Return to search

Out in the open

As the regulator's gaze becomes ever more sharply focused, the lid is gradually being lifted on the way private equity firms go about their business.

There is plenty of commentary today portraying the private equity and venture capital industry as secretive and opaque. Hardly a day goes by without a deal coming under the scrutiny of the mainstream press, often accompanied by undercurrents suggesting governments, regulators and the public should all be concerned and that surely it is time for someone to stand up to this dangerous phenomenon.

The response from the industry sometimes seems to be to forget that ?private? was originally used as the opposite of ?quoted? and to suggest that what goes on within the industry is nobody's business but the participants.

In this article I will examine whether the industry can indeed claim to be founded on good governance principles or whether its detractors have a point. I will argue that while external commentators may have good reasons for seeing the industry as opaque, they are mistaken in thinking this means it is badly governed.

I will start by looking at two key reasons the industry appears opaque: its complexity and its exclusivity. I will offer a view of governance which suggests that the industry is actually well governed. Lastly I will set out a simple but effective governance framework, and conclude with some observations on the consequences of increased exposure for the industry as a whole.

Into the spider's web
Commentators see the industry as opaque for two main reasons: complexity and exclusivity. The more they examine the affairs of portfolio companies and their owners, the more they uncover structures and vehicles they do not understand. The public markets are open to anybody – if I have money, I can open an account and buy shares. Private equity investing, by contrast, is an exclusive club.

The structure above private equity-owned business includes a spider's web of holding companies, debt vehicles, Luxcos, off-shore vehicles, nominee companies, limited partnerships, general partners, management companies, carried interest vehicles and more.

In a typical private equity structure, everything except for the operating entity is out of the public eye. The operating entity could be any one of thousands of household names owned by private equity firms. Every time one of these household names makes workers redundant, instigates a product recall or is accused of damaging the environment, the question ?who owns this business?? is asked.

Nobody is trying to disguise the fact that the answer is a private equity firm. Yet it should not be surprising that, from outside the industry, such structures and the jargon that goes with them create the impression they are intended to baffle.

Those who sit outside the industry and accuse it of poor governance do not understand that the complex structuring of investments is done for bona fide reasons. They do not understand that the purpose of these structures is to make the investment as efficient and effective as it can be for investors.

To put the argument that the structure is in the best interest of investors is also difficult because commentators also view those investors as opaque entities – frequently as ?large pension funds and insurance companies?.

If I want to get the kind of returns that private equity reportedly delivers, I do not know how to get into these funds. They are not advertised to me and their managers shy away from the press. I suspect, rightly of course, that if I could even find out how to get in, I would not be allowed to do so.

From the outside, the industry is complex and exclusive – it is both hard to understand and hard to join. In short, it is no wonder that commentators think it is opaque.

Code of Conduct
The Charter establishing the European Private Equity and Venture Capital Association (EVCA) includes in its statements of purpose ?establishing high standards of business conduct and professional competence? achieved in part through the publication of professional standards.

At the core of these is the Code of Conduct which emphasizes the long-term nature of private equity investment, the importance of maintaining the confidentiality of commercially sensitive information, and the importance of full disclosure to investors. It also establishes firmly the alignment of interests between the investors and the general partner.

To support the Charter and the Code of Conduct, the Professional Standards Committee at the EVCA has published other guidance for members including the International Valuation Guidelines with which most people will be familiar.

The range of guidance, however, covers the full spectrum of activity in the industry from the treatment of investors to interaction with investees. Governing Principles and Reporting Guidelines address the treatment of and communication with investors. Corporate Governance Guidelines address the relationship with the investee.

Throughout these publications there are some consistent themes which do not change: obey the law; keep your contract; maintain personal and collective integrity; balance commercial confidentiality and transparency; and approach conflicts of interest with honesty.

If private equity firms are following their own industry's guidance then they should have no cause for concern. Every business faces challenges in governance and sits on a spectrum at one end of which is perfection and at the other end of which is, ultimately, complete lack of control and business failure.

The management challenge for private equity firms is to determine where they want to sit on this spectrum.

The best way to do this is with a simple but effective governance framework.

You've been framed
Good governance is good business practice and good business practice involves well-informed decision making. Anything which aids good decision making is therefore a good governance practice.

In determining the risks facing the business it is important to be as comprehensive and inclusive as you can. Everyone in the team will have a different perspective on risk and what they think is acceptable. It is a mistake not to take all those perspectives into account. It is also important to recognise that risk assessment should cover the whole business, including the business environment, strategy and business operations.

The importance of a risk is a function of its potential impact and the likelihood of it actually happening. Consensus will come from open communication as to what concerns individuals and why. This should be supported by a predetermined way of assessing potential impact which takes into account that not all impacts are financial.

In assessing what is done about risks currently, the participants in the risk assessment should have an eye to the cost of control. When we help clients with this process it is inevitable that we find controls that operate over risks that nobody is actually concerned about and genuine risks that are uncontrolled. Good risk management should involve making the right amount of investment in control.

For this exercise to be worthwhile it must be driven by the leadership of the private equity firm. This is obvious when you recognize that the inevitable result of the exercise will be changes to how the team works. The action plan, with clear individual responsibilities, will only be implemented with senior management support. When we have worked with private equity firms, big and small, the success or otherwise of the program has been almost entirely determined by the willingness of the leadership to participate.

Finally, this should not be a one-off exercise. The loop which takes you back through reassessment of the risks and review of the program on an ongoing basis will underpin and embed the management of risk in the firm, thereby turning the firm's good governance into good business practice.

Veil of secrecy
Good governance implies many things but at its core are knowledgeable, well-informed investors taking a long-term view and supporting management teams in an environment where there is a clear association of the individual's reward with the decisions that they make.

The veil of secrecy around the industry is being lifted whether the industry likes it or not. It is absolutely vital that the industry collectively ensures that when that happens – and now that it has started, it will become unstoppable – that which is revealed is shown to be good business practice. There is plenty of evidence that this is the case if the industry is willing to provide it.

Participants in the industry need to be able to demonstrate that they have embraced good governance in the form of the standards that exist together with best practice in risk management and control. Such things are not just cosmetic, they make good business sense.

Vincent Neate is a Partner in the Private Equity Group at KPMGand a member of the Professional Standards Committee at the European Private Equity and Venture Capital Association. He can be contacted at vincent.neate@kpmg.co.uk .