Management of an investment

Explanation

Most jurisdictions have legislative obligations regarding information to be provided to stakeholders of portfolio companies. However, it is common practice for funds that invest in portfolio companies to require more frequent and detailed information than required by legislation. In particular, the GP may require more frequent and detailed quantitative and qualitative information regarding the portfolio company. Reporting should reflect the GP’s desire to impact strategy and value creation as well as enabling compliance with the Invest Europe Investor Reporting Guidelines and with any other specific reporting obligations to the LPs in the fund, or to regulators, as applicable. Such requirements may also depend on the GP’s ownership stake.

Typically, key performance indicators (KPIs) are developed that allow portfolio company management and the GP to carefully monitor company performance.

This investment monitoring function and information flow should enable the GP to confirm that the investment is progressing in accordance with the relevant business plan and the GP’s investment thesis. It should also provide sufficient information to identify any failures to meet targets or milestones and form the basis of remedial plans where necessary.

Recommendation

The GP should ensure that it dedicates sufficient time and resources, including senior and experienced resources, to monitoring the investments of the fund and apportions these resources and responsibilities appropriately both between funds and individual investments.

At the time of the investment, the GP should agree with the portfolio company’s management and incorporate in the Investment Agreements, the financial and non-financial reporting requirements (including content, frequency and timing) that take into account its own reporting obligations, its ability to perform its responsibilities on behalf of the fund as shareholder and the efficient and effective use of resources within the portfolio company.

The GP should prepare regular written analyses of investments, which should be reviewed by senior and experienced executives of the GP. The written analyses could address performance of the portfolio company against the agreed investment thesis and its targets and milestones detailed in the business plan for the portfolio company. They could also note significant developments since the last review and those likely to occur in the near term, provide information on any changes to personnel and the financial and non-financial status of the portfolio company. Non-financial information should include environmental, social and governance KPIs. Recommendations should be made on any remedial action that the GP should consider taking in order to ensure the portfolio company continues to achieve the financial and non-financial targets set.

Explanation

Some portfolio company information will be confidential; the GP should be aware of this, and more generally the need to treat corporate information with due consideration to commercial sensitivity and the requirements of the portfolio company’s other stakeholders.

Recommendation

The GP must not disclose any information that it may receive on behalf of the fund from a portfolio company in a manner that may breach any duty of confidentiality that it may owe to the portfolio company. Therefore, the GP needs to agree the rights it needs with the portfolio company and in particular should seek to agree appropriate rights to disclose information to the fund’s LPs so that they may, in turn, monitor their investments in the fund and comply with their own reporting requirements including, if applicable, to regulators. Also, the GP should ensure that its own LPs are bound by appropriate confidentiality obligations with respect to the confidential information, which they receive.

Explanation

Generally, GPs should support a prudent and sustainable approach to environmental risks and opportunities that can affect their portfolio companies. Such risks could concern a range of factors including resource use/depletion, water scarcity, waste production and disposal; emissions to air, land and water; energy use, cost of carbon and climate change; biodiversity and habitat conservation. Conversely, environmental opportunities may include energy (or other resource) efficiencies, waste reduction or the development of new products with positive environmental attributes (e.g. using timber labelled as being from sustainably managed forests).

GPs are generally expected to influence the management of environmental risk and opportunity factors in portfolio companies, so as to reduce risk and/or create value, with a view to long-term sustainable change.

Recommendation

Management of investments should include an ongoing evaluation of the likely impact of portfolio companies, their products and their supply chains on the environment. Such evaluation should take into account the efficacy of environmental risk management policies and procedures. For example, leading companies institute full environmental management systems, certified to ISO14001. Consideration should also be given as to the likely impact of environmental factors on the portfolio companies and their supply chains (e.g. climate change, extreme weather events, etc.).

GPs should recommend to the boards of portfolio companies, pursuant to shareholder documents, to identify and take material environmental factors into account in the formulation of the portfolio company’s business plan.

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Explanation

Generally, factors which affect the workforce, customers, suppliers and communities of a portfolio company should be evaluated at board level. Social factors can include stakeholder dialogue and human rights issues, such as the observance of core labour standards in areas including health and safety, child labour, illegal or forced labour, employment of migrant labour, trade union rights and discrimination in the labour market.

