Sustainable Companies, Excellent Governance, Responsible Investors, New Stakeholder Value Measure Needed
Poor governance destroys stakeholder value. Maximisation of Shareholder Value has clearly failed; General Motors and BP as recent examples cost $57.6B and $25B respectively. It drives perverse managerial behaviour. A new measure is proposed to support the UN Principles of Responsible Investment to encourage long term value creation.
For the last thirty years the concept of Shareholder Value Maximisation has ruled much of corporate governance in the Anglo-Saxon world, leading to significant levels of short-termism in both executive and investor behaviour; one example is the failure of General Motors, which required $57.6B US government support. (Chang, 2011).
There has been much criticism of the “Shareholder value maximisation” approaches of Anglo-American corporations (Chang, 2011), which has lead to a range of adverse behaviours, such as short-termism, excessive project risk taking (Lin-Hi and Blumberg, 2011 and Hubbard, 2009) and questionable executive remuneration practices (Pryce, Kakabadse and Lloyd 2011) which resulted in the destruction of shareholder value..
Anglo-Saxon corporations, both in the banking sector and in many other sectors, are locked into bonus schemes for executives of up to 300% of base salary, subject to achievement of “stretching targets” (Costello, 2012), whilst at the same time pensions for other staff are being reduced (Costello, 2012). However, the governance of UK remuneration committees is very weak with the majority of the membership being composed of “insiders” (Clark, 2012).
We have had the 2008 Sub-Prime Mortgage Securitisation created Credit Crunch which was partly caused by inappropriate and failed approaches to Risk and Compliance management, short-term profit maximisation (Zuckerman, 2009) and also by a strong belief that powerful computer systems would protect our organisations (Curtis, 2011).
Current stock market indices provide a single view on the valuation of a corporation, based on the current traded price of the relevant equity and the number of shares issued. Little evidence is available to provide any indication to investors how well the corporation is managed for the long term; many do not care, due to the short time that they intend to hold the investment. There is a lack of diversity in available indicators to help executives and investors identify how organisations are managed for either sort-term or long term perspectives.
Too many people attempt to solve a complex problem with a simple minimisation or maximisation of the chosen single solution parameter. For example, if product prices are tightly controlled by the market, the simple solution to margin management and growth is to minimise costs. However, this can then lead to a “dive to the bottom” in terms of quality, ultimately leading to loss of customers and sales, damage to the workforce and the local community.
The world is very complex and interlinked, it is, therefore, not appropriate to follow a maximisation or minimisation approach to a single problem. Instead, an approach of optimisation is required. Indeed, much of what has and is happening results from following the principle of maximising whatever parameter of management is considered fashionable or good, (see Archilochus’ aphorism of the tortoise who knows just one big idea as compared to the fox who knows many things (Rodrik, 2011)).
The UN Principles of Responsible Investment states
“As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognise that applying these Principles may better align investors with broader objectives of society” (UNPRI 2005).
In order to identify the breadth of the optimisation rquired a brief review of business, governance and informatics literature spanning the last twenty years suggests that there is a wide range of areas where investor and executive behaviours have lead to initial sort-term gains but which have, over the longer term lead to significant destruction of both shareholder and stakeholder value (Zinkin, 2010). This can either occur by executive actions or is facilitated by lack of understanding of the related risks and failure to effectively implement appropriate risk management policies, a failure in compliance with authorised policies.
Short term gains of a few days and a few tens of millions of dollars finally cost BP, on current assessments $25B and thousands of people their livelihoods (Lin-Hi & Blumberg, 2011) and (Macalister, 2012).
Technology and other complexity and risk and programme management issues (Project Governance) resulted in the B787 and the A380 aircraft being ready for customers several years late with consequential costs on a wide range of stakeholders (Airlines, passengers and airports).
The Standish Group have consistently demonstrated since 1994, through their bi-annual Chaos Reports, that only about 30% of projects involving information technology are fully successful (on-time, to budget and delivering the contracted functionality), and that approximately 20% fail to deliver (Standish Group 1994, 1995, 1999, 2005, 2009) . The remainder, their “Challenged” projects, are over budget, late and deliver only a small part of the contracted functionality. Whilst this is debated by some authors and practitioners, the fact of large numbers of high value IT projects is incontrovertible. Their analysis of the caused of failure strongly suggest significant failures in Project Governance, often including failure to comply with existing, authorised policies. The costs associated with IT failures of governance is estimated as being between $50B and $200B worldwide per year in an industry which is equivalent to some 3% to 6% of world GDP ($2T to $3T).
The governance of operational systems is also highly deficient. Analyses of the problems of the failure of operational systems to deliver the required functionality leads to high levels of End User computing with very high levels of organisational risk (Panko, 2008, Panko & Port 2012 and Deloitte, 2010). Over 95% of all spreadsheets contain one or more significant errors, yet they are used in many organisations in large interconnected data analysis systems for operational purposes and decision making (Cluster seven, 2011). Most end user systems are un-maintainable, leading to re-creation of the spreadsheets at a later date. This represents a high level of wasted corporate and stakeholder value.
Remuneration and bonus systems for executives are high in the public consciousness and clearly do not have the intended consequences of driving strong governance and alignment of management and shareholder value. They are rarely constructed to consider the wider issue of improving stakeholder value. The failure of Lehman Brothers clearly demonstrates that even the highly developed use of long vesting share bonuses did not protect the company from overly risky behaviour and failure to comply with existing policies. The UK debate on bonuses for achieving the agreed targets, rather than exceeding the targets is a further indicator of the problems in the governance of businesses for long term stakeholder generation.
