Private equity

Picture this: a giant industry superannuation fund backs the takeover and delisting of a mid-cap company from a stock exchange. A condition of the fund’s investment is the privately owned company forming a board and adopting governance best practices.

As custodian of its members’ retirement savings, the super fund wants to be satisfied the private company has broadly similar Environmental, Social and Governance (ESG) practices to a listed firm, or even that it adopts ASX Corporate Governance Principles and Recommendations, where relevant (some larger not-for-profits and private companies use the Principles as a guide).

Moreover, the industry fund expects the private company to have a larger, diverse board that includes professional company directors. It wants more detailed governance reporting and greater transparency from the private company, and for it to consider financial and non-financial goals for a broader range of stakeholders.

This is a different governance approach from the traditional private-equity model, where a fund that invests in the sector may appoint a director to safeguard its interests. Private companies sometimes form a Board of Directors when they raise significant external capital, but these boards tend to be much smaller and less formal than their listed-company peers.

It’s too early to tell how the move by Australian and international investment funds to allocate extra capital to the private sector will affect its governance. But a confluence of trends suggests governance and board expectations in the private sector are on the verge of faster change.

Here are nine trends to consider:

1. Worldwide decline in listed companies

The number of listed companies in the United States has fallen by half since 1996, according to the Centre for Research in Security Prices at the University of Chicago’s Booth School of Business.

The figure is not as alarming as it sounds: many listed companies have become much larger in the past decade, absorbing small listed and unlisted rivals and reducing the number of listed entities. But global growth in publicly listed companies, by volume at least, is easing.

2. Fewer Initial Public Offerings (IPOs)

An IPO was once considered a key success milestone for private companies and a vital source of funding. But there were only 190 IPOs in the US in 2018 of companies with a market capitalisation above US$50 million, from 486 at the peak of the technology boom in 1999, reported Statista. Remarkably, IPO volumes in the US have been broadly flat for almost two decades.

“…a stock exchange listing is often a trigger for a company to form or upgrade its board. Fewer IPOs means fewer boards being formed and less market scrutiny of governance standards.”

This trend, seen in other developed markets, has significant governance implications because a stock exchange listing is often a trigger for a company to form or upgrade its board. Fewer IPOs means fewer boards being formed and less market scrutiny of governance standards.

3. Private-sector investment boom

The private markets’ assets under management surpassed US$5 trillion in 2017, up 8 per cent on the year, according to the latest McKinsey Global Private Markets Review.

International pension funds and sovereign wealth funds continue to pour money into funds that invest in private companies, and increase their portfolio’s allocation to alternate investments. They believe returns from private equity will exceed those from public markets.

Large and listed

With so much potential capital available for high-growth private ventures, more companies are staying private for longer and the attractions of a stock exchange listing – access to capital, share liquidity, price discovery and profile – may have lost some appeal.

4. Australian institutional investment capital

The move by industry superannuation funds, such as AustralianSuper’s joint venture with BGH Capital to buy out Healthscope and Navitas, is worth watching.

ANZ chairman David Gonski reportedly told an Australian Institute of Company Directors conference this month that he expected more private-equity raids on listed companies – a move that is hugely significant for governance and company directors.

As leading super funds become larger, internalise more of their investments and have higher ownership stakes in smaller companies, it stands to reason they will want more say on the firm’s board and governance.

Free from insider-trading rules that apply to listed companies, institutional investors could have greater scope to join private-company boards and influence organisation strategy.

5. Entrepreneurs wanting to retain control

There is a growing view in the global entrepreneurship community that the costs of listing on a stock exchange are starting to outweigh the benefits. The main cost is rising compliance and regulatory requirements that eat into the firm’s financial resources and management time.

Another cost is the short-term focus of equity markets. Some entrepreneurs complain that the market’s emphasis on next quarter’s result is at odds with their “long game” to build a venture. They believe their venture is better placed to cope with volatile, disruptive markets by remaining privately owned than being listed on an exchange.

Tesla founder Elon Musk controversially said last year via Twitter he was thinking of privatising the US$70-billion company – a comment that got him into hot water with the US Securities and Exchange Commission (SEC) and resulted in a US$20 million settlement. “It actually makes (Tesla) less efficient to be a public company,” Musk once told Rolling Stone magazine.

