Survey Says… Corporate Governance Matters to Investors in Emerging Market Companies By Vikramaditya Khanna and Roman Zyla Financial crises have a way of bringing corporate governance to the foreground. For in- terested parties wanting to know more, there is an impressive body of research that looks About the emerging mArket investor survey at companies and the connection between strong governance and better performance. However, the existing literature only goes so far. It does not look at whether the level and • Twenty-nine respondents, culled from a total universe quality of firm-level corporate governance plays a role as large-scale investors consider of 1,000 emerging market investment decisions in emerging markets. investment firms. • Respondents included decision-makers at This study of emerging market investors sheds light on this issue and reveals that emerging institutional investment market investors care deeply about corporate governance. firms, private equity funds, hedge funds, pension plans, and investment The findings have significant implications, not only for the emerging markets business and advisors. finance community, but for policy makers, academics, the media, as well as for develop- • Respondents included firms investing in publicly-held ment finance institutions focused on sustainable economic development in these countries. companies in one or more emerging markets. • The interviews with investment decision makers Key findings: were off-the-record and were conducted through At a For emerging market Company face-to-face and telephone interviews in New York and global level fund investment specific London. decisions • Interviews took place in April–May 2010. 1 Recent financial crises have elevated the importance of good 3 Corporate governance is a critical factor in emerging 5 Investors often do not invest in emerging market companies with poor market investment governance. decisions. governance. 2 Specific corporate governance-related reforms could make 4 Investors are willing to pay a premium for 6 Lack of transparency is a red flag for emerging market investors. better-governed emerging countries more attractive market firms. investment destinations. Emerging market investors 7 Board independence is a low-level concern for emerging market believe that better firm- investors. level governance can make up for country weaknesses in corporate governance. Background Increasingly, emerging markets are becoming important engines of global growth. Many have become the focus of the investment community and the average inves- tor. In fact, business publications around the globe are spotlighting a number of “The literature has grown these countries, particularly in the aftermath of financial crises, because some of to include studies of these nations, such as India and China, represent the few bright spots in an other- how governance reforms wise moribund global growth outlook. and practices in specific countries have influenced There is a vast literature on corporate governance, and specifically corporate firms in those countries.” governance in emerging markets. Connections between better governance and firm market value and performance, especially in emerging markets, are captured. Additionally, there are also studies that explore whether the investment decisions of foreign investors are connected to governance concerns, and how these investors may change the governance and performance of the firms in which they invest. Some “law and finance” studies examine the connection between better governance and greater dispersion in ownership structures, and deeper equity markets.1 The literature has grown to include studies of how governance reforms and practices in specific countries have influenced firms in those countries. For example, a series of recent papers have found that better governance in Indian firms correlates with higher firm market valuations, and that the governance reforms promulgated in India caused higher firm market valuations for those firms subject to the reforms.2 Further, studies on other emerging markets, in particular Russia and Korea, found that better governance is associated with higher valuations and that the relationship may be causal (from governance to performance).3 More recent studies of emerg- ing markets have attempted to explore what features of governance matter most in enhancing firm value, and through what channels do they operate with reduc- ing tunneling being a factor of prime importance.4 These findings are now being amalgamated into various governance rankings, which are being adjusted to reflect the unique concerns in certain markets and ownership structures.5 Despite the relative plethora of studies, there are few that explicitly inquire from investors what importance they place on corporate governance arrangements when making investment decisions. However, it seems important to explore this question because governance, which is a form of investor protection, might be expected to influence how investors behave; this will be critical for understanding the role of governance. This is especially so in the context of emerging markets where many of the institutions protecting investors in more developed markets may not be fully present. In light of this, it is important to obtain a better appreciation of how 1 See La Porta, Lopez-de-Silanes, Shleifer and Vishny (1997); La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1998); La Porta, Lopez-de-Silanes, and Shleifer (1999); and La Porta, Lopez de-Silanes, and Shleifer (2006). 