Local and global risks in 2015 are likely to reach their most worrying level since the global financial crisis. Tony Featherstone considers the implications for boards entering a period of increased volatility.
Boards face their biggest test in 2015 since the global financial crisis (GFC): ensuring their organisation can grow in a sluggish global economy, withstand regulatory confusion, and adapt to the unknown.
Dealing with higher volatility is a recurring theme among leading directors. Risks are plentiful: how a trillion-dollar money printing experiment by central banks will end; whether Europe will have another financial shock; and if Chinese growth will disappoint. War in parts of the Middle East, a greater terrorism threat, volatile commodity and currency markets, and the Ebola virus add to the geopolitical risks for business and boardrooms.
Although these risks seem a world away, their influence on the Australian economy could reverberate next year. Back home, political and regulatory uncertainty is a huge concern for boards.
The Financial System Inquiry, the Harper Competition Policy Review and myriad other reports and potential reforms are clouding decision-making for boards. A critical debate on tax and federation reforms adds to potential regulatory volatility in 2015.
“My number one concern for boards next year is dealing with the pace of change and levels of volatility,” says Dr Nora Scheinkestel FAICD, a non-executive director of Telstra Corporation, Macquarie Atlas Roads and chemical and explosives maker Orica.
“Boards are governing in a period of significant uncertainty. They must ensure their organisations are capable of responding quickly to whatever emerges as well as, ideally, anticipating change.”
Diane Smith-Gander FAICD (Twitter @Diane SmithG), chairman of operations, maintenance and constructions business Transfield Services, says financial stress in the economy will be a bigger board concern in 2015.
“A number of key indicators are heading in the wrong direction, and there are anecdotal reports of accounting firms experiencing a sharp rise in insolvency or work-out matters. Although headline growth for Australia looks okay, conditions can deteriorate quickly and boards cannot afford to be caught napping next year by a weaker-than-expected economy,” says Smith-Gander who is also a Wesfarmers non-executive director and on several prominent not-for-profit boards.
The right balance
Boards responded to volatility in 2008 and 2009 during the GFC with tighter compliance and risk-management controls, notably around the alignment of executive pay and performance, and on financial reporting and independence issues. The market responded with a vigorous assessment of the depth and speed of these changes and ferociously attacked governance outliers.
Now there is more focus on ensuring that boards have the right people to help their organisation grow organically or by acquisition, in what could be an extended period of lower global growth, characterised by weak demand, oversupply, and ongoing asset booms and busts.
Ongoing debate on gender diversity and director tenure goes to the heart of concerns around volatility. Does the board have the right mix of directors to steward the organisation through uncertain times and help it grow when there is little or no growth in some economies?
There is little room for error. The latest Australian Institute of Company Directors Director Sentiment Index (DSI) showed board sentiment fell noticeably in 2014, amid rising concerns over the economy, regulation, productivity and the federal government’s performance.
The rise of shareholder activism, class actions, litigation funding and an increased compliance and disclosure burden add to the governance challenges for listed companies in 2015. Dissatisfied beneficial owners seem more willing than ever to force board change. Directors interviewed for this feature nominated organisational culture and executive leadership as key issues in 2015. In other years, such topics might have been seen as governance clichés. However high-performing boards are focusing on how their organisation would adapt to significant, unforeseen, fast change, and if the executive team is well suited to the task. A year ago, directors nominated the impact of technology on business models, innovation, the Australian economy, the new federal government, mergers and acquisitions, board diversity and executive pay as key governance challenges. Each persists today, but the great governance challenge for next year will be dealing with the unknown rather than the known. Here are five board challenges for 2015:
1. Organisational culture
Boards that do not understand, measure and monitor their organisation’s culture could have significant risk in 2015. Private-sector workers are experiencing record low wages growth and tens of thousands of Commonwealth public servants face a cut in real wages over the next few years. This could damage morale and in some cases create security risks.
