Many argue that at least part of the reason for private equity’s sustained success is its approach to portfolio company governance. Industry insiders (and some academics) point to the sector’s superior decision-making structures, and the aligned incentives of the main protagonists, as driving value creation in private equity-backed companies. But the question has always been: why don’t other companies – especially public companies – capture the same benefits by emulating those structures?
A recent academic paper suggests why that has been difficult in the past, but explains how a new approach could help larger companies to satisfy their widely dispersed and increasingly institutional and engaged shareholders, and to make more informed operational and strategic decisions.
In their essay, Professors Ronald J. Gilson and Jeffrey N. Gordon argue that the modern public company board – which they label Board 2.0 – was designed around 40 years ago, in the wake of various corporate governance failures, mainly to “monitor” management. Reacting against boards of “insiders” put together by CEOs, these new structures focused on independence from management. Over time, their roles have developed significantly, with committee structures overseeing important aspects of compliance and executive compensation, and regulators relying on them heavily to ensure that compliance issues are given sufficient attention.
But modern investors are also focused on whether management’s strategic and operational decisions are optimal. According to Gilson and Gordon, public company boards suffer from three important constraints when it comes to challenging and evaluating those decisions: (i) the boards are under-resourced, meeting relatively infrequently with agendas that are largely set by management, and they have little independent analytical capability; (ii) they are thinly informed, having to rely heavily on the share price and information provided by management; and (iii) their incentives will probably make them risk-averse and less inclined to support business risk than the ultimate investors would like. These constraints – well understood by shareholders – make room for activist investors, or (if the activists haven’t arrived yet) lead to sub-optimal shareholder returns.
Other research bears out this view of public company boards – see, for example, this UK-oriented paper by Acharya, Kehoe and Reyner – and it will also accord with the experiences of many in the sector.
But how can public companies move towards Board 3.0, preserving the benefits of the existing structures while getting better at analysing and challenging strategic and operational decisions?
Gilson and Gordon use the private equity board as a model and propose that, in addition to the existing directors, public company boards should recruit an additional set of directors to serve on a “Strategy Review Committee”. Like their private equity counterparts, these new directors would have full access to confidential information and analytical resources, would be mid-career with high-powered financial incentives based on long-term share price performance, and would serve a limited term – building a reputation for helping companies to realise value. Their interactions with management would be more frequent and more business- and strategy-focused, with agendas set by these informed semi-insiders. No doubt, private equity deal professionals would be a rich recruitment pool for this new cadre of value creation non-execs.
Indeed, another potential shortcut to this outcome is also set out in the paper: that private equity firms might themselves become “relational investors” in public companies. This is a more formalised version of the “PIPEs” – Private Investments in Public Equity – that some private equity firms have undertaken in the past. This variant of the model sees private equity fund managers taking meaningful stakes in publicly traded companies, with warrants to boost their upside, a right to appoint directors to the board (maybe even to control it), and redeemable shares to provide an orderly exit after an agreed period. Whether that model gains any traction among private equity fund managers remains to be seen, but the academics say there is some attraction to it in the private equity community.
The authors of this interesting paper conclude that public company boards need to evolve to cope with a demand for “high-powered governance” and private equity offers the obvious model. There are, they say, many explanatory factors driving private equity’s success but “development and systemization of a corporate governance model” is an important one. Public companies may yet learn to emulate this, perhaps with help from the private equity industry.