Corporate Governance Is Essential Before Going Public

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Darrin HarzlerDarrin Hartzler is Global Manager of the Corporate Governance Group, Environment, Social & Governance Department, International Finance Corporation (IFC).

 

Attending to a firm’s corporate governance is critical to its long-term growth and success. Good governance plays a particularly important role for firms preparing for an initial public offering (IPO) of shares. At the International Finance Corporation (IFC), an increasing amount of our corporate governance work with some clients takes place as part of their pre-IPO preparation because of this connection. 

IFC has long focussed on corporate governance as part of its broader efforts to promote private sector investment, strengthen capital markets, and foster inclusive economic development and growth. We have seen that when companies undertake corporate governance improvements to gain business benefits, they become more attractive to outside investors, including investors such as IFC or other early investors in emerging markets. Nowhere is the benefit as easily discernable as with companies preparing to list shares in an initial public offering.

Establishing a track record of good corporate governance before seeking to attract outside investors requires attention to several key areas of a company’s operations, such as structure and functioning of the board of directors; shareholder, board and management roles; and the control environment. Improvements in these areas enable an orderly distribution of decision-making authority and formalise important oversight processes, all of which helps mitigate risk, improve compliance, efficiency and effectiveness, and yield a corporate environment better able to deliver on its strategy. 

 

“Establishing good corporate governance ahead of an IPO holds the key to attracting outside investors”

 

Of equal importance, good corporate governance makes decision making and results more accessible to outsiders so they can assess the corporation as it approaches an IPO. In addition, a focus on transparency, disclosure, communication and shareholder protections delivers the message to investors that they are valued as owners and that their money will be deployed responsibly and in the best interests of the shareholders.

Here are five reasons that companies preparing to go public should care about corporate governance.

1 Sound governance ensures that the growing company is guided by professional management and a well-structured board, working within organised systems and processes pre-IPO, which will enable the IPO.

Stated simply, unless your corporate governance house is in order, you might not get to the IPO. Or, you might be disappointed with the results.  Most stock exchanges have minimum listing requirements, such as an earnings baseline and audited financial statements going back several years. Without formalised systems and processes in areas such as audit and control, it can be difficult to generate reports and provide the necessary documentation to demonstrate corporate maturity.

Separate from listing requirements, which admittedly vary from exchange to exchange, IPOs require support from financial underwriters, who will look carefully at all aspects of company operations to determine its soundness. Companies that lack governance fundamentals might have difficulty finding an underwriter – or they may have to pay a hefty premium to make it happen.

By contrast, companies that do attend to their governance are better positioned for the IPO. For instance, in preparing for its 2005 IPO, Jordanian pharmaceutical firm Hikma implemented several changes to its governance structure after an IFC assessment uncovered gaps in controls, audit, international financial reporting, and board structure and practices. 

The result of this internal work was a successful listing on the London Stock Exchange, which raised £70 million. Since then the company has continued to upgrade its governance even as it has expanded into a global presence and a regional pharmaceutical leader. For Hikma’s investors, the work has paid off: between the years 2005 and 2013, Hikma has delivered a 364 per cent return on shareholders’ investments, according to a recent company report. Clearly, improved corporate governance allowed investors to recognise the company’s strong business model and attractive positioning in the global market.

 Philippines energy giant PNOC undertook an even lengthier route to its IPO, following an ambitious initiative to divest from state ownership and improve its governance structures and practices. The company’s fully subscribed listing included cornerstone, institutional and private investors from the Philippines and abroad.

2 Improving the company’s corporate governance yields clarity on the strategy behind the IPO, helping to optimise the long-term value of going public.

Companies considering an IPO sometimes make the mistake of viewing this as a one-time event to generate liquidity or elevate the company’s profile. They see it as the end goal, rather than as a means to meeting a strategic objective. They may not have a carefully planned strategy on how to use the cash raised or what to do once the company’s profile has been elevated. And this can cause a bad fall after the fact even if the initial offering was a successful.