Potential for more restructures and redundancies in some industries, and lower executive and management bonuses could also threaten organisational cultures. Increasingly, companies will ask staff to do more for the same or less, to lift productivity in a low-growth environment. “More than ever, the leaders of organisations, be they directors or the executive team, need to examine the organisational culture and ensure it is fit for the business world we live in,” says Scheinkestel.
“That requires an openness in organisations and the boardroom so that all questions and assumptions can be challenged and that nothing in such a volatile environment is taken as given. The culture must be truly inclusive and willing to change.”
Scheinkestel says board diversity will be put to the test next year. “There has been much debate on diversity, but it’s during periods of uncertainty that one understands the value of having true diversity of thinking around the board table, not just gender, but across skills, experience, race and age.
“Directors will need to test any decision-making bias and the robustness of board methodology, be probing and curious and capable of fundamentally rethinking the organisation’s business model in quick pace, if needed.”
Transfield’s Smith-Gander says boards have become more adept at dealing with the “new normal” of higher volatility since the GFC. “Any board that is not constantly challenging and refreshing their risk matrix, and their understanding of risk-management mitigation and potential business stress, is not discharging their responsibility,” she says.
“The range of outcomes for business has substantially broadened in the past few years. I’m not suggesting boards micro-manage the executive team, but they do need to have a clear line of sight about trading conditions, and not be caught out by an outcome that in the past might not have been considered to have a high probability.”
2. Executive leadership
Most boards argue that choosing, incentivising and monitoring the right CEO is their most important task, regardless of economic or market conditions. But regulatory change across so many industries will test executive leadership in new ways in 2015.
“Lots of boards will ask if they have the right executive team and the depth of talent, because they face a more diverse set of challenges in 2015,” says Graham Bradley AM FAICD. Bradley, a former president of the Business Council of Australia, chairs property group Stockland Corporation, HSBC Bank Australia, metallurgical coal business Anglo American Australia, Virgin Australia International Holdings, and Po Valley Energy.
“Leadership challenges will be different across industry. In banking, the challenge will be meeting rising regulatory standards and balancing rising compliance costs against risk in a responsible way,” Bradley says.
“In mining, it will be the challenge of adjusting strategy and lower costs in the face of declining revenues from lower commodity prices. In services, the challenge will be taking advantage of opportunities in Asia. In manufacturing, it will be adjusting to continued cost pressures due to higher labour costs, and volatility in the Australian dollar.”
Scheinkestel says succession planning around executive leadership is an even greater priority during periods of volatility. “The board must ask: do we have the right people to manage during greater uncertainty? Are those people capable of developing and maintaining the right organisation culture to deliver the strategy, respond quickly to threats, and capitalise on opportunities?”
Smith-Gander says developing the next generation of executive leaders will be a critical issue for boards in 2015. “Australia is well served with a deep pool of management talent. But boards will need to think more about the next cohort of leaders coming through the organisation. Are they sufficiently experienced, skilled and mentored? If market volatility next year leads to more executive turnover, boards will need to know the next generation of leaders can step up.”
3. The global economy
After benign conditions for most of 2014, financial markets experienced sharply higher volatility in September and early October, and the Australian sharemarket came within a whisker of a 10 per cent correction, despite no obvious reason for the sell-off.
Financial markets have plenty to be twitchy about: the end of quantitative easing in the US, the first expected US interest rate rise in this cycle in 2015, and potential for a higher US dollar. The European economy appears to be going from bad to worse, and the Japanese government has again slipped into recession.
Despite these economic problems, several sharemarkets in developed nations are at, or near, multi-year highs and possibly overdue for a significant correction, which would affect the Australian share market, business conditions and investor sentiment in 2015.
Steven Cole FAICD, deputy chairman of Reed Resources and a non-executive director of Matrix Composites & Engineering, says the world has been on a “growth agenda” for too long.
“There has been too much manipulation by governments and central banks to drive an extended period of super economic growth,” he says. “People forget that the global economy does not always grow and that there have been long periods of low or no economic growth in the past.
“The question now is: how much have we borrowed from the future and what happens when there is greater recognition in financial markets that the world is in an extended period of low economic growth, possibly similar to the 1970s or early 1990s?”
