Despite being a critical factor for investor outcomes in Asia, the growing focus on sustainability in the push towards improving ESG practices in the region has left corporate governance issues lagging, according to abrdn’s David Smith.
The senior investment director said the recent growth in the interest in sustainability, while encouraging, has unfortunately come at the expense of corporate governance.
He argued in recent years there has not been enough attention on the corporate governance issues that are necessary to create long-term shareholder returns.
One corporate governance issue particularly important in Asia is related-party transactions, which Smith (pictured) said is probably the “number one risk” that comes from ownership structure in the region.
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Many companies in Asia tend to be owned and controlled by a family, who will often have interests outside of the company in either related or unrelated industries, which can sometimes lead to bad actors siphoning money away from the listed company.
Related-party transaction scandals
Smith said: “Related party transactions is the number one way that the less scrupled promotor can tunnel value outside of a listed company into his private interests”.
“Typically, there’ll be a number of ongoing transactions or potentially some one-off transactions,” he explained. “It could be some kind of software license or ancillary services that is a regular payment or lease. Or a one-off can be the injection of an asset or buying something every now and again or, with alarming regularity as you sometimes see.”
Investors don’t need to look far back in history to find examples of this in two of the region’s biggest markets.
In China, it was discovered in 2017 that related-party transactions within one of its largest dairy producers, China Huishan Dairy Holdings, were designed to inflate its sales and mislead investors, forcing the company to eventually declare bankruptcy.
In 2019, Indian Telcom firm Reliance Communications faced scrutiny over related-party transactions and accusations of diverting funds to related entities, which also ultimately lead to its bankruptcy.
However, this problem is not new for Asian stockmarket investors, and over time, awareness from investors and regulators has improved.
In markets such as China and Singapore, for example, there are now more approvals required for transactions above a certain threshold or for asset transfers.
“Generally, protection for minority shareholders has evolved such that we tend to get a vote on these bigger transactions and the controlling shareholder can’t vote,” Smith added.
“So protections have got a lot better; we’re in a better place than we used to be, but that doesn’t mean there’s no related-party transactions. But, there are probably fewer abusive related transactions than there were when I first came to the region almost 20 years ago.”
Shift in focus away from corporate governance
However, as the focus on sustainability and thematic investing has grown over the past few years, Smith warned less attention is being paid to these corporate governance issues that were considered more important in earlier years.
“I think we’ve seen a lower focus in some parts of the market on the quality of firms as people have looked for thematic investments,” he said.
“Things like quality of balance sheet, quality of strategy, and quality of management — such as how many cycles has it been through, for example.”
Because technology stocks have experienced strong returns over the past decade, Smith thinks the market has been more forgiving when it comes to governance in the tech sector especially.
Smith said: “I think people in some places put lower emphasis on the quality of boards of directors because they want to believe in a strong founder.”
“So, you have tended to see much lower constructive, robust engagement around the need for a strong and demonstrably independent credentialed board of directors,” he said.
With a changing macroeconomic backdrop, with interest rates at levels not seen for a generation, Smith argued that it is even more imperative that tech founders and management teams have a “counterweight” given by an experienced board of directors.
“I think the market has under prioritised governance,” he said. “I think we will see a greater focus on this as we do after every period of volatility.”
“I think that would extend to questions around boards, questions around related party transactions, questions around the credentials of independent directors and questions around payment of options to non-executive directors, which was something that the market used to be very strong on 10 years ago.”
This article first appeared on ESG Clarity’s sister site Fund Selector Asia