Corporate governance is omnipresent, yet overlooked in certain respects, across the investment landscape. It’s a common talking point in investing, and something that many portfolio managers will mention in describing what they like (and don’t like) in companies. At the same time, most public companies have at least baseline governance standards, given what’s required by listing exchanges and regulators, while past scandals and corporate miscues have generally raised the bar as to what’s acceptable behavior from corporate leaders.
This means that governance is probably an area of less differentiation for the average investor than it once was, with the main element being the achievement of a minimum level that avoids setting off warning signals. Indeed, verbiage about shareholder value and alignment may not translate into real effort around governance, and therefore may come up short in identifying specific ideas that could have a positive impact on a given company and its stock.
Still, even if governance tends to fade into the background, that doesn’t mean it’s not important or an effective tool in the right hands. A lack of good governance is certainly noticed when things go wrong at a company, and for those willing to put the time and effort into fundamental research, it can be a key part of assessing the durability of a stock or engineering corrective action in the event of management missteps. Moreover, governance takes on particular relevance when considered in the context of environmental, social and governance (or ESG) investing, where it can help foster new perspectives and greater attention to risks that might get lost in traditional analysis.
Digging Into Governance
Let’s consider the basic idea of governance, which is to have rules and safeguards in place to ensure that management and board will serve the best interests of shareholders—something that is fundamental to the corporation as we know it.
What goes into “good governance”? There are many elements, and opinions vary. It may include an independent-minded board, with a balance of internal and external members, the separation of CEO and chairman roles, and effective mechanisms to highlight shareholder views, as well as executive compensation that’s tied to the company’s economic performance and aligned with the interests of shareholders. Depending on who’s talking, it may also cover capital allocation, and how earnings are allotted among business reinvestment, dividends and buybacks.
Beyond such structural safeguards, evidence of good governance and alignment with shareholder interests may appear in various qualitative signals: Does the board have a history of shareholder-friendly actions? Has it been an effective capital steward? Are there consequences for those who make bad decisions? Has management been open to input and listened to investor concerns?
In terms of compensation, the general, unhealthy trend has been for companies to establish pay structures based on competition versus peers, rather than tying pay to performance and value creation for shareholders. Although opinions vary, our managers generally prefer remuneration plans that incentivize longer-term thinking, including those linked to return on invested capital, economic value added and other measures that are closely aligned to shareholder interests and encourage a more stable capital base for the company. By the same token, we tend to like it when board members are paid in stock and are only able to sell after they have exited the board.
As for capital allocation, truly bad choices can become evident fairly quickly, but more subtle deficiencies may take time to surface. Standards may vary depending on the sector or, more subjectively, the preference of a given investor. For example, telecom stocks may have relatively high debt levels given the need for growth, while some industrial companies may be better off with less leverage in light of their more stable businesses and conservative investor base. Within such parameters, the choices may depend on opportunity levels available to a particular company.
What Can Investors Do About Governance?
As we’ve said, governance tends to be solid in major markets. So the extent to which managers actually can use governance issues as a differentiator, rather than paying them lip service, really depends on their ability to look below the surface for meaningful insights and then act on their convictions. Do they have the capacity— the breadth of resources to research and understand what is actually going on at the corporate governance level in addition to the fundamental issues affecting a company? Do they have the capability—the knowledge and insight to understand what steps could take place to actually make it better? And do they have a game plan to “monetize” their opinions?
Typically, a manager’s views on governance will translate into action in a variety of ways:
Screening. At a basic research level, governance standards may be part of the screening process—if a company does not do certain things to benefit shareholders, it is simply left off the manager’s short list.
Valuation. Investors may consider governance factors in setting the value of a given company; for example, certain real estate companies trade at a discount by virtue of state-imposed antitakeover protections. Other companies’ valuations may be limited by family control provisions or by a pattern of poor behavior by management.
Sell signal. Governance may also provide a signal for exit. A company may have strong businesses, and perhaps have a plan to improve governance structures over time. But a series of weak decisions reinforced by a dysfunctional compensation system, and combined with a failure to listen to critical shareholder voices, may cause investors to think twice about their commitment.
Engagement. Communication with management is an important avenue to press for change, but success may depend on resources and strategy.
Making Engagement Work
A well-established brand of “activist” investor sees governance and other corporate issues as an opportunity, swooping in with demands to address board issues, return capital to shareholders, exit non-core businesses and the like.
Casting no shade on that approach, we favor engagement of a different sort—that is based on long-term constructive relationships with companies, and built around the creation of value over time. In our view, it’s an effective way to leverage fundamental research-based investing beyond traditional stock-picking and actively encourage managements to make good choices on governance and an array of other issues.
The issues of capacity and capability play an especially important role in the context of engagement. A strong research capability is essential to analyze issues in detail and understand the nuanced situations at different companies. This is often the result of experience and pertinent skill sets to evaluate issues and come up with potential solutions to share with management.
