Governance Arbitrage: 3 Short Case Studies: Emulation of Private Equity Governance Model in Public Companies

In my book, I argue that public companies can achieve higher performance and increased value via a “governance arbitrage”, i.e. a change in governance model. This article presents some of the salient points in support of that thesis.

According to a McKinsey study done with 20 chairman or CEOs who had served on the boards of both public and private equity companies, “Advocates of the private equity model have long argued that the better PE firms perform better than public companies do. The advantage, these advocates say, stems not only from financial engineering but also from stronger operational performance. Directors who have served on the boards of both public and private equity companies agree — — and add that the behavior of the board is one key element in driving superior operational performance. Among the 20 chairmen or CEOs we recently interviewed as a part of a study in the United Kingdom, most said that PE boards were significantly more effective than those of their public counterparts (emphasis added).”

More specifically, the results of this study showed:

? 15 of the 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

Here is another look at the comparison between the public company governance model and the PE portfolio company governance model:

All of this presents a nice argument but how does it play out in the real world? The following brief summaries and charts provide succinct case studies — two at public companies with restructured boards that functioned with many characteristics of private equity boards and one at a public company that was taken private.

Canadian Pacific Railway:

In September of 2011, activist investment firm Pershing Square Capital Management began to build a stake in CP. Prior to this, CP had been the worst performing major North American railroad for 5 years. Their board was filled with captains of industry, had gender diversity and had won numerous good governance awards yet the performance and the stock price was abysmal. Pershing Square launched a proxy contest resulting in all 7 of their nominees being elected to the board.

Darden Restaurants:

Unhappy with the multi-year stagnation of Darden’s operating performance and stock price and accelerated by the Darden board’s irresponsible sale of the Red Lobster chain without shareholder approval, activist investor Starboard Value, via a proxy fight, replaced the entire board of Darden. Starboard’s presentation on Darden was a masterpiece.

Public To Private Situation:

The following is a situation in which I was involved where a public company was taken private. Post-acquisition, the entire board and senior management team were replaced. Certain details are omitted due to confidentiality issues.

In all three case studies, the governance model shifted from the standard public company “oversight/compliance” model to one that was more entrepreneurial and focused on maximizing value. As such, the types of directors changed significantly as did the functioning and focuses of the board. And, in each case, performance and stock price, over time, improved materially.

All of this presented and said, each of the companies in the case studies were underperformers and undervalued relative to their potential. A shift in governance model and subsequently in board members clearly resulted in increased performance and value. But the really big question is:

Would approximating a private equity governance model in a public company that, at least on the surface, did not appear to be an under-performer, result in increased performance and thus value (governance arbitrage)? To that end consider the following.

In their highly informative book Lessons From Private Equity Any Company Can Use, Orit Gadiesh and Hugh MacArthur, chairman and head of the global private equity practice at Bain & Co. respectively, say the following in discussing why the lessons in the book are not applied rigorously at companies around the world: “…..many leaders apply the lessons we will discuss but incompletely. It is easier to do “fine” than to do the “best” a company can do. We call this satisfactory underperformance — — a pervasive disease in business that is the direct target of this memo.”

And, in answer to why they wrote the book, Gadiesh and MacArthur have this to say, “The best PE firms have shifted many of the resources that they once poured into financial engineering into creating operating value — and they are doing it in a more systematic, focused and aggressive way than most public companies.

“If you are not the clear-cut leader in your industry, you can’t afford to ignore how the best PE players are transforming the business landscape. If you are the clear-cut leader, then we believe it is even more likely that you are below your full potential.”

The Bain authors have developed this point of view after many years of working with thousands of companies globally. I believe that they are correct in that most companies do not develop their full potential even if they appear to be doing “fine.”

And, there are others who also recognizing the significant value that accrues from implementing the right governance model and who have similar director selection criteria. Partners Group, a Swiss based private equity firm with $80 Billion under management recently published a paper entitled Partners Group Q&A: How To Build an Effective Board. A side bar section of the Q&A addresses the question “What is entrepreneurial governance?” In this section, Partners group makes their director selection criteria crystal clear:

“A portfolio company board usually comprises key members of our investment team [General Value Creation], industry value creation experts [Industry], a Lead Operating Director (independent chair) [specific type of chairman], and a handful of Operating Directors (non-executive directors) with extensive relevant experience [Value Driver Specific Experience]. Directors are selected based on their ability to contribute to strategic growth in a specific way and not merely to act as a counterbalance to the executive directors and investment team representatives.” [Emphasis Added]. This tracks exactly with what is outlined in my book in the chapter on director selection as proposed for a new public company governance model.

In this same piece, Partners Group also makes this critical point:

“A governance structure that enables value creation is the key element that separates an average investment an excellent one.”

In my view, Gadiesh’s and MacArthur’s Satisfactory Underperformance and Partners Group’s Average Investment are synonymous. And further, Partners Group is emphatic that the governance structure (aka governance model) is at the core of superior performance and value creation.

In conclusion, another question becomes obvious: If a shift to a governance model that approximates the PE model not only drives increased value at clear underperformers but can also materially impact average companies, how much value is being left on the table by public companies as a result of a governance model that is not designed to maximize longer term performance and value?