Managed badly, social factors can give rise to risks to brand and reputation (e.g. a key supplier attracting negative publicity for poor labour practices), to the attraction and retention of high quality staff, and to productivity (e.g. strikes at production facilities). There may also be legal consequences for the company and its directors.

Conversely, when managed well, social factors can add real value. Examples include establishing a reputation as an “employer of choice” through progressive employment policies and practices (thereby reducing recruitment costs and improving productivity), maintaining a “social licence to operate” (through strong community relations), and ensuring continuity of supply (through effective supplier selection, engagement and auditing).

GPs are generally expected to influence the management of social risk and opportunity factors in portfolio companies, so as to reduce risk and/or create value, with a view to long-term sustainable change.

Recommendation

Management of investments should include an ongoing evaluation of the likely impact of social factors on the businesses (e.g. availability/quality of workers, conduct of staff or business partners, trends in customer attitudes, diversity and inclusion, etc.) as well as the social impact of products (e.g. responsible marketing, or health and safety concerns) or operations. Consideration should be given to the completeness and effectiveness of any existing socially-related policies and procedures, to manage risks and leverage opportunities and to the need for, and implications of, change.

GPs should recommend to the boards of portfolio companies to identify and take material social factors into account in the formulation of the portfolio company’s business plan.

Human rights (covering workplace and supply chain issues – see Explanation) are likely to be an integral part of the social factors and board level discussions may include development of strategies to prevent direct and indirect involvement in human rights violations. Depending on the size and nature of the business, a portfolio company should also consider integrating its management of social factors into a full corporate sustainability programme and publishing progress reports on a regular basis, as part of a defined external stakeholder engagement strategy. A GP should ensure that such items are put on the agenda for board discussion where appropriate.

Explanation

One of the key areas of due diligence that should be completed by a GP prior to investment is corporate governance at the prospective portfolio company. The corporate governance systems, processes and controls applied by the senior management team at the company will reveal much about the effective running of the business to be invested in. A business with effective corporate governance in place will provide a strong platform for the rapid implementation of value building initiatives. A business with weak, ineffective corporate governance will make a higher risk investment but is likely to reap considerable benefit from the implementation of robust governance systems and processes that are suitable for the business.

Effective corporate governance, once installed, should support the decision-making process and follow-through within the organisation and the alignment of interests across the stakeholders in the business including management, employees, the GP and investors in the fund. Such alignment of interest is also part of a responsible investment framework.

A portfolio company is likely to be provided with guidance on governance requirements by the GP at initial investment. In some cases, the implementation of specific requirements will be a condition of closing the transaction. The management of a portfolio company can be strongly influenced by the attitude of the GP to board effectiveness, controls, checks and balances.

Ensuring the GP’s governance objectives are achieved, whilst preserving the autonomy of the portfolio company board to drive business growth and not hamper it with bureaucratic processes and controls, is an important balance to achieve and to be able to demonstrate at the point at which the business is sold.

Recommendation

If not already in place, the GP should typically ensure that each portfolio company has appropriate governance structures to safeguard against fraud, bribery, corruption and other breaches of legal rules applying to the company and to ensure internal financial control, quality assurance, risk and conflict management, and transparent reporting and communication.

To ensure that portfolio companies are applying appropriate good governance practices and standards, the GP should ensure it remains up to date and familiar with legal rules, good practice and guidance in the respective countries and industries in which its portfolio companies are based. Typically, the GP should periodically review the adequacy of its practices and standards.

This can be done in a number of ways, for example through a suitable law firm or adviser which can ensure that relevant Codes and Standards are understood, particularly by those individuals who will be representing the GP on the board of the portfolio company. It can also be achieved by ensuring diverse and experienced executives are members of the board or respective supervisory committees of the portfolio company, who can demonstrate a good understanding of and track record in applying the required governance standards and practices.

Poorly structured incentivisation packages can adversely affect governance. Therefore, the GP should consider the incentivisation packages in light of their impact on alignment with the objectives of long-term growth and good corporate governance.

