Redefining Corporate Governance for the Long Term
Over two hundred Business Roundtable CEOs publicly rebuke the idea of shareholder primacy. The world’s largest investment management company, BlackRock, requires all companies in its portfolio to demonstrate a path for long-term value creation. Institutional investors, who own 60 percent of Fortune 500 companies, expect leaders to keep the short term and long term in proper equilibrium.
Balancing the short term and long term is a perennial struggle, but these new developments—as well as imperatives to emerge stronger from economic crisis, address climate change, and eliminate racial inequity—put boards squarely at the center and in need of guidance.
To meet these new expectations, what changes do boards need to make? What new principles and practices of corporate governance do we need to lead for the long term? The three of us have been on the front lines of changes in company ownership and in shareholders’ expectations of managerial behavior.
As CEO of Vanguard, Bill McNabb helped drive the change in the investment community that owns and evaluates these companies. Bill’s efforts date back to 2010, when he first spoke up at a Drexel governance event and left the CEOs in the audience so upset by his suggestion that their boards engage with investors that he thought they were going to throw him out of the room. “They went bananas,” he recalls. By 2017, Vanguard had conducted nearly a thousand in-person and virtual meetings on the subject with directors and managers around the world.
In his work as an adviser, Ram Charan has helped boards and senior leaders rethink and redesign their governance practices. Over time, he noted a widening gap between the focus of boards and the concerns of investors, and sharp contrasts between the boards of public companies and those of private and family-owned firms.
As vice chair of Korn Ferry, Dennis Carey has helped reconstitute boards and recruit CEOs to meet the new expectations. He has seen a steady rise in the sometimes-conflicting demands on boards over the years, and he and his Korn Ferry colleagues have conducted extensive research on how boards affect company performance.
We combine our many years of experience working with boards, managements, and the investment community to explain the shifts in perspective and practice that companies must make to escape the traps of short-termism and to drive long-term value creation.
It starts with rethinking total shareholder return and, instead, focusing on a different kind of TSR.
Redefining TSR
For investors, the standard measure of corporate performance is total shareholder return, or TSR—the change in a company’s share price with accumulated dividends over time. For boards and for managers, chasing after TSR can put a premium on short-term activities designed to boost the company’s stock. The pressure to do so may come from security analysts and the business press, and from activist investors when they think that a company is lagging its market potential.
Yet a focus on TSR brings with it no rules of behavior. Despite their best efforts to build total return, companies continue to make ill-advised mergers, invest in dead-end lines of business, and hire chief executives unsuited to the changing business landscape, all of which hurt shareholders.
Companies got in these straits through shortsightedness, inconsistency, and a focus on the wrong achievements. Companies typically judge each value-creating initiative by its own set of measurements—eyeballs for a content initiative or inventory levels for a manufacturing effort—rather than by a single set of meaningful financial metrics, such as gross margin, revenues, cost reductions, and asset utilization. Timetables are often fuzzy, and accountability for delivering results is typically diffuse, with initiatives placed in the hands of project leaders asked merely to finish the job. CEO pay is often tied to short-term results, not to the success or failure of the seed projects on which the company’s future depends. And many boards are oblivious to what management is doing to prepare for the future. All these endemic faults are enemies of long-term value creation.
It’s time for companies—led by their boards—to refocus their attention on a new imperative. From the perspective of permanent capital and long-term value creation, we think the best way to create total shareholder return is by focusing on talent, strategy, and risk—the new TSR. (See figure I-1.)
By that we mean first attracting the right talent—the people who you will want to stay, grow, and evolve with you; then creating a strategy that aligns your company not with Wall Street expectations but with the interests of your longest-term investors; and finally, owning at the board level all of the risks that could get in the way of your strategy.
The shift to the new TSR started with investors. As index funds began to assume a more active role in corporate governance, they zeroed in on how management and boards dealt with key corporate functions, such as selection of the CEO and the leadership team; the steps management is taking to ensure that proposed mergers or changes in strategic direction are worth making; and the measures companies adopt to mitigate and take advantage of risk. In other words, they are looking at talent, strategy, and risk directly, both to protect the company and to enhance its value.
So how did we settle on these three elements as the rightful focus of the board instead of the traditional measure of total shareholder return? Our insight is that an increase in shareholder value is merely an output—the result that managers wish to achieve. We wanted to step back and look at the inputs that generate this output. And the trio of talent, strategy, and risk encapsulate the work of a company, broken down into its discrete functional elements—the functions that the CEO must manage and that the board must oversee to enhance long-term shareholder return. The new TSR is a tool that boards can use to escape from short-termism and reorient for the long term. If the board can get the new TSR right, the old TSR will take care of itself.
Certainly it’s what we see work at Vanguard, which is zealously focused on talent, strategy, and risk. Its business may be investing, but it is also a pretty complicated enterprise in its own right, with eighteen thousand employees, offices around the world, and billions of dollars of investment in technology. Vanguard knows firsthand the importance of the new TSR and the ability to execute around it.
