People often think of private equity (PE) as a mysterious field of high finance where people make a lot of money and companies go through big changes. The mechanism of private equity control is at the heart of this activity and is essential to its success. This is about the rules, methods, and steps that a PE firm (the General Partner, or GP) uses to manage and control the businesses it invests in (the Portfolio Companies) for its holders, or Limited Partners. Publicly traded companies are governed by their many clients and the rules that govern them. Private equity (PE) companies are governed by a small group of owners who are very involved in running the business and have a limited amount of time to make decisions. This arrangement makes a strong and unique model for control and making value.
The Basic Building Blocks: GP, LP, and Portfolio Company
When it comes to PE governance, the limited partnership arrangement is where it all starts. This is how most PE funds are set up. Most of the money comes from big investors like pension funds, endowments, and sovereign wealth funds, who are called Limited Partners (LPs). Their main job is to commit money and get returns on it, but they don’t have to worry about the day-to-day managing of the fund’s investments or have any direct responsibility for them. The Limited Partnership Agreement (LPA) is their main tool for governance. It spells out the fund’s purpose, fees, sharing waterfalls, and important rights, like the ability to fire the general partner in the worst situations.
The PE company itself is the General Partner (GP). The general partner (GP) only puts in a small amount of capital (usually 1% to 5%), but they are responsible for all of the fund’s debts and have full power over all investment and management decisions. The general partner’s pay structure, which is called the “two and twenty” structure and includes a management fee (about 2%) and a carried interest (about 20% of earnings), makes it clear that the general partner’s main financial goal is to increase the value of the portfolio companies. This clear and strong motivation is what drives PE governance. To read more about the mechanics of PE governance, click here.
Lastly, the Portfolio Company is the business that the fund bought and runs. This is where PE governance is most noticeable, as the GP tries to make operational, strategic, and financial changes that will create value in the three to seven-year holding time that is common.
The Way Control Works: Board Governance and Unequal Access to Information
The Portfolio Company Board of Directors is the main way that the GP controls the company. When the GP buys the company, it gets a majority of the board seats, giving it unquestionable power to make decisions. These seats are usually filled by the GP’s own investment pros, who are known for being smart with money, and a small group of Operating Partners or Independent Directors who have a lot of experience in the field.
The nerve centre of government is this controlled board system. It turns a public company board, which isn’t always accountable, into a very focused, results-driven group. This PE-controlled board makes important decisions like approving the yearly budget, setting limits on capital expenditures, giving the go-ahead for big purchases or sales, and most importantly, hiring and firing the Chief Executive Officer (CEO). The CEO and the management team are directly and often responsible to the board, but they are still in charge of day-to-day activities.
The GP’s better access to information is a key part of this governance plan. Unlike how listed companies only sometimes share information with the public, the GP wants the portfolio company to give them full, real-time operating and financial data. This close knowledge, which is often protected by detailed reporting requirements in the purchase agreements, reduces the information gap that usually exists between owners and managers. The GP uses this information to do regular reviews of performance, set up complex financial controls, and compare performance to that of other companies in the same industry. This lets them step in quickly and precisely when performance strays from the planned investment thesis.
Creating value and getting involved with operations
PE governance isn’t just about keeping things under control; it’s also about actively making money. There are four main types of intervention that the governance structure makes possible:
Strategic Clarity: After an acquisition, the board, with the GP’s help, makes a clear, and often bold, strategic plan. This helps the management team focus on a few key goals, getting rid of activities that aren’t important, and making the business model better for when it’s time to leave.
Financial engineering is the process of improving a company’s returns by making the best use of its capital structure, which is usually a mix of stock and debt. Oversight by the government makes sure that debt levels stay manageable compared to expected cash flows and that cash management is very effective.
practical Excellence: This is where the GP will use their network and practical knowledge. Operating Partners are on the board or act as advisors and work with management to make the whole value chain more efficient. This includes everything from buying things and managing the supply chain to making sure the sales team is effective. Best practices and new tools are put into place with the help of the board.
People management: The board’s most important role is choosing the management team and giving them incentives. The GP often gets rid of executives who aren’t doing their jobs well and puts in place aggressive equity-based incentive plans that link management’s personal wealth directly to the company’s value going up during the holding time. This makes agency alignment as high as possible.
What limited partners do to keep an eye on governance
Even though LPs don’t have a hand in running their portfolio companies, they do keep a close eye on the GP. Their main worry is the GP’s fiduciary integrity, which means making sure the GP always does what’s best for the fund and its investors. This monitoring is kept up through a number of means, including:
Advisory Committees: Most funds set up an LP Advisory Committee, which is an official group of chosen LPs that advises the GP on things like possible conflicts of interest, how to value assets that are hard to sell, and any big changes to the fund’s investment strategy. The group keeps the GP from being too powerful.
Transparency and Reporting: The GP has to give LPs detailed reports every three months and once a year on the success of the fund, the value of its assets, and key metrics for its portfolio companies. LPs can keep an eye on performance and hold the GP responsible for the general results of the fund thanks to this constant flow of information.
Alignment of Interests: The LPA strictly controls how profits are shared (the carried interest), making sure that the GP doesn’t get its part of the profits until the LPs have gotten back their initial investment and often a higher return (hurdle rate). The GP’s reward is structurally linked to the results for the LPs thanks to this mechanism.
Problems with governance and ethical issues to think about
There is a lot of power in PE governance, which can be both a strength and a problem. There may be conflicts of interest because the public doesn’t have a lot of access and there is a lot of control. For example, a general partner (GP) might put pressure on a portfolio company to do business with another company owned by the same fund. This is called a related-party deal, and it needs to be carefully regulated by the Advisory Committee to make sure that prices are fair. In the same way, the need for quick returns can sometimes make people make choices that put short-term profits ahead of long-term sustainability. Quality governance tries to reduce this tension by finding a balance between the immediate investment thesis and keeping the business viable for the eventual buyer.
Stakeholder management, or how the board balances its duty to the fund’s investors with the needs of workers, customers, and the community as a whole, is often the ethical part of governance. Because the board is small, strategic changes like large-scale cost cuts or selling off assets can be made quickly and without any problems. This shows how powerful and sometimes controversial the PE governance model is.
In conclusion, private equity governance is a strict, difficult, and very efficient system that is different from public corporate models. It has a board of experts who run the company, access to information that is unmatched, and a strong focus on quickly creating targeted value. The private equity industry’s financial results are determined by this structure of power, which is set up by the LPA and maintained by a strong board majority.