Many portfolio companies of private equity groups (PEGs) tend to fill their boards with insider directors, such as members of the fund and select representatives of company management. In doing so, they miss the boat on the benefits that can be offered by independent directors, whose unvarnished opinions can prove invaluable in areas like risk management oversight, executive hiring, and approval of mergers and acquisitions.
The Current State of PEG Boards
The most common examples of investor-owned private companies are the portfolio investments of private equity groups, often resulting from the acquisition of successful private businesses (often family-owned). Just as relatively few of those businesses had truly independent board members prior to their acquisition, many PEGs populate the boards of their portfolio companies post-acquisition with insider directors. Board composition often includes a few people from the fund (aka, “the deal team” – those responsible for the acquisition) and a lesser number from company management. PEGs have increasingly hired “operating partners,” industry specialists who help management make and oversee acquisitions from their industry of expertise. These operating partners are often among the fund’s representatives on the portfolio company board. Their industry experience is no doubt valuable, but they are not independent, since they are employees of the PEG.
Independence is required in the case of public company board members by applicable legal and stock exchange regulation. There are certain situations in which independent directors may be required for private companies. For example, if a company plans to file Chapter 11 and all of the incumbent directors are potential creditors of the company, or if the company may potentially have a claim against them, then they may be considered “not disinterested.” Similarly, if a private company that is owned by several funds and is planning a sale that may be deemed to not benefit all the funds in an equivalent manner, the board members who are affiliated with those funds and will benefit preferentially from the sale may similarly be considered “not disinterested.” In such cases, it is typical for such boards to appoint one or more directors who are “disinterested” and meet the requirements of independence, either in addition to or as a replacement of the incumbent board members, who, if they remain, will recuse themselves from voting on such matters.
In general, it’s advisable to err on the safe side when navigating issues of director independence, and most bylaws make it relatively easy to add independent directors when necessary. However, it would be preferable to have had independent directors on the board throughout the entire process of considering a Chapter 11 filing or a sale. The previous situations are just two examples of decisions that a board may face during which director independence may become an issue. Apart from the intrinsic value of having independent directors, a failure to do so in situations like those cited above may give rise to litigation that could easily have been avoided.
It is reasonable to assume that PEGs would prefer an acquisition that already has a board with independent members over an otherwise identical target lacking in independent governance. While there is no statistical evidence for this assertion, it would seem obvious that, if the PEG were choosing between two identical acquisition targets, both family-owned and profitable, except one of them has a board that includes independent board members who do not even play golf with the owners – with board minutes evidencing their participation that they can read as part of their due diligence – the PEG will prefer that one. Similarly, PEGs preparing for an “exit” – the sale of a portfolio company as part of the periodic preparation to return funds to PEG limited partners – would be well advised to add independent directors, since the subsequent owner is likely to be another PEG.
Independent Directors Bring Value to Board Responsibilities
However, these somewhat extrinsic reasons for the value of independent board members overlook the more important intrinsic reasons. The legal or regulatory requirement of independent directors in the case of publicly traded companies is the result of a widespread belief that independent directors will be less susceptible to improper influence on their fiduciary duties and will not hesitate to speak up and take action, even when such action may create discomfort for management and investors. In other words, they will “speak truth to power.”
A key duty of board members is the oversight of company risk management, which includes the identification and possible mitigation of risk (which may involve cost), as well as monitoring changes in risk, including new risks arising as the company grows and its activities change. This important board role may be undermined if none of the board members is independent. Nonindependent directors may be hesitant to bring up difficult matters or ask sensitive questions. They may fail to be “healthily skeptical” or be less inclined to treat respectful disagreement as potentially useful.
Another important area of board responsibility is hiring senior management, setting its compensation and evaluating its performance. The perspective of board members in dealing with such matters should be as unaffected as possible by any relationships with management or the company. Having independent board members will likely strengthen oversight of management, since that role can involve difficult conversations and decisions.
Oversight and approval of mergers and acquisitions is another vital board role. Often, senior managers can be seduced by a “bigger is better” mentality, leading them to favor acquisitions that are not advisable. Consideration of the timing and terms of selling the company may include possible future roles for management with the buyer, which can affect the judgment of nonindependent directors.
It is not an overstatement to say that all areas of board activity, including board composition and evaluation, committee assignment and litigation oversight, would benefit from independent directors.
Slow Progress on Private Equity Independence
While I have not seen any research reports on the subject, anecdotal evidence suggests that PEGs have in fact been including more independent board members for their portfolio companies. But progress is slow. For many PEGs, the default setting for their portfolio company board membership is limited to representatives from the fund and company management. Some PEGs may agree that including independent directors is a plus, but they express concerns about the costs of board compensation and engagement of board recruitment search firms.
However, board compensation is often modest in terms of cash payments, and alignment of financial interests can be created between the PEG and the portfolio company board by making all or part of board compensation a function of company performance, and by focusing on the ultimate gain upon exit. And while search firms can be useful in board recruitment, especially if a type of industry experience is being sought that is relatively rare, there are other easier and cheaper ways to find qualified board members. The key to effective board composition is creating a skills matrix depicting the ideal combination of knowledge and experience for a board, and then focusing on those areas that are not yet represented on the board. This method also makes achievement of board diversity easier.
PEGs will remain an important and sizeable force in our economy. They are a frequent way for family businesses and other owner-operators to achieve a successful exit. By including independent board members on their portfolio companies, PEGs can potentially improve their performance and reduce their risk profile.