Few areas of business stir up more controversy than private equity. Critics slam private equity firms for destroying companies by layering on debt, firing employees, and cutting costs at every opportunity. Proponents, on the other hand, respond that any changes they make to companies are painful but necessary to improve the inefficient companies that they acquire—and they dispute the charges about destroying jobs.
In The Public Cost of Private Equity, I explore a different, and potentially more worrisome, aspect of private equity: its corporate governance structure. While less visible to outside observers, corporate governance plays a critical role in determining how private equity works. It is also a matter of public interest, given that much of the money flowing into private equity comes from pension funds and endowments.
Conventional wisdom holds that private equity has resolved, or at least significantly mitigated, one of the fundamental tensions in corporate governance, that is, the conflict between management and ownership. According to this line of thought, private equity firms’ corporate governance structure enables them to manage companies better by (1) creating strong financial incentives for managers to improve company performance metrics, (2) closely and actively monitoring management behavior, and (3) deploying deep industry, capital market and financial expertise in support of these mechanisms. Taken together, these governing arrangements supposedly create a virtuous cycle of mutually shared interests among sponsors, management, and ownership, thereby creating incentives for optimal corporate decision-making and the maximization of overall equity-holder wealth.
This conventional wisdom, however, overlooks the many ways in which private equity in fact exacerbates conflicts of interest between management and ownership. First, the compensation structure for private equity sponsors (the private equity firm itself) creates a classic situation of moral hazard: Sponsors capture much of the gain from any profits on their investments, but are largely insulated from any losses. The result is that private equity sponsors have financial incentives to take excessive risk in their investment strategies. Second, limited partners invest in private equity funds on significantly less advantageous terms than those offered typical investors in public companies. They have limited governance rights, little access to information, and few avenues for transferring or selling their equity interests in the fund. Finally, private equity funds treat investors differently, often giving better terms to favored investors. So, for example, an individual investor may enter into a side letter with a private equity fund to ensure that the preferred investor pays lower fees than other investors. Or a private equity fund may grant one investor a greater right to access information about company performance, or even a right to veto certain investments.
In sum, the private equity governance model creates a number of corporate governance costs that are endemic to the industry and are largely unrecognized as a potential source of conflict between private equity firms and their investors. This state of affairs presents a puzzle for traditional contract theories, under which agreements willingly entered into by arm’s-length parties should be expected to maximize joint wealth. In other words, if private equity’s governance terms substantially harm investors, why would investors agree to them, rather than negotiate for better terms or simply walk away?
The article argues that the persistence of private equity’s governance costs can be explained as a result of three related phenomena. First, private equity’s structure benefits from strong inertia (what scholars sometimes refer to as path dependency) that locks in the current structure even in the face of changes in external markets. Second, private equity investors face collective action problems on multiple levels that inhibit cooperation between investors and encourage opportunistic behavior by private equity firms. Third, the reputational constraints on private equity firm behavior have been systematically overestimated as a tool for aligning the interests of firms and investors.
But these corporate governance flaws in the private equity model are not inevitable or, for that matter, unchangeable. One approach is increased regulation of the private equity industry to better align the interests of private equity firms and their investors. Another approach is increased cooperation among institutional investors outside of the transactional context to re-set governance and compliance norms and overcome path dependency problems. Yet another approach is a greater role for independent information intermediaries, such as ratings agencies or third party consultants, who can help improve the quantity and quality of information provided about private equity funds. It may well be that all of these approaches are necessary to fully resolve the structural problems inherent in the private equity corporate governance structure.
This post comes to us from Professor William Magnuson at Texas A&M University School of Law. It is based on his recent article, “The Public Cost of Private Equity,” available here.