The Master CFO Series

A tale of two markets

Telling the story of investment across developed and rapid-growth markets

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In light of sluggish performance in many developed markets, business leaders are increasingly looking to rapid-growth markets to sustain growth.

This fundamental shift of resource allocation requires the CFO to master the attributes of ambidextrous management. Not only do they need to manage a portfolio of investments that combine very different risk and return profiles, time horizons and characteristics, they also need to be able to distill this complex, and sometimes contradictory, strategy into a clear and coherent narrative for investors.

To tell a tale of two very different markets will require the CFO to rethink traditional communication strategies and reporting frameworks.

In balancing investments across markets, the CFO has to constantly manage contradictory forces: the drive to capture the growth opportunities in rapid growth markets, despite inadequate data to evaluate these opportunities, as well as the need to protect sources of profitability from mature markets. Few CFOs believe their company is effective at managing investments across markets that are growing at such different rates.

Two-thirds of CFOs agree that inadequate data and poor transparency mean that it can be difficult to build a robust evaluation model for investing in rapid-growth markets. This puts added pressure on the CFO when addressing tough questions from investors seeking evidence for a rationale that shifts resources to rapid-growth markets.

CFOs neglect developed market assets at their peril

87% of CFOs agree that it is difficult to build a rationale for increasing resource allocation to developed markets when other parts of the world are growing more quickly. But long-term growth must be funded by short-term profitability, and this is currently more likely to be greater in developed markets.

The CFO’s focus on investor communication needs to increase

98% of CFOs have changed the way they communicate with investors as a result of increased exposure to rapid-growth markets. And yet the majority lack confidence in this aspect of their role, with over two-thirds reporting they find it difficult to convey an over-arching narrative when balancing investments across these markets.

Traditional reporting frameworks are in need of a rethink

Almost three-quarters of CFOs agree that increased investment in rapid-growth markets means that they need to communicate more frequently with investors. Investors are also looking for greater immediacy, citing regular trading updates as the form of communication they find most useful for gathering information about investments in rapid-growth markets. This suggests that traditional channels, such as the annual report, may no longer be enough to satisfy the increasingly time-sensitive needs of investors.

Companies need to manage the balance between a need for more granular information and insight that is concise and relevant

Almost two-thirds of investors say that they would like CFOs to provide more granular information about the prospects for rapid-growth and developed markets. Investors say that they would like to see more narrative reporting that explains how the business intends to create value and provide greater clarity on key risks.

Increased allocation to rapid-growth markets could change the investor profile

84% of CFOs and 63% of investors expect that the higher risks and more volatile returns associated with investing in rapid-growth markets will trigger a churn in the investor base and attract investors with different risk appetites.

In this report, we look at:

This study includes findings from interviews with leading CFOs and investors, as well as two surveys conducted with the Economist Intelligence Unit – one of 759 CFOs worldwide and one of 244 professional investors.

Roger Barker, Head of Corporate Governance, Institute of Directors

Roger Barker, Head of Corporate Governance at the Institute of Directors, discusses with Ernst & Young the role of the non-executive board in striking the balance between developed and rapid-growth markets.

EY: What are some of the governance issues that companies are likely to encounter when investing in rapid-growth markets?

Roger Barker: When companies invest in emerging markets, one of the common issues they face is that it’s often not possible to enter without forming a partnership with a local enterprise. Companies may have to form a joint venture, an alliance, or enter into a distribution agreement with a local firm in order to gain access. This may require some kind of formal corporate arrangement or it may simply mean that you need to work through intermediaries in the local market.

This can create all sorts of governance issues. If you’re investing through your own company, you can transfer a certain corporate culture and an understanding about behavior, conduct, and what is appropriate. But if you are working with another company in a joint venture arrangement, for example, that is more difficult. You’re therefore in a novel situation where you have less control, and where all sorts of difficulties can arise.

Another issue is the whole challenge of bribery and corruption. Even if you are operating through intermediaries or agents of some kind, you can potentially be held responsible for their behavior if it transpires that you haven’t put adequate procedures in place to ensure that they don’t operate in a corrupt way.

How should CFOs interact with the board when outlining their rationale for investments across developed and rapid-growth markets?

I think it’s absolutely right that a key executive in the organisation like the CFO brings strategic ideas to the board based on their expert knowledge of the business and all the information that they’re getting about the growth prospects in different markets. The board then plays a key role in challenging those strategic ideas and has to somehow find a way to form a judgment about how viable those ideas actually are.

What are the obstacles that boards face in reaching that judgment?

One may be a lack of expertise in those markets among the non-executive directors. The composition of the board may not reflect the new markets into which the company is planning to invest. In those circumstances, it is very important for the board to seek external advice, rather than rely exclusively on the proposals and justifications coming from the CFO and other executives.

