Corporate governance spotlight: who manages management?

Our fund manager and partner, Investec Asset Management, provides some insight into their corporate governance process when assessing stocks for inclusion in our funds. Corporate governance is one of the key pillars of the ESG process – which examines environmental, social and governance factors that can have a material impact on a company’s financial report. When we refer to our ESG process, this incorporates our review of corporate governance measures.

Earlier this year, corporate governance authority and author of the original King report used as an international guidance resource for good corporate practice, Professor Mervyn King went on record saying the fact that a handful of listed companies have been found wanting in complying with principles of good corporate governance should not taint the reputation of all big corporates.

Speaking at an event in Johannesburg, King noted companies today operate in an environment of radical transparency compared with a decade or two ago.

What is corporate governance?

Corporate governance has been defined as the system by which business organisations are directed and controlled. This definition – originally articulated by Sir Adrian Cadbury in the early 1990s and later adopted by the OECD (Organisation for Economic Co-operation and Development) neatly conveys the inherent dilemma faced by any director: i.e. the need to drive the company forward while keeping it under prudent control. The tension between performance (driving forward) and conformance (prudent control) provides a useful framework for analysing the corporate governance system of any organisation. At the same time, the degree to which the fundamental governance principles of accountability, honesty and transparency inform board processes is extremely important. It is generally accepted that “independence of thought” and “care, skill and diligence” are among the key capabilities that directors need to bring to the boardroom.

According to the King IV report released in 2016, corporate governance is defined as “the exercise of ethical and effective leadership by the governing body towards the achievement of the following governance outcomes:

• Ethical culture
• Good performance
• Effective control
• Legitimacy.”

Our dedicated global ESG team is steered by a senior Investment Governance Committee and together with all the investment teams, the ESG team focuses on integration strategies, ESG research and engagement efforts.

The anticipated introduction of a formalised toolkit will allow the analysts to assess ESG risk on a quantifiable scale, as well as adopt a formal guideline which considers risk factors and how these factors may impact credit risk. This toolkit will produce a score for each ESG pillar, as well as an overall ESG score. These scores will be used to identify possible ESG risks and opportunities and will be integrated into the core investment decisions.

What are the questions when it comes to assessing corporate governance?

Some of the key questions we ask in an effort to identify potential risks with regard to corporate governance typically relate to:

• Leadership and strategic governance – is the board structured to ensure an appropriate level of independent oversight and are its members suitably experienced?
• Are management’s interests aligned with the long-term sustainable performance of the business?
• In the case of equity, are shareholders’ interests protected through effective share capital management?
• Does the company have an adequate and effective risk management system in place?

It is important to note that appropriate disclosure in a transparent manner is key to construct an informative investment view on a company. We do, however, employ tools in collaboration with our ESG team to identify poor corporate governance. These tools include:

• MSCI ESG research, in the form of various reports which assist analysts and portfolio managers to better understand the ESG risks and opportunities of various equities. These include holistic country reports in addition to reports which pertain specifically to sovereign ratings. We use MSCI ESG data for company ESG ratings to provide us with a characteristic view of the business, as well as a controversy flag.
• A comprehensive ESG risk database building by business intelligence provider, RepRisk. IAM uses this service as an additional tool for assessing the ESG risks and controversies in which a company may be involved.

Both Steinhoff and Resilient have complex organisational structures, which include cross-shareholding. This in and of itself is not a warning signal, but it is a reminder that the audited financials and company disclosures may not present the full picture and highlights the importance of integrated annual reports.

What went wrong at Steinhoff?

In the case of Steinhoff, it is difficult to identify any “lessons learnt” considering that there is still no detailed information regarding the scope of the fraudulent activities, and fraud, by its very nature is difficult to detect, especially from an outsider’s point of view. 

The Steinhoff structure became ever more complex as it expanded offshore. Conventional analysis of the published information presented no warning signals. Nor did the formal corporate governance reviews which were conducted internally and by third parties. The only aspect of analysis that remained was more qualitative and required a judgment regarding whether the various accusations against the company suggested a deeper problem. At Investec our response was to test again that our analysis held and that we did understand our investment sufficiently well. 

Resilient

One of the main concerns raised regarding Resilient has been the complexity of the group’s structure as a result of the number of cross share-holdings between the companies.  This has been one of the key reasons we were underweight in our equity exposure to the Resilient group of companies for an extended period of time and currently have no exposure to Resilient.  While this has been an aspect we continuously monitored for a number of years, it was impossible to determine if and when this would become a concern for the market.

In this regard, we believe it is important to be more active in terms of voicing our concerns with companies which employ complicated corporate structures.  Unwinding companies’ corporate structures is one of the key steps undertaken by the current Resilient management team in their recovery process. 

Similar to Steinhoff, Resilient also has a complicated corporate structure that made it less straightforward to analyse. The underlying physical property underpin is the primary protection for lenders.  Again credit is different to equity in that credit has direct exposure to the property owning company (through a guarantee).  And the listed assets and income from related party loans create additional comfort and formed part of the credit assessment.  With complex groups such as Resilient, the formal analysis, including published financials, ratings and corporate governance reviews are not enough on their own under certain circumstances. The qualitative aspects and judgment that come with experience remains critical.

Disclaimer
Nothing contained herein should be construed as financial advice and is meant for information purposes only. Discovery Life Investment Services Pty (Ltd): Registration number 2007/005969/07, branded as Discovery Invest, is an authorised financial services provider.

The views contained herein are not those of Discovery Limited or any of its subsidiaries and are those of the author/s.