Small and mid-caps and corporate governance: Battle for a common ground
Despite broad reforms, the quality of corporate governance practices across the European small to mid-cap sector is a work in progress. Some companies view it as a compliance exercise while others see it as an integral part of the business proposition.
At a glance
• Corporate governance is generally more developed in northern Europe than in the south.
• The rules do not specifically cover small and mid-caps but those that are listed fall under their remit.
• From an investor perspective there are pros and cons to investing in family companies.
• The key to good governance is practical implementation rather than a series of codes.
Efforts are being made to create a uniform framework for all listed companies. However, co-ordination will not be easy because of the different national guidelines and interpretations of the codes and directives.
For now, there seems to be a north/south divide with countries such as the UK, Germany, the Netherlands and the Nordics leading the charge. Their counterparts in Italy, Spain and Portugal are lagging behind. This gap is mainly because corporate governance is a more established and developed concept in northern Europe. It is a relatively new idea in the southern part of the region.
“Although it is hard to generalise, it is true that disclosure standards and levels of transparency are higher in the UK,” says Paul Lee, head of corporate governance at Aberdeen Asset Management. “This is largely down to culture and heritage enshrined in company law, listing rules, various transparency standards and a longer-standing equity culture. Expectations have been built up and shareholders assert themselves more.”
The UK was one of the trailblazers with the publication of the Cadbury Report in 1992. It set the scene for the Combined Corporate Code of Governance in 1998 that has since been renamed the UK Corporate Code of Governance. In addition, the country is one of the few that have guidelines for the smaller end of the spectrum – the QCA Corporate Governance Code for Small and Mid-Size Quoted Companies covering nearly 2,000 firms. The UK was also one of the first countries to encourage asset managers and owners to exert more influence through the UK Stewardship Code which was launched five years ago.
Germany can also trace its corporate governance roots to the 1990s and has recently updated the Deutscher Corporate Governance Kodex (German Corporate Governance Code). In the Netherlands, the 40 recommendations issued by the Peters Committee in 1997 laid the foundation for the Dutch Corporate Governance Code, which was introduced in 2003 and updated last year.
The European Commission has been trying to level the playing field with long-term initiatives, such as EU Europe 2020 and the EU Action Plan (2012), that endeavour to develop corporate governance practices, increase competitiveness, and create sustainability for companies of all sizes. The EC’s efforts, though, only began in 2006 with a directive that required all listed companies to produce a corporate governance statement in their annual report to shareholders for the first time. A long list of directives followed including the Transparency, Market Abuse, Prospectus and European Shareholder Rights Directives – the latter currently subject to amendment.
The European Shareholder Rights directive demonstrates how difficult it is to find a common ground. Proposals had to be watered down for a binding vote on executive pay and now individual countries will be allowed to decide whether or not votes should be compulsory. The original draft dictated that the vote should be mandatory. There is also expected to be dissent among the ranks on proposals to increase transparency on related-party transactions because EU member states tend to already have their own, different rules that they prefer.
None of the European rules specifically target small to mid-caps but they are in the catchment area simply because they are listed companies. They also share the same issues as their larger brethren in that they are dominated by family holdings. Figures from the Ernst & Young Family Business Yearbook 2014 show that 85% of all European companies are family businesses but they wield undue influence in smaller organisations.
There are, though, pros and cons for investors. On the positive side, small to mid-cap companies that are controlled by one family have outperformed their peers significantly in the past decade. Research from UBS last year revealed that these firms surged 345% globally in the past 10 years to March 2015, far outstripping the global mid-cap index which gained only 72% during the same period. Additionally, the value of family-owned businesses outperformed similar-sized competitors in every region UBS analysed including Asia, Europe, Latin America and the US.
The downside is if the family runs the company for its own sake rather than to improve performance for all shareholders. This is why many fund managers say there needs to be greater focus on the individuals than on the corporate governance structures and frameworks.
“Typically in the type of small to mid-caps we invest in, we have to deal with one or two significant family shareholders and as a minority shareholder we would have less influence,” says Frans Jurgens, fund manager of Netherlands-based Juno Investment Partners, which focuses on companies in the €250m to €4bn range. “The other issue you have to be careful of is the Kommanditgesellschaft auf Aktien, (KGaA) structure which has recently gained popularity in Germany. This allows founding families to reduce their majority holdings although they still control the vote. This is why it is very important to do your homework and make sure that the majority shareholder’s long-term interests for the company are aligned with yours.”
According to Jurgens, the KGaA combines the structures of a publicaly owned company (AG) and a limited partnership (Kommanditgesellschaft, KG). It connects the entrepreneurial commitment and personal standing of the individually liable shareholders (general partners) with the function of the AG as a public company and source of capital. The KGaA can be described as a stock corporation having individually liable shareholders (general partners) instead of a management board.
Greater attention should also be paid to those at the senior level. Lee notes that there are also often more gaps at board level because smaller boards naturally have more skills gaps, and many high quality people are less attracted by the opportunities at smaller businesses. The other challenge is that the sector tends to be under-researched and the situation may be exacerbated if the unbundling proposals that separate research from execution are approved under the new Markets in Financial Instruments Directive (MiFID II).
“The lack of information makes price discovery problematic,” says Lee. “This is why investors have to be active and do their own research to find those mispriced opportunities. It is important to really understand and get to know the people around the board room table.”
Although some companies may be wary, the general consensus is that these relative minnows open the door wider, since the asset manager has done the correct due diligence. The larger companies have sizeable polished investment relations departments that can answer every question, according to Sam Cosh, manager of small-cap equity funds at BMO Global Asset Management. “However, I think you get better access to management as it is easier to meet the CEO at a smaller company than a larger one. For us, some of the most important factors are the independence of the board and remuneration committees, transparency, engagement as well as if the interests of management are aligned with us as long-term shareholders. Although the greater focus on corporate governance has helped, the improvement is still very much on a case-by-case basis.”
The key is in practical implementation, according to Antony Marsden, head of governance and responsible investment at Henderson Global Investors. “I think the codes have had an impact but they should not be overestimated,” he adds. “The catalyst, though, is not having a code of best practices but a best corporate governance culture that goes beyond the tick-box exercises. For example, do they have good calibre people on the board and not just the right number of independent non-executives? Are there channels where shareholders can express their views on tangible issues such as remuneration and audit? These are some of the important questions to look at.”