2 See Balasubramaniam, Black and Khanna (2010); Dharmapala and Khanna (2010); Khanna (2009); Black and Khanna (2007); and Khanna and Mathew (2010). 3 See Black (2001) (Russia); Black, Love, and Rachinsky (2006) (Russia); Black, Jang, and Kim (2006) (Korea); Black, Jang, and Kim (2006a) (Korea); Black, Kim, Jang, and Park (2006) (Korea); and Black, Kim, Jang, and Park (2008) (Korea). 4 See Bertrand, Mehta, and Mullainathan (2002); and Atanasov, Black, Ciccotello, and Gyoshev (2010). 5 See Bebchuk and Hamdani (2009); Khanna (2009); Gilson and Gordan (2004); and Aggarwal, Erel, Stulz, and Williamson (2009). 2 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies emerging market funds use governance in their investment decisions, what gover- nance attributes matter most to them, and if these attributes vary with the country, the size of the firm, its ownership structure, or its industry. Other studies examine whether the investment decisions of foreign inves- tors are connected to governance concerns, as well as how these investors may change the governance and performance of firms in which they invest. At a conceptual level, if governance is important for any set of investors, then it should be for this set of investors (as they may have enough invested and enough expertise) to be able to overcome collective action and information asymmetry concerns. The studies to date provide evidence that governance is important to these investors, but these studies do not focus on the largest emerging markets nor do they uncover the kinds of governance factors inves- tors look at when deciding where to invest in emerging markets. Given that emerging market firms may raise certain kinds of governance concerns in a more prominent manner than developed market firms (e.g., controlled versus dispersedly held firms governance concerns), and that the background institu- tional structures are less consistent across emerging markets, one might expect that the behavior and optimal governance of emerging market funds could be different than the behavior of similar investors in more developed markets. Along with the heightened focus on emerging market investment opportunities has come an increased attention to corporate governance considerations. There has been a considerable amount of research conducted, but a comprehensive review of this research revealed a significant information gap: most of the studies look at developed markets, with little in-depth research on the role of governance in the investment decisions of funds and blockholders in the major emerging markets. Until now, that is. The Emerging Market Investor Survey directly addresses this information gap, focusing on the specific corporate governance issues of importance for investors in emerging markets. To explore this issue, this paper engages in a series of interviews with funds investing in emerging markets. Engaging in interviews allows one to obtain a more textured and qualitative assessment of the role of governance in the decisions of investors in emerging markets. Moreover, by examining these qualita- tive assessments one obtains a better appreciation of what attributes of governance matter most in emerging markets, and why and how these attributes might differ from those relied upon in developed markets.6 6 See F&C study (2009) (discussing that sovereign credit ratings of the major emerging markets may be ranging into invest- ment grade category, but their corporate governance characteristics are very mixed, with Russia and China trailing behind Brazil, India, and Korea). Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 3 One also begins with a few priors in this study. In particular, firms in emerging markets may suffer from greater concerns associated with minority expropriation than firms in more developed markets due to the ownership structure in emerging markets. Thus, it seems that one might expect investors in emerging markets not to rely on the same kinds of governance attributes as in developed markets, but perhaps only some of them or different ones altogether. Second, funds investing in emerging markets also face a different enforcement and institutional structure than funds investing primarily in more developed markets (e.g., slower and more incon- sistent enforcement at times). This suggests that investors in emerging markets can- not expect to use litigation as easily (if at all) in the home countries of their target firms. Thus, self protection measures (perhaps in the form of greater due diligence, larger discounts on price, or greater focus on firm level governance attributes) may be more important. Both of these matters, and others are difficult to assess by relying on financial data alone. Detailed and informed interview responses can provide a better sense of these matters and add a broader context to other studies. Moreover, this study also provides firms and policy-makers in emerging markets with a sense as to what investors in emerging markets focus on and how good prac- tices corporate governance plays a role in that equation. STUDY ApproAch The approach involved talking directly with the people whose business is to make investment decisions about opportunities in emerging markets. defining Corporate Engaging decision-makers in conversation and using a standardized set of ques- Governance tions enabled a more nuanced assessment of the role of governance in their For the purposes of this study we investment decisions