“The real challenge for directors isn’t regulatory compliance, its high performance,” wrote David Nadler in the May 2004 edition of the Harvard Business Review. But despite these refreshing utterances, there is growing feeling that the ‘corporate governance industry’ has complicated the essential role of the board. One well-known Australian director said recently that he now immediately “bins the volumes of corporate governance material and seminar invitations that hit his desk”. Many others probably share the sentiment!
A corporate governance fog has descended and the task of steering businesses along competitive roads is now harder not easier. Skilful, motivated directors are needed now more than ever and yet given the landscape and conditions, with much personal risk, there is little surprise that demand outstrips supply for real talent. The problem is not easily fixed by price mechanisms, as market conventions and perhaps public opinion have imposed glass ceiling on what directors are paid. These issues are undoubtedly true of public companies and also evident in private companies.
Understandably some directors have become confused as to what is expected of them and concerned that despite the irony of being directors of limited liability entities, considerable personal liability lurks in the new regulatory and legal environment. More clarity of purpose is needed. It is important not to lose sight of the primary role of directors and the board – the effective stewardship of shareholder property. Shareholders are never homogenous bunch and have different needs and tastes, but they do have similar expectations. No one invests to get poorer and invite equity risk. The expectation is of an appropriate risk weighted return.
But some good has come from the imposition of new corporate governance requirements and some boards have used change as catalyst for fresh look at the structure, function and role of the board. Many positive changes have come as result. Other boards muddle on ensuring compliance, but little else.
I agree with Nadler that the real corporate governance issue is performance. The sum of wealth destroyed through fraud and other malpractice is drop in the ocean compared to that destroyed through poor performance, fact often ignored in the debate on governance.
GE’s Jack Welch captured the essence and context of the compliance emphasis when he said: “This isn’t about hiring boards who all have green shades and sharp pencils, but to me, this about hiring boards that understand integrity, ethics, management – leadership, that get involved with their nose not their pencil. They must smell what’s right from wrong and must be in charge of putting good managers in seats, and being responsible for the behaviour of the teams. They must climb down in the organisation and feel them. This isn’t about getting more people technically qualified to look at balance sheets, because Christ couldn’t do it in most of these places. So the idea of somebody showing up once month to find flaws is not the answer; the answer is to select leadership with integrity and teams with ethics and set culture where integrity rules.”
Welch was saying that non-executive directors must really get to know the businesses they accept stewardship responsibility for, and that means putting in the effort to get outside the comfort of the boardroom and carefully crafted board papers. They must care about the business and their ability to add something to it.
Good directors understand that there are million and one ways to run business badly, but common set of principles governs how businesses are run well. To grow shareholder value in sustainable way, there are certain conditions necessary in all businesses, excluding monopolies. Highly motivated, talented people who care about customers; who care about product competitiveness, about product innovation, who care about the firm’s reputation in the community, who care about the future prospects for the business and who care not just about the number at the bottom of the profit and loss account, but the quality and sustainability of that number. These people will, ideally, have an equity interest in the business to strengthen the bond and so they too will care about how well the business has done in growing wealth.
How many directors can, with hand on heart, say they have feel for the level of care that exists in the business that they have accepted stewardship responsibility for? My guess, like that of Back to the Drawing Board authors Carter and Lorsch, is about 50 percent.
I’m concerned that many businesses fail to grow shareholder wealth, not because of lack of talent or effort, but because there are structural flaws in the way performance is measured and rewarded. As measurements and rewards drive behaviours and can shape culture, this is arguably the single biggest area of attention for any director wanting to add value. In nutshell, too many businesses focus on what is counted rather than what counts.
What gets counted and rewarded are too often outcomes based on accounting-based measurements such as Earnings Per Share (EPS) and P/E ratios, EBIT and EBITDA multiples, RoE and so on.
These measures ignore the cost of equity and can often be poorly correlated to cash and thus be misleading if used in isolation! EPS, for example, has weak correlation to share price changes. Research shows that EPS changes account for only 8-12 percent of changes in share prices, whereas the predictive value of Economic Value Added (EVA) is three times greater.
EVA can provide much better measure of performance. simple example illustrates this: consider the performance of two businesses – Company and Company B. Both companies are in the same industry and both have cost of capital of 10 percent. Which has performed better?
Using the traditional accounting lens, Company B would appear to be the better performing company with net operating profit after tax (NOPAT) of $600, $100 higher than Company A, and off lower revenue base. But Company B has tied up $2000 more in capital than Company and when that capital is paid for, Company B has made insufficient profit. It is destroyer of shareholder value. This insight is both simple and powerful. As investor maestro Warren Buffett once said: “When returns on capital are ordinary, an earn-more-by-putting-up-more record is not greater managerial achievement. You can get the same result personally while operating from your rocking chair. Just quadruple the capital you commit to savings account and you will quadruple your earnings.”
Enron provides an excellent illustration of the power of EVA compared to traditional measures – and also highlights the dangers of traditional measures: similar analysis of number of companies that ran into financial difficulty in the period 1995-2003, shows much the same picture – strong accounting earnings growth, combined with negative EVA is followed by crisis. It is impossible to sustain business over the long-term if EVA is consistently destroyed and for that reason this should be key focus for caring directors.
Most boards still focus on the accounting measures and pay scant regard to EVA. One look at how executives are compensated reveals sense for what people focus on. In many companies, there remains poor correlation between compensation and wealth creation, but high correlation between Hays points – the system developed by the consultancy firm to scope job and thus assign seniority rating/pay scale to it – and remuneration. Addressing this structural flaw would be good place for directors who care about adding value to start. But it’s marathon not sprint, so stamina and conviction are necessary and they only come from those who care.
• By Joseph Healy, head of integrated capital solutions at ANZ Bank, Sydney.
