In a recent study which analysed 70 successful private equity deals, perhaps surprisingly, McKinsey found that the primary source of value creation in the majority of these deals was the out performance of the company – not price arbitrage, not financial engineering and not overall sector gains or stock market appreciation – just better management of the business.
Even more surprising, however, was McKinsey’s finding that this out-performance was primarily driven by changes to the way the boards of these enterprises worked – what McKinsey calls “a more engaged form of corporate governance”.
Egon Zehnder is often called on to assist private equity firms build boards for their portfolio companies. We have spoken to a number of successful directors who straddle the worlds of private equity and traditional public company boards to better understand McKinsey’s findings.
Four key themes emerged from these discussions: private equity boards are characterised by focus – clear agreement with management about what is important; decisiveness – a preparedness to act; results orientation – a restless search for super-returns; and engagement – robust and regular communication within the board and with the executive team.
Typically the directors on private equity boards are proprietors or their representatives. They have strong sense of personal ownership (ensured by the carry arrangements of PE firms), clear shared expectations of risk return and the timeline that frames their investment.
Their approach to assessing risks and determining returns is inevitably very different to that of the directors on large, public company boards. Those directors are typically there as representatives of a diverse range of shareholders, often with quite different risk return expectations. The recent Qantas experience is illustrative of this: hedge funds, pension funds, mums and pops and executives, all significant investors but with quite different expectations.
In this sense, there is a powerful alignment of interests around the private equity boardroom table that is quite different to the public company board. Private equity directors have the benefit of representing a relatively homogeneous shareholder group; they have significant personal vested interests and clear risk return expectations.
This distinctive alignment of interests around the private equity board table enables the board to focus on a few, often simple measurable objectives. These metrics shape the board’s agenda and enable directors to hold the executive team accountable for performance in a very clear and unambiguous way.
It also means private equity directors tend to probe management in a level of detail that traditional directors would often feel, oversteps the line between executive and non-executive. They ask the hard, detailed questions about performance variances and will not be swayed by vague or self-serving answers.
This closeness to the business is enhanced by the very short lines of communication in the private equity environment relative to most large public companies. Private equity directors, we are told, tend to receive information more quickly and more succinctly.
It is the combination the clarity of purpose and shorter lines of communication that enables private equity boards to act quickly. Moreover, being proprietors they are able to back their judgment and move on, to the point of being bold and often, contrarian.
Private equity boards have the benefit of not being loaded down by history. Their frame of reference is always fresh. Performance data under previous ownership seems irrelevant to the targets they are prepared to set.
Witness the Myer buyout in Australia where the new owners set bold, new expectations dramatically out of line with the company’s previous performance. There was much skepticism, even in the retail industry, at the time that these expectations were unrealistic and unachievable. Although the final chapter is yet to be written on that transaction the private equity investors appear to be winning that debate.
Such radical performance expectations inevitably necessitates the business be managed differently if they are to be achieved. To this end, the board spends much of its time identifying, with management, innovative ways to release capital, improve productivity and drive growth.
At Myer this involved collapsing supply chains, closing warehouses and dramatically rethinking the day to day management of the business. One board member at Myer said no idea has been off the agenda. Creative, sometimes outrageous ideas have been encouraged. There is a sense of ownership and engagement which is more focussed on outcomes than focus. This, it seems, is the private equity way.
The proprietorial mindset of private equity boards, and the concomitant drive for results, almost by definition means there is a distinctive level of engagement with the executive team. Directors on private equity boards comment on the relative lack the formality; the robust nature of debate and the high level of contestability on key points. They also report, however, that by the end of the meeting there is no doubt in anyone’s mind what has been agreed and why.
It is not just around the board table however where modes communication differ from more traditional boards. Private equity directors do not tend to respect the normal hierarchy of communication. They assume the right to visit operations, talk to staff and meet customers, often at will. In this way they develop a degree of familiarity and engagement with the business which enables an authoritative engagement with management.
Even if they are new to the business, as they often are, private equity directors are prepared to ask the “naïve” questions – and they will typically have the observations and data to support their line of questioning.
One CEO of a private equity portfolio company said he was amazed at the ability of the private equity board members to zero on key metrics. Although he resented the level of probing – after all he was the industry expert – he conceded the fresh eyes and willingness to look silly enabled the private equity directors to often “hit the nail on the head”.
This level of familiarity and engagement with the business also enables the directors of private equity businesses to provide the executive team with timely observations; immediate feedback and, where appropriate, coaching, often drawing on their experiences from other sectors or business.
This contrasts sharply with the large public company arena where top executives often report they rarely experience such engagement with their boards or Chairman. This is particularly true of the relationship between the Chairman and the Chief Executive Officer which, when it breaks down, can be so damaging to the overall company.
In the private equity environment, on the other hand, there is typically a close and productive working relationship between the Chairman and CEO. When there is an issue it is dealt with quickly and openly. Sometimes this means CEOs of private equity companies do depart prematurely but rarely does the relationship deteriorate into dysfunctionality or resentment.
So where’s the catch?
While it is clear the private equity model can teach us something about the better functioning of boards, it cannot be the whole answer.
First, complete alignment of interests around the board table is not always a good thing, particularly when it comes to assessing and managing risk. Good boards need a dissenting voice – someone who is willing to declare the emperor has no clothes – if that is what is required. Moreover, when it comes to representing the interests of a wide range of shareholders it is true that a truly diverse board will arrive at better decisions than one which is highly homogeneous.
Second, close engagement with the executive team is not always a good thing. This is particularly so when it comes to supporting, or terminating, the CEO which is arguably the most important thing a board does. The Chairman/CEO relationship can be dysfunctional when communication falls down but equally can be dangerous when they are too close. The relationship between Chairman of Alinta and his CEO is perhaps one recent example of the latter.
Moreover, the downside of too much engagement with management is dependency. Private equity investors typically back the CEO and his management team when they make their investment. The investment is predicated on top management’s ongoing involvement because of their knowledge of the business and/or relationships with customers and other key employees. This can create a level of dependency however which impedes the ability of a private equity board to be independent of management and, for example, deal with a problematic CEO in a timely fashion.
Private equity boards are clearly very different from the boards of public company. They are after all made up of proprietors, or their representatives, with a relatively homogeneous, if not fully aligned, risk return profile. They have better access to information through their close engagement with the executive team and, by virtue of their control, an ability to move quickly.
Public company boards, on the other hand, typically represent a wide range of investor interests. Witness the recent Qantas takeover bid and the complex range of investor concerns that emerged during that saga. The directors on public company boards cannot be closely involved in the business and consequently rely heavily on information provided by management. This information is often highly filtered and sometimes not timely.
But some public company boards do manage to exhibit the best of both worlds. Often such boards have a dominant shareholder who wields considerably authority. In Australia such companies include Westfield and PBL but there are others.
These companies exhibit the kind of decisiveness and results focus that is analogous to many private equity businesses. They move quickly and know the business intimately. This typically translates into above average shareholder wealth creation but on occasion reconciling the interests of the dominant shareholder with the interests of minority shareholders can be problematic.
In summary, the more “engaged form of corporate governance” exhibited by private equity boards does provide us with some clues as to how more traditional public company boards could be more effective. It is not the whole answer, however, and as the cycle runs its course the private equity governance model might be found wanting.
Regardless, the Chairmen of big public companies might be well advised to promote a more focused, results-oriented and decisive board culture; one which is engaged but not too close to the executive team. At least this way, public company boards will be more prepared for the arrival of a private equity bid if and when it emerges.