Where the GP has identified risks and opportunities (including ESG risks and opportunities) that are deemed material to the success of the investment, the GP should ensure that practices are developed to mitigate risks and pursue opportunities. The implementation and effectiveness of these practices should be monitored and reported on as appropriate. The GP should regularly review the responsible investment risk/opportunity analysis and revise, remove or add policies, procedures and tools for implementation as appropriate (see also question 2 in the section “Planning and making investments”).

Finally, it is important that the GP also demonstrates to its wider stakeholder community sound ESG practices and standards that are both appropriate and proportionate to its own business.

Explanation

A GP may be in a position of considerable influence as regards the development, implementation and monitoring of ESG strategies, policies and practices in place at portfolio companies.

The GP, ideally through the information produced and provided by the portfolio company, should be in a position to identify, monitor and support the mitigation of relevant risks and the recognition and pursuit of opportunities in responsible investment matters that can affect the portfolio company. Where appropriate, the GP, through its board representation or through the exercise of shareholder voting or contractual rights, where so permitted, should be available to assist and advise the portfolio company on how to investigate and address the ESG factors that are relevant for the business. The GP should ensure that it remains informed of the progress being made towards achievement of ESG objectives.

These may manifest themselves in a wide variety of ways from the specification of and capital investment into a new production facility through to the criteria applied to potential add-on investment targets for the portfolio company.

Recommendation

The GP should ensure that at portfolio company board and management level there is appropriate awareness and adequate knowledge of responsible investment matters relevant to the country and sector the portfolio company operates in, including familiarity with appropriate external guidance issued by national, supranational and private bodies.

The GP should ensure that responsible investment matters are discussed on a regular basis in board meetings.

A GP should aim to ensure its own and its portfolio companies’ awareness and due consideration of responsible investment guidance and codes of conduct as applicable to the sectors and geographic regions in which each portfolio company operates are maintained.

Explanation

Dependent on the level of ownership, the GP will typically appoint one or more experienced members of its own staff or representatives to the board of the portfolio company. Appointees of the GP will normally have in-depth experience of the sector and will often have been involved in the original due diligence and review of the investment.

Depending on the jurisdiction, a company may have a single or two-tier board structure. There are many variations in the overall composition of boards, but in relation to non-executive members of a board, these may include some/all of the following: one or more single directors who are members/employees/representatives of the GP of the fund; an independent non-executive chairman; and/or, an independent non-executive board member. These non-executive members of the board may be selected because they have specific and appropriate knowledge and insight.

Recommendation

The GP should ensure that the board is structured and appointments are made to ensure relevant experience and diversity, and are made in the best interests of the portfolio company. The relationship between the board and the management of the portfolio company should be clear and supported by appropriate documentation of roles and responsibilities.

Explanation

There are a number of think tanks and organisations offering best practice guidance on the office of director and on the governance of companies.

The minimum and maximum size of the board is usually stipulated in the Investment Agreement reflecting the specific situation of the company, the governance goals of the owners and any local legal requirements.

Thinking has evolved on optimum board size. Factors to bear in mind when considering board composition include: the skills required to run the business; the interests of the shareholders and their desire for active participation in, as well as efficiency of, decision-making; the governance and logistics and cost implications of convening a large group of people frequently; and the need for balanced decision-making through diversity of opinion.

Recommendation

No number can be stipulated for optimum board size, but the board should periodically review its composition and its success and adjust its size accordingly.

Explanation

Boards function as decision-making and review forums involving people with differing skills and approaches. Diversity of skills and styles leads to better balanced and informed decision-making.

Recommendation

In reviewing board composition, the board should be aware of the benefit of diversity in its selection as well as any applicable regulatory/legal requirements regarding Board diversity. A policy need not be codified to be effective, but it may be helpful to have a written diversity policy to further the selection process.

Explanation

A portfolio company’s strategy consists of a number of core components which are the responsibility of the board. First and foremost is the development of long-term value creation through sources of current and future revenue. Of importance here are the efficient, effective and sustainable delivery of appealing products and services, the development of competitive future products and services, attracting and retaining talent and management capacity, the effective use of available resources (including financial resources) and obtaining future financial resources to help grow the business effectively and efficiently.

