Hermes Equity Ownership Services Limited 1 Portsoken Street London E1 8HZ United Kingdom Tel: +44 (0)20 7702 0888 Fax: +44 (0)20 7702 9452 www.hermes.co.uk EU Interest Representative Register ID number: 727725510117-60 June 25 2013 Dear Sir/Madam, Green Paper on Long-term Financing of the European Economy We welcome the opportunity to comment on the European Commission s Green Paper on Long-term Financing of the European Economy. This paper covers a wide range of highly important issues and we believe that the Commission s attention to these is extremely welcome. By way of background, Hermes is a leading asset manager in the City of London. As part of our Equity Ownership Service (Hermes EOS), we also respond to consultations on behalf of many clients from around Europe and the world, which are collectively responsible at least in part for the long-term financial wellbeing of millions of beneficiaries in the EU. Among these clients are PNO Media (Netherlands), VicSuper of Australia, Canada s Public Sector Pension Investment Board, the National Pension Reserve Fund of Ireland and the UK s Lothian Pension Fund, British Coal Staff Superannuation Scheme and Mineworkers Pension Scheme (only those clients which have expressly given their support to this response are listed here). In all, EOS advises clients with regard to assets worth a total of over 149 billion (as at March 31 2013). Most of our clients, in common with much of the institutional investment community, do not have fixed allocations to particular regions, including Europe. They seek the best risk-adjusted returns available around the world. This means that there is an opportunity for Europe: by making its investment markets more attractive for longterm capital and by making it more straightforward to make long-term investments in the real European economy, Europe can and will attract more of the patient capital that it needs. As we discuss in response to the individual questions below, we believe that there are a number of steps which Europe can make to enhance its regulatory system so that it makes this greater long-term investment more likely. Among these are: regulatory regimes shifting to reflect the long-term nature of institutions' liabilities, enabling them to look through short-term volatilities in asset values; regulation of pension schemes and other long term investors needs to value investment risk appropriately and proportionally; asset owners being empowered and encouraged to assert their status in the investment chain and ensure that their agents act more fully in their interests, Hermes Equity Ownership Services Limited: Registered office: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. Registered in England No. 5167179.
delivering investment with appropriate attention to the time-horizons of beneficiaries and relevant long-term risks; clarity that fiduciary duty applies to all participants in the investment chain, and cannot be excluded through contractual means, and that fiduciary duty encompasses issues which are about long-term value, not just short-term returns; that there should be less scope for frictional costs to limit the returns enjoyed by asset owners over the life of long-term investments; that new models of investment mandate are introduced and encouraged which press fund managers to adopt their clients and beneficiaries long-term perspectives and see risk and returns through their eyes; among other things, this may require that there are investment vehicles available which facilitate unlevered direct access to the underlying cashflows from infrastructure and other long-term investments; and that asset owners are enabled and facilitated to combine with other institutions whether by way of an overall consolidation or through collaboration in particular vehicles or through the offices of advisers or other parties. We answer relevant individual specific questions below. Yours sincerely, Paul Lee Director
Question 1. Do you agree with the analysis out above regarding the supply and characteristics of long-term financing? Question 2. Do you have a view on the most appropriate definition of long-term financing? We agree that the analysis is an appropriate high-level overview of the nature of long-term financing. We have no definition to provide, but would note that long term is generally understood to be a period in excess of an economic cycle. We tend to view it as 10 to 30 years and of similar length to a pension scheme s liabilities. In infrastructure, most assets have a life expectancy in excess of 20 years and most government concessions and subsidy regimes are between 20-30 years. Properly structured infrastructure investment opportunities with inflation linkage are therefore in theory a good match for pension scheme liabilities. Question 3. Given the evolving nature of the banking sector, going forward, what role do you see for banks in the channelling of financing to long-term investments? The paper rightly makes a clear distinction between investment in the productive economy and investments in the financial sector, with the former having much more positive effects for economic growth and job creation. It could also be noted that the latter carries much more systemic risk. It is striking therefore, that as noted by Andrew Haldane of the Bank of England in a recent speech (Constraining Discretion in Bank Regulation, see http://www.bankofengland.co.uk/publications/documents/speeches/2013/speech6 57.pdf, particularly chart 7), bank risk weightings for investments in the productive economy are markedly higher than those for lending to other financial institutions in the case of SMEs, four times higher meaning that there is a significant disincentive for banks to lend to the productive and growthstimulating elements of the economy. In order for banks fully to play their role in long-term investment for the benefit of growth this disincentive would need to be dismantled or addressed in some way. Even if this disincentive is addressed, banks are unlikely to make significant long-term investments of this nature, given their unwillingness to hold significant levels of assets on their balance sheets for prolonged periods, and therefore we agree with the analysis that the EU should be focusing its attention on other providers of capital in supporting a diversity of finance sources, and reducing the current dependence on bank financing. Investment banks may have a significant role to play in the short term provision of riskier capital such as the provision of funds for construction but the refinancing risk at the end of construction needs to be reduced or eliminated for them to play this role. Question 4. How could the role of national and multilateral development banks best support the financing of long-term investment? Is there scope for greater coordination between these banks in the pursuit of EU policy goals? How could financial instruments under the EU budget better support the financing of longterm investment in sustainable growth? State aid rules
