We thought it would be interesting to share the common approach to integrating corporate governance (CG)  into investment decisions that 34 DFIs have adopted. DFIs cover emerging markets around the world, including Africa, Latin America, the Caribbean, Asia, Middle East, North Africa, Europe and Central Asia, with total assets of more than $850 billion. DFIs investin equity, debt and mezzanine deals.

What does it provide?

The corporate governance framework establishes a common approach for evaluating governance practices in the due diligence phase of a deal and subsequently improving the corporate governance of investee companies.

While not designed as a one-size fits all approach that can easily result in undesired tick-the-boxes behavior, a unified approach makes it more predictable for investee companies what to anticipate in terms of corporate governance expectations by investors. By signing on to the framework, the DFIs hold themselves accountable to actively implement the common approach. In addition, the framework initiative provides a set of corporate governance tools such as corporate governance assessment methodology and guidebooks that are ready to be used. It also establishes incentives for investee companies to embark on governance reforms.

The signatories of the framework undertake to:

1. Integrate Corporate Governance (“CG”) in its investment operation

a. Adopt CG procedures and tools in line with the Framework’s methodology;

b. Where considered appropriate, conduct CG assessments of investee companies and develop CG action plans;

c. Monitor progress of the implementation of CG action plans.

2. Ensure internal responsibility

Identify and assign an internal function that is responsible for the implementation of the Framework.

3. Provide or procure training

Ensure capacity building and knowledge transfer to staff for the implementation and further development of the Framework.

4. Collaborate with other signatories

a. Share experience and resources in training and implementation

b. Contribute to developing case studies and progress reports on the above.

5. Report on implementation

Report annually to the other signatories on the internal implementation of the Framework.

What can private investors in emerging markets learn?

The take-away for private investors is at least two-fold.

1. Coordination of efforts can be effective.

We don’t expect private investors to share their evaluation methodologies any time soon, but the increasing focus big private investors such as Black Rock put on governance and sustainability issues can ha e a significant impact on company behavior and efforts. Coordination efforts by pension funds in some emerging markets such as Chile, where the Administradoras de Fondos de Pensiones (AFP), the country’s private pension funds, operate a shared data base for independent directors show that cooperation can take many different and fruitful forms.

2. Emerging market companies want to improve their governance.

The DFI experience over the last decade shows that there is appetite by emerging market companies to implement corporate governance reforms. If investors provide additional incentives to their investee companies, governance reforms are even more likely to be initiated.

Nigeria to roll out National Framework of Corporate Governance

We find that the index setup and methodology chosen should serve the CGRS well in achieving its goals. After the test phase in 2014, participation for all listed companies will be mandatory. This will give the rating credibility since companies cannot pick and choose to participate. The chosen rating criteria are an adequate blend of Nigerian and international standards, with the explicit aim of evolving over the years to make them progressively harder to meet. In addition, the CGRS has developed a unique three-component rating setup, consisting of a corporate compliance, a director fiduciary awareness and a corporate integrity component. With the explicit addition of a focus on actual company practices and corporate integrity, of special importance in the Nigerian context of course, the CGRS setup is unique in the international context. The plans for the setup of the CGRS also contain a well-thought through selection process for the evaluators engaged in the CGRS rating process which should  – in theory – work well to prevent conflicts of interest and protect the integrity of the rating process. The proposed governance structure with one steering board and three specialized committees is elaborate when compared to other corporate governance indices, but seems appropriate to ensure the credibility, transparency and integrity of the rating system.

In our previous studies of corporate governance indices we have noted the critical importance of transparent communication about an index’s setup and results. Given the complex CGRS setup, including the incorporation of non-public information in the corporate integrity rating component and the generally negative perception of Nigerian business practices, a very high level of index transparency is crucial for the CGRS. The planned comprehensive disclosure of the full methodology and rating results on a singular website would put the CGRS ahead of all existing corporate governance stock exchange indices by a wide margin. In fact, of the currently existing six stock exchange indices based on rating corporate governance, none discloses the individual company rating results.

The success of the CGRS hinges on the successful implementation of its well-conceptualized setup. We are looking forward to see the completion of the pilot phase with volunteering companies later this year and the subsequent launch of the CGRS. An increasing number of stock exchanges is in the process of launching indices incorporating corporate governance factors, often as part of a sustainability index also factoring in environmental and social factors. The Moscow Stock exchange is still planning to launch Novy Rynok some time in 2014 and the Santiago Stock Exchange in Chile has just commissioned a feasibility study for a sustainability index.  In what is a growing number of stock exchanges with indices incorporating corporate governance factors, the CGRS has the potential to stand out for the transparency of its setup and the attempt to measure implementation.

