Role of institutional investors in Corporate Governance

An institutional investor is a legal entity that accumulates the funds of numerous investors (which may be private investors or other legal entities) to invest in various financial instruments and profit from the process. In other words, an institutional investor is an organization that invests on behalf of its members.

Types of Institutional Investors

There are several types of institutional investors, such as:

  • Banks
  • Credit unions
  • Pension funds
  • Insurance companies
  • Hedge funds
  • Venture capital funds
  • Mutual funds
  • Real estate investment trusts

At the heart of the issue about institutional investors and corporate governance is the fact that there is something called an agency problem that creeps up with professionally managed organizations. What this agency problem indicates is that managers have conflicting responsibilities to themselves and the organization and in most cases; they seek to promote their interests at the expense of the organization’s interest. The point here is that managers by nature seek to maximize their benefits in relation to the profits and hence there is a need for counterbalancing this with other forces.

These forces or the countervailing balance is brought about by the institutional investors who have an interest in promoting the longer term health of the company. By actively pursuing the boards of organizations to follow effective corporate governance, institutional investors would ensure that the corporates put the longer term interests of the organization as well as ensure that organizations put shareholder interest over the interests of the managers. The point here is that institutional investors often represent large chunks of shareholders and hence they can be an effective check to the tendency of the managerial class to put their own interests first. The other aspect relates to the way in which they can monitor the health of the organization because they have the necessary expertise and knowledge in running organizations since they sit on the boards of other companies as well.

The third aspect of institutional investors is that they are more effective than minority shareholders or small shareholders. In most annual general meetings, we can see small investors raise questions related to corporate governance. In some cases, these concerns are addressed whereas in most cases, the small shareholders despite voicing objections are overruled because they do not have the numbers. This is where institutional investors come into the picture since they represent humungous numbers of shareholders and hence have the bargaining power needed to make a difference. Of course, the flipside to this is that institutional investors do not usually pursue radical changes and instead focus on maintaining the financial and operational efficiencies of the organization and promoting good corporate governance.

Finally, institutional investors can be a rock of stability in turbulent times as was evident during the recent crisis over Coal India. This case where the PSU was trying to override many objections of the shareholders was thwarted in its attempts because of the activism of the institutional investors. Further, in the case of Vedanta, institutional investors made sure that the company followed social and environmental norms and did not ride roughshod over its obligations to society and the government.

The Combined Code (2003) principles of good governance state the following concerning institutional shareholders:

(1) Institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives;

(2) When evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional investors should give due weight to all relevant factors drawn to their attention;

(3) Institutional shareholders have a responsibility to make considered use of their votes

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