Corospondent - January 2019
Engaging responsibly - January 2019
Responsible investing has risen in prominence over the last few years as companies, investors and asset managers have had to respond to and deal with the investment impact from ethical and governance lapses, environmental challenges and social pressures. Integrating an assessment of environmental, social and governance (ESG) factors into the investment process has now become standard operating procedure. The manner in which ESG is built into the process can, however, differ significantly across the industry.
At Coronation, we believe the evaluation of ESG should be handled within the investment team who has a better understanding of the complex issues that underpin each individual company. As each potential investee company operates in different industries and geographies, there is no overall generic checklist of factors that can be uniformly applied. While we do subscribe to the services of ‘specialist’ ESG research providers and consider their views, the intricacies of each investment also mean that it is inappropriate to outsource this function.
As long-term investors, we have always explicitly identified and factored in the impact of environmental and social issues on the long-term health of the business and its various stakeholders. In addition, we strive to ensure that the companies we are invested in maintain high standards of corporate governance. Responsible investing is a dynamic environment, and our ESG process has been enhanced and adapted over the years as we have taken learnings on board. Recently it has been tightened to include additional governance requirements involving mandatory audit firm rotation every 10 years and increased scrutiny of the tenure and capability of directors.
As the emphasis on responsible investing has increased, we have responded through greater engagement with management and directors of investee companies. Our engagement process focusses on the most material issues that a company must address and can be broken down into two main categories:
- A continuous engagement on ESG issues that are unresolved and can have a material impact on the investment case. Examples of this would be pending new carbon tax legislation, outstanding legal claims relating to health and safety risks, and changing environmental regulations. These engagements allow us to quantify the impact of uncertain variables on our valuation, which assists us to make informed investment decisions based on robust valuations.
- A continuous engagement on ESG issues that relate to the stewardship of the company. This will commonly involve discussions relating to capital allocation strategy, the composition of the board in terms of skills and diversity, and the adequacy of key performance indicators and targets in setting the remuneration policy for senior management. In addition, as investors with a long-term time horizon, we think it is important to understand what companies are doing to protect the sustainability of their business and the environment in which they operate.
Our engagement process involves discussions on several topics, including but not limited to waste management, health and safety processes, and labour relations. This helps us to assess whether the company has a coherent strategy to deal with the environmental and social impact that its everyday operations have. A company’s awareness of these affairs and a willingness to address them in a formal, proactive manner indicate that the business is committed to being a good corporate citizen and protecting its sustainable long-term value.
The issues that we engage on are often complex and require that we have multiple discussions with the relevant companies. Our ultimate intention is to drive the change we feel will be most beneficial for shareholders in the long run. We find that a strategy of constructive, behind-the-scenes engagement directly with a company is far more productive than debating issues at a public annual general meeting (AGM) or through the press. Conversely, a strategy of merely selling out of companies without any engagement does not address societal needs and merely shifts the burden elsewhere.
ESG issues can often be resolved in direct meetings with a company’s senior management team. Where appropriate, we escalate issues by writing a letter to the board of directors, setting out our key concerns. In addition, we also engage with fellow shareholders to apply more pressure for change.
If these actions still do not result in the desired outcome, we will take the appropriate steps at either the AGM or call a special meeting to highlight our grievances and make the necessary recommendations. If our best efforts are unsuccessful, we will re-assess our investment case and valuation and take the appropriate investment action in our portfolios. All our interactions are fully documented in a central ESG database which records the relevant issue, the company’s response and how the issue was resolved.
Below we have included three examples of issues that we have engaged on in the past.
ESG ISSUE: CAPITAL ALLOCATION
Sector: South African resources company
Since 2012, we had numerous engagements with and wrote two letters to the board of a listed resources company to discuss their capital allocation strategy. We highlighted that the company’s track record of past acquisitions and investments had not created value for shareholders. We encouraged the company to consider using higher hurdle rates when embarking on future investments to mitigate execution risk. We also suggested that new capital projects should be assessed against the value created from returning cash to shareholders via increased dividends or buybacks.
Following the initiation of our engagement process in 2012, the board of directors took note of our suggestions and in late 2017 announced a new capital allocation framework to the market. This new framework presented a medium-term focus on strengthening the company balance sheet while improving the dividend payout ratio. Once the balance sheet had been returned to a healthy state, the company would evaluate small- to medium-sized growth options and further increase the dividend payout ratio. We felt this revised capital allocation framework was properly constructed and balanced the need for the company to continue to invest in a considered manner as well as improve returns to shareholders.
ESG ISSUE: EMPOWERMENT DEAL
Sector: South African resources company
To comply with the provisions of the Mining Charter in force at the time, a resources company was required to enter into a black economic empowerment (BEE) deal to replace a previous transaction that had ceased to exist. As significant shareholders, we engaged extensively with company management and external advisers over a period of approximately six months to shape a deal with an innovative funding structure that achieved genuinely broad-based empowerment while at the same time addressing the concerns of potential dilution for existing shareholders.
A deal was concluded that resulted in the raising of significant capital for the company’s expansion plans funded through a high-yielding tradeable instrument, making it attractive to investors. The resulting BEE ownership comfortably exceeds the minimum requirements. More importantly, the deal incorporates a significant allocation (75% of the deal) to employees, surrounding communities, women’s groups and historically disadvantaged organisations. We ensured that long-term incentives were created to align management with the objectives of the transaction, and we continue to engage on issues such as board representation of BEE participants.
ESG ISSUE: CORPORATE RESTRUCTURE
Sector: South African listed-property company
A property company was listed as a property unit trust (PUT). While this is allowed by the JSE, it significantly limits the ability of shareholders to influence the governance of the company, and as a result the company failed to attract meaningful shareholding on the JSE. The essence of a PUT structure is that the fund is managed under the Collective Investment Schemes Control Act guidelines, with unit holders having no say in the governance of the vehicle, while the fund manager is outside the listed vehicle. Through extensive engagement with the company itself and its ultimate controlling shareholder, we reached an agreement whereby the PUT structure would be converted into a real estate investment trust (REIT), allowing better governance via requiring normal shareholder meetings and AGMs. In addition, the company internalised its management company, and the holding company chose to cancel its greenfield put option to place properties into the structure.
The restructuring of the company from a PUT to a REIT resulted in a significantly more investable company, with appropriate levels of governance and control in place. A more sustainable company structure should provide for greater returns over time.
The examples above highlight that the ESG engagement process involves sincere communication with the company, usually taking place over multiple instances to help us shape the outcome that is most value enhancing for shareholders. We believe this understated approach is far more constructive than airing the issues out in a public forum for the sake of a few headlines. Our aim is to resolve these matters in a way that leads to more sustainable and better corporate behaviour. This, we believe, is one of the ultimate aims of responsible investing.