In this piece, we explain some of the specific considerations which relate to stewardship in a small and mid-cap company context. By doing so, we hope to illustrate the breadth of the issues we consider when researching and engaging with our companies, as well as the depth of the ESG integration within our investment process. We give a range of company examples. Where possible, we have provided the name of the company. Where the engagement is ongoing, or where we engaged on specific issues and concluded that there were no concerns, we have not named the companies involved.
Our approach to responsible investment is fully aligned with Jupiter’s Responsible Investment Policy, which you can read here.
Small and mid-cap companies represent 91% of all companies quoted on the London Stock Exchange, providing a huge and varied universe of potential investment opportunities. Employing over two million people, the contribution of UK small and mid-caps in terms of economic output and tax take is significant.1
As a team, we invest across the spectrum of small and mid-cap companies, employing both long only, directional long/short and market neutral strategies. We also act as the Investment Adviser to Chrysalis Investments, which invests in late-stage, pre-IPO private businesses, typically as a minority investor with board representation.
These different approaches provide our clients with different risk and return parameters. They also present us with different stewardship transmission mechanisms, and we tailor our approach accordingly.
The above diagram illustrates our approach. In our view, the most powerful influence channel open to us is the provision of primary capital to entrepreneurs, where we can have a direct impact on which companies have access to capital. We therefore prioritise in-depth due diligence on ESG factors when considering potential private investments and IPOs. Where we have a board seat or board observer status, we use our influence with the objective of ensuring that private portfolio companies are managed sustainably.
Stewardship is the next strongest influence channel available to us. As one of the largest investors in UK SMID (small, mid-cap) listed companies, we believe we can evidence the influential role we play in how these companies are run. This includes both our own stewardship efforts but also collective engagement which, while less common among smaller companies than in large caps, is an important escalation route available to us.
Capital allocation in secondary markets is the key to our ability to deliver risk-adjusted returns for clients in our listed UK equity strategy. However, because listed companies in secondary markets already have access to capital, our decision to invest (or exclude) companies is, in our view, a weaker mechanism to effect change on investee companies than stewardship. Our ESG analysis in listed equity markets is therefore focused primarily on identifying risks and opportunities which influence our expected returns. However, as part of our analysis we seek to identify engagement opportunities by which we may be able to improve a company’s fundamental value over our investment time horizon.
Short positions, which are executed via derivatives with no voting or engagement rights, represent the weakest influence channel available to us. Our ESG focus is therefore purely related to managing risk and delivering returns, in the context of portfolio construction.
Transmission mechanisms: How we exert influence
The purpose of public equity markets has long been a matter of debate, but at their core, we believe that equity markets are a means to provide equity capital to entrepreneurs with which to grow their businesses, in exchange for a risk-adjusted return on that capital.
This purpose is often most evident among smaller companies, including those considering an IPO. One of the biggest opportunities for investors to generate returns in our asset class is by spotting companies creating long-term value early in their development, then staying invested as they continue to grow.
We firmly believe that in order to grow successfully, companies and their founders must not only execute strategically; they must also lay the foundations for future growth by fostering a healthy corporate culture, a talented and diverse workforce and creating appropriate corporate governance structures. They must also seek to minimise any direct and indirect negative impact on the environment and broader society.
On the flip side, the history of stock markets is littered with companies which failed to live up to expectations, often after promoters made promises on which they could not deliver. The unproven nature of many newly-listed businesses, and their relative lack of analyst coverage, represent both the challenge and opportunity of being a small and mid-cap investor.
To us, then, as active fundamental equity investors, ESG analysis is a core aspect not only of identifying companies with a route to sustained and profitable growth, but also establishing whether management’s claims about their business withstand scrutiny, and whether they have the ability to execute. For this reason, ESG analysis is a core aspect of our due diligence process, one which we do not believe can be effectively outsourced to third parties.2
As broad market investors in UK small and mid-cap companies, we do not claim that ESG factors will lead certain sectors or types of thematic exposure to outperform others over specific time periods. At the stock-specific level, however, we do observe that ESG factors can be a critical determinant of returns. As fundamental active investors, our job is to analyse these factors at the company level and use judgement to determine our view of their materiality to an investment case.
In our view, a company’s exposure to and management of ESG factors is often an indicator of the quality of a business. However, as investors we must always ask ourselves ‘what’s in the price’? Material ESG risks may already fully reflected in a low valuation, or we may come to the view that investor perceptions are overly bearish and that the company has the capacity for positive change. We always try to consider ESG alongside traditional bottom-up stock selection tools, of which valuation is often the most important.
For us, then, a more meaningful way to assess governance is to consider the point a company has reached in its post-IPO development, and whether we believe management are aligned with the interests of minority shareholders. Shareholders in public companies rely on boards to oversee the business. Appointing high-quality non-executive directors with the ability to challenge management and bring diverse perspectives is critical to the long-term success of any business.
Within our portfolios, Wise and Auction Technology Group are two examples of recently listed companies which have continued to strengthen their corporate governance since IPO. Both companies are founder-led, technology businesses, but each has appointed experienced, independent board chairs who know what is required to succeed in the public markets.
