What Could Go Wrong? The Case for Governance

Environmental, social and governance (ESG) factors are all important to the sustainability of an investment. Governance may be listed last, but it should never be an afterthought for fixed-income investors. After all, by studying an organization’s governance—the practices and processes used to direct and manage the organization—investors gain vital insight into a country’s or company’s ethos, risk management and overall sustainability.

Bond and Equity Investors Agree on Governance Basics

Equity and fixed-income investors agree that good governance includes fair treatment of stakeholders, accurate and transparent reporting with appropriate disclosures, and minimal conflicts of interest between management and the company. Unfortunately, not all companies rise to these standards.

Consider Carvana, a web-based used car seller, whose bonds have underperformed their CCC-rated peers. The ownership structure includes super-voting shares for the CEO and his father, the company’s largest shareholders, granting them control of the company. The company has relied on ongoing equity offerings to fund itself, which can limit access to capital in the future. And with limited shares available for trading, the stock price and market value have fluctuated wildly. The biggest red flag for us, though, is the CEO’s father’s bank fraud conviction in 1990. The two men remain very close, and the company’s control structure combined with the fraud conviction casts a shadow on company financial statements.

But Fixed-Income and Equity Investors Have Differing Needs

Even when governance is good for equity investors, it isn’t always good enough for credit investors. Bond investors are primarily concerned with reducing risk to their investment, while equity investors focus on increasing returns. Equity investors, for example, might be happy for management to spin off valuable brands to shareholders. However, unless the spin-off assumes a pro rata share of existing debt, leverage and default risk increase for creditors of the remaining company. Shareholders might even ask management to fund significant dividends with debt, which harms credit investors by transferring capital from the company to equity shareholders.