THE GOVERNANCE STORY IN PRIVATE EQUITY

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By Zeina Zein El Abedine


In that respect, the private equity story is worth telling. Although the business model is not flawless, as an asset class, private equity has been outperforming public markets over mid to long term investment periods. This is particularly true in times of crisis.  The intrinsic features of private equity have obvious corporate governance advantages and offer many lessons to learn and benefit from. Since breadth is one of the private equity distinctive features, the industry can understandably spread corporate governance awareness, and raise the standards in a universe of inter-locked players.  The high motivation of these very same players to align interests is another distinguishing trait of the private equity proposition and is embedded in its three constituents: fund raising, investing and managing, and exiting. Corporate governance is after all about creating incentives and controls that will ensure that managers use the firm’s resources in the interest of its owners and pursue value maximization[1]. All private equity players get to work very quickly after an acquisition, if not before its official closing, in what is known in the industry’s jargon as the 100-day-value-creation plan. This is, in part, to set the tone from the very beginning. But the other reason is that some of the changes require time. It is the luxury of the time horizon that private equity players have that gives them the confidence in their ability to implement each and every improvement they deem important, knowing that these improvements will become anchored in the culture. These efforts are recognized, with 40% of respondents of a KPMG 2013 published survey[2], giving PE managers credits for generating more than a quarter of the company’s value increase at the time of exit.


So what do most successful private equity firms and their portfolio companies do right? They understand fiduciary duties; they have stronger boards; their approach to risk management is pro-active; and they have an impact on the quality and timeliness of reporting and communication.


They understand fiduciary duties – The word fiduciary is derived from the Latin word “fides” meaning trust. In the legal and private equity context it refers to the relationship of trust linking two or more parties together. Fiduciary duties include the duty of loyalty, care and candour. The PE model is supported by a chain of checks and balances. PE managers are entrusted with the funds of investors who aim to derive economic benefits, and are entrusted by the portfolio companies to help them grow and create value. The fact that fewer investors and investee companies are part of any private equity fund, in comparison to the dispersed shareholders base of listed companies, creates a closer relationship between parties, and allows them to pay more attention to their needs. Increasingly, to give an example, private equity managers have been investing in environmental and social best practices, impacting the communities they serve. The greater attention to these matters stems from their impact on the bottom line and the ability to be more attuned with stakeholders, as referenced in the new UNPRI ESG Disclosure Framework.


They have stronger boards - In comparison to listed companies, private equity backed companies have more commanding and on average more informed boards of directors. Private equity managers have the owners’ mind-set and if they are determined to make improvements and create value in their portfolio companies, then how best to execute other than through their boards. As Peter Drucker points out: “in every single business failure of a large company in the last five decades, the board was the last to realize that things were going wrong[3]” in a reference to the correlation between disengaged boards and business failures. PE players always request board seats. Naturally, boards start hosting more vigorous debates with a higher level of contestability on key points. Many of the portfolio companies do not have appropriately functioning boards and committees prior to the private equity investment. And in cases where they had one, they are usually not as effective as the business requires them to be. In the above mentioned KPMG survey, the majority of those surveyed rated the quality of the private equity director’s involvement in the business as good or excellent and reported the top 3 qualities of a PE director to be his or her: ability to work with the board and management, strategic vision, and financial acumen.


Their approach to risk management is pro-active - Risk is pretty much universal. How organizations manage risk, however, is not. Managing risks in a logical and structured way holds numerous benefits. It supports the decision making process on an informed basis increasing the possibility of achieving the business goals and as a result creating value to stakeholders. The origin of the word RISK goes back to the 16th and 17th centuries, when western explorers left their homes and sailed into unfamiliar waters. In some dictionaries, it was a metaphor for “difficulty to avoid in the sea”.  It is this notion of navigating into the unknown in particular that private equity managers have a very low tolerance for. The process of identifying risks starts as early as the investment screening and the due diligence stages. The due diligence process is a well-thought thorough process. It aims to identify early on the risks associated with a potential investment. A systematic approach building on the fund’s pre-defined risk appetite investigates the different risk categories, covering financial, technical, governance, operational, all the way to legal. Many of the risks are controlled prior to the deal execution and are set as conditions precedents.  Beyond the investment stage, the board maintains a focused approach to risk management and mitigation.


Their drive improvements in the quality and timeliness of reporting and communication – What cannot be measured cannot be managed. Improving the quality and timeliness of reporting comes hand in hand with the better instituted boards, introduction of audit committees and discussions on internal and external auditors. Private equity backed companies have an advantage over listed companies whose leaders having to answer to many investors, may lose focus. Not having these distractions and the pressure of quarterly reporting allow portfolio companies to focus on the agreed objectives and to measure progress on these objectives.


The private equity model is not flawless. Not all deals within the PE ecosystem turn out to be successes. Studying the model however offers insights how corporate governance makes good business sense and how in a non-regulated sector, good practices where voluntarily adopted and promoted. In emerging markets, as private equity evolves, it develop and brings along more informed, sophisticated and responsible investors. It also impacts family organizations and small and medium enterprises which when they start competing for PE managers’ attention, they are more aware that better governed organizations are the attractive targets that make it to the radar, and start putting their house in order accordingly. Alternatively, If you are the owner of a company and want to instigate improvements, ask yourself, what would a private equity fund manager do in the case of my organization?










[1] Private Equity and Corporate Governance: Retrospect and Prospect. Mike Wright*, Kevin Amess, Charlie Weir and Sourafel Girma. https://www.hse.ru/data/984/481/1225/Oct%2021%20Private%20Equity.pdf






[2] Working with Private Equity Portfolio Companies https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/private-equity-portfolio-value/Documents/working-with-private-equity-v1.pdf



[3] Peter Drucker, Managing for the Future




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