The five Cs of credit – turns out there is a sixth!
As a young professional entering the world of investment banking, specifically credit risk, I soon found myself well-versed in the acronyms that many young risk professionals are introduced to at the start of their careers, the famous Five Cs of Credit.
They are Character, Capacity, Capital, Collateral and Conditions and encapsulate the five basic principles of credit risk
These five C’s have, over the last few decades in our country and indeed around the globe, guided many an investment committee debate on the merits of doing a deal or not. However, over the last few years, it has become apparent to me that a sixth C exists.
The Sixth C of Credit Risk – Conscience
Conscience refers to an investor’s duty as a corporate citizen to invest in a responsible and sustainable manner. I must admit that the concept is more commonly known by the investment community under a different acronym, namely ESG (Environmental, Social and Governance factors). The events of the last few years have shone a spotlight on governance in our country. It began with governance failures at our country’s largest state-owned enterprises (SOE’s), with many in the investment community believing that this is where it ended. This has not been the case. A sobering dose of reality over the last year has brought to the fore the lack of good governance within corporate South Africa. The result is that the hot topic of the day is ESG.
Admittedly, ESG and similar concepts, like “Responsible Investing” aren’t new. In fact, they have been around for some time. Unfortunately, many investors and companies alike have paid lip service to the concept, treating it as a tick-box exercise. It has typically been confined to the few pages of a company’s annual integrated report, which typically provide generic descriptors of the company’s commitment to act in an ethical and sustainable manner. This has been against the backdrop of South Africa taking a leading role in the international community by embracing good governance and adopting the King Code of Corporate Governance. The King Code has been lauded internationally for its insightfulness and principles-based approach.
From an investors perspective, our previous Finance Minister, Mr Pravin Gordhan, also had the foresight to fight for a framework upon which institutional investors could be guided. This led to the implementation of the Code for Responsible Investing in South Africa (CRISA) in 2011. CRISA is based on the United Nations Principles for Responsible Investing (UN PRI). It is widely recognised as the global standard for Responsible Investing. At the heart of CRISA is the recognition of the importance of integrating sustainability issues, including ESG, into long-term investment strategies.
Governance standards such as the King Code and CRISA have not yet been drafted into legislation and remain voluntary. This means that companies have the choice to adopt or reject the principles outlined in these codes. The evolution of the King Code, from King 1 and 2, which contained a “comply or else” approach, to King 3 which adopted the concept of “apply or explain,” was a step in the right direction. Unfortunately the non-mandatory market-based code still provided options to companies and this has by and large, been exploited. I believe this short sighted approach by such transgressors will be to their own detriment in the long run. As the economic lessons cited in the remainder of this article suggest, ESG should be a fundamental part of an organisation’s DNA and culture. It should not be seen as something to comply with, but rather one of the pillars upon which any sustainable business practice should rest on.
How do ESG factors affect the credit risk of the counterparty?
A culture of good governance and appreciation of risk within an organisation can mean the difference between a successful or uncompetitive one. For a construction company like Group 5, it’s the difference between entering into a large scale project in Ghana, which on the face of it may seem like a dripping roast, but was actually fraught with underlying execution risks that eventually led to the inevitable demise of the company. From a retail perspective, it is the decision of Woolworths to expand into a new region like Australia, without having a full appreciation of the nuanced market dynamics of the target destination, leading to significant value destruction in the business and for shareholders. Mr Price has unfortunately followed a similar fate in Australia and may be headed down the same path in Poland, in its latest offshore venture.
The overall tone of governance within an organisation is set by the executive management team, and overseen by the Board of Directors. The fundamental principles enshrined in the King Code include independent representation on the Board and the allocation of appropriate sub-committees, such as the Audit & Risk Committee, a Nominations Committee and a Remuneration Committee, to name but a few. These are all important considerations. However, equally important, yet often overlooked aspects include:
- The capacity of Non-executive Board members – In South Africa, the tendency is for seasoned business professionals to take up seats on multiple Boards, simultaneously. I have seen examples of Board members occupying as many as 17 separate positions as non-executive members across various listed companies. Based on a conservative estimate of four board meetings a year for each company, that equates to 68 meetings annually for the non-executive. One has to question how such a person is able to apply their mind effectively to all the seats occupied, let alone physically attend all required meetings.
- Another common occurrence in the country is the phenomenon of pack-hunters. These are familiar groupings of non-executive directors that tend to pop-up on various Boards across the JSE, by virtue of them occupying the same social spheres. This presents a risk to independence, as these packs are at risk of voting with a herd mentality when it comes to important and often difficult decisions facing companies. In this regard, the importance of a truly diverse Board that brings together divergent views cannot be overstated.
Equally important is a company’s approach to managing environmental and social risk factors. A fundamental tenet of approaching such factors is the recognition by a company that it does not exist within a vacuum and is very much a part of the eco-system of its operating environment. Companies should therefore be aware of their impact on a wider set of stakeholders. The concept of “externality” is an important consideration in this regard.
An externality is a consequence of an economic activity experienced by unrelated third parties. Pollution emitted by a factory that spoils the surrounding environment and affects the health of nearby residents is an example of a negative externality. Companies can be significant contributors to such negative externalities and an appreciation and awareness of this impact underpins any effective Environmental and Social risk management policy.
Furthermore, in the case of negative externalities, there is always a cost associated with it. In the example cited above, the cost would be borne by the family affected by the pollution, in the form of increased medical costs, or quite possibly by the state, if government-subsidised public healthcare is utilised.
There is growing empirical evidence being gathered globally that supports the business case for integrating ESG factors into investment strategies. A 2012 Deutsche Bank survey of academic research was one of the first meta studies asserting this point, but more recently, studies conducted by Hamburg University as well as Harvard University confirm that companies with high ESG ratings had a lower cost of capital in terms of both debt (bonds and loans) and equity to those with low ratings (source: Kudos Capital).
Closer to home, the Old Mutual Investment Group of South Africa (OMIGSA) Responsible Investing (RI) equity index saw cumulative returns of 71.13% between October 2012 and December 2016, compared to 62.85% for the JSE ALSI SWIX. This points to a growing school of investors that recognise the investment case for ESG factors when allocating capital.
The dire state of local SOE’s is cause for concern. It presents real risks to the economy, but equally concerning is the Trojan horse that is the present state of governance within our corporate sphere. As allocators of capital, I believe that the burden rests on us, the wider investor community, to help impose better standards of governance and an appreciation of Environmental and Social risk factors in the marketplace.
Over and above our moral obligation to hold companies to account, under Regulation 28 of the Pension Funds Act, the following is but one of the obligations conferred upon any such fund and it’s Board, when allocating such monies for investment purposes:
“…Understand the nature of the assets in which the fund invests. To this end, they must conduct reasonable due diligence before making contractual commitments to invest in assets managed by a third party for both local and foreign assets. They must also understand the changing risk profile of assets over time, as well as the need to consider environmental, social and governance characteristics.”
For too long, investors have turned a blind eye to this important facet of investment analysis that is ESG, to the detriment of the market as a whole. It is only when investors begin to hold companies to account that the winds of change can begin to sweep over our marketplace.