Corporate governance becomes hot topic for hedge funds

Over the past decade, the markets have seen a well-publicised rise in activism by investors focused on the strategy of individual companies and on the way they are governed, remunerated and structured. Even mainstream institutional investors have been involved in requisitioning resolutions to remove board members at companies like Management Consulting Group and Whatman.

With activists, institutions and hedge funds taking an increasing interest, it makes sense to ask whether good corporate governance leads to improved company performance and value creation.

The Association of British Insurers (ABI) has a long-standing interest in corporate governance, driven by its members’ role as large investors and derives from their desire to secure value for policyholders over the longer term. To assist these investors with their voting decisions, the ABI operates the Institutional Voting Information Service (IVIS). This analyses the level of compliance with corporate governance best practice within FTSE-All Share companies. ABI members hold 20% of the market and when added to the interests of other subscribers, IVIS users now account for 35%.

IVIS uses the principle of comply-or-explain. This approach was adopted by the Combined Code on Corporate Governance issued by the UK Financial Services Authority. This accepts that one-size does not fit all. Different companies may legitimately follow different paths.

Rather than giving explicit voting advice, it highlights key issues for investors to consider at the general meeting, highlighting their seriousness through the use of a colour-coded system. Red denotes the strongest concern followed by amber. A blue top indicates no areas of major concern, while a green top indicates an issue that has been resolved.

Three reports are produced: one each on the combined code;, environment, social and governance (ESG issues) and an analysis of all the resolutions for a meeting including those on remuneration.

Although some investors see remuneration as a sideline, many are beginning to see remuneration policies and the composition of the committee as an indication of the health of a board. Some of the questions asked include who leads policy, do targets reflect business strategy and are committee members independent?

Governance and Performance in Corporate Britain used the IVIS colour system as a proxy for governance quality. It found that where a company persistently breached key governance guidelines, there is a correspondingly negative impact on both the operating performance of the company as measured by return on assets and on the share price. Each additional red top reduces the company’s industry-adjusted return on assets (ROA) by one percentage point a year.

To put this in context, focussing on the top quartile ROA performers across all sectors, a one- percentage point drop in ROA implies an 8.7% decrease in profitability a year.

In the past role and importance of non-executive directors (NEDs) has been questioned. Tiny Rowland, of Lonrho, dismissed them “as useful as baubles on a Christmas tree”. ITV Chairman Michael Grade likened them to bidets: “They add a touch of class but no-one really knows what they are for.” Since the introduction of the combined code NEDs have become an important boardroom feature.

 

The ABI study shows more NEDs on a board improve operating performance but performance decreases if the proportion of non-executives to executives is too high. This suggests there is a happy mean and a risk of swamping the board with too many NEDs. The balance also depends on who the individuals are and their dynamic — something that cannot be captured quantitatively.

The ABI also considered the direct affect of governance on share price by dividing the all-share sample into portfolios by governance quality, and measuring it over a five-year period. A portfolio of well-governed companies delivers higher average share-price returns to investors than a portfolio of poorly-governed companies The difference in performance is substantially larger when returns are industry-adjusted. Investing £100 in the portfolio of well-governed companies yielded around £120 by the end of 2007 but investing £100 in the portfolio of poorly-governed companies yielded just £102.

The research suggests there is a genuine benefit to good governance. It can improve operating performance and increase the return on shares, while at the same time reducing the volatility of that return. To add real value to a company, governance must be seen as a holistic device for delivering better performance, not as an exercise in box-ticking.

This is the advantage of the IVIS approach. Adding extra value is beneficial for shareholders, and executive directors, employees, customers and the wider society as a whole.