The Law and Other Anomalies

Harry Broadman, PWC’s Chief Economist and leader of its emerging markets practice, makes an overwhelming case that the economic future of the world lies in the Far East, including but not limited to China and India (which between them have 1/3 of the world’s population).

In remarks delivered this weekend in Philadelphia, Broadman demonstrated that emerging countries are the engines of global growth, and that the trend is increasing.  The growth of the economies of emerging countries is not cyclical; it is a long-term structural change driven by the world being flat, the speed of communication and change, and the rise of the middle class.  Indeed, emerging economies fared better than established economies in resisting the 2008 economic collapse. 

According to Broadman, we need a strategy which he calls “China 2.0.”  It is not just China; it is Vietnam, Myanmar, Philippines, South Korea, Indonesia. 

A related trend in emerging economies is more sophisticated buying.  Noting that equipment purchased at low cost often is of lower quality, buyers in emerging markets are moving toward buying the best possible equipment, as the amortized true cost over time is less. 

The key to marketing emerging economies is that you need a package; the country may need railroads, but it also needs banking, water management, IT and the like.  Larger companies servicing the emerging market must cobble together a package responsive to a broad spectrum of needs. 

Finally, we have to stop thinking about emerging economies as markets, or as labor pools.  To a growing extent, innovation itself is coming out of emerging markets, including out of Africa. 

So we used to say glibly that the “East is red” but, at least to PWC and Broadman, it looks more like greenbacks.  There are lessons for United States manufacturers, service firms and, indeed, mid-term and long-term investors in the equities markets.  Ladies and Gentlemen: replace your bets.

At this morning’s meeting of New England Chapter National Association of Corporate Directors, a panel of experts struggled to define issues that directors should be worrying about today – issues which might not arise until 2015 or thereafter.

The list of subjects was not surprising. 

In the technology sector, issues of cyber security and cyber crime, with particular focus on protecting customer data by reason of high economic and reputational risk, predominated.  In the patent area, company boards were admonished to establish a portfolio strategy and to pay attention  to whether their enterprise was indemnified against patent risk from third parties and whether they, in turn, were incurring potential liability by indemnifying their own customers.

In the health care sector, the restructuring of the delivery of medical care predominated.  Directors are responsible for establishing a health care strategy to be implemented by management.  There are three trends today:  (1) companies are getting more involved by driving employees to adopt healthy behaviors, to choose better providers, and to pick the right level of insurance; (2) other companies are stepping back, providing a “voucher” to employees and allowing the employees to decide their own level of care, generally by going to private exchanges and rolling their own; and (3) some companies are opting out, by reducing the amount of insurance, not offering insurance to family, and/or not providing insurance for part-time employees (Federal law requires insurance, generally, if you work 30 hours/week or more).  Boards must determine the level of obligation that their company adopts toward its own employees, bearing in mind that there is a tension between saving money by reducing benefits vs attracting better employees by providing benefits.

In the financial services sector, regulatory pressures dominated the discussion, particularly with respect to banks.  Boards must structure themselves to identify and adequately staff, with capable directors, all regulatory requirements, while at the same time fighting for enough agenda time for strategy in an increasingly competitive environment.

In response to a question concerning placing company data on the cloud, panelist Paul Sagan  (a partner at General Catalyst) noted that professional companies managing data in the cloud have much greater expertise than is likely to obtain for most companies protecting their own data and, therefore, placing data in the cloud (while not risk-free) is probably safer.

How accurate are these predictions of important future board focus?  Wendy Watson, chair of the Audit Committee at Citizens (among other Board memberships), noted that current bank regulatory reforms are designed, by necessity, to address failures leading to the 2008 meltdown.  Will they be effective in preventing future meltdowns?  Since risk may appear in situations we cannot even now imagine, no one can be sure that “it” won’t happen again. 

This admonishment, that the future is opaque, should be applied to all predictions.  Indeed, if we had a present and accurate understanding of the future, lives of companies would be more benign, and Board directorship a lot easier than it actually is.

Venture capital support for early stage businesses in Massachusetts, at least in the life sciences and in internet software, has not been this robust for many years.  Such was the consensus of a panel of three Boston-based early stage venture capital firms (Third Rock, Sigma Prime and Point Judith) at this morning’s breakfast meeting of ACG in Boston. 

