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Home > Corporate Governance Checklists > Corporate Governance Practices in Private Equity-Owned Firms

Corporate Governance Checklists

Corporate Governance Practices in Private Equity-Owned Firms


Checklist Description

This checklist examines how firms operating under the ownership of private equity companies can keep pace with growing corporate governance demands.

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Definition

The relative ease with which acquisition funds can be raised from the capital markets and global investors’ push for higher rewards from specialized forms of investment have significantly raised the profile of private equity companies. As leading private equity players have capitalized on opportunities to expand their investment portfolios, their disclosure and other corporate governance responsibilities have also grown, with reforms such as the Sarbanes–Oxley Act (2002) increasing the costs associated with meeting regulatory requirements for listed companies. However, such higher costs may actually have played a role in the growth of the titans of the private equity industry. While the regulatory costs associated with the acquisition of medium-sized, medium-growth companies could lessen the attraction of these deals for smaller private equity firms, the largest private equity houses can use their fund-raising clout to capitalize on the effective regulatory economies of scale achievable through the acquisition of much larger industry players. The elimination of costs associated with regulatory requirements can also be very significant among smaller companies, such as those merged into larger entities owned by private equity firms.

There is no shortage of evidence that the combined benefits of active ownership and the improved corporate governance approach taken by private equity firms are important drivers of the success of private equity-driven deals. From a governance perspective, the representation of private equity firms at the board level is an important mechanism for improved effectiveness, while the streamlining of management structures can help to address agency issues. Private equity firms are also frequently able to call on external governance experts with experience of potential conflicts of interest at other companies in the same industry. The higher management incentives created by private equity houses can help to accelerate change by sweeping away long-standing inefficient working practices, creating an enhanced performance culture and generally improving the transparency of decision making.

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Advantages

  • Private equity firms can use their board-level representation to improve corporate governance standards.

  • Improved governance can be an important driver of the improved financial returns resulting from private equity firms’ investment in underperforming companies. Most private equity deals are also heavily levered with the view of reducing the cost of capital to enhance returns.

  • The improved performance associated with better governance standards can also be implemented at the subsidiaries of a conglomerate acquired by a private equity company.

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Disadvantages

  • Despite evidence that the involvement of private equity specialists strengthens acquired businesses and creates new jobs over the medium term, private equity companies are sometimes still regarded as “asset strippers.”

  • The poor perception of private equity companies among such bodies as trade unions could slow the pace of change in countries where union representation on company boards is commonplace.

  • Unless they are subject to a heavily discounted valuation, smaller businesses in mature, slower-growth markets are generally unattractive to private equity companies, with the result that the private equity route to improved governance is rarely an option.

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Action Checklist

  • Private equity firms do not regard corporate governance improvements as merely a “bolt-on” measure after the acquisition. Governance considerations should begin as early as the due diligence process, so that the benefits can be realized as early as possible.

  • Every effort should be made to achieve consistency in corporate governance standards across a private equity firm’s investment portfolio. Plainly, some acquired companies are likely to require more reform than others.

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Dos and Don’ts

Do

  • Be transparent on governance issues, notably executive incentives, to help build trust and ease lingering suspicions about the motives of the private equity industry.

  • Take account of cultural and social considerations when implementing change in acquired companies. It can be helpful to retain the support of the workforce when introducing structural reform to improve efficiency and raise governance standards.

Don’t

  • Don’t wait for regulations to be imposed on the private equity industry on issues such as accountability for decisions taken and transparency in areas such as management remuneration. The best approach is to be proactive.

  • Don’t overlook the need to inform all stakeholders of progress made in improvements to corporate governance structures. Investors in private equity firms, such as pension funds and sovereign wealth funds, are likely to take an active interest in reforms introduced in companies within the private equity firms’ portfolios.

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Further reading

Books:

  • Cendrowski, Harry, James P. Martin, Louis W. Petro, and Adam A. Wadecki. Private Equity: History, Governance, and Operations. Hoboken, NJ: Wiley, 2008.
  • O’Brien, Justin. Private Equity, Corporate Governance and the Dynamics of Capital Market Regulation. London: Imperial College Press, 2007.

Article:

  • Cumming, Douglas, Donald S. Siegel, and Mike Wright. “Private equity, leveraged buyouts, and governance.” Journal of Corporate Finance 13:4 (September 2007): 439–460. Online at: dx.doi.org/10.1016/j.jcorpfin.2007.04.008

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