Adding value to the board

Non-executive directors have long been described as pretty but fundamentally useless adornments to the board.
Sir Ken Morrison, chairman of the eponymous UK grocery chain, reportedly said a couple of extra checkout staff would deliver more value to the company than a full team of non-executive directors, while Sir Michael Grade, chairman of UK broadcaster ITV, likened them to bathroom bidets: “No one’s quite sure what they’re for, but they add a touch of class,” he said.
Given this context, it was not surprising that parts of the UK private equity industry were dismayed by recent recommendations that firms add outside directors to the boards of their largest portfolio companies. The proposal was contained in an industry review led by Sir David Walker, the former chairman of Morgan Stanley International.
Walker’s enquiry, set up the British Venture Capital Association, was charged with investigating how private equity could improve its transparency and so enhance public trust.
The outside director proposal attracted the most criticism of any of Walker’s proposals. One investment banker reportedly told the Financial Times: “The industry will absolutely hate this.”
Such hostility stems from the view that outside directors are a feature of publicly listed companies that has little application to private ones. Public company governance is characterized by the ‘gap between ownership and control,’ reflecting the fact that the people who run the company (management) are different from those who own it (shareholders). In today’s market, in which most publicly listed companies have a diverse and diffuse shareholder base, this gap is closed via reporting requirements, annual and extraordinary meetings of shareholders, investor relations activities, and the appointment of outside directors.
These directors act as the elected stewards of shareholders’ assets, responsible for providing the kind of oversight of managers that owners, spread far and wide, cannot provide for themselves.
In a private equity owned company, the gap between ownership and control is effectively closed. Ownership is highly concentrated; the general partner has access to all company information, as well as the power to hire, incentivize and fire management. As Walker reports: “Lines of communication are short and direct, with effectively no layers to insulate or dilute conductivity between the general partner and the portfolio company executive team.”
Opponents of Walker’s proposal ask: why clog up this streamlined structure with distractions like outside directors? Private equity relies on a wholly different ownership model to the listed sector, according to this argument, so why should the industry be forced to borrow an ill-fitting and arguably inferior governance regime?
The opposition of private equity to outside directors is understandable, but depressingly familiar. When we established Hanson Green in 1989 with a focus on placing independent chairmen and non-executive directors on the boards of UK public companies, there was little enthusiasm for the role. Non-executives will be fig-leaf appointments, we were told, and talented people won’t take the job. Critics added that boardroom outsiders would prove divisive and that financial objectives would be diluted by woolly ‘stakeholder’ interests.

Partners in crime
All of these fears have proved groundless. Today, almost no one involved with publicly listed companies denies that non-executive directors can and do make a vital contribution to board effectiveness and company performance. When the role is properly defined and the right person found to fill it, outside directors provide superb strategic insight and industry experience.
Outside directors bring fresh perspective to the board. Generally men and women with a proven record, they can challenge ‘groupthink,’ slay sacred corporate cows, and bring their contacts and experience to bear in developing new strategy. Strong corporate governance cannot make bad companies into good ones, but it can certainly
make good companies better.
Critics of the reformed governance environment tend to emphasize the ‘oversight’ element of a non-executive director’s role, saying it has become a job for corporate ‘policemen.’ This overstates the case.
Overseeing management is plainly part of a non-executive’s duties in a public company, but it is not the dominant requirement. The first principle of the UK Combined Code asserts: “The board’s role is to provide entrepreneurial leadership of the company.”
It is this aspect of the outside director’s role that applies equally to both publicly listed and private equity-owned companies. In either case, the job of a non-executive director is to create a climate which encourages managers to perform at their best. Non-executives have courage, curiosity and tenacity; they ask tough questions, insist on results, and are hungry for commercial success. What manager would not want such a partner by his side?
This is not to say that outside directors are necessarily a benefit to company boards. The mere presence of an outsider does not stimulate debate, which is why the unreformed boards of old failed to punch their weight. Fifteen years ago, we found ourselves in a market characterized by a lack of professionalism. Non-executive directors existed, but they were thin on the ground and generally appointed as the result of being a friend of the chairman or chief executive. Companies in those days devoted far more time and energy to graduate
recruitment than they did to identifying the right directors.
Much has changed. The role of non-executive has become thoroughly professionalized in the past decade and a half, care of several high-level reviews of boardroom practice. If private equity is to maximize the advantages of outside directors, they should heed this experience.
The first lesson is to define the outside director’s role. Given that the oversight function on a private equity-backed board is minimal (in contrast to a publicly listed company), the focus should be on the strategic and entrepreneurial input that an outside director can bring.
Private equity-owned companies must look for relevant experience and drive, and not merely seek to appoint an impressive name.
A second important area where outside directors can contribute, and where public company boards have greatly improved their expertise, is in the area of controls and risk management. Reviews by high-level luminaries such as Nigel Turnbull, a former finance director of Rank, Sir Robert Smith, the chairman of the Weir Group, and Douglas Flint, a finance director of HSBC, have provided UK listed companies with an intelligent, flexible best practice regime for audit committees and internal controls. It provides a framework for assessing and managing risk that does not undermine entrepreneurial risk-taking and carries with it none of the onerous burdens of the US Sarbanes-Oxley Act.
Next, outside directors on private equity-owned companies can play a role in fostering good relations with the company’s wider stakeholders. This has become increasingly relevant as private equity targets ever larger companies – this year saw the first acquisition by private equity of a FTSE 100 company. This is not to say that the economic interests of shareholders should ever be diluted by stakeholder interests; the primary objective for any company is and always should be to earn returns for its investors. But companies, especially large ones, must recognize that intangible assets such as reputation, environmental performance and stakeholder relations can have a significant impact on commercial success.

Regular evaluations
The need to recognize stakeholder interests has been reinforced by a new statutory code of directors’ duties, introduced as part of the new UK Companies Act in 2006. The code requires directors to promote the success of the company, while also having regard to the interests of the company’s employees and to the need to foster strong relationships with suppliers, customers and other stakeholders.
Outside directors with listed company experience can help private equity-owned companies navigate these tricky waters.
Taking a professional attitude to running the board continues after the appointment of an outside director. A thorough induction process can ensure that a new recruit hits the ground running.
The Combined Code offers an exemplary guide to director induction, though few listed companies report on how they put this part of the code into practice.
That is a pity, because it is an essential element of board effectiveness.
So too is a regular evaluation of the board’s own performance. While employees have long been subject to a battery of assessments, until recently no one asked how the board itself was performing. The Higgs review of non-executive directors, published in 2003, recommended that public company boards conduct a regular review of their own effectiveness, either via internal discussions or with the help of an external consultant.
Listed UK groups have responded with alacrity. A 2006 survey found that nearly every FTSE 100 company had carried out a review of its effectiveness, with nearly a quarter using an outside facilitator.
Most companies based their evaluation on a questionnaire or interviews, or a mixture of both. While few companies report on the outcome of any review – unsurprisingly, no board wishes to identify areas of weakness – anecdotal evidence suggests that listed company boards are finding that regular self-assessment has greatly contributed to board professionalism and standards of performance.
No one wants corporate governance to become an industry, and private equity-owned companies operate in a very different governance environment to their listed peers. But a strong board can add value to any company, whatever ownership model it subscribes to.
Public companies have improved standards of board effectiveness via a professional appointments process, and by adopting techniques such as induction and performance evaluation. As a result, public companies have equipped themselves with talented outside directors who add value, and who help to lead the company and drive it forward.
Private equity should be ready to borrow best boardroom practice from the quoted sphere, where appropriate. The industry will find its portfolio companies perform better as a result.