Board composition is at the top of the investor wish-list in the U.S. this year, with implications for board discussion of strategy. Many investors are concerned about director tenure, especially on boards with limited recent turnover. U.S. boards on average have longer tenure than we see in some other markets, creating particular concern about boards that have unusually long tenure even within the U.S. context. In the view of these investors, there should be regular renewal to bring fresh perspective into the boardroom.
Many investors also would like confidence that board nominating committees are thoughtful about the optimal mix of skills and background, and in particular how this may change as the business evolves. In many industries facing complex challenges, this suggests there be outside, independent directors with strong and demonstrable subject matter knowledge and experience. Investor confidence requires a thoughtful process of director succession planning and search, and clear explanation. In this view, subject matter expertise from an independent perspective is vital to board discussion of strategy.
Finally, investor focus on boardroom diversity, particularly in gender and ethnicity, is on the rise. In the view of many investors, diversity fosters stronger board decision-making. We have not yet seen much focus on age diversity, but with (1) rapid economic change, (2) the fact that U.S. boards that are significantly older on average than a decade ago, and (3) higher director retirement ages than in the past, we may see some pressure to consider recruitment of younger directors. I could see this combined with more widespread adoption of term limits (as seen recently at General Electric) so that appointment of younger directors does not eventually lead to even longer board tenure.
Every business is looking for the edge that will help them outperform the competition, or trying to find the panacea for its performance woes. Today, that edge comes from driving an ethical culture across the organization. It’s something that all top-performing boards will need to address throughout the year.
A number of high-profile troubles at major companies in recent months have highlighted what happens to a company as a result of a skewed culture. The scandal that came from Volkswagen’s emissions reporting fraud led to numerous investigations on how a bad culture leads to outright cheating at the company. At VW, these perceptions trickled down from the top, across the organization. With better board oversight, this culture likely could have been discovered and nipped in the bud before it became the scandal it is today.
It’s worth noting that having an ethical culture is not just about risk mitigation, it also gives companies an edge. In fact, Ethisphere has found that share price of the publicly traded companies recognized as the 2016 World’s Most Ethical Companies consistently outperform other major indices, including performing 3.3% higher than the S&P 500 last year, and even greater outperformance as compared to the MSCI ACWI. Similarly, other research has found that portfolio managers today actively review a company’s governance practices when deciding whether or not to invest. Rivel Research for example has found that CSR is cited as an important investment driver by 22% of portfolio managers, a number that has steadily increased for the past few years.
None of this can happen without clear leadership and engagement from the board and the rest of the executive committee. The message is clear: Boards must get involved in strengthening their companies’ culture if they want to stay ahead of the game.
Boards no doubt will face governance issues and challenges of many kinds in the coming months, but I believe that the governance issue which will (and deserves to) have the broadest and deepest influence on boards in the second half of 2016 is preparing to live with the intensified focus by large institutional investors on long-term value creation, and its many implications.
While institutional investors have become increasingly active on the governance front in recent years, in 2016 it has become crystal clear that they:
This development is bolstered by strong fund flows into indexed investment funds, which have given institutional investors more muscle and a business imperative to use it for the benefit of their investors and growing their own businesses.
The impact of long-termism on governance practices can be seen in recent letters to boards and public statements made by BlackRock, Vanguard, State Street Trust and others, and a detailed exegesis is provided by BlackRock’s Q1 report, aptly titled “Building Connections for the Long-Term.” In this report, BlackRock discusses its views and company engagement practices in the first quarter of 2016 on governance and other issues and describes nine cases, which demonstrate how building long-term value intersects with issues such as the independence, composition and competence of boards, management succession, capital allocation, executive compensation, legal compliance, and oversight of regulatory and business risks.
Boards are on notice and need to study these letters and reports, assess their companies’ strategies and governance practices and prepare to proactively engage on them before institutional shareholders (or even worse, short-term activists) come calling.
As we look toward to the latter half of 2016, one of the key issues we see commanding more of boards’ time is talent risk. Despite the business challenges many companies are facing in the current economy, it’s still a highly competitive market for senior leadership talent. This is true for companies or industry segments that are performing well and those currently doing less well.
Some industries are doing quite well, and the competition for talent in those sectors can be fierce, requiring boards to pull all of the talent management levers in the toolkit. Notably, high performers within high-performing industries are the most sought-after talent and retaining them can be a significant challenge. Compensation offerings need sufficient leverage to reward for top performance.
Alternatively, in industries that are struggling, retention risk becomes heightened as companies find themselves constrained from a compensation standpoint. There is a tension between pay for performance alignment and retention. Retention sometimes requires rewarding “at-risk” executives despite company performance, and that creates negative optics internally and externally.
When you think about the various governance responsibilities of corporate directors, succession planning and talent management are certainly key ones. As part of these responsibilities, boards have to consider both the talent needs underlying the company’s business strategy as well as how to attract, retain and motivate that talent. Compensation is, of course, a critical tool at the board’s disposal for carrying out the talent strategy, but it’s not the only tool. Boards also need to consider how pay fits into executives’ broader career trajectory as part of a comprehensive talent management framework that also includes performance management, leadership assessment and developmental opportunities.
We expect to see boards in a number of industries devoting more attention to this tension as the year progresses. But, talent risk seems certain to be a key strategic issue for boards in many sectors of the economy.
One of the most significant governance issues is regulatory change and heightened regulatory scrutiny. Protiviti and North Carolina State University’s ERM Initiative conduct an annual global survey of board members and C-suite executives on the top risks likely to affect their organizations. Regulatory concerns have topped the list of risks for organizations in each of the four years of the study, with an increased rating this year.
The cost of regulation and its impact on business models remain high in many industries. Compliance costs are embedded within prices consumers must pay and affect employee compensation. Depending on the industry, regulation and its high costs can contribute to an uneven playing field in the global marketplace that can affect a company’s competitiveness and lead to lower levels of economic growth. As a result, business leaders must make investment and hiring decisions in the face of the uncertainty imposed by continued and, in some cases, heightened regulatory mandates.
Yet when it comes to governance and oversight, there certainly are other issues affecting board strategy. Other concerns include economic conditions restricting growth opportunities, succession planning and the ability to attract and retain top talent, and insufficient resources to address cyberthreats, privacy and other information security risks.
Another critical risk calling for effective board oversight is the rapid speed of disruptive innovations and new technologies potentially outpacing the organization’s ability to compete. Whereas disruptive innovations may have once taken a decade or more to transform an industry, the elapsed time frame is compressing significantly, leaving very little time for reaction. As boards have come to understand, sustaining a business model in the face of digitally enabled competition requires constant innovation to stay ahead of the change curve.
Most certainly, these issues impact the board’s oversight agenda. The ones with the biggest influence in the second half of 2016 are likely to vary by industry.