Nowhere to hide

Private equity’s corporate governance procedures are superior to those of public companies, argues Simon Wildig of Close Brothers.

You’d have to be stranded on a desert island to have missed recent debates on the topic of corporate governance.  Opinions have been heard far and wide on the matter, heightened by collapsing share prices and the inevitable finger-pointing which followed. 

The debate rumbles on with a current focus on the fact that many fired Plc chief executives have, rightly or wrongly, received significant pay-offs, triggering less than welcome accusations of reward for failure.  In defence of these ‘golden parachutes’, it should be remembered that it is the shareholders who normally approve the executive compensation packages in the first place – so is it really fair to blame executives for simply insisting on receiving that which they are entitled to?

Not just policemen

At the heart of the problem lies the difficulty in pegging executive incentives to ‘acceptable’ measures of corporate success.  Neither growth in earnings per share, as is commonly used, nor the share price itself can be a truly objective measure of executive achievements.  An executive could be heralded (and handsomely rewarded) for attaining a significant rise in EPS but since the P&L account has become such a subjective measure of corporate performance because of the widespread inclusion of accounting estimates and provisions, growth in EPS doesn’t necessarily equate to genuine growth in shareholder value.  Indeed, it may have been achieved at the expense of all important cash generation!

Derek Higg’s attempts to improve UK business’ approach to corporate governance have been widely criticised as too unwieldy and hence roundly rejected.  Apart from anything else, NEDs and chairmen shouldn’t be encouraged to approach their roles solely as corporate policemen – surely they must add value too?  Non-Executives should be recruited according to what they can bring to the Boardroom.  A fresh perspective, commercial contacts in specific sectors, rounded experience in addressing business issues or the creation of networking opportunities.  However, if at least part of the objective of the practice of corporate governance is to improve the transparency of performance, and indeed to help improve performance itself, then the private equity model offers a sound alternative to that of the public arena.

The key to successful corporate governance in the private equity model lies in its ability to deploy two sets of individuals whose objectives are entirely aligned with those of the shareholders/investors, namely the general partners (GPs) and the NEDs. 

In the private equity industry, GPs’ rewards are driven by the performance of the portfolio companies and, most importantly, the profits which investors receive.  Whilst there has been some fair criticism of GPs earning substantial management fees whilst delivering mediocre performance, actually in most circumstances GPs will only genuinely profit as and when the LPs do – via successful portfolio exits.  Similarly, at CBPE, we go as far as we can to ensure that it’s in the interests of the serial entrepreneurs with whom we work to operate in the same manner. They are required to invest in the businesses and only profit when the investment in successfully exited.  In this context, ‘reward for failure’ does not exist. A completed exit from a private equity investment is the perfect measure of the success of those individuals involved as it’s an indication of true market value.  But importantly, no one benefits until cash is returned to the providers of the risk capital.

This cash focus is paramount in the private equity model as it drives the financial engineering which creates shareholder value and capital gains to investors.  Unfortunately, the linkage does not always operate in the same way in public company situations.  Executive and NEDs in public companies do not necessarily receive their rewards at the same time as their investors.  An institutional investor can buy and sell public shares whenever they wish and thus their objectives won’t necessarily correlate with that of the management.  In private equity, we buy shares in a portfolio company at the very same time as the management team, so achieving an ‘in it together’ approach.

Know thy NEDs

An NED in the private equity arena will be expected to attend the same monthly meetings as an NED in the public sphere and they will receive the same routine reports.  The difference between the two is that the PLC NED is not required to be directly responsible to the shareholder body, whereas NEDs on the private equity side will have a GP such as ourselves standing in-between them and the investors, both policing and adding value for the institutional investors.

NEDs at public companies are frequently appointed by the management team and this brings into question their position as independent guardians of the shareholders’ interests.  In this scenario, shareholders will usually get to approve applications but this is not enough.  They should be generating the shortlist themselves.  At CBPE we won’t consider a NED candidate unless he/she is extremely well known to us.

In fairness, comparing corporate governance procedures between private equity houses and public companies is to compare two different beasts.  There are no lone investors in the public sphere and, other than in takeover situations, you won’t find a natural crystallisation of investment such as the private equity exit.  However, as the public sphere rightly strives to implement best practice in corporate governance, it should perhaps note a few pointers from the private equity community.

If however institutional investors remain concerned that they’re not as well protected in the public sphere, they should perhaps consider increasing their private equity asset allocation as it clearly provides a more transparent model of corporate governance and, more importantly, leaves underachieving managers with nowhere to hide.  Private equity returns have outperformed public indices in both good and bad economies – the role its approach to corporate governance has played here should not be underestimated.

Simon Wildig is a partner at UK mid-market investor Close Brothers Private Equity.