Anguish on the doorstep: Monitoring investments into private companies

Friday, 01 October 2010
Christian Mustad explores the rarely pursued topic of monitoring investments into private companies.

The notion that an investment made directly into a private company cannot be properly monitored, and its value protected, without close attention being paid to it is not controversial. More interesting is the fact that despite this broad consensus, such investment situations are very rarely being given anywhere near the required level of attention. Let us explore this paradox.

Those who take it upon themselves to monitor how an investment made in a private company is faring – trustees, family officers or the beneficial owners themselves – know that relying solely on financial statements and management reports will not do; they know that what is required is to get familiar with the key aspects of the inner workings of the company in question. In other words, they know that they need to cross the threshold of the company and not stay outside.

This is where dizziness often takes hold. As they consider getting to grips with how the company they own actually generates value, most people back off and abandon the idea of getting more insight into the company than what a seat on the board and periodic financial statements can provide. Why such anguish on the doorstep? Because several obstacles spring to mind at that time.

First, industry expertise. Each industry, and each company, relies on specific know-how and skill sets, and the management teams that operate in them tend to have long track records. How can anyone that doesn’t have the same degree of specialised industry knowledge possibly gain any kind of useful insight? And how can they avoid the risk of being manipulated by their interlocutors within the company?

Sensible and cost-effective monitoring is a very real possibility

Second, practicality. Even if the obstacle of industry expertise could be overcome, the sheer complexity of any company – just think of standard functions like operations, marketing and sales, human resources, finance, IT – poses a challenge in terms of getting all the relevant facts. Where to begin? What questions to ask? This looks like a process that can potentially take up a lot of time, or if outsourced, generate costs that bear no relationship to the benefits. And if we add to that the fact that private companies are in general not required by law to provide anything beyond financial statements to their directors, the obstacle looks formidable indeed.

Third, sustainability. Let us assume that the relevant information can be gathered and that issues that deserve to be brought to the attention of management have been highlighted. How can these points possibly be presented to management without generating a defensive reaction and damaging the trusting relationship between the shareholder and the management team? How can it be ascertained that management effectively acts upon the concerns raised by those that monitor the company? Won’t that all create a second layer of management?

The sense that these obstacles do indeed prevent any meaningful or economically viable way of monitoring private companies is shared by many that face such investment situations. Yet sensible and cost-effective monitoring is a very real possibility. To see why, let us consider the three obstacles mentioned above keeping in mind the actual process of company monitoring. 

Industry expertise

The notion that deep industry expertise is a prerequisite for meaningful monitoring of a company has to be dispelled first. There is no doubt that profound familiarity with a given industry provides instant insight into the big strategic issues, prevalent operational challenges, and what competitors are doing. All very important information. But there is a caveat: if the industry expert that one relies upon has gathered experience through a career in one company only and with strong emphasis on one functional area (operations or finance for example), then the insight may be truncated and suffer some important blind spots.

In the set-up used by investors in private companies, industry experts can bring extraordinary value as board members, shedding light on the strategic choices made by the company, or as third party experts brought in at specific times of the company’s development to offer fresh perspectives. But as we know, monitoring an investment is about preventing the loss of value, and strategic considerations alone are often only a default explanation for losses of value within companies. What is required is a much closer look at the productive activities of the company, or, in other words, at the way the strategy is implemented on the ground, and that is a task industry experts generally don’t take upon themselves to perform.

Although company monitoring is about observing and listening, it is primarily about asking the right questions

So deep industry expertise, or rather the lack of it, is not a show stopper when it comes to implementing effective mechanisms for monitoring a company. In any given industry, there are a large number of accessible individuals that will be happy to impart their knowledge. That is a fact that many journalists and business consultants take full advantage of when preparing for a new assignment. This information gathering technique will provide very useful insights to anyone preparing for a company review. As for the risk, mentioned earlier, of being ‘manipulated’ by company executives who, although unwittingly, may use their superior knowledge of the company to lose their interlocutors, industry expertise is also not necessarily the answer. Although company monitoring is about observing and listening, it is primarily about asking the right questions.

Practicality

That brings us to the second obstacle, practicality. Let us start with the last point raised in relation to practicality: access to information. It is true that often the law does not require management of private companies to disclose any more to their board members than financial statements. But it would be wrong to conclude that this fact constitutes a de facto obstacle to information gathering. Company managers know that maintaining a trusting relationship with their shareholders is a major key to their success. Refusing or restricting access to information would therefore be downright irresponsible on their part.

The key concern about practicality is how to get all the relevant facts, given the complexity that characterises any company. We have said above that the key to protecting the value of an investment in a private company is to get familiar with the important aspects of its inner workings. That should not be taken to mean that whoever undertakes that task has to be able to sustain a detailed discussion about the latest trends in supply chain management with the head of operations, followed by an expert discussion on cash management techniques with the CFO and the same on viral marketing with the head of sales and on the implications of cloud computing with the head of IT! Company monitoring is not about finding the optimum in terms of the way it is managed; that is the responsibility of the management team. Company monitoring is about preventing severe loss of value for the investor. This happens – and it happens very often – not because one aspect or the other of the company in question is not managed to its absolute optimum; it happens when one these aspects is purely and simply neglected.

With all that in mind, implementing company monitoring is not about lining up experts in every major functional area applicable to the company in question. It is about organising a ‘health check’ covering all major productive activities that can be found within any company, very much like a medical check-up on an individual focuses on vital organs. That is not so daunting, since business management theory has, over the last decades, developed and updated a body of knowledge and of generally accepted best practices for each functional area within companies. Preparing for a company review then primarily means being clear about three things for each functional area:

  • the key objectives of each function;
  • the related best practices; and
  • the expected outcomes.

Sustainability

Sustainability, the last big psychological obstacle to implementing serious company monitoring, is about the usefulness of the process over time, and its impact on the relationship between shareholders and management. Making sure that the outcome of a company review is not perceived by management as an attack on its work is important, and it is a matter of implementation strategy and communication style. An assertive and aggressively judgmental approach will indeed lead to tensions with the management team, but focus on the communication of factual findings compared to a set of generally accepted best practices will not. For the monitoring efforts to have a real impact, they have to be maintained over time. The only way to ensure that management actually acts to sort out the issues that have been highlighted is to be back ‘on the shop floor’ on a regular basis to see how the company’s practices evolve.

For the monitoring efforts to have a real impact, they have to be maintained over time

None of this suggests that the monitoring process boils down to creating a second layer of management. It is about rebalancing the relationship between well-informed shareholders and management by ensuring that the ongoing dialogue is and remains centred on the right topics, those that make a difference to the company’s ability to generate value. The implementation of such a monitoring may, at first glance, appear to be fraught with difficulties, but as we have just explained, it is not.

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Christian Mustad

Christian Mustad is a Partner at Edgar Brandt Advisory SA.

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