PRINT THIS PAGE Private equity: the quiet (but effective) corporate governance revolution11/04/2007. Source: David Haarmeyer. 
A lively roundtable on private equity published in the summer issue of the Journal of Applied Corporate Finance offers an insightful look at this misunderstood organisation form. The discussion by leading practitioners and academics lifts the veil on the leveraged buy-out process and highlights the link between governance and value creation. Generating enormous returns, attracting hundreds of billions of dollars from institutional investors, targeting bigger and bigger companies such as Equity Office Properties ($36B) and HCA ($33B), and drawing away more and more top public company executive talent, the LBO business is booming.
Success and greater media attention are generating a rising tide of criticism, skepticism, and plain old sour grapes. These include both overpaying (and underpaying) in taking companies private, over-leveraging target companies, pulling out capital from investments too early, and doing nothing more than what can be replicated by public company managers.
Organizations That Run Governance Systems
Looked at from a private equity investor’s viewpoint, why is it worth investing with a buyout firm that will pay a 20 percent premium for a public company, require a 2 percent management fee, and take a 20 percent cut in the profits it generates taking companies private and subsequently exiting the investment? Where is the value? As the JACF roundtable makes clear, at bottom, LBOs are about overhauling public company governance systems.
The incentive-alignment transformation that private equity performs on a company-by-company basis, out of public view, differs fundamentally from the highly public push for all companies to implement one-size-fits-all governance practices. Michael Jensen, one of the attendees and a pioneering scholar on “LBO associations,” defines private equity firms as “organizations that run governance systems that run businesses.” Back in 1989, he wrote that the inability of public companies to address the inherent conflict between public company owners and managers would lead to “the eclipse of the public corporation” by these LBO associations.
Steven Kaplan, a professor at the University of Chicago’s business school, describes the process of adding value in LBOs as “financial and governance engineering.” Leverage concentrates equity in management hands sharpening their incentives to unlock value. The need to make interest and principal payments to pay down the debt makes this an urgent matter. As the majority owner, the sponsoring buyout firm provides active oversight at the board level. That is the theory and it appears to have worked extremely well in practice.
“Converting professional managers and board members into committed owners can lead to amazing transformations in management, morale, and motivation,” says John Moon, a founding partner and managing director of Metalmark Capital. As the practitioners note, the board-level oversight of private equity-backed companies is more intense and continuous than that of public companies. Meyer Feldberg, a senior advisor at Morgan Stanley who has served on both public and private boards, observes that “given their incentives, controlling board members spend more time and energy monitoring operations and performance than their non-controlling counterparts.”
Boards of private equity portfolio companies are highly informed and motivated. Due diligence, says Feldberg, is on “a different level of intensity.” As the economically motivated representatives of the investor base, John Moon states that the boards of private equity-backed companies “make it their business to know as much about the prospects and opportunities of the business as the management teams that run them.”
As competition to take companies private has intensified buyout groups have added “operational engineering” to their toolbox. Scale in fund size has further spurred industry and operating specialization. Add the potential to gain a substantial stake in the company and there is little wonder why managerial talent is gravitating to private equity. As Brian Hoesterey of AEA Investors, one of the longest running private equity shops, outlined, his firm takes advantage of experienced operating partners and a “global footprint” to provide portfolio companies with an international network of professionals, investors, and market opportunities.
The disciplined cycle or raising and returning capital to investors also explains private equity’s success. According to Jensen, “because the limited partners have to be paid back in seven to ten years, those principals who want to stay in business have got to maintain a reputation that will allow them to get back into the markets and raise new funds.” Consequently, “in private equity business you are only as good as your last fund,” observes John Moon.
Lessons for Public Companies
If the world of private equity is so successful in creating wealth should, and can, public companies attempt to replicate it? Can they simulate the governance and operational wonders of private equity?
Though he believes that public companies can simulate the benefits of both leverage and equity ownership, Jensen confesses that few have chosen to go down this path. Moon goes to the heart of the matter when he notes that “private equity provides both powerful management incentives and effective board oversight.” Missing from the governance transformation at public companies is an outside economically interested investor.
Incrementally, Kaplan sees progress in public companies adopting many private equity practices including increasing equity ownership by management, focusing on shareholder value, increasing pay sensitivity to performance, and CEO turnover sensitivity to performance.
Standing in the way of organizational change, the roundtable attendees agreed, are a host of barriers such as the inertia that comes with large organizations, board members not wanting to give up jobs, or CEOs not wanting to lose their freedom.
More troubling is how public regulations and listing requirements to promote “independent directors” drive out private equity from public companies—investors who could play a key monitoring role. Once a buyout group’s ownership of a public portfolio company falls below 50 percent, it is required to remove its directors from key board committees. “When that happens,” says Carl Ferenbach, managing director at Berkshire Partners, “you tend to have one focus, and that’s unloading the rest of your stock as quickly as possible.” The end result—“an inefficient form of governance,” he says.
Today’s Catalysts: Hedge Fund Activists
What does it take to get management to make difficult but value-enhancing changes? Alan Jones, head of corporate finance at Morgan Stanley, suggests that hedge fund activists have become the new catalysts. Not surprising from a group of private equity experts, there is not a great deal of support for hedge funds’ ability to beneficially transform public company governance systems. Their alleged shortcomings: little experience and need for shortterm liquidity.
Yet, among the 7,000 or so hedge funds are more than 180 “activists,” which lock in investor funds for longer than a year, take 5 to 15 percent stakes in a small number of companies, often take board seats to influence corporate policy, and in some cases are specializing along industry lines. Atticus Capital, ESL Investments, Steel Partners, and Cerberus Capital Management, each with over $5 billion under management, are actively involved in reshaping companies and in some cases, industries.
What makes the general partners of private equity and hedge fund activists more similar than different, especially compared to other investors, is the fact that each has a substantial portion of their net worth invested alongside of their limited partners. Moreover, when a hedge fund activist with a substantial stake in a company gains a seat on the board, his incentives to actively govern are little different from private equity. Hence, it is not a leap to classify both as highly attentive active investors whose interests are aligned with their shareholders.
David Haarmeyer
David Haarmeyer is a Boston-based consultant who focuses on the nexus of active investors and corporate governance. This article originally appeared in the February 2007 NACD Directors Monthly. The article, "Morgan Stanley Rountable on Private Equity and Its Import for Public Companies," appeared in the Journal of Applied Corporate Finance, vol. 18(3): 8-37. Used with permission of the titles and (c) David Haarmeyer 2007.
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