For example, if a company proposes a new director, analysts may be able to assess the candidate’s experience and effectiveness at other companies; they may actually be able to suggest individuals that would be well-suited to the role. They may also have opinions as to compensation approaches—what may or may not work in the industry or be suitable for the particular goals of the company. If they have an established relationship with the company and build on long-term investment, their voice is likely to be heard.
Beyond these specific issues, it’s important for managers to take a thoughtful and transparent approach to proxy voting: not simply leave this role to advisors, but leverage their deep knowledge to assess proposals and their impacts in individual cases.
Governance Through an ESG Lens
With governance as a traditional component of company analysis, it’s worth asking what changes in the context of sustainability—how environmental and social issues (the “E” and “S” in ESG) may inform efforts around governance and vice versa.
Clearly, governance does not operate in a vacuum. Any number of operational and competitive issues may point to problems at the top. Environmental and social factors can be an additional set of tools providing information about the company and its leadership; they just happen to be less traditional, and thus, we would venture to say, potentially more differentiating than others.
A quick look at the chemical industry illustrates this point. Operational and worker safety is a major issue for the sector, and the ability of a company to make progress will catch the eye of those assessing it from an ESG vantage point. Such issues, however, can also affect the bottom line; success in dealing with them can go a long way in signaling a company’s broader competence while failure may have the opposite effect.
Looking at E, S and G from the inverse perspective, we believe effective governance is essential in addressing a company’s environmental and social challenges. Serious consideration of such issues requires open-mindedness to nontraditional ideas and a willingness to commit resources to assess and quantify risks they may bring to the surface. In essence, you simply can’t have impactful environmental performance or community engagement without an effective board.
Pulling Things Together
Governance, writ large, represents a key if sometimes forgotten pillar in the success of any company, but its specific elements are subject to debate. For investors, having a defined set of governance standards can help in assessing the appeal of a stock, assigning it a valuation, and then determining whether it has the potential to meet market expectations. However, at some point, investors may want to act to influence management and the board on governance and other issues. Deep understanding of the company, combined with a long-term perspective, can facilitate communication and improve the chances of a positive outcome.
Better Governance Through Engagement
Cultivating healthy and productive interactions with companies can benefit portfolio managers seeking to have a positive impact on corporate strategies and behavior. Some situations our firm has been involved with support this point:
Pipeline of Improvements. An energy company that initially enjoyed valuable infrastructure, healthy returns on capital and solid execution saw these characteristics wane. As a longtime investor, we asked management to address key governance priorities: to navigate a complicated regulatory environment, simplify corporate structure, reduce leverage and improve communication with shareholders.
We met with management and the board regularly, communicating our dissatisfaction with their shift from rigorous, conservative financial management, and their confusing corporate structure; we argued that these issues were distracting from various positive developments, including increased attention to maintenance and safety, and extensive outreach to indigenous groups and local communities.
Following the engagement, the board laid out a more return-focused strategy, simplified its corporate structure, improved its credit quality, and expanded its communications regarding ESG and other issues of concern to investors.
Board Takes Flight. An aircraft leasing company with a history of diversified fixed income issuance has experienced volatility in recent years. Despite its economies of scale, moderate debt levels and generally positive industry trends, media attention on the leveraged balance sheet of a key equity owner heightened investors’ concern that the company’s governance and ownership structure would allow value to be removed from the company at the expense of creditors.
In multiple interactions with the company, we advocated ways to strengthen the existing separation from the key equity owner and reinforce its independent governance structure. We also asked management and the board to commit to a transparent capital allocation policy and more protections for creditors.
The company eventually instituted those protections and also diversified its equity ownership in a more creditor-friendly manner, while enhancing the board structure to require the approval of a second large equity owner to make material changes. The company’s improved financial profile has led the rating agencies to upgrade it from a high yield to an investment grade ratings profile.
Avoiding a Destructive Proxy Fight. A company in the chemical sector was transforming itself from a portfolio of commodity and differentiated businesses with loose strategic links into a focused, high-margin specialty company. However, its decision to financially lever its balance sheet to add a new business made us concerned that it was straying from its pledge to simplify its corporate structure and stay focused on managing its existing product portfolio. We voiced our objections, but “held fire” to give management more time to make adjustments.
Soon, an activist investor was publicly calling for change at the company, having become impatient that its suggested reforms were not being executed. The activist began a proxy fight, calling for four new directors, as well as operational changes.
This altered our engagement, as we believed that a proxy battle could prove distracting and increase risk. So, we told management we would support it in return for certain conditions, including the retirement of the lead director, the addition of new board members, the creation of a subcommittee on capital allocation, and the reintroduction of return on capital as a key metric in long-term incentive plans. The board agreed and, with some of its conditions met, the activist investor signed on as well.
We believe the outcome was a result both of our long relationship with the company and the knowledge-driven insights we were able to bring to the table to resolve a difficult situation. More generally, these examples point to the value of a constructive approach to company interactions, which can make management more open to proffered solutions that can help solve thorny issues on governance and other key concerns.