How can you price-in ‘good’ governance?


“[we are] trying to join the pinpricks of light coming out of the boardroom” Paul Lee, Aberdeen Asset Management, PLSA December, 2015

In one short comment came the admission. Corporate governance teams at investment firms are struggling to make sense of company boards, how they function, and how they drive value creation and manage business risk. In short, conventional governance analysis is not able to give investors the complete picture and the reassurance they need. Moreover, finding ways to help direct companies in a more value-focused direction is often simplistic and sometimes extreme, e.g. pushing for heads to roll when things are going badly.

Why is this so? The room full of governance professionals at a recent PLSA event mentioned a number of factors. Poor information, little transparency, board dysfunction and a lack of senior level ‘quality’ were some of the insights. Ineffective board structures (auditors not gauging risk effectively, for example), weak industry expertise and inappropriate or excessive incentives (executive pay) were others. All contributors made valid points, to varying extents, but all painted a depressing picture of weak boards and blunt tools for investors with which to examine, diagnose and offer coherent advice.

Is this a failure of governance both within organizations and by the people trying to bring higher standards? Can the present approach to governance be fixed? There appear to be two inherent problems:

  1. There is no coherent framework that defines and measures “good” governance – as was admitted by the UK IOD earlier this year. When you look for factors at board level that drive value and risk, to what extent are each actually material? Is the existence of effective NED’s as important as the nature of executive pay? Is board level industry expertise a sign of good or inferior management quality? Does each factor work together to make analysis meaningful on a comparative basis? If we do not know what ‘good’ looks like and how this drives value, how can it be improved?
  1. Corporate governance is one part of a much bigger, whole human management system that must be considered – traditional governance analysis concentrates efforts on the nature and activities of the board. But what about the rest of the organization? Is the board a good proxy for how the organization manages itself? For example, if the board is good at acquiring and sharing critical knowledge, does this mean that the rest of the company is too?

Our approach looks at the governance problem in a different way – something we have called Human Governance analysis. The question we seek to answer is to what extent is a company maximizing value and effectively managing risk arising from its entire human capital management system? This acknowledges and includes important board and C-suite factors but, critically, evaluates how this plays out and connects to the entire human capital management system; including for example, the management of supply chains.

When we analyze Human Governance, we look at all the key facets of value that arise from human capital. Our starting point is to identify underlying organizational purpose, how this relates to business strategy, and then to the performance of all a company’s human capital. We are interested in how value and values are intertwined and permeate and inform both senior leader actions and people outcomes across the entire human system. We are, of course, interested in key aspects of a traditional governance focus that materially impact value, such as executive reward and decision-making. This is an analytical whole system methodology that specifically assesses corporate Human Governance and the extent to which an organization is aiming to achieve maximum value from its human capital.

At the same time, we also analyze company capability to consciously and explicitly manage and mitigate human capital risk. Human capital risk arises out of unclear, distorted or non-committal organizational purpose and seeps through all company systems: from decision-making, resourcing, reward, learning and performance management to quality assurance. We view people risk arising from 12 core dimensions and only by understanding risk in this interrelated context can we understand and predict the likelihood of corporate problems or failure.

So back to the original question – how can you price-in governance? Through our ratings, we carry out comparative analysis across firms and sectors. We are able to identify not just the nature of value and risk areas but also the potential value and risk quantum for particular organizations. We believe you can price the nature of this whole system Human Governance, either through a value or risk factor built into an investment algorithm, or perhaps through more qualitative stock picking processes. Investment professionals can also use the analysis to ask better questions of the board and demand better information: companies are wasting too much time measuring and reporting on meaningless metrics such as training hours rather than learning impact. It is something which investors and investment professionals are now beginning to understand.