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Travers Smith's Alternative Insights: Reporting by large UK private companies

Travers Smith's Alternative Insights: Reporting by large UK private companies


A regular briefing for the alternative asset management industry. 

In launching the UK's consultation on corporate governance and audit reform in March, Kwasi Kwarteng, the Business Secretary, acknowledged the "economic importance of the largest privately-owned companies" and asserted that they should be held to the same reporting standards as public companies. Restoring trust is the key theme of the wide-ranging review and, in this respect, it is crystal clear that the government is not solely focused on the needs of shareholders: stakeholders and society at large need to know what large private companies are doing and how they are doing it – and there is an expectation that executives who fall short will be held to account.  

The government's proposals, which have been criticised by a number of business groups, would add significantly to the increased reporting on corporate governance and stakeholder matters that was introduced in 2019, and the climate change reporting obligations that are already on the way for many UK companies. As well as more disclosures, though, this regime will bring new responsibilities and potential liabilities for company directors, overseen by a new and more powerful regulator: the Audit, Reporting and Governance Authority (or ARGA).  It could, therefore, lead to significant changes to the way in which large UK companies are governed.

The entry point for the new rules will be the definition of "public interest entities" (PIEs). At the moment that covers listed companies, banks and insurance companies, but the government proposes to expand the definition to include (among others) large private companies, asking for views on how to define those. Even if the narrower definition is chosen, over 1,000 private companies will be in scope, rising to almost 2,000 if the alternative test is adopted. The additional compliance costs for these private companies (and the audit firms they use) are not trivial, as the impact assessment makes clear. The reforms are also likely to push up the cost of directors' insurance.

One central recommendation relates to the internal control framework. The government's "preferred option" is that directors – which, on the current proposals, would include non-executive directors appointed by private equity investors – acknowledge their responsibility for an adequate internal control structure and financial reporting procedures. On an annual basis, the directors would then need to carry out a review, disclose details of the procedures and make a statement as to whether they consider the systems to have operated effectively. An audit committee would need to decide whether that statement should be subject to external assurance. Alongside that, it is proposed that there would be a requirement for an annual "resilience statement", covering the short, medium (five years) and long term and including two reverse stress tests, and an "audit and assurance policy" that describes how the company will seek internal and external assurance of the information in the annual report.

Application of these rules to private companies will not be immediate, but when it comes it will carry with it the threat of sanctions (including fines and temporary disqualification) by ARGA. That will certainly give pause to non-executive directors, perhaps especially those who generally rely heavily on the audit committee and senior executive team. No doubt the regulator will exercise its powers "in a proportionate manner" (as the consultation puts it and the Regulators' Code requires) but, especially in the early years, many will be cautious. The government dismisses the risk that non-executive directors will be reluctant to accept these additional obligations as "small", but if it leads some investors to avoid putting directors on the board, and pushes UK private companies further towards a two tier governance structure, that would surely be a retrograde step.

... Application of these rules to private companies will not be immediate, but when it comes it will carry with it the threat of sanctions (including fines and temporary disqualification) by ARGA ...

There is also a specific concern for the private equity industry in the restrictions on non-audit services that an accounting firm can provide to companies in the same "group" as a public interest entity.  It is important that the new rules recognise that different businesses in a private equity fund portfolio, and the fund manager itself, are operationally independent and it would not be appropriate to restrict the choice of advisers to one company simply because it had a private equity investor.  A sensible accommodation on this point has been reached in relation to the UK's restrictions for "Other Entities of Public Interest", and (post-Brexit) a similar approach could be taken in relation to the EU-derived definition of PIEs.

It seems clear that the UK government is determined to apply new rules on corporate governance to some large private companies and to increase the potential liability of directors who fail to comply. Indeed, greater transparency is something that many private equity-backed companies have already embraced: there is a growing recognition that the public reputation of a private company – and of its private equity owner – is critical to its value creation proposition. Moreover, effective risk management and proper internal controls are an essential part of a sound governance structure, and putting them in place is at least as important for a private equity investor as it is for other stakeholders. 

But proportionality is also a key criterion for any new regulation, and many responses to the current consultation will argue that the cost / benefit analysis of a number of the proposals does not stack up – some arguing that there is no evidence that the changes will actually improve audit quality. In this regard, it is perhaps also regrettable that the government has rejected the notion that "proportionality" should be a key duty of the new regulator – that could be one way to ensure that ARGA's laudable mission to promote high quality reporting and corporate governance does not result in regulatory overreach.

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A series of regular briefings for the alternative asset management industry.

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