Nexus between governance & share value

CEOs are under constant pressure from internal and external stakeholders to improve share price performance. Typically this expectation translates into the management focusing on top-line growth, bottom-line accretion and other financial metrics such as return on capital and dividend distribution. A close look at the winds of change in investor priorities, however, shows that there is a growing nexus between corporate governance and share value. We believe CEOs and boards can, and must, strategically unlock this “governance premium” as an avenue to drive stock performance. 

This assertion is backed by OECD’s observation that investors do pay a higher premium for good corporate governance. The premium is justified by the perception that a well-functioning governance framework drives better present value through: (a) attracting and retaining better talent; (b) receiving better quality capital for growth; (c) reducing the cost of debt; (d) ensuring better risk management and lower volatility; (e) improving the stability, operational efficiencies and longer-term sustainability of businesses; and (f) yielding reputational value, which will, in turn, translate into better top-line and bottom-line metrics. 

The presence of this governance premium is also backed by empirical data. A quantitative analysis of price to book ratios and corporate governance scores by Roberto Newell and Gregory Wilson concluded, “even after allowing for the effect of characteristics such as financial performance (measured by returns on equity) and size on valuations, we found that companies with better corporate governance did have higher price-to-book ratios, indicating that investors will pay a premium for shares in a well-governed company”. 

Illustration by Binay Sinha

In fact, the most recent 2018 study by IFC, Institutional Investor Advisory Services and BSE Ltd, shows that the BSE Sensex companies that were scored in 2016 and 2017 in the “Good” and “Leadership” categories based on their scorecard have shown a stronger price performance than those in the “Fair” and “Basic” categories over a two-year period, and one-year period, respectively. We anticipate that as more data becomes available over the next few years, there will be a more robust endorsement of this trend. Conversely, companies with seemingly bad corporate governance standards have seen a slow decline or on occurrence of specific “governance issue” lost value immediately.

Driven by these compelling rationales and market evidence, it is hardly a surprise that investors are closely monitoring governance scores. Internationally, companies are being evaluated and rated on their environmental, social and governance (ESG) performance by various third party providers of reports and ratings for instance Bloomberg ESG Data Service; Corporate Knights Global 100; Dow Jones Sustainability Index (DJSI); Institutional Shareholder Services (ISS); and MSCI ESG Research. 
 

Of the $88 trillion assets under management globally, more than one quarter is now invested bearing in mind ESG principles — a trend that is, and will continue to be, on the rise. Various jurisdictions including the United Kingdom, Sweden, Australia and Netherlands have mandated investment entities such as pension funds, insurance companies and asset managers to consider ESG factors and also report on the manner in which they are taking ESG factors into account. Leading asset managers such as BlackRock, State Street and Vanguard have also taken a strong and open position on the role of ESG factors in their investment decisions. There are more than 2,000 asset managers globally that are currently signatories to the United Nations Principles for Responsible Investment.

There is also the shift in the changing demography of the “investor”. E&Y, in its report Sustainable investing: The Millennial Investor has noted that there is a greater demand for sustainable investments, with such demand being driven by millennials who, when compared to non-millennials, are more likely to invest in companies that use high ESG practices and have specific social or environmental outcomes. 

In this changing investment environment, a focused and concerted effort to adopt and engage with better governance practices that speaks to the “Sustainable Investor” could go far in improving share value by meeting the needs of this fast growing market segment. In addition to ensuring compliance with mandatory regulatory norms, the board and management would do well to strategically consider the voluntary adoption of best practices. In the spirit of “we get what we measure”, we would recommend close review of measurable improvements in the areas of wholesome composition of the board, the quality of disclosure, stakeholder engagement, conflict of interest and related party transactions, sustainability (both environmental and social) and business responsibility initiatives, strategy, integrated reporting, risk management, succession planning, transparency in executive compensation and employee welfare. 

While currently it is the quarterly financial results that are closely monitored for CEO performance, with the changing investor priorities, we anticipate that the day is not far when the announcement of governance scores and movements on ESG indices trigger buy-sell decisions of investors.  This may even be accelerated by the increasing institutional holding in the markets and decreasing holding of traditional Indian promoters. It is time for India Inc to prepare for this game changer. 

Shroff is managing partner, Cyril Amarchand Mangaldas; Katragadda is a partner in the firm’s disputes, governance and policy practice