Many companies state that their value is based on the quality, knowledge and experience of their staff. Yet, little of this is explicitly recognised in any standard measure of the shareholder or stakeholder of an organisation. In addition, Anglo-American companies are prone to cutting staff costs, as a general principle, using outsourcing, off-shore outsourcing and staff reductions in times of temporary economic downturn. In contrast organisations in other cultural environments, with government, staff and union support, use temporary short time working to retain the knowledge capital and skills of their workforce, thus benefiting both the company and also the local community.
Existing measures of the value of companies generally revolve around market capitalisation (number of shares issued multiplied by stock market price. This is a highly volatile valuation primarily driven by short term issues and investor horizons. Up to 50% of all share trading across all exchanges are held for short periods of time. At the extreme end, High Frequency Traders may only hold the equities for a period of a few seconds or less, whereas pension funds may have investment horizons measured in years.
Existing Sustainability indices operate by factoring the market capitalisation by some form of sustainable governance factor, however, this maintains the volatility of valuation, giving little indication of the long-term value of a company to responsible investors. Many of the factors included in sustainability indices are related to the existence of, rather than compliance with, governance policies and procedures, which are often not complied with in order to meet short term benefits and equity price targets ( BP Deepwater Horizon being a significant example (Lin-Hi and Blumberg 2011)).
There is, therefore, a need for a new way of valuing an organisation that takes account of a wider range of governance and stakeholder factors that provides a more stable indication of the value of a company over the long haul.
This Hack (like the Archilochus fox) synthesises a wide range of disparate concepts with the objective of creating a new approach to evaluating the quality and impact of the governance of organisations which will offer all stakeholders in corporations a clear view of the sustainability and value of the organisation. The problem analysis suggests a starting list of the factors which might be incorporated. It is clearly not exhaustive and will need considerable further research and analysis.
The key to the solution is the creation of a new valuation of a corporation which is isolated from the fractal volatility of equity prices and provides a stable estimate of the stakeholder and shareholder value over periods of years to enable responsible investors (using the UNPRI concept) to better judge their portfolio investment decisions. In addition a new Sustainability Factor should be defined, similar to (but extended) the SAM defined factor (SAM 2012) used in the Dow Jones Sustainability Index.
A suitable starting point is the balanced Score Card of Kaplan and Norton (1992) because it introduced the idea of incorporating non-financial factors into an evaluation of the company. The current proposal is to add a set of criteria developed for Environmental, Social and Governance (ESG) associated with the UNPRI initiative and extended with new criteria addressing the additional problems identified above, such as:-
- Quantification of value, growth and preservation of Knowledge Capital
- Quantification of the Risk Management governance processes and outcomes
- Quantification of Information Governance (emphasising costs, benefits and risk and compliance management, including those of technology and end-user-computing related risk factors and costs ). Some aspects of this are very similar to the concept of Operational Risk in the Basel II and Basel III frameworks.
These additional factors will be controversial and may face resistance. It can be observed that the SAM questionnaire is remarkably intrusive but has been accepted by many organisations, suggesting that companies may be receptive to further disclosure if this provides greater stability to the assessments of the long-term sustainability and value of the company in the eyes of both the investors and wider society and reduces the necessity for short-term behaviour that leads to such high stakeholder value destruction.
The overall objective will be to provide two tools to evaluate the value of the company:-
- An concrete valuation of the long term value
- An index factor relating to the quality of the long term sustainability practices and behaviour of the company
Combination of the two will then provide a weighted evaluation of the impact of the company behaviour on its overall value.
Several practical impacts are intended:-
The development of stronger consideration of the wider stakeholder interests in sustainable corporations. This can draw on the ideas embedded in the UK Companies Act 2006 Section 172(1) relating to the responsibilities of Directors to a “duty to promote the success of the company” and to consider long term impact, interests of company employees, impact on the wider supply chain and customers and the impact of company operations on the community and the environment. This has been called the principle of “enlightened shareholder value” (Kay, 2012). This proposal will provide quantitative and qualitative metrics to enable responsible investors and the wider stakeholders have the ability to exert pressures on aberrant, short term approaches to decision making and governance.
The second impact will be to provide responsible investors with a more effective understanding of the long term value of their investment programmes and portfolios. This will be of significance to all investors who take a long view of their investments, whether institutional or private investors. Clearly they will still need to take account of the volatile prices of equities in terms of their purchasing and disposal. However, in the long term, they will be served with better information. There will always be sudden, unforeseen occurrences which will drive some level of volatility, but over the long term it is likely that such investors will be better provided with better information (a key objective of transparent, relatively free markets).
Thirdly, a suitably constructed metric should provide stronger incentives for companies to implement strategies to deliver the wider stakeholder shared value. This will be of significant value both in developed and developing countries and could provide significant mitigating programmes to counter the wide-scale adverse perceptions of multi-national corporations (Porter and Kramer, 2011).
Step one is clearly to develop a more detailed definition of the useful content of the new means of valuing the long term value of a company. This will require involvement of experts from across the business and financial fields, both practitioners and academics and the creation of a governance body for the process.
Step two will then be to back model and validate the process using as much historic data as possible to demonstrate that this approach is feasible, practicable, stable and relates to the real world of business management and investment.
Step three will then require that executives and shareholders buy-in to the process and agree to operate it. It is unlikely that all the information can be obtained from what is currently publicly available, hence active cooperation will be required. However, the example of the Dow Jones - SAM DJSI evaluation process gives some basis for believing that it could be accepted.
This is based on a range of discussions with colleagues at the University of Derby (UK), Cambridge University (UK) and in the Financial Services community in London.
It also draws from and synthesises many of the ideas presented in other M-Prize Hacks, to the authors of which I am also grateful.
One in particular is this one by Galit A. Sarfaty