Unbalanced: Why private equity governance and strategy-making can go wrong
Does private equity governance add value?
There have been various research reports in the UK and US suggesting that private equity generates higher returns than public markets, even when adjusted for risk and fees. However, those returns seem to have declined over time due to increased competition, higher entry multiples, changes in debt markets and the greater instability of major economies. In that context, all sources of value creation (or destruction) need to be considered and, where possible, optimised.
Investors, supported by advisers during due diligence and Chairs (and others) post-deal tend to think of that optimisation as relating mostly to the target/investee company and its management. Hence the increased focus on value creation planning as well as the kind of work Catalysis is involved with, thinking about how team and organisation arrangements can underpin growth plans.
By contrast, the ways in which investors set up governance, and influence strategy, seem to receive only sporadic attention. That is a shame because they are both likely significant influences on subsequent performance. Systematic proof for that last statement is limited but there is we see enough anecdotal evidence to suggest that this topic deserves serious exploration.
Let’s start with views from investee management teams about the value of governance to them. Data on this is drawn from a team and organisation effectiveness questionnaire Catalysis uses for deep dives into businesses and mostly covers internal issues. However, it asks executives three questions about governance and then scores the results using a net scoring system (similar to net promoter scores) ranging from +100% to -100%, where +25% is the threshold of decent scores.
The data below needs to be treated with caution because:
It is drawn from just nine management teams where we have used the tool post-deal which creates a risk of randomness. Moreover, some of the cases involved companies who were struggling in various ways which may create gloominess.
Scores varied significantly between situations. For example, in a couple of cases, there was a club of various investors whose squabbles were seen as hurtful to coherent good governance.
As one investor observed, when we discussed the possibility of trying to measure the effectiveness of investor directors on boards, there may be a risk that managers who have been appropriately held to account might give negative feedback regarding governance.
Nonetheless, the table suggests that teams are sceptical about the value-add of the governance they experience.
We may note that the score is less mediocre regarding support and advice but was surprisingly low related to helpful challenge. The view of coaching and mentoring was genuinely bad. There is probably little expectation that investors will provide such coaching but often a hope that Chairs or other NEDs can assist mid-market teams which are often hungry for guidance and development.
If we compare scores from PE investees with 20 non-PE companies where we have used the same questionnaire, the PE advantage is only mild:
The involvement of investors seems to boost governance scores a little overall, and non-private equity boards seem even less likely to provide coaching and mentoring.
Even without taking these scores too seriously, how can investors become more aware of whether their governance set-ups are value-creating or not? We suggest engaging with the following questions.
Do we have the right investor director on the board?
Very typically, the investor who has built the relationship with a management team pre-deal will stay on the board post-deal to provide continuity both of knowledge and connection. However, there can be exceptions:
A few PE houses move investees under portfolio teams and it possible that those allocations might not be optimal.
When investors exit a PE house, there is again the need to find the right replacement. A few years ago, I was asked to mediate the breakdown in a relationship between a CEO and a PE house in circumstances when a very supportive investor – who was also very generous with her time – was replaced with a fuzzier relationship involving less interaction. That was only solved by the on-going involvement of the managing partner.
Sometimes, changing assumptions of governance needs might imply the need for a change in investor. We supported the turnaround of an investee where the original investor was mostly an expert in financial engineering whereas the business was very operational. That gap was mostly solved through an exec Chair but a change in investor might have been helpful too.
Even when the primary deal doer remains on the board, we have heard stories from CEOs of some who are micro-managers, others very aloof or unable to talk about anything but financial matters.
Do we have the right Chair?
The processes of appointing, on-boarding and managing Chairs can be surprisingly unpredictable, with worries from investors, Chairs and CEOs about how often the right decisions get made. That situation can lead to Chairs who do not fit the requirements of the business, and may end up being, for example:
Too executive, or too detached (like one who lived in Portugal and only came to the UK two days/month).
Too aggressive (like a Swedish one whose only response to underperformance was to tell the exec team repeatedly that they were all idiots), or too cosy.
Too prominent (like one Chair who created two weak co-CEO roles with the result that he retained control) or too invisible when hard issues appear.
Are governance and reporting approaches appropriately balanced?
As mentioned in a previous post group structure blog, private equity funds have similarities with corporate groups with the same possibility of both adding value – or destroying it inadvertently by over-managing. There is a fine line for investor directors between providing appropriate accountability as an engaged NED and becoming effectively a corporate boss for investee CEOs.
The symptoms of where things have gone too far typically arrive in three forms:
Board packs which have grown into time-expensive burdens. One leisure business told us, for example, of a 200-page monster document which had sprawled over time.
Finance functions spending disproportionate time answering queries from investors.
CEOs who see their biggest priority as managing upwards.
What those symptoms have in common is that:
Scarce management bandwidth is dedicated to too much to satisfying hungry NEDs with insufficient consideration for the opportunity cost involved.
Other stakeholders – especially clients and middle managers whose voices are quieter – can get ‘crowded out’.
Checking at least annually about how the board can achieve proper accountability without excessive time cost would seem like a good topic for Chairs to oversee.
Strategy
Questionnaire scores from management teams regarding the quality of their strategies (i.e. how well backed up by sufficient insight; the degree to which an executable strategy has crystallised; whether high level strategies have been converted into practical plans) show no advantage for PE-backed companies over non-PE ones. While that may be due to fact that our PE-backed sample is overweight in businesses experiencing difficulties, it is still surprising since one of the main investor contributions to returns is meant to be helping companies focus their efforts, informed by extensive CDD.
The main reason why the contribution to executable strategy may be smaller than intended is that substantive strategy process is rushed past both pre-deal and post-deal. For example, the majority of information memoranda we see appear to deliberately avoid focusing strategy in case a potential acquirer might pay more for a strategy initiative which especially pleases them: expansion in geographies, offerings, margins, client types as well as acquisitions – all are covered even if, in practice, management admit that half of those are not really priorities.
The nature of transactions means that a financial model needs to be constructed pre-deal for investment committee based on plausible assumptions which are often only partly related to management want to do and can deliver. The diagram below shows how some of the stages of a robust strategy process are sometimes skipped to allow that to happen.
Post-deal, value creation plans suffer from the same two sins: throwing too many elements into the mix to give greater apparent stretch while avoiding enough consideration of how initiatives will be executed given limited bandwidth; jumping past deeper reflection in favour of creating tidy-looking plans punctuated with metrics.
The result of these biases is to create a ‘strategy’ which is full of goals and KPIs, but often short on logical foundations, realism about the route-map and managerial conviction. That can lead to unpleasant surprises in due course.
The other issue with such a strategy process is, as mentioned above regarding governance, that stakeholders not represented in the board, especially middle managers and clients, tend to have their substantive and informational needs under-represented in the outputs. Both may end up unclear on where company priorities lie and managers may disperse their energies across insufficiently prioritised initiatives.
Conclusion
Boards are both the structure dealing with the most consequential decisions for a business but also often the least optimised element of organisational structure. That combination can lead to various unintended consequences. The ability of investor directors and Chairs to reflect on how their contributions impact company performance is likely to be a growing concern as making money continues to be tough.
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