Will there be a ‘next’ if corporate governance is focused on the ‘now’?

The survey shows that the financial implications of the pandemic have challenged the long-term investment strategy of CEOs and directors:

• A majority (59%) say that the pandemic’s impact on financial performance has challenged their ability to focus on long-term growth.
• Over half (60%) say that there are significant differences of opinion within their leadership team on how to balance short-term crisis response with long-term investments.

However, the pandemic has also reinforced the importance of a long-term value approach:

• Stakeholders: It has increased the expectations of stakeholders – including employees and the wider public – that organizations should play a more active role in tackling major societal issues, such as inequality and climate change.
• Business leaders: CEOs and boards have questioned and changed the role of their organizations in terms of who they are serving, the contribution they can make to society, and what constitutes value. They have used these uncertain and anxious times to lead with increased purpose – focusing on employee well-being, developing products and services for front-line workers, making financial donations, and cutting executive pay.

The survey sends a strong message that the net effect of the pandemic has been to reinforce the importance of an approach that looks to the long term rather than bowing to short-term earnings pressure:

• 66% said “COVID-19 has increased expectations from stakeholders that our company will drive societal impact, environmental sustainability and inclusive growth”.
• 78% said “a focus on sustainable and inclusive growth has been critical to building trust with our stakeholders in today’s uncertain times”.
• 79% said “companies that maintain their focus on long-term value will emerge stronger in a post-pandemic world”.

It also reinforces the importance of stakeholder capitalism to rebuilding trust in businesses and their leaders. When respondents were asked to pinpoint the most significant benefits of pursuing initiatives that create long-term value, “improved brand, reputation and trust” emerged on top, selected by 53% as one of the main benefits, followed by “improved customer acquisition and retention” and “attracting new investors or different types of investors”. 

Encouraging progress in turning words into action

Today, boards and CEOs are making encouraging progress in turning their ambition into reality by deploying the approaches needed to drive a long-term, multi-stakeholder orientation. As part of the analysis, EY teams segmented the survey respondents into two groups based on their long-term value maturity – those firms that are “Leading” (43% of all respondents) and those that are “Developing” (57% of all respondents). The Leading organizations are making significant progress. For example, 89% continuously reassess their company’s strategy and organizational structure to improve the ability to generate long-term value.

While this progress is encouraging, this long-term, multi-stakeholder approach needs to become the new normal for companies, not just a select group of high performers. 

While encouraging progress has been made, significant challenges – both external and internal – still stand in the way of driving long-term value and meeting the interests of investors and other stakeholders.

External challenges

The Leading-Developing analysis finds that “short-term earnings pressure from investors” is the critical external challenge facing the Leaders.

While leading companies appear to be making significant progress, around one in three (32%) have not put in place a consistent approach to decision-making that balances near-term and long-term value creation. This may help explain why the number one external pressure facing this group is the short-term pressure. It suggests that as you focus on long-term value, the tension and awareness of balancing near-term and long-term growth may increase, not decrease.

Investor pressure on short-term earnings risks causing companies to redirect capital and human resources from long-term strategic initiatives to meet short-term financial goals. All those in the sample who selected “short-term earnings pressure from investors” as a critical challenge were also asked how this short-term pressure manifests itself. The answer is: increased price volatility. 

The major challenge of short-term pressure reflects a number of issues – first, the growing importance of institutional investors with a limited length of share ownership, which creates pressure on boards to focus on short-term market value of the share; second, the continued emphasis on short-term disclosures within listed companies, including quarterly returns and earnings guidance, which can drive a focus on short-term financial performance.

For this reason, it’s crucial that boards establish effective engagement with investors – including activists – to build trust, explain purpose, identify common ground and ensure support for long-term oriented strategic approaches.

This is not a new idea, yet it feels more relevant than ever. Warren Buffet made the point in 1979 in his letter to Berkshire Hathaway shareholders when he said: “In large part, companies obtain the shareholder constituency that they seek and deserve. If they focus their thinking and communications on short-term results or short-term stock market consequences they will, in large part, attract shareholders who focus on the same factors.”1 The opposite should also be true.

Internal challenges 

The greatest portion of respondents chose the following as an internal challenge to a long-term value orientation: “CEO and executive compensation are tied to short-term performance”. 

Shifting to an approach that supports long-term value creation will require boards and compensation committees to rethink the design of executive compensation plans.

1. Attributes

Executives were asked to nominate what board attributes were most critical for making decisions that generate long-term value. Interestingly, the main attribute that emerged was behavioural – for a board to focus on the long term, the ability for directors to speak their mind is seen as critical. The top three attributes are:

• First: “A board that has enough trust to be honest, debate openly, and have healthy disagreement”
• Joint Second: “A board that engages and considers the interests of all stakeholders when making decisions” and “A board that implements management remuneration schemes linked to long-term value goals”
• Third: “A board that proactively identifies and engages potential investors focused on long-term value”

Strong dynamics within boards are critical to effective decision-making and making the tough calls that will inevitably occur when organizations are trying to resolve the trade-offs between long-term value and short-term pressures. This means that boards need to have a culture based on trust and respect, have devoted time to team-building, and mechanisms for members to feed back to the chair on how effective discussions are (or not).

