ESG Review 2024

Fairlight focuses on building a portfolio of high-quality businesses purchased with valuation discipline, supporting our objective of delivering superior investment returns to clients. A core belief is that Environmental, Social and Governance (ESG) issues directly impact company performance and thus portfolio returns. We have found that, over the long term, ESG leaders are more likely to sustain above-average returns on capital while helping to minimise risk.

In our inaugural Annual ESG Review for the year 2023, we explained how ESG issues are considered at each stage of Fairlight’s research process and discussed our software investment to develop a system to better record, organise and track the progress of ESG activities. Leveraging this investment, the 2024 review discusses Fairlight’s engagement with portfolio companies on ESG matters, the voting of proxies and how the outcome of these efforts impacted our valuation estimates. Going forward, we plan to provide a similar review on a yearly basis.

ESG engagement

In 2024, Fairlight recorded 19 formal engagements, of which 84% were linked to governance topics (Figure 1). This high percentage is mostly explained by Fairlight’s focus on businesses with long histories of generating high returns on capital, which tend to be both ‘asset-light’ and competitively advantaged. Usually these advantages are ‘intangibles’ linked to superior know-how and/or corporate culture. These capital light characteristics typically limit negative direct impacts on the environment and often have strong positive social impacts across the communities where these businesses operate.

Figure 1.

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Governance focus

When it comes to governance, Fairlight’s main goal is to ensure that the interests of minority shareholders are considered by the management of our investee companies when making important decisions.

This mainly involves analysing:

• Board structures and executive remuneration plans;

• capital allocation policies and decisions; and the

• quality of disclosure.

Subsequent to this, we may provide management with feedback.

Given Fairlight’s preference for investing in businesses run by management teams with established track records, this feedback is usually positive. Nevertheless, when we believe that governance could be improved, we voice our concerns and suggest enhancements.

Equity compensation

An area where we have been particularly engaged, both historically and in 2024, has been that of equity-based compensation. As discussed in December 2024, striking the right balance between creating long-term shareholder value and retaining high-performing executives is paramount when evaluating these plans.

Our preferences for effective equity-based compensation structures are as follows:

• Avoid share price-based metrics: Incentives based on share prices can encourage management teams to become overly promotional in order to drive short-term share price appreciation versus making decisions which prioritise long-term value creation.

• Prefer returns on capital: Fairlight prefers compensation plans skewed towards return on capital metrics versus earnings metrics like EPS growth which can be boosted artificially by rushed and poor-quality acquisitions.

• Maintain a long-term focus: While it is important to remunerate talent for outstanding performance in any given year with cash-based bonuses, we prefer plans where remuneration is skewed towards long-term equity awards.

Capital allocation

Most of our investment companies generate significant amounts of free cashflow and so capital allocation decisions such as mergers and acquisitions, buybacks and dividends have the potential to impact the success of our investments significantly. Changes to our Nordson and Bechtle investments in 2024 were made in response to capital allocation considerations.

As discussed in September 2024, after several years of rewarding ownership we decided to sell our investment in niche-manufacturer Nordson on the back of a series of acquisitions which were both larger and more expensive than what we would have liked. While management provided solid arguments for why these acquisitions will support Nordson’s long-term strategy of value-creation, given the abundance of attractive investment options residing on our investment bench, we decided to sell Nordson and reallocate the proceeds to lower risk opportunities.

Earlier in the year, we communicated to the management of Bechtle, Germany’s leading IT reseller, our dissatisfaction about their decision to issue convertible debt. The potential equity dilution was limited at 4% but given Bechtle’s minimal existing debt, improving cash conversion and ability to borrow from banks at relatively low rates, we believed that straight debt financing would have been a far better choice.

Management indicated no desire for further issuances of that type and took our feedback, along with that of other shareholders, as an opportunity to reassess future financing decisions. While this response was pleasing, we lowered the company’s quality score for capital allocation which impacted our valuation estimate and helped to trigger a partial sale of our investment over the following months.

Improving disclosure

Fairlight generally views public companies that are led by owner-managers or their families favourably, as these key decision makers are naturally incentivised to perform at their best, minimise risks and think longer-term by virtue of their sizeable personal wealth tied to the business. However, high family ownership often comes with less formalised disclosure frameworks. Encouragingly, though, change is possible through ongoing engagement.

A case in point is IT-consultancy Reply. Mario Rizzante launched the company in 1996 to help large Italian corporations embrace new technologies. Since then, Reply has grown sales at an impressive annual rate of almost 20% while maintaining an operating margin of at least 10%. Today, Rizzante and his family remain the main shareholders and are heavily involved in running the business.

The Fairlight Fund has been a shareholder in Reply for more than four years and members of the team have travelled to Italy yearly to meet with management. While we have been vocal supporters of the company’s effective corporate culture and stellar financial performance, we have also been advocating for an improvement in the company’s disclosure. We believe this ongoing dialogue has contributed to the company’s recent willingness to improve disclosure and engage more openly with investors. For example, late last year, Reply hosted its first earnings call for analysts since listing in 2000.

2024 voting activity

The voting of our proxies is another important avenue for Fairlight to provide feedback to management about ESG matters.

We generally vote in line with the recommendations provided by proxy-advisory firm ISS and spend little time reviewing ‘routine’ agenda items. Most of our time, instead, is spent on better understanding items where ISS identified ESG risk and recommended to vote against management recommendations.

In 2024 we voted on 520 items, voting against on 28 occasions, or 5% of the time (Table 1). This was broadly in line with our 2023 statistics. There were no instances where we voted differently from ISS, while in 2023 that happened 3 times.

Against votes clustered around poor compensation policies and the re-election of specific directors. These ‘protest votes’ were mostly linked to:

• Subpar compensation plans;

• the re-election of directors who in the past were members of the remuneration committees of companies with subpar compensation plans; and the

• election of non-independent directors to audit/supervisory committees.

Table 1. 2024 Proxy voting statistics

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The Fairlight View

Fairlight’s focus on quality businesses means that the Fund’s investments score well compared to the average company in the SMID index^* when it comes to ESG considerations. Nevertheless, the team is committed to active ownership and, where possible, to help portfolio companies improve their ESG leadership. We believe that this approach supports our commitment to build a portfolio of businesses which can outperform over the long-term while minimising overall risk.

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^{*MSCI World SMID Cap Index}