Corporate Governance and Financial Health

Three years ago I did some work for an independent credit rating agency utilizing a quantitative methodology to determine financial health of corporations.  Dr. Patrick Caragata founder of Rapid Ratings conducted a study of 200 TSX listed firms with high Corporate Governance (CG) ratings according to Governance Metrics Inc.     He wanted to determine the correlation of CG and financial health.  His findings "CG ratings failed to indicate when a company was in poor health 75% of the time.  In fact, they wrongly identified 32% of weak companies as being strong."  Dr. Caragata also put together a study course for the Australian Institute for Company Directors.  He's a brilliant guy.  His firm was bought out by a private equity firm but you can still locate him at Rapid Ratings.

Caragata also extended his model to use financial health score as an early warning signal for a listed company's share price.  KMV, established ratings agencies, Altman's Z Score were also determined as lagging predictors of share price.  Caragata's research on bond pricing and CDS where better predictors of financial health momentum and ultimate predictors of share price but still failed to correlate financial health score as an early warning signal for share prices.  The problem that the model continually encountered was that valuation always exhibited a bias towards share price not financial health score.  The determination of a “fair value” based on historical spreads of financial health score and share price was overly and overtly price sensitive.  This was particularly true for bubble stock anomalies and commodity sensitive equities.

Purveyors of Business Process Management (BPM) suggest that listed practitioner’s of BPM trade at a 15% premium to non-practitioners.  I think it more marketing boast.  Though BPM is not CG;  it does speak to having CG excellence in the corporate DNA.   That’s what our firm is about.  Sound practices create valuation premiums and sustainable business models.  That’s the message we consistently deliver as central to our value proposition.  Integrating sound practices, BPM and CG excellence into the corporate culture does create valuation premiums because it suggests an intentionality of business process deeply wedded to enterprise mission.

I believe the radical reconfiguration of Wall Street offers a telling example of incongruity of good CG practitioners and financial health.  It was always a self evident truth that Wall Street firms that folded or transformed into commercial banks were probably some of the best rated CG enterprises.  CG excellence can do nothing to save an enterprise with a structurally flawed business model.  Though CG excellence does presuppose a board of directors in tune with the vicissitudes of the market; who would have thought that we would be looking at the extinction of global investment banking business?  Merrill Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns and the mighty Goldman Sachs were walking dinosaurs with flawed unsustainable business models.  I still can’t believe it but it’s true.  The world is being turned upside down.

Sum2 is a firm believer in coupling quantitative and qualitative risk measures to maintain operational excellence to build a healthy sustainable enterprise.  Effective CG alone cannot assure financial health.  It  must be a critical pillar of the governance, risk and compliance (GRC) triad.

When we speak about the principles of good governance, how about the original dissertation on the ideal of governance excellence.  Seemingly an insistence on an honest evaluation of reality to determine what is good is all it takes.  Its really that simple.

Visit the blog Risk Rap and the Allegory of the Cave post on FAS 157:

Sum2 welcomes the opportunity to speak with partners who share our passion for GRC excellence.

Full disclosure, I have no commercial connection to Rapid Ratings.