The rewards of this new conception of TSR go beyond market gains. Boards can help create a better measure of shareholder value: long-term growth that will benefit both shareholders and society at large. Investors often view social benefits as contrary to financial results—that initiating, say, a zero-carbon strategy will mean higher costs and lower profits. In the short run, that may be true. But such a focus can deliver long-term gains—from future savings and the creation of new lines of business, and from the higher value people will increasingly place on companies that pursue such goals.
Until now, the loudest voices have been skewed toward the near term, and corporate practices have reinforced that perspective. The sanctity of earnings per share, combined with the rhythm of budget and operating reviews, ensures a high degree of myopia. In spite of efforts to balance incentive pay and performance, compensation is still based largely on short-term measures.
In addition, the security analysts who evaluate companies are themselves rewarded for short-term performance. And though shareholder activists are increasingly diverse and have varied time horizons, some are more adept than others at commanding management’s attention.
The good news for companies is that institutional investors—the ones who hold some 50 percent to 60 percent of the stock of Fortune 500 companies—have found their voice, and they are urging boards to serve as a counterbalance to this short-termism. This book captures their perspectives and presents best practices for boards to streamline their work while meeting the expectations of a broad spectrum of shareholders.
Leading for Tomorrow: An Example of What We Mean
A board can create tremendous value if it supports decisions that are unpopular in the here and now but are necessary for the company’s future. Consider what transpired at PepsiCo in 2013, when the board came under pressure from activist investors to split up the company. Earnings were suppressed and the share price was flat. But CEO Indra Nooyi presented the board with a detailed plan to ensure the company’s long-term growth, featuring a shift of resources to emphasize healthier drinks and snacks. After evaluating her plan and monitoring the steps that Nooyi was taking to implement it, including the introduction of new brands, the board decided to back her. The board’s confidence in Nooyi and its willingness to stand up to the activists would soon be vindicated: in 2014, PepsiCo began its steady climb to a record share price.
But perhaps the most prominent example of the rewards of a patient board comes from Amazon. CEO Jeff Bezos has always taken a long view, and the board has supported him through initiative after initiative, from expansion of the product line beyond books and unlimited free deliveries for subscribers to video streaming, data management services, and content production. Only a decade ago, critics were complaining that Amazon wasn’t generating sufficient profits and wondering when the company would ever make enough money. Now Amazon owns the universe: in the summer of 2020, it became the first company to achieve a trillion-dollar valuation.
With the board’s backing, CEOs are more likely to take actions that will pay off in the long term. Without it, they may delay. And worse, any company that wants to invest in its future may be driven into private hands, as Dell Computer was in 2013, when its investor base wouldn’t tolerate the effects of a radical shift from the PC business.
Indeed, board inefficacy has become a threat to the existence of public corporations. If a public company fails, it has three choices: a merger with another company, a takeover by private equity, or reformulation to the tune of activist investors. All three have led to a declining number of US public companies. Legal issues and regulation have played a part in the shrinkage, too.
Pressure from activist investors can pose a particular problem for the boardroom. They may threaten to change the CEO or to break up or merge the company with the aim of forcing it to pursue short-term gains instead of building long-term value. If that pattern of privatization takes hold, the capital markets will become a trading venue instead of a capital allocation one, with huge implications for society through the narrowing of the number of people who will be able to participate in creating economic wealth. Boards can be pivotal in arresting this trend.
To preserve their companies, boards can cultivate relationships with the institutional investors who have the largest positions in the corporation. The support of these investors will be crucial to companies as they try to fend off outside forces and achieve their long-term goals. Activists with 2 percent or 3 percent of a company’s shares won’t be able to have their way without support from some of those institutional investors. This book will teach you how to get them on your side.
Despite the call for boards and CEOs to think more broadly about corporate performance, the competition among companies to create value for their shareholders will remain paramount. But as conditions change, the board must redefine the measure of shareholder value, in collaboration with long-term and permanent shareholders.
In this view, total shareholder return becomes more than just the increase in share price and dividends paid. It also encompasses factors that position the company for long-term growth—such as the quality of a company’s market share, its capital efficiency, and its brand. Those are the elements that will determine success in the future.
Besides adopting a longer time horizon, boards must embrace a broader conception of corporate responsibility beyond the immediate financial interests of the shareholders. The Business Roundtable and other voices representing the community at large are asking corporations to go beyond Milton Friedman’s dictum that “the only . . . social responsibility of business” is “to use its resources . . . to increase its profits.” That, instead, running great companies requires boards and management to focus on other stakeholders, and doing so will lead to greater long-term shareholder return.
To successfully steer their companies in new directions, boards must wrest control from management. Boards have essentially been led by the CEO’s team. They have been almost totally reliant on information management has provided. As a result, they have been reactive to external change.
Boards must adopt a new modus operandi and mindset. Directors today function at their best when they are a Zoom meeting away from one another, not a quarterly meeting away. While they should cultivate a collegial relationship with management, they must also be independent of it. We will show you how to generate your own sources of information so that the board can ensure the right balance between long-term and short-term goals and the interests of all stakeholders.
