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Culture of change

Corporate governance is an important yardstick for assessing emerging market companies.

Whether a company is an Armenian yogurt manufacturer or a big technology firm in Germany, corporate governance is a universal concept. But corporate governance practices in the emerging markets have long been viewed as far less rigorous and transparent than in developed markets.

Things are changing. Corporate governance in the developing world has improved and continues to evolve. This is good news for investors as it is an important yardstick for assessing a company’s fundamentals and unique risks.

The following are key characteristics that we believe should be present.

– Adequate legal system.

– Accounting transparency.

– Appropriate compensation to ensure that incentives for the company’s management are aligned with the interests of all stakeholders.

– Minority shareholder protection.

These are the most desirable guidelines for corporate governance but there are a number of areas where emerging markets companies often struggle. Emerging economies often have less well developed legal systems, yet clear and enforceable corporate laws should benefit companies in a developing economy.

Accounting transparency, while improving, is still rather poor across the developing world. Since valuations are still relatively low, aggressive raiders can threaten weak minority shareholder rights. This can lead to greater control for majority shareholders and the potential for abuse owing to limited minority shareholder protection.

Corporate governance as a matter of policy was all but absent in the developing world until the financial crises in Latin America, the Far East and Russia in the mid to late 1990s, leading to seven years of famine for emerging market investors.

The Organisation of Economic Co-operation and Development has identified a number of factors critical to the long-term development of emerging economies. One is the transition from relationship-based to rule-based governance.

In many emerging market countries, wealthy individuals or families may own controlling interests in one or more big companies. In some instances, this may take the form of a pyramidal business group where those one or two companies have controlling interests in many more companies, each of which has controlling interests in even more companies. An individual, a family or several families could effectively exercise control over a significant portion of an emerging country’s economy, leaving companies vulnerable to problems of abuse.

Catalysts for change in corporate governance standards can come from many sources – government-led legislation, as a takeover defence, because of pressure from institutional investors, or even public opinion (witness the Thai people’s outcry over then prime minister Thaksin Shinawatra’s tax-free sale of Shinawatra to Singapore Telecom).

Today, there are many incentives for an emerging markets company to adopt a more transparent corporate structure. Additionally, as an emerging country adopts more market-friendly economic policies, it can effectively institutionalise the formal and informal rules and guidelines comprising corporate governance policy.

There are a number of things to look for if trying to identify when corporate governance is inadequate or failing. Rarely part of the investment process, these issues can materially affect company performance. Asset transfers by government-controlled or family-controlled companies are a red flag issue as these have often been conducted at arbitrary levels. Excessive management contracts and non-aligned incentives, including big cash bonuses, all detract from the potential performance of a stock.

Governance is a sector and company-specific issue and must be addressed on a company-by-company basis.

James Donald is portfolio manager for emerging markets at Lazard Asset Management.

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