We believe that there is a significant role for national and multilateral development banks in helping to foster the conditions for long-term investment. In particular, development banks can help provide support and mitigate some of the risks associated with long-term investments, making it more likely that genuinely long-term investment can be unlocked. One significant hindrance to development banks playing this role, however, has been the application of state aid rules; we firmly believe that the application of state aid limitations to development banks must be reconsidered if they are to be able properly to fulfil their valuable role in long-term investment. State aid rules allow the guarantee of fixed return bank debt but not the underpinning of minimum returns to long term equity investments (which by definition have variable returns). Breadth of activity We believe that the role of development banks needs to be broader than the current focus, which in the case of some of these banks seems to be principally on the area of project bonds. Rather, we believe that development banks can play significant risk mitigation roles and, perhaps more importantly, foster new infrastructure investment models which will make long-term investment markedly more attractive for institutional investors. The current typical infrastructure investment vehicle follows the model of the private equity industry, and is therefore highly leveraged and applies a shorter term structure (the standard is 8- to 15- year holding periods) with fee structures favouring the investment team rather than the capital provider; development banks can play a role in assisting the underlying investors to develop an infrastructure investment model which matches their interests more fully, by allowing less levered access directly to the assets in question. Market information, transparency and due diligence A further potential role that the development banks can play is the provision of independent information on the risk and returns of assets and projects for potential investors who may not have the resources to research new assets such as low carbon energy generation. The market is also very untransparent due to the competition for assets during bid processes; again the development banks could assist in improving the transparency of the risks and returns of existing projects though providing case studies and the like. Question 5. Are there other public policy tools and frameworks that can support the financing of long-term investment? Too many European countries have amended, in some cases retrospectively, the support that they have provided to new infrastructure in the form of renewable energy generation. This has been significant detrimental for investor confidence in making long-term investments in this sector and more broadly. EU and national public policy measures to support long-term investment, which are welcome, must be stable, reliable and affordable for the national finance ministry over the long term, and in particular there should be no scope for retrospective changes. In the absence of this confidence being in place, long-term investment will remain too risky to be attractive.
Question 6. To what extent and how can institutional investors play a greater role in the changing landscape of long-term financing? Institutional investors are willing and indeed keen to make long-term investments which more fully reflect the time-horizons of their beneficiaries and so match the duration of their liabilities. They will be able to do so most effectively if: regulatory regimes reflect the long-term nature of their liabilities and so enable them to look through short-term volatilities in asset values; regulation of pension schemes and other long term investors needs to value investment risk appropriately and proportionally; asset owners are empowered and encouraged to assert their status in the investment chain and ensure that their agents act more fully in their interests, delivering investment with appropriate attention to the timehorizons of beneficiaries and long-term risks; there is an understanding that fiduciary duty applies to all participants in the investment chain, and cannot be excluded through contractual means, and that fiduciary duty encompasses issues which are about long-term value, not just short-term returns; there is less scope for frictional costs to limit the returns enjoyed by asset owners over the life of long-term investments; new models of investment mandate are introduced and encouraged which press fund managers to adopt their clients and beneficiaries long-term perspectives and see risk and returns through their eyes; there are investment vehicles available which facilitate unlevered direct access to the underlying cashflows from infrastructure and other longterm investments; and asset owners are enabled and facilitated to combine with other institutions whether by way of an overall consolidation or through collaboration in particular vehicles or through the offices of advisers or other parties. The UK s Kay Review rightly identified issues with the domination of the investment chain by intermediaries, rather than by the beneficial owners such as pension funds. This arises in large part in our view because the beneficial owners in many markets are dispersed and so lack internal capacity to play their full role in making sure that the system works in their interest. In those markets where pension funds have more scale and so have been able to build internal capacity notably Australia, Canada and the Netherlands they have built more influence over the investment chain and so have been able to make more direct investments, or require the creation of structures which suit their time-horizons, leading in many cases to more long-term investments. We would welcome the Commission directing further attention to this issue.
