Time was when corporate governance was not common parlance. Only a few years ago, the term was largely the preserve of a select band of UK and US investors and listed companies. Now it seems corporate governance is everywhere. It’s discussed on television, written about in newspapers. Government ministers, CEOs and investors are queueing up to talk about the need for good governance.
Nowhere has the scrutiny been more intense than in emerging markets, where the Asian crisis of the late 1990s provided an ugly lesson in the damage mis-governance can do to shareholder returns.
‘The emerging markets crises of 1997 and 1998 in Russia and Asia put corporate governance at the forefront of market attention,’ summarizes Amra Balic, associate director of corporate governance services at Standard and Poor’s. ‘The big players lost money because they didn’t look closely enough at how the companies they were investing in were run.’
Few disagree with this opinion. ‘In the early 1990s institutions bought emerging markets stocks to give their portfolios diversification and better returns. But these returns failed because corporate governance let people down,’ adds Amar Gill, head of Hong Kong research at Credit Lyonnais Securities Asia (CLSA).
The diagnosis was clear: emerging markets corporate governance was in dire need of an overhaul. There followed a raft of new national governance codes, arriving in tandem with bold reform promises from governments and stock exchanges. A whole industry of governance scrutineers was spawned, analyzing corporate practices for twitchy investors who have had their fingers badly burned. A string of studies into corporate governance have been published lately, prime among them CLSA’s second annual report confirming that well governed companies tend to outperform their less well governed peers – echoing the claim made originally by McKinsey & Co that investors will pay a premium for good governance.
But while the CLSA study finds that standards across the emerging markets are improving, enforcement of new governance regulations remains patchy. ‘2001 was a year when lots of improvement took place in regulations and listing requirements.
But we now need to see enforcement without exception. I believe we will only see integrity of enforcement arrive with the next major financial crisis,’ comments Gill.
Sharing the mood of skepticism is Stephen Davis, president of US-based proxy consultants Davis Global Advisors. ‘Some very good foundations have been laid, but there’s still a long way to go. That said, there’s been more progress than expected over the past two years.’ And that progress isn’t surprising when you consider the importance attached to corporate governance by investors. In the past, only a few specialized institutions would pay much attention to this issue. Now, with figureheads such as emerging markets guru Mark Mobius of Templeton leading the charge, governance expectations among international investors have shot up.
And this isn’t an issue just for emerging markets companies. National governments are paying attention, too. ‘If you don’t have an infrastructure in place that gives international investors confidence then you won’t attract money into companies or countries,’ asserts Caroline Phillips, international governance expert and director of the policy unit at the UK’s Institute of Chartered Secretaries and Administrators. Phillips is keen to press home the importance of good governance to the institute’s international students. ‘The profile of corporate governance has been raised because of pressure from institutional investors, but there remains great variation between countries, particularly those that have no history of financial regulation and enforcement,’ she adds. The problem of deficient regulatory frameworks is a major obstacle to corporate governance reform in emerging markets, as acknowledged in a report last year by McKinsey & Co (see below, Listen, don’t shout).
Getting better
Some national governments have wised up. The past year has seen tough new codes introduced in two of the largest emerging markets, Russia and China. These developments are welcome news to Michael Watt, emerging markets fund manager at Henderson Global Investors. Standards, he believes, are ‘a lot better than they were. Everybody had to sit up and take notice after the 1997 Asian crisis and there’s now a much clearer understanding and stronger framework than before.’
Watt highlights Malaysia as one country that has been particularly keen to improve its governance performance. ‘If you tick the boxes, Malaysia does quite well. The corporates have become much more transparent and there’s now an aura of respectability for listed companies,’ he says. But Watt remains wary: ‘We’ve seen our hopes raised there before and we’ve been let down on several occasions.’
Gill agrees, but also praises South Korea for improving shareholder rights and encouraging the break-up of the lumbering chaebol which dominated the corporate scene. And Seoul is getting its reward: ‘Korean stocks are moving up from very cheap valuations principally because of improving corporate governance,’ Gill says.
Korea’s progress contrasts sharply with Taiwan’s. According to Michael Watt, Taiwanese companies are not yet thinking in terms of minority shareholder rights and are resisting boardroom reform: ‘They didn’t go through the same [Asian crisis] bloodbath as Korea and Malaysia, so their financial regulation remains quite backward.’ Watt’s opinions are confirmed by the findings of S&P’s global transparency and disclosure survey, which places Taiwan at the bottom of the Asian pile.
Corporate governance problems in Latin America appear more acute. ‘Our recent survey on transparency and disclosure in emerging Asia and Latin America shows that on average, Asian companies have higher levels of transparency and disclosure than companies in Latin America. This can be explained by the severity of the financial crisis in Asia that put transparency and disclosure at the forefront. In Latin America this process has been certainly slower,’ comments Amra Balic.
Only Brazil has been blazing a trail in this region. ‘Brazil stands head and shoulders above the rest,’ asserts Stephen Davis. ‘They realized the key to reform was mobilizing domestic investors, not just international investors. In Korea a similar thing has happened, but it’s the small shareholders who are leading the way and they have limited clout. By contrast, in Brazil it’s the domestic pension funds and other institutions that are stepping up to the plate.’
But success stories like Brazil’s are all too rare for many investors, who have been getting more proactive. In February Calpers announced tough new emerging markets investing guidelines that exclude all bar 13 countries from receiving a slice of the fund’s sizeable assets – a move criticized by some for not rewarding countries that are making efforts to improve standards.