In our view, the best way to assess the quality of non-executive directors is to meet them. We regularly meet the chairs of our core holdings, a process which is not only informative but also opens a channel for dialogue in situations where a change of approach is needed.
We are shareholders in this AIM-traded company whose principal business focus is the recovery of metals from historical mine waste material and tailings. In our view, this fast-growing and profitable business has significant opportunities to deliver positive sustainability outcomes by recovering metals needed to enable the energy transition with lower environmental impact than new mining projects, and by rehabilitating environmentally hazardous tailings sites in Sub-Saharan Africa.
Since December 2021 we have been engaging with management with the goal of ensuring that the company’s corporate governance arrangements keep pace with its growth. Specifically, the company’s Board reflected its entrepreneurial history and lacked independence and diversity. We encouraged the company to address this and were pleased when the company subsequently announced the appointment of its first independent Chairman, a highly experienced former mining executive, in June 2022.
Given the nature of its operations, the group has a range of direct environmental and social impacts which it must manage effectively. We noted that the group’s ESG disclosure framework was at a nascent stage of development and encouraged the company to provide sufficient transparency for investors to gain confidence in its status as a sustainable mining company. The company subsequently appointed the former Group Head of Sustainable Development at Anglo American plc as an independent director and chair of a newly created Safety and Sustainability Committee. She is also the group’s first female director. The group’s ESG disclosure framework has significantly improved. We are pleased with the company’s development, remain invested and continue to monitor progress.
Corporate culture, human capital & diversity
Corporate culture is among the most important considerations for any investment case. It’s also one of the hardest to analyse. Bad culture reduces operational efficiency, weakens the alignment between a business and its stakeholders and increases forecast risk. Culture is even more important in regulated industries, where cultural failures have often proved disastrous for shareholders in the past.
We use a variety of information sources to form a view, accepting that we will never have an insider’s perspective on culture. Sources open to us include the tone of management commentary, social networks like Glassdoor and LinkedIn, interviews with former employees, customer service reviews and site visits.
The world operates in a variety of shades of grey, not black and white. Ultimately, our views on culture are often integrated via position sizing, risk control and valuation, rather than a definitive list of ‘good’ and ‘bad’ companies. Intrinsically linked to good corporate culture, human capital management supports both value creation and business resilience. We believe that investing in human capital is often correlated with longer-term business success, particularly in an inflationary environment where competition for talent is fierce.
Unlike culture, elements of good human capital management can be measured. A particular focus of our dialogue with companies in 2022 was understanding the steps being taken to attract and retain a highly skilled and diverse workforce. Creating an inclusive culture helps companies to attract talent from a wider pool. We would argue there is a strong correlation between gender and ethnic diversity and good corporate culture. Assessing diversity and pay equity has been a core area of our activity .
Culture & human capital case study 1: Fintech portfolio company
Our engagement took two forms: a series of interviews with former employees arranged via an expert network service, and a site visit to the group’s head office. Prior to these engagements, we also reviewed employee reviews on Glassdoor to get an insight into how past and present employees rated the company. The ex-employee feedback provided useful colour but did not indicate specific evidence of cultural issues at the group. During our site visit we met the CEO, who emphasised his own long-term outlook as the group’s largest shareholder, and interviewed members of the company’s in-house recruitment team. Our conversation covered the wide range of channels the team use to recruit team members from outside the industry, how the group trains and integrates new recruits and the continued challenge of building a gender and ethnically diverse workforce.
While we recognise that engagements of this type can only provide glimpses into the inner workings of a business, it is very important to test our assumptions periodically in this manner. We came away reassured by the engagement and remain invested in the group, which continued to execute strongly over 2022.
Culture & human capital case study 2: SAAS (software) portfolio company
Culture & human capital case study 3: Gamma Communications
As companies grow, executive pay levels tend to increase as Remuneration Committees benchmark themselves against larger listed peers. While we recognise this market reality, it’s very important that boards retain a sense of proportion and don’t allow themselves to be held to ransom by executives.
During 2022, two of the best executives in our portfolios, the CEOs of Future and RS Group, announced their departures, and the impact on the share price was significant in both cases. Both boards made efforts to retain them, drawing up remuneration packages which were approved by shareholders, including ourselves. Ultimately, the rewards on offer were not enough. Both directors had served for over seven years, and arguably this illustrates the toll leading a listed business takes on even the best CEOs.
The two case studies below illustrate our approach to remuneration, and how we try to strike a balance between retention, proportionality and pay for performance.
Remuneration case study 1: Trainline
Remuneration case study 2: Boohoo
We voted against the remuneration report due to our concerns regarding the use of upward discretion to FY22 bonus outcomes for executives from a shareholder alignment perspective, given the disappointing share price and operating performance during the year. We are no longer invested in the company.
Audit and control environment
As well as hiring effective independent auditors, it’s also important that fast-growing smaller companies invest appropriately in their internal finance function to maintain clear visibility on group performance, particularly when engaging in mergers and acquisitions.