Question 7. How can prudential objectives and the desire to support long-term financing best be balanced in the design and implementation of the respective prudential rules for insurers, reinsurers and pension funds, such as IORPs? We are concerned that the balance between the two aims of prudential rules and encouraging long-term investment has swung too dramatically in the direction of prudential rules. Insurance companies and pension funds, which did not cause the financial crisis, are being much more aggressively regulated since the crisis, with prudence being the main aim. What's worse, the impact of this swing of the pendulum towards prudence, and a focus on the need for short-term liquidity is in fact more negative for financial stability because life insurers and pension funds as long-term investors could, in the absence of prudential rules pressing them into more liquid, minimal risk portfolios, invest counter-cyclically and be a counterbalance to short-term market volatilities. In contrast, recent prudential rules encouraging short-term liquidity mean that long-term investors cannot act in a long-term, counter-cyclical way. This is significantly detrimental for long-term investment and also for the stability of the markets. Here we are referring particularly to the Solvency II regulations and the possibility of their reflection into similar standards for pension funds in the revision of the IORP Directive. We are encouraged by the recent statement by the European Commission that this Autumn s review of the directive will no longer cover the solvency of occupational pension schemes, and welcome this intention being carried forward in practice. We are firmly of the view that long-term investors need to be free to invest in a long-term way and those who face no likelihood of needing to liquidate assets over the short term should not be compelled to hold excessively liquid portfolios. It is clear to us that Solvency II has forced European insurers into highly liquid, high credit-rated particularly bond market portfolios, helping to reduce financial stability by increasing the bubble in that asset class, and forced them away from equities and longer-term investments. It would be significantly detrimental for the European economy as a whole and in particular its growth prospects were pension funds to be compelled in a similar direction in the future. It would clearly and unhelpfully reduce the funds available for long-term investment into illiquid assets such as the infrastructure investments (including into green infrastructure) which will help Europe grow out of its current problems. In addition, we note that equity investment, and not least private equity investments, are needed to fuel the growth of smaller and mid-sized companies in Europe, and argue that, again, prudential rules should not militate against such investment. Additionally, we note that the regulations in relation to derivatives clearing (EMIR), despite the short-term pension scheme exemption, are likely to force pension schemes and other long-term investors to reduce the amounts they invest in the real economy to enable the significant holdings of cash needed to facilitate the provision of cash margining to derivative counterparties and clearing exchanges. Question 8. What are the barriers to creating pooled investment vehicles? Could platforms be developed at the EU level? Barriers to longer-term investment include the fragmentation of Europe's pension schemes and the domination of the investment industry by intermediaries.
