Here we are! The idea of integrated reporting is significantly growing in France. It does not mean that numerous integrated reports will be published next year, but that most major French companies have now assimilated the idea. Most are at least pondering what it could mean for them over the next few years.
It was about time. According to the IIRC, 1,000 companies worldwide have published a report qualified “integrated”. Even though the practices remain heterogeneous and are sometimes far from the original philosophy, this number illustrates a growing interest for this new approach. Integrated reporting has already become a reality for some years in South Africa where it is recommended in the governance code. It also won its nobility title in the UK where, since October 2013, boards are requested to publish an annual “Strategic report ” which guidelines are largely inspired by the IIRC framework. And many other countries have expressed a strong interest in the concept.
The International Corporate Governance Network (formed by the world’s largest investment funds which collectively represent $26 trillion of AUM) has been interested for several years in providing shareholders with non-financial information. It clearly states in its 2014 General Governance Principles that: “The Board should provide an integrated report that puts historical performance into context and portrays the risks, opportunities and prospects for the company in the future, helping shareholders understand a company’s strategic objectives and its progress toward meeting them.”
France is still lagging behind with only a handful of so-called integrated reports published in 2015 (like Engie, Vivendi or Eurazeo PME whose reports reflect the diversity of the possible approaches). Given the importance of the non-resident shareholders in the share capital of French listed companies and especially the Anglo-Saxon funds, it is urgent to accelerate the renovation of shareholder information, catch up with the international evolution and capitalize on our companies’ growing interest in this idea.
The starting point is a very mundane and old observation: the information currently provided to investors is not always sufficient to help them take their investment decisions properly (see The KPMG Survey of business reporting, 2014). The information is too complex, accounting focused, huge, historical and technical to allow investors to answer the only critical question they have: Will the company’s management strategy contribute to creating extra value over time beyond that already embedded in the share price?
Answering this question is particularly challenging in a digital economy where value creation relies on the company’s ability to extract the greatest possible economic benefits from its ecosystem and constantly recreate an increasingly transient competitive advantage. Boundaries of companies are becoming porous and value migration from and to the environment must be identified and ideally quantified.
That is the reason why major active investors meet at least once a year with the management board of companies in which they have invested. This direct dialogue primarily focuses on medium and long-term corporate strategy and the risks and opportunities in their business models, while the review of financial results comes later, as recently identified in a KPMG / AFG study.
Listed companies must realize that aligning their share price on their intrinsic value depends on their ability to provide investors with relevant information about their short, medium and long term value creation strategy.
This is why integrated reporting (<IR>) is an important source of inspiration for CFOs and IROs. This initiative is in line with the reports and reflections of many professional organizations (ICAEW, ICAS) and institutions (IASB, FASB, FRC) about the necessary adaptation of financial information (see for example: Towards clear and concise reporting, FRC, 2014). Adopted by the IIRC in 2013, <IR> is probably the best synthesis of what should be a real strategic communication when it comes to value creation. The reason why France remains behind is because the debate has been continuously conducted on the basis of three mistakes.
The first one concerns the objective of <IR>. The subtitle of the original framework was “Communicating value in the 21st century”. The word “value” is particularly ambiguous and misleading. Some ideologists see in integrated reporting yet another argument to denounce “shareholder value”, which they depict as antithetical to the “true” value supposed to be delivered to the other stakeholders of the company. According to this black and white story, there would be on one side the good guys, concerned with the long-term viability of the company, and on the other side, the greedy short-term shareholders.
Actually, if we look at facts, we realize that this is a highly prejudiced view. Contrary to common belief, share price is indicative of the long-term value of the company. It is true that traders are primarily interested in short-term performance and influence daily prices. They constantly monitor the news flow and bet on how the market could react on short-term issues. When share prices depart too significantly from the company’s fundamental value, long-term investors show up. They invest less frequently than traders do, but when they decide to build a position after a careful due diligence review, their daily investment is 7-30 times higher than traders, and this occurs over a period of 10 to 15 days. Therefore, these sophisticated investors, whose decisions are based on long-term expectations of the quality of a company’s management and the strength of its business model, are the main driver of share prices over time.
In a liberal economy where real and financial markets perform reasonably well, shareholder value is not contradictory with “stakeholder value”. How can one think that long-term shareholder value could be maximized with unhappy clients, demotivated staff, strangled suppliers and rebelled communities? It is in the shareholders’ best interest to satisfy these stakeholders enough to get their by-in and ensure future expected returns.
