State involvement and issues with majority shareholders are the top corporate governance concerns in the CEE region. But the need to tap markets means companies have a greater incentive to listen to their investors, writes Nina Röhrbein

Corporate governance issues have been less important for investors in the CEE region than diversification and higher returns. But the issue is moving up the agenda as investors – both inside and outside the region – seek to promote transparency and an alignment of interests between themselves, majority shareholders and management. Vast differences can still be found when it comes to corporate governance in central and eastern Europe, but there are signs of a gradual improvement, which could benefit both local and international investors and their beneficiaries.

“The region is culturally and historically very diverse and despite the enormous development that the EU enlargement and integration has managed to jump-start, differences in corporate governance remain and investors should learn to account for them,” notes Alvar Roosimaa, who is setting up a new sustainable global emerging markets fund with Limestone Advisers. “But in general, there are no countries in the region where corporate governance in itself would scare off interested investors.”

The main drivers of corporate governance in CEE have been legislation, pressure from export partners, opportunities for EU grants, and competition rather than demand from local or international investors. CEE pension funds mostly have small allocations to equities in any case, and these are largely domestic.

The financial crisis has been anything but helpful in the advance of corporate governance in CEE, and recent years have presented more existential challenges that have precluded
a furthering of ‘nice-to-haves’, including better governance, according to Roosima.
“Governance, though an important pre-requisite for long-term success, is not the priority when sales drop dramatically. Development may have continued in the companies that were less affected by the crisis but the main focus has been elsewhere. Current financial markets are too fixated on short-term factors to make any connection with long-term issues such as governance.”

Capital needs turn the tables
Local investors do not spend a lot of time on corporate governance, and in any case many pension funds face the double bind of a strict quantitative restriction on their allocation to equities, as well as restrictions on diversifying away from their domestic stock market.
However, large international investors, particularly those from western Europe, also view good corporate governance as a way to reduce risk and volatility. Well-governed companies are perceived to be more resilient to country risk, whether political or regulatory.

Colin Melvin, CEO of Hermes Equity Ownership Services (EOS), whose owner is the €46bn BT pension fund, and whose asset managerHermes has been voting in the region for 10 years, says the need for liquidity is driving better governance standards. “This is why the local exchanges are keen on encouraging trading, which requires the presence of a larger investor pool than just the local one,” he argues. “In these markets, the demands of outside investors have a good chance to be listened to.”

Alexandre Dimitrov, head of equity management in CEE at Erste Asset Management in Vienna notes that the investment universe for local investors is narrow and includes many state-owned companies. “But the main push for corporate governance will eventually have to come from local pension and mutual funds,” he says.

Melvin sees a cleft between Poland and the rest, with its larger companies being under greater influence from the EU, particularly those with German and Dutch parents. “In addition,” Melvin notes, “the Warsaw Stock Exchange has the ambition to be the main trading hub for the entire region, which is why it looks at corporate governance as a means of attracting interest and listings in its market. It has also created a corporate governance index.”

One of the positive developments is a willingness to bring reporting and company transparency to international standards as well as voluntary disclosure of sustainability.

Czech mates
“Czech companies generally apply best practice,” believes Nathan Griffiths, portfolio manager at ING Investment Management. “We do have question marks over strategy in countries such as the Czech Republic, in this instance mainly state-owned companies where often there is a strong misalignment between the strategy the company is pursuing and the best interest of shareholders. This can lead to sub-optimal decision-making, although these are not real corporate governance concerns.”

One Czech state-owned utility, for example, embarked on a heavy nuclear investment programme. But investors voiced concerns as they did not foresee strong returns from the investment programme and after management presented those concerns to the government, the investment programme was scaled back.

“At the private level we have not seen any significant issues,” he adds. “Hungary, typically falls somewhere between the Czech Republic and Russia – we neither see the same high levels of corporate governance as in the Czech Republic nor do we see hugely negative issues even in its state-owned companies. Russia, however, stands out with very average corporate governance, both with regard to state-owned as well as private companies.”

In underdeveloped countries such as Bulgaria, Serbia and Ukraine any improvements in corporate governance stem from legal changes or management’s own ideals, says Dimitrov.

The majority owner of one Russian company recently placed a block of shares despite being halfway through a six-month lock-up, with the bankers involved agreeing to waive this. “Outside Russia this is not standard practice and as a result of this action the company shares fell substantially. It probably shaved 20% off its estimated value on the basis of this action,” says Griffiths. ING Investment Management stated its displeasure about the action to company management and spoke with the controlling shareholder.

