The series of financial crises that the global marketplace experienced during the early years of the new millennium - the failures of Enron, WorldCom and Global Crossing in the US, the collapse of HIH in Australia and the troubles that beset Vivendi, Ahold and Parmalat in Europe - have led to increasing scrutiny of the way in which listed companies manage their risks and ensure that effective governance procedures are in place. Much risk management has been driven by the need for compliance with a wide range of legislative and regulatory requirements. However, this approach has been criticised for being reactive rather than proactive, and for taking too narrow a view of the threats to which an enterprise is exposed.
A study conducted by the Cullen Centre for Risk and Governance at Glasgow Caledonian University in 2005, sponsored by Zurich Financial Services, compared perceptions of the value of risk management and corporate governance held by senior corporate executives and institutional investors. Particular attention was paid to value creation through such activities, and how approaches to, and changes in, risk management and corporate governance might be perceived by major institutional investors.
The rise of institutional equity ownership, combined with the UK's culture of shareholder activism, leads us to assume two things: firstly, that institutional investors place value in corporations pursuing efficient risk management and corporate governance and, secondly, that information regarding the nature of risk management and corporate governance structures within companies is reaching investors in sufficient quantity and quality to influence their evaluations and investment decisions.
Separate but related postal questionnaires were designed and distributed to these two groups. With regard to the senior executives, the key findings are as follows:
- Companies perceive their environments as risky, with internal non-financial risk emerging as the most critical. Furthermore, company risk appetites are geared towards high levels of risk.
- Evidence suggests that companies believe efficient risk management and corporate governance structures can improve corporate performance. In addition, they report that disclosures on risk management and corporate governance can positively influence corporate performance.
- A variety of performance gains resulting from both risk management and corporate governance are noted by respondents. There was greater enthusiasm for risk management, which is generally thought of as creating ways for performance improvements to occur internally. In contrast, corporate governance is generally linked to performance through external routes, with the focus lying upon the impression made on investors.
- Risk management practices have evolved considerably over the last decade, to the extent that they are generally used for strategic purposes. Risk measurement emerges as the area of risk management which the majority of companies remain keen to develop.
- Risks are generally communicated in order to achieve a company-wide understanding, comply with regulation and inform investors. Despite senior executives regarding employees as the primary audience, risks are communicated through the annual report and OFR, rather than through internal communications and announcements. The types of risks faced, and procedures for managing them, are the aspects of risk management most frequently addressed within these communications. Larger companies appear particularly interested in risk communication.
- Companies are overwhelmingly likely to report that their corporate governance has been transformed over the past 12 years. Internal audit, disclosure and CSR are the areas most likely to receive attention in the future.
A wide variety of performance gains, resulting from both risk management and corporate governance are described by the senior executives who responded to this questionnaire. Interestingly, these responses indicate a greater enthusiasm for risk management, which is generally perceived as creating a means for performance improvement within the company, through cost reduction or improved managerial insight. On the other hand, corporate governance is generally linked to performance through external routes, where it is the impression made on investors and other stakeholders that is decisive.
Institutional investors' views
The views of the other group of respondents, institutional investors, revealed the following:
- Investors are interested in company risk management structures. In particular, they are prepared to pay a premium for strengths in risk monitoring.
- They regard efficient risk management as a proxy for high quality strategic management, which may lead to enhanced corporate value. Evidence linking risk management reporting to enhanced corporate performance or maintenance of share price remains modest.
- There are signs that improvements to risk management or corporate governance can bring about tangible performance gains. Investors also believe to a degree that risk management and corporate governance announcements can influence share price.
- Institutional investors maintain their individual shareholdings for over two years - a sufficient length of time to justify an interest in corporate governance, risk management and corporate value. This longer-term outlook is supported by the finding that value investing appears to be the most favoured investment strategy.
- Investors are prepared to take on high levels of risk and use risk categories for stock selection purposes. They prioritise financial and non-financial risks to their investee companies before risks which are external to those companies, or the trading risks to the investors themselves.
- They are prepared to pay a premium for improvements in board independence and areas which facilitate shareholder engagement. Investors place less emphasis on a company's corporate governance. Views vary regarding whether efficient corporate governance can serve as a proxy for high quality strategic management and whether it can enhance the quality of corporate disclosure.
Of particular interest is the value that investors placed on company risk management structures. A full 50% admitted to placing a high degree of emphasis on this factor - a clear signal of the importance of risk management as a contributor to corporate value. Looking more closely at the different aspects of managing risk, it appears that risk monitoring was most highly valued by institutional investors, with risk measurement in second place. This shows a slight divergence between the views of the two groups of respondents as current concerns over legislative compliance appear to be leading companies to stress risk measurement as the area of risk management requiring further attention, while investors are more likely to pay a premium for companies with strengths in risk monitoring.
Companies appear moderately keen to improve all areas of corporate governance. Investors, however, are much more likely to pay a premium for improvements which allow themselves and directors to exhort managers to deliver performance gains. Both groups appear to agree that corporate governance improvements have some potential to bring about enhanced corporate performance. While investors believe this is also true for risk management, companies take a much more positive view. This suggests investors should pay more attention to what companies know about risk management's internal links to superior corporate performance. Companies and investors currently regard risk management and corporate governance disclosures as having a low potential to create share price effects, although corporate governance may be viewed as having a marginally greater potential. In view of earlier findings, both companies and investors have incentives to pay greater attention to these matters.
The findings reported by the study provide evidence that perceptions of the value enhancement possibilities of putting in place efficient risk management and corporate governance structures may be more positive than previously reported. The results indicate that senior executives believe efficient risk management and corporate governance structures can improve corporate performance, and that disclosures on risk management and corporate governance can positively influence corporate performance. In addition, a variety of performance gains resulting from both risk management and corporate governance were found.
Interestingly, there was greater enthusiasm for risk management, which was generally believed to create more avenues for performance improvements to occur internally within the company. It also emerged that risk management practices have evolved considerably over the last decade and today are also likely to be utilised for strategic purposes.
The responses from institutional investors were also positive regarding possible value enhancement, which would suggest that companies wishing to add value should look to further enhance their risk management function. Institutional investor feedback indicated that they regard efficient risk management as a proxy for high quality strategic management. Further, they showed a belief that by improving risk management and corporate governance it may be possible to bring about tangible performance gains.
Given these findings the main conclusion of the study is that senior executives need to continue to focus on creating efficient corporate governance and risk management structures and to emphasise to the external institutional investors that this is taking place as part of a cohesive strategy to manage the future profitability of the company. By doing this, the company will be well placed to absorb changes in circumstance, manage change and reduce asymmetric information to key shareholders - all of which will enhance future value.
Lynn Drennan, Rob Webb and Alasdair Marshall, work at the Cullen Centre for Risk and Governance, www.caledoniancrag.com/Cullen%20home%20intro.html About the Cullen Centre
The Cullen Centre for Risk and Governance at Glasgow Caledonian University is dedicated to providing applied research and consultancy services for industry, commerce, professional institutes, government agencies and the voluntary sector, both within the UK and internationally. As an interdisciplinary centre, it focuses on a broad range of governance-related areas including accountability, auditing, internal control, risk management, governance, corporate social responsibility, ethics, regulation and occupational health and safety.
The Centre employs a dedicated team of full-time research fellows and research assistants, who support the work of senior academic staff in Glasgow Caledonian University.
The study, on which this article is based, was sponsored by Zurich Financial Services in 2005 and is titled Perceptions of Value Creation from Risk Management and Corporate Governance: A Study of Senior Executives versus Institutional Investors.