The investors’ guide to corporate governance in Latin America published by BNamericas looks at the ownership concentration and a lack of minority shareholders’ rights that have defined the landscape for many years.

This week BNamericas spoke with the report’s author, Andreas Grimminger, founder and managing director of PGS Advisors international, a policy and corporate governance consultancy, to take a pragmatic look at the level of corporate governance standards in the region and gain a better understanding as to the role of capital market development in encouraging better standards.

The full report can be found here.

BNamericas: How do corporate governance standards compare between Latin America and other emerging markets?

Grimminger: Most emerging markets face very similar corporate governance issues, as concentrated ownership is a prevalent feature across markets. Asian markets, as well as some Latin American markets, are further characterized by significant cross-shareholdings and sometimes pyramid structures, which make related-party transactions an issue of particular importance.

Corporate governance practice standards and their integration into law and regulation have improved significantly in both developed and emerging markets over the last decade, but the distinguishing factor lies in their implementation and enforcement and in developing a culture of good corporate governance that is part of the business fabric.

For sound corporate governance practices to become truly engrained in the business culture, I believe a balanced mix between regulatory and private initiatives is essential. Latin American markets, especially Brazil, compare fairly well to other emerging markets in this respect.

Corporate governance reforms in Brazil have been to a large degree driven by private actors, such as the Brazilian institute for corporate governance (IBGC) and self-regulatory initiatives such as the Novo Mercado segment on BM&F BOVESPA.

On the other hand, initiatives in Malaysia, which can be considered a regional corporate governance leader in Asia, have been top-down, driven by the Malaysian Security Commission.

In contrast, investor groups like the Brazilian association of capital market investors (AMEC) are private investor initiatives. This is not to say that the Brazilian securities regulator CVM is not playing an increasingly important role in corporate governance reforms, but many initiatives have come from the private sector.

Other Latin American markets like Colombia and Peru and especially Chile, on the other hand, are predominantly driven by regulatory initiatives in their corporate governance reforms. So there is room for more private sector initiative, even though Chile can already count on three corporate governance institutes.

BNamericas: Can you differentiate the role of foreign investors from local investors when it comes to pressuring companies to follow certain standards?

Grimminger: Given the low liquidity of most equity markets in the region and the AFPs’ preference to invest locally, AFPs are clearly the dominant institutional investors and minority shareholders in the region. For minority investors, whether they are AFPs or foreign investors, securing representation on the board and obtaining the disclosure of relevant company information to protect their rights are the most important issues.

AFPs certainly have a leg up on foreign investors as they usually fill the few seats for independent directors, but there are already many successful examples of cooperation between AFPs and foreign investors and, ultimately, the growing influence of AFPs is beneficial to all minority investors.

This increased influence can, to a degree, be tracked to the introduction of regulatory requirements forcing AFPs in Colombia, Chile and Peru to vote their shares, nominate directors, actively consider corporate governance and report on all these issues.

BNamericas: What is required for the pace of improvement in corporate governance practices to speed up?

Grimminger: Good corporate governance practices are important for companies for two principal reasons. First, to assure outside investors that their investor rights are respected. Second, sound corporate governance structures, such as diverse and independent boards of directors, benefit any company regardless of its capital structure as they improve decision-making and risk management.

In order for reforms to continue or even accelerate in the region, two developments are necessary. First, liquidity needs to increase so outside investors become more relevant and companies more likely to listen to their governance demands. And second, companies’ awareness needs to be further raised with respect to the many economic benefits of good corporate governance.

We see both occurring, albeit at a slow pace. However, improved corporate governance practices, in particular when it comes to the disclosure of company information in the region, are critical for the continuous development of the regional economies and capital markets.

BNamericas: With the rise in cross-border consolidation within the region, do you foresee new issues arising with regards to standards of corporate governance and regulations?

Grimminger: Regional integration initiatives such as MILA and the rise of the multilatinas will not lead to the rise of new issues, but – in my opinion – to the intensification of already existing ones.

A larger and more diverse investor base will demand better governance standards, such as increased disclosure of company information ahead of the annual general meeting and more say on board nominations.

