Governance: An act of leadership or service, or both?

19/2/2019

I have just returned home from a busy but most invigorating week on the East Coast of the United States. The purpose of the trip was two-fold. First, to invest in myself by attending a course; and second, to participate in a series of meetings and discussions to explore matters relating to boards, board effectiveness and how high performance might be achieved.

The following paragraphs summarise some of my learnings. If you want to know more, please get in touch.

The Boards that lead programme at Wharton Business School attracted 49 serving and aspirational directors from ten countries. Professors Michael Useem and Ram Charan and their colleague Dennis Carey led the course incredibly well; a highly interactive exploration of when boards should lead, when they should follow and when, simply, they should get out of the way. The insights and commentaries from both the course leaders and several highly-esteemed company chairs, activists and academics during 'fireside chats' provided great assurance that it is possible to make a difference. A notable theme was that directors cannot afford to be aloof in their role. If [strategic] decisions are to be informed and value is to be created, directors need to ensure they understand the business of the business well—and that takes time.

Many boards in the United States are still caught in the 'compliance' trap—the protection of personal and professional reputation continues to be a more pressing priority for many directors (than the achievement of performance goals). As a consequence, boards are not paying sufficient attention to the strategic future of the companies they govern. While compliance matters are by no means discretionary, boards need to get more courageous with their time allocation, and also demand better reporting, to ensure compliance matters do not dominate the agenda.

Several directors lamented—some at length—that the promotion of ESG in recent years has been counter-productive. Rather than focussing boards on performance dimensions beyond money (the intention), boards have in practice become more concerned about adherence to prescribed 'best practice' frameworks. The directors I spoke with said that 'G' (governance) element in particular is problematic—adding little in terms of focussing boards on the creation of value over the longer-term. The alternative that sits more comfortably with directors I spoke with is SEE (social, environmental, economic).

The value of purpose reared its head in several discussions—director awareness of the need for clarity in relation to why the companies they govern exist is increasing. However, more needs to be done, to ensure a collective understanding is achieved. Time spent explicitly sharing thoughts and assumptions, with the intention of reaching agreement on a single, stated purpose is crucial: A North Star for decision-making.

The diversity discourse continues to evolve. Thankfully, a growing cohort of directors are realising that physical attributes of boards (number of directors, ethnic or racial heritage, or gender diversity, for example) provide little assurance of board performance let alone company performance. A more sophisticated understanding is crucial. My colleague, James Lockhart, has been vocal on this point for some time.

I was asked on several occasions to explain the Strategic Governance Framework, a key finding to emerge from my doctoral research completed in 2016. Both individual directors and boards were fascinated to learn that a framework for better board effectiveness (one informed by actual board observations) is now available for consideration and deployment. This was most gratifying. Boards interested in exploring this framework further should contact me directly for a private discussion.

Capping off the week, I spent 36 hours in Washington DC, taking in the sights and sounds of the National Mall, and visiting a couple of two of the Smithsonian Institution's fine museums. Returning to the hotel, the last eighteen words of Lincoln's address at Gettysburg rang in my ears. If companies are to prosper in the future, boards need to embrace a strong sense of purpose and service—to the company and legitimate stakeholders. Anything less is not only selfish, it is unsustainable.

Finally, and more personally: to the many unnamed folk I met through the week, thank you for your generosity. If the high level of interest throughout the week is any indication, the likelihood of me spending more time in the United States, to wrestle with both the opportunities and challenges of rethinking board effectiveness, and concentrate on company performance more so than compliance tasks (although such tasks cannot be neglected), is high.

If you would like to discuss any aspect of this summary, challenge my observations, or explore implications for your board, please get in touch, I'd be delighted to hear from you..

8 Comments

Dr Stuart Farquhar

16/10/2019 00:38:58

As usual Peter this is very interesting and informative. But, I still think the idea of value creation is a nebulous concept without any definition of and theory of value. Without such, it can mean anything to anyone and as such it becomes meaningless. You’ll likely be aware of correspondence I’ve been having on this subject, but this is a major weakness in the entire value creation concept and thus why I prefer only to use it to critique it as I would shareholder value maximisation.

Those who advocate the idea of value creation can easily be criticised on the same grounds as to what they are critical of with an agency theoretic approach. I would thus prefer the concept of value creation to be used with caution.

I thus think we have a long way to go theorising in corporate governance which requires a solid theory of value to enhance the entire notion of what do we mean by value creation.

Take care and enjoy your next trip

Peter Crow link

16/10/2019 06:26:35

Thanks Stuart

Indeed, this is one of the great challenges. I look forward to exploring this with you further, and will contact you directly.

