The Importance of Good Governance and Why We Require Control in our Investments
When Carpedia Capital considers investment opportunities, we always frame the potential for returns against the magnitude of risk (recall our definition of risk as the likelihood actual realized returns are lower than those required over a reasonable time period and the potential for permanent loss of capital) we are taking to ensure this relationship is appropriately balanced.
In our opinion, the primary determinant of investment risk in private equity deals is how “good” the business is today and how likely it is to become exceptional during our holding period than it is likely to become the converse. Consequently, we spend the bulk of our time assessing businesses against these two criteria when deciding which companies to seriously pursue. After making the investment, our attention hones in upon the “how likely” qualifier to ensure our odds of success are “highly probable” as opposed to something less certain – with comprehensive governance being a key tool to ensure the likelihood of success remains in our favour.
Our Approach to Good Governance: Given that we provide our management teams with a great degree of autonomy and responsibility, it is essential to us, as owners, that we know our managers are making decisions (both small and big, on the front line as well as in the executive suite) through the same shareholder value framework they would if the owners directly oversaw day-to-day operations. Creating and sustaining this degree of partnership and alignment throughout the lifecycle of a private equity investment is a complex matter which evolves over time. It is, however, in our opinion, simplified and enhanced by having from an early stage the following comprehensive approach to governance to ensure a focused implementation of the company’s strategies to build an exceptional business that experiences sustained profit improvement:
Engaged Ownership: We are active, hands-on investors that have a passion for the businesses with which we partner. While we do not meddle in day-to-day operations, we are keenly interested and patiently observe to stay abreast of developments to ensure we have the context required to make considered decisions at key points – often on short notice. Our hard work and enthusiasm resonate with management and our willingness to contribute insightful analysis and commentary to issues makes us indispensable partners towards making the right decisions.
Alignment with Management: We spend a tremendous amount of time and effort sizing up those with which we partner to ensure they are cut from the same self-motivated, hard-working, humble-but-driven cloth which are we. For managers that have an ethos of doing only great work and which choose to work hard every day at building their business, we establish clearly communicated, transparently calculated reward systems to ensure they meaningfully share in the value creation over both the short and long term.
Clear Direction: Collaboratively with management, we set the agenda for the business’ future direction and define the areas of managerial focus and pacing necessary to achieve the required results. We are explicit in communication of our strategy and the requirements flowing therefrom.
Clear Expectations: Collaboratively with management, the Carpedia approach to operational excellence develops clear requirements for results, from the warehouse to production floor departments, sales, engineering and the executive suite – both operationally and financially. This establishes the baseline against which all departments and stakeholders can easily gauge ‘how we did’ relative to the requirements set by the strategy. We are explicit in communication of our expectations and requirements.
Tangible, Value-Added Tools: The Carpedia approach to operational excellence ensures that the processes, systems and behaviours of our partner businesses are optimized and that our management teams are empowered to produce improving results by utilizing the right information to make decisions. Actual results for each area are then measured versus requirements for hourly, daily, weekly, monthly, quarterly and annual periods.
Strong and Consistent Oversight: We regularly review actual results against requirements, understand the reasons for variance, the resulting action items necessary and persons responsible as well as the resources to be applied and time frame in which action will be taken. We follow-up on open action items in a structured manner until results meet requirements.
Outright Ownership Control: There is no substitute to the economic and legal right to set the agenda, define requirements and follow-up to ensure management is focused and effective.
Conclusion: Good governance is fundamentally about setting the business’ agenda, defining the requirements, clearly communicating these to management and following-up on progress and action. We have found that this approach results in the highest likelihood of success in building an exceptional business that experiences sustained profit improvement – thereby delivering the business case upon which the investment was premised. It is for these reasons that we choose to require control of the businesses in which we invest.
What’s Next: How we create value in ways other than through operational improvement will be the subject of our next blog.
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