Are Enthusiastic IPO Investors Missing an Elephant in the Room?

Richard Chambers, CIA, CGAP, CCSA, CRMA, shares his personal reflections and insights on the internal audit profession.
 
The past few weeks have witnessed extensive media coverage of two subjects for which investors should have taken extensive note: (1) There are an increasing number of high-profile companies whose shareholders are expressing dismay over corporate governance practices, and (2) high-profile initial public offerings (IPOs) have been drawing extraordinary interest from excited investors.
 
As I contemplate these two phenomena, I am struck by an interesting thought: Prospective shareholders do not scrutinize corporate governance nearly as often as shareholders who have lived with the governance of their companies over a longer period of time. I can’t help but wonder if investors who are caught up in the excitement and promise of IPOs aren’t missing an “elephant in the room”: What type of governance will the new company have once they own a piece of it?
 
A recent article published by the Harvard Law School Forum on Corporate Governance and Financial Regulation examined prospectuses filed with the U.S. Securities and Exchange Commission (SEC) by the 50 largest domestic IPOs between January 2009 and August 2011. These large companies were valued at between $132 million and $18.4 billion at the time they went public. The results were fascinating:
  • Only 34 percent of the IPO companies separated the role of CEO and chairman of the board (for S&P 500 companies, the number was not much better at only 38 percent).
  • More than one out of five did not have fully independent audit committees.
  • More than one out of four board members were not independent at the time of the IPO (with one company reporting only 29 percent were independent).
  • Two of the IPO companies reported that they had no financial expert on the audit committee at the time they went public, and only 32 percent had more than one.
In fairness, many of these glaring shortcomings in corporate governance were only permitted by the listing exchanges or the SEC for a short period of time following the date of the IPO. Still, I have to wonder if potential investors paid much attention to the corporate governance models of these companies before making significant investments.
 
I tend to be a bit too conservative in my personal investment philosophy to invest in IPOs. And, far be it from me to give anyone financial advice. However, if I were to make such an investment, I would want to satisfy myself about more than the business model and earnings potential of the pending IPO. I would also ask some very critical questions about its corporate governance model. (All these questions don’t have to be answered affirmatively, but a pattern of “no” answers may require further scrutiny.)
  • Does the company have a strong/qualified (primarily independent) board of directors?
  • Does the company separate the role of CEO from chairman of the board? If not, is there a strong "lead director” who is independent of management?
  • Has the board adequately described its role in oversight of risk management? Does it play an active role with management in setting the risk appetite of the company?
  • Does the board have a separate compensation committee made up entirely of independent directors, and does it clearly link performance and effective risk management to compensation of key executives?
  • Does the board have a strong and effective audit committee composed entirely of independent members? Has it identified one or more financial experts?
  • Does the audit committee charter clearly spell out the committee’s role in oversight of the external and internal auditors?
  • Does the company have a well-resourced internal audit function with a clear reporting relationship to the audit committee and a key member of senior management (preferably the CEO)?
  • Does the company have a strong corporate code of conduct with an unequivocal endorsement from the CEO and the board? 
I am sure there are many other characteristics of strong corporate governance that I have overlooked. However, the point of the questions provided above is simple: You are much more likely to be satisfied with the corporate governance model of the company in which you invest if you do your “homework” before you make the investment. It beats learning the hard way that the board and management of the company in which you have already invested do not share your philosophy on strong and effective corporate governance.
 
I welcome your views. 

Posted on May 24, 2012 by Richard Chambers

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  1. Richard: 

    I think you have raised a very important point for individual investors but also a point internal auditors need to understand is becoming an increasingly important dimension of a company's share price. Institutional investors are absolutely starting (it's at an early stage of evolution) to evaluate this dimension as part of their due diligence.

    It is important for readers to be aware the ICGN, an organization/association that represents institutional investors who manage trillions of dollars of assets have written some excellent guidance for fund managers to help them assess and evaluate the effectiveness of risk management and governance in general.  A summary of their guidance is available at: https://www.icgn.org/files/icgn_main/pdfs/best_practice/icgn_cro_guidelines_(short).pdf

    How many fund managers are listening I don't know.  I have the full report but my memory suggests it must be purchased. 

    When boards truly believe that the quality of their risk management and governance processes and the market's perceptions of those dimensions is directly linked to the company's share valuation we will see far more focus from boards on these areas.  I am not sure if many board's believe the correlation today is high which reduces their focus on these areas.

    Watch for the release of the CICA guidance for directors on risk oversight later this month or early next month.  This report is likely to discuss the importance of this dimension of governance and its link to share valuation.

  1. Hi Richard,

    Completely agree with you and Tima Lech here. But for as long as i can remember, by and large, IPO's have always attracted institutions (who can take large postions for a short time) and speculators rather than "true" knowledgeable investors. The time for Corporate Governance and Risk Management are really an after-thought for the former... as they deal with short term spikes in the price of the stock and book their profits.

    Your points are absolutely essential reading and well atken for average investors who invest for the long-term (an exception these days on the IPO market at least) and the retirement/mutual funds.

     

  1. Hello Richard,

    Whether or not enthusiastic IPO investors are missing the elephant in the room depends on the lens from which you are viewing it.  In my opinion, I believe that many of the institutional investors are not "missing" the elephant in the room but rather ignore it in a quest to continue to the trend of short term high profits resulting from the IPO.

    Your points are absolutely relevant for appropriate oversight, but are often ignored (in my humble opinion).

  1. In terms of recent IPOs, Facebook may be one of the most glaring examples of toothless corporate governance and its effect on shareholders.  

    As Facebook CEO Mark Zuckerberg retains 57% of the voting rights of his company even after the IPO, and has stacked the Board of Directors with loyalists, investors in Facebook are assuming all the risks of stock ownership without any effective ability to protect their interests. Even in the event of death, the iron grip Zuckerberg maintains would be transferred to an appointed successor.  

    The following articles provide additional insight:

    http://www.reuters.com/article/2012/02/02/us-facebook-ipo-idUSTRE80U29V20120202

    http://gust.com/angel-investing/startup-blogs/2012/05/24/second-class-investor-citizens-facebooks-ipo-and-dual-class-equity-structures/ 

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