Regards –prc.

Henry D. Wolfe link

16/10/2019 09:35:38

Peter:

It seems that there is a never ending story of public company governance being made too complex and too complicated. And, it is axiomatic that as complexity increases, efficiency and productivity decrease.

And, respectfully, I will have to disagree with Dr. Farquhar that value creation and value maximization are nebulous concepts. I have been a director on over 15 for profit boards and as non-executive chairman in most of these situations. There has not yet been a single instance in which we did not have a tangible 5 Year Equity Value target, i.e. a specific value creation target that was the primary focus of the board.

In none of these situations was there anything nebulous about the target. Each was a product of a significant deep dive due diligence process, either initiated by the board itself or by the private equity firm with whom I was co-investing. The intent of the diligence process was to determine the full potential of the company and to identify the most productive major initiatives that would drive the company forward toward the 5 Year equity value target.

Board members were then recruited based on the value creation drivers of the company in question. The board's primary focus was on heavy monitoring of management's progress toward the milestones and targets set for each initiative all in the context of the longer term equity target. In every situation, the targets and plans were very aggressive but were grounded in what was learned during the detailed diligence process. This detailed due diligence process addresses the continuing issue of a lack of knowledge of the business on the part of the board. (That said, increased knowledge for public company directors won't accomplish much if the governance model does not change).

While requiring a huge amount of work, this is not a difficult process. Further, it results in total clarity and much greater simplicity for the board. But, in order to be successful, it does require a different type of director than is typically found on most public company boards.

I addressed all of this and more in my recent book regarding the need to blow up the public company governance model. In addition, another great look at it was provided in a white paper entitled "Governance Correctness." This was written by the chairman of Partners Group, a Swiss private equity firm with over $90 Billion under management and one of the best track records in private equity. In this paper, he pointed out clearly and succinctly the shortfalls of the public company governance model and the superiority of the more entrepreneurial private equity governance model.

16/10/2019 10:25:59

Hi Henry,

Whilst I agree with some of your points, I respectfully disagree with your good self on value creation. What do you mean by value? How is it measured? How do you do know value is being created and not destroyed when there is no single clear definition of value?

Shareholder value maximisation is usually clearly understood but there are many issues with it, especially the difference between the short run and the long run. But for value creation to have generalised meaning there has to be a shared understanding of what value actually is and for whom? This is where a theory of value is critical to any serious development of corporate governance theory.

Value creation can mean anything to anyone so it means whatever you like and the result is it becomes meaningless. If your board has a shared understanding of the factors driving value creation, what is value to your board members? Do they have a similar understanding of what value is and for whom is this value? Value to different stakeholders is likely to have different meaning. For shareholders value is often seen to be share price growth and dividends, for employees value will be seen differently, for customers, value is something else, suppliers will view it in another way. So my point is what does one mean by value creation when value has different meanings to different constituencies of a company. Until we have a shared understanding of the meaning of value and a theory of value we are left with a concept that is largely nebulous.

Your point about the private equity governance I would contend rather defeats your own argument for seceral reasons. First, the argument is largely similar to Adam Smith’s contention that partnerships will be a more efficient form of organisation to limited companies. Arguably private equity firms are akin to partnerships in terms of control. So why have public corporations survived for do many years? For all it’s limitations this was the original purpose of agency theory - an attempt to explain the success of what Smith considered an inefficient form of organisation. Second, evidence on private equity suggests that in at least some examples efficiency is seen in short-term value extraction rather than long term value. Third, the arguments of a chairman of a private equity company need to be considered in light of one example and ignores the shortfalls demonstrated by several private equity organisations. They may be a helpful contribution but it is no panacea nor necessarily an improvement.
Thank you for your contribution. It is helping in further crystallising my thinking.

16/10/2019 11:17:16

Stuart:

I will keep this simple: I am a capitalist. As such, for me, value is equity value and value creation references the increase in the value of the equity over a medium to longer term period.

What it does not reference is an obsession with quarterly earnings nor the starving of a company of adequate capital investment.

In regard to boards on which I have been a member, value creation and value maximization is crystal clear as to the reference to equity value and to the underpinnings of value creation including highly efficient and productive capital allocation, revenue growth, talent maximization, productivity/cost improvement and EBITDA/EBITDA Margin growth. All board members understand clearly what the governing objectives are which in a nutshell are to optimize capital allocation and maximize company performance and shareholder (equity) value. There is no ambiguity regarding these objectives.

