One of the most important areas of due diligence that a GP should conduct before investing is the corporate governance at the potential portfolio company. The corporate governance systems, processes and controls employed by the company's senior management team provide insight into the effective management of the company in which to invest. A company with effective corporate governance provides a strong platform for the rapid implementation of value-enhancing initiatives. A company with weak, ineffective corporate governance will make a higher risk investment, but will likely reap significant benefits from implementing robust governance systems and processes that are appropriate for the company.
Effective corporate governance, once installed, should support the decision-making process and implementation within the organization, as well as the alignment of interests among all stakeholders of the company, including management, employees, GP and investors in the fund. Such alignment of interests is also part of a responsible investment framework.
A portfolio company is likely to be provided with guidance on governance requirements from GP at the time of initial investment. In some cases, implementation of certain requirements will be a condition of closing the transaction. The management of a portfolio company can be strongly influenced by the attitude of GP to board effectiveness, checks, balances and controls. It is important to achieve the governance objectives of GP while preserving the autonomy of the portfolio company's board to drive business growth and not impede it through bureaucratic processes and controls, and to be able to demonstrate this at the time of the sale of the business.
If not already in place, GP should typically ensure that each portfolio company has adequate governance structures in place to safeguard against fraud, bribery, corruption and other breaches of the legal requirements applicable to the company, and to ensure internal financial control, quality assurance, risk and conflict management, and transparent reporting and communication.
In order to ensure that the portfolio companies apply appropriate good governance practices and standards, GP should ensurethat it remains up to date and familiar with the legal requirements, best practices and guidelines in the respective countries and industries where its portfolio companies are located. Typically, GP should periodically review the adequacy of its practices and standards. This can be done in a number of ways, for example by using an appropriate law firm or consultant who can ensure that the relevant codes and standards are understood, particularly by those individuals who GP are represented on the board of the portfolio company. This can also be achieved by ensuring that diverse and experienced executives serve on the board or respective boards of the portfolio company who have a good understanding and track record of applying the required governance standards and practices. Poorly structured incentive packages can have a negative impact on governance. Therefore, the GP should review incentive packages in terms of their impact on alignment with long-term growth and good corporate governance objectives.
In case GP has identified risks and opportunities (including ESG risks and opportunities) that are considered material to the success of the investment, one 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. GP should periodically review the risk/opportunity analysis for responsible investing and revise, remove or add policies, procedures and tools for implementation.
Finally, it is important that GP also demonstrates to its wider stakeholder community sound ESG practices and standards that are both appropriate and proportionate to its own business.