Recommendation

A key component of the industry’s investment and ownership model is to ensure that the interests of the members of the portfolio company board are aligned. All members of the board should seek to understand, support and further develop the business strategy of the portfolio company and should challenge that strategy in the context of their individual understanding of market, product, service, financial and societal developments as appropriate. The corporate governance structure implemented by the board should support the strategy. The GP representatives also bring additional value over and above their own personal knowledge, skills and experience, having the wealth of knowledge from across the GP firm to draw upon for the benefit of the portfolio company when required.

Explanation

A key element of a portfolio company’s business strategy execution is the identification and assessment of risk and opportunity, including decisions on what levels of risk are acceptable, what risks are associated with each opportunity, how such risks can be mitigated and controlled and how to manage the business accordingly.

The components of risk management include the clear communication of the values of the portfolio company and its appetite for risk. For example, when pursuing new business opportunities, the allocation of roles and responsibilities and the design and implementation of policies and procedures relating to the identification, control and management of risk, and the measurement of and timely reporting on the impact of risk on performance.

Recommendation

All members of the board are ultimately responsible for, and should actively participate in, risk and opportunity identification, assessment and management across all business areas, including the review of financial and non-financial (e.g. ESG) factors.

This includes ensuring that the management of the portfolio company establishes effective policies and procedures that adequately address the identification and control of risk, including legal risks. Members of the board should actively and regularly seek assurance that risk management procedures are in place and are operating effectively.

Explanation

The structure and remuneration of portfolio company executives and senior management should provide an incentive for excellent long-term performance, reward for sustainable financial and non-financial results and ethical conduct. Balancing remuneration in the context of the relevant industry, the expertise and contribution of individuals and the long-term needs of the business is a key role of the board. In many cases, consideration of these factors will be led by a remuneration committee.

Recommendation

Frequently in private equity investments, the portfolio company executives will have built in incentivisation at the time that the original investment by the fund is structured and executed. The board’s (or remuneration committee’s) role should therefore be more appropriately focused on ensuring that existing incentives continue to be appropriate for both the business and the shareholders as the circumstances of the business change over time.

The board should determine the appropriate levels of remuneration of portfolio company executives and regularly evaluate and review remuneration levels and, where appropriate, introduce changes thereto. Conflicts of interest in establishing or reviewing remuneration levels for board members should be avoided wherever possible and managed openly and constructively in all cases.

Explanation

An overriding duty of loyalty to the company applies to each director, whether executive or non-executive and whether or not appointed by a particular shareholder, although the precise legal responsibilities vary according to the type of company and jurisdiction.

A director is expected to devote such time and resources as is reasonably necessary to carry out his/her duties as a director. Attendance at and being well prepared for board meetings should be assumed. Directors with particular skills may be asked to serve on additional board committees (e.g. directors with accountancy training serving on audit committees).

Recommendation

A director must be prepared to invest time in their role as a director to understand the needs of the company and to participate in review and decision-making affecting the business.

The GP should ensure that its appointee(s) to the board fully understand their responsibilities to the GP and their legal duties to the portfolio company as a member of the board. GPs and the individual directors should familiarise themselves with local law requirements in this regard.

Explanation

Whatever the means of appointment, directors do not serve the interests of one particular shareholder but act in the interests of the portfolio company. The position of director is a fiduciary one. A director does not act as the representative or advocate of the body which appointed them. Fiduciary duties generally are summarised as a duty of loyalty to the company, a duty to avoid and disclose conflicts, duties of confidentiality, and a duty to act in good faith, to exercise care, skill and diligence and to act with integrity.

Recommendation

A GP-appointed director should always be aware that they must act in the interests of the portfolio company and all its shareholders. The individual may find that they are in a personal position of conflict, owing duties both to the GP and the portfolio company. Whilst there is normally an alignment of interest, where conflicts arise, the GP may need to excuse the director from being involved in the GP’s decisions relating to the portfolio company, and/or the director may need to resign from the board of the portfolio company. The GP should ensure that its board appointee(s) clearly disclose any conflicts of interest with respect to their role as members of the board promptly when they arise, and comply with relevant legal rules and the policies and procedures established by the GP and/or the portfolio company.

