CLLNY - ClearBridge ESG Investment Q4 2022 Portfolio Manager Commentary

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Governance engagements offer insights on the kinds of impact ClearBridge’s approach to active ownership can have on and through public equities.
• Capital allocation is a major governance topic that can involve difficult tradeoffs for companies as they balance the interests of shareholders and other company stakeholders, such as employees and customers.
• Governance provides a direct link to developing strong sustainability practices at a company, for example through the establishment of a corporate sustainability function that collaborates with the core business functions.

By Marshall Gordon | Mary Jane McQuillen | Todor Petrov

Governance Changes Can Move the Needle

As one breaks down the components of ESG, governance comes last in the set, but it is often the first and most foundational element for active investors seeking to improve sustainability practices at companies in which they invest. Overall corporate structure, board composition and business ethics are central in creating long-term value. At the same time, in terms of effecting real change, as the World Economic Forum notes, "effective corporate governance is essential to ensuring that ESG enthusiasm translates into concrete action and systemic change." ¹ Many companies also view incorporating ESG factors into corporate strategy as tied to revenue growth and resilience to increasing ESG risks (Exhibit 1).

Exhibit 1: ESG Factors Can Be Key to Corporate Strategy

ClearBridge regularly engages holdings on governance factors such as resource allocation and board composition and oversight in order to lay the foundation for long-term value creation and sustainability improvements. Other topics include audit controls, board effectiveness, capital allocation practices, executive compensation, operating best practices, quality and integrity of management and shareholder rights and controls. Like engagements targeting environmental and social improvements, governance engagements can take place over extended periods of time and involve other stakeholder voices. They too offer insights on the kinds of impact ClearBridge's approach to active ownership can have on and through public equities.

Governance questions are also thoroughly integrated into how ClearBridge votes proxies and builds proprietary ESG ratings. In terms of proxies, our policy is to vote for management proposals supporting nomination of most qualified candidates, inclusive of a diverse pool of women and people of color, to the board of directors and senior management levels. However, ClearBridge will withhold our vote from a director nominee on the nominating committee when there is no gender diversity and no racial/ethnic diversity ² on the board (or those currently proposed for election to the board do not meet that criterion). We will vote for shareholder proposals requesting comprehensive disclosure on board and employee diversity and those requesting comprehensive reports on gender and racial pay disparity.

It is also our policy to vote against proposals to create dual share classes unless it is intended for financing purposes with minimal or no dilution to current shareholders and provided it is not designed to preserve the voting power of an insider or significant shareholder.

For management proposals on executive compensation, when management and an external service provider disagree, our policy is to take into account: company performance over the last one-, three- and five-year periods on a total shareholder return basis; performance metrics for short- and long-term incentive programs; and CEO pay relative to company performance, among other factors. Increasingly, we are asking our companies to include ESG performance factors such as environmental and safety goals or diversity, equity and inclusion in CEO and named executive officers' compensation.

We also have governance factors such as those listed above built in to all proprietary ClearBridge ESG ratings for companies owned and under active coverage. Along the same lines, governance is an important part of our determination of sustainable investments under Europe's Sustainable Finance Disclosure Regulation. ClearBridge's own governance of climate-related risks and opportunities also features prominently in our TCFD Climate Report.

Cellnex Hears Shareholder Voices on Capital Allocation

Engaging a company on strategy can sometimes lead to concrete changes. Capital allocation, for example, is a fundamental corporate governance consideration. It is directly relevant to the interests of shareholders, stakeholders and a company's long-term success. Capital allocation is closely connected to questions of company purpose, strategy, business model, risk appetite and public disclosures - and, ultimately, to a company's ability to generate sustainable returns. Key capital allocation themes could include the use of debt leverage, the appropriateness of dividend policy and share buybacks, the level of capital spending and executive pay structures - all areas that can involve difficult tradeoffs that balance the interests of shareholders and other company stakeholders, such as employees and customers. ³

In an October 2022 engagement with Spanish wireless telecom company and ClearBridge portfolio holding Cellnex ( CLNXF ) ( CLLNY ), we encouraged the company to embrace a fiscally responsible strategy in order to protect the business in a high interest rate environment. In a proactive dialogue with Cellnex management on governance and shareholder feedback, we conveyed our recommendations for a necessary shift in capital allocation and strategic priorities. We insisted that: 1) shareholders and bondholders are unwilling to provide capital for large acquisitions, which increase leverage and uncertainty; 2) Cellnex should commit to obtain an investment grade credit rating, which will limit cost of capital increases; 3) management should focus on refinancing debt maturities immediately to avoid liquidity drying up next year; 4) focus on the balance sheet debt leverage should take priority over dividends and share buybacks.