The current practice that board nominees are not disclosed until the AGM (with the exception of Brazil) will certainly come under increased pressure. We already see the disclosure of at least the names and background of nominees ahead of the board elections at companies needing the votes of outside investors to reach a quorum.

At PGS Advisors we believe that companies across the region will increasingly follow best practices, not only in the case of multilatinas and other blue chip companies, but also more and more in the case of medium-sized and even family-owned companies.

It is important in this context to demonstrate the economic and reputational benefits of good corporate governance and good sustainability practices for all kind of companies. The growing regional importance of ESG (Environmental, Social and Governance) standards for corporations and investors in the region will be an important trend to watch.

Every two years, Aon asks risk leaders across industries to identify the main risks their companies are facing in their operations. More than 1,400 practitioners responded to the 2013 survey. The 2013 survey ranked the top 50 risks companies face, focusing on the top 10 risks in 2013 and how they may change in 2016, displayed in the table below. Overall, the survey found that most respondents found their organizations less risk-ready than in the previous survey in 2011, which might in part be attributed to the prolonged economic recession, which has strained many organizations resources.

Source: Aon Risk Solutions – Global Risk Management Survey 2013

We have three main observations about this ranking:

1. It is certainly interesting to see that damage to reputation/brand is perceived to be diminishing in risk, according to the survey. From our perspective, this seems to be an optimistic scenario. With social media – both a valuable marketing and communication tool as well as potent potential reputation killer –– being only ranked as risk factor number 40, it certainly appears as if companies seem to underestimate reputational and social media risks.
2. Political risks and uncertainties are ranked 10th and are expected to be more relevant going forward. Weather/natural disasters, while not far off the radar at the current ranking of number 16, are also projected to jump into the top 10 risk list at number nine. Both rankings make sense. Somehow though, the connection is not made between environmental risk, climate change and severe and erratic emerging weather patterns. Environmental risk is ranked only 28th and climate change 38th. This seems to be an underestimation of these factors – especially moving forward – and in particular in the light of recent weather events in the United States.  These numbers also imply that companies that take the development of sustainable strategies serious should be able to gain an edge over companies that do not.
3. What’s more, and we will be focusing on this issue in a subsequent blog post, these are all external risks. One might argue that the most relevant risks a company faces are internal, of the organizational nature, ranging from inadequate board oversight to lack of monitoring capabilities to insufficient risk strategies. It can be argued that it is quite essential to get these issues right before one sets out to worry about global external risks.

This brief defines the responsible investment approach and differentiates it from standard investing practices. It also discusses the key debate whether it is profitable in the long or short term to align societal and investment values.

Highlights the motive for investors to engage in public policy debates since it decisively influences their long-term financial interests.

Discusses imminent shifts in the interpretation of fiduciary duties imposed on trustees and other fiduciaries away from being solely focused on maximizing return on investment in the short term.

Elaborates on the rationale for being an active owner and debates the effectiveness of active ownership.

The last brief focuses on the critical question whether ESG issues are relevant for investors, i.e. whether they are financially significant.

Emerging markets have been lagging in the development of ESG investment and investment products though. However, it seems that the time has come for the systematic incorporation of ESG risk assessments into emerging market investment decisions.  Three major trends are responsible for bringing emerging markets and ESG investing together, until recently separate investment specialty areas, although two of the fastest growing:

1. Emerging markets growth is diversifying and is not predominantly based on infrastructure investments anymore. In addition, a rising middle class represents a new class of consumers increasingly paying attention to sustainability concerns. Both developments lead to an increasing role for sustainability considerations in emerging markets.

2. Many emerging market companies are entering their mature growth phase, consolidating and affording the ability to focus more on management quality and corporate responsibility. These companies also are also facing increasing challenges such as resource constraints, demand for more corporate accountability and compliance with global best practices such as labor standards and reporting guidelines. Companies that embrace the challenge can truly differentiate themselves from companies that do not and offer attractive investment opportunities.

3. Information on ESG practices of emerging markets companies was very difficult to obtain only a few years back. This has changed significantly in a short time span. An increasing number of emerging market companies today publish sustainability reports, a growing number of them in compliance with the guidelines of the Global Reporting Initiative. In addition, for investors willing to purchase rating reports, GMIRatings has increased its ESG rating service for emerging market companies from 688 in June 2012 to 998 as of April 2013.

Indeed, underlining these developments, two commercial emerging market ESG indices have been launched in the past two months.