than other approaches. The approach also helped develop assumed IFC’s view that corporate a deeper understanding about the aspects of governance that matter most in governance refers to the structures and processes for the direction emerging markets, along with why and how these aspects might differ from what and control of companies; a matters most in developed market investment decisions. definition very similar to that of the OECD. During the interviews The approach allows a tightly targeted focus on emerging markets: out of a we consciously did not define corporate governance per se, but universe of several hundred firms that have investments in emerging markets, a took the Funds representatives’ use surprisingly small number (35) have business exclusively in emerging markets. of the term to assume any aspect From the 35 firms identified, 29 agreed to participate. of corporate governance, hence several references to issues of ethics or honesty are not included in IFC’s definition. 4 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies Profile of respondents Respondents included individuals who made investment decisions for their firms or who advised others on such decisions. FIGURE 1. WHERE DO FIGURE 2. INVESTMENT FIGURE 3. OWNERSHIP FIGURE 4. INVESTORS’ RESPONDENTS INVEST? HORIZONS STAKES in TARGET FIRMS INDUSTRY PREFERENCES 7% Southeast Asia 3% Media 7% Natural Resources 7% India 3% None but Liquidty is Key 7% Brazil/Latin America 3% China 34% Various Levels 10% Asia 3% Above 40 % 69% Longer Term 10% Shorter Term 53% Between 5% and 40% 10% Less than 5% 66% Board Based 21% Multiple Term 87% Board Based Range of countries suggests that Different time horizons might influence The percentage of the fund’s own Respondents are focused on governance concerns are not driven by governance considerations and response ownership stake could influence their investments in a broad range of issues in a single market. strategies if problems arise after approach to governance. industries. Their responses likely investment: depending on duration of represent the views of a broad section investment, investors might sell their of emerging market investors. shares, try negotiating with management, or take the litigation route. Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 5 “There are certain triggers key STUDY findings that alert us to potential The key findings of this study fall into two categories: areas of concern, such as • Overall importance of governance considerations in emerging market investment decisions, the ratio of derivatives to and total assets and the loan- • Specific governance factors that influence emerging market investment decisions. to-deposit ratio.” In this section, the findings are detailed in turn. —Emerging Markets Investor Survey respondent 1. Corporate governance is a critical factor in emerging market investment decisions A detailed approach to All 29 respondents said that governance is an important factor in making their governance assessments investment decisions. They all said that governance was part of their pre-invest- One investor described his ment due diligence on a target firm. organization’s approach to assessing the governance of target firms as follows. Target firms are assigned Still, respondents reported different approaches to conducting governance assess- three separate ratings: ments, ranging from the very formal to the more informal. The larger the invest- • Quality of governance: internal ment—and the more resources the firm has—the more formal and standardized proprietary governance rankings the approach. based on thorough due diligence, including assessment of objective and subjective factors such All reported a process that includes learning about the firm, its controller, and its as overall ethical standards, management; and it often involves traveling to the country and spending time at responsiveness to institutional the firm. This is particularly the case for investor organizations with less formal investors, conflicts of interest, assessments, which tend to rely on the opinions of their locally-based employees and general levels of trust in who visit the firms. management. • Directional indicator: to signal On the other hand, groups with more formal assessments tend to rely on both whether the firm’s governance is improving, getting worse, or objective and subjective governance factors, and often purchase assessment ser- staying the same. vices from an outsourced service provider. The number of firms spending more • Investment position: target firms money on such outsourced services since the financial crisis has significantly receive “buy,” “sell,” or “hold” increased. rating. Target firms are assigned a grade (1, More than one-quarter of the respondents reported that they conduct back- 2, or 3) based on country-level and firm-level factors. ground checks on the firm and its key players. Others noted the value of a relationship with native-born professionals from “We find that the subjective factors the country of interest who also had experience working in developed markets. within the governance indicators Respondents said that such individuals are valuable assets who can offer deeper are more closely tied to stock price insight into the local business culture and how things work. movements than the objective factors,” the investor noted. 