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WHEN I TOLD colleagues that I was writing a book on corporate governance in private equity, a few couldn’t resist the obvious joke: “That won’t take long!”. The best thing about private equity, they said, is that there isn’t any “corporate governance”.
They were, of course, completely wrong. If anything, the opposite is true: private equity is mostly about corporate governance.
There is strong evidence that private equity-backed companies experience gains in revenues, profits and productivity relative to their peers. In my book, I argue that this is at least partially – perhaps mostly – explained by the corporate governance mechanisms that buyout firms typically establish.
The private equity playbook combines powerful equity incentives for the management team with an operational and strategic decision-making process that drives evidence-led and carefully considered decisions. Boards are relatively small, but all the key decision-makers are usually there. Even more vital for effective decision-making, board members tend to share a common vision for the business – and have the skills to help the company achieve them. This facilitates constructive challenge of senior management, and a partnership between investor and management to ensure effective implementation of an agreed business plan. It also means that a business can adjust swiftly and effectively when a crisis hits – as many have seen over the past two years.
Some worry that the private equity model is not aligned with the increasing societal focus on “stakeholder governance” – the idea that good boards should be concerned about stakeholder welfare as well as shareholder returns. In my book, I look at the incentives of private equity investors and disagree with that common characterisation.
I firmly believe that the most successful long-term businesses are those that pay attention to their key stakeholders. What’s more, the current focus on the place of business in society – and its role in helping to solve the “problems of people and planet” – makes that even more true with every year that passes. Private equity investors also know that, of course. They know that looking after a company’s workforce and its customers helps to build a successful long-term business. They know that, if a company embraces the opportunities created by the transition to a more sustainable economy, it can deliver financial outperformance.
Some worry that private equity is short-term. I argue that private equity firms are incentivised to focus on the long-term. Their holding period, which tends to average around six years, is not the point. What matters is their motivation during that period. An investor who knows they will eventually sell to a well-informed buyer is motivated to spend their time building a business that will be strong when they come to sell. The buyer will do extensive due diligence and if the business looks weak, or its business model is not sustainable, they are unlikely to pay top dollar.
So if it is true that doing well and doing good are correlated – which I think they are, at least over the long-term – private equity firms will use their corporate governance expertise to drive sustainable businesses that they can sell well.
But there’s another reason why I think private equity firms are incentivised to focus on ESG issues, even if they are not directly relevant to the value they can create in a business.
Most private equity firms have to go back to their investors every few years to raise a new fund. Those investors are mostly institutional: pension funds, insurance companies and the like. It is now commonplace for such investors to have an ESG policy and to look carefully at the sustainability credentials of their private equity fund managers. Like any good business, private equity firms respond to what their clients demand – and the pressure to demonstrate positive impact in portfolio companies is driving change.
Some argue that the current focus on “sustainability” in private markets is window-dressing. In my view, it is entirely rational for private equity firms to respond positively to investor and societal demands for more responsible business – and that is what I see many doing. ☐
Simon Witney’s book, Corporate Governance and Responsible Investment in Private Equity, was published in 2021 by Cambridge University Press.
A full version of this article appeared in PLATFORM 07, Summer 2022