Governance standards: A matter of integrity

Governance is the most elusive aspect of the sustainable investment triptych. While the environmental and social issues can be aligned with visible goals, the G in ESG defies easy definition. It serves as a catch-all for a company’s performance objectives, readily linked to honesty, integrity, fairness, diligence and respect. But this breadth can be its undoing. In claiming strong governance standards, an investor might be saying everything or nothing.

This much became apparent when EMPEA’s ESG thought leaders formed a working group to examine approaches to governance for private capital in emerging markets. The move was essentially a response to LP concerns arising from the collapse of Abraaj Group, but it opened up a much wider set of issues.

“There was the shock of Abraaj and what people want to know about governance, but that’s just the start of the uncertainty,” Harry Assaad, chief portfolio and risk officer at Avanz Capital, a frontier markets investor, told the International Finance Corporation’s (IFC) global private equity conference. “Governance in emerging markets is not a well thought through area. Local regulations make it difficult to ensure good governance on every level.”

At the fund manager level, governance follows a typical path from functioning boards, through quality control, to transparency and disclosure, and ultimately the protection of shareholder rights. But these considerations must be bound together by a culture of business integrity that percolates through a private equity firm. Abraaj is a cautionary tale of what happens when governance is not properly embedded.

Changing priorities

The demise of the emerging markets-focused GP has prompted a change in behavior in certain quarters of the LP community. Abraaj imploded because of governance failings and several executives have since been arrested on fraud charges. They stand accused of lying to investors about the fund performance, inflating valuations, and misappropriating funds to disguise liquidity shortfalls or for personal benefit. 

Nearly half of respondents in EMPEA’s latest global limited partners survey said they have requested additional information from prospective GPs over the past two years, while approximately one-third have updated their due diligence policies and guidelines.

Avanz is among those asking more questions. There is increased focus on understanding how portfolio GPs make decisions and the oversight mechanisms around that. Processes and procedures are also scrutinized, including approaches to cash management, cybersecurity, and anti-money laundering (AML). “You safeguard your reputation by looking at the culture of the institution,” Assaad says.

Cybersecurity represents a specific governance risk, yet one that has become increasingly severe. Communication between GPs and LPs is seen as an area of weakness. Walter van Helvoirt, an environmental and social officer at FMO, a Dutch development finance institution (DFI) referenced a situation in which a capital call was hacked. A drawdown notice was falsified with a view to intercepting the money. It was picked up and the transfer called back.

Institutional investors want to know more about portfolio managers’ security protocols, recognizing that as their disclosure requirements increase, the risk of leakage rises. However, competence in this area can speak volumes for governance levels across a private equity firm. 

“If you don’t have the cybersecurity element and you are not protecting LP data as a fund, you will be in violation of your governance commitments,” says Steve Okun, ASEAN representative at EMPEA. “But it goes deeper than policy and process – it goes to how you conduct yourself, your business integrity.” Van Helvoirt added: “If you want to make sure E and S are working, you must address the G.”

There is an abundance of material on corporate governance oversight, typically broad in scope so it can be applied across different asset classes. EMPEA identifies five governance considerations that are particular to PE: ownership and management of the GP; legal compliance; fund structure and domicile; LP advisory committees (LPAC); and reporting.

For most of these, investors must decide whether the manager in question meets required levels of transparency. Is the firm being run professionally in terms of risk assessment, human resources management, and segregation of assets? Is there a regularly updated compliance manual that covers areas such as AML, confidentiality, and recordkeeping? Is the fund structured so that it maximizes tax efficiency without testing the investor’s ethical comforts? Are industry standards being met for reporting?

Talking shop

The LPAC is arguably more interesting as the official open forum for exchange between LPs and GP. In theory, this is where investors can exert the most influence on governance. LPACs are supposed to facilitate oversight of the manager and the discussion of any concerns. The level of transparency is often a function of what was agreed during fundraising, but there are more fundamental differences in how managers perceive the role of the advisory committee.

“GPs really need to pay some consideration to the LPs they seek to be part of the LPAC,” says Mike Casey, founder and a managing director of Portico Advisors, which works with fund managers and institutional investors in emerging markets. “Some use the LPAC as a forum for the transmission of information and updates on what is happening in the portfolio. Others use it to bring in the commercial expertise of LPs, to piggy back on their expertise.”

If GPs can be criticized for their reticence, LPs are sometimes guilty of overreaching. There have been instances in which they have pushed too far, taking on quasi-operational roles by communicating directly with underlying team members. In doing this, LPs could be putting their limited liability status at risk.

The LPAC serves as a dynamic example of how the GP-LP relationship continues to evolve. There is no-one-size-fits-all answer to questions of governance – geography, sector and manager resources must be taken into consideration – but it is no longer the overlooked sibling of E and S. “It’s only recently that governance has started getting the attention it gets now,” Okun says.   

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• Topics
• Southeast Asia
• GPs
• LPs
• Performance
• ESG
• FMO
• Emerging Markets Private Equity Association (EMPEA)
• IFC