An Entrepreneurial Board of Directors
A Value Maximization Governance Model For Public Companies
Corporate governance is a hot topic. Every day, it seems, there is a bombardment of new proposals for improving or fixing public company boards: diversity, inclusion, corporate social responsibility, ESG, and a continual roll-out of new “governance codes.” Politics is involved including all Senator Elizabeth Warren’s bill that would require 40% of directors to be elected by employees for companies with a market cap of over $1 billion and California’s (and others) diversity quota requirements. For whatever reason, there is a continued insistence on the part of those involved in governance to make it perpetually more complex, complicated and less oriented to company performance (hint: there is an inverse relationship between efficacy and complexity)
But will these steps improve public company governance?
To answer this question, we need to look at what the objective of governance should be. With so much focus on the board’s role in compliance, process and quarterly results, it’s easy to lose sight of the fact that far more than an “august deliberative body above the fray,” a public company board should be viewed as an asset — one that can and should be fully developed to optimize capital allocation while maximizing longer-term operating performance and shareholder value. It seems to have been forgotten that at the core of governance there is an actual business with products and/or services. It stands to reason, then, that when we think about boards we should simultaneously think about the development of the full potential of these companies.
Public Company Governance Model Shortfalls
But the current public company governance model, which all the new proposals attempt to “improve”, is not designed to develop this full potential. These proposals are attempting to make changes to a model that is already suboptimal in regard to developing really great companies but not designed to materially change the model itself. As one of many examples of this governance model shortfall, extensive studies of public companies and their boards has revealed the following:
• Only 34% of directors surveyed agreed that the boards on which they served fully comprehended their companies’ strategies (1)
• Only 22% said their boards were completely aware of how their firms created value (1)
• Only 16% claimed their boards had a strong understanding of the dynamics of their firms’ industries (1)
• Of 1,500 companies surveyed over a 20 year period, the majority doled out the same amount of capital to business units they did the previous year. (The most aggressive re-allocators — those that shifted more than 56% across business units — delivered 30% higher returns to shareholders.) (2)
• More than 1/3 of the $8 trillion of capital invested in the S&P 1500 does not earn the cost of capital. Optimizing capital allocation should be a primary responsibility of a board. (3)
• Over a 5 year period, half of S&P 1500 companies experienced a significant write-off, divested a major business or saw a decline of 50% of more in value. (3)
The above provides just one snapshot of the considerably larger panorama of the shortfalls of the current public company governance model. What is needed are not attempts to unnecessarily further complicate the existing model that is already burdened with process, boxes to tick and haziness regarding governing objective but instead a radically new entrepreneurial governance model aligned with the high performance requirements of the current hyper-competitive environment.
Private Equity Portfolio Company Governance Model
The governance model implemented at the portfolio companies of the best private equity firms provides sound direction toward what a new model for public companies could entail. Research by EY has shown that the portfolio companies of the top PE firms outperform their publicly traded peers in key measures such as enterprise value creation, productivity growth and EBITDA growth over 5 year periods. (4), (5), (6) Moreover, consider the following results from a group of 20 Chairmen/CEOs who have served on both public-company and private equity boards: (7)
• Most said that PE boards were significantly more effective than those of public boards.
• Three-quarters (15 out of 20) said that PE boards added more value; none said that the public counterparts were better
• On a 5-point scale (where 1 was poor and 5 was world class), PE boards averaged 4.6, public boards 3.5
• The intensity of the Performance Management Culture of PE boards was the single largest variance between the two types of boards
• Public boards focus much less on fundamental value creation levers and more on quarterly profit targets/market expectations
• Public boards seek to follow precedent and avoid conflict rather than exploring what could maximize value, i.e. more focused on risk avoidance than value creation
An Entrepreneurial Governance Model For Public Companies
At the top private equity firms, the boards of portfolio companies are clearly viewed as a key asset and are developed, led and function in ways that maximize this asset value. It is time to think about public company boards in this manner, i.e. as an asset. However, in order to maximize the performance and value of this asset the shift to a radically new governance model, one that approximates the private equity model, is required.
Let’s call this new model the “Value Maximization Model.” At a high level, the core of this model is an intense focus on the business being governed. But, not just on the business but on the development of its full potential over the longer term. More specifically, as I explain in my book Governance Arbitrage: Blowing Up the Public Company Governance Model to Maximize Long-Term Shareholder Value, this model would:
● Have the clear governing objective of optimizing capital allocation and maximizing longer-term company performance and shareholder value
● Be led by a high performance chairman with responsibilities and qualifications distinct to this governance model (not just the lame criteria of “independence”)
● Initiate an effective due diligence process that results in deep knowledge of the industry, the company and is levers for maximum longer-term value.
● Remain aggressively and continually on the hunt for the optimum levers and initiatives to maximize the company’s potential
● Be populated by directors with experience and track records (the latter cannot be overemphasized) relative to the company’s industry, specific major value drivers/initiatives and general value creation and who have an owner’s mindset
● Be intensely and proactively engaged to ensure the governing objectives are met.
Business now functions in an environment of hyper-competition. And this aggressive competition is not going to slow — instead, it will continue to accelerate. Although in my view boards have the responsibility to ensure that the companies they govern are maximized regardless of circumstances, the competitive environment will make this become increasingly mandatory. Just one example of many, can be seen in manufacturing. A March 2019 McKinsey podcast focused on “lighthouse” manufacturers, i.e. those that are “combining automation, artificial intelligence, the Internet of things and more to fundamentally change how they operate.”(8) Companies that are making this leap are jumping out ahead in performance and productivity growth; those that are not leading the way will find it extremely difficult to catch up. Concern during the podcast was voiced because the lion’s share of these plants are in China, other parts of Asia and Europe with the US being a laggard. [Emphasis Added]. And, as I have noted in numerous articles, Dr. Kai Fu Lee, who has deep experience in both Silicon Valley and the Chinese tech scene stated emphatically that Chinese Tech entrepreneurs make Silicon Valley look downright sluggish.
No apology is offered for this capitalistic view of the board as an asset and for advocating for a model that can lead to significantly better capital allocation, higher performance and greater longer- term value. Some (not all) of the current proposals for boards are good — if approached rationally and with an economic mindset. But, let’s not let these overwhelm and obscure the fact that the current public company governance model has already resulted in an underperforming and undervalued asset that leads in many cases to companies falling short of their full potential. Let’s not forget that there is an actual business to be “governed” and let’s consider that a shift to a more robust and focused governance model, one that approximates the top PE firms’ model, could actually result in a governance arbitrage — an increase in value resulting from this shift.
Notes:
(1) McKinsey & Company, Improving Board Governance: McKinsey Global Survey Results, August 2013
(2) Dominic Barton and Mark Wiseman, “Where Boards Fall Short,” Harvard Business Review, January-February 2015
https://hbr.org/2015/01/where-boards-fall-short
(3) Gerry Hansell and Dieter Hueskel, “The CEO As Investor,” Boston Consulting Group, April 14, 2012
(4) Ernst & Young, How Do Private Equity Investors Create Value? A Study of 2006 Exits in the US and Western Europe
(5) Ernst & Young, How Do Private Equity Investors Create Value? A Global Study of 2007 Exits
(6) Ernst & Young, Returning To Safer Ground. How Do Private Equity Investors Create Value? A Study of 2013 North American Exits.
(7) Viral Acharya, Conor Kehoe and Michael Reyner, The Voice of Experience: Public Versus Private Equity, McKinsey & Company Insights & Publications, December 2008