Talent, Strategy, Risk: The New Board Playbook for Managing for the Long Term
The three of us have watched these trends play out in boardrooms for years. We based the recommendations in this book on our many years of experience working on these issues with boards, management, and the investment community
To write this book, we’ve talked to dozens of leaders from public and private companies, investment firms, and activist shops. We’ve gathered their best insights, and we’ll let them share the whys and the hows of their success. You’ll hear from Mary Barra of GM on how to keep your board engaged, Warren Buffett of Berkshire Hathaway on how to make a merger, Michele Hooper of the Directors’ Council on CEO succession, Rajiv Gupta of Delphi Automotive on acquisitions, and more. All are talking about escaping the traps of short-termism and leading for the long term.
The directors, leaders, and investors we interviewed for this book are turning the old way of doing business upside down. The new tools we provide will help you do the same.
In part one, we lay out the framework of the new TSR. We start with talent, in chapter 1. Of all the inputs, talent is the most important. Talent drives strategy and conceives new directions, seizes novel opportunities, and makes corporations more adaptable and agile. Talent manages and mediates risk. It executes plans. Boards can offer crucial support by learning about their company’s talent in depth. Then they will be in a position to make recommendations to management about senior leaders and help them face reality about the suitability of staff for short-term and long-term needs, with special emphasis on managing for the long term. You’ll hear how the CEO of WSFS Financial Corp. laid the way for his succession by going on the road for three months and putting his heir apparent in charge.
The board’s new role in strategy is the focus of chapter 2. In a fast-changing world, setting strategy can no longer be a once-a-year off-site event. It must be an ongoing process, with every meeting an opportunity to challenge the company’s strategic framework. We offer a new standard, the moneymaking model, and tie it to long-term goals. You’ll read about how GM taps the expertise of board members to help it enter new lines of business. You’ll also hear how Delphi Systems focused its portfolio on the businesses that mattered most to its future, how Warren Buffett makes the right decisions about potential mergers, and how boards can help build value for the future by looking out for the interests of all stakeholders.
In chapter 3, we turn our attention to the third leg of the new TSR—risk. Too many companies practice risk avoidance, not risk management. We show how a new focus on risk management shifts the perspective to long-term gains. When properly executed, risk management treats the company as a single system rather than an amalgam of parts. You’ll see how Tyco’s approach to total enterprise risk helped it survive the financial fraud of its CEO and stave off the threat to its worldwide operations posed by the H1N1 swine flu pandemic of 2009. And you’ll read about how Warren Buffett manages audit risk at Berkshire Hathaway.
In part two, we shift to the board’s playbook, showing, one by one, the changes in governance that ensue when a board shifts its focus to managing talent, strategy, and risk. (See figure I-2.)
Chapter 4 focuses on the new board capabilities necessary to support long-term value creation. Talent matters not just within the company but also in the boardroom. Most directors have experience in selecting talent along with scars from making wrong decisions, and they have years of collective judgment in taking action. The trick is to learn how to continually adapt to change by having the right mix of talent and fair representation of gender, ethnicity, and age. This chapter will walk you through how to manage these changes. And you’ll hear how GM, Verizon, and other companies manage the tricky proposition of replacing board members who aren’t delivering.
Restructuring board committees is an essential aspect of managing talent, strategy, and risk. In chapter 5, we will show you how division of labor is the only way for directors to use their expertise and achieve the depth of knowledge necessary to do their jobs. For instance, boards have long held that their most important job is selecting the CEO. But if they are going to have a successor ready when they need one, boards must know how to bring talent along. Here you will see why the compensation committee—which we would refashion as the talent, compensation, and execution committee—is best situated to discharge this responsibility. You will read about how Providence Health brought a disrupter from the tech world onto its strategy committee, where he helped transform the company into a health database powerhouse. And you’ll see how Wendy’s ad hoc technology committee helped turn a burger maker into a digital player, positioned for long-term growth based on a new ordering platform.
In chapter 6, we turn to how boards can diversify the information they have. Reducing the asymmetry of information between the board and management is essential to the board’s mission of overseeing talent, strategy, and risk. You’ll see how a conscientious CEO like GM’s Mary Barra can help keep her board fully informed about the competitive marketplace without pushing her own agenda. You’ll learn how GE’s board missed out by not digging into the information that could have revealed how badly out of whack its balance sheet was. And you’ll see how one exemplary director, Michele Hooper of the Directors’ Council, develops her own sources of information by going out on the road by herself.
Finally, to expand on Bill’s prologue, in chapter 7 we focus on how boards can engage with investors, a company’s most powerful constituency. Here you’ll find the culmination of the book’s themes as we show you how investors are promoting measures that create value in the long term, with important implications for the board’s management of talent, strategy, and risk. You’ll see how an activist investor helped DuPont revamp its cost base, capital structure, and portfolio, all to the benefit of long-term shareholder value. And you’ll read the terrific tale of Motorola’s encounter with the most notorious alpha activist of all.
We’ve seen how companies that have reinvented their playbooks around these ideas are better prepared to meet the changes in company ownership and in shareholder expectations. We hope this book will help form the basis for a radical new thinking around TSR. Adopting the practices of the new TSR can help you resist short-term pressures and focus on the issues that will let your company thrive, both now and in the future.