Home > Board Performance > PRIVATE EQUITY: how do they behave after the money arrives? (I)

PRIVATE EQUITY: how do they behave after the money arrives? (I)

If an entrepreneur gets a loan, nobody appears at the next board meeting. Private equity firms (PE) do, as their aim is creating value through deal management and governance.

  • As for “Deal Management”, authors refer to all formal and informal processes through which PE generate value. It distinguishes PE investing from other types of investment, not so active in nature.
  • As for “Governance”: we refer to the systems to ensure execution, accountability and ownership mentality.

a) Creating value takes many forms:

• Assisting management for better implementation of an existing strategy, for instance adding talent.
• Changing the strategy: sometimes for a more focused growth, that allows to free capital then used for paying down debt or other purposes.

b) Governance leading to value creation stems from the board; in PE, boards are made of investors, management and outsiders. Corporate governance details are negotiated with the deal; investos use to control the board through sheer numbers or special voting rights. And the board has fiduciary duties to shareholders, all of them represented, (unlike public company boards, where shareholders are dispersed, passive and not represented). Private equity boards are active, ty between shareholders, board and management, so that governance is strong.

1. Boards and governance.

PE basically receive effective control on the board and the firm in exchange for the money they invest. The board represents all shareholders and makes decisions, (not interfering in daily business directly). Management implements these decisions.

Size of the board varies; between five and seven is normal in most firms, even nine in big buyout transactions. Investors use to have a majority of seats, (if not, very often they do have the majority of voting rights in crucial matters). Some investors may not be represented in the board: they may have not invested enough, nor negotiated strong; other firms feel confortable having observers in the board, with information rights, having access to executive meetings or not.

Populated boards are not too effective, but growth and the fact that new investors appear sometimes forces firms and participants to find an equilibrium.

Board composition and responsibilities.

VC board members use to have spent several years in the VC industry, and time dedication is relevant. Tasks are mainly fund raising, strategy and management recruiting, altogether with advise and oversight.

An interesting question appears when analysing the failure rate of early VC backed companies, if directors are so experienced and dedicate so much time to them. Sometimes firms fail for a lack of confidence and lack of additional funding for the firm to pursue success; secondly, they use to be narrowly provided with resources, as additional needs mean dilution for founders and VC`s, so resilience to bad times is low; finally, the fact that investments concentrate in fashion sectors leads to failure of a large part of them for excess of competition.

Also VC firms usually blame senior management for failure, and Ceos are replaced as a coinsequence.

VC backed firms`boards use to be smaller and to include less instrumental directors, (lawyers, consultants and the like).

When VC backed firms grow, several things happen:

  • Usually new funds come from new VC firms, and the board grows.
  • Boards become more populated with other outsiders, usually domain experts, or additional insiders, (a Ceo having gone down to CTO positions, for example, may remain at the board).
  • Before IPO VC directors still remain, but more industry experts are usually added.
  • Also a Ceo replacement uses to lead to new finance rounds and VC company intervention.

In later stage firms, and before an IPO occurs, the board composition is the result of a bargaining process between Ceo and VC firm, their respective reputations weighing in.

Firms having been bought out and then launched again to the equity market also tend to be more efficient, that is, they have less populated boards, fewer insiders and directors owning larger stakes. Not only formal, but mainly informal meetings and conversations use to be very relevant in these firms.

Board powers.

The distribution of seats, voting rights and the like is connected to the relative reputation of Ceo or founders and VC firms, although these usually control boards more than their relative investment would allow them to.

A mechanism to obtain control is voting rights assignment; some boards use the “one director one vote” rule, others weight votes by ownership, others vote by class; in some specific situations, some boards grant more weight to some votes than they grant to others, (for example a budget may require the positive vote of the VC director to be approved). These are usually very crucial matters: a new Ceo, a budget, a strategic change, M&A, capital allocation, debt increases, etc.

Sometimes, when there are several investors having added their funds at different prices, later and expensive share buying investors are granted the power to block any transaction that is favorable to some shares but negative for their investment.

Also, preferred shares owners usually need to accept that new shares preferred to theirs are issued.

Different classes of stock set the path to rent seeking behavior in difficult situations, though.

Board powers and the staging of financing.

Different classes of stock generally arise from different financing rounds, and this is also the case of debt, in this case involving matirities, interest rates and payment preference.

Staging supports governance because after each round manager-founders have the incentive to do their best so as to obtain the following round at the best of prices and preserve capital, both for them and for investors, so that interests are aligned. Sometimes this may lead entrepreneurs to “meet” short-term targets, to avoid investors from leaving, but investors can also protect against this investing with bad information using convertible financing tools, (which act as a future dilution threat in the case of underperformance).

2. Board and value creation

After the money arises, investors and founders cooperate within the board to build value through different phases, where the efforts are differently deployed in VC investments and buyout transactions:

 

  • Strategies are set up for value creation in the first phase.
  • Implementing them all may lead to an extended number of additional steps; some strategies are external, (every factor affecting the companies`s valuations), and some of them are internal, (financial structure, operations, cost of capital, asset volume, and so on).
  • The final step is exit.

We will go deeper into the Value Creation process in a forthcoming post, in which we will also refer to governance techniques, the importance of informal relationships in order to create value, and re-contracting.
(1) Based on Chapter 6 “When the money arrives” of Lerner-Leamon-Hardymon`s “Venture Capital, Private Equity and the financing of entrep`reneurship”, published by John Wiley&Sons, 2012.
http://www.amazon.com/Venture-Capital-Private-Financing-Entrepreneurship/dp/0470591439

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