How is corporate governance linked to financial performance?

Calvert Institute publishes whitepaper detailing 10 governance factors affecting financial performance

A whitepaper published by the Calvert Institute has established corporate governance factors are positively linked to financial performance.

The research element of Calvert, a subsidiary of Eaton Vance, examined how 10 governance factors, ranging from accounting risk to shareholder rights, materially affected financial performance of more than 8,500 companies in 72 countries for the whitepaper How corporate governance factors can influence financial performance.

Below, the Calvert Institute’s ESG senior research analysts Hellen Mbugua and Daniel Rourke answer ESG Clarity‘s questions on the key findings of the report.

Why did you decide to explore the relationship between governance and financial performance?

Corporate governance is a core factor in Calvert’s ESG research. We believe that governance is an indicator of how well a company identifies financially material ‘E’ and ‘S’ issues and manages associated risks and opportunities. There is an abundance of widely available and publicly obtainable information on companies’ corporate governance. With so much information available, we wanted to determine what information had efficacy and, therefore, provide more meaningful insights when making investment and engagement decisions. 

See also: – What we can learn from a company’s governance in a crisis

What were your key findings?

We found that understanding a country’s context is key. Consequently, we created four-country clusters based on corporate governance practices and corporate governance regulations or ‘rules’. This type of country grouping facilitates better like-to-like comparisons and yields a clearer understanding of the corporate governance landscape. Practices are the widely observed governance actions based on shared beliefs and values in society, while rules are the legal framework within which the company must operate.

Are you able to provide examples?

Without understanding a country’s context, one might compare two similar companies in countries A and B and conclude that, say company A is of a higher quality than company B due to a lack of accounting risk concerns. However, if company A belongs to the weak practices / weak rules cluster, it could be that these issues are not apparent due to the lack the transparency and enforcement mechanisms. And therefore, not reflecting the full extent of the investment risk exposure. 

What were the main factors affecting the relationship between governance and financial performance?

Depending on the country cluster, of which there are four – Weak Practices / Weak Rules (WP/WR), Weak Practices / Strong Rules (WP/SR), Strong Practices / Weak Rules (SP/WR), and Strong Practices / Strong Rules (SP/SR).

  • Factors that were tied to financial performance broadly.

Accounting risk – Captures flags such as revenue/expense recognition

Ownership structure – Captures flags such as controlling shareholder and Government intervention concerns

Both factors were found to be material in three of four of our country clusters. These are two basic measures which would be an automatic red flag for any investor.

  • Cluster specific factors tied to financial performance.
  • WP/WR – Focus on pay basics. In these markets (e.g., Mexico, South Korea), policy makers have not yet responded to weak practices by strengthening rules. Consequently, without adequate rules, enforcement is weak.  What differentiates one company from another in these markets are baseline measures of absolute pay, including disclosure.  
  • WP/SR – Focus on basic governance factors. These are markets (e.g., Brazil, China) where the policy makers have acted to improve weak governance practices, but those improvements are not yet widely observable across firms and likely take time to manifest. In these markets, investors should focus on basics first- such as companies with a credibly independent boards and clear respect for minority shareholder rights.
  • SP/WR – Focus on Pay basics and Pay quality factors. In these markets (e.g., Sweden, Singapore) corporate boards can generally be trusted to do the right thing, even in the absence of explicit rules. However, due to the trust afforded to the boards and the absence of adequate rules, there tends to be a lack of checks and balances around pay, sound pay practices are what distinguish one company from another. 
  • SP/SR – Focus on Board and Pay quality factors. These are highly professional markets (e.g., US, UK) where board and pay basics are largely ironed out and quality separates the leaders from the laggards. For example, board effectiveness (material in this cluster) moves beyond the basic measure of board independence and focuses on board expertise, skills, attendance and entrenchment. 

Are there any caveats/exceptions to the rule?

On the broadly material factors.

  • Accounting risk was not found to be material in the WP/WR cluster. These countries tend to have weaker transparency and enforcement mechanisms, which may result in cover-ups.
  • Ownership structure was not found to be material in our SP/SR cluster. Investors in these countries tend to be soundly protected by strong conventions and adequate enforcement.

How has Covid-19 impacted your findings, if at all?

Covid-19 has not impacted our findings, but reinforced that country nuances – conventions and the regulatory environment – may influence how certain jurisdictions respond to unprecedented events such as the pandemic or climate change. And, consequently, affect the related companies and stakeholders.

How should investors apply this to their own research?

The research can guide investors on what governance factors to emphasise and, therefore, better manage associated investment risks and opportunities. For example, at Calvert, we have previously found the low weight placed on gender board diversity to be inconsistent with our research, which shows that gender diversity at the board level has a significant and positive impact on a company’s financial performance. Therefore, we have historically overweighted this factor relative to other governance factors. Investors could use our findings as a guide towards making better investment and engagement decisions.

By publishing your research what do you hope happens within the industry?

We hope that our research spurs conversation on corporate governance and that the industry incorporates country-specific nuances when evaluating the subject more. Historically at Calvert, we looked at governance from a global perspective, as this is how most data vendors presented it. One can also look at governance from a regional, market cap, or industry angle. However, the problem with assessing governance from a global angle is that it introduces the bias of holding every country to the same standards, and not including the different country nuances.


Natalie Kenway

Natalie is editor in chief at MA Financial covering ESG Clarity, Portfolio Adviser and International Adviser. She was previously global head of ESG insight for ESG Clarity and has been an investment journalist...