Multinational subsidiaries are no safe haven in AfricaSeptember 2011
It is generally accepted that Africa should deliver strong portfolio growth in the decade ahead. Yet African markets have specific environmental, social and governance (ESG) risks that need to be diligently addressed. In order to manage these risks, some investors have a positive bias towards African Listed Subsidiaries of Multinational Companies (LSMC), which represents up to 20% of the top 100 African companies by market cap. My experience is this ‘blind’ strategy can be anything but safe as investing in LSMCs does not correspond de facto to better protection of minority shareholders.
In fact, minority shareholders of LSMC face the risk of material value destruction when the time comes to ‘slice the pie’ – distributing value between parent companies and minority shareholders. This risk is often exacerbated by perverse incentives whereby the LSMCs’ management teams are employed by the parent company and – in over 80% of cases – benefit from share-based incentives at the holding company level that provide no meaningful incentive for value creation at the local, subsidiary level.
According to my research, the disconnect between management incentives and LSMCs’ minority shareholders interests tends to materialise in ‘management fees’ and capital allocation. Management fees and ‘brand licenses fees’ are paid to the parent company, and directly impact the LSMC’s earnings available to common shareholders. The details of these arrangements are typically set out in undisclosed contracts between the parent company and its subsidiary. These fees can amount to material profit appropriation by the parent company, accounting for up to 24% of the profit before tax. The difference between the fees paid to the parent company and the intrinsic value of these ‘services’ amounts to a tax on minority shareholders.
On a positive note, parent companies generally impose strict capital expenditure policies on their subsidiaries, which minimises the risk of value-destructive ‘empire-building’ projects. However, capital allocation decisions by local management are sometimes negatively constrained by parent companies’ interests. For instance, I encountered a cement company which hadn’t had any net debt on its balance sheet over the past ten years. Retention of excess capital in the LSMC is clearly not in the interests of minority shareholders but is not inherently negative for the controlling shareholder, who may withdraw cash from the LSMC when desired.
As long-term investors, I believe it is our fiduciary duty to engage constructively with the African LSMC and their parent companies to protect our rights as minority shareholders and improve African financial market efficiency. This, eventually, would contribute to the sustainable development of Africa.
Gaëtan Herinckx is senior investment analyst at Sustainable Capital and may be contacted at firstname.lastname@example.org
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