Cellnex's response during the meeting was thoughtful and receptive. The CFO expressed the company's fiduciary responsibility to allocate capital only in a way that enhances shareholder value and stressed the importance of growing alongside its telecom customers, building its networks and investing in projects that save customers money and provide good returns for Cellnex at the same time. He provided updates about financial and refinancing risk management, including: 1) inflation indexation of lease contracts that accelerates earnings in an inflationary environment; 2) $3 billion of available undrawn credit lines that are enough to refinance debt maturities in 2023 and 2024, before free cash flow turns positive from 2025 onward, supporting the refinancing of large maturities in 2026; 3) options to sell assets as a measure of last resort.

In a follow-up call in November, Cellnex announced it would make all the strategic changes we asked it to consider. The CFO acknowledged the current environment provides new factors to take into consideration in Cellnex's decision process, and said the company is listening to the market. He shared Cellnex's new unconditional commitment to an investment grade rating. This would include a commitment to 2025 financial guidance, a clear capital allocation framework with conservative assumptions, a focus on organic growth with limited capex and high-return projects, limited M&A activity, and a focus on free cash flow, with excess cash deployed in the best interest of maximum long-term shareholder value. The company now expects free cash flow will exceed debt maturities after 2024.

This ESG engagement was a successful example of an impactful dialogue with management, where concrete results were achieved and real shareholder value was created. ClearBridge was just one voice contributing to the realignment of the company's strategy, but it was encouraging to witness an overhaul of management priorities that fully matched our clearly communicated recommendations.

Cellnex's ability and willingness to adapt reduced business and financial risk and significantly lowered the likelihood of a large downside to the share price. This brought a significant positive change in our investment thesis, as we were able to incorporate a lower-risk outlook for the company and lift our price target. For example, as a result of the changes, Cellnex bond spreads improved by 180 basis points to 280 basis points, while its 10-year bond yield declined from 6.6% to 5.1% within a span of roughly three weeks, lowering Cellnex's cost of capital.

Governance Can Strengthen Overall Corporate Sustainability

Governance also provides a direct link to developing strong sustainability practices at a company. Managed care company and ClearBridge holding UnitedHealth Group ( UNH ), for example, has been making important governance changes in response to investor feedback, with sustainability a growing priority. The company has historically faced criticism, from ClearBridge and other investors, for the long tenure of its board of directors. In response, it has turned over seven board seats in the past five years and split the chairman and CEO roles.

A related change is that, as sustainability has increased in importance, UnitedHealth has revamped and elevated board oversight of ESG. Now the Governance Committee of the board is charged with oversight of UnitedHealth's ESG initiatives and progress. The company also appointed a corporate Chief Sustainability Officer who is part of the office of the CEO, reports directly to the CEO and attends and presents at each Governance Committee meeting.

Part of UnitedHealth's existing strong ESG profile has been a focus on "health equity" as it seeks to raise the standard of care in underserved communities in the U.S. This focus includes screening Medicare members for basic social needs such as nutrition and housing, establishing local pharmacies, improving mortality and life expectancy for African Americans, especially women, and addressing mental/behavioral health, with a heightened focus on teenagers. UnitedHealth has also made a $100 million commitment to improving the diversity of the U.S. healthcare workforce and to enhance what it views as "culturally competent care." It expects to train 5,000 new minority clinicians and provide "upskilling" for an additional 5,000.

Another recent governance change at UnitedHealth has been the placement of its healthcare equity goals, in addition to its clinical policy, under the oversight of the board's Health and Clinical Practices Policy Committee. Also, the Audit Committee will review the quality and accuracy of all ESG disclosures.

Overall, the establishment of a corporate sustainability function that collaborates with the core business functions represents important progress on sustainability at UnitedHealth over the past year and is a good example of how the voice of ClearBridge and others calling for governance improvements can help improve sustainability practices as well.

Marshall Gordon, Senior Analyst - Health Care

Mary Jane McQuillen, Head of ESG, Portfolio Manager

Todor Petrov, Senior Portfolio Analyst

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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