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There is no clear winner between a broad and a concentrated investor base, with benefits and drawbacks to both ownership models.
A concentrated ownership base has the obvious benefit of vested alignment of interests and keen eyes on the operations of a firm (but fewer of them), while a broader ownership base has more eyes on a firm (but not necessarily as keenly interested).
Ownership structures are not necessarily predetermined
We should take a moment to remember that ownership structures are not predetermined outcomes of some grand design, but rather the result of incidental historical paths.
Global financial systems have developed with each country’s unique history influencing its own particular structure.
Financial systems do not only vary among one another, but also within themselves over time as they are continuously evolving and adapting in response to economic tides, crises and regulatory changes – so governments, policymakers and central banks are also important role players.
These developments have also played an important role in determining the investor base structure variations between countries.
Consideration should be given to these and other factors that determine the development of financial systems.
Trust is a cornerstone of financial development
Trust goes hand-in-hand with the development of financial markets, and is one of the most valuable commodities in business and investing.
By extension, a governance framework that offers better protection to investors (fostering their trust) can reasonably be expected to lead to better functioning financial systems.
It is not surprising that the legal system of a country is an important factor behind the development of its financial system: countries with better developed financial systems tend to have a common law framework, which has shown to provide better investor protection.
Unfortunately trust can be broken even when all the checks and balances seem to be in place: the recent events surrounding Steinhoff highlighted how even the concentrated control structure of the company left many investors exposed, resulting in substantial losses.
Monitoring by financial intermediaries
Financial intermediaries such as banks, insurance firms and asset managers exist for reasons that are obvious to us all.
But they also fulfil an important role of monitoring in an economy.
Monitoring refers to the collection of information, both before a financial commitment (such as a loan) is given and also during the life of the transaction.
Monitoring can include either one or a combination of the following: screening investment projects, examining a counterparty’s outlook and creditworthiness, preventing opportunistic behaviour from borrowers, ensuring that they abide by the terms or covenants of the agreement, and enforcing contractual agreements.
Monitoring activities are more important when there is asymmetric information: when the borrower has private information which the lender is unable to observe.
Obtaining information brings with it benefits to the lender, for instance: improved loan contracts, lower risk of defaults, and increases in real savings or returns.
But monitoring also brings with it associated costs. This means that monitoring will only take place if the benefits outweigh the costs (i.e. C = Costs < S = Savings).
The higher concentration and importance of equity ownership by financial institutions in countries like Germany and Japan suggest that agency issues can be solved by the financial institutions who act as the outside monitors of the firms.
Who is monitoring those who monitor?
When the control of a firm is centred in the hands of a few (i.e. a concentrated control structure) then it could be a better way of monitoring a firm compared to an ownership structure that is spread widely among a large number of unconnected shareholders.
It has been suggested for decades that one of the best ways to maximise the value of firms is through concentrated ownership of a firm’s shares.
When there are very few shareholders in a firm, then there is a stronger incentive to closely monitor and maximise value.
But a concentrated control structure also has its shortcomings, some of which are more opaque.
For instance, when there is a close relationship between a funder and a firm then it could lead to a monopolistic situation where the funder uses information to extract excess profits from the firm – also referred to as ‘rents’.
If there isn’t a sufficient amount of public information available to other potential funders about a firm, it could be difficult for the firm to find alternative sources of finance.
The funder could then use its position of power as the only supplier of finance and charge higher interest rates than the firm would otherwise have been able to obtain elsewhere.
In extreme scenarios, funders could potentially even collude with a firm’s managers to limit the outside influence on the operations of a firm – not necessarily in the interest of the firm, nor minority stakeholders.
Conflicts of interest arise everywhere and should be managed appropriately.
The examples of collusion and excess profits are somewhat extreme scenarios – more relevant are the more recent examples which highlight the potential for financial losses, bank failures and inherent risks in financial systems.
The need for continuous improvement
Neither a highly concentrated nor a broad investor base can claim to be the optimal solution.
A diversified investor base is a good starting point, but it does not negate the necessity for continuous monitoring and improvement.
We need to learn from recent examples, incorporate these lessons into our frameworks and so improve future investment decisions.
*If you happen to find your way to New York, the author recommends going to a good comedy club off the beaten track.
Melville du Plessis is a portfolio manager in the fixed interest team at Sanlam Investment Management (SIM).
This article is part of our February 2018 Collective Insight supplement, which appeared in the 15 February edition of finweek. To download the entire supplement, click here. Buy and download the magazine here.