Enabling pension schemes to collectivise and collaborate - or even to consolidate fully - would be important steps to ensuring that the investment industry begins to work in the interests of the underlying beneficiaries, and also in the interests of the companies and economies in which they invest as well as potentially reduce the costs of investment. This should also help ensure that fiduciary duty is applied appropriately across the investment industry, ensuring that beneficiaries' longterm interests are kept paramount. We would particularly welcome consideration being given to the application of fiduciary duty and governance standards to pooled investment vehicles. Such vehicles need to be fully accountable to those who provide the capital which they invest, and should face obligations of full transparency about the nature of their investments, their investment processes and ongoing performance, including attribution of that performance. Their governance structures should be independent and responsive to the needs of underlying investors. Where possible, the shareholder rights attached to investments by these vehicles should be exercisable by the underlying investors; at least there should be scope for these investors to influence how those shareholder rights are exercised. It is also important that fiduciary obligations apply to all defined contribution pension offerings, whether these employ trustee-type structures or whether they are contractually based. Ideally, even contractual defined contribution schemes would have individuals who act as trustees and fiduciaries on behalf of the individual beneficiaries. This should help ensure appropriate accountability of such structures to their beneficiaries. While on the topic of defined contribution structures, it is worth noting in particular that for some DC schemes - those that face daily or otherwise regular liquidity calculations - the use of pooled vehicles is necessary to enable access to illiquid investments. We would welcome the European Commission giving greater thought to ways in which it might assist the collectivisation, collaboration or consolidation of pension funds. Question 9. What other options and instruments could be considered to enhance the capacity of banks and institutional investors to channel long-term finance? We believe that the creation of specific government-backed investment banks can be an important catalyst to facilitating more long-term investment by asset owners. Notably, the European Investment Bank and the UK's Green Investment Bank have started to facilitate ways to channel more investment into long-term infrastructure, including low carbon infrastructure. Their role in helping bring parties together, in changing the risk characteristics of particular investments, and in taking on the construction phase of investments so that the private sector can buy the assets once constructed, are important mechanisms for enabling the longterm investment which the European economy needs. We would note that some of these organisations have found their powers trimmed by state aid regulations which have applied a mechanical test which has led to these investment banks being less able to support such long-term investment. We believe that this is highly unfortunate and would request that the Commission
reconsiders the application of state aid rules to such bodies, considers at least a short-term exemption until growth recovers but preferably a more wide-ranging amendment to state aid laws. In the absence of a change in approach in this regard, the simple fact is that there will be less investment of the sort which the Commission is seeking through this Green Paper and of the sort which the European economy needs. Additionally, while we are aware that the carbon price was not designed as a mechanism to encourage investment into low carbon, its currently artificially low price is a clear reason why investment in low carbon projects has recently stalled. Question 10. Are there any cumulative impacts of current and planned prudential reforms on the level and cyclicality of aggregate long-term investment and how significant are they? How could any impact be best addressed? Please see our comments in response to Question 7 on the detrimental impacts of the excessive current stress on prudential standards. We firmly believe that the pendulum has swung too far in favour of prudential rules and too far away from encouraging long-term investment, and we would strongly encourage the Commission to shift the balance back to a more appropriate level. Specifically, the cumulative effects of the IORP directive review, EMIR and derivatives clearing and the forthcoming Financial Transactions Tax are all pushing institutional investors in different directions with significant unintended impacts for pension schemes. We would also note that the coincidence of moves on prudential regulation regarding the insurance, banking and pensions industries means that all elements of Europe s financial system are being herded into the same forms of investment approach and the same conservative mindset at the same time. This risks creating systemic risk, bubble pricing (most notably in bonds, particularly sovereign bonds) and reducing the resilience of the system to shocks. Question 12. How can capital markets help fill the equity gap in Europe? What should change in the way market-based intermediation operates to ensure that the financing can better flow to long-term investments, better support the financing of long-term investment in economically-, socially- and environmentally-sustainable growth and ensuring adequate protection for investors and consumers? We believe that the equity gap is perceived to exist due to the continued existence of excessive leverage in financial structures. This leverage, fed by historic cheap bank debt and driven by tax optimisation, has led to equity being excessively risky without the necessary certainty of high returns and often with the inflation linkages hedged out. We believe that more investors would be attracted if the regulatory regimes could foster changes to the financial structuring of long term assets and infrastructure to reduce the risks. Additionally, our experience is that equity investing through low-leveraged equity rather than debt often leads to better governance at the investee company due to the fact that a significant minority stake will generally come with shareholder agreements and/or a seat on the board or other forms of shareholder rights and influence.
