Investor and regulatory demands for improved corporate governance have pushed many companies to take a closer look at their joint ventures – especially the public disclosure and accounting treatment of their most material ventures. Changes in SEC and Financial Accounting Standards Board (FASB) policies, for example, prompted a number of companies, including PepsiCo, Dell Computer and AT&T, to consolidate onto their corporate balance sheets certain joint ventures in which the companies owned only a minority interest. The change in financial treatment – which added revenues to the companies’ books without adding income – was driven by changes in accounting standards (the “primary beneficiary test”) that linked financial consolidation not to percent of equity ownership but rather to the partner that derived the majority of economic value and risk from the venture.
The SEC also increased its public disclosure and reporting demands for joint ventures. Revised SEC guidelines require that parent company public filings contain a separate section within the Management Discussion & Analysis (MD&A) on the firm’s off-balance-sheet ventures. The idea here is to increase transparency for ventures that could have a material impact on the firm’s performance.
Concurrently, rating agencies like Standard & Poor’s started to look at issues like joint venture debt that appears on books of the parent. And CalPERS issued a set of JV Governance Guidelines aimed at good governance minimums for material joint ventures of public companies.
“Many companies need a ‘serious upgrade’ to their corporate-level system of joint venture governance and controls.”
These are important changes – but there is a much larger issue at play here. And it is this: Many companies lack sufficient internal controls and governance processes for their joint ventures. This is not a question of accounting treatment or public reporting. Rather, it is a question of how much does the corporate board and senior management really know about the company’s joint ventures, and whether the firm is applying the right level of governance oversight and discipline to manage risks and drive results.
Failure can be costly. Consider a large European industrial conglomerate. An experienced user of joint ventures, the company nonetheless took more than 18 months to discover that one large joint venture had incurred a $400M debt. At the same time, several of the company’s other major joint ventures were dramatically underperforming prior to the economic crisis – delivering 3-5% returns on invested capital, a figure well below the 12% corporate hurdle rate. The cause of the problems: Senior corporate management simply did not hold joint ventures to the same standard or governance disciplines that it applied to 100%-owned businesses. For example, it’s billion-dollar joint ventures were not part of the semi-annual business review process. Sub-par performance was tolerated because of a willingness to cut joint ventures additional slack due to the perceived management difficulties and inherent strategic constraints in running them.
The above example is not an isolated case. Joint ventures are exposing many companies to serious downside risks and that many companies are foregoing $1 billion or more in upside value from restructuring under-performing ventures that have been left to fester.
Many companies need a “serious upgrade” to their corporate-level system of joint venture governance and controls – an upgrade that directly and rigorously addresses the unique challenges that joint ventures introduce.