In February, RobecoSAM, a sustainable investment specialist and S&P Dow Jones Indices launched the Dow Jones Sustainability Emerging Markets Index with 69 companies. The companies are selected based on RobecoSAM’s annual corporate sustainability assessment, which evaluates companies’ sustainability performance based on economic, environmental and social criteria.

In March, asset manager Northern Trust announced the first emerging markets custom index based on MSCI ESG Research and Institutional Shareholder Services’ (ISS) governance screens. The design of the fund applies three screens to the MSCI Emerging Market (EM) Index universe, followed by a sequence of checks on governance and executive independence. The first screen eliminates constituent companies of the MSCI EM Index that have been found to be in breach of the UN Global Compact’s ten principles. The second screen removes manufacturers of controversial weapons ant he third tobacco manufacturers. Following these exclusions a filter is applied targeting companies lacking sufficient independence across ownership, board representation, key corporate committees and audit and remuneration committees.

In addition to these indices representing select companies from a variety of emerging markets, stock exchanges in a number of emerging markets had already launched ESG indices over the past decade. Prominent examples are the Johannesburg Stock Exchange Socially Responsible Investment Index and Sao Paulo’s BM&FBOVESPA’s Corporate Sustainability Index, launched in 2004 and 2005 respectively.

While these are encouraging signs, much work still needs to be done. Two reports published late last year, EIRIS’ “Evolving markets: what’s driving ESG in emerging economies?”, and the Forum for Sustainable and Responsible Investment “Lessons Learned: The Emerging Markets Disclosure Project, 2008 – 2012” found that poor corporate environmental and social governance disclosure remains the number one challenge to investing in emerging markets. The reports also highlighted that knowledge of sustainability reporting practices and international norms varied widely between markets.

As investors are integrating ESG risk factors into their investment decisions in emerging markets, it is clearly time for emerging market companies to take the sustainability challenge serious.

Participants in the forum identified as the critical issue that both sides rarely speak the same language. A typical analyst will not necessarily ask questions about sustainability but is certainly interested in issues concerning succession planning, regulatory compliance, energy efficiency or customer relations. All of these issues of course about corporate sustainability, when defined by a company’s triple bottom line of social, environmental and economic performance, but it might not be apparent to the investor. While a company with a strong sustainability strategy and record shows superior risk management and long-term growth prospects, the terminology used to describe sustainability practices may alienate investors. Eric J. Hespenheide, global leader of Deloitte’s Sustainability Audit and Enterprise Risk Services is quoted in the article as raising the question: Is the disconnect “all a grand misunderstanding? It sounds like analysts are actually interested in this but not getting through because of the language.”

And, at least in the US and Europe, the language is clearly the problem, since there is no shortage of disclosure on nonfinancial performance data anymore. On the contrary, as one senior investor pointed out, there is lots of bad and irrelevant data released, essentially creating noise, preventing investors from seeing the real CSR picture of a company.

To allow companies to remedy this communication gap, Mehallow summarized five steps suggested by participants at the forum.

1. Investors need industry-specific data. While companies can and need to produce the data, it is difficult to know what exactly individual investors are looking for. The work of the Sustainability Accounting Standards Board (SASB), which is developing standards for ten sectors and 88 industries and is set to release standards in 2015, will facilitate bridging this barrier.
2. Avoid loaded language. The term CSR is a good example in itself, as its terminology suggests that there is no economic benefit for the company and investors involved. Communicating that a company’s sustainability engagement is really about integrating social, environmental and economic performance to create lasting value is more accurate and certainly more appealing from an investor perspective.
3. Talk to the right players. Issues of sustainability should be a routine and integral part of an investors’ assessment of companies and part of the conversation with management, not just a company’s sustainability officer.
4. Provide useable data. Where sustainability performance can be measured and standardized, companies need to go ahead and provide such data as easily digestible as possible to investors, so it can be fed into models. Examples include carbon emissions, human capital, natural resources and other sustainability performance metrics.
5. Explain the meaning behind the data. Companies need to explain why their sustainability performance is good for its bottom line. 

In order to accelerate the transition to a better representation of women on boards, a number of European countries such as Italy, France and the Netherlands have taken to impose mandatory quotas for women in board positions. France, for example, passed a law in 2011 requiring women to hold 20 percent of board positions by 2014, and 40 percent by 2017. In November 2012, the European Commission adopted a proposal for European Law requiring female representation of 40 percent on company boards. The proposal still needs to be approved by the European Parliament and a majority of member states to become European law. If adopted, the law will not be mandatory but introduce a range of administrative burdens to coerce companies to appoint more female non-executive directors.

