Learning from Private-Equity Boards
Boards of professionally sponsored buyouts are more informed, hands-on, and interventionist than public company boards. HBS professor emeritus Malcolm S. Salter argues that this board model could have helped Enron—and perhaps your company as well. Key concepts include:
- Boards compiled by professionally sponsored buyout firms are typically more informed and hands-on, and have more investment at risk than boards of public companies. That makes them more likely to spot problems and intervene before the problems become crises.
- Public companies need to consider a different population of directors to include the large pool of former executives and successful entrepreneurs who have stepped down after decades of accomplishment and have the time, energy, and interest to be truly focused directors.
- Given increasing time commitments and responsibilities, public companies need to present a better financial reward for directors—a doubling of director compensation may be an absolute minimum.
- Directors should be required to invest between $250,000 and $1 million in personal holdings depending on revenue size of the company.
If Enron had been owned and controlled by a small group of private-equity investors, could the monitoring and control practices of a professionally run buyout shop have protected Enron's shareholders and employees from the problems that destroyed the company and threaten other public companies today?
The answer is yes and no. The no (or probably not) answer reflects the likelihood that executives of private-equity firms do not, on average, possess any more ethical discipline than leaders of public companies. Maintaining ethical discipline, Enron's greatest failing, is a never-ending challenge for corporate boards.
The yes answer reflects the fact that many productive aspects of corporate governance and control that have proven effective in the private-equity industry were noticeably absent at Enron. If Enron's board (which was never charged with a breach of fiduciary duty in the class-action suit against the corporation) had adopted the salient structural characteristics and processes of experienced private-equity boards, I believe that many of the red flags signaling Enron's economic woes and ethical drift would have been noticed and acted upon promptly.
Boards of professionally sponsored buyouts are typically more informed, more hands-on, and more interventionist than public company boards. There are several reasons for this:
- Private-equity boards typically have the advantage of in-depth due diligence that precedes a buyout, and they use this highly specific knowledge to oversee the ongoing business.
- Private-equity directors typically spend more time with their companies after the buyout than many of their public company counterparts.
- Private-equity boards are typically small working groups composed of individuals with relevant operating and financial knowledge.
- Private-equity boards are typically composed of members with substantial wealth at risk.
- Private-equity boards know how to structure financial incentives that deter reckless gambling and reward profitable growth.
- Private-equity boards rarely rely upon quarterly or monthly meetings alone. They review a continuing flow of detailed monthly earnings reports, and many directors engage in weekly and often daily conversations with management. The idea is to pursue a candid, informal, and continuing dialogue with management.
- Finally, most private-equity boards operate with a time horizon stretching beyond quarterly earnings reports, reflecting the complexity of corporate restructurings and other long-term growth strategies.
Lessons to be learned
There are important implications of these differences for public company boards, even though they operate with a different shareholder base and statutory requirements pertaining to independent directors.
First, public companies need to consider a different population of directors to include the large pool of former executives and successful entrepreneurs who have stepped down after decades of accomplishment and have the time, energy, and interest to be truly focused directors.
These three innovations can lead to a more arm's-length relationship between directors and the CEO.
Second, public companies need a different level of director compensation. The average annual compensation for S&P 1,500 company directors is about $125,000, corresponding to a per diem fee of slightly over $4,500. This is one-fifth the per day equivalent of the average CEO, and nearly one-tenth that for CEOs of companies over $10 billion in revenues. My guess is that, given the increasing level of work required and personal risks run, a doubling of director compensation is an absolute minimum.
Third, public companies need a different degree of directors' wealth at risk. According to a recent poll by the Investor Responsibility Research Center, the average dollar value of stock held by directors of companies with stock ownership guidelines (only 20 percent of the sample!) was roughly $175,000 in 2004, although how that amount was accumulated is unclear. We can debate how large an investment directors should be required to make in a company, but my analysis leads me to propose a threshold commitment of $250,000 to $500,000 for companies in the $1 billion to $3 billion revenue range, and $500,000 to $1 million in personal holdings for directors of large companies with more than $3 billion in revenues. The directors of professionally sponsored buyouts typically have comparable personal wealth at risk.
These three innovations can lead to a more arm's-length relationship between directors and the CEO. The lack of such an arm's-length relationship—together with outdated board processes, a lack of technical mastery, and a touch of lassitude—was one of Enron's greatest points of vulnerability.
Reprinted with permission from "Enron's Legacy: Governance Lessons from Private-Equity Boards," HBS Alumni Bulletin, Vol. 82, No. 4, December 2006. See the current issue of the HBS Alumni Bulletin.