Private benefit of public governance

Is good corporate governance only necessary for publicly-listed companies? Venture capitalist Philip Latham says in order to prosper, private businesses must adopt it too.

Good governance is as critical for private businesses as public companies, especially where:

• the business is looking to raise new capital

• the owners of the business are looking to exit at some point

• the business is going through major growth or major change

• the management team and/or business model is new Venture capital, or "private equity" as it is more commonly known, frequently lives with all of the above challenges.

As private equity professionals, it is our job to chart a course through these challenges, while minimising the risks in our investments. Strong corporate governance plays a major part in managing those risks. Most people believe corporate governance protects the interests of shareholders and other stakeholders in public businesses. So why should the interests of stakeholders in private business be any different? Why is there often a perception that private business and corporate governance are mutually exclusive? Perhaps it is due to stereotypical anecdotes concerning the way small private companies are run. One of my investee companies once told me: "Yes ... we used to have board meetings once every few months – my job was to bring the beers". Another explained that the owners would toss a coin each meeting to decide the chairman. The winner's first job would be to set the agenda.

In my business, RMB Ventures – primarily focused on later-stage buyouts of private businesses – the private equity process is simple: invest in promising businesses, add value as a shareholder, then pass on ownership to the next group of owners, be they public, private investors or trade buyers. An essential element of "adding value" is the creation, or maintenance, of processes allowing the business to develop and manage its growth, while protecting the interests of owners, employees and creditors. Significantly, good corporate governance will support management's drive to create value and not restrict it. Our investment process focuses heavily on understanding "who is responsible for what", and how they are measured against those responsibilities. An optimal exit process and price for all shareholders is mostly dependent on an incoming buyer's view of the strength of governance controls in the business. Numerous studies have attested to the increase in value investors place on businesses which appear to be well-governed compared to businesses with the same performance which are considered to be poorly-governed.

There is no rocket science in governance. Basic rules which work well for private equity-backed businesses are: Balance the board between executives, shareholder representatives and independent non-executive directors (NEDs) The tendency in private business is to weight the board in favour of shareholders. This is natural, given the additional cost of bringing on independent NEDs, but this is sub-optimal for three reasons:

• True independence will often provide important lateral thinking, expert or "devil's advocate" viewpoints, which are harder to achieve from a board consisting solely of major shareholders and/or executives.

• In the case of a capital raising, a joint venture, a merger, or any other event involving a major decision by a third party, the existence of independent NEDs is helpful in gaining their confidence.

• From a private equity practitioner's viewpoint, there are seldom the resources available to afford more than one representative from each private equity shareholder.

Avoid the cocktail party director set

Private businesses undergoing significant change need "working directors" who are prepared to put in the necessary time and effort. We are all familiar with the cliche of the director looking for a "stocking filler" to round out the portfolio. We are constantly looking for directors, with relevant industry experience, who understand the demands of a role on the board of a private equity-backed business. The board must be well led by a non-executive chairman and also have the right mix of skills for it to function as a board A dysfunctional board can be terminal for a business. Insist on a strong chairman who actively maximises the contribution and effectiveness of the board. This includes such activities as preparing for meetings well in advance; setting the agenda and meeting structure; working with executives to prepare clear, unambiguous papers; and spending time with NEDs before board meetings. In addition to a strong chairman, seek a mix of skills on the board. Look for consistency of objectives and an open approach to issues. Beware hidden agendas and, above all, look for an understanding of the difference between the roles of shareholders, directors and executives.

Be prepared to make the hard decisions

NEDs don't run businesses. Executives do. But NEDs exercise judgment on issues at board level. A strong board acts decisively and without ambiguity on recommendations by directors, key executives and shareholders. In this context, private equity-backed businesses are no different to well-run public businesses. However, the immediacy of the decision is arguably heightened by major shareholder representatives on the board. A weak board avoids or delays difficult decisions, such as replacing under-performing senior management, selling or shutting down non-core businesses, or ending unproductive relationships. A role as an independent director of a private equity-backed business can be highly rewarding. In particular, an incoming director can usually be assured a major private equity shareholder has thoroughly measured the experience, drive and capabilities of the management team before getting involved. An incoming director can also be certain shareholder representatives are experienced directors who take their governance responsibilities extremely seriously – not least because of a firm belief in the value-adding role of governance to an investment.

Philip Latham MAICD is a director on seven boards. The founder and managing director of RMB Ventures, he was the chief executive of Lend Lease Development Capital from 1994 to 1997 and was a case leader at the Boston Consulting Group from 1990 to 1994

Disclaimer

The purpose of this database is to provide a full-text record of all articles that have appeared in the CDJ since February 1997. It is aimed to assist in the research and reference process. The database has a full-text index and will enable articles to be easily retrieved.It should be noted that information contained in this database is in pre-publication format only - IT IS NOT THE FINAL PRINTED VERSION OF THE CDJ - therefore there might be slight discrepancies between the contents of this database and the printed CDJ.