In light of current economic conditions, and the continued downturn in the M&A and credit markets, many private equity funds have been focusing on stabilizing the health and increasing the value of their existing portfolio investments. This focus has come in many forms, from making small, add-on acquisitions in an effort to bolster the underlying business, to spending more time on refining the underlying business operations. Indeed, today’s challenging economic environment and the generally limited ability of private equity firms to use financial strategies to increase value requires a different approach by these firms to manage their portfolio investments.

This environment presents an excellent opportunity for firms to review their corporate governance approach, as there will be a greater emphasis placed on the ability to create value through board oversight. Moreover, making corporate governance a top priority can provide much-needed comfort to a firm’s limited partners that their current investments are being well-managed in these uneasy times.

Below are a few practical suggestions for best practices that private equity firms ought to consider in reviewing the corporate governance of their portfolio investments. While none of the suggested practices is likely to create value in its own right, as a whole they have the ability to influence the effectiveness of a company’s governance and thereby increase the likelihood of its success over the long run.

Board Composition
When it comes to board size, it is important to remember that, “no one size fits all.” Rather, the appropriate board size depends on a number of factors, including the company’s stage of development, the complexity of its business operations and the company’s shareholder mix. That being said, however, sponsor-backed boards tend to be very hands-on and significantly involved with company operations, requiring a certain level of agility. Limiting the board to a maximum of five to six members makes agility possible and facilitates coordination of meetings and overall communication. Moreover, smaller boards tend to be more cohesive and work more effectively than larger boards.

With respect to the types of directors to elect to the board, seek out directors with relevant, hands-on operating and industry experience, particularly those with a specific area of expertise in an upcoming company initiative, such as a new product launch, entering a new market or an international expansion.

While there is often a desire to add multiple co-founders or executive management to the board, consider limiting the company insiders to the CEO and, perhaps, the CFO. The CEO can act as a representative of the other insiders and serve their interests, without the burden of adding a whole cast of characters to the board.

For a company considering a potential IPO, consider moving towards compliance with SEC and exchange rules egarding board composition and governance, including adding directors to the board who satisfy the various definitions of “independence.” Finally, review the company’s governance structure on an annual basis, and be both willing and prepared to implement changes that reflect the needs and growth of the company.

Board Agenda
When planning for board meetings, take time to consider and prepare the meeting agenda carefully. A well-planned agenda can make a big difference in the quality of a board meeting, serving a purpose beyond the mere content of the meeting by establishing the meeting’s overall tone and pace.

The agenda should clearly articulate each topic, as well as the expected length of time to be devoted for each topic. There should be no surprises about what is to be discussed in the board meeting; rather, the agenda should be clear about what is being covered. Additionally, order the agenda so that the topics that are most important to discuss in the meeting are addressed first, to ensure that those topics are discussed in appropriate detail. Finally, consider circulating a draft agenda to the board in advance, soliciting feedback on the topics to be covered and confirm that the agenda covers areas that the board feels should be discussed.

Board Packages
In order for board members to fulfill their fiduciary duty of care, they need to be adequately informed about the decisions they are asked to make, as well as about overseeing the management of the company. The best source of information about the issues confronting the company is most commonly the company’s management. As such, it is extremely important that management prepare and distribute, in advance of every board meeting, a well prepared board book along with the draft agenda, documents and financials for review and proposed resolutions.

Every board package should include the company’s most recent financial reports, including the current budget, pipeline and year-to-date comparisons against the budget. Obviously, each industry will require its own, unique data. Significant attention should be given to the presentation of the data and consideration should be given to the board’s unique circumstances (i.e., are the directors “financial experts” or, rather, more technically focused?). To the extent possible, put most of the data into a condensed, easy-to-read format. Distributing complete, articulate packages in advance of meetings can reduce the need for lengthy management presentations in most meetings so that maximum time is preserved for discussion.

Board Meetings
As with the board size, the number of meetings the board finds necessary depends on a number of factors, including the company’s stage of development, the complexity of business operations and the company’s culture. For earlier stage companies, consider holding eight to twelve meetings per year, with at least half of them in person. As a company grows and matures, the number of scheduled meetings will decrease, but should never fall below one each quarter, plus special meetings as needed. A regular dialogue will help keep the board members informed on the status and performance of the company, as well as ensure their engagement in the decision-making process.

