Understanding critical risks: how valuable is a healthy company culture?

Putting a value on corporate culture requires whole system thinking and specific expertise but Human Governance analysis allows us to do just that

The UK Financial Conduct Authority recently decided not to publish its long awaited review into the culture of the banking industry. This was widely seen to be a politically driven decision to bring “banker bashing” to an end and avoid further reputation damage to UK banking. There is one very positive outcome from this: it is now clearly understood that culture dictates reputation and that it is material to corporate, financial value.

Whether the FCA review itself would have facilitated positive change in our banks is unclear. However, in dropping the review, the FCA advised the Financial Times that “each company is unique and cannot be easily compared”. This statement contains an element of truth; every company is unique, yet they are all the same in one sense – they have to have a common purpose of creating value, a strategy, effective structures and systems. These are the common building blocks that can be analyzed and assessed for comparison. Our analysis not only makes this possible but we believe essential; to identify the comparative ‘health’ of these important organizations, whose purpose should be to provide value to shareholders, employees and wider societal stakeholders.

As with medical practice and the human anatomy, company ‘health’ has to be viewed holistically through a thorough analysis of very specific risk factors: in this particular context, risk factors that arise from the management of the corporation’s human capital. OMS’s Organizational Maturity Rating (OMR) uses these factors to identify where companies fit along a 22-point “AAA” scale. This continuum of progress and performance plots their relative positions; from high investment risk and instability to mitigated risk and greater stability (see Figure 1.).

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Figure 1. The OMS risk assessment scale

For example, several companies who have recently suffered significant reputation damage, and material value impact, arising from Human Governance failures are HSBC, GSK and Tesco. Each company is rated on our OMI at BB-, BB- and B respectively, highlighting our view that they all continue to carry material risk from their human capital. Moreover, following the same diagnostic method as the medical clinician, it offers a prognosis for current and future health. This is not only critical insight for Boards; investors see the value of this predictive aspect in informing their decisions around stock picking, valuation and corporate engagement strategy.

OMR Risk Analysis

So how do we carry out our analysis?

Most companies identify and manage human capital risk through a narrow lens e.g. ‘talent’ attraction and retention, health & safety, or human rights. For example, Microsoft state in their latest 10-K filing that material risk with respect to human capital is limited to attracting and retaining key talent that provide them with necessary skills and expertise. With respect to the Principal Risks and Uncertainties that Nestlé identify in their 2014 annual report[i], the company’s only material risks with respect to human capital is limited to the health & safety and wellbeing of staff & contractors. While both companies identify aspects of human capital risk, it is for only small parts of a much bigger Human Governance system. Moreover, this risk is in no way quantified in the common language of ‘hard’, commercial value (or loss).

This traditional approach to assessing and managing people risk is no longer fit for purpose. Firstly, it fails to quantify the magnitude and probability of material risks identified. It also omits a significant number of potentially material risks. These should be communicated to key stakeholders, with information as to whether they are being carried and may manifest, or sufficiently mitigated to be of no material concern. The absence, or limited nature, of meaningful Human Governance risk assessment means that investors do not have adequate information upon which to make sensible judgements on organizational value. With the recent VW scandal, we are finally seeing investor questions being raised with company Boards that directly address company culture as a source of corporate failure and these questions demand answers that demonstrate progress in reducing risk.

Our approach recognizes that the roots of human capital risk can be traced right back to questions of organizational purpose and how corporate values and principles permeate through the entire company system: from decision-making, resourcing, reward, learning and performance management to quality assurance. Only by understanding risk in this context can we understand and predict the likelihood of corporate problems or failure. We adopt whole system human capital risk analysis to identify the nature and quantum of business risk that is inherent with and intrinsic to the organization. This involves analysis of 12 Human Capital Risk Factors that are core, interrelated and causally connected to material business risk.

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Figure 2. The 12 Human Capital Risk Factors

For example, one of the core Factors is knowledge & learning, where we identify any failure to utilize existing, critical, internal knowledge which leaves a firm in a disadvantaged or precarious market position, or any inability to learn from mistakes or innovate for the future; causing material value damage. The symptoms of an organization carrying this risk include a lack of an internal learning system, no common discipline of problem solving throughout the organization, or no explicit feedback loops. We might also see training inputs used as a proxy for learning value and a much higher probability of whistle-blowing activity and information leakage, as “employee voice” is not systemically integrated or is considered unimportant.

Another core risk Factor is the supply chain relationship, where we firstly analyse the nature of company relationships and how this affects outcomes within the human governance system. For example, are suppliers chosen according to a broad or a narrow definition of value such as cost, and how does this affect product or service quality? In our latest pharmaceutical sector report, we noted a number of key human capital risks, and made a concluding statement with respect to suppliers of outsourced research & development:

“Even the most mature corporations can struggle to maintain quality within their value chains[ii] and this can have significantly material impact. We are not convinced that this industry sector understands the level of management expertise necessary to ensure that it operates according to stated standards.[iii] This is a critical question for pharmaceutical companies and is perhaps the single biggest source of business risk.[iv]

Our approach to analyzing Human Governance related risk means that the health of corporate culture can now be professionally and objectively assessed using a common benchmarking platform to produce meaningful insights and data. Senior leaders can see where they are in relation to competitors and gain a fresh perspective on how to address these critical challenges. Investors, who need to fill this gap in their capability for accurate company valuation, can assimilate this new perspective in stock picking and enhance how they communicate with Boards and Excos.

If you would like more information about the nature of our work, please contact stuart.woollard@omservices.org

References

[i] http://www.Nestlé.com/asset-library/documents/library/documents/annual_reports/2014-annual-report-en.pdf

[ii] http://www.industryweek.com/quality/new-toyota-recall-targets-175-million-vehicles-3-separate-problems

[iii] http://www.astrazeneca.com/Responsibility/Research-ethics/Clinical-trials/Our-standards

[iv] http://www.medscape.com/viewarticle/736013