Dynamics of corporate governance premium

Written by YRK Reddy | Updated: Sep 16 2006, 05:30am hrs
The idea of corporate governance premium gained prominence with the famous McKinsey survey in 1996, which concluded that institutional investors were willing to pay an average of 11% more for well governed companies. A subsequent survey, in 1999-2000, revealed a relative premium between 20-27% in the selected Asian countries; 18-22% in Europe and the US and 21-28% in Latin America. Since then, corporate governance advocacy included propagation of this critical incentive to improve its standards.

The idea is too simplistic, though intuitively appealing, with a potential for validation in the long run. Corporate governance by itself is too fuzzy an idea, unless disaggregated. Similarly, shareholders are a bundle of small individual investors, domestic institutional inv-estors, FIIs, etc each of whom will have a range of ideas on the importance of specific mechanisms of corporate governance in their decision-making in different regions and contexts.

Most people believe corporate governance only means compliance with the regulatory standards. While debating the corporate governance premium in different regions, an important question was posed to me at an international insurers meet. If there is such a premium of between 18-22% in Europe and the US, does it imply that companies in this region also do not fully conform to international standards The answer is that investors, especially institutional investors, are not so naive as to pay a premium for mere compliance. They can make a distinction between form and substancethey will not pay for mere hygiene.

Premium arises when a company shows qualitative improvements in vital aspects of corporate governance such as transparency and disclosures, shareholder rights, board structures, duties and responsibilities and stakeholder engagement. For example, mere induction of independent directors may not cut any ice, but the quality and competence of such directors may receive some weight.

But for a few corporate governance icons, India appears to be still struggling at concept selling and compliance
Further, all institutional investors are not willing to pay a premium. For instance, while many investors with a value mandate or those who are patient long-term investors appear to be keener on corporate governance, those with growth mandate or short-term players would not care for the quality of corporate governance as much as the immediate promise of profit.

Most companies have yet to develop a belief system and strategy for corporate governance development that makes sense for their sustainability and financial structures. There are obvious trades-off to be made. For example, would a company appeal to an institutional investor who values dispersed ownership and enormous rights, or to those who might prefer blockholders running the company honourably, as it might imply lower agency costs and better performances

Research has indicated inconclusive results on the existence of corporate governance premium. While some mechanisms of corporate governance correlated well with stock market valuations, others had poor correlations. Cynics of corporate governance have always wondered why there is such a gush of financial flows into China, where the pillars of corporate governance and institutional mechanisms are relatively weak.

The answer is that corporate governance is not the only criteria for investment; and the quality of investors and their behaviours may differ between China and, say, India. Studies indicate that large companies in China have improved their compliance standards, and yet lack in substance, which perhaps is the case in India. Nevertheless, there has been steady improvement in recent years and companies listed with the Hong Kong Exchange evidence decent correlation between the quality of corporate governance mechanisms and stock market valuations.

Except for the handful of corporate governance icons in the country, India appears to be still struggling at concept selling and compliance. There is a huge void in research relating to corporate governance mechanisms, qualitative parameters, investor profiles, behaviours and stock market valuations. Companies can develop a strategy for improving corporate governance and benefit from it only by supporting deeper research and analysis mere compliance and hope for a corporate governance premium may indeed lead to cynicism.