ANALYSIS OF IMPLEMENTING GOOD GOVERNANCE PRACTICES POST PRIVATE EQUITY IN FAMILY-RUN PORTFOLIO COMPANIES
BDO INDIA GOVERNANCE ADVISORY SOLUTIONS
November 2009
CONTENT 1. Private Equity Investments in India
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2. Focus on Family run businesses
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3. Governance challenges
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4. Private Equity Responses
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5. Conclusion
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BDO INDIA GOVERNANCE ADVISORY SOLUTIONS
1. Private Equity Investments in India The Private Equity industry in India took shape in the 1990s in the form of early investments through private placements or GDRs. Despite a slowdown due to the Asian financial crisis and dot-com bust in the mid 1990s, Private Equity in India saw solid, if not spectacular growth for more than a decade on the back of healthy returns and sectoral reforms. The period from 2002 onwards has marked an era of phenomenal growth for India’s private equity industry with a flood of domestic and international players entering the market. Between 2002 and 2007, India witnessed an exponential rate of growth in funds raised and invested by Private Equity firms on an absolute basis as well as relative to Asia. The last year and a half have been particularly challenging for the Private Equity industry the world over, including in India. After the explosive growth leading into 2007, there has been a marked decrease in fundraising, new investments and exits amongst a climate of tightening credit, global economic slowdown and corporate governance scandals.
Source: Venture Intelligence – India Roundup
Sentiment indicates that while India will emerge as one of the preferred destinations for Private Equity investment in the coming years, the next year will remain challenging for private equity players in India with improving, but still limited exit opportunities.
Source: Venture Intelligence – India Roundup
BDO INDIA GOVERNANCE ADVISORY SOLUTIONS
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2. Focus on Family run businesses A large portion of private equity investments in India have been, and will continue to be, growth and expansion capital investments in family-run firms. Various surveys indicate that between 40-50% of Private Equity investments in India fall into this category. The relatively small size and family-run nature of these firms pose particular and differentiated challenges from a corporate governance perspective.
3. Governance challenges While strengthening corporate governance standards remains an imperative for private equity players across the globe, this is particularly challenging in an Indian context. CATEGORY
CORPORATE GOVERNANCE CHARACTERISTICS AT FAMILYRUN FIRMS
CHALLENGES AND IMPERATIVES FOR PRIVATE EQUITY INVESTORS
Management Structure
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Separation of roles: Most family-run firms are dominated by a principal promoter. There is no separation of roles and responsibilities with regards to family, management and ownership (i.e. Head of family is typically also Managing Director, Chairman of the Board and Largest Shareholder)
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Establishing a clear organizational structure with separation of duties and powers and clear reporting lines
Culture
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Control: Promoters of family-run firms – especially firstgeneration founders – build tight yet informal individual control and oversight over all key aspects of operations. There is typically a strong aversion to ceding any control.
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Obtaining reliable information for due-diligence post-investment
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Transparency: Information about company operations, transactions, finances and interactions is restricted to a few key insiders, leading to lack of transparency
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Building a culture of ethical conduct
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Ethics: Notions of ethical conduct vary widely across firms. There is typically no formalized code of ethics and conduct or whistleblower mechanisms
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Establishing fraud detection and prevention mechanisms e.g. whistleblower mechanism
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Related Party Transactions: The promoters sometimes create assets under associate firms from their family run businesses and thereafter enter into related party transactions with pricing arrangements that are not at arms length
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Identification and disclosure of related party transactions
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Governance Framework
Human Resources
Board decision making
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Board Composition: Given the traditional reluctance of family-firms to share information with outsiders, boards are typically “Insider Boards” composed largely of family members and insider managers
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Reconstituting board to include independent directors
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Board Governing Documents: There is typically no formal documentation of board roles, responsibilities and decisionmaking
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Establishing formal framework for board decision-making
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Oversight: There are no mechanisms for oversight of financial controls, executive remuneration or related party transactions
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Establishing oversight mechanisms through audit committee
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Documentation: Family-firm boards rarely maintain exhaustive and thorough minutes of board meetings. There is a lack of sufficient documentation of “audit-worthy” activities and decisions
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Strengthening secretarial function for efficient stakeholder reporting
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Professional Management: Key positions at family-firms are typically held by family members, even for positions requiring specialized skills such as the CFO
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Assessing and strengthening management capabilities by bringing in professional management for key positions
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Performance Management: There are no formal performance management and remuneration systems, particularly for family members
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Building performance management and remuneration systems
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Succession Planning: There is no formal succession plan in place for transfer of ownership and management to the next generation or professional managers
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Guiding the family on succession planning and transition
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Focus: Board meetings are typically focused on compliance or fulfilling statutory obligations. Most key decisions take place outside of the boardroom.
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Availability of decision making MIS/structured information
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Basis: Major decisions are typically taken by few key insiders on an ad-hoc basis. There is a division of responsibility on the basis of mutual understanding amongst the family members and the decision making revolves around the span of control.
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Establishing framework and process for enterprise risk management
BDO INDIA GOVERNANCE ADVISORY SOLUTIONS
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Risk and Internal Controls
Management Information Systems
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Risk Management: There is no understanding and management of risk or this takes place on an ad-hoc basis at a business unit or functional level
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Establishing internal control framework for key processes
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Internal Controls: Ad-hoc, informal or inconsistent internal control mechanisms over key processes. Lack of segregation of duties and audit trails
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Establishing standard operating procedures
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Systems: Smaller family-run firms typically have excel-based or local-database systems for management reporting, leading to inconsistency in reporting and verification
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Implementation of comprehensive MIS systems
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Reconciliation: There is no link or reconciliation between disparate management reporting and accounting systems
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Reconciling management reporting and accounting systems
4. Private Equity Responses The PE players that operate in India deploy several measures to meet the above challenges; however, the measures don’t match up to these challenges and growth risks. These measures include: •
Comprehensive due diligence at the investment stage and thereafter rigorous follow up on specific control improvements
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Change in board composition
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Introduction of new audit firm (external and internal)
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Post investment monitoring through Board seat, approval of capital expenditure, disclosure of related party transactions, MIS reviews, variance analysis, budget vs actuals, etc.
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Change of CFO/Key management personnel
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Tightening of controls over cash management, funds transfers, accounts vulnerable to frauds, fair valuations, property/asset transfers, etc
BDO INDIA GOVERNANCE ADVISORY SOLUTIONS
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5. Conclusion With the increased scrutiny being placed on corporate governance by stakeholders across the private equity ecosystem, Private Equity funds operating in India will have to redouble their focus on evaluating, monitoring and strengthening corporate governance at their portfolio firms. Traditional due-diligence and post-investment monitoring activities must be adapted to take into cognizance the unique characteristics of family-run firms in an Indian context. In order to effectively meet stakeholders’ demands for stronger governance, Private Equity firms must recognize that familygovernance is a distinct component of corporate governance in family-run firms, and work with promoter families to clearly define their roles, responsibilities and obligations to the business, guide succession planning, and support cultural change in addition to their existing responses to enhancing corporate governance .
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