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Governance: Follow the leader

12 Aug 2019

How companies are directed and controlled makes governance, some would argue, more important than climate change when making investment decisions, but does its lack of prime-time appeal mean that it is being overlooked? Mark Dunne reports.

Corporate governance is not sexy. It does not make mainstream headlines in the way that climate change has in recent years.

Sir David Attenborough did not interrupt this year’s Glastonbury Festival to talk about how companies should improve the way they engage with their shareholders. Children did not leave classrooms sitting empty to march against the government’s failure to promote greater corporate transparency and protestors did not block roads in London to demand that there are more independent voices in company boardrooms.

Unlike climate change, governance is not fashionable. Yet how executives make decisions and execute a company’s strategic objectives are crucial to protecting investors. Governance has always been high up the agenda for institutional investors, it just doesn’t have hour-long television specials dedicated to it.

This, Daniel Peters, an investment partner at Aon, puts down to it being almost universally expected that governance will be assessed and reviewed by fund managers. “There is less focus on it because it is less debateable,” he adds.

Corporate governance is more of a mainstream discussion than the environmental and social pillars of ESG. It is also the only one of the three that is applicable to all companies and typically is the only one that companies can provide data on.

But asset owners need to remain vigilant. Just because governance has been part of furniture in investment analysis for decades does not mean it is always thoroughly carried out. The mishandling of personal data by tech giant Facebook and the emissions scandal at German car maker Volkswagen in recent years are examples of poor governance.

“It is important that it does not get missed in the ESG piece, because it is almost taken for granted that it has to happen,” Peters says. “If a fund manager is not exercising their voting rights it would generally be seen as unacceptable.”

If there is one word that Michael Herskovich, BNP Paribas Asset Management’s head of corporate governance, would use to summarise corporate governance it is “trust”. “If we do not trust the corporate governance it means that we do not trust management, so you shouldn’t invest in the company,” he says.

Indeed, risk management incidents related to accounting fraud or environmental catastrophes have frequented the news in recent years. Often those failures were due to inadequate corporate governance structures, says Carola van Lamoen, who leads asset manager Robeco’s engagement and voting activities.

Strong governance structures are crucial. Peters emphasises this point by referencing the growing body of research showing that high ESG standards could have a positive impact on a company’s financial performance.

David Czupryna, head of ESG client portfolio management at asset manager Candriam, uses two of the world’s largest companies as an example of why investors need to consider the structure of a company.

Mark Zuckerberg controls 51% of the voting shares in Facebook. It is a similar problem with Google. “At Google it is two people, at Facebook it is one person who controls the fate of the company and beyond that everything that the company does with our data,” he adds.

Czupryna likens these structures to new forms of “extractive monopiles akin to the oil barons of the early 20th century”.

THE BALANCE OF POWER

When Newton Investment Management assesses a company’s governance standards, it is looking to get a “flavour of the corporate culture”. “We want to understand what we are getting into as an investor,” says Ian Burger, the firm’s head of corporate and stewardship.

To achieve this, questions that need to be answered include where does the responsibility in a company sit? Who are the main influencers? What are the motivations and incentives for the board and senior management? Do those incentives fit with the company’s strategic objectives? Do they sit well with your investment objectives and expectations? Is there a good level of independence on the board? “It is about building a big picture, so that we are able to invest with our eyes wide open,” Burger says. For BNP Paribas’ Herskovich there is one core issue he must get to the bottom of when assessing a company. “The balance of power is something that we look at carefully between the three main bodies of corporate governance: shareholders, directors and management,” he explains.

It is about building a big picture to invest with our eyes wide open.

Ian Burger, Newton Investment Management

Understanding where the power lies is crucial as many people reading this will be taking minority stakes in companies and need to know how the little guys on the share register will be treated. “Going in as a minority investor carries risk and it is about understanding that risk,” Burger says.

Part of understanding governance risk is also to identify any biases that might creep into the decision-making by executives or how an organisation, whether it’s a company, trustee board or football club, is structured and managed.

For Susan Hoare, a partner at Aon, poor execution of strategic objectives, trustees not considering all factors when making important decisions or exposing a company to lots of risks are symptoms of poor governance.