Also, more entrepreneurs are launching ventures with dual-class shares that involve two classes of stock – non-voting shares and voting shares. The goal: to maintain the founder’s control over the company even though he or she may not be the majority shareholder – a development that governance purists detest but one that has been embraced by Silicon Valley tech companies.

Dual-class shares strike at a pillar of traditional governance: the one-share, one-vote model. Stock exchanges are under growing pressure to change their listing rules to better facilitate dual-class share structures favoured by tech companies.

Chinese e-commence giant Alibaba Group Holding famously bypassed the Hong Kong stock exchange and listed in 2014 on the NASDAQ in the United States so its founder could preserve company control through a dual-class share structure.

6. Shareholder activism

The rise of shareholder activism worldwide is creating another incentive for companies to stay private for longer, and for some listed companies, particularly those needing restructuring, to delist from stock exchanges and transition to private ownership.

Shareholder activism is almost becoming an asset class in its own right as hedge funds in the US and other developed markets target underperforming listed companies and force change.

Environmental activism, where sophisticated non-governance organisations target listed companies on their climate-change, human-rights or other practices, is also growing.

Aggressive short-selling campaigns, where hedge funds look to profit from a falling share price, have been a recurring problem for Australian companies such as Harvey Norman Holdings and others that detest the practice and believe short-sellers are a scourge of equity markets.

Accompanying these trends has been growth in litigation funding and shareholder class actions as investors seek compensation from companies alleged to have breached continuous disclosure rules or failed other requirements.

US governance experts, such as Professor David Beatty, Conway Director of the Clarkson Centre for Business Ethics and Board Effectiveness at the University of Toronto, believe the boom in private-equity investment is partly a response to growth in shareholder activism.

He told the Governance Leadership Centre (GLC) last month: “I suspect we are at a point where high-growth organisations believe the cost and complexity of being a listed entity, and all the governance and market interaction that entails, is no longer worth it. Private-equity capital is plentiful and executives who run privately owned companies can get on with their job rather than spend so much time on board, governance and investor-relations issues.”

7. Expansion of local entrepreneurship support

Australia’s entrepreneurship ecosystem is rapidly expanding as more incubators, accelerators and co-working spaces form to support high-growth ventures. The result: high-growth ventures are being exposed to the benefits of governance earlier in their firm’s journey.

As this edition of the Governance Leadership Centre reports, entrepreneurial ventures are considering forming Advisory Boards consisting of mentors/advisers, or fiduciary Boards of Directors earlier in their venture’s journey.

Some start-up incubators and accelerators (which help early-stage and more established start-ups grow) are teaching entrepreneurs about basic governance and board skills – as are universities that continue to launch entrepreneurship subjects and degrees.

8. Private sector’s governance appeal grows

There is little doubt that financial, legal and reputational risks for directors of listed companies have grown this decade, amid rising regulatory requirements and greater market and public scrutiny. The fear is these risks will reduce the pool of top director talent to serve on boards.

At the same time, board workloads are rising, director fees are growing slowly, and there is pressure on directors who are perceived to hold too many board roles. Some directors might feel the rewards of listed-company directorships are not worth the risk.

In contrast, board roles in private-equity-backed firms are typically more focused on performance than conformance, are hands-on and have higher potential returns for directors through equity incentives.

Also, private-sector board roles have a different risk profile to those for listed companies that are subject to continuous disclosure rule and have far greater market and public scrutiny.

Diane Smith-Gander, FAICD, non-executive director of Wesfarmers and AGL Energy, last month told the GLC: “More board talent is gravitating to the private sector because there are potentially higher rewards and less risk compared to governing listed companies. I fear we could see a talent drain in listed-company boardrooms quicken in 2019 as extra regulation, risk and workloads make these directorships less attractive.”

9. International moves to strengthen private-sector governance

The UK has taken steps to strengthen private-sector governance through the Wates Corporate Governance Principles for Large Private Companies. The Principles, part of reforms to the UK Corporate Governance regime, were released in the UK this year.

The new reporting requirement applies to companies in the UK that have either 2,000 employees or a turnover of more than £200 million and a balance sheet of more than £2 billion. Private companies that meet this criterion must publish a corporate governance statement in their annual report and on their website.

The UK’s move is targeted at large private organisations and, for now, has reasonably modest governance requirements. The expectation is the Principles will become more detailed and possibly apply to smaller private companies in the next decade, as they are accepted.