Meanwhile, the Washington DC-based Institute of International Finance (IIF), which represents over 300 financial institutions, recently published a new action-oriented corporate governance code for financial regulators. ‘The bottom line is that there won’t be adequate foreign equity investment inflows unless we see improvements,’ explains spokesman Frank Vogl. Last year’s dramatic drop in emerging markets investments is proving slow to bounce back, mainly due to governance concerns. ‘These numbers are very low and companies desperately need foreign equity investment far more than they need debt,’ Vogl concludes.
Shaping up
So how have listed companies reacted to the challenge? ‘Companies are finding they are being asked more questions about their governance practices and they are beginning to realize the importance of answering. This is especially true of those companies that we’ve ranked low. They want to know why they did badly,’ reports CLSA’s Gill. He adds that few companies try to resist the tidal wave of opinion in favor of improved governance, with most conceding the need for transparency and disclosure.
But that’s not always the case. ‘Some companies resist quarterly reporting, claiming it will encourage volatility and short-term investing. Similarly, transparency regulations are viewed by some as giving an information advantage to unlisted competitors,’ Gill says.
Davis believes new economy companies in emerging markets are more responsive to the needs of international investors, while the behemoths of old often remain stuck in their untransparent ways. Ironically, the reverse is true in the US, where new economy companies are notorious for poor governance. But fund manager Michael Watt takes a slightly more cynical view: ‘Corporate governance is very much flavor of the month and the investment banks that help emerging markets companies prepare their presentations know that,’ he opines. ‘But I’m sure you can make the same criticism of western companies.’
Indeed. Recent scandals have shown that in terms of corporate governance, the west may no longer be best. Such has been the impact of fiascos like Enron in the US that CLSA’s recent corporate governance study, Make me holy… but not yet!, argues that a reassessment of the valuation discount between developed and emerging markets equities may occur. Indeed a recent Merrill Lynch survey of fund managers found that 37 percent of fund managers believe emerging markets equities are undervalued, while only 5 percent think the same is true of US stocks.
‘People ask me what on earth Asia must be like if standards in the US are so awful,’ adds Henderson’s Watt. ‘It’s true that Asia is more basic in terms of accounting and off-balance sheet financing, but auditors are perhaps more disciplined and cynical in Asia because they have fewer blue-chip reputations to protect,’ he concludes. You can almost forgive emerging markets regulators and companies, battered by western criticism over their corporate practices, a little smugness over the US governance failings exposed by the Enron scandal.
In fashion?
Certainly emerging markets are not the sole focus for governance activists. But is the current scrutiny merely a product of the difficult global investing climate, destined to go out of fashion as soon as returns improve? Stephen Davis thinks not. ‘This is not a fad. This is something that’s embedded and it’s not going away,’ he says.
Amar Gill distinguishes between the approaches of individual fund managers in comparison to whole institutions. ‘Fund managers are looking for stocks that will outperform in three to twelve months – a time period during which, barring crisis, corporate governance will not change much. It’s a lower priority than with chief investment officers who decide which market to go into for the long term and, if they see improvements, will decide to invest more in that market.’
It is left to fund manager Michael Watt to add a dose of skepticism: ‘I don’t know whether people will be so zealous when the market recovers. People are always on their best behavior when at the bottom of a cycle. In contrast, they think they can get away with anything when at the top of the cycle.’ But for Amra Balic at S&P, good corporate governance and a market recovery go hand in hand: ‘The market will pick up when investors regain confidence and for that to happen, we need improvements in corporate governance practices in these regions.’
So it’s agreed: if you need capital and if you want to attract international investors, you cannot ignore corporate governance concerns. Regulatory and legal barriers remain, but there is a growing body of evidence proving that better corporate governance pays dividends in the form of higher share prices and lower cost of capital.
But how to keep up with best practice? Stephen Davis advises companies to stop viewing corporate governance as a box to tick: ‘They need to think about corporate governance as a subject of research and development. Find the best strategy, put it into place and then develop it as an asset.’ Corporate governance as an area for R&D? Now there’s a thought.
Listen, don’t shout
It is known to many simply as ‘The Firm’. Its alumni number CEOs, politicians, academics and top regulators. Now influential consultancy McKinsey & Company has turned its attention to corporate governance. Two years ago they grabbed the headlines after proving most institutional investors would be willing to pay a premium for well-governed companies. Last year, McKinsey’s emerging markets investor opinion survey drew similarly powerful conclusions, arguing that greater understanding is needed between emerging markets and western-based investors if corporate governance is going to progress.
‘You’ve got to be realistic,’ warns Paul Coombes, director of McKinsey’s London office and co-author of its corporate governance reports. ‘Emerging markets differ from the Anglo-American model of capitalism in many respects and there are good reasons for that. They have different preoccupations, especially where property rights are insecure and commercial law is not as well developed. In this environment, those who run a large company will want to keep control, not cede to someone else’s idea of what good governance is,’ he explains.
Coombes urges investors to consider the local emerging markets context before demanding radical governance improvements. ‘We need patient, modest institutional capital which will influence corporate governance standards and aid the quality of the supporting regulatory infrastructure.’
Ultimately, he believes better mutual understanding is critical to the reform process. ‘The stakes are high and this matters to people in emerging markets. But we need healthy reform and it won’t happen if investors are shouting and not listening.’