Explanation

Many skills are applicable to membership of a board of directors. The company may particularly need directors with industry experience, with legal, corporate finance, accounting or sustainability experience, or with general management experience that are relevant for the company and/or the sector and geography it operates in. All these skills, plus the ability to evaluate risk, the ability to build consensus and demonstrate leadership and other skills, are likely to be needed by every company over time and are unlikely to be offered by one sole director.

Recommendation

The GP should encourage its board appointee(s) to seek appropriate support and training to enable them to carry out their duties as board members to the best of their abilities and in accordance with their legal duties and contractual commitments. The GP should seek to ensure that all appointees to the board are individuals of appropriate authority, skill and experience who can provide value and insight to the portfolio company. Also the ability to work collaboratively and openly with senior management and other directors is of great importance.

Explanation

The office of director is a position of responsibility and trust and no one should be forced into accepting the position. Some individuals may be unwilling to accept office because of the potential liabilities attaching to the position of director.

Depending on the jurisdiction, directors may incur personal (including potentially criminal) liabilities in particular for failure to maintain company books and records; non-compliance with applicable tax, anti-trust, anti-corruption, health and safety, environmental and other laws; transactions not performed at arm’s length; and/or in certain insolvency situations. Directors are generally entitled to expect indemnification from the company and from their appointing GP in the case of GP-appointed directors. Directors and Officers liability insurance (often called “D&O” insurance) may typically be purchased to address such risks.

Recommendation

Directors should ensure that the boards on which they serve obtain legal or other specialist advice for complex board decisions. The GP and portfolio company also procure adequate liability insurance is in place and commensurate with the specific circumstances.

Explanation

Someone with a track record of good performance as a board director may find themselves invited to join multiple boards. This may lead to the person having limited time to perform their duties fully.

Recommendation

A director must only accept the number of board seats that they can reasonably expect to perform effectively, taking into account unforeseen developments in companies and the need to participate not only in full board meetings but also in committees and to devote sufficient time to review board information.

Explanation

The level of GP (investor) consents that are deemed appropriate will generally be agreed when negotiating the Investment Agreement. This is considered in question 6 in the "Planning and making investments" section.

Normally, an investment will be structured in such a way that certain proposed actions by the portfolio company will require consent from shareholders, including the GP on behalf of the fund. These shareholder consents should be differentiated from consents required from members of the portfolio company’s board where the GP has appointed one or more executives to that board.

Recommendation

The GP must ensure that when giving or withholding consent it acts in the best interests of the fund and in accordance with its policies. Executives who are on the board of a portfolio company normally have to act in the best interests of the portfolio company. It may therefore be advisable to have a different member of the GP staff or representative exercising shareholder consents.

Explanation

The nature of private equity investments is such that, in certain jurisdictions, it is not uncommon to operate with different classes of securities with different rights and obligations attached to them.

Additionally, all private equity investments will have a number of other stakeholders including, but not limited to, employees, customers, suppliers, government authorities, regulators, trade unions and the wider community.

Recommendation

The GP should act openly, honestly and with integrity, balancing the interests of the portfolio company, and the needs of effective decision-making with an informed understanding of the needs and information requirements of its other stakeholders.

Within this context, GPs should also note that applicable legal rules (including under the AIFMD) may require periodic and ad hoc reporting and disclosure to national competent authorities, portfolio companies and other shareholders in those companies.

Explanation

It may be necessary or desirable to make follow-on investments into a portfolio company (e.g. to fund expansion plans or to re-finance a poorly performing portfolio company).

The opportunity to make a follow-on investment in a successful portfolio company may give rise to a conflict of interest where the GP is managing more than one fund that has invested, or where the GP or its associates have invested directly, in the portfolio company.