I do not agree that private equity boards are more effective due to the legal structure of the PE firms. It is the governance model itself that results in superior performance at the top (not all) PE firms. I have implemented this model in every company in which I have been involved - both private equity owned and others without the involvement of a private equity firm.

I agree with Smith that public companies, relative to private equity, are an inefficient form of ownership. But, I further argue that it does not have to be this way. Change the governance model and the problem with public companies' inefficiency and performance shortfalls can be eliminated. I am not suggesting that this is easy to do but it can be done. Best case in point is Darden Restaurants after Starboard Value removed the entire 12 person Darden board. See my LinkedIn article regarding this (which is an excerpt from my book). Article is entitled "The Board (and Governance Model) Matters: A Case Study."

16/10/2019 18:23:42

Henry,

Thank you and it raises two points. First, value creation here is value to equity holders and thus is largely no different to the shareholder value model of which many corporate governance scholars are highly critical due to scandals, ethical issues et al. This rather supports a point I’ve made elsewhere. That value creation seen this way is value to shareholders and no different to the concept of equity maximisation in the agency model in finance. The difference might then be between value extraction as evidenced in some examples of private equity rather than value creation or short versus long term.

Second, the private equity model in effect reduces to the model where there is no separation of ownership and control which is arguably the issue to which corporate governance attempts to address. It does not in itself solve the governance problem when public corporations exist. Changing the model requires changes in law but is this needed?

A final observation resulting from the previous point, is the private equity model efficient in the sense of lowering the cost of finance for firms? If so, then why do public corporations exist and arguably thrive? It brings us back to the entire purpose of the development of agency theory. We need to consider theories of the firm alongside theories of corporate governance.

Best regards
Stuart

17/10/2019 03:58:46

Stuart:

First, in regard to the current public company governance model, I believe that it has been wrongly assumed (for many years) that this is a model that is focused on shareholder value maximization. Instead, what I suggest is that the current model is not robust nor entrepreneurial and is focused on compliance, risk avoidance, directors who as Peter notes are obsessed with covering themselves and who further have an obsession with quarterly earnings. An obsession with quarterly earnings is not shareholder value maximization. Shareholder value maximization is about the development of the full potential of a company (that can empirically be determined by a robust due diligence process) over a longer period of time.

In regard to ethical dilemmas, these will always exist. Capitalism, or at least the reasonable facsimile thereof that exists in the U.S., is not a perfect system and never will be. It is highly likely that the door would be opened even wider for ethical breaches and material conflicts of interest if public company boards were to develop a "stakeholder model" of governance as promoted by the Business Roundtable.

You are quite correct that the PE portfolio companies do not have the separation of ownership and governance that public companies do. But, the top PE firms' portfolio company boards, beyond this issue, have a completely different governance model that is much more entrepreneurial, far more robust and populated with much more competent directors relative to the value creation requirements of the particular company. In one of my previous posts here, I noted the situation at Darden Restaurants when the entire 12 person board was replaced in a proxy contest in 2014. The link below is to my LinkedIn article on Darden. This provides a succinct case study into what the model I am advocating looks like in a public company and tangible performance results that accrue (and continue to accrue today):

https://www.linkedin.com/pulse/board-governance-model-matters-case-study-henry-d-wolfe/

In regard to your final point about public companies thriving. It is important here to remove all of the noise in regard to the markets driven by silly interest levels and multiple rounds of QE. My thesis is that if the governance model of the portfolio companies of the top private equity firms can be approximated in public companies (and Darden proves that it can) then most companies will experience a "Governance Arbitrage" i.e. a tangible increase in longer term underlying performance and value simply as a result of a more robust and entrepreneurial governance model with a greater clarity of governing objectives and significantly more competent directors. I further suggest that this is applicable to most public companies, even those that appear to be doing well. As the chairman of Bain & Co. so eloquently put it, most public companies suffer from the disease of "satisfactory underperformance" (I am paraphrasing). The governance model I propose hits that satisfactory underperformance head on.

17/10/2019 05:00:35

Henry, I agree with most of your sentiments in the first two paragraphs. There is what I perceive as the misplaced obsession that shareholder value is represented by focus on quarterly earnings rather than longer term value enhancement. It often leads to an emphasis on cost cutting at the expense of investment. There is also an issue with the over-emphasis on the monitoring function of the board. In this respect I think we are on common grounds.

However, I remain unconvinced that the private equity model is the solution to the problem or can be easily replicated in public corporations.

Governance: An act of leadership or service, or both?

Leave a Reply.

Search

Musings

Categories

Archives