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Corporate Governance in Private Equity

Corporate Governance in Private Equity

Overview

Earlier this year, we launched a series of webinars on the theme of "Sustainability and alternative asset managers: the new normal".

We recently hosted our second webinar in the series, "Corporate Governance in Private Equity". The webinar featured a keynote speech from Simon Witney, Senior Consultant at Travers Smith, BVCA Council member and author of the recently published book – "Corporate Governance and Responsible Investment in Private Equity". Simon's opening speech was followed by a lively panel discussion, chaired by Lucie Cawood, a partner in our Private Equity and Financial Sponsors team.

Joining Simon and Lucie on the panel were Julie Bradshaw, General Counsel and Compliance Officer at DH Private Equity Partners, Professor Marc Moore, Chair in Corporate and Financial Law at University College London, and Michael L. Arnold, partner at US law firm, Cravath, Swaine & Moore LLP.

The panel considered corporate governance in private equity-backed businesses, and the extent to which either (i) law and regulation or (ii) the private equity business model is more effective in driving private equity firms and their investee companies to focus on ESG issues. This is a note of the key points from the webinar, including the keynote presentation, the panel discussion and the Q&A which followed.

Keynote presentation

Simon Witney opened with a strong proposition that private equity firms are well-equipped to rise to the challenge of providing social as well as financial value, describing corporate governance in private equity as a force for good in wider society as well as a major source of value creation. A recording of Simon's speech can be found here.

 

The strength of the private equity model

Referring to a leading article written by Michael Jensen in 1989, "The Eclipse of the Public Corporation", Simon observed that the traditional checks and balances inherent in the PE governance model ensure that the interests of all stakeholders, as well as those of the shareholders and managers of the business, are protected. This is important given that good corporate governance is now expected to deliver more than shareholder value and must address negative externalities, including those inherent in the ESG agenda such as climate change, human rights abuses and social inequalities.

 

Long-term value creation

Simon argued that the boards of private equity-owned companies have powerful incentives to focus on long-term value drivers in the business, challenging the notion that PE firms approach corporate governance and the management of ESG performance in their portfolio through a short-term lens focussed on maximising exit value over the typical 3-7-year holding period. On the contrary, PE investors must demonstrate long-term value creation looking forward at the point of exit, and for that reason, PE investors are proactive in responding to commercial and legislative challenges which may impact on future value in their portfolio. This is particularly so given the long tail nature of some potential ESG liabilities, such as environmental.

 

Policy interventions as a driver of change

Whilst the incentive to maximise long-term shareholder value may therefore have more direct impact than company law in driving change in corporate behaviour, Simon would welcome further policy interventions, such as new liabilities for bribery and corruption, data breaches or carbon emissions, to which companies and their investors will respond with appropriate governance mechanisms to minimise the risks of non-compliance.

Panel discussion

Magnified incentives

The significant reputational risk from irresponsible or unethical behaviour in the portfolio, coupled with the heightened expectations of investors as regards ESG, also provide strong incentives to respect the legal and regulatory framework. The regular fundraising process amplifies the level of accountability of the fund to its investor base on ESG issues – which Simon referred to as the "magnified incentive". Julie Bradshaw agreed, adding that potential litigation and reputational risks sharpen the focus of PE firms on good corporate governance and compliance, citing the example of the recent Goldman Sachs anti-cartel ruling.

 

Good governance makes business sense

Julie's perspective was that the focus on corporate governance among PE houses and investors is strong, and always has been, but is driven by good business sense and a desire to create long-term value with a view to a successful exit, rather than company law obligations. For example, PE investors typically reward employees of portfolio companies via incentive arrangements, and in some cases, have accepted co-determination, and promote good relationships with customers and suppliers, but not because they are compelled to do so by law.

 

Law reform proposals

Whilst Simon saw value in directors' statutory duties under Section 172 Companies Act in reinforcing the structural incentives mentioned above, the panel voiced doubts as to whether the various corporate governance law reform proposals currently being considered, particularly to enhance the rules around directors' duties to reflect corporate purpose, would achieve the desired changes in corporate behaviour.

