CFA Level 2 | ESG Considerations in Investment Analysis

CFA Level 2 | Corporate Issuers| Learning Module 2

Introduction

• ESG considerations are increasingly integrated into investment analysis.
• Evaluating ESG factors provides a broader perspective on risks and opportunities.
• Investors are increasingly concerned with environmental and social factors alongside corporate governance.
• Mismanagement of resources relating to environmental and social factors has led to negative effects on security prices.
• Stringent regulations, resource scarcity, and trends toward conservation emphasize the importance of environmental risk management.
• Worker health and safety, community impact, and marketing practices highlight the visibility of social capital management.

Ownership Structures and Their Effects on Corporate Governance

• The global corporate governance landscape has a vast range of ownership structures reflecting economic, political, social, and legal forces.
• Understanding ownership structures is important for analyzing corporate governance in the investment process.
• Dispersed ownership: Many shareholders, no single controlling entity.
• Concentrated ownership: Individual or group (controlling shareholders) with the ability to exercise control.
• Hybrid ownership: A mix of dispersed and concentrated features.
• Concentrated ownership is more common globally.
• Control can be disproportionate to ownership due to horizontal/vertical arrangements and dual-class shares.
  • Horizontal ownership: Cross-holding share arrangements between companies with mutual business interests.
  • Vertical ownership (pyramid ownership): Controlling interest in holding companies, which control operating companies.
  • Dual-class shares: Different voting rights for different share classes.
• Different ownership structures lead to different potential conflicts.
  • Dispersed ownership & dispersed voting: Weak shareholders, strong managers; principal-agent problem (managers prioritizing own interests).
  • Concentrated ownership & concentrated voting: Strong shareholders, weak managers; principal-principal problem (controlling shareholders benefiting at the expense of minority shareholders).
  • Dispersed ownership & concentrated voting: Principal-principal problem (controlling shareholders with minority ownership exerting control).
  • Concentrated ownership & dispersed voting (voting caps): Legal restrictions on voting rights of large share positions.
• Types of influential shareholders vary globally.
  • Banks: Significant control in Europe and Asia; potential conflict of interest between lender and shareholder roles.
  • Families: Predominant in Latin America, Asia, and Europe; lower principal-agent risk but potential for poor transparency and disregard for minority rights.
  • State-Owned Enterprises (SOEs): Common in strategically important sectors; may prioritize social/public policy over shareholder value.
  • Institutional Investors: Significant ownership in many countries; can promote good governance through active engagement.
  • Group Companies: Horizontal and vertical structures; risk of related-party transactions at the expense of minority shareholders.
  • Private Equity Firms: Strategic owners focused on value creation; may bring changes to corporate governance.
  • Foreign Investors: Can demand higher transparency and accountability, especially in emerging markets.
  • Managers and Board Directors (Insiders): Increased ownership aligns interests with shareholders but can also lead to self-interest.
• Ownership structures affect corporate governance policies and practices.
  • Director Independence: Higher in dispersed ownership structures; strengthens board monitoring. Requirements/recommendations for independent directors vary by jurisdiction. Independent directors may have a narrower role in concentrated ownership structures.
  • Board Structures: One-tier (single board) or two-tier (supervisory and management boards). Two-tier boards can provide a control function.
  • Special Voting Arrangements: To improve the position of minority shareholders (e.g., separate approval of independent directors by non-controlling shareholders in the UK).
  • Corporate Governance Codes, Laws, and Listing Requirements: National codes, company law, or stock exchange rules to promote good governance (“comply or explain” approach common).
  • Stewardship Codes: Encourage investors to exercise their rights and engage in corporate governance (can be voluntary or semi-voluntary).

For more information about our CFA Level 2 exam prep courses, check out our CFA Level 2 All-In-One Prep Course or the CFA Level 2 Corporate Issuers e-learning course.