To avoid such problems, Hoare calls for more people from different backgrounds to be sitting around boardroom tables to avoid the “group think” that has been all too evident in recent years. “If you put people on the board who do not think the same way you have a better chance of highlighting things that could go wrong,” she adds.

Czupryna points to academic research that shows companies with diverse boards are better at resisting the temptation to embark on value destructive M&A. “Having a more diverse board, for us, guarantees a coolerheaded attitude at board level,” he adds.

DIFFERENT STROKES

Additional expertise might be needed when investing in companies outside of the UK as governance standards vary throughout the world. Indeed, those targeting tech giants in the US or the growth protections and double-digit returns offered in emerging markets need to look at companies in the context of their market to understand the regulatory structure. “You have to take this on a company-by-company basis, because their approaches will often be different,” Burger says.

“It is unfair to look at a US company through a UK governance lens. It is comparing apples with oranges,” he adds. Czupryna says that the merits of factoring governance into your research should not be underestimated. “The further we go away from the traditional asset classes and developed markets towards high yield, unquoted companies in emerging markets is where governance becomes more critical.”

It is unfair to look at a US company through a UK governance lens. It is comparing apples with oranges.

Ian Burger, Newton Investment Management

Herskovich points out that emerging market companies are often family-controlled or majority state-owned. “You should not look at them in the same way as you would a company that has no controlling shareholder.”

But he adds that emerging market companies are moving in the right direction when it comes to governance. “There have been a lot of improvements.”

Brazil and Korea are two countries using regulation to lift their governance standards. “Several emerging market countries are trying to lift their corporate governance standards as they understand that having a good track record on this front is in their own interest to attract foreign capital,” Lamoen says.

Brazil has set stringent rules around board composition and executive pay transparency, while India is considering making potential independent directors sit an exam before joining a board. South Korea, meanwhile, has improved the rights of minority shareholders and wants greater representation in boardrooms.

ALL TOGETHER NOW

These improvements have been driven not only by shareholders, but also by the introduction of corporate governance and stewardship codes.

“Governance codes have been effective,” Burger says. “It is part of a toolkit from a regulatory or best practice setting perspective.

“We have a long-term view on investments and long-term interest in the companies in which we are investing,” he adds. “Ultimately, the stewardship codes that we see are fostering that investment thesis, as it were, for long termism.”

Stewardship codes not only promote enhanced transparency and dialogue between directors and investors but also defines a board’s responsibilities.

“[Governance codes] are a necessary first step to promote higher levels of investor engagement, which initially is translated in more comprehensive disclosures on how investor stewardship responsibilities are discharged by the signatories,” Lamoen says.

They have also been useful in making local investors more active as shareholders, especially in parts of Asia.

Japan is one country that has seen improvements in its corporate culture in recent years. “We are seeing significant improvements in Japan, but there is still a way to go, which creates great opportunities,” Burger says. “We can identify quite readily whether a company is merely ticking the box or if it understands the value of the substance behind that reform.”

Japan has evolved because the main driver was the government, it wanted to revive the economy from a decades-long depression, it wanted a more shareholder-friendly culture and to start handing their hordes of cash back to investors as dividends.

In many cases it is just investors who are pushing for reform, but Japan is an example of success being driven by various stakeholders.

Boardroom expertise and how it fits in with the corporate’s strategy and long-term risk management will be one of the biggest issues in the governance arena over the coming years, Herskovich believes.

“10 years ago the market was focused on boardroom independence,” he adds. “Five years ago it was executive pay, but not enough on having the right skills on the board. This is key. The board sets the strategy to challenge management to think about the long-term vision.”

Herskovich calls for investors to continue pressuring boards into identifying the skills needed to set and execute the right strategy, which is a key element of corporate governance. “There is still a lot of work that needs to be done on that.”

Hoare says that if there is one habit that executives and managers need to adopt in the coming years it is to look beyond the governance code. “The governance requirement from the regulator is low, so we look beyond that. If you are not reviewing your governance, are not taking it seriously,” she adds. “There is enough material, in my view, that sets out that great looks like.”

Czupryna concludes by saying that there is still a huge amount to do when it comes to corporate governance that the size of the workload “cannot be underestimated”.

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