What’s the difference between an underwriter and an undertaker?
According to a recent article in The Economist, Vexed in the City, not that much. Both operate in arcane and little-discussed areas. And since buying underwriting services from an investment bank for a corporate fund-raising (sometimes known as an equity “rights issue”) and organizing a funeral are both “distress purchases”, suppliers can charge pretty much what they like.
When a stock market-listed company needs a “rights issue”, it is usually because it needs additional funds to stave off collapse, fund a cherished acquisition or to see off some sort of crisis. The board are preoccupied. It’s a one-off, and not the sort of thing that board directors will do too often.
As a result, says The Economist, the board is usually happy to sign off on investment banking fees for such services, however exorbitant these are. Add their naiveté of the City of London (comparable, perhaps to the bereaved family’s knowledge of the "business of death") into the mix, and it’s easy to see why important things like looking after their fiduciary duty to shareholders gets forgotten. As the Economist article stated:
Britain’s executives, it seems, are all too easily seduced by the smooth patter, tailored suits and solicitous manners of their brokers…
Buyers are inexperienced, under pressure to act quickly, and have little time to consider terms. Discretion, competence and a talent for hand-holding are prized of underwriter and undertaker alike. Haggling over fees seems almost distasteful, especially for squeamish Brits who tend to pay what is asked and resent it later.
You may ask why all this is relevant. Well the thorny issue of rights issue fees has been creeping up the UK’s political and corporate agenda in recent months, not least because investment banks, benefiting from substantially reduced competition since the crisis, have been quietly bumping up the rights issue fees in recent years.
Pension funds (and other institutional investors) have also belatedly woken up to the fact they are paying over the odds for these fees, and at the same time recognizing that their role is supposed to be looking after the interests of end-user investors, not stuffing the pockets of investment bankers.
An organization representing institutional shareholders (the Institutional Investor Council) has become remarkably outspoken on the issue.
Launching a campaign to rein in rights issue fees in December, it produced a report outlining the problem and proposing solutions. Paraphrasing, the Rights Issue Fees Inquiry (RIFI) said UK listed companies were being fleeced, given that the risks against which they are insuring (of the rights issue flopping) are minimal or virtually non-existent risks.
Douglas Ferrans, ex-boss of asset management firm Insight Investments and chairman of the Rights Issue Fees Inquiry (RIFI), said:
“There’s a significant lack of clarity around fees and a complete lack of transparency… On average companies who have had rights issues have paid ten times more in fees than that which was paid to their executive team in total reward. …Companies and their shareholders are not getting a fair deal and that needs to change.”
The matter has also risen in prominence because competition watchdog the Office of Fair Trading (OFT) has investigated rights issue fees and, even though it claimed that there were sufficient providers in the market to ensure vigorous competition, the fees being charged were stubbornly high and this was mainly because of the failure of customer firms to drive a hard bargain with their bankers or to shop around.
The report found underwriting fees have soared since the financial crisis, “with the average fee for rights issues rising to more than 3% in 2009 from around 2%-2.5% in the period from 2003 to 2007”, and this is despite the fact rights issues are today much more heavily discounted, often by 30% as opposed to the pre-crisis norm of 15%, which means the risk being born by the underwriter has significantly diminished.
Ferrans said the way investment banks fudge their fees by bundling ongoing corporate-broking charges with one-off underwriting fees muddies the waters and makes it more likely that customers - and end user investors - get a raw deal. In an earlier blog post, I mentioned that Ferrans believes that "under the current system, conflicts of interest are tolerated and a disproportionate share of the spoils of capital investment is going in financial intermediation - a dangerous form of agency capitalism if you like."
Ferrans would prefer that fees for ongoing “corporate broking” services - which basically means sweet-talking investors about the company and its outlook - were treated as running costs and not rolled up in a one-off charge on shareholders. However as The Economist pointed out:
"The trouble is, the status quo suits both bankers and executives, who can enjoy the City’s attentions at little cost. Clarity on fees might lead to red faces all round."
In my view, it’s time for a few red faces in the City, as the status quo looks horribly like another form of “rent gouging” which is only made possible by inefficient markets, the acceptance by customer firms of conflicts of interest and coziness. The overall impression is one of incompetent and complacent corporate boards who are serially failing to look after shareholders’ interests - and I am glad that institutional investors are waking up to all this. Tackling the "business of death" is probably going to be an even more difficult undertaking!
Further reading on rights issue fees and ethics in the City of London:
- Investors shooting themselves in foot with acceptance of "golden hellos" by Ian Fraser [blog post]
- Having recognized role in crisis, fund managers put themselves on the couch by Ian Fraser [blog post]
- Equity Issues by Listed Companies: Rights Issues and Other Methods by Seth Armitage
- The Morals of Money - How to Build a Sustainable Economy and Financial Sector, by Roger Steare, viewpoint
Tags: equities , institutional investors , investment banking , rights issues , transparency