Standing up to MNC misbehaviour

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Two decades ago, foreign multi-national companies (MNCs) were sought after by investors in the region and generally speaking, their shares always traded at a premium. Before seeking these companies out, global asset allocators in the large foreign funds would start by looking for countries that showed the “correct fundamentals”. Such fundamentals usually included both the review of the financial strength of a country as well as a political risk evaluation.

Once such fundamentals were confirmed present in a particular country, herds of investors would immediately invest their funds into the companies that they understood best, which were inevitably the MNCs domiciled in that country. In this way, big money always flowed in, chasing the same companies. This led such companies’ valuations to rise, with investors still willing to pay such premiums.

The reason why investors would still pay more for MNCs was because such companies had “better” corporate governance, and so would likely be more accountable to investors and be transparent about their earnings and business ethics. Such best practices, of course, should generally translate into making more money for shareholders and investors. This mindset of investors resulted in their funds investing primarily in the MNCs, which led to some funds willing to pay as much as 30% above the value of an MNC’s underlying fundamentals.

That was then. But time has moved on and in today’s volatile world, MNCs may not always retain the large premium value they once had.

Sometime late last year, the investing community in the region got a nasty jolt when a majority shareholder of a local company revised upward the royalty payments the company had to make to its holding company. This meant the local company’s earnings stream would suddenly be severely affected by the higher royalty payments to its parent holding company.

One would assume that the local company’s other shareholders would have a say in this? Could they stop such a hike in royalty payments? After all, with such a unilateral rise in royalties, this local company would make as much as 20% less net profits in the next financial year.

Astute investors would immediately question whether or not the local company’s independent non-executive directors stood up to this sudden spike in royalties paid out. Or did these directors just accept that the “home nation” or parent company needed the extra income and so no one should ask questions? If this was the practice, it would mean that brands with foreign parent companies that were struggling in their home nations could easily be at risk.

Also, having to pay much more to a parent company will dent a subsidiary’s bottom-line such that it may not be able to pay attractive dividends to all of its shareholders. In short, royalties and other such fees enrich controlling shareholders at the expense of the remaining investors.

On the cusp of 2013, one of the world’s leading MNCs raised the rate of royalties due to it from 1.7% to 4% this year and 5% for 2014 all with just one stroke of the pen. The timing of its announcement was really cheeky too, as it came when most investors were on their year-end holidays and their offices were staffed by skeletal teams.

That ensured fewer immediate reactions to the hike.

The big risk now is that parent companies in difficult times will not think twice about squeezing more out of their well-performing subsidiaries, leaving the smaller shareholders dry. Worse, the latter have no recourse because they are up against majority shareholders that generally own more than 50% of the company, which in turn means controlling the decision-making of the board of directors.

The same issue made big headlines in India late last year, when a firm that advocates the rights of minority shareholders, questioned the corporate governance practices of MNCs on the increase of royalty payments from their Indian arms. The firm claimed that such payments by the Indian subsidiaries had gone up as much as two-fold over the last two years.

The firm says the Top 20 royalty remitting Indian companies paid $672m in financial year 2012 compared to $223m five years ago. While the royalty payments have more than doubled, sales for these companies grew by only 70% over the same period. The firm claims the companies camouflage royalty payments under various headings and high royalty is iniquitous to minority shareholders. It is like a super dividend to the foreign (majority) shareholders. It reduces the net profit, and therefore causes the valuation of the subsidiaries to fall.

Such unconscionable self-interest of the big over the small will no doubt come back to bite those who treat minor shareholders shabbily. This will come in the form of shrinking premiums for MNCs, and even perhaps a discounting of their shares.

That will be the ultimate trade-off for squeeze-happy parent companies which sacrifice strong brand share and high valuations for quick, short-term gains.

Datuk Shireen Muhiudeen is the Managing Director and Principal Fund Manager at Corston-Smith Asset Management in Kuala Lumpur.



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