 

Company law is a blunt instrument

Marc Moore observed that the law on directors' duties is of some, but relatively limited value in promoting good corporate governance, as it is rarely enforced and, other than the rules on directors' conflicts of interest, has little practical impact on corporate behaviour. There is an argument that Section 172 Companies Act has even had a detrimental effect on stakeholder capitalism by highlighting the pre-eminence of shareholder interests above those of stakeholders. Marc suggested that a more radical approach would be to introduce co-determination on company boards, with compulsory worker representatives, but the cultural barriers and unionised workforce in the UK make this a difficult proposition.

 

The effectiveness of reporting and disclosure obligations

The panel expressed mixed views on whether reporting and disclosure obligations drive genuine changes in corporate behaviour, although recognised that process reporting regimes such as the Modern Slavery Act and Gender Pay Gap reporting requirements have been particularly beneficial in bringing such issues to the boardroom agenda and as a tool for public accountability in these areas. There was also agreement that the "adequate procedures" defence in the UK Bribery Act has been an effective means of effecting behavioural change as it provides guidance on how to avoid liability and is therefore a sensible model for legislative measures. Michael Arnold commented that, in the US, corporate reporting and disclosure mechanisms have made a significant difference, in particular due to the enhanced litigation and reputational risks for those companies who fail to follow through on their public statements.

 

The role of corporate purpose reporting

The panel commented that corporate purpose reporting can be misused by companies wishing to report only positive measures whilst failing to disclose any deficiencies, but recognised the value in a requirement to formulate and articulate the company's purpose, by providing a focus for the board's decision-making and a means for shareholders to hold the board to account.

 

The US approach, and the rise of B Corps

Looking at the US perspective, Michael said there was little evidence to suggest that state company laws (such as constituency statutes, intended to give directors of US corporations the discretion to balance the interests of stakeholders and the need to maximise shareholder value) will significantly influence corporate behaviour, especially since the vast majority of companies are organized in a single state (Delaware). B Corps, by contrast, are a potentially relevant regulatory development, and have become more popular in Delaware since it became easier to opt into the B Corps structure in 2020 but he was sceptical that B Corps would become a significant force given that to date most are small companies.

Q&A

Walker guidelines

In response to an audience question, Marc Moore queried the continuing relevance of the Walker Guidelines for Disclosure and Transparency in Private Equity. Simon reflected on the introduction of the Guidelines in 2007 when corporate reporting was increasingly being seen as a public accountability tool and there was considerable political and public interest in the private equity model given the increased flow of private capital into larger investments around that time. The Walker Guidelines met a concern that large private equity-backed companies were not subject to the same disclosure standards as listed companies and the perception is that these standards are now embedded in corporate governance structures, although the Wates Principles have since built on these foundations.

 

Avoiding box-ticking

In response to a question as to how to avoid a box-ticking approach, Julie related her experience that the focus of many investors on ESG issues is genuine, less so for others, but investors' concerns about their own reputation leads to strong accountability mechanisms in any event.

Future webinars

Our next webinar in this series will look more closely at litigation risk as a driver of corporate behaviour in private markets. Doug Bryden, Head of Operational Risk at Travers Smith, and Heather Gagen, a partner in our Dispute Resolution team, will talk us through recent litigation trends in relation to ESG issues – and we will assemble a panel to debate the extent to which the spectre of liability arising in the value chain can be a catalyst for responsible corporate behaviour, and the measures investors can take to avoid such liability arising.  

If you would like to take part in this and future sessions, please register your interest here.

Our response to the sustainability question

We are committed to supporting our clients in their transition to a more sustainable future and in meeting the challenges presented by a commitment to Net-Zero targets. On our Sustainable Business Hub, we present a range of resources, including news, views and guidance, designed to help our clients to anticipate regulatory change, proactively manage risk, and achieve sustainable business objectives. Right across our practice, we are making sure that ESG and sustainability expertise is integrated into all of the advice that we provide – recognising that responsible business is the "new normal" for our clients.

Our Sustainability Initiative is led by Senior Partner, Kathleen Russ, Environment and Operational Risk Partner Doug Bryden, Corporate Partner George Weavil and Senior Consultant, Simon Witney. Please do get in touch with any of them, or your usual contact at the firm, if you would like to discuss any ESG or Sustainable Business issues.

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