S&P Global Ratings has completed a two-year review of how issues of management and governance (M&G) are reflected in our ratings. For that period, we found 77 cases where a revision of our view of management and governance factors led to rating changes, and a total of 262 cases where these factors were a part of the analysis and resulted in a change of our management and governance assessment.
We consider M&G factors explicitly in every corporate issuer credit rating. Our M&G criteria encompasses a range of factual and qualitative assessments that we apply and revise as necessary based in part on our in-person meetings with management as well as our understanding of how governance impacts credit quality more broadly.
This analysis looks at the universe of rated corporate entities and transitions of their M&G scores from July 2015 to August 2017. We have complemented the analysis of our scores with the application of a natural language processing technology highlighting some other notable instances of M&G factors considered elsewhere in the rating analysis. Finally, we have selected a number of past rating actions to illustrate our analysis of various governance factors.
This report is part of a series covering the impact of environmental, social, and governance (ESG) factors in our credit ratings. In October 2015, we published our first review of how environmental and climate factors affected our ratings between 2013 and 2015 (“How Environmental And Climate Risks Factor Into Global Corporate Ratings,” Oct. 21, 2015); last November we conducted our second (“How Environmental and Climate Risks and Opportunities Factor into Global Corporate Ratings – An Update,” Nov. 9, 2017). We then expanded the series to review social factors (“How Social Risks and Opportunities Factor Into Global Corporate Ratings,” April 11, 2018). These reports showed that environmental and climate factors contributed more frequently than did social factors over the same period, and that while environmental and climate factors affected ratings in a nearly even split of negative to positive, social factors were overwhelmingly negative in terms of impact on credit quality. We will continue to track how we incorporate ESG risks and opportunities into our credit analysis, and we plan to further report on how those factors may affect entities' creditworthiness.
Governance in Ratings Processes
Our view on management and governance could significantly influence credit factors other than solely the M&G assessment, such as a company's competitive position, its credit metrics, and our view of its financial policy, each of which, on its own merits, can have direct impacts on the issuer rating.
An effective management team may, in times of market duress, seek to balance the needs of debtholders with those of shareholders by making efforts to reduce leverage. By contrast, a management team could be excessively focused on pursuing debt-funded mergers and acquisitions (M&A); while growth is part of every company's strategy, it can become a governance issue if it involves excessive risk-taking or results from skewed management incentives causing a misalignment between management's interest and that of debt- or shareholders.
This illustrates another aspect of the governance analysis: while management can actively take actions that worsen credit quality, it can also fail to take actions that would support credit quality. This duality is part of the reason why management meetings, which are part of every rating, are of such importance. Management teams have a finite level of resources that can be dedicated to mitigating risk; our interactions with them indicate which are of the highest priority, and this selection can influence credit quality.
Relevance and definition
Sudden management and governance developments can often have an immediate or future impact on an issuer's creditworthiness, and weak policies or structures can often be red flags that herald adverse credit developments. Among actions and behaviors that could impact an M&G assessment are matters like:
- Executive/board and auditor departures and changes (particularly when sudden, unexpected, and repeated) can herald changes in strategic direction, indicate management dysfunction, or presage accounting, legal, or regulatory problems or operational underperformance.
- Delayed financial reporting or a qualified audit report can be a signal of underlying performance issues. Even if resolved, it often is accompanied by reduced access to capital.
- Lack of in-depth involvement by the board and/or its owners of management's strategic plans or complex areas of operations reduces their effectiveness to oversee risks.
- Badly-designed management compensation (with excessive focus on short-term results and pay-out) or ineffective compensation or audit committees can cause excessive risk-taking and/or damage the long-term sustainability of the company.
- The presence of activist investors. While their presence is not invariably negative for credit quality, they can also prompt or signal change in an issuer's strategic direction, risk appetite, and the potential for personnel changes to board and management, often at the expense of debtholders.
Our working definition for management and governance, as reflected in our M&G criteria, "encompasses the broad range of oversight and direction conducted by an enterprise's owners, board representatives, executives, and functional managers. Their strategic competence, operational effectiveness, and ability to manage risks shape an enterprise's competitiveness in the marketplace and credit profile.
"If an enterprise has the ability to manage important strategic and operating risks, then its management plays a positive role in determining its operational success. Alternatively, weak management with a flawed operating strategy or an inability to execute its business plan effectively is likely to substantially weaken an enterprise's credit profile."
Process and criteria
As shown in table 1, our M&G score is an amalgamation of assessments. We assess eight "Management" factors relating to strategy, risk management, and organizational effectiveness, each of which we score positive, neutral, or negative.
We also assess seven "Governance" factors, which are each scored as neutral or negative. In a circumstance when a governance deficiency or deficiencies impairs the ability of the enterprise to execute strategy or manage its risks, can be labelled severe.
These 15 factors are aggregated into the management and governance assessment, which can result in a strong, satisfactory, fair, or weak score. The result of the management and governance score, combined with certain anchor ratings, can result in increase on that rating of up to one notch, or a decrease of two or more notches, as shown in table 2. Sometimes these adjustments are only triggered if we feel we have not already captured the benefits of strong management and/or governance in the business risk profile or financial risk profile.
Each of the seven governance factors is primarily concerned with the structures and systems a company has in place that govern how it operates strategically (or not) given the various regulatory, political, economic, social, and natural environments it operates in. The governance systems are ultimately in place to guide, advise, and at times intervene in management's actions and planning to ensure the company's growth and longevity. Unlike the management factors that can be scored positively, governance factors are scored neutral or negative, and serve as an overarching scoring indicator when the two are combined. The rationale is that management cannot manage to optimum performance if the governance structures and systems are not in place that allow them to do so. This is reflected in the criteria, which caps the overall M&G Score at fair with just one governance negative subfactor, even if there are many positives among the management factors.