Corporate governance and responsible investment in private equity. 2021. Simon Witney. Cambridge University Press (series on international company law and financial market regulation).
Private equity as an investment class is older than many reading this review. This is a part of the investment universe that is growing faster than listed companies, whose numbers are shrinking. Taking into account the legal responsibilities of the manager and the board of directors, as well as the monitoring efforts of (mainly) institutional investors, Simon Witney presents a groundbreaking investigation into how corporate governance and responsible investing work in private equity and how the two functions actually work together. Witney is a visiting professor in practice at the London School of Economics and Political Science and has been a private equity lawyer for over 20 years.
Many investors may overlook a topic that emphasizes corporate governance. It does, however, have broad implications for improving investment practice. The author defines corporate governance in private equity as the various rules that govern who makes decisions in private equity-backed companies, in whose interest decisions are made, and the processes for making them. . According to Invest Europe, private equity firms portray themselves as active investors demanding rigorous accountability, transparency and the adoption of best practices by their portfolio companies. (Formerly known as EVCA, or European Private Equity and Venture Capital Association, Invest Europe represents the private equity community across Europe.) They are often also industry specialists, with employees who bring specific expertise. More importantly, they negotiate bespoke governance arrangements when they invest.
Tailored contracts in private equity-backed investments allow for close alignment of interests with reduced inherent agency conflicts, an informed and influential shareholder, and significant incentives to organize governance effectively. Negotiated contracts, according to the author, are essential in determining the applicable governance mechanisms in companies financed by private equity. The main objectives of the contracts are to facilitate effective management control, improve the quality of decision-making and ensure that investors’ preferences are taken into account.
In a reputational context of private equity, active governance is essential as some regulators and members of the public mistakenly perceive private equity operators as asset strippers, debt loaders and unemployment creators. The author cites the distressing example of the bankruptcy of Toys”R”Us in September 2017, where private equity ownership was blamed by the press and some politicians for the company running up huge debts and unsustainable interest charges. Many politicians articulate such criticisms, to the detriment of private equity operators who genuinely pursue good business practices, seeing beyond high returns on assets and lucrative withdrawals within set timeframes.
Readers outside the UK and the Eurozone will be surprised by the applicability of ‘Corporate Governance Regulation in the UK and the Private Equity Response’, the larger section of the book. It focuses on the Companies Act 2006, with particular attention to the duty of loyalty, which is described as the duty to promote business success. A second important aspect of the duty of loyalty is that directors must exercise “independent judgement”. The substance of the Companies Act 2006 can be seen as the default regulation, although it is clearly not optimal for a private equity funded company that has a contractual agreement with legal effect. The discussion also touches on European competition law; the Alternative Investment Fund Managers Directive (AIFMD), consisting of legislative responses intended to mitigate systemic risks following the financial crisis of 2007-2008; guidelines for walkers; and the Wateres Principles (more on those below).
A “Governance and Oversight Model” was created by the UK government in 2018. Sir James Wates CBE was appointed to develop principles that could be applied to shape the corporate governance of large private companies. For me, these high-level principles encapsulate the message of the book and could be adapted to serve small businesses. These principles include the following:
- An effective board of directors that develops and promotes the purpose of the company
- Effective board composition that requires an effective chair and a balance of skills, background, experience and knowledge
- Accountability and liability of directors
- Promoting sustainable and long-term business success
- Board compensation aligned with this mode of success.
- Effective relationships with stakeholders
Part IV (the final section of this tidy volume) examines how corporate governance can affect business performance. Some academic studies cited by the author show that holding companies outperform their publicly traded counterparts in terms of profitability, productivity, employment, and working capital management. These parameters potentially provide a strong rationale for investing in private equity-backed vehicles. Witney notes, however, that many performance studies need updating, especially for the current decade.
In summary, readers – especially regulators, business executives and investors – will find answers to many of their questions about effective governance and responsible private equity investing in this comprehensive text. Most will consider the information provided as vindication of their confidence in private equity-backed investing.
The bigger question, however, is about parallel governance and regulation in their own countries. Is a given country’s set of rules like weak tea, or is it strong, efficient and enforced? In the United States, how do the Dodd-Frank regulations compare to those presented here? Will the Stop Wall Street Looting Act (a bill introduced in the US Congress in 2019) grow in scope or become redundant with the emergence of effective corporate governance and responsible investment in private equity?
If you liked this article, don’t forget to subscribe to the Enterprising investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and report professional learning (PL) credits earned, including content on Enterprising investor. Members can easily register credits using their online truck tracker.