Companies will have to prove they are trying their best to increase the number of women in top management positions to at least 40 per cent. They will have to try pretty hard. According to EU data from January 2012, women represented 13.7 percent of board positions in large listed companies.

A new study “Why women make better directors”, published in the International Journal of Business Governance and Ethics, offers compelling support for proponents of greater female representation on boards, whether achieved by quota or not.  The study surveyed 624 directors over nine years, almost all in Canadian companies, including large listed corporations. 75 percent of the survey participants were men and 25 percent were women. The study used a standardized test called the Defined Issues Test (DIT).  The test was taken by directors who participated in the Directors College training course for corporate directors in Canada

Prof. Chris Bart and his research partner Gregory McQueen of A.T. Stills University in Arizona used the DIT analysis to determine to what degree directors relied on three basic reasoning methods in deciding a series of hypothetical cases:

• Personal Interest: “What’s in it for me?” The decision maker is motivated by ego, selfishness, and the desire to avoid trouble for self.
• Normative: “Don’t rock the boat.” The decision maker adheres to existing group norms, rules, or the status quo.
• Complex Moral Reasoning: “What will be most fair to everyone concerned?” The decision maker considers all stakeholder perspectives, and uses cooperation and consensus building, consistently applied in a non-arbitrary manner.

As can be expected from individuals serving on a board, most strongly relied on complex moral reasoning. But women did so to a much higher degree than men, who relied relatively more on the normative approach. This suggests women may be better on average at applying “complex moral reasoning” factors in decision-making, which involves considering viewpoints of multiple groups, using co-operative and consensus-building approaches. Men on average rely more on making decisions based on rules, regulations, or traditional ways of doing business.

Given these finding, “companies may actually be shortchanging their investors” if they have no women around the table, Prof Bart suggests. Indeed, a 2007 study of Fortune 500 companies across five industries by Catalyst, an organization dedicated to expand opportunities for women and Business, found that companies with women on the board recorded:

• 53 percent higher return on equity
• 66 percent higher return on invested capital
• 42 percent higher return on sales

So getting more women on boards should be a priority for any business, but change is slow to come around. And contrary to a popular argument, in most parts of the world, the underrepresentation of women on boards is not due to a shortage of qualified women. Prof. Bart argues that men are reluctant to have women enter boards because they have a more challenging decision-making style and are less deferential to tradition or defined power structures. His reasoning is supported by a study by the World Economic Forum, the “The Corporate Gender Gap 2010”, based on a survey of 600 heads of human resources at the world’s largest employers. The two biggest barriers for the advancement of women to leadership positions identified in the study were “general norms and cultural practices in my country” and “masculine/patriarchal corporate culture”.

So while quotas may not be most companies’ favorite solution to increase female representation, it may be the most effective way forward to break through those cultural barriers. As Viviane Reding, the EU Justice Commissioner responsible for the EU quota proposal is quoted: “I don’t like quotas, but I like what they do.”

In a recent article in Pensions & Investment, Anne Simpson, senior portfolio manager and director, corporate governance of CaLPERS was cited as explaining that under the new initiative, CaLPERS will buy additional shares of companies it owns already under its indexed equity portfolio. The additional investment will go into companies that CaLPERS views as underperforming but displaying growth potential with CaLPERS engagement. The names of companies it engages are not normally disclosed, but CaLPERS makes exceptions when it files shareholder resolutions to force governance changes. Last year’s examples of such companies included Chesapeake Energy Corp. and Nabors Industries Inc. . According to Ms. Simpson, CalPERS has about 10 other companies also under engagement.

Another CaLPERS official said the funds allocated to the concentrated portfolio would be US$50 million indefinitely for five to 10 companies each year with the potential to grow significantly if successful. According to Ms. Simpson the new initiative is “an important signal to the market that we believe in this, we have conviction.” She also called the strategy “monetizing our company focus list”.

Lev Janashvili, managing director of corporate governance research firm GMI Ratings, is quoted in the article as believing that CaLPERS is the first pension fund to build a separate portfolio of companies it has engaged in.

Since CaLPERS has been a pioneer in incorporating financial standards, corporate governance and broader ESG issues into its portfolio allocation decisions, it seems only fitting that the fund would be the first to build a separate portfolio of companies it is actively engaging on such issues. Depending on its success, one can expect more institutional investors with comparable clout to enter such strategies.