Good corporate governance now key to accessing investor finance
Environmental and social considerations are becoming as important as bottom-line results
Ask any seasoned credit risk professional what the most famous acronym in the profession is, and you are likely to get a response that it is the five Cs of credit risk. They stand for character, capacity, capital, collateral and conditions.
Character refers to the track record or reputation of the borrower, capacity measures the borrower’s ability to repay a loan, capital takes into account the borrower’s “skin in the game”, collateral is about the security provided to strengthen the investment case, and conditions refers to the legal construct of the deal.
A sixth C has been growing in prominence and is probably the most important of all, because it influences all the others. I call it “conscience”, and it refers to our duty as investors and corporate citizens to invest in companies that are responsible and sustainable.
The global investor community calls it ESG, which stands for environmental, social and governance factors. You don’t need to venture further afield than corporate SA to realise why it should be a fundamental basis of any investment view.
ESG factors significantly affect the credit risk of a counterparty. A culture of good governance and appreciation of risk marks the difference between competitive and uncompetitive organisations. Construction company Group 5 could have avoided severe losses if it had more carefully weighed the risks of entering into the largescale $410m Kpone gas-fired power project in Ghana.
Although Kpone appeared attractive, it has been fraught with execution risks and for the six months to December 2017 caused Group 5’s headline earnings a share to drop 151%.
The overall tone of governance within an organisation is set by the executive management team and overseen by a board of directors. The King report on corporate governance, which was introduced to SA in 1994 and revised as recently as 2016, puts forward fundamental governance principles for companies to follow. On the face of it, many companies follow the principles, but hidden details, such as overcommitted board members, can be overlooked.
There is a tendency in SA for seasoned professionals to take up seats on multiple boards simultaneously. I have seen examples of board members occupying as many as 17 separate nonexecutive positions.
Based on a conservative estimate of four board meetings per company a year, that equates to 68 meetings annually. You have to question how such fully committed people can apply their minds effectively to all those companies, let alone physically attend all the meetings.
Another trend is the emergence of “pack hunters”. These are groupings of nonexecutive directors who hold seats on the same boards across SA.
This risks independence and objectivity the very thing nonexecutive directors are supposed to contribute. As packs become increasingly familiar with each other, the risk of herd mentality sets in: everyone votes the same when it comes to important decisions, or the pack dominates decisions and drowns out the voices of other directors. The importance of a diverse board with divergent views cannot be overstated.
Equally important is a company’s approach to managing environmental and social risks. Companies often fail to consider the full economic effect of their activities on their environment. Numerous mining firms in the Witwatersrand historically ignored the impact of acid mine drainage on water sources. The result is now a risk of water contamination, the burden of which is borne by society.
From a social perspective, a company such as British American Tobacco (BAT) has regularly been in the crosshairs of antitobacco lobbyists.
It must be hard for BAT to constantly defend itself when its success is based on increasing sales of a product that has been linked to such harmful diseases as lung cancer, heart disease and others. Once again, the cost of this is usually borne by someone other than BAT, in this case various countries’ public and private health-care systems.
Increasingly, we as investors are looking at how a company accounts for its direct and indirect effect on society and the environment. Our approach is backed by numerous studies, including one carried out by Hamburg University, which confirmed that companies with high ESG ratings have a lower cost of capital, both for debt (bonds and loans) and equity, compared with companies with lower ESG ratings.
Doing good in the environment and society and applying good governance are no longer activities that companies can boast about. They are fast becoming a basic requirement to get any kind of funding or investor interest.
A CULTURE OF GOOD GOVERNANCE AND APPRECIATION OF RISK MARKS THE DIFFERENCE BETWEEN COMPETITIVE AND UNCOMPETITIVE ORGANISATIONS