Capturing value from tenant governance

Written By:

Victoria Ormond, Knight Frank

16 Jun 2019

6 minutes to read

Categories: Publication Active Capital 2019 All Change Topic ESG World Regions UK

The last few years have seen an increase in focus on Environmental, Social and Governance (ESG) investing, across the financial markets, but also in the commercial real estate sector. The number of BREEAM and LEED environmentally rated buildings continues to increase, there has been a marked pick up in ESG specific funds and many real estate fund houses now have dedicated ESG managers. The CFA Institute has also recently launched their ESG Investing course.

Much of the focus in ESG has been on the environmental and to a lesser extent, social elements of the ESG equation. Governance, a less tangible, less understandable, more nebulous concept, has largely been left alone in the ESG narrative.

However, analysing the ‘G’ in ESG, can be beneficial for investors, both in considering their own ‘G’ markers, but also those of their tenants. For a sample of global listed retailers, we find that better management governance, reflected by a diverse board making the decisions, appropriate independence and board structure as well as good practices related to corporate and social responsibility (CSR), leads to stronger profitability and performance. This ultimately leads to a better ability to withstand the structural changes happening in the retail sector. This is positive for the investor as this enhances tenant covenant and value.

What is Governance?

Governance, or more fully corporate governance, relates to the effectiveness of the company, the management of that company and the strength of stakeholders in the decision making process. In the wider finance arena, for listed companies there have been various codes of conduct, for some time. For example, in the UK the Cadbury Code was initiated in 1992. Publicly listed companies had to ‘comply or explain’ with certain requirements related to leadership, effectiveness, accountability remuneration and shareholder relationships. This code has been updated over time and today includes benchmarks ranging from board level diversity to workforce, but also an understanding that stakeholders in the form of shareholders should also be benchmarked against a code of conduct. Similar governance requirements are now embedded for publicly listed companies around the world.

Why does governance matter?

Effective governance makes it more likely that the environment and social elements of ESG will also be taken care of. It also reduces the risk that can arise from the divorce of ownership and control in cases where the managers are not the owners. So this means it is important to consider the ‘G’ of target firms / real estate management companies.

Considering the governance of tenants can also enhance value for investors as well however. Tenant covenant is an important consideration and contributes to the value of an asset. A stronger tenant covenant means lower risk of tenant default. As well as looking just at the credit risk of a tenant to determine this, analysing the strength of corporate governance of the tenant can help capture an element of covenant not necessarily picked up as part of the credit analysis.

Tenant governance informs on covenant

To illustrate why it can be useful to analyse tenant governance rather than just credit and other ratings, we have analysed the Thomson Reuters governance scores for 140 global, listed retailers. We focus on retail, as the structural headwinds this sector is facing, can best be navigated by firms that have rigorous structures to optimise value and make the best decisions for the key stakeholders. 

We extract three governance summary scores for i) Corporate Social Responsibility (CSR) ii) Management governance and iii) Shareholder governance and set out the average results for the top and bottom ten retailers based on their management governance scores, as well as the average scores for the sample of 140 global listed retailers. Each score is out of 100 (best for governance):

Governance scores across global listed retailers

There is a significant difference in governance levels across the retail industry and these levels directly impact on the performance of the firm. 

To illustrate this, we also extracted key performance metrics for the listed retailers including five year average return on equity (ROE), net margin, operating margin, EBITDA margin and pretax margin.

Firstly, looking at the top ten listed retailers for management governance and comparing this to the bottom ten retailers for management governance, the top retailers on average enjoyed a five year average ROE +10.7% higher than for the bottom ten retailers. 

For all of the profit measures, the higher management governance retailers consistently outperformed the poorer governance retailers, both based on their most recent results and their averages over the last five years.

Average profit measures for the ten global listed retailers with the highest management governance scores

Average profit measures for the ten global listed retailers with the lowest management governance scores

Better corporate governance improves retailer profit and performance

On average, both high and low governance retailers had positive profits, but the higher governance retailers demonstrate a more comfortable margin on average. In an environment of structural changes and geopolitical headwinds, having a well-functioning board and external oversight in the form of active shareholders, can only be positive to help navigate the challenges ahead and make the right strategic decisions. Good decision making, facilitated by good governance, means a tenant which is more likely to continue to perform and less likely to suffer failure or need to pressure landlords to reduce rents. 

Looking beyond simple credit scoring measures of tenant covenant levels and reviewing tenant governance adds another string to the bow for investors, helping them position their assets with strength in this all changing retail environment.

If governance is important for listed retailers, it will be even more important for private retailers

All of the companies analysed are listed and therefore bound by rules of their exchanges, which would also help support transparency and governance. For unlisted, private retailers, governance we expect governance indicators to be even more important for predicting their medium and long term retailer health. 

Appendix: What goes into the governance scores?

The Thomson Reuters governance scores comprise of 34 factors contributing to the Management score, 12 for Shareholder governance and 8 for CSR strategy.

What is Management Governance?

Management governance covers details such as around independent of boards and sub-committees, for example compensation or audit committees. Board diversity, skillset, size and structure is also considered, as well as tenure, and meeting attendance.

What is Shareholder Governance?

This includes details around voting rights and policies, as well as the presence of structures which make it harder for boards to be replaced and corporate controversies. Shareholder governance measures can also include the presence of activist shareholders and the degree to which blockholders (large shareholders) take an active role in monitoring the company

What is CSR Strategy?

This considers the degree to which policies and reporting are in place related to stakeholder engagement, sustainable practices and ESG.