Asia Insight

May 2008

Minority Report

Jesper Madsen, CFA
Portfolio Manager
Matthews International Capital Management, LLC

Corporate governance is a key concern for minority shareholders and probably one of the most challenging issues for investors to get their hands around. However, as investors in Asian businesses, it is an issue we constantly have to wrestle with, and dedicate resources to better understand. We do this for the simple reason that corporate governance matters—especially for minority shareholders. The level of corporate governance will often decide to what extent minority shareholders will participate in the growth opportunities of a business, and whether or not they will receive their fair share of company profits. If companies are not run for all shareholders, profits are more likely to be expropriated by the controlling stakeholders, which, in Asia, are often founding families and conglomerates. In essence, in a framework of poor corporate governance, minority shareholders put their capital at risk as holders of the equity, while they do not reap the full economic upside. In times of strong equity market per formance the issue of corporate governance tends to strike market participants as a mere academic problem. When equity markets perform poorly, however, management teams and majority shareholders will be under closer scrutiny and pressure to improve corporate governance. The focus on governance tends to move in cycles and intensify as profit growth slows or equity markets become more volatile.

Investors have indicated a willingness to pay a premium for good governance or, conversely, apply a discount for poor governance. According to a survey by McKinsey & Company, institutional investors indicated they were willing to pay a 20% to 25% premium for good governance. This was especially applicable to foreign shareholders in Asia, who have been substantial net buyers of Asian equities over the past five years. Many of these institutional investors employ third party vendors to assist them with proxy voting, which has generally resulted in more scrutiny and pressure to improve disclosures. It is not a coincidence that Hong Kong and Singapore have become the "funding windows" of choice for many Chinese companies seeking to list. Both countries top the league table in terms of corporate governance in Asia, offering investors a firmer set of rules and regulations.

Corporate governance policies in Asia have generally improved during the past decade, oftentimes at an impressive pace, considering the relatively short history of some stock markets. China's mainland exchanges in Shanghai and Shenzhen, which have been in existence since 1990 and 1991 respectively, are by some measures governed by stricter rules than their much older cousin in Hong Kong. Regionally, the greatest overhaul of regulatory oversight and securities laws occurred after the Asian financial crisis of 1997 to 1998. This was partly due to the notion that poor corporate governance, especially the heavy influence of dominant shareholders, had played a role in the corporate excesses that preceded the Asian crisis. Specific regulatory improvements vary from country to country. Changes have generally resulted in a more stringent set of rules and regulations regarding transparency, disclosure and timeliness of reporting. However, for real change or a culture of corporate governance to take root, these tightened policies require enforcement. The rapid expansion of company listings across the region has further burdened the regulatory bodies, making enforcement the weakest link in the corporate governance chain. Without the tangible threat of prosecution for wrongdoing, changes in the behavior of management teams and major shareholders have lagged enhancements made to the legal framework meant to protect minority shareholders. It is difficult to envision corporate governance in Asia moving beyond the current "check the box" style of regulation to a more encompassing culture of corporate governance without a considerable strengthening of the enforcement capabilities across the region.

Asia has a growing pool of small- and mid-sized companies managed by driven and resourceful entrepreneurs. As investors, we try to identify not only attractive businesses, but also capable management teams. A certain personality is required not only to start a business, but also to grow it successfully. Many companies are still run by the founder or first generation of management, often resulting in a high degree of dependency on a few key individuals. However, oftentimes, entrepreneurs believe the company is theirs to run as they see fit, while minority shareholders are along for the ride. This creates an "agency problem" in which the goals and incentives of minority shareholders and company management diverge. Furthermore, since the founder is often the largest shareholder, this agency problem is not just one of shareholders versus management, but one of minority versus majority shareholder. There are many ways in which this majority shareholder/management structure can manifest in abuse. Asian entrepreneurs or their family members often have several businesses that reside outside of the listed company. These could include suppliers to the listed company, either of goods and services, or property rentals. It is easy to see the potential for abuse in setting transfer pricing in these transactions. Two other potentials for abuse: asset injections from unlisted companies owned by the major shareholders, and partial listings of businesses undergoing an initial public offering (IPO). We have seen an example of a retail chain IPO that listed only a portion of its stores. The remaining stores were conveniently owned by the founder, with the potential of being injected later at higher prices.

Regulations regarding related party transactions have been sharpened and disclosure has improved. However, identifying the expropriation of cash may not always be simple. Sometimes publicly traded companies can still fund unlisted entities, extending loans on favorable terms to companies related to the major shareholder. Minority shareholders end up bearing the risk, while seeing none of the potential upside. More than anything, else these examples of wrongdoing stress the importance of understanding the incentives and motivations of the key individuals behind the business. Are they not only shrewd business people, but also trustworthy?

The evolution of corporate governance in Japan deserves special mention. Transformations there illustrate how change can often be an iterative process of "two steps forward, one step back." Japan's economic model prior to the mid-1990s was centered on the "keiretsu," tight webs of corporate alliances, often with financial institutions acting as the spider in the center. The threads of the web were formed by cross-shareholdings, whereby companies would solidify their relationship by acquiring and holding shares in each other. This structure was heralded by many as having played an important role in the successful economic development of Japan after the Second World War. During the 1990s, however, as Japan's banking system was drowning under the weight of non-performing loans, banks came under pressure to unwind the cross-shareholdings. This culminated in the Banks' Shareholding Restriction Law, further requiring a sell-down of cross-shareholdings. As a result, foreign and domestic institutional shareholders replaced the passive "friendly" shareholders of the past. The new contingent of minority shareholders was more demanding, especially regarding the use of surplus cash on the balance sheet or the use of company earnings. Suddenly, minority shareholders had to be taken seriously. This paradigm shift is clearly reflected in the dividend policies implemented by corporate Japan since 2004. Previously, companies were not pressured to pay dividends to shareholders and instead paid a fixed low nominal amount per share, irrespective of company earnings. This pay-off structure in some sense treated equity holders more in line with holders of the company's debt—an important distinction since debt holders are not the owners of the business, except perhaps in the case of bankruptcy. The earnings of the business therefore belonged to the company's stakeholders, not its shareholders. As a result, most companies simply did not have a dividend policy. However, starting from about 2004, companies across many industries initiated a move toward dividend policies based on earnings, giving into mounting pressure to recognize that shareholders had a claim to company profits and, as such, should be included in the circle of stakeholders.

While the change to dividend policies was revolutionary, and unequivocally positive, for minority shareholders in Japan, another less shareholder-friendly measure, "the poison pill," was introduced, at about the same time, as a means of protection against hostile takeovers. More than 600 companies now have poison pills, compared to just two in 2004, according to UBS. Poison pills tend to benefit management rather than minority shareholders, and are therefore a move in the wrong direction. While Japanese companies are not taking a straight path toward better corporate governance, they are moving in the right general direction.

Another factor to improving corporate governance is an independent news media—one that is free, not only from state scrutiny, but also from influence by the deep pockets of the tycoons it should be covering. This kind of public accountability could supplement the regulatory enforcement needed, especially when the latter falls short. Some politicians and high-ranking Asian officials continue to advocate what amounts to statesponsored disregard for minority shareholders, especially if the investors happen to be foreign. These overtures send the wrong signals to business leaders, making it harder to nurture a culture of corporate governance. With time, the influence of the many founding families of Asian businesses will likely diminish as management teams with less ownership in the business play a greater role. The treatment of minority shareholders in Asia has made great strides and continues to improve at the margins. However, as long-term investors, we must remain vigilant in monitoring whether or not the seeds of better corporate governance will truly take root.

April 30, 2008

The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.