Agency problems are common in relationships where one party is expected to act in another party’s best interests instead of their own. Such conflicts often exist in the relationship between a company’s owners and managers. Corporate governance provides the framework through which these risks are managed. Companies with strong governance use a combination of processes, controls, and incentives to ensure that managers work to maximize the value of a business for its owners and other stakeholders.
Governance standards and norms differ around the world. The development of these varied frameworks has been influenced by political, societal, and economic factors. Interestingly, this includes the roles that the capital markets and banks have played in financing a nation’s economic development. Countries with stronger capital markets vs. banks tend to have more shareholder-oriented governance models.
As part of our research process, we review the quality of a company’s governance to ensure that managers’ interests are aligned with those of its owners. We engage with executives and evaluate their track records to better understand how they think about their business and how they allocate capital. As part of our analysis, we carefully consider several key issues:
Duties & responsibilities of the corporation and its officers
All governance models require that directors and officers act in the best interest of the corporation. But what does that really mean? In the United States and a few other markets (UK, Australia for example) it is generally believed that a company should work to maximize its value for shareholders, and many businesses are in fact run this way. Yet it is not universally accepted that shareholder value creation should be the primary objective of the corporation. Understanding how views on this might differ from country to country, and even between businesses within countries, can provide valuable insight into what factors might influence a manager’s decision-making process.
Directors play an important role in governing the owner/manager relationship. We prefer boards with independent, well-qualified, and diverse directors.
Standards regarding director independence vary around the world. US public companies are leaders, with 85% of directors classified as independent.1 At the other end of the spectrum is Japan, where only ~40% of directors of TOPIX 100 companies are independent.2
Other criteria may also be used to shape board construction. For example, employee board representation is required in several European nations, including France, Germany, and the Netherlands. Employee representatives make up 50% of the non-executive Supervisory Board at large German corporates. This can limit the flexibility of business leaders to restructure or take other strategic actions.
Is a board willing to replace an underperforming manager? Do CEOs hand-pick their successor? Are outgoing CEOs allowed to stay on the board where they can continue to exert influence? The answers to these questions may give us some insight into whether a struggling company can really be expected to implement necessary change.
Executive compensation and share ownership
Thoughtful executive compensation can align the interests of shareholders and managers. Ideally, we like to see compensation include an equity component and be linked to appropriate long-term performance targets. We want managers to act like owners; the right incentives make this more likely to happen.
The use of long-term, performance-based, equity-linked compensation continues to grow around the world. We highlight Japan as an example of this trend, with the share of long-term incentives as a percent of total compensation doubling since 2015.3
Ownership base/cross shareholdings
Friendly ownership can insulate managers from outside pressures. Bank-centric economies like Germany and Japan were long characterized by webs of corporate cross-shareholdings between capital providers (banks & insurance companies), customers, and suppliers. German networks were largely unwound at the start of the current century but this was not the case in Japan, at least until recently. Governance reforms, spearheaded by former Prime Minister Shinzo Abe, have taken aim at this inefficient practice.
Founder or family-controlled corporations
Controlled corporations are still relatively common in parts of Asia, Europe, and South America. On the one hand, large ownership positions create economic alignment between managers and owners. However, independent shareholders typically have little ability to effect change in these situations.
When evaluating these opportunities, we consider both the managerial capabilities and economic motivations of controlling shareholders, recognizing that their influence on operating performance is unlikely to change.
We must also understand the existence and enforcement of rules protecting minority shareholder rights when investing in controlled companies.
Golden shares & national champions
Governments may view certain companies to be of strategic importance to a nation’s well-being or security. The list of companies core to a nation’s interests can be surprisingly long. In such cases, governments may take action to protect these companies from outside interference, even at the expense of shareholder value. Managers can exploit this position to defend themselves from external pressure to perform.
Good governance is not just a box-checking exercise. The right incentives and structures can steer leaders to decisions that increase the value of their businesses. On the other hand, poor governance can insulate management, forestall change, and ultimately inhibit growth. The considerations discussed above can shape investment outcomes. This is especially the case when investing in international markets.