Despite the fact that most private equity investors hold themselves out as governance experts – introducing superior incentivisation models to portfolio companies that drive value creation – governance models at the private equity firms themselves are often poorly developed.
Such governance gaps may not prove too damaging in economically vibrant periods when everything is going well, while founder teams are in place and providing entrepreneurial leadership centred around growth and purpose. But they can be seriously exposed in times of economic dislocation and organisational stress, particularly when there are founder transitions or other major changes.
Virtually all founders and leaders in PE will articulate an apparent understanding of the importance of team-based approaches to leadership and governance founded in a desire to build high-quality groups of peers with different backgrounds and experience bases, and with the professional and personal maturity to provide robust challenge and debate. But the reality will often look very different.
This is step one in effective governance: migrating beyond the “partnership in name only”, where the founder/managing partner has built a group of “partners” around him or her, but where the title “partner” belies a subordinate relationship. This role has little sense of ownership, provides limited challenge and has a sense of deference to the leader. Decision-making is concentrated in the managing partner.
The goal here should be to achieve a “true partnership” where the managing partner has the confidence to surround him or herself with true peer partners with the maturity to share leadership, provide robust challenge and to dissent where necessary.
This means, ideally, close collaboration across a partnership of peers with different, yet complementary, areas of professional experience, gender, and where possible and relevant, national and cultural backgrounds. Importantly, all partners will signal their alignment and engagement as true partners by jointly putting capital at risk alongside their third-party investor LPs. In other words, the “GP commitment” or GP investment alongside LPs will be meaningful to each partner and funded to as large an extent as possible, pro-rata, in cash. Economic arrangements should be structured to support and signal the partnership intent.
However, achieving effective governance goes beyond the creation of a true partnership. More forward-thinking PE firms are at inception, or at least in the early years of their existence, putting in place structures to deal with issues attached to the evolution of their firms over time to ensure that they have a chance to grow and succeed beyond the active timeframes of their founders. This is not simply an issue of ensuring long-term opportunities for others who are contemplating careers within such firms, but is critical to ensure appropriate ongoing stewardship of investee companies and assets where holding periods can extend over many years. Such elongated hold periods also highlight another element of forward-thinking governance – that of active and broad stakeholder management, versus the narrower traditional PE firm focus largely around limited partner investors and firm principals.
Important elements of governance
There are three broad elements that are important to governance arrangements that will stand the test of time.
First, such structures should include independent boards with clear remits to provide counsel, provide appropriate checks and balances and resolve zero-sum issues. Such boards will benefit from diversity of background and experience and will be comprised of professionals that are sufficiently senior, independent of mind and long term in their thinking to balance the necessary operational orientation of the executive team.
Additionally, such boards will provide balance to the often strong entrepreneurial single-minded decision making that tends to come with successful firm founders, whose professional identity is otherwise inextricably linked to the firm itself.
Second, they will also include well-thought-through and formally-documented partnership or shareholders’ agreements and decision-making processes. These will formalise the economic and decision-making arrangements attached to all scenarios for the evolution of the organisation, allowing and preparing for the economic and business consequences of the addition, evaluation and retirement of individual partners, in addition to dealing with the day-to-day business of investment and divestment decisions.
Third, they will include carefully developed approaches to broad stakeholder management, including not only transparent communications with LP investors, but also appropriate communications with governments, regulatory bodies and society at large, especially with respect to the impact that investment activities and portfolio company businesses have in areas such as the environment, job creation and the inclusion of minority and disadvantaged segments of society.
Most successful PE firms have proven to be highly thoughtful and skilled at the implementation of these elements of governance within their portfolio companies, but remarkably poor at putting in place analogous arrangements within their own firms. The consequences, particularly in periods of change or economic dislocation, can be profound: decision-making stalemates, inability to agree on economic arrangements to buy out retiring partners, unresolvable conflicts around a sharing of economics, team fragmentation, negative external publicity and ultimately investor dissatisfaction and a failure of such firms to outlive their founders.
Again, this is not just an issue limited to the niche circles of PE firms themselves, as today such firms play a fundamental role in relation to tens of thousands of predominantly mid- and smaller-sized businesses, in relation to millions of jobs, and increasingly in achieving scalable social and environmental impact. Much like public company governance, we as society should care that they get this right too.
Neil Harper is chairman of Zamo Capital and chairman of Turkven. He was previously the chief investment officer of Morgan Stanley AIP Private Markets, and prior to that, a partner of McKinsey & Company. Patrick Scheurle is a partner at Zamo Capital and was previously chief executive of impact firm Blue Orchard.