On the other hand, changes to corporate governance – mandatory interventions in corporate decision-making processes – are likely to be more contentious.
The Commission appears to be clear about what is required: according to Action 10 of the 2018 plan, the EU needs reforms that "promote corporate governance that is more conducive to sustainable investments". It is asserted that "corporate managers may become overly focused on short-term financial performance and disregard opportunities and risks stemming from environmental and social sustainability considerations".
Building on that objective, the recent consultation on sustainable corporate governance, leaning heavily on a study published in July, raises some very important questions – and its reach may go beyond the widely-held public companies that are the more traditional target of EU company law initiatives. It therefore matters to private equity firms and investors in private markets.
However, the evidence to support the reform proposals is far from clear, and there is a risk that they could do more harm than good. The European Commission would be wise to tread carefully, thinking hard about the unintended consequences of any changes it contemplates.
As it is the building block for reform, it is troubling that the earlier study made some important assumptions that are not supported by robust evidence. For example, the authors appear to have assumed that the pursuit of "shareholder value" would lead directors to focus mainly on short term financial performance, when in fact shareholder value is an inherently long-term concept. It may be the case that directors are not sufficiently focused on the long-term, but it is not clear that paying more attention to stakeholder views, rather than seeking to build value for shareholders, would change that. The study also assumes that long-term investors are desirable, without recognising that what matters is the motivation for an investor's decision to sell, not the length of time it owns shares. And it asserts that share buybacks are damaging, when the reverse is actually quite plausible, and negative reasons for engaging in buybacks are usually the result of more fundamental distortions – such as over-emphasis on quarterly reporting. These and other criticisms are included in the feedback received by the Commission: see, for example, the response of Professor Alex Edmans.
But perhaps most worrying for private equity investors is the suggestion that changes to directors' duties are needed – but without specific detail on what is proposed. Most will agree that directors should aim to build companies that are successful in the long term, taking proper account of the interests of all relevant stakeholders in doing so. However, as another respondent to the Commission's study has pointed out, it is unclear how the Commission envisages that directors should weight stakeholders' interests and, therefore, how directors are expected to resolve conflicts between the various constituencies. If, as also seems to be envisaged, directors can be held to account by outsiders for a breach of duty, that would create significant uncertainty and litigation risk, with directors apparently having no clear yardstick by which to judge the merits of any decision. The prospect that good faith business judgements will be judged with the benefit of hindsight by those with a particular agenda – which may, indeed, be a short-term agenda – could have a chilling effect on entrepreneurial management. Significantly more detail would be needed, therefore, before any conclusions could be drawn on the merits of these nascent proposals.
Private equity-backed companies design corporate governance structures that hold management to account and incentivise long-term value creation. It is a model that is not well understood outside of the industry, but attempts to impose mandatory rules could undermine its effectiveness. Private markets can be the crucible for long term sustainable governance, but ill-judged policy interventions could put that model in jeopardy.