6 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies Some of the surveyed investors said that their approach to governance was as- More than half of investors sociated with a staged investment strategy. First, the investment firm decides on a surveyed said they would country and gathers information about a specific industry that tends to generate pay at least 10 percent higher returns. Before making a direct investment in a company, the investor more for a better-governed tests the waters by purchasing shares in a fund active in this country. firm compared to a similar, poorly-governed firm in “This gives us some say in governance, and helps us find out more about a particu- the same emerging market. lar firm and its environment before we risk too much,” explained one respondent. 2. Investors are willing to pay a premium for better-governed emerging market firms Investors interviewed said they would pay more for a better governed firm in an emerging market than they would for a firm that came with some governance gaps. Although it was difficult to put an exact number on the value of gover- nance given the range of other country and firm-level factors to consider, all surveyed investors expected to pay a higher premium for better governance in an emerging market firm than the premium they might pay for a firm with better governance in developed markets. What is the reason for this variance? There is an assumption that more developed markets come with stronger institutional frameworks and better institutional governance. The perception among investors is that a well-functioning gover- nance framework in a country can help minimize their concerns. The reverse also appears to be a strongly-held perception among investors. Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 7 The data (see Table 1) clearly show that investors will pay more for emerging market companies with good governance. However, in response to a question about the exact size of the premium they would be willing to pay for better governance in an emerging market firms, sur- vey respondents were divided. Of note: more than half of the investors surveyed said that they would be willing to pay at least 10 percent more for a better-governed firm, compared to a similar firm in the same emerging market that lacks strong governance. While 38 percent responded that they would pay at least 20 percent more for shares in such a company, some few suggested that would pay even more—closer to a 40 percent premium. Table 1. The investment premium for good governance in emerging markets Percentage of respondents who agreed Statement read to 29 emerging market investment decision-makers with statement My firm would pay a larger governance premium for emerging market companies than for developed market companies 100% My firm would pay a premium of at least 10 percent for good governance in an emerging market company 55% My firm would pay a premium of at least 20 percent for good governance in an emerging market company 38% My firm considers governance a threshold for an emerging market investment decision, and for how much of a premium we would be willing to pay 41% One hundred percent of Emerging market investments versus developed market the investors interviewed investments: a corporate governance comparison said they would pay a Investors surveyed said there were differences in the way developed markets investors higher premium for good think about corporate governance compared to how they approach the issue. Here governance in an emerging are some highlights: market firm than what • “Developed markets investors tend to focus on governance as a way to avoid risk while emerging markets investors often focus on governance as a way to enhance they would pay for a profitability.” similar firm in a developed • “Developed markets investors often look at governance later in the investment market. cycle, but they could benefit from the due diligence approach used by emerging markets investors, for example, to look at management quality early on.” 8 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies The combination of a threshold effect and then a higher premium in emerging markets relative to more developed markets raises interesting questions about the impact of governance. If this is an accurate description, then the following graphs (Figure 5, Panels A to C) provide a view of the impact of governance. This visual depiction of the impact of governance shows its importance and opens up areas that should be explored further. For example, how far would firms need to go in improving governance before investors would be willing to invest? What determines these thresholds? What are the key corporate gover- nance attributes that would influence the decision? Figure 5. IMPROVED CORPORATE GOVERNANCE IMPACT ON PREMIA Panel A Panel B Panel C Premia Gap Between Better and Average Governance Developed Markets Emerging Markets Firms in Developed and Emerging Markets 16 8 12 14 7 10 12 6 8 10 5 Premia Premia Premia 6 8 4 4 6 3 4 2 2 2 1 0 1 2 3 4 5 6 0 0 1 2 3 4 5 6 1 2 3 4 5 6 Governance Governance Governance Better Governance Average Governance Better Governance Average Governance Developed Markets Emerging Markets 3. Emerging market investors believe that better firm-level governance can make up for country weaknesses in corporate governance More than 40 percent of the investors surveyed said that well-governed firms in emerging markets could mitigate some of their concerns about investing in cer- tain countries. Investors would look positively on firms that outperform gover- nance practices in the market in which they operate. Respondents also agreed that it is important to understand the country’s context and local business customs: “In some Latin American countries, the best way to make things move more quickly was to court the local church bishop and get him to advocate for your cause, rather than relying on other typical community outreach methods to en- courage locals to support your venture,” one of the interviewed investors said. Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 9 Another investor shared this story about doing business in Russia: “In Russia, it is essential to have at least one Russian citizen involved in your ven- ture, and to let it be known widely that at least one Russian was involved. This is partly for familiarity reasons. It is also a preventative: sometimes, local Russians might attempt to forge the articles of association and file them with the registrar without informing other shareholders. The presence of the local Russian as an investment partner can help reduce this risk, or ensure more effective policing.” 4. Investors often do not invest in emerging market companies with poor governance Survey respondents also said that they expected steep discounts for shares in emerging market companies that lack strong governance practices. All of the surveyed investors said that they would not invest in a firm with deeply problematic governance. Trust plays an important role here, they said: • Can investors trust that management is speaking the truth? • Does management demonstrate clear commitments to better governance by working to institute basic corporate formalities, a code of ethics, a governance officer and the like? 10 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies While this finding—and the finding that investors are willing to pay more for better governance—is significant, some questions still remain: • What is the corporate governance threshold for investment? • How do investors determine these minimum thresholds? • What specific governance factors influence the size of the premium paid for shares in a better-governed firm? Such questions could form the basis for future research. 5. Lack of transparency is a red flag for emerging market investors Investors surveyed noted that the corporate governance factors they would pri- oritize for emerging market companies might not be the same as the factors that are important for developed market investments. Of critical importance to emerging market investors: transparency and disclosure. All of the investors surveyed said that willingness to disclose factored heavily into their decision making. All emphasized the importance of information on the motivations of a target firm’s controlling shareholder. All said that a target firm’s reluctance to provide information or meet with shareholders would represent significant causes for concern. Several respondents elaborated on these concerns. Here is what one respondent said: “The opacity of disclosure at a firm we were looking at, related to payments made to government officials for licenses to conduct business, led us to be concerned not only about the general bona fides of the other representations being made, but also about the potential for being caught in violations of the U.S. Foreign Corrupt Practices Act.” In fact, nearly 40 percent of respondents expressed concerns about compliance with this law, and observed that they look carefully at investment targets with this issue in mind. One investor pointed out that lack of disclosure could be indicative of additional problems. For example, a management team that did not want to discuss finan- cial results with shareholders is not in itself a reason for change in the firm’s stock price. However, this cluelessness on the part of the management team would not reflect well on the company or how it is run. As a result, investors might think twice before purchasing a stake—or they may decide against making an invest- ment in the firm altogether. Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 11 These findings are consistent with prior research suggesting that better disclosure helps attract foreign investments, and that increased disclosure appears to make firms more attractive investments.7 tAble 2. importAnt governAnce CHARACTERISTICS for emerging mArket investors Governance characteristics Very important Moderate importance Little importance Disclosure 100% 0% 0% Related party transactions 90% 10% 0% Board structure/ board independence* 3% 48% 48% Shareholder rights, such as “tag-along rights” 83% 17% 0% Board process 0% 3% 97% Separate Chairman and CEO 52% 41% 7% *Does not sum due to rounding. tAble 3. specific governAnce CHARACTERISTICS of importAnce to emerging mArket investors Governance Characteristic Very important Disclosure in general 100% Disclosure in English 31% Quarterly disclosure 59% Willingness of senior management to meet 100% Motivations of controlling group/management 100% Succession planning and compensation structure 59% 7 Increased disclosure appears to make firms more attractive investments. See Hermalin and Weisbach (2009). Further, the recent study by Leuz, Lins, and Warnock (2009) suggests better disclosure helps attract foreign investors. Although their study does not focus on the major emerging markets (with no firms from India, China or Russia and only 16 from each of Brazil and Turkey out of their 4,409 firms), their results are consistent with the findings in this paper. This suggests that disclosure in particular may be a governance factor that is significant across jurisdictions whereas board independence may matter more in some contexts (e.g., dispersely held firms) than in others (e.g., controlled firms). 