Headlines were made again a few months ago with significant concerns regarding governance at Adani Group, an Indian conglomerate, raised by Hindenburg Research, a US short seller. Accusations of stock manipulation and accounting fraud erased more than 50% from the value of Adani’s publicly traded companies and rocked an empire that spans many industries like ports, mining, real estate, financial services and energy. While the drama is still playing out, it demonstrates the importance of governance in all markets, but especially within emerging markets.

Adani Green Energy was perhaps the most famous group company given its ambitious plans to contribute towards India’s energy transformation into solar and wind. Last year, its market capitalisation increased from $28bn to $59bn by mid-year, before coming back down to $37bn at the end of the year. It now stands at $18bn. It was a popular stock among ESG-focused funds. According to media reports, 11 ‘Article 9 funds’ (the EU’s highest ESG classification) had some exposure to Adani companies. In just two years, the MSCI India aggregate index weighting to Adani companies increased from 1.2% to 5.8%, despite concerns of poor governance. Interestingly, we have not met any EM or Indian equity manager that held Adani companies, and omitting such would have been a big detractor to relative returns over the period. Furthermore, most of the concerns raised in the Hindenburg report were already well known, and the subject of multiple media reports.

A key question is whether the “E” (within ESG) was so compelling in this case that the “G” could be compromised? Were some ESG funds simply tracking ESG indices or had they not done their research correctly? Or were they (or the ESG index providers) too distant from the reality on the ground?

We believe that in emerging markets, governance is the single most important factor that needs to be focused on. Analysis should be tailored to each country’s cultures and customs. Ultimately a well-run, sustainable company should have a better approach to ESG aspects that affect all stakeholders. However, Adani Green Energy shows that the reverse is not necessarily true and can lead to big losses (i.e., company with good E but bad G).

One of the main reasons for relatively weaker governance in emerging markets is due to the presence of a controlling shareholder – usually the founder and their family, or the state. These companies will almost always lag best practice in corporate governance. No successful entrepreneur wants to relinquish control. This is true everywhere: witness Facebook controlled by Mark Zuckerberg or Tesla by Elon Musk, who both resist attempts to have independent oversight. The same applies to state-controlled companies.

Where there is a controlling shareholder, it is far more important to understand the alignment of interests with minority shareholders than for example the composition of the board or how it operates. A good board means little if the controlling shareholder has bad intentions. In emerging markets it is essential to do the homework on the controlling shareholders, assess their historical actions, and understand their quality and integrity.

Not all founder-controlled companies are poorly governed. They often do follow best practices in corporate governance like establishing compensation and audit committees and having non-executive directors. Emerging markets, overall, are seeing a steady improvement across the board in corporate governance.

There are idiosyncrasies that we need to study on a case-by-case or country-by-country basis. China is dominated by State-Owned Enterprises (SOEs) which mean potential state interference in business affairs, whereas corporate India is run by large family dynasties. Korea has chaebols and complex cross-shareholding mechanisms.

Chinese SOEs are at risk of being run for the benefit of the State, or used as a policy tool, and consequently may not have an ordinary corporate mission. The Chinese state-owned commercial banks are good examples. During the pandemic they were asked to increase lending and provide relief to small businesses despite rising defaults and falling profitability. Even if that is not the case, most SOEs often tend to lag when it comes to best practices and are run far more inefficiently than private enterprises.

On the other hand, private enterprises run the risk of being managed for the benefit of the majority shareholder and not stakeholders in general, which in its extreme could lead to fraud. There have been many well-publicized cases demonstrating that, such as the reckless Chinese debt-ridden developer Evergrande, accounting frauds of Luckin Coffee and Sino-Forestry, widespread corruption at Petrobras in Brazil and further back Bre-X with a massive gold discovery in Indonesia that was faked. Investors of these companies and many more incurred heavy losses when share prices eventually collapsed. Of course, frauds and misaligned interests happen everywhere – including in the UK – but emerging markets simply have less mature capital markets where founder control is still more common and the possibility of rogue actors is higher.

China Resources Land is an example of a well-governed, market-driven Chinese SOE. Typically, one would not expect an SOE to have good governance due to the controlling influence of the State. The company develops residential and commercial properties and operates large luxury shopping malls. It has a strong management team which is incentivized to achieve long-term growth targets. As such, it enjoys access to cheap financing and good land resources as an SOE, while being managed like a private enterprise. Despite a challenging environment in the property sector, it continued to deliver double-digit earnings growth in the past year and generate strong absolute and relative share price returns.

In the private sector, we all know how much value a visionary leader, usually the founder and controlling shareholder, can create over time.

The upshot is that it is very important to do the work to understand who you are effectively partnering with. If there is a genuine alignment of interests then any businesses can deliver strong long-term returns for shareholders.