For directors, the virtue of independence should be leavened with the strengths of industry knowledge and experience.

By Doug Raymond

The current dialogue on directors’ roles has largely focused on the value of independence, particularly for public company directors, who are seen as the protectors of the stockholders’ interests against the otherwise unchecked self-interest of management.

Of course, the more independent the director, the less likely that she will have significant depth of knowledge and experience in the business. The completely independent director, with a “pure heart and empty head,” may be a great gatekeeper, but perhaps not so effective at assessing the corporation’s strategic plans and visions.

A recent study by Moody’s Investors Service reminds us again that a balance of perspectives has tremendous value when considering directors and their roles.

While the relationship between corporate governance and credit quality has received relatively little attention, Moody’s has conducted several studies in this area in recent years. Moody’s focuses on corporate credit risks as part of its ratings of debt issuances. It recently published a report that addresses some of the credit risks particularly associated with the governance aspects of private equity ownership.

Food for Thought

While some of Moody’s conclusions were unremarkable, such as the finding that private equity-backed companies have a high tolerance for debt (which can increase the risk to existing bondholders), other observations were less obvious and should provide boards with food for thought as this election season gets under way. The starting point for Moody’s analysis is the fixed investment horizon of most private equity funds, which typically is between three and five years. While public companies also have a relatively short-term focus, the focus on quarterly earnings does not have a fixed endpoint, which, as Samuel Johnson pointed out in another context, “concentrates the mind wonderfully.” Unlike directors in a public company, the directors of a typical private equity portfolio company anticipate a major liquidity event for the stockholders within a fixed time frame and generally are focused on how best to accomplish that goal. Moody’s observed that this short-term view may sacrifice a company’s longer-term prospects to the detriment of its creditors.

Whether the public market’s almost overwhelming emphasis on quarterly earnings is better or worse for bondholders — and stockholders — is, however, far from obvious.

But the Moody’s study makes a broader point: “Boards of private equity-owned companies, which are comprised mainly of representatives of the owner, are arguably the most engaged boards.” This is in part because these directors are often employees of the private equity owners and have personal accountability to the owners in a way that directors of public companies just do not have, even with the recent growth of majority voting.

Perhaps more important, these directors often were the ones advocating that the private equity fund make the investment in the first place, and are often financially committed to its success.

Knowledge and Insights at the Board Level

In addition, these directors probably have a strong knowledge of the sector in which the company conducts business and may even have participated in the pre-acquisition due diligence, which means they may have important insights into the challenges and issues facing a particular business.

These committed and engaged directors can, of course, be subject to conflicts of interest when there is more than a single owner. When conflicts arise, they may have a motivation to act in the interest of the private equity fund that employs them.

And this highlights the challenge for today’s boards, whether of public or private corporations. While the benefits of independence have been much discussed, that independence should be leavened with industry knowledge and experience.

Equally important is finding ways to motivate the independent director to be engaged at the same level as the typical private equity director, whether by compensation plan or otherwise. It is ultimately the level of engagement, knowledge, and experience that he or she brings to a directorship that determines the director’s value to a company.

What Really Matters

In the final analysis, the board’s overall effectiveness is what matters. Independence serves many important values, but experience, commitment, and overall engagement are also necessary.

Determining how to effectively strike a balance between director independence and director engagement, experience and knowledge is one of the primary corporate governance challenges facing companies today.

Doug Raymond is a partner of the law firm Drinker Biddle & Reath LLP and heads its Corporate and Securities Group (http://www.drinkerbiddle.com). He is the “Legal Brief” columnist for Directors & Boards. He can be contacted at douglas.raymond@dbr.com. Joy Fontaine, an associate with Drinker Biddle & Reath, assisted in the preparation of this column.

This article originally appeared in the First Quarter 2008 edition of Directors & Boards. All rights reserved.