Corporate Governance in Emerging Markets: Why It Matters to Investors—and What They Can Do About It
Priyansh Solanki
Corporate Governance in Emerging Markets: Why It Matters to Investors—and What They Can Do About It
By. Paul Coombes Chairman, Centre for Corporate Governance, London Business School
Melsa Ararat and George Dallas
What should investors do when scholarly research on corporate governance in emerging markets does not provide conclusive evidence on which aspects of governance matter most across all the emerging markets and how they affect firm performance? A researcher and a practitioner team up to offer guidelines and recommendations that focus on board independence and business group affiliation.
Foreword
Every day, institutional investors in emerging markets must make practical decisions on the basis of incomplete and at times conflicting information. So, it is critically important that they make the best use of this imperfect knowledge. Moreover, investors too often enter emerging markets with misguided perceptions of the underlying realities. And worse, they may cling to a conceptual framework of governance that does not allow them even to consider the searching questions they should be asking.
This Private Sector Opinion, by Melsa Ararat and George Dallas, explicitly highlights this problem. The authors identify a serious gap in research on emerging markets—between high-level cross-country studies, with their inconclusive findings on good governance indicators at the macro level, and the separate effort to establish firm-level or country-specific governance metrics, typically based on what works “in the West.” Unfortunately, fewer than one percent of the research papers available on corporate governance focus on emerging markets.
The challenge for institutional investors is how to weight country factors, even if the investors conclude, as this paper notes, that “optimal governance is firm-specific.” Alongside the country factors—rule of law, risk of corruption, competitive intensity, and capital market capabilities—the indicator that bridges to the firm-specific context is the structure of ownership. The heart of this paper is an exploration of two key dimensions of ownership structure: the quality of board independence, and mitigation of the risks of business group affiliations. The authors also provide practical guidance to investors in each of these areas.
In discussing the first of the two dimensions, the quality of board independence, Ararat and Dallas address the fundamental difference between the governance challenge for boards that operate in those developed markets where shareholders are dispersed, and boards that operate in emerging markets, which are characteristically dominated by controlling shareholders, often family members. In the former, the key governance risk is the agency problem of self-interested management. In emerging markets, the central issue is subversion of minority interests by the controlling shareholder bloc, whether it is a family, a group of business partners, or a state-owned enterprise.
Can good governance practices overcome, or at least offset, the power of the dominant ownership bloc? The authors are cautious, noting that a wealth of scholarly literature suggests that the influence of independent directors is hard to demonstrate. More research is needed to better understand the links between outside shareholders, such as institutional investors, and their board representation.
But, to its credit, this paper does not stop there. Recognizing investors’ enduring interest in identifying well-functioning boards, the authors provide their own set of health checks and warning lights, designed to squeeze as much substance as possible from the limited evidence that is typically available. Their recommendations on what investors should press for are clear and well-reasoned. However, the inescapable problem is the uneven balance of power: controlling shareholders will be receptive to such proposals only if these proposals are demonstrably in their own interests. Ararat and Dallas set out some promising mechanisms; it is up to the global investor community—equity investors and bondholders—to devise inducements that will encourage controlling shareholders voluntarily to make some concessions to achieve best practice.
The second dimension explored in this paper—how to mitigate the risks of business group affiliations—presents a similar story. These risks have provided a field day for cynical scholars, who have delighted in categorizing the multiple routes through which related-party transactions can siphon or “tunnel” resources away from minority investors. The presence of large-scale business groups maximizes the potential for such practices. Offsetting this risk, as Ararat and Dallas point out, internal markets can at times be highly beneficial when external product, labor, and capital markets are functioning poorly.
Too often, however, controlling shareholders have the opportunity to engage in abusive behavior, a circumstance that can be exacerbated in jurisdictions where transparency is poor and where a weak rule of law fails to give minority investors proper judicial recourse. Once again, the authors offer a practical helping hand. If on other grounds a potential minority shareholder is inclined to invest, here are the health checks that will offer some comfort, even if no certainty.
The overriding theme of this important and highly practical paper is the need for institutional investors to work assiduously with boards and controlling owners to demonstrate the value of ongoing engagement. The authors argue convincingly that investors can and should play a role in shaping governance practices in emerging markets through informed voting and, perhaps more importantly, ongoing engagement with companies and regulators.
Yes, naïve and opportunistic investors can be exploited by manipulative bloc holders. Yet, ultimately such exploitation is a short-term strategy for incumbent owners and their management teams. The tide of events is moving inexorably, if gradually but inexorably, toward the greater integration of capital markets. Far-sighted controlling shareholders will increasingly see the merits of responding more openly and willingly to investors’ reasonable demands. Meanwhile, this paper provides practical guidance to investors in emerging markets.
Paul Coombes Chairman, Centre for Corporate Governance, London Business School
Priyansh K. Solanki