Direct investment management

By Christian Mustad

Everyone agrees that investments made directly into private companies are inherently risky, and that serious monitoring is required to manage that risk properly, writes Christian Mustad.

In short, that means going beyond what a seat on the board and periodic financial statements can provide. The reality is that such monitoring is very rarely put in place. Why? Because putting in place serious monitoring necessarily implies getting familiar with the inner workings of the company in question. That is when most people get scared. They get scared by what we believe are in fact imaginary hurdles.

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?

Second, practicality. Even if the obstacle of industry expertise could be overcome, the sheer complexity of any company – just think of the standard functions like operations, marketing & 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.

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? 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.

Reality check

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.

So no, 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. 

That brings us to the second obstacle, practicality. The key concern here is how to get all the relevant facts given the complexity that characterises any company. We've 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 shouldn't 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 of these aspects is purely and simply neglected.

With 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.

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.

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 centered 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 isn't.

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