The G in ESG: a vital consideration for small caps

Viewpoint

• Within our broader approach to ESG, specific attention is directed towards governance, namely board composition, executive pay and incentives. We believe this is of particular importance when assessing smaller, growing companies.
• A unique feature of investing in small caps is the prevalence of founder-led businesses. Founders, through extended tenure, large shareholdings and cultural influence can challenge governance objectives, including board independence.
• Growing, maturing companies need to ensure that executive incentive structures are transparent and appropriately tailored – and ultimately anchor to shareholder returns.

As the significance of environmental, social, and governance (ESG) factors continues to rise in the investment landscape, and discussions centre around decarbonisation, emissions, and climate change, the critical role of governance can sometimes be overshadowed.

In the context of the Australian small-cap sector, we believe governance is currently the most influential ESG factor driving shareholder returns, as shown by the extensive back-testing conducted by our team. This belief shapes our research efforts and company engagement strategies for the Maple-Brown Abbott Australian Small Companies Fund.

Board composition and the role of founders

Board composition, being pivotal to both governance and shareholder returns, demands a nuanced evaluation of diversity, skills, independence and alignment with shareholders.

In our observations, the heavy influence of founders within smaller, newer companies is a prevailing feature of the small cap cohort. Implicit in the name, these key individuals commonly retain senior executive roles and substantial shareholdings back to a company’s genesis. Balancing a founder’s undeniable influence against the need for independent thought can become a delicate task, contingent on company performance and board effectiveness.

We also recognise that a director’s extended tenure has the potential (inadvertent or otherwise) to compromise board independence, as directors who have been with a company from its inception may develop particularly close relationships with employees, suppliers and customers, potentially biasing their oversight role. Consequently, maintaining objectivity where directors have been on a board beyond 10-12 years becomes a critical consideration.

Where the board has discretion to determine whether performance objectives were met in compensation plans this independence and objectivity is even more important. Further to this we also stress the importance of separating the roles of the chairperson and CEO for effective oversight.

Executive incentives

The realm of executive pay and incentives is a crucial consideration for investors, as it is central to determining management priorities. We believe aligning incentives with activities that enhance shareholder returns becomes paramount for smaller companies, particularly those operating in rapidly evolving markets. We look for tailored incentive schemes respecting all stakeholders, for example safety metrics in short-term incentives may be pertinent for the mining sector, whereas new customer contracts may drive positive returns for technology companies.

In cases where we observe poor incentive alignment, particularly in management receiving additional compensation for routine activities, we engage with the company and exercise our voting rights by opposing remuneration reports and other incentive packages during annual general meetings. The outcome of exercising these voting rights will largely depend on the number of voting shares we may hold in a company, and the extent to which other shareholders are like-minded in their view.

Transparency is key

The best incentive programs are transparent, measurable and easily comprehensible. High expectations for detailed, metricated disclosure and industry-specific tailoring underscore our commitment to transparency. During recent engagements in proxy voting seasons, as active and engaged investors we agitated for increased disclosure of short-term incentive performance indicators on a number of occasions. This also extended to pushing for greater transparency of long-term incentives, advocating for clear, objective measures such as relative shareholder return and earnings per share growth.

We scrutinise whether management targets are sufficiently challenging to warrant performance incentives, firmly believing that financial metrics should align with driving shareholder returns, echoing our philosophy that earnings drive share prices we believe earnings per share metrics are the optimal measure of long term performance.

Incentive case study: MVF

Monash IVF Group (MVF) operate what we believe is an example of a clear and easily comprehensible incentive program. The program’s strategic objectives of patient engagement, people engagement, doctor engagement, scientific success rates, domestic market growth and doctor acquisition/retention closely align with the key business growth drivers and shareholder return. Furthermore, for each strategic objective there are clear measures of success such as net promoter scores and employee engagement percentages. In line with best practice the company discloses the annual outcome on these measures so shareholders can easily assess if incentives have been earned. While the company has an allocation to non-financial objectives, 70% of short term incentives are financial in nature, allocated to earnings per share – which is our preferred measure of financial performance in line with our investment philosophy.

Parting thought

For smaller companies, board composition and appropriate remuneration structures are central to both governance and shareholder returns. As such they demand a nuanced evaluation of, inherent biases, independence and alignment with shareholders.

In our role as active owners, we consider it our responsibility to foster good corporate governance, ultimately aimed at enhancing returns for our clients. We aim to cultivate enduring relationships with the companies in our portfolio, intending to support them throughout their growth journey while concurrently building value for our clients.

Disclaimer
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