Recommendation

The fund’s constitution should make provision for follow-on investments by the fund into a portfolio company. This may include allowing the GP to retain or recycle an appropriate amount of capital, to draw down commitments on an as-needed basis, or to make appropriate follow-on investment(s) where necessary after the end of the investment period. How such follow-ons are dealt with is something that should be clearly set out in the fund documents.

Decisions to make such follow-on investments should be subjected to the same rigour and made in the same manner as the original decision to invest. These decisions should be supported by adequate written evidence that demonstrates a clear benefit to the fund in making the follow-on investment and that the decision is supported by the fund’s policies.

Any conflict of interest that arises out of an opportunity to make a follow-on investment should be resolved in accordance with the GP’s conflict of interest resolution procedures. Due to the inherent conflict, it is generally not advisable for follow-on investments to be made by a different fund from the fund which made the original investment (although it may be possible in certain cases on a fully transparent and agreed basis with robust safeguards).

Explanation

Unfortunately, not all investments will succeed, and while it may not be possible to save an investment made into a portfolio company with a fundamental structural problem, it may be possible to turn around a poor performance record or preserve value in an investment through:

• meeting with the management of the portfolio company to discuss performance and to agree strategies and tactics through which turnaround can be achieved;
• increasing the frequency and depth of monitoring of the investment and meetings with management;
• agreeing the need for and type of remedial action required with management. This might include the introduction of expert advisory firms to help solve issues, develop new approaches and identify new opportunities;
• supporting the company with outside resources;
• introducing changes in the portfolio company’s management team, perhaps introducing a senior level “trouble-shooter”;
• agreeing to reschedule payments (e.g. loan or fixed payment commitments) or renegotiate banking covenants to allow a portfolio company “breathing room” with its bank(s).

GPs should be aware that while bankruptcy laws may vary from country to country, they may impose a personal liability (including criminal liability under certain circumstances) on a portfolio company’s directors (including de facto and “shadow” directors) if they permit the portfolio company to carry on trading in certain circumstances.

Recommendation

As soon as information, received as part of the monitoring process, reveals that an investment is not “performing”, the GP should look to take rapid action and meet with the management of the portfolio company and, as necessary where the underperformance is financial, other providers of finance such as banks and co-investors, to agree remedial action plans and any additional information requirements.

When managing an underperforming investment, the GP should ensure that adequate local legal advice has been sought and that the portfolio company remains in compliance with all applicable legal and regulatory requirements, including where they relate to ESG factors. Directors who are not familiar with the specific legal requirements in turnaround, restructuring or insolvency situations (or the specific jurisdiction where the portfolio company is located) should seek legal advice in due time.

If the GP has appointed director(s) to the board, if permitted in the particular jurisdiction, consideration should be given to having a different executive responsible for exercising the fund’s rights as shareholder to reduce conflicts of interest. It is important that communication with LPs remains open and clear in order to manage expectations in relation to the investment.

GPs and portfolio companies should consider the need for timely provision of information to and communication with other stakeholders when an investment is in difficulty. The timing of communication with employees can be particularly complex and the role that employee representation groups might play should be carefully considered.

When managing underperforming investments, the GP should ensure that sufficient resources remain committed to the monitoring and management of other investments.

Explanation

The obligations of the GP and LPs of a fund toward each other, portfolio companies, stakeholders and the wider public are fundamentally the same as for other types of private equity investing. What is different is the higher likelihood of the actions of the GP to affect stakeholders and attract attention from the general public and for their ongoing processes to be subject to wider scrutiny.

Recommendation

GPs of such funds should be aware of the increased legal, reputational and other risks, and carefully describe the particular risks associated with the asset class to prospective LPs. In turn, LPs should carefully consider the ability of a prospective GP to effectively manage stakeholder, public and regulatory relations in what can be a particularly challenging environment.

Parties to investments in distressed assets should be prepared for their decisions and actions to be challenged by a wide range of stakeholders, both those directly affected by such decisions and actions and by a wider group of external parties. Detailed understanding of the legal rights and duties of all parties involved is essential, including the directors and others involved in decision-making on behalf of the portfolio company. It is important to be clear in the allocation of responsibility for managing these legal issues, and to be aware of the wider issues in relation to any decisions taken.