It’s Time for Private Equity Boards to Step Up
Despite a challenging economy and rising interest rates, private equity and venture capital investors are flush with more than $1.93 trillion of dry powder to deploy over the next 12 to 24 months. Most private equity investors continue to be optimistic for dealmaking and value-creation opportunities.
Private equity boards are created every time a deal is closed, and these boards will continue to grow. Given a tumultuous economic future, the emergence of new business models, and the shortage of great talent at all levels, private equity investors must put more thought and care into establishing boards for portfolio companies.
As the founder and CEO of Summit Leadership Partners, I’ve worked with, advised, and presented to countless public company boards, private equity-backed boards, and everything in between. While public company boards tend to govern and advise, private equity boards can play a greater role in providing strategic direction, coaching the management team, and sharing expertise as we navigate the next several years in the business world. It requires dealmakers and lead investors to rethink how they establish and optimize the value of the board.
Establishing the Board
In public companies, boards have a fiduciary responsibility to shareholders as well as over the governance, legal, and ethical aspects of the businesses. In private equity-backed companies, boards are there to advise and counsel other investors and the CEO. Yet all too often these boards are made up of investors or members appointed by investors, and therefore their perspectives can be narrowly focused.
Populating the board with investors, close colleagues, or acquaintances risks creating a board that is insular and leans on the main investor. This clouds the board’s judgment, focusing directors on what matters most to the company’s investors rather than on the best way to grow the business. It also limits directors’ expert insights for uncharted waters.
Private equity investors are beginning to see this and are adding more independent directors to the boards of their portfolio companies. On private company boards in 2021, 51 percent of directors were independent, according to the NACD 2021 Inside the Private Company Boardroom survey report. Private company boards need to continue bringing in outside talent to gain new insights, increase independence, and ensure diversity of thought and industry experience.
The good news is that private equity boards can play a more valuable role in support of the business. It starts by identifying proven operators to serve on the board and taking a thoughtful approach when identifying the experiences and skill sets needed. Investors should identify potential independent directors early—and before the deal is closed. They should also consider having potential directors involved in the screening or due diligence process of the deal to evaluate their knowledge and contributions.
Additionally, the private equity firm should ensure that the board’s skill set aligns with the strategic needs of the company. Outside directors are often those with a high degree of industry or technical experience that will benefit the company but are not significant investors. Most are proven operators. They are expected to add something unique that the primary investor may not possess. In the 2021 Inside the Private Company Boardroom report, 71 percent of private company directors said that their boards added outside members as a “source for new ideas.”
Bringing in outside directors is more important than lead investors calling someone they know. Our experience is that appointing operating partners, whose job is to improve performance within the business, and even hold a CEO accountable to agreed changes, presents a conflict for the CEO, as the operating partners need to trust the CEO and be vulnerable to help. This can be compromised when the operating partner also sits on the board.
Changing the Board Dynamics
The tone and culture of the board should also evolve from a small group of insiders to true expert advisors who can provide independent points of view. Appointing people with broader experiences and backgrounds to the board will invariably create some tension over how and when directors can voice their opinions. The board culture must be open, collegial, and encourage all perspectives. Lead investors have an important voice, but directors should not merely follow their lead because they were appointed by them. The tone for board discussions and expected engagement must be established when recruiting directors and reiterated in the first formal board meeting.
Given that most private equity investors have never run a business, private equity boards need more independent and diverse opinions to solve the most complex business challenges. While the investors bring a unique perspective on how their capital creates value and represents expected return horizons, the independent board members share their industry, technology, and operating expertise. It is critical for the board not only to share outside insights but also to relate to and understand the portfolio company’s challenges. For example, when establishing a board for a founder-led company, I often suggest to private equity investors that they seek people who at some time in their career have been founders themselves to ensure relatability.
Change is also needed in board committees. Because private company boards tend to spend more time on strategy, value creation, and business performance and less on fiduciary responsibilities, governance, and reporting, they may fall behind public company boards in terms of the committees they have in place. Most private companies have an audit committee and a compensation committee but rarely have other committees. Private equity boards must engage more on talent, succession, and organization topics and should thus broaden the role and charter of the compensation committee. Given the pressure to have environmental, social, and governance policies and practices in place, private equity boards could raise their engagement here as well.
Onboarding and Continuous Improvement
Onboarding is critical for each board member’s success, but private company boards tend to have a less structured onboarding process compared to public company boards. At the same time, private company boards often have first-time board members, meaning onboarding is even more important. According to the 2021 NACD report, about half of private company boards (48%) added new members in the preceding year.
There are two learning curves new board members tend to face: understanding the company and understanding their role on the board. Those new to a board may be hesitant to speak up, so boards need to have a disciplined process for educating members on the industry and the business. Investors and current directors should give them support and coaching in their first year so that they understand when to share their insights and knowledge.
Suggested best practices include having new board members go on site tours, meet with key accounts, and have one-on-ones with the CEO and other key leaders. Any information and readings on the business, financials, strategy, and market should be sent well in advance of meetings. We have seen some boards assign a peer board member to mentor the new director for the first 12 months.
Another suggested practice for improving private equity board impact includes taking a page from the public company playbook and holding an annual or biannual board assessment. This process involves evaluating the board’s functioning, alignment to expected goals, culture, individual directors’ contributions, and areas to improve. This can be as informal as the board chair calling each director for some feedback, or as formal and professional as having a third party interview board members and using an anonymous survey. While most public companies conduct board evaluations, it is far less common at private companies. The bottom line is that boards should routinely have a “health check” to ensure that they are optimally serving the needs of the business.
Private equity boards are moving toward more independence given the complexities and challenges facing companies today, but the movement is still too slow. It is time for investors to challenge the lead investor, bring in new voices, and encourage all board members to share their knowledge.
The current operating environment is creating the ideal opportunity. While the public markets are talking about a potential recession, private markets still have a tremendous amount of dry powder to deploy and historically are less affected by economic downturns. Boards will continue to be formed and reshaped by these trends, and they must have the right amount of objectivity to help companies increase their value. With the right team players, processes, and protocols in place, the private equity board can meet the needs of investors, the business, and employees. Now is the time for private equity boards to improve their game.
Dan Hawkins, NACD.DC, is founder and CEO of Summit Leadership Partners.