Insights
How corporate governance factors can influence financial performance

You can read the full paper here, but, in short, we established that corporate governance factors can be positively linked to financial performance. The impact of those corporate factors on performance differed depending on the relative strength of governance practices and rules in its country of domicile.

We assessed the impact of governance factors in four country "clusters:" Strong practices/strong rules; strong practices/weak rules; weak practices/strong rules; weak practices/weak rules.

Broadly material factors

Accounting risk and ownership structure were both found to be material in three of four of our country clusters. As such, we consider these "gateway factors" for investors in almost any country, with a few notable exceptions.

In some ways, the finding that accounting risk and ownership structure are broadly material is intuitive. Weak performance on either measure would be a red flag for most investors. For example, our measure of accounting risk identifies companies for anomalies in financial reporting, which can signal problems with how a business is run or indicate if there are potential problems with internal controls. Similarly, weak performance on the ownership structure composite can be an indication of imbalances between share ownership and decision-making power.

Basic governance factors

Board independence, pay figures and shareholder rights are basic measures of governance performance that emerge as material factors in both "weak practices" clusters. Not having an independent board majority is much more common in jurisdictions where practices are weak (62% of companies in "weak practices" countries do not have an independent board majority).

In "weak practices/strong rules" jurisdictions, the governance basics of board independence and shareholder rights are material to corporate performance, in addition to the gateway factors of accounting risk and ownership structure. In these markets, getting the basics right can make a difference in corporate performance.

In "weak practices/weak rules" jurisdictions, the basic issue of pay figures is material to corporate performance, in addition to the gateway factor of ownership structure. In these markets, policymakers have not yet responded to weak practices by strengthening rules. Consequently, without adequate rules, enforcement can become a moot point.

Quality governance factors

"Strong practices" markets allow for further investor differentiation by quality governance. In "strong practices/strong rules" jurisdictions, the advanced governance quality factors of board effectiveness and pay performance alignment are material, in addition to the gateway factor of accounting risk. These are highly professional markets, where board and pay basics are largely ironed out and quality separates the leaders from the laggards.

"Strong practices/weak rules" jurisdictions are highly professional markets with strong customs, but the absence of adequate enforcement creates challenges in and around executive pay. From a performance perspective, investors should consider how pay decisions are governed, whether a company is transparent about internal pay equity, and whether the CEO pay makes sense for the size and performance of the business.

Bottom line: The country-level cluster classifications outlined in this paper serve as a foundation for further research that investigates the relationship between corporate governance and financial performance. Given the amount of publicly available information on the governance topic, this research guides company-level assessments toward those factors that are financially material depending upon where a company is domiciled. We think these findings can empower the broader investment community to more meaningfully integrate corporate governance assessments into investment and engagement decisions.