Our view is that the regulatory framework for the markets and the structure of those markets has increasingly moved to favour liquidity and trading activity over long-term ownership. We also believe that the negotiating power of the different parties in the investment chain is such that in general asset owners are takers of both prices and terms, and fund managers and other agents are givers of both prices and terms ('terms' here including fees, governance and transparency). While larger schemes can often negotiate better terms than those available to others, even they need to weigh up their various aims in any negotiation, and the starting point for discussions is the terms of trade typically set by the fund management industry. There is a particular problem with the dominance of fund managers over asset owners: the application of fiduciary duty to fund managers is not clear and poorly understood. While on the face of it, fund managers are burdened with fiduciary duties through the simple fact that they are looking after money on behalf of others, not all accept this analysis, and in many ways the fiduciary duties are crowded out or limited by the specific terms of the contractual relationship between the parties. In a sense, this means that fund managers are able to contract out of fiduciary duty. We believe that the application of fiduciary duty to fund managers needs to be made much clearer and the implications of that application also need to be made clear. We note that it would be helpful also to have greater understanding of the nature of fiduciary duty. Many currently have a narrow understanding, indicating that pension fund trustees and their fund managers are obliged to think only of shortterm financial impacts and are not permitted to look beyond to longer-term notyet-financial factors. We do not believe that this narrow understanding appropriately reflects the interests and time-horizons of the underlying clients and beneficiaries and so cannot be a full understanding of fiduciary duty. Clarifying fiduciary duty so as to ensure its clear application to all parties in the investment chain and such that it is understood as a broader form of enlightened shareholding are important and necessary steps forward. Question 16. What type of CIT reforms could improve investment conditions by removing distortions between debt and equity? One simple, if limited, way to reduce the advantage enjoyed by debt financing would be to remove the approach which allows the expenses of raising debt finance to be tax deductible while the costs of raising equity are not. We believe that both expenses should be deductible. While this would be only a small step with limited immediate benefits, we believe that it would send an important signal. A broader and more ambitious approach would be to consider actively thin capitalisation rules, which have been applied for many years in some but not all European countries. Essentially the approach would be that interest payments on debt burdens over a specified level - perhaps 4x EBITDA - would no longer be tax deductible. This would set an effective ceiling on the tax benefits of debt, and encourage much less levered companies which would be more likely to be
sustainable through the business cycle. If this thin capitalisation rule were associated with an increase in capital allowances, it should shift the focus of corporate investment without adding to the overall tax burden and so risking a reduction in the competitiveness of the European economy. We would welcome this approach being applied in, among other places, the infrastructure market, where at present those seeking to make unlevered investments that allow direct access to the cashflows are all too often outbid by those willing to leverage the assets and remove the profits from the tax regime. We do not believe that this model is best suited to incentivising long-term and growing investment in infrastructure. Question 20. To what extent do you consider that the use of fair value accounting principles has led to short-termism in investor behaviour? What alternatives or other ways to compensate for such effects could be suggested? We do not believe that fair value accounting - not least given the limited extent to which it has been applied - has had a significant impact on the appetite of investors to invest for the long term. Rather, the current form of accounting has helped companies acknowledge the scale of their exposures to pension scheme liabilities and the need to address any deficits. In this sense, it has been helpful in increasing the long-term viability of pension funds by ensuring that their funding levels are much more sustainable, enabling them to invest in a more long-term fashion. Where mark-to-market accounting does give rise to problems is the way in which some regulators have tended to respond too eagerly to the volatile information which these disclosures provide. We are concerned that there is a risk that some ESAs such as EIOPA may be considering extending the uses to which such volatile and short-term numbers are put; we believe that wise regulators are willing to look through these volatilities and take the longer-term view which long-term investment institutions require. Question 21. What kind of incentives could help promote better long-term shareholder engagement? We do not believe that there is a need to incentivise shareholder engagement: it is clear to us that the benefits of the activity significantly outweigh the costs, even where the bulk of the benefit is enjoyed by parties that free-ride on the activities of a few though we do note that the introduction of Stewardship Codes and their equivalents in a number of European markets have encouraged institutional investors to take the issue of engagement more seriously. We would welcome the European Commission giving consideration to how such codes might be encouraged and created in other markets across Europe. Stewardship codes have proved an effective way to make comply or explain or apply or explain work most effectively, by ensuring that shareholders play a more effective role in listening to explanations and debating whether they are sufficient to address any perceived deficiencies. We are convinced that the downsides of loyalty incentives for long-term shareholders (such as enhanced voting rights or dividends) exceed their benefits