In the longer term, if the strategic direction of the company is likely to involve a major shift towards rapid-growth markets, then the board may want to think about the skills and experience it needs in future to reflect that new international mix. There has been a significant trend towards greater international diversity on non-executive boards over the past decade or so, in the UK and elsewhere.

What are the challenges that can prevent board members from getting the information they need to evaluate a particular strategy, particularly in rapid-growth markets?

The big challenge that faces a non-executive director is getting hold of information about what’s happening on the ground in a way that doesn’t undermine the executive management who are actually managing the operation. This is always a tricky balance to strike.

Non-executive directors have to develop those information flows and that will involve them going out to visit these countries. It will involve establishing contacts with various individuals in the management structure, people they can speak to directly, and utilizing the internal eyes and ears of the company from functions like internal audit.

They also have to utilize external sources of information. This might include consultants and analysts who are looking at these markets and assessing how the company is performing in those countries.

How should CFOs communicate with investors about their investments in rapid-growth markets and what are the challenges associated with that?

Most investors recognize that these markets have tremendous growth potential. So the key thing for CFOs is to demonstrate to investors that they are capable of exploiting that potential. Often, the key issues in terms of being able to get a return out of that strategy are related to corporate governance. We all know that these economies will be an important part of the investment mix, so the question is whether a company’s corporate governance is going to be robust enough to extract the financial return for getting involved in those markets.

It’s also very important in the eyes of investors that the non-executives, particularly independent non-executives, appear to be fully persuaded that the chosen strategy is the right approach. Because after all, those independent non-executives are the people on whom the shareholders are relying to exercise independent judgement on what is being proposed by the management. It’s fine for the CFO and CEO to say that these are great plans, but investors will find it much more convincing if the Chairman and the other non-executives are also behind a particular strategy.


Vanessa Jones, Head of Corporate Governance, Institute of Chartered Accountants in England and Wales

Vanessa Jones is Head of Corporate Governance at The Institute of Chartered Accountants in England and Wales (ICAEW). Here, she talks to EY about the challenges of managing risks in rapid-growth markets from a governance and reporting perspective.

EY: Companies increasingly consider rapid-growth markets to be their key source of future growth. As they increase their exposure to these markets, what are the issues that CFOs and other business leaders need to think about from a disclosure perspective?

Vanessa Jones: Companies have always invested in new markets but the difference today is the speed and the extent to which they are doing it. Rapid-growth markets pose particular challenges because they are more complex and often less transparent. This highlights the importance of putting in place relevant internal controls and then being able to articulate to external and internal stakeholders how they are managing risks across these markets.

When a company straddles developed and rapid-growth economies, it will inherently be running multiple business models, each of which has a different risk profile. From a governance perspective, it is a real challenge for companies to provide clear and transparent information about those different business models, particularly now that disclosure requirements are much more stringent in many countries.

A lot of the governance frameworks that have been in place for years need to be reassessed. When a company enters emerging markets, it may need to manage risks that it has never encountered before or that are inherent to that particular jurisdiction. If I were a director, I’d be looking for assurance that the information flows were as best as they could be and that there were continuous efforts being made to improve them.

How do companies balance the need for greater disclosure with the desire to protect their own competitiveness?

There is a consensus in public policy circles, stemming from the financial crisis, that what we need is greater transparency. Yet everybody recognizes that lack of transparency was not the cause of the financial crisis. In fact, most of the businesses that failed were incredibly transparent. There’s nothing wrong with having more transparency but we shouldn’t be fooled into thinking that greater transparency is going to prevent another crash, because it won’t.

There is also a contradiction at play here. Policy-makers want greater disclosure and transparency. Yet, at the same time, they are asking companies to produce annual reports that are shorter, tighter and more succinct. Those pressures pose significant challenges to companies.

Obviously, policy-makers would argue that companies need to report more smartly, and most focus on disclosing the key and major risks. But the problem is that what’s a key and major risk is in the eye of the beholder. And if companies make decisions that turn out to be wrong, then there are implications for them not to have disclosed those decisions to stakeholders.

How do companies ensure that they have internal controls that are effective and embedded in the business?

There is a danger that you put policies and procedures in place, but they sit in splendid isolation and they’re not lived and breathed. If I was a CFO, I'd want to make sure that the company had an iron grip on these risks, particularly those related to the Bribery Act and the Foreign Corrupt Practices Act in the US. Even then, you can never legislate for everything, but at least you can say that you did everything that you could.

The problem with internal controls is that once you start writing rules, it is human nature to find ways around those rules. So when internal controls are too prescriptive, there is a danger that they run the risk of being circumvented or do not cover all the eventualities. That’s why assurance is so important because these controls need to be constantly monitored and updated. Good companies do this by embedding the controls within their employees’ behavior and making them part of their incentives through key performance indicators.


