Unfettered Discretion is Paramount: The Governance Relationship between the Private Equity Firm and the Underlying Portfolio Investee Company

• Jurisdiction: South Africa
• Date: 01 June 2020
• Pages: 158-180
• Author: Oaker, W.
• Published date: 01 June 2020
• Citation: (2020) 31 Stell LR 158

158

UNFETTERED DISCRETION IS PARAMOUNT:

THE GOVERNANCE RELATIONSHIP

BETWEEN THE PRIVATE EQUITY FIRM AND

THE UNDERLYING PORTFOLIO INVESTEE

COMPANY

Wentzel Oaker*

BA LLB LLM LLD

Post-Doctoral Law Fellow, Stellenbosch University

Visiting Post-Doctoral Law Fellow, Duke University

1 Introduction

This art icle will discuss corpor ate governance as it relates to the pr ivate

equity fund’s underlying por tfolio investee companies. This w ill include,

inter alia, a discussion on the duties of fu nd managers, par ticularly in their

capacity as direc tors serving on t he boards of such companies. Typically, a

private equity r m1 appoints a staf f member(s) or independent expert(s) to

serve on the board of the investee companies i n which the rm invests on

behalf of the private equity f und which it is contracted to manage. The mode st

goal of this article, inter alia, is to analyse the law of duciary duties with

respect to corporate directors and ofcers of limited liability companies and

to illustrate the ex tent to which corporate-law concepts and prece dents should

be applied (or not be applied) in the context of advancing higher st andards of

corporate governa nce to the private equity business model.

However, this article will rst t ake a closer look at the active ownership

principle because the pr ivate equity business model is cha racterised by the

active involvement of t he pr ivate e quity rm in the underlying portfolio

investee companies.

2 Active ownership

Active ownership is a key element central to t he private equity busine ss

model. First, the private equit y rm plays an active role in raising money

from investors; sourcing a nd executing private equit y investments; actively

managing the private equity fund’s interest i n such investments; and, n ally,

exiting the private equ ity fund’s interest from such investments. This acce des

* This art icle is derived from part of the a uthor’s LLD dissertation: W Oa ker A Critical Analysis of th e

Legal Environm ent in Respect of the Pri vate Equity Indust ry in South Afric a Doctoral LLD disse rtation

Stellenbosch Universit y (2018)

1 A private equit y firm is an investm ent management company th at manages private equit y fund(s) and

employs, inter alia, fund m anagers; and t hat sources and makes inves tments on beh alf of the privat e

equity fu nd(s) in underlying invest ee companies The te rms ‘‘private equit y firm’’ and ‘‘fund man ager’’

are used inte rchangeably thr oughout this art icle

(2020) 31 Stell LR 158

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to the point that private equit y rms need to t ake into ac count the exi sting

corporate governa nce issues of a prospective port folio investee company

when they rst conduct their initial due diligence of the investment and

must address any cor porate governance issu es for the entire period t hat

they hold the investment, right up to t he point where a complete exit from

the investment has been execute d. Secondly, the remuneration model of

private equity rms have evolved based on the underlying principle of active

ownership, particularly when it comes to justifying a pr ivate equity rm’s

primar y source of remuneration, na mely carried inte rest.2 In this regard ,

Gilligan and Wright state t hat:

“While they do not exercise day-to-day control, they are actively involved in setting and monitoring

the implementation of strategy. This is the basis of the argument that private equity has become an

alternative model of corporate governance.”3

It is submitted that the pr ivate equity investment model can be chara cterised

as value creation throug h active ownership. For example:

“The key characteristics of private equity investing can be highlighted as being that it requires equity

participation; there is value added through active and ongoing involvement with the companies in

which they invest; and that the investment objectives are of a long-term nature.”4

Nevertheless, it is beyond the scope of this ar ticle to discuss the var ious

denitions of private equit y but for noti ng the common characteristic in all

the de nitions of p rivate equity namely, active ownership. For example, an

extract of the Emerging Ma rkets Private Equit y Association (“EMPEA”)

denition of private equity r eads:

“Given the core facets of the PE model – active ownership, often of minority stakes, in private

businesses seeking not only capital but also enhanced governance or more professionalized

management, over a period of several years”.5

Further, an extr act of the Australian Pr ivate Equity and Venture Capita l

Association Limited’s (“AVCAL”) denition of private equity read s:

“Both involve active involvement by the investor in the governance and management of the investee

business and both contemplate, at the time of investment, the subsequent sale of the investment rather

than the indenite retention of it.”

6

Private equity rms select portfolio companies at var ious stages of

development into which they invest money and so acquir e shareholder

rights. The nancing of the por tfolio company is restructured to align better

the incentives of management and i nvestors and increase the p otential for

growth and value creation. Representatives from the private equity rm,

often highly exper ienced in the industry of the port folio company, take a very

2 Carried i nterest is a shar e of the profits of the f und’s investments , typically 20% , paid to the priva te equity

funds’ mana gement company as a perfo rmance incentive The re maining 80% of the prof its are paid to

the fund’s investors

3 J Gilligan & M Wrig ht Private Equity D emystified: An E xplanatory Gu ide 2 ed (2010) 5

4 DJ Cumming & SA Joh an Venture Capital an d Private Equit y Contracting: An Int ernational Per spective

2 ed (2013) 3-6

5 Emerging Mar kets Private Equit y Association (EMPEA) “Fac ts about Private Equ ity” EMPEA ps://

www empea org/facts-about-private-equity/> (accessed 14-04-2018)

6 Australia n Private Equit y and Venture Capita l Association Lim ited (AVCAL) Private Equity in Australia

submission to t he Senate Standi ng Committee on E conomics (2007) 8, par a 51

UNFETTERED DISCRETION IS PARAMOUNT

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