Can you first tell us why Royce thinks ESG issues and proxy voting are important?

We’re bottom-up, long-term small-cap specialists in an asset class that isn’t always well understood by other investors. We’re constantly looking for ways to evolve and refine what we do to create the best outcomes for our shareholders. In this context, proxies offer us an important point of engagement with management while ESG integration has added a significant set of analytical tools that enhances the existing rigor of our investment strategies. In fact, we’ve recently developed an inhouse tracker that formalizes and better measures our engagement outcomes.

How long has ESG been a priority for the firm?

In many ways, Royce was ahead of the curve with governance, especially within small cap. Evaluating effective corporate governance has always been a crucial element in the analytical process. Owning companies with talented management teams who run their businesses with integrity is critical to successful long-term investing. And over the past year, we’ve been able to focus more on environmental and social factors as the number of disclosures in those areas has been growing rapidly. Smaller companies were initially slower to dedicate resources to sustainability reporting, but that’s beginning to change.

What’s an example where a company’s strength in ESG made it a more attractive investment?

We own an online retailer that stands out for its commitment to accountability and social factors. The firm continues to raise its internal standards on diversity and inclusion, with 56% of employees, 52% of leadership, 67% of the executive team, and 50% of the Board of Directors identifying as female or non-binary. The company’s engineering team is 38% female, compared to its peers, which average 20%.

That’s impressive from an ESG perspective—but did these factors affect the investment thesis?

In this case, the positives were definitely not limited to ESG. The company’s favorable employee satisfaction scores and resulting long-term tenures have helped it accrue a cost advantage that’s 140 basis points below its peers’ average. This business also serves a seller base that’s 87% female, with 49% of its sellers having started their business to meet a financial challenge. In terms of environmental issues, the company has both effected 100% carbon offset to all shipping related to its marketplace and signed power purchase agreements to effect 100% renewable electricity powering operations. The overall positive impact of these practices made this company an even more attractive investment for us than when we first looked into it.

Are there other issues outside ESG where you also engage companies?

Absolutely. One of the most common involves acquisitions. On the whole, we’re usually supportive when our companies take advantage of a fiscally sound opportunity to expand their market share or otherwise grow their business. But there have been less frequent instances where the proposed transaction looked like it had the potential to erode shareholder value or saddle the balance sheet with more debt than the portfolio managers thought appropriate. There have also been companies wanting to acquire businesses that from our perspective didn’t complement their own and/or that lay well outside the acquiring companies’ expertise. In these kinds of cases, the portfolio managers let the company know our views.

Do you have an example of a successful effort of engagement with a company?

We owned an international stock in the industrial distribution area where one of our portfolio managers analyzed the company’s disclosures and suggested improvements that he thought would both boost corporate performance and facilitate more effective corporate governance. A series of conversations took place that resulted in the company formulating plans for greater transparency around disclosing its financial and operating information. We see this kind of engagement as a value-enhancing exercise and encouraging greater transparency in disclosures has become a primary area of focus for engagements with our international holdings.

How does proxy voting intersect with ESG?

For every proxy we vote, we engage ISS, an independent third-party research firm. After considering the recommendation from ISS, the portfolio manager directs that any proposal be voted in a way he or she believes appropriately takes environmental and social issues into account alongside traditional financial measures to provide a more comprehensive view of the value, risk and return potential of an investment. When our portfolio managers vote on ESG proposals they also take into account the risk that companies may face significant financial, legal, and reputational risks that result from poor environmental and social practices, or negligent oversight of these same issues.

Are there significant concerns for Royce when voting proxies?

Yes—but they’re few and far between. When we do vote against management, it’s nearly always because we think the company proposes something that in our view goes against the best interests of the shareholders. These usually relate to compensation packages that we think over-emphasize short-term goals or simply look excessive.

Are there other issues that lead Royce to vote against management?

We also generally vote against what’s known as ‘over-boarding,’ that is, when a prospective board member is already sitting on several other boards. This can lead to potential conflicts of interest or a lack of the necessary attention to help the company set goals and fulfill its fiduciary responsibilities. Fortunately, these issues come up rarely, which allows us to vote with management in most cases. Much of this goes back to the scrutiny we put on management teams during the early stages of the analytical process. We want to be confident that the right people are running the companies we own. Of course, managers come and go, and conditions can change frequently, so we stay very focused on management changes for our holdings.

Can you give us an example of when Royce voted against management?

One of our portfolio managers analyzed a proxy proposal for executive compensation in a retail business we held. We performed our usual due diligence around new or revised compensation policies, including how much risk we thought it entailed, the proportion of compensation that was tied to the creation of shareholder value, and the structure and content of both the short- and long-term incentive plans. The portfolio manager initiated a dialogue about potential improvements to the plan, which the company ultimately chose not to adopt. This decision led our portfolio manager to vote against the compensation package.

How do you see Royce’s approach to integration evolving as ESG momentum grows?

Given our deep and wide small-cap domain knowledge and the relationships we’ve cultivated with thousands of companies over our nearly 50-year history, we believe we can be a leader not only in evaluating the sustainability of businesses but also in working with companies on how best to report on their activities.

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