The G in ESG has often felt like the poor cousin of the three pillars of sustainable investing. An AI-assisted review of sustainability reports from a random selection of asset managers revealed that the highest weighting given to governance was 22%. This is despite an MSCI study revealing that governance was at least as important a driver of share price performance overall and arguably a stronger performer in the short term.
It seems that investment managers want to talk more about the E and the S when the G is just as important.
We think from the perspective of a credit manager, the G is arguably even more important as it drives event risk which in turn drives default risk. This is not to diminish the long-term implications of poor performance on Environment and Social risk factors but to emphasise that governance should not be an afterthought.
In recent months several events have reminded us of this fact. Last month, the AFR reported on an Australian non-bank lender, Marketlend, who missed payments on a warehouse facility late last year with the financier taking control and being unable to verify large parts of the loan book. In February a large bridge lender in the UK called Market Finance Solutions was placed into administration following accusations of fraud and double pledging of assets (with another smaller bridge lender falling into administration in the same month). In September of last year, similar issues were uncovered at Tricolor, a US based auto lender and First Brands, a US based auto parts supplier. Even the major banks in Australia have uncovered widespread fraud on their lending books although this relates to money laundering and is not expected to result in any direct losses.
So, if governance risks are so important, why do managers seem to spend so little time on it?
One possible reason is that it is hard to assess. In general, environmental and social risks are much easier to spot. Often inherent in certain businesses and sectors with the assessment from investors really about the management of the risk which is as much about governance as the underlying social or environmental risk. At Challenger Investment Management we talk about the layering of risks; our risk appetite drops sharply when a borrower with heightened social or environmental risks also exhibits weaker governance controls.
Our approach to assessing governance risk has several key principles that apply across all asset classes.
One, the underlying business must be profitable or have a clear path to profitability. This may seem trivial but there has been a significant amount of lending to borrowers that don’t meet this threshold. Simply taking comfort because you have asset level security or a low loan to value ratio is not sufficient. Very few cases of fraud start out as frauds; fraud tends to follow poor performance especially at an institutional level.
Secondly, assessment of the management team is critical. Founder led businesses have their positives especially during the growth phase of a business, but this often comes with a lack of controls whether it is through expanding and empowering management, investing in IT and systems, lacking transparency or bringing on strong and credible oversight (private equity ownership, non-executive boards, external audits from credible firms).
Lastly, the governance assessment is not independent of the credit underwrite nor is it static. It is important to maintain oversight of a borrower throughout the life of a transaction. This means reviewing monthly financials for changes in performance or inconsistencies/irregularities in the data, identifying changes in personnel, assessing how information is shared (“does the management team tell us about issues in advance or leave us to find out ourselves”).
The good news is that governance is now front and centre of investors’ minds and in fact, on borrower’s minds as well. To borrow Jamie Dimon’s cockroach analogy (where there is one cockroach there are probably more), investors are on the lookout for cockroaches and borrowers are looking to prove that they aren’t cockroaches. Already we have seen borrowers reach out to us and proactively explain how they mitigate the risk of fraud including offering to provide far more transparency than they have shared previously.
A greater focus on governance can reduce the risk of cockroaches. We’ve turned on the lights, packed away the left out food and are spraying the Mortein where we know the cockroaches like to hide. The cockroaches have always been there. Now we are doing something about it.
In the short term, as investors stress about finding the next cockroach there is likely to be an increased risk premium attached to borrowers with weaker governance and even borrowers with strong governance that operate in similar sectors where fraud has been uncovered previously. But longer term the proactive steps being taken by lenders land investors should result in lower governance risks and a more stable and sustainable market. This is a positive for borrowers and lenders alike.
On behalf of the team, thanks for reading.
Challenger Investment Management
For further information, please contact:
Linda Mead
Senior Institutional Business Development Manager | T +612 9994 7867 | M +61 417 675 289 | lmead@challenger.com.au |
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