KING IV AND THE 'G' IN ESG

KING IV AND THE 'G' IN ESG

By Brondwyn Douglas, Senior ESG Officer, Spear Capital

ESG has proven resilient even among listed investments, where ESG funds have tended to be overexposed to the technology companies that have seen significant falls this year and underexposed to the fossil fuel companies that have seen the biggest gains this year.

Technology companies tend to bring together progressive values, an assetlight approach, and sophisticated HR processes that monitor things like diversity as a matter of course. That makes them a natural fit for ESG purposes.

Investors view ESG as a viable way of achieving returns while having a positive impact on society and the planet. And with a growing number of institutional investors, including pension funds putting strict ESG guidelines in place, it only makes sense for companies of all sizes to meet those guidelines.

While the environmental and social aspects of ESG are relatively easy to measure, governance is not monitored nearly as closely in the South African small to medium enterprise (SME) space as it is among listed companies. But SMEs should care deeply about governance, not only because it makes them a better investment prospect but also because it can help foster a smoother growth path and reduce the chance of falling foul of regulators later on.

Investors in the SME sector have a role to play too. They can help SMEs put the proper governance structures in place to ensure the best possible outcomes for everyone concerned, easing the investment process and setting themselves up for an exit later on.

The consequences of bad governance

Before looking at how SMEs can set themselves up for good governance, it’s worth looking at what some of the consequences of bad governance are. You don’t have to look far to find examples of those consequences either. In late 2022, the collapse of FTX, the world’s second-largest cryptocurrency exchange, dominated business headlines around the globe. The evidence of poor governance that emerged as a result of investigations into the company’s collapse has been nothing short of astonishing.

It was revealed, for instance, that managers at FTX used emojis to approve payments and that company funds were used to buy houses in employee names. There also doesn’t appear to have been an official company roster, making it impossible to know how many people actually work for FTX. So chaotic were things at the company, that new CEO John Ray III, said that he had no confidence in its financial statements.

Beyond that, Ray (who was previously on the team charged with rescuing Enron) provided the following scorching feedback:

“Nearly every situation in which I have been involved has been characterised by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”

As a result of this endemic chaos, investors (some of whom probably should have known better) have lost billions of dollars.

If that’s what bad governance can do at one listed company, imagine the damage widespread bad governance could wreak in the SME sector. After all, SMEs represent more than 98% of South African companies and employ between 50 and 60 percent of the country’s workforce across all sectors.

Following corporate prescripts

Fortunately, South African SMEs have easy access to an incredibly valuable resource when it comes to putting good governance principles in place and avoiding the fate of FTX and Steinhoff. The King IV Report, compiled by the King Committee, aims to provide businesses with best practices and guidelines for corporate governance. In doing so, it aims to, “encourage organisations to see corporate governance not as an act of mindless compliance, but something that will yield results only if it is approached mindfully, with due consideration of the organisation’s circumstances.”

Following, as it does, many of the precepts set out in UK governance guidelines, recognised by many as among the most thorough in the world, King IV is an invaluable tool for any business looking to improve its governance.

King IV defines corporate governance as the exercise of ethical and effective leadership by the governing body towards the achievement of the following governance outcomes:

• Ethical Culture

• Good performance

• Effective control

• Legitimacy

Whereas its predecessor, King III, had 75 principles for organisations to follow, King III has reduced those to 17, with one applying to institutional investors only. That makes for a simplified, but still effective, guide to governance. For SMEs, especially those operating with an ESG lens, perhaps the most relevant of those is Principle 4.

It states that:

“The governing body should appreciate that the organisation’s core purpose, its risks and opportunities, strategy, business model, performance and sustainable development are all inseparable elements of the value creation process.”

Putting the right structures in place

Once SMEs have familiarised themselves with the principles laid out in King IV, they can ensure that they put the right structures in place. What those structures look like will depend, at least in part, on where an SME is in its growth journey.

Early on, for instance, the focus should be on ensuring that leadership roles within the organisation are clearly defined. You don’t, for example, want the CEO clearing payroll one month and the CTO doing it the next. Of course, it’s absolutely fine to have fail-safes in place, but everyone should be aware of their evolving roles and responsibilities as the organisation grows.

Later on, when the organisation is looking for funding or to take on debt, it can set up a Board. That Board should, from the outset, be diverse and representative in terms of race and gender.

Another area where SMEs can start putting the right structures in place early on is disclosure. Proper disclosure involves making customers, investors, and any people involved in doing business with the company aware of pertinent information. It’s particularly important for businesses with an ESG focus or which are seeking out investors who operate with an ESG lens. If a business isn’t fully transparent in its disclosures, it can’t get an accurate rating, jeapordising the chances of a complete investment deal. In other words, governance sets the tone for a business’ environmental and societal initiatives. Given that European investors increasingly require disclosure, it’s something that SMEs should get right from the start.

The positive role investors can play

Even with a resource like King IV and the right structures in place, SMEs may still struggle with some aspects of governance. Here, private equity investors have a significant role to play. Most private equity firms have strict sets of governance guidelines they have to meet. Between advisory boards, investment councils, and various other measures, they’re well set to help out portfolio companies with governance.

That’s especially true for investment houses with international funding or which look to set up portfolio companies for international exits. They likely know the governance requirements in those territories far better than their investees and can guide them through the process. It’s part of being a partner investor that empowers and capacitates investees, rather than simply providing capital and hoping for substantial returns.

As such, private equity investors (particularly those investing with an ESG lens) should actively look for governance opportunities.

Governance only becoming more critical

As the world of business realigns to focus on impact, rather than purely on profit, ESG and governance in particular are becoming increasingly important. By focusing on best practice from the start, it becomes ingrained into the company’s culture. That in turn means that the step-up needed for every additional governance requirement is easier than it otherwise would be.

This means that the company is a more attractive investment prospect and can finalise investment deals far quicker and smoother than would otherwise be the case. And, as international investors increasingly put strict ESG requirements in place, that can be a significant competitive advantage.

Ultimately then, it should be clear that the days of viewing governance as a simple box-checking exercise are long gone. Instead, it should be seen as something that’s not just good for business in general but which is good for every business, no matter how big or small it is.