares in the big banks have halved in the past year, leaving fund managers nursing large losses. Yet, as Mr Burgess points out, the only senior UK banker to leave has been Steve Crawshaw, the Bradford & Bingley chief executive who resigned due to a heart condition.

By contrast, he adds, the heads of American banks including Citigroup and Merrill Lynch, plus several senior Swiss bankers, have been replaced.

Privately, City institutions accept that demanding heads roll could make bad situations worse by leaving banks leaderless.

But they are clear that senior executives must pay the price for their part in the current crisis – through their pay packets or their positions.

After so long dancing to the banks' tune, equity investors are enjoying their moment of power and intend to claim their prize.

How the funds have flexed their muscles

City fund managers prefer to impose their influence out of sight, not least as drawing attention to a company's lapses in corporate governance risks damaging their own investment. But they are increasingly using the sanction of voting against decisions they don't like.

Their most famous move remains the rejection of the remuneration report at GlaxoSmith-Kline five years ago, when the drugs giant devised a scheme under which then chief executive Jean-Pierre Garnier (pictured) could receive £22m if he left. Yet it was a narrow victory, just 51 per cent, and still left the company free to make the payment.

Two years later, when BSkyB proposed a share buyback scheme that could have lifted News Corporation's stake to 39 per cent, opponents lost by a similarly tight margin.

And last month's opposition to Marks & Spencer chief Sir Stuart Rose becoming chairman mustered less than 25 per cent support. Yet the publicity ensured the City view was known and may act as a warning to other companies.

Cable & Wireless had to endure similar publicity over its plan to remove the cap on its generous bonus scheme and pay its chairman £11m.

Behind-the-scenes discussion ensured Sainsbury's dropped its plan to make Sir Ian Prosser chairman and helped remove Michael Green from Carlton and Sir Philip Watts from Shell.

But the management changes likely to follow a period of falling profits are a concern to investors worried about extravagant payoffs. Institutions say they are prepared to fight rewards for failure.

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