Most private equity firms understand the importance of good governance. Indeed, a credible argument can be made that improved governance and decision-making processes are a key driver of private equity’s outperformance. But they also understand that a one-size-fits-all model is not available: every company’s governance system is bespoke, tailored to fit many variables, including its sector, strategy and size. And while some general best practice principles can be distilled, rules that mandate particular structures can do more harm than good.
So this week’s consultation on a set of corporate governance principles for large UK private companies (named the Wates Corporate Governance Principles, after the chair of the group that drafted them) will be of great interest to any private equity firm that invests in Britain. Not only are these principles – drafted following meetings with a coalition of stakeholders that included the British Private Equity and Venture Capital Association – are wide-ranging, and imminent changes to UK company law mean that the very largest companies are likely to adopt them.
The company law changes are part of a package of measures announced by the UK government on Monday, aimed at improving corporate governance in UK companies. For large private companies, the most significant change, effective for financial years beginning on or after 1 January 2019, is a requirement to publicly disclose whether they follow any corporate governance code and, if not, to explain why not (and to describe the company’s actual corporate governance arrangements). Where a code is followed, the law will require an explanation of how the code has been applied, and any departures from it. As well as making these disclosures in the directors’ report (part of the annual accounts), the company will also have to publish them on a website.
This requirement will only apply to “very large” companies, defined as those with either (i) over 2,000 employees (wherever in the world those employees are based), or (ii) a turnover of over £200 million (€225m) and a balance sheet total greater than £2 billion (€2.25bn). The government reckons that about 1,700 UK companies will be caught by these thresholds (excluding companies that are already required to publish similar statements because, for example, they are listed).
No doubt the government hopes that these companies will opt to follow a code (rather than disclose that they do not) – and would expect most to adopt the Wates Principles, even though that is not prescribed, and other Codes are available. That means that the consultation on the draft Wates Principles will be important, not least because many private equity-backed companies in the UK will end up following them.
The six proposed Wates Principles are quite general and, unlike the Corporate Governance Code for UK listed companies, the accompanying guidance is not part of the Code itself (so deviations from it do not need to be explained). For that reason, the approach is one of “apply and explain”, rather than “comply or explain”. The idea is that the Principles are so high-level that non-compliance will not be an option, and the requirement is to explain how compliance is achieved rather than why compliance is not appropriate. Rather presumptuously, companies are also asked to describe “how the application of the Principles has resulted in improved corporate governance outcomes”.
But despite being high-level, some of the Principles will change behaviours and processes for many companies. For example, the requirement in Principle Five to set executive remuneration structures “taking into account pay and conditions elsewhere in the company” will require some Remuneration Committees to think again about how they present their deliberations.
Similarly, Principle Six requires the board to oversee “meaningful engagement with … the workforce”, and companies will have to explain how this is achieved. It seems unlikely that the informal processes that many companies currently rely upon will stand up to external scrutiny, and companies will seek to ensure that more formal mechanisms are in place. This obligation chimes with a more general obligation to disclose how a board engages with its stakeholders: related changes to company law will soon require the boards of all large private UK companies, not only those that qualify as “very large”, to state publicly how they have complied with their obligation to “have regard to” a range of non-shareholder interests when taking decisions.
For the most part the Wates Principles are a sensible statement of good practices, and no doubt many companies will benefit from the guidance they provide. Some will see the additional compliance burden as an unnecessary cost, but it is hard (and counter-productive) for large companies to argue against greater engagement with stakeholders and openness to public scrutiny. The consultation is open until 7 September and the private equity industry should continue to engage with the details of the draft Principles – it undoubtedly has the expertise to make further, well-informed suggestions. But firms should also begin to prepare for finalisation of the Wates code, and the related disclosure requirement. Although no disclosures will be needed before 31 December 2019, affected companies will need to start thinking now about how they will comply.