Market Views: Adani crisis and the risks of EM investing

A version of this story was first published in sister publication, AsianInvestor.

A  January 25 report by Hindenburg Research accused India’s Adani Group of stock manipulation, accounting fraud and a host of other misconducts, sending the investment community into a tizzy.

Soon after the release of the US-based short-seller's report, the industrial empire of Gautam Adani - once Asia's richest man - lost approximately $112 billion of its market capitalisation, equivalent to roughly half of its original value.

The crisis brought to the fore the risks and challenges of investing in emerging market (EM) companies.

While EMs are highly desirable for their growth potential, they are also quite risky. Regulatory oversight and corporate governance issues can be challenging and not as mature as their developed counterparts.

Despite the  Adani Group’s size and reputation, it is still representative of a typical emerging market conglomerate.

The business is family-owned and operated and has been known to consolidate control and fuel its expansion with debt. Several high-profile investors have bought stocks related to the Adani empire, and are now in a state of panic. 

The Adani Group has denied all wrongdoing.

Against this backdrop, AsianInvestor asked asset managers and analysts how sophisticated investors could conduct due diligence and avoid getting caught up in the failures of corporate governance in emerging market equities.

The following contributions have been edited for clarity and brevity.

Claire Shen, head emerging markets and China equity manager research
WTW

Governance in ESG refers to how companies and other institutions are managed. In this respect, emerging markets are different from developed markets and that can be an advantage for investors who know what to look for.

Some indicators we look at include board independence, CEO pay versus peers, tax transparency, separation of the CEO or chair, and gender diversity of the board.

Given a sufficiently robust research methodology and investment process, it is possible to identify and manage the ESG and other risks associated with emerging equity markets.

Jane Ho, head of stewardship, Asia Pacific
BNP Paribas Asset Management

Companies should focus on long term sustainable value creation and ensure protection of shareholder rights. There should be a counter-balancing structure at the board and its committees with a strong presence of qualified, engaged and independent directors to allow for effective oversight of management.

Hence, a key red flag is the lack of board independence, particularly for companies and conglomerates that conduct many related party transactions (RPTs).

More specifically on RPTs, the lack of appropriate board oversight policies and public disclosures is a red  flag.

RPT review by independent directors and a shareholder vote are key to protecting the interest of minority shareholders. The board should disclose the process for approving, reviewing and monitoring related party transactions and any inherent conflicts of interest.

The International Corporate Governance Network (ICGN) also recommends the establishment of a committee of independent directors to review RPTs, with conclusion of the committee disclosed to shareholders.

Strategic or large RPTs should be put to a shareholder vote. Whilst family ownership is not an issue in and of itself, when the founder and family members have majority holdings, which means voting rights too, it is harder to enact change.

A company’s auditor, if disproportionately small relative to the size of the company’s business, can also be a red flag.

Overly long tenure of an auditor is another red flag- best practice is a mandatory rotation of the auditors after no more than 15 years, with a clear water period of at least five years before the auditor can be re-appointed.

Jerry Goh, investment manager of Asian equities
abrdn

Institutionalised boards and regulatory oversight in emerging markets are typically not as mature compared to developed counterparts.

As bottom-up long-term shareholders with holding periods longer than the average investor, we therefore scrutinise the quality and track record of both the board of directors as well as senior management of a company before we invest, to reduce the probability of an idiosyncratic risk event.

This involves conducting due diligence on the backgrounds of the professionals, including founders or families if any, and to hold regular interviews with senior management where possible to track progress of execution.

We want to gain insight into whether the team is credible enough to execute on their strategy, and that they are meeting the milestones they have set in prior periods. Ultimately, we are investing in a group of people who can deliver on growth and look after the interests of minority shareholders.

Financial transparency is also another area where we tend to spend time on, given reporting standards are often not as established. We typically drill down extensively on the qualitative reasons behind changes in the financial numbers, and to question the logic behind the explanation, while cross checking with due diligence done in other markets or peer companies in similar sectors.

We encourage better transparency and engage with the company on making adequate disclosures so that the market is better able to appreciate and understand the company.

Lara Kesterton, head of mtx ESG research
Vontobel

Family or founder firms are common in emerging markets and can signal concerns when combined with other factors such as complex ownership structures, unrelated businesses in the group mix or a shallow history in that business field, key-person risks, succession or exit concerns.

Concerns over accounting practices are also common triggers for deeper research.

State owned enterprises are another not-uncommon structure in EM – information asymmetry can be an issue as they are typically less open to investors’ questions.

Sudden changes of leadership for opaque reasons occur occasionally and corporate strategy can be more subject to the social agenda.

In all cases, wide-ranging research is essential, from desktop searches (home language where possible) into backgrounds and controversies, speaking with local experts and of course, speaking to the company itself.

Frequently the strength of these direct engagements gives insights on how important the issue at hand is to management and give a much rounder understanding on the companies’ commitments on certain issues.

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