Cole says the economy could have a painful adjustment in 2015. “Australia ducked the last two global recessions. It might not avoid the next one.
“We typically have some sort of financial shock every seven to 10 years, so the probability of one in the next few years is rising. Boards need to be prepared for the risk of a local recession and ensure their organisation can survive a global financial shock,” he adds.
More directors are pessimistic about the Australian economy and general business outlook. The latest DSI found that directors expect the US and Asian economies to be stronger than the Australian economy in 2015, and 40 per cent of those surveyed said the growth of their business had weakened in the past 12 months.
Directors expect the Australian dollar and level of wages growth to decline in 2015, and the official cash rate, unemployment rate and inflation rate to rise. On balance, these suggest the Australian economy would face significant headwinds in 2015.
For the first time in the survey’s history, sentiment about the Australian sharemarket turned negative. More directors expect a fall in the ASX All Ordinaries than those who expect a rise. A weak sharemarket could pressure boards on capital management policies around dividends, capital raisings, mergers and acquisitions, shareholder activism, and investor relations.
4. Growing uncertainty
The federal government’s standing with Australian business has fallen. More companies and not-for-profit organisations, such as universities, are struggling to budget for next calendar year and to develop and implement strategies, such is the heightened regulatory confusion.
One of Western Australia’s leading directors, Fiona Harris FAICD, says dealing with regulatory uncertainty will be a key issue for boards in 2015. “The federal government’s approach to reform and its inability to implement change is causing massive confusion and disruption for Australian business and boards,” she says.
“Too much policy is being driven by politics rather than hard economic data. At times, boards don’t know which way to turn.”
Harris adds: “I gave this federal government that absolute benefit of the doubt when it took office last year. Change was badly needed and like many in business I was eager for new reform to help the economy and business.
“But I am deeply concerned by the government’s behaviour in the past year, particularly as they seem to prefer slogans to data. Policy uncertainty is now creating significant sovereign risk for Australia.”
Harris is non-executive director of property entity BWP Trust, Oil Search, Infigen Energy, Aurora Oil & Gas, and Sundance Resources. She says the government’s energy policy is particularly frustrating.
“The fact that the government is playing politics with something so important, and disregarding the facts over climate change, is deeply concerning,” she says.
“How can companies in the energy sector invest when nobody knows where the goal posts will move next?
Some renewables companies could die as a result of the government’s approach to energy policy. The price of what they produce will fall, and investment and the best talent will inevitably go overseas.”
Harris is far from alone in her criticism. The DSI found director support for the federal government has fallen to its lowest level since the September 2013 election – a remarkable change from a year ago, when the incoming government had strong support from industry, and its election win boosted business confidence.
Few sectors have a more challenged outlook in 2015 than resources. Sharp price falls in coal and iron ore, which hit a five-year low in October, could force more resource companies into administration and create a bigger challenge for boards to keep them from insolvency. Cole believes the mining downturn is changing how boards of exploration companies, and those approaching production, operate. “Boards of small miners have to rethink how they do things,” he says.
“In the past, exploration companies were encouraged by their board to develop their resource and tap equity markets for capital when they needed it. Now the board has to help the executive team find a market for the product (through an off-take agreement) before the product is developed.
“Boards will have to look much further down the supply chain than they might have in the past, before approving projects.”
Cole says a sharper slowdown in China in 2015 would send more Australian mining companies into insolvency. “I can see Chinese economic growth coming back from around 7 per cent to 4 to 5 per cent this decade, given the amount of surplus infrastructure there.
“Such a slowdown is healthy for the world economy in the long run, but it would drive commodity prices even lower and threaten the viability of more mining companies.” Understanding bank debt covenants and the organisation’s relationship with its financiers will be an even bigger priority in 2015, Cole says. “It doesn’t take much to push a company into insolvency and destroy it once it’s there. Our current insolvency laws can crystallise small losses into much bigger ones.
“Boards of small and mid-cap companies will need to think carefully about their organisation’s solvency, given the potential for continued volatility in commodity prices.”
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