ING IM has lively discussions with investee companies when it can, but Griffiths does not believe that outside investors’ corporate governance concerns have really penetrated the consciousness of many senior executives in the region. “While they may pay lip service to shareholder concerns, there is no evidence thus far that corporate governance plays a higher role in their decision-making as a result of shareholder engagement.”

He believes the Russian company engaged because it is likely to return to the market in 2013 to raise more equity – in other words to secure its future capital needs rather than seeking better corporate governance per se. And now that Russian companies may have to tap the capital markets more to finance growth, this should encourage better corporate governance.

Broadly, there is heightened sensitivity to state influence, which can lead to blocked shareholdings, particularly in sectors such as energy, utilities and mining. Because of this, some, like Melvin, would like to see more independent directors.

Transparency and the willingness to communicate management decisions and dividend policies to investors are other issues.

Corporate governance is of greatest concern in Russia because of the conflicts of interest between management and shareholders in its state-owned companies and the dominance of majority owners in others. At the state company level in Russia, remuneration is often high and not tied to key performance indicators, according to Griffiths.

“Return on capital has been diminishing, companies are not delivering earnings growth and yet there is such a high remuneration, as in the case of Gazprom’s CEO,” he says. “Bribery is also a concern; but difficult to prove.”

Information flow and alignment of interest
“Part of our investment decision is trying to understand where our interests align with the owners’ interests,” says Griffiths. “The biggest disappointment for us is that US and European investment banks that are fully aware of best practice in corporate governance tend to go along with company management and boards in CEE. There simply is no implementation of best practice coming from international banks.”

Griffiths believes that national legislation is the key to better corporate governance due to the number of large state-owned companies in Russia.

“At the market level, the level of corporate governance is reflected by the low valuations Russian companies trade at,” says Griffiths. “Poor corporate governance and poor alignments of shareholder interests are the single biggest factors that cause Russian markets to trade at huge discounts to global equity markets. But we may be starting to see a better alignment with shareholder interests in Russia.”

The Russian government is set to require most state-owned companies to pay out a quarter of their net income in dividends, which could lead to stronger corporate governance by discouraging corruption.

“Some modernisation of corporate law would make it easier for shareholders to cast their
votes and reduce the need for written powers of attorney, which can be used as an excuse by some fund managers not to participate in voting,” adds Melvin. “The process of bringing shareholder proposals is also complicated in many of these markets, which reduces accountability.”

Sowing the seeds of investor relations
Whereas investors used to struggle to obtain any information from companies, there is now an increasing emphasis on investor relations.

“We have seen a vast improvement on this due to investor relations work,” remarks Dimitrov. “Companies are more welcoming now to our engagement efforts and quicker in answering any queries we have. However, while some are making the effort to pay us annual visits, others continue to be distant and opaque.”

Activist engagement is rare in CEE. Roosima attributes this to the small number of CEE companies that do not have a dominant majority investor. “With more than half of the shares controlled by one shareholder, any revolt by others is technically powerless,” he says. “It takes many decades as well as scalable and healthy capital markets to make companies truly public and not just listed.”

To address corporate governance issues in state-owned companies, Hermes EOS tries to build bridges by working with state authorities.

“Techniques for engaging in emerging and developing markets often include finding ways to work with block shareholders,” says Melvin. “That generally means encouraging them to recognise that we have aligned interests and that we want the companies to succeed in the longer term.”

Melvin says there is a case for the protection of minority interests in some places and there are some innovative ways of doing this. “Although not an emerging market, Italy is an interesting example of having state-owned companies where minorities can put board members forward collectively,” he says.

Asking about the government’s plans and privatisation intentions is also crucial with state-owned companies, according to Dimitrov.

“Ambitious investors should take the opportunity to be an active owner in CEE,” says Martin Pitura, managing director at GES Investment Services Poland. ”If it seems costly at first glance there are ways of engaging collaboratively. Those investors who can identify corporate governance risks and are able to assess individual companies’ preparedness to handle these risks can reap the benefits of a reduced risk premium and increasing share price in their investments via proactive and constructive engagement.”

Nevertheless, in the past six months, ING sold some Russian stocks because of corporate governance concerns. Erste AM has also divested from CEE companies on corporate governance grounds.

The scale and structure of capital markets remains a big obstacle to the advance of corporate governance, believes Roosima. “The change of the overall investment culture is a big threat,” he says. “The more investors move to exchange-traded funds (ETFs) and other anonymous basket-investments before they have grasped the idea of what it means to be an investor in a company, the more the move towards good corporate governance is discouraged.”