12 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies 6. Board independence is a lower-level concern “Governance features such for emerging market investors as independent directors have less meaning when Respondents expressed less concern about board composition. Specifically, they the independent directors said that the presence of a board with a majority of independent directors was are selected by the not as important as other factors. It is not that this feature is undesirable in a controlling shareholder.” target firm. Rather, there are other, more pressing issues to consider, most said. —Emerging Market Investor Survey respondent Investors surveyed pointed out that most emerging market firms have a controlling group—a family or a government—unlike firms in developed markets. And since the controlling group appoints directors, the independence of the board itself is questionable, even if the directors are not associated with the controlling group. 7. The global financial crisis has elevated the importance of good governance Another key finding from the survey: in the wake of the global financial crisis of 2008–09, investors are more cautious about investing in firms in countries that have problems with corporate governance. When asked about China, more than 40 percent of investors surveyed responded with one of the following: • “We are concerned about our investments in China because of corporate governance issues.” • “We have slowed down our investments in China because of corporate governance issues.” • “We need a higher rate of return to invest in Chinese firms because of corporate governance concerns.” • “We have pulled out of China because of corporate governance concerns.” In particular, they pointed to opacity of ownership structure and general disclosure concerns as reasons for their more cautious approach to Chinese investments. Respondents had similar thoughts about their Russian investment portfolios. Of note, investors surveyed said that they were more inclined to look seriously at targets in countries with improving governance: • 48 percent expressed increased interest in India • 45 percent expressed increased interest in Brazil • 26 percent expressed increased interest in South Africa • 24 percent expressed increased interest in Turkey Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 13 8. Specific corporate governance-related reforms could make countries more attractive investment destinations Investors who were interviewed discussed reforms they hoped to see in the emerging markets where they invested or where they were thinking of invest- ing. Respondents suggested that reforms focus on improved and more consistent enforcement, specifically in: • Investor protection laws • Contracts Respondents also highlighted a number of country-specific corporate gover- nance-related changes that would improve the investment climate and increase the attractiveness of investments in these countries: • Less opacity in China • Fewer judicial and bureaucratic delays in India • Reduction in the number of multiple class structures in Brazil • Improvements to the rule of law in Russia 14 | Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies Why this study matters The Emerging Markets Investor Survey provides clear evidence that corporate governance plays an important role in the decisions of emerging market inves- tors. Some are steering clear of firms in countries where governance remains problematic, or they are demanding higher returns from such investments. The information comes first hand from the investors themselves, and offers insight into how corporate governance considerations impact their decisions. While an admittedly small sample set, the frank and honest commentary can offer a road map for where improvements and reforms should be focused. Such information can help inform policy reform agendas of emerging market nations, as well as provide guidance for emerging market companies that are seeking financing. The study also points to future avenues for follow up investigation, to identify more specifically the kinds of governance changes that would be of value, and how to implement the changes at the firm level and at the country level, with the goal of expanding the private sector and supporting economic growth. About the authors: Vikramaditya Khanna is a Professor of Law at the University of Michigan Law School. S.J.D. Harvard Law School 1997. Email: vskhanna@umich.edu Roman Zyla is a Corporate Governance officer at IFC. Email: rzyla@ifc.org Survey Says…Corporate Governance Matters to Investors in Emerging Market Companies | 15 2121 Pennsylvania Avenue, NW Washington, DC 20433 USA The material in this publication is copyrighted. IFC encourages the dissemination of the content for educational purposes. Content from this publication may be used freely without prior permission, provided that clear attribution is given to IFC and that content is not used for commercial purposes. The findings, interpretations, views, and conclusions expressed herein are those of the authors and do not necessarily reflect the views of the Executive Directors of the International Finance Corporation or of the International Bank for Reconstruction and Development (the World Bank) or the governments they represent, or those of the companies interviewed for this survey.