Effective corporate governance and superior investment returns work together rather than independently. It’s so important to Aberdeen Asset Management that it is David Smith’s responsibility to work with its fund managers to highlight governance trends and maximise and protect shareholder value in special situations and takeovers.

 His mandate - improving Asian corporate governance, one investment at a time - places him in an ideal vantage point to observe if Asian companies have made any real progress. The Head of Corporate Governance outlines Aberdeen’s emphasis: “It is important to protect our investment when we are co-investing with a family, a big shareholder, state or sovereign which is likely to occur in Asia.”

But why not simply accept bad or compromised governance as merely being the cost of doing business in Asia, especially if markets keep rising? Smith says: “Bad governance appears to be a permanent part of the Asian corporate landscape. But, bad governance is also an investment risk and like other risks, a governance discount or outright avoidance should be applied to poor companies.

“There is extra risk created when investing in a poor quality company and/or overpaying. And this is not benchmark relative and cannot be hedged.”

Governance analysis is modeled and structured much like investment analysis for portfolio construction. The due diligence involves common factors such as management risk controls and company visits with senior officers. All are studied independently and together to determine pass/fail, review or monitor. Basic information and issues driving a corporate governance analysis is similar to a buy or sell decision of traditional securities analysis. Who owns and runs the company? Any transactions with companies related to owners? What is the quality of management?

Closely examining the company’s history for bad governance warning signs, such as frequent change of auditor, profitable assets privatised or taken out of the company before IPO, outstanding litigation and aggressive accounting techniques are some of the flagrant problems to unearth. “Good governance becomes a long term performance benchmark - a well governed company is a well-run company. This is also a growing expectation of many other relations to a company: clients, suppliers, regulators, consumers and the general public.

“The more work you do up-front, the easier your life will be afterwards.”

Smith also urges investment managers to “meet management face-to-face before investing. Don’t be afraid to ask tough questions, utilise sound judgement and your institutional experience. Avoid simple box ticking. Think of governance as a part of a broader quality check.”

Other common problems that can occur in publicly-listed companies are high executive pay and related party transactions, all of which can undermine value for outside shareholders. “Executive pay can turn into a conflict when the CEO is also the owner of the company, allowing him to set his own pay. Then rationing of executive pay becomes an issue.”

Aberdeen may ask him to place a listed company under observation and study before making an investment to see if the owners understand and act consistently with good and transparent corporate governance. They usually meet senior executives like CEO, CFO. The key, Smith says “is to identify the good families.” A family owner with widening holdings means you have to watch out for family dynamics. This affects succession, which if done properly can be positive for governance and management, in terms of creating value.

A corporate governance check can be as easy as attending an annual general meeting and observing how the family, executives and directors interact with public shareholders. “Aberdeen is not an activist shareholder seeking or being an agent of change. But, we are active in our goal of seeking great managers. So we regularly meet companies and managers to gain confidence in them.”

Smith admits: “It is difficult to draw a line between activist versus concerned shareholders. But, we would rather enter a business without an activist intent.”

While the activities of alternative asset managers usually signal improvements in corporate transparency, Smith says industry associations and the media are also intrepid. “Private equity managers have made some difference in the governance environment. But, not as much as public equity fund managers and shareholder advocates like the Asian Corporate Governance Association.”

The pressure that corporate governance has come under, due to the tremendous growth of Chinese companies, presents significant monitoring issues. Smith adds: “New and changing regulations in China and across Asia need to be consistent. China will continue to be complex and challenging. There are cases such as reverse takeovers of NASDAQ shells where Chinese companies exploited regulatory arbitrage to their advantage.”

Still, Smith is positive about China and believes “the cottage investment industry of shorting China stocks is not a symptom of widespread governance problems in Chinese companies. Rather, it is a subset of mainland companies who managed to use reverse takeovers of listed companies. Regulators and investors failed to closely study these companies.”

The more reputable, listed Chinese companies are fighting against the tarnished reputation of Chinese stocks by staging “reverse road shows” where they bring fund managers and bankers to view their factories and developments.

A new generation of owners is also beginning to succeed the patriarch tycoons around Asia. “We ask who really runs the operations and what is the source of earnings? I avoid fooling myself that everything is fine or that it is acceptable to suffer some bad corporate governance in order to achieve gains. Over time, we will come to a decision if this is the kind owner and his managers that we want to associate with over the long term.

“Corporate governance is a grey area - it’s all about achieving balanced results with a clear headed viewpoint. Ultimately, we are trying to align wealth between the owner and the investors.”