they breach the principle of equal treatment of shareholders and also risk entrenching vested interests. There is absolutely no certainty that loyalty rewards would in practice lead to more shareholder engagement. We note that loyalty incentives in effect discriminate against institutional investors because the length of the chain of ownership for institutions is long and because the duty of institutional investors actively to consider whether their service providers continue to provide quality services at an appropriate price regularly leads to changes in their various intermediaries. This means it will be rare even for the most consistently invested institution to appear as a long-term shareholder when viewed from the company s perspective through the lengthy investment chain, so institutions are much less likely to qualify as loyal investors. The investment consultant Mercer recently carried out a survey on the issue of loyalty rewards and the firm conclusion of the institutional investors who participated in the study from our experience of the process those participants were disproportionately from those likely to invest over the long term and so who might be imagined to be more supportive of loyalty rewards than the market as a whole was opposition to loyalty shares. There seemed firm agreement that the problem lies elsewhere and needs to be addressed in other ways. The principal alternative route to addressing these was generally agreed to lie in the area of fund manager mandates, as discussed below. We believe that there should be clarification that the votes attached to shares held within pooled funds belong to the beneficial owners of those shares, which should therefore be enabled to exercise these rights. Our experience is that this is entirely possible in practice, and the only limitation is a lack of will among the fund management community. We would welcome the Commission considering whether there are barriers in this respect which it could remove. This move should be associated with steps to ensure that share registers are adapted to reflect the intent of the Shareholder Rights Directive that they reflect those often the beneficial owners which control the voting rights over shares, not just those with fund management responsibilities. Question 22. How can the mandates and incentives given to asset managers be developed to support long-term investment strategies and relationships? We believe that significant attention needs to be paid to the area of fund manager mandates and incentives as these provide important mechanisms for changing the time-horizon applied by investors to their activities, extending the mindset to more closely match the interests of their clients and beneficiaries. It was for this reason that we worked closely with the ICGN in developing its Model Mandate Initiative, which we commend to the Commission s attention. We would welcome the EU giving active consideration to whether and how it might support the ongoing debate regarding fund manager mandates, and we hope that the Model Mandate Initiative may make some contribution to this thinking. We would welcome the opportunity to discuss with you ways in which this might be effected.
Question 23. Is there a need to revisit the definition of fiduciary duty in the context of long-term financing? We would agree that a reconsideration of fiduciary duty is needed. We note that the UK's Law Commission has been charged with such a reassessment; we would welcome a similar process being launched at the European level. First, we have raised with other regulators the question of to whom the notion of fiduciary duty should be applied: the intermediaries in the investment chain may be more likely to act in the long-term interests of their underlying clients and beneficiaries if they feel very directly a fiduciary duty to act fully in their interests. Some intermediaries which on a simple understanding of the situation might be considered fiduciaries in effect exclude fiduciary duties by a highly detailed contractual agreement: it is for this reason that the Model Mandate Initiative proposes a specific clause through which fund managers might acknowledge that they owe fiduciary duties to their clients. Second, we believe that there would be value in a reconsideration of the breadth of obligations embedded within the concept of fiduciary duty. In particular, we note that in some markets and on some occasions the concept has been very narrowly understood to mean only the short-term narrow financial interests of beneficiaries. This has led some asset owners to hesitate over making investments which might be attractive and have longer-term financial benefits due to their low carbon characteristics, such as investments in renewable energy generation or with other climate change-associated characteristics, but which might be less attractive than alternatives in the short run. Thus we firmly believe that clarifying the breadth of the interests of beneficiaries which is encompassed by a proper understanding of the concept of fiduciary duty would be extremely helpful in facilitating greater long-term investment. Question 24. To what extent can increased integration of financial and nonfinancial information help provide a clearer overview of a company s long-term performance, and contribute to better investment decision-making? We are among those who believe that integrating not-yet financial information into the analysis of corporate performance is a necessary step to understanding fully the company s position. This was among our reasons for signing the UN Principles for Responsible Investment. We continue to make efforts to enhance our own approach in this regard, to work with fund managers to deliver this more effectively, and to work across the industry to develop best practices in this respect. Question 25. Is there a need to develop specific long-term benchmarks? We do not believe that specific benchmarks would assist. In common with many investors, we are increasingly moving away from the use of benchmarks, conscious of the negative behaviours which they can encourage. We believe that the industry as a whole needs to move towards a broader understanding of risk than simple deviation from a benchmark which too often is the principal risk tool applied by all investors and that therefore the creation of new benchmarks, even were it possible, would be of only limited value.