When it comes time for the board meeting, take care to document the processes followed, and any decisions reached, by the Board. Carefully review all documents before approving them, and ask questions and probe and test all information that has been provided. Consider whether the advice of outside advisors, such as counsel or investment bankers, is appropriate. Also, consider the advice of the company’s officers and employees, to the extent they possess information that is relevant to any particular decision. Finally, be sure to give all directors an opportunity to be heard, and confirm that all directors’ questions have been addressed.

Executive Sessions
If the CEO serves on the board, then, immediately following meetings of the entire board, consider holding executive sessions without the CEO and other members of senior management present. These sessions can be a regular agenda item, either the first or last part of any meeting. The executive session enables the board to discuss sensitive issues or express their true feelings without jeopardizing the relationship with the CEO or senior management. Take care, however, not to defer important discussions to the executive session, as full and open discussion is important for the proper functioning of the full board. Consider having the lead director sit down with the CEO following the executive session and de-brief the CEO on what was discussed, so that there are no misunderstandings or suspicions.
Committees
The use of committees by portfolio company boards generally depends on the size of the board and the overall governance strategy of the sponsor. If the board consists of only a handful of directors, it is difficult to effectively distribute work among the board. However, in the case of larger boards, committees can be a valuable tool in
improving the overall efficiency of the board by delegating tasks to those directors who can most efficiently do the work. With respect to governance strategy, some firms tend to run their portfolio companies entirely at the board level, whereas others view the board as responsible for broad strategic objectives, policy guidance and legally required matters, utilizing committees for monitoring and oversight.

If committees are utilized, a few guidelines should be considered. First, directors should not serve on more than two committees, to assure one or two directors are not undertaking the bulk of the board’s work. Second, these committees should be made up of no more than four members, to maintain efficiency. Third, directors should be selected for committees based on their expertise and interests. Finally, the general advice concerning agendas, pre-read materials, meeting process and executive sessions set out above all apply equally to committee meetings.

Chairman/CEO Split
While institutional and activist shareholders have been increasingly advocating for separating the chairman and CEO roles of publicly held companies, private equity firms have long maintained their independence from the CEO of their portfolio companies by reserving the chairman role to a representative of the private equity firm. In so doing, private
equity firms are able to preserve their objective judgment of management’s performance, as well as promote a balance of governance power. However, the success of such a split is dependent on the individuals who hold these roles and how they work together. In order for the separation to be effective, it is important that the chair and CEO roles be clearly defined, and that the responsibilities and limits of each role be respected.

Identify Risks and Put in Place Oversight Procedures
A private equity firm’s due diligence on its portfolio companies should not end with the closing of its acquisition. Rather, due diligence should continue into its initial ownership phase. Managers and employees are more likely to let their guards down and speak more freely about the business to their new owners once the keys have changed hands. As such, managers and other key employees should be interviewed and asked about specific risks they believe the company faces.

Once those risks are identified, put in place proper oversight procedures to carefully monitor those risks. For example, is there a risk of mismanaged inventory levels, creating excessive warehousing costs? If so, then implement an inventory management system. Is there a risk that accounts receivable days outstanding are being allowed to stretch too far? If so, then put trigger mechanisms in place that alert management when a customer’s account becomes overextended, in an effort to minimize further exposure. Or rather, is there an internal risk that employee withholding taxes are being diverted? If so, then require management to submit quarterly withholding and payment reports. Also, consider borrowing a page from the Sarbanes-Oxley play book and have an officer certify as to the accuracy of such reports. Whatever the particular risk is, be sure that it is a risk that can be monitored.

Indeed, boards play a crucial role in providing oversight in the area of enterprise risk management (ERM). In an effort to improve the board’s oversight of risk management, consider adding directors with a variety of expertise and proper risk management training. Also, in an effort to increase directors’ ERM oversight, dedicate time at each board meeting to discuss various risk management relevant topics. Finally, identify those key executives who have the best perspective on the organization’s risks and foster an ongoing dialogue among such individuals and the board.

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