Study shows boards must play their part to ensure corporate survival
RESEARCH done in 2004 by Booz & Co found there were three ways of destroying shareholder value: wrong strategic choices; poor implementation; and failures of compliance.
The study concluded that mistakes of strategy destroyed 60% of shareholder value; poor implementation 27%; and failures of compliance 13%. As custodians of shareholder value, boards are responsible for trying to ensure they help management deliver long-term shareholder value. Consequently they must appreciate where to focus attention in the little time they spend each year acting on behalf of shareholders. What the research shows is that boards should spend most of their time thinking about strategy, followed by monitoring how well they are doing it and then consider whether they are breaking the rules.
Strategy
Boards must spend time deciding what business they are in. This demands a regular review of: which markets to serve geographically and by segment; their customers now and in the future; what difference they will make to their customers’ lives; what products or services they will offer; and the resulting rate of return to shareholders.
The failures during the Global Financial Crisis (GFC) are powerful examples of boards not spending enough time challenging strategies proposed by their CEOs. The collapse of Bear Stearns, Washington Mutual, Countrywide Financial, Lehman Brothers, and Merrill Lynch in the United States, and of HBOS, RBS and Northern Rock in the UK was the result of inappropriate strategies. The total shareholder value destruction ran into the trillions of dollars. The failure of Lehman Brothers alone is estimated to have wiped out US$660bil, more than the five worst natural disasters in history combined. Rescuing AIG cost US$180bil.
Lehman’s collapse was the result of the board failing to challenge Dick Fuld because the directors did not know enough to understand the risks being taken by a CEO who totally dominated them. The boards of Bear Stearns and Merrill Lynch failed to prevent Jimmy Cayne and Stan O’Neal from destroying their companies through hubris in much the same way. The board of RBS did not stop Fred Goodwin from the disastrous acquisition of ABN-Amro, even though he had originally said it was not a must-do deal.
Instead, they approved a deal that “can now be seen as the wrong price, the wrong way to pay, at the wrong time and the wrong deal”. Washington Mutual, Countrywide Financial and Citi were brought low by their exposure to subprime mortgages – a market segment they should not have entered. Northern Rock collapsed because of its excessive dependence on wholesale funding.
There are many examples of companies outside financial services that made serious mistakes entering geographical markets for which they were not prepared or for which their products were not suitable. Tesco and Carrefour have lost millions trying to take their successful domestic retail formulas abroad. Some of Sime Darby’s problems in the Middle East were the result of an inadequate understanding of the differences in business culture between the Gulf and Malaysia.
According to McKinsey, 80% of mergers and acquisitions destroy value. This may be because of the wrong strategic basis for the deal or of paying too high a price for the target. Often it is because of poor post-acquisition implementation. Good examples of all three were the failed merger of Time Warner with AOL and Hewlett-Packard’s acquisitions in an attempt first to double its size in PCs by acquiring Compaq, only to then try to move away from hardware to software, as the PC business continued to decline.
Implementation
Any strategy is only as good as its implementation. The key implementation pitfalls are poor leadership; lack of clarity of purpose; miscommunication and inappropriate KPIs. The impact of clashes of culture is almost always underestimated: between different companies when they are merged; between different departments within the same organisation; and between the organisation’s legacy and its future direction.
In US banking, the Glass-Steagall Act was repealed to allow the merger of securities traders and deposit takers. The goal was to combine two quite different traditions, cultures and values to create a new more dynamic and profitable banking business model. The large low cost deposit base of retail bankers could be used to fund the risk taking of entrepreneurial and innovative investment bankers.
The less attractive features of investment banking behaviour would be controlled by the responsible retail bankers. Instead, high profile investment bankers came to dominate staid retail bankers, spreading the values of traders who were only interested in the deal, in the short-term, in maximising personal bonuses. The result was the recent banking scandals involving money laundering, mis-selling, and market-rigging. These banks became “too big to fail” and “too big to manage”. Sandy Weill and John Reed – the architects of the repeal of Glass-Steagall – admitted last year they were wrong: Weill said the two types of business were too different to manage effectively; Reed said the clash of cultures, values and behaviours was too great to reconcile.
Compliance
Failures of compliance have led to unprecedented fines that would have been unimaginable before the GFC: JP Morgan has had to pay out a total of more than US$13bil; HSBC US$1.9bil; Deutsche US$1.9bil and the list goes on. Even so, despite being mind-boggling fines, they represented only a few days of profits, reinforcing the finding that failures of compliance are relatively inexpensive in the short term compared with failures of strategy, though the impact on reputation may be large. This in turn affects the long-term “licence to operate”, causing changes in regulations and raising the cost of doing business for banks in the long run.
Conclusion
If directors are to minimise shareholder value destruction, they will have to focus more on strategy and its implementation. This will require them to be competent technically so they understand the business model and how to implement it effectively. They will need to spend more time in the business, verifying that what they are told is true, if they are to ensure compliance.
Datuk John Zinkin is managing director of Zinkin Ettinger Sdn Bhd.
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