Introduction to ‘equity governance’

The ‘equity governance’ approach intends to counteract shortcomings – causing ‘governance arbitrage’ – in increasingly demanding corporate governance by emphasizing active ownership, represented by the board of directors vis-à-vis management.


Corporate governance – the practices, processes and relations by which a corporation is directed and controlled with its legal (‘de jure’) and factual (‘de facto’) regulatory framework – has become more and more ambitious during the recent years, also notably with respect to the interaction of management board and board of directors.[1],[2] On the one hand, this is due to an increasingly dynamic and complex operating environment in the wake of globalization with increased financial inter­dependence among economies, of disruptive technologies[3], like digitization based on ‘smart data’, as well as of the influence of demographic changes in societies on politics (cf. Smith (2015b)). In addition, listed companies are confronted with the opposition of activist shareholders, who are collaborating more and more with traditional asset managers (Beatty (2017)). On the other hand, corporate governance faces greater scrutiny due to strengthened compliance legislation and regulations, e.g. Sarbanes-Oxley or Dodd-Frank in the U.S.[4], with impact on accounting rules, regulatory requirements and governance responsibilities (Smith (2015b)). The intensity of the discussions around corporate governance, involving institutional investors as well as family owners, gives evidence that it still seems to be an underestimated or at least underexploited lever for long-term value creation. Hirsch (2015) points out that, “while people chafe at increased regulation, it does bring increased professionalization”. Whereas the outer, visible structural changes of corporate governance like disclosure of remuneration or composition of committees have faced widespread investor and regulatory review[5], the inner workings of the boardroom have not (Useem (2006)).


Governance arbitrage’ expresses the risk of economic loss from more or less obvious deficits of corporate governance and thus also the improvement potential of an enterprise[6] from avoiding such failures. Beroutsos & Kehoe (2006) refer to ‘governance arbitrage’ in the context of successful private equity firms, which come into situations of mediocrity or misaligned governing structures as opportunities for value creation based on rapid change (for corresponding use of the term cf., e.g. Oesterle (2008), Szilagyi (2010), O’Brien (2007)). Deficits in governance may result from lagging the investment case, the already implicitly mentioned – in particular due to dispersed ownership – dysfunctional interaction of management and board of directors, and insufficiently linking decisions, behaviours and actions to the required impact. The later implies that ‘governance arbitrage’ may also arise where market inefficiencies are not recognized.[7] ‘Governance arbitrage’ may occur as latent risk in going concern, in the context of M&A or in restructuring situations.


“But the overwhelming effort [to improve governance] has been directed not at governance that creates value, but at compliance – ensuring no codes are breached” (Beroutsos & Kehoe (2006)). The ‘equity governance’ approach intends to contribute to corporate governance from an economic perspective with long-term value creation as the inherent goal alongside with the commitment that equity entails ownership interest and responsibility.[8] Such responsibility for future viability requires managing the equilibrium between customers, employees[9] and shareholders (‘micro view’) and considering economic rationality and corporate social and environmental sustainability as two equal objectives of entrepreneurial behaviour (‘macro view’). In order to pursue these objectives, ‘equity governance’ places an emphasis on bringing the dialogue of management and board of directors to life, including how decision-making (rights) has to be divvied between executives and the non-executives (cf. Useem (2006)). ‘Equity governance’ is founded on the basic assumption to “exert ownership control over management … [, i.e.] active assertion of ownership”[10] (Beroutsos et al. (2007), cf. Beroutsos & Kehoe (2006)), and that “effective board decision-making … [is] the essence of good governance” (Useem (2006)). With the focus on the collaboration between management and board of directors, the approach intends to complement, for example, ‘value-based management’ as a broadly known concept for generating shareholder value.[11]


In doing so, the ‘equity governance’ approach addresses the challenges, broadens and intensifies the dialogue and further structures its contents. As starting point, it comments on overcoming misalignment, misinformation and/or misjudgement as well as biases as permanent corporate challenges to avoid negative ‘governance arbitrage’. To cope with the challenges, ‘equity governance’ argues for making corporate governance more effective along three levers: I. Thinking in investment cases as precondition for corporate governance, II. defining the agenda and drawing the decision-making lines for management and board of directors, and III. improving the ‘market-to-equity’ algorithm to increase governance yield. Thinking in investment cases, i.e. aligning on aspirations and goals, and adopting a common agenda with defined decision-making lines between board of directors and management provide the framework for effective corporate governance. Within this framework, the ‘market-to-equity’ algorithm as model formalism to systematically convert market potential and customer benefit into shareholder value, leads to corporate governance indicators for the management dimensions decision-making, organizational execution and financial management, which should allow for the improvement of clarity and for more focus of the corporate governance dialogue.[12] The algorithm is derived from the key value formula, which expresses enterprise value as ratio of free cash flow and the difference of capital cost rate and growth rate: EV = FCF / (WACC – g). It takes the topics industry dynamics, portfolio momentum, capital intensity, productivity and debt capacity (resilience) into account. In order to ultimately demonstrate what impact ‘equity governance’ can have on long-term value creation if being consequently applied, assessment options against yardsticks, such as (market) value, competitiveness and teamwork, have to be an integral part of the approach.


Frankfurt, 15 January 2017


[1] The term ‘management’ stands for (members of) the executive / management board, mainly the top senior executives (the so-called C-suite) and the term ‘board of directors’ (respectively ‘board’) for the non-executive / supervisory / advisory board.
[2] Reding et al. (2013) define governance as “the combination of processes established and executed by the board of directors that are reflected in the organization’s structure and how it is managed and led toward achieving goals”.
[3] Disruptions are typically based on simpler and cheaper products, require a fundamental change of business model and market, and lead to displacement (versus replacement through substitution). Although beneficial, disruption is about exclusion (in contrast to stability, which is about inclusion), which complicates change even more (cf. Zhu (2016)).
[4] The Sarbanes-Oxley Act (SOX) (2002, as response to the Enron/MCI scandals) intends to restore/maintain investor confidence and to protect (minority) shareholders by improving the accuracy and reliability of corporate disclosures, and the Dodd-Frank Act (2010, following the financial crisis) to promote the financial stability by improving accountability and transparency in the financial system.
[5] For example, the German corporate governance codex focuses on the four indices transparency, incentive systems, supervision/control and diversity (Rapp & Wolff (2015)).
[6] The terms ‘enterprise’ and ‘company’ are used synonymously, i.e. the term ‘company’ includes all group companies.
[7] “Lots of people don’t want to live in a perfectly efficient world, because lots of people make a living from inefficiencies.” (Hirsch (2015))
[8] In this context ‘equity’ should be understood in the sense of, for example, the German constitution, which after all requires in Article 14 that property entail responsibility.
[9] Employees in a broader sense here also stand for suppliers.
[10] Beroutsos et al. (2007) “… found that private equity firms at the top of their game exert ownership control over management and in this way create levels of sustainable above-average performance … Without the incentives, resources, and voting power of private equity nonexecutives, the public-market cadre face an uphill struggle.”
[11] For a detailed explanation of ’value-based management’ see, for example, Koller et al. (2010).
[12] Quite deliberately, driving performance from a market respectively industry perspective pushes financial figures at first into the background.