The panel noted that the venture capital community has shrunk nationally and in Boston is now reasonably stable; they also acknowledged the debt which venture capital owes to angel investors for making high risk investments which sometimes bubble up into venture-financeable enterprises. Other significant points:

There are key elements that venture capital looks for in making an investment: an entrepreneur with deep domain experience and vision, a concept that has the potential of creating a truly large enterprise, a special technological edge, and a product or service which fills a fundamental need. 

The two VCs investing in life sciences had quite different appetites in terms of the size of an A round; one was looking for a range $2,000,000 to $6,000,000, another would go much higher (against milestones) in order to nurture the company to a point where professional management for ongoing operations could be brought in. 

When do you sell?  “Companies are bought, not sold.”  The venture capitalist knows when to sell when buyers are circling the company, and your professional management is listening to them. 

The IPO market is open for life sciences, and for larger internet/software based companies.  Will the IPO market open for the smaller SAAS companies?  The panel agreed that the prospect was dim; given needs for liquidity and the size of investment typically made by institutional investors, it doesn’t make sense to bring a software company public unless its market cap is in the range of $500,000,000 or more.  This size target in turn is only driven by sales of $50,000,000 to $100,000,000.  If you have a software company which has sales in the $30,000,000 to $50,000,000 range, it is too difficult to justify the requisite market cap so as to support an IPO.

What are the accounting issues most often being encountered by public companies filing annual reports with the SEC?  The following trends were noted at the February 11^th meeting of the National Association of Corporate Directors/New England:

• Request for detail as to effective tax rate as compared to the United States corporate rate of 35%, explaining variances above or below that rate. 
• Discussion of the judgments applied to adjustment to valuations of balance sheet assets. 
• Explanation of why a registrant believes that earnings held offshore are not subject to a balance sheet entry showing a deferred tax liability (why is the company saying that it does not intend to bring money held offshore into the United States?). 
• More detailed segment reporting for different businesses. 
• Discussion of assumed rate of return in funding retirement plans, measured against historical performance. 
• Discussion of the judgment reached in not marking down goodwill (which must be reviewed annually for comparison of carrying value to fair value). 
• Clearer labeling of non-GAAP financial reporting. 
• Greater clarity in the accounting treatment of investments in China, Russia, India and other places where foreign direct ownership is limited and where companies enter into joint venture agreements. 
• Increased focus on the robustness of internal financial controls, driven by PCAOB focus. 

A few years ago there was an effort to seek “convergence” of United States accounting principles (GAAP) with international accounting (IFRS).  Full convergence lacks steam; the different accounting systems have reached agreement on specific areas of reporting but full convergence is now viewed to be “a long way off.”

This is the first of a series of four blogs reporting on corporate board developments.  These posts are based upon remarks at the February 11^th breakfast meeting of the National Association of Corporate Directors/New England.  This first post relates to developments in the operation of boards of public companies. 

Gender diversity.  Although boards of all Standard & Poor’s Index Companies over the last five years increased from 12% to 17% female, the gap is obvious notwithstanding compelling documentation that diverse boards simply perform better.  In Europe, where gender diversity is sometimes mandated, companies are beginning to recruit qualified United States women for service overseas. 

Age, Term Limits.  There is an increasing trend to impose age limits on boards, although few boards have instituted term limits.  Most boards in larger public companies have enacted declassification and imposed majority voting, developments which favor shareholder activism and which are now cascading into mid-tier and lower-tier public companies. 

Risk.  The perennial major issue for boards: risk oversight.  Much of this effort is confined to committees, and the question therefore is: does the whole board get a complete understanding of its risk profile?  The boards tend to get into risk only through discussions of strategy. 

Proxies.  For the next proxy season, can we be informed by the past?  Last year, proposals for dividing CEO and chair functions passed 30% of the time; proposals affecting executive compensation (such as changes in option policy and holding periods) passed 23% of the time; majority voting proposals 60% of the time; declassification 80% of the time; private ordering of inclusion of shareholder-proposed candidates for directorships passed one-third of the time. 

Social Media.  Many boards these days are seeking experts in the use of “social media.”  This is liable to drive a younger cohort of directors.  The question was asked: will this effect built-in long term board members, who have a lot of ramp time before retirement?  One comment was in the negative; this type of person will not become entrenched.  To my mind, an optimistic view of human nature.