Colin Melvin, Chief Executive, Hermes Equity Ownership Services Ltd

As companies diversify their footprint across rapid-growth and developed markets, investors are increasingly seeking assurances that the executive team takes environmental, social and governance (ESG) issues seriously. Here, Colin Melvin, CEO of Hermes Equity Ownership Services, outlines the process for engaging with companies on ESG.

EY: What is the role of an organization like Hermes Equity Ownership Services?

Colin Melvin: At Hermes, we act on behalf of 24 pension funds and advise our clients on environmental, social and governance (ESG) issues. We recognize that many pension funds today are interested in their stewardship of the companies in which they invest. Stewardship describes the relationship between the end owner of an asset, such as a pension fund, and the company. The idea here is that the long-term shareholder as a steward has a responsibility and an opportunity in its interaction with companies to raise their long-term value through dialog.

How do you interact with companies on ESG issues?

Every year, we have between 550 and 600 engagements with companies. What we mean by engagement at Hermes is a face-to-face conversation with a senior officer or director of the company, such as the CFO. Normally what happens is that we will contact companies where we have a concern and where we think that our concerns can be addressed through that contact or engagement.

Unlike a normal investment meeting, we’re not seeking information or trading advantage in any sense. Instead, what we’re doing is challenging and supporting companies to promote their long term value. It’s not our role to second-guess strategy or micro-manage companies but where companies have a stated strategy and they seem not to be following it then that would be a concern. Alternatively, there may be something in the company’s recent past that suggests their risk management is not as effective as it could be. That would also lead us to engage.

As companies rely increasingly on rapid-growth markets as sources of revenue growth, does that change the types of issues around which you are engaging with companies?

It does to some extent. Bribery and corruption is one issue that we might need to address more frequently and that clearly affects certain companies more than others. In extractive industries, for example, it’s common for companies to have to deal with this when they have operations in difficult or sensitive territories. We’d also look for assurance that there is good-quality risk management and reporting processes in firms.

How do you gain reassurance that a company’s operations in rapid-growth markets have robust ESG procedures and performance?

We will visit companies’ operations to see how things are working on the ground as part of an engagement when we think it’s helpful to do so. Within the past year, for example, we have visited the mining operations of certain companies in South Africa, Russia and India. These types of visits are also very helpful in demonstrating our clients’ commitment as good stewards and long-term shareholders. Every month, we’re somewhere in the world testing what we hear from companies. We can’t visit the companies’ operations on every occasion and so we do need to rely heavily on interaction with senior management. But it’s important from time to time to do these deep-drill visits to verify what we’re hearing.

From a risk management perspective, what are you looking for in companies?

It would depend on the nature of the risks but we’d certainly expect effective reporting of risk management at board level. We would expect someone on the board who is accountable and responsible for risk. We would also want to see chief risk officers attending board meetings where required and reporting directly to the board. There should be documented whistle-blowing procedures within companies. If we can be satisfied that the officers of the company can describe properly the procedures, that certainly gives us some comfort.

Do you see differences in the level of ESG maturity between developed and rapid-growth markets?

The companies that tend to report best on ESG issues are those that are likely to face problems in those areas and those that are large and well resourced. It tends to be the smaller companies in developing markets with less obvious ESG challenges that are not as well prepared. But that can give rise to opportunities. Often, some of the easy wins for us are in encouraging companies towards better reporting. That said, we do find that some of the smaller companies do a really good job in reporting on ESG issues. So it’s not a strict linear relationship.


As CEO of Hermes Equity Ownership Services Ltd, Colin Melvin advises and represents pension funds and other long-term institutional investors in the areas of responsible investment and corporate governance.

Colin is an active member of several industry steering groups and committees including the Commission on Ownership in the UK and the Supervisory Board of Eumedion (the Dutch Corporate Governance Association.) He has co-founded and led various investor groups and initiatives such as the United Nations Principles for Responsible Investment (for which he was the first Chairman) and the Performance Pay Group and Socially Responsible Investment Forum in the UK. He also drafted guidelines for corporate disclosure on social, environmental and ethical matters, which have been widely adopted by the UK investment industry.

Previously, Colin was Corporate Governance Manager and Secretary to the Ethics Committee at Standard Life Investments and Head of Corporate Governance and Responsible investment at Baillie Gifford. He is also a former member of the Advisory Board to Aberforth Limited Partnership, a fund engaged in relational and active-value investing.