As well as the dynamics point above, there are other priorities when it comes to attributes:

• Values: Directors who are committed to long-term value creation with values that recognize the importance of ESG and of understanding stakeholders are important in a number of ways. First, boards setting the right tone at the top and acting as role models for management teams and wider employees is essential to embedding a culture that supports a company’s long-term stakeholder-focussed strategy. Second, for external advocacy – demonstrating the passion and commitment is needed to court the right shareholders to support the strategy.
• Diversity: Healthy disagreement and honest debate is also a factor of diverse opinions. Diverse and inclusive boards – including dimensions such as race, gender, career background, age, etc. – bring a full range of perspectives and solutions to big issues, like climate change or inequality, and can challenge established thinking and biases in a way that homogenous boards will not. Diverse and inclusive boards are also better-placed to ensure that different stakeholder impacts have been taken into account in decision-making.
• Skills: Companies will need to make sure they have the skills, experience and knowledge that will help them deliver on their long-term value strategy over time, for example on matters like climate change or ESG metrics. Companies are likely to need to actively refresh and change the skills profile of board members as they reach different stages of the long-term value strategy execution.

Internal and independent external board evaluations should naturally incorporate an assessment of these attributes moving forwards.

2. Risk

When executives were asked what would likely deter their board from pursuing an initiative that was expected to improve long-term value but diminish near-term financial performance, the top two factors were:

1. High degree of uncertainty in the likelihood that the initiative will succeed
2. A risk framework and appetite that is geared towards short-term shareholder return rather than long-term, inclusive growth

However, “lack of committed support and leadership from management” was much less of a concern for executives. This suggests companies have the willingness to pursue initiatives with longer time horizons, but need to improve their risk assessment and management capabilities to better understand long-term risk and the likelihood of success. In other words, it could allow boards to increase their risk appetite because they will have greater confidence about long-term risk-taking and the potential upside of doing so, including being able to explain it to stakeholders.

A critical function of boards has always been to understand and mitigate business risk – but the pandemic has brought that responsibility into sharp focus. Its unprecedented impact has highlighted the interconnectedness of risks and the velocity at which the landscape can change. In this environment, how can boards be sure that long-term risks – such as climate change – are appropriately forecasted and managed effectively across the organization?

3. Reward

Compensation schemes need a mixture of near- and long-term incentives to reward executives for generating sustainable growth. Coming up with the right mix can be challenging, but boards can consider the following guidance as a starting point to evaluate what is right for their company:

• The short game: companies can focus first on short-term plans, such as annual bonuses. This will allow them to get a feel for how the metrics are working and whether hurdle rates are reasonable. If adjustments need to be made, it is relatively easy to do this with short-term plans. Learnings from the short-term plans can then be applied to the design of long-term plans. If companies focus first on long-term compensation plans, it may be hard to course-correct if things are not working as intended.
• The long game: long-term incentive plans should be designed so that they use multi-year measurement periods. In our experience, three-year measurement periods are a common tactic. In some countries, there is increasingly an expectation that senior executives hold shares for a minimum period after they leave their firms, with two years being typical. Extending this principle to other countries can encourage executives to focus on the long-term consequences of the decisions they make. 

Compensation schemes also need to alight on the right metrics, which can be challenging to both define and assess. Metrics related to ESG goals are an increasing focus. However, not all ESG metrics are relevant for all companies, and companies need to assess their strategy and determine which metrics are most relevant to them. This will vary by industry. Such metrics must be reliable if they are to influence executive remuneration, and therefore robust processes and controls will be required including board committee oversight.

Finally, there is the question of how much pay to tie to long-term measures. In most companies today, the percentage of executive pay tied to metrics that reflect long-term value is fairly modest. But, if companies are to change executive behaviour and drive long-term performance, they need to ensure that a meaningful portion of pay is at stake. Based on their experience, EY remuneration professionals believe that a range of 15-25% of pay connected to long-term metrics, with clear performance targets, would make a significant difference. 

4. Engagement

While stakeholder engagement is not a new topic, many organizations still struggle to bring the stakeholder voice to the boardroom table and really consider their feedback in decision-making. Therefore, it is worth taking another look at the building blocks that are required for effective engagement:

• As a start point, organizations need to define their key stakeholders. While there will be any number of potential stakeholders for a company, these need to be prioritized and boards need to be clear on who are the most important.
• Once stakeholders are identified, the next step is the engagement strategy. This has to take account of two factors. On the one hand, it is about getting the stakeholders onboard, to develop loyalty and buy-in. On the other, it is important that boards use the engagement to understand what is important to the stakeholders. In other words, this is about understanding their needs and how those factor into the board’s decision-making about what is required for long-term value creation.
• The engagement strategy should also be pragmatic. It may not be possible for the board to engage even with all key stakeholders, from suppliers to communities. Therefore, boards must decide who they engage with directly, and who they engage with indirectly through management.
• Finally, boards need to close the feedback loop. Getting feedback from a key stakeholder does not obligate boards to act in accordance with their viewpoint. However, there should be communication back to the stakeholder on how the feedback was considered, or else the quality of the relationship will deteriorate.

There is increasing focus on engagement between independent board members and investors. As a starting point, it would be valuable for this director group to hear more about growing investor expectations regarding long-term value and ESG principles. However, if directors are to engage more directly with investors, it is important that they buy into a long-term value/ESG approach and have a deep understanding of the subject. This will be critical to ensuring not only that boards play an effective role, but that a focus on long-term value and ESG principles is achieved across the company.