A strong, diverse, and well-functioning board ensures that the company has in place structures and a long-term growth strategy, demonstrating readiness for this next stage – that it can properly manage the sudden influx of liquidity, that it can handle shared ownership with minority investors, and that it is committed to doing things in the right way. Such companies benefit from more rational decision-making, with an effective board that encourages outside voices and opinions as a ‘reality check’ while professional and qualified managers oversee day-to-day operations. This combination of balanced strategic planning and effective operational leadership will enable the company to ease into post-IPO operations, well on the way to meeting its strategic goals. 

3 Good corporate governance shows a commitment to valuing diverse opinions, mitigating risks and operating in the company’s and shareholders’ best interests, all of which will lead to better share pricing and subscription rate. 

Research has shown that such factors serve as strong signals, lending assurance to the market, elevating the stock price and increasing the potential that the company can meet its subscription goals. This is particularly true for emerging market companies where the broader operating environment may not require rigorous governance standards. 

Our experience with Fratello Trade, a Bosnia and Herzegovina seafood distributor, bears out findings that better firm-level governance can compensate for country regulatory weaknesses. As part of its preparation for an IPO, the company undertook a governance improvement initiative with IFC’s assistance. Focus was on shareholder protections to ensure that new equity investors’ rights would be respected and were aligned with international best practices. Despite the fragility of the macroeconomic environment, the company met its goal of raising $770,000 in a 2008 IPO, selling nearly 300,000 shares. This was a landmark event, representing the first successful IPO of a private company on the Banja Luka Stock Exchange.  

4 Good corporate governance sends a strong and positive message to potential shareholders who are increasingly concerned about the environmental, social and governance practices of the companies they invest in. 

Investors care about good corporate citizenship. They want to support companies that behave ethically, that support the communities in which they operate, that attend to the environment and that give back to society. Aside from the compassion aspect, savvy investors understand that companies adhering to higher environmental, social and governance (ESG) standards often outperform their counterparts. 

The exchanges themselves are taking note. A recent survey by the United Nations-led Sustainable Stock Exchange Initiative reveals that 86 per cent of surveyed exchanges indicated that they already had or were planning to launch sustainability indices. Nearly 20 of the world’s leading exchanges – including NASDAQ OMX and Deutsche Börse – have partnered on this initiative, which promotes sustainable investment and improved ESG disclosure and performance.

A 2010 IFC report on one such sustainability index, part of Brazil’s BM&F BOVESPA, reveals that the companies listed on this index noted valuable benefits ranging from improved reputation to positive impacts on their stock price, access to capital and liquidity in the stock market.

5 Even if the IPO never happens, governance improvements will yield significant bottom line benefits, including better credit ratings, increased access to capital, improved operational efficiency, reduced risk and broader market reach.

IFC’s work with family-owned companies demonstrates the value of governance improvements, even if they have no intention  of going public. We also have seen that good governance eases other types of transition. For example, Banca Comerciala Romana – formerly a state-owned bank – significantly lowered its cost of capital through improved credit ratings as part of a privatisation preparation program that focused on corporate governance changes even before the bank was successfully sold. Others, like Mongolia’s Khan Bank, have increased access to finance as a result of improved governance. Following an extensive, two-year corporate governance improvement plan, Khan Bank received a $121 million investment package of subordinated, syndicated and parallel loans from IFC and its affiliates. Now, the bank is well-positioned for a future that may or may not include an IPO – a true corporate governance success story.

 

About the Author:

DARRIN R. HARTZLER is the Global Manager of the Corporate Governance Group in the Environment, Social and Governance Department at IFC. His unit is responsible for addressing corporate governance issues in new IFC investments and it is also in charge of IFC’s policies on nominating directors to the boards of our investee companies. Darrin joined IFC in 1998 in Ukraine to design and run a corporate governance advisory services project assisting the country in its transition to a market economy. He has steadily worked to expand these efforts across the globe. In 2002 he moved to headquarters where he helped develop and roll out an IFC Corporate Governance Methodology for assessing corporate governance practices in emerging markets companies. Corporate governance analysis is now required as part of every IFC investment, and the Corporate Governance Group is working with other development finance institutions to take a common approach to corporate governance due diligence. A U.S. national, he is fluent in Ukrainian and Russian. He is based in Washington, D.C.