Colin joined Hermes in 2002 and became CEO of Hermes Equity Ownership Services in 2005. He is an associate member of the Chartered Financial Analysts Institute and the UK Society of Investment Professionals. He holds an MA from Aberdeen University and an MPhil from Cambridge University, both in History, and a Diploma in Investment Analysis from Stirling University. He is an Associate of the Centre for Corporate Governance Research of the University of Birmingham and a Non-Executive Director of Aedas, an architectural firm.

Deirdre Mahlan, CFO, Diageo Plc

The UK based consumer drinks company Diageo has been an enthusiastic investor in rapid-growth markets. By 2015, the company expects to derive half its revenues from these emerging economies. Here, Chief Financial Officer Deirdre Mahlan discusses the company’s approach to investing in these markets.

EY: How have you seen the opportunity in rapid-growth markets change over the past few years?

Deirdre Mahlan: Beginning around 2004 or 2005, we saw an important shift in these markets. At that point, we had a strong business in Scotch whisky, and we could see big opportunities in both Asia and Latin America. At the same time, we were starting to see our beer business in Africa take off. But we were still learning about consumers in these markets and assessing routes to market by importing international brands, which were very aspirational.

But then in 2008, we had the start of the financial crisis. What became obvious was that the high-growth emerging economies had reached a level of development and maturity and had fast-rising per capita incomes. These markets were still risky, but nevertheless we saw that there was going to be a sustainable level of growth coming from them. So we started thinking more fundamentally about how we were going to capture what we now see as a dominant source of growth in the sector from places outside developed markets.

The opportunities in rapid-growth markets are undeniable, but how do you ensure that you are making the right investments?

In high growth markets, local teams will identify multiple opportunities and sometimes want to invest in all of them. The challenge is therefore to insist on the appropriate level of strategic analysis to determine which opportunities are suitable.

You have to be very disciplined and insist that the markets set a period of return and stick to it. And, if they don’t deliver on those targets, then you may have to shift the strategy. In many ways it’s no different from developed markets, although it does require you to make very quick decisions and you have to be prepared to invest ahead.

In developed markets, we’ll insist that the return is fast because routes to market are established and the consumer understands the category. But in emerging markets, you’ve got to give it more time because it takes longer to know whether or not your brand investment is going to make a return. You’re effectively building equity in brands and, in some cases, educating the consumer about a new category.

To what extent do operations in developed markets fund investments in rapid-growth markets?

The developed markets, which still represent 60% of our business, have a strong return. The problem is that the growth is slower and competition is also established so you have to balance investments to ensure that they sustain a very strong leading position.

Our “premiumization” strategy in markets like North America has helped to fund our increased investment in the emerging markets. It’s therefore very important that we continue to invest appropriately in North America to continue to support that premium strategy and to drive scale benefits. We also have to manage our European business so that we’re getting the best possible, most efficient growth.

Do you need different management capabilities in developed and rapid-growth markets?

In a market like India, you have to make decisions very quickly because opportunities are only going to be available for a short period of time. So the people that you have on the ground need to be able to grasp these opportunities, and be very focused on making decisions, implementing them, and then moving on to the next thing.

In the developed markets, agility is still very important, but I would emphasize sales interactions as a key capability. These economies have brands that have been built over a long period of time. They’ve got leading positions. Very often, the difference between winning and losing in developed markets that are relatively low growth is in the execution.

Does this mean that you have to incentivize people in a different way depending on the maturity of a market?

You have to make sure that you create the right tension in your incentive plans between growth and return in each market. For example, if you incentivize a very low-growth market on net sales growth, then the danger is that you are inadvertently incentivising high levels of discounts. So you have to be very clear that you’re looking to drive returns. The emphasis should be more on margin because these businesses are at scale and we expect them to deliver scale benefits.

But in a rapid-growth market, if we incentivise only growth, there is a danger that the team will think that growth is all that matters and that it’s not important how much the margin erodes. So you have to be very clear on strategy and performance expectations. If there are additional sales, then the ratios have to stay in line.

I always start from the point that, all things being equal, teams should aim to get the same dollar of sales next year by spending less by becoming more efficient. Even in emerging markets, I expect them to deliver the base business next year more efficiently than they did this year. It’s an important discipline to deliver sustainable high-performing business.


Deirdre Mahlan is CFO at Diageo Plc; the world’s leading premium drinks business.

Deirdre has 20 years experience in the beverage alcohol industry, primarily in the US with Diageo and Seagram. In 2007 Deirdre moved to the UK to head up Tax and Treasury for Diageo and assumed the role of CFO in October 2010.

Diageo is the world's leading premium drinks business with a collection of beverage alcohol brands across spirits, beer and wine. Diageo’s products are sold in more than 180 countries around the world. The company is listed on both the New York Stock Exchange (DEO) and the London Stock Exchange (DGE).