We are currently engaging with the audit committee chair of one portfolio company where we identified issues with elements of the financial reporting framework, with the objective of ensuring that the audit framework is enhanced. The trigger for our engagement was the appointment of a new auditor from outside the ‘Big Four’ accountancy practices, along with a significant year-on-year increase in audit fees.
To assist our engagement, we sought clarification from an independent accounting expert on points of detail regarding the group audit. The audit committee chair has since set out an enhanced scope of audit to be undertaken by the new audit partner during the financial year.
An example of the risks supply chains can pose is Boohoo, a former holding. In 2020 a national newspaper published allegations of poor working conditions in factories operated by the company’s local UK suppliers. This had a material impact on the company’s share price. The company subsequently commissioned an independent review into the issues, which highlighted significant flaws in its approach to supplier due diligence and made a range of recommendations to improve its practices and oversight.
We engaged with the company consistently on these issues between 2020-2022. Further details about the engagement can be found in Jupiter’s Stewardship Reports for these years. In our view, clear progress and substantive change was evident in the final independent report on the company’s practices by the time we exited our position in 2022.
Where we identify potential material issues in a company’s supply chain, we consider their supplier due diligence policies and use engagement to understand the quality of oversight they exert. It is vital that companies use their purchasing power responsibly and take steps to encourage suppliers to build environmental and social sustainability into their business practices.
The following case studies provide examples of our approach to supply chain due diligence on four material ESG issues: human rights, forest biodiversity, climate change and marine biodiversity. Few companies can rule out possible supply chain issues with absolute certainty, which is why continued vigilance and oversight is needed.
Marine biodiversity case study: Restaurant chain
We submitted a list of questions on these topics to the company, exploring areas including the supplier oversight framework and whether key performance indicators had been established around sustainable seafood sourcing. The company provided written responses and a call was subsequently arranged with the CEO to discuss the group’s strategy in these areas in detail. Following the call, we were satisfied that the group’s oversight and due diligence framework for its franchisee workforce was robust. We also concluded that its sustainable marine sourcing strategy was already at a high standard and, if the group’s targets were met, had the capacity to market leading. In our view, its management of both issues was sufficiently well-developed to pass the scrutiny that would accompany any flotation. The group met our investment criteria, however the IPO was subsequently postponed.
During a follow-up call, the company confirmed that a probe by Mexican authorities had been reviewed during its due diligence process. The acquisition target had previously conducted several internal investigations, including a probe by an external law firm, into the issue, following previous allegations of malpractice in its supply chain. These investigations did not uncover any evidence of inappropriate conduct or criminality and there had been no subsequent dialogue with the Mexican authorities.
We considered the proposed equity placing in light of these facts and subsequently decided to participate. Our decision was influenced by the following factors:
- Neither company’s due diligence had uncovered evidence of irregularities in the supply chain
- The assets were being acquired from a US listed multinational company, providing a degree of comfort regarding the management of these issues
- There had been no further follow up by the authorities
- The local assets were a small unit within the acquired business, with only marginal contributions to group revenue and profit
Since the acquisition was completed, no further media reports regarding the alleged supply chain issues have been identified. Our due diligence process helped us to establish that it was appropriate for us to provide equity financing for the transaction.
in Q2 2022, we arranged a call with Drax’s Head of Sustainability to gain insight into biomass sourcing policies and practices and how the group manages biodiversity and sustainable forestry. We subsequently wrote to the Chairman encouraging the company to go further in playing an influence role in improving forestry practices in the Canadian province of British Columbia (BC), and to develop a biodiversity strategy, informed by science, with a goal of preserving and enhancing biodiversity within the regions in which it operates.
In October 2022, Drax faced further scrutiny following a BBC Panorama documentary about its sourcing practices in BC. Enviva, a supplier of Drax UK and the largest global biomass producer, also faced similar allegations about its sourcing practices. These reports renewed a debate about the role of biomass as a source of renewable energy. Drax has maintained that all the practices reported in Panorama are consistent with BC forestry standards and its own sourcing policies.
The UK SMID Team exited our position in Drax in Q4 2022. The decision was influenced by the UK Government’s decision to impose a windfall tax on electricity generators, as well as our view on the increased likelihood of an adverse policy response following the media reports described above. We believe that biomass, when sourced from waste material such as sawmill residues, managed forests or reforested areas, has a role in the energy mix as a source of renewable energy. Since we wrote to the Board, Drax have set themselves a target to attain nature-positive status by 2027. This means they will have to demonstrate that they are enhancing and improving nature in the areas that they operate through increasing the health, abundance, and resilience of species. We view this as a positive outcome of our engagement.
Please note: Holding examples are for illustrative purposes only and are not a recommendation to buy or sell.
2 In any case, third-party data can only provide limited assistance, given that less than half of the issuers in the Numis Smaller Companies Index have an ESG rating (Source: Aladdin, 46% of index constituents at 31 December 2022 rated by at least one of Sustainalytics, Clarity AI, Refinitiv or ISS.).
The value of active minds – independent thinking
A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.