The second mistake, less ideological but equally pernicious, is to conceive <IR> as a merger between the sustainability report and the financial report. For sustainability proponents it is a long time awaited legitimization of the CSR function that has always struggled to find its place within the company. This idea of merged document builds on the previously mentioned idea that the “true” value is not shareholder value and that more relevant indicators of essentially non-financial nature should be developed and communicated. This approach reflects a misunderstanding of the mechanisms of value creation. Long-term financial value is based on a complex mix of tangible and intangible resources of the company properly allocated to support its strategic vision. It depends on the positioning of the company in a moving and easily disrupted business web, with risks as well as opportunities. It is this complex mechanism that should be presented to the market in a synthetic and convincing manner and with an understandable language. The question is not to promote classical CSR’s indicators, which for the most part have no real relationship with shareholder value, but to identify soft information representative of financial value creation, alongside hard information.
The third misconception is based on the belief that a standardized approach should be put into place. It is an illusion. Indeed, value creation comes from the company’s transient competitive advantages, which are by definition unique. How can uniqueness be standardized? An assurance given by an independent auditor could be considered, but it would remain limited to the few key indicators that the company decides to reveal to the market. The IIRC framework is an inspiration for companies. It should not be a corset. At most, a “comply or explain” logic could be implemented.
These three misunderstandings must be dissipated in order to give way to a more positive and realistic view of the integrated report. Companies must realize that this report is intended primarily for investors and meets an essential need in terms of financial market information. They must understand that this is a matter of investors relations, not sustainable development. The objective is to create and promote a more rigorous “equity story”.
Still skeptical? Consider the benefits of integrated reporting which are beginning to be fairly well documented.
First, it favors the alignment of the fundamental value and the share price. The first studies carried out show that its adoption by a company changes its shareholders’ ecology: a growing number of long-term investors replacing short-term investors. Hence, a greater influence is given to the fundamental component of the share price. It does not necessarily mean that its short-term volatility is reduced, but in the medium and long term, the likelihood of a gap between fundamental value and the share price is lower.
In addition, and this is a well-documented fact, information asymmetry is reduced when the weight of “soft information” is increased relative to that of the “hard information” (the latter explains only 10% of the price changes after the announcement of results). This leads to more reliable analysts’ forecasts, a reduction of opacity discount, a positive effect on the cost of capital, etc. However, a balance must be maintained between the two categories of information to give credibility to the process. Replacing hard information by soft information could create a distrust reaction in a financial community who wants to ensure that the company meets its anticipated milestones regularly.
The second category of benefits affects the business itself. Experience shows that integrated thinking (a necessary preliminary step towards integrated reporting) is not trivial. It changes the culture of a company by building bridges between the organization’s silos, identifying the relationship between non-financial performance and shareholder value and instilling the perspective of the investor in key decisions of the company. In the logic of Shared Value developed by Michael Porter, companies can also rationalize financial decisions related to their ESG strategy.
Overall, the process of strategic thinking and rigorous capital allocation decisions can be improved. This cultural change has a positive impact on shareholder value, and if properly explained to the markets, it will be increasingly integrated into the investors’ expectations.
But be careful! This approach is not as simple as it seems. First, it requires having a clear plan of how the company will create value over short, medium and long term, identifying key parameters to measure the execution progress, and setting up an organization and tools to integrate shareholder perspective in major capital allocation decisions and risk management. The aphorism created by the French poet Nicolas Boileau: “What is well understood is expressed clearly and the words to say it come easily” applies perfectly. Before communicating, companies must reach a clear consensus on their value creation strategy.
But a clear value creation project is not sufficient. The company must also develop a strong empathy towards investors who are the main targets of this communication. They must understand the mental models of their investors, which, contrary to the belief of many leaders, are not reducible to financial analysts’ views. It is through a genuine dialogue with fundamental investors that a company can understand their expectations, check its ability to meet them and decide what to do in case those expectations are far off what the company can reasonably do.
The integrated report is not an additional standard or fashion. The success of this approach requires a discipline and a mobilization of all the organization around long-term value creation. Led by the CFO, it requires the full support of the top management and should be put under the control of the Board of Directors that is ultimately responsible for the quality of information given to the market.