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E-MailThis post is by Randall S. Thomas of Vanderbilt University.
Does private equity create value when it acquires a company in a leveraged buyout? If so, how? This question has fascinated scholars ever since the first big wave of buyouts occurred in the mid-1980’s, but has yet to be resolved. A second, even bigger wave of LBO transactions in 2003-2007, brought to a shuddering halt by the recent sub-prime mortgage crisis, has raised the question again even more forcefully as the current market for private equity deals has collapsed. In our recent article “Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance,” Ronald W. Masulis and I offer an important new motivation for private equity deals in the future: private equity firms and managers can do a better job of monitoring of derivative transactions and derivative contract positions than their public company counterparts.
As the subprime crisis has illustrated vividly, the growing use of, and trading in, derivative instruments by corporations has eroded the effectiveness of several critical corporate governance mechanisms – the board of directors, the financial accounting system and oversight by regulatory authorities – because firms lack effective means of monitoring derivative risk exposure on a real time basis. This change has increased the importance of attracting financially sophisticated, highly motivated corporate directors, who can deliver intensive monitoring of corporate risk management strategies, who are capable of independently and effectively controlling firm management as part of regulating derivative exposure and who will make the appropriate choices in creating managers’ financial incentives to insure that these executives’ personal risk exposures are aligned with the interests of the firm.
In this paper, we argue that private equity concentrated ownership is now, and will continue to be in the future, a very effective way of attaining all of these objectives. Private equity involvement strengthens boards monitoring of derivative exposures by reducing board size, increasing boards’ control over managers, improving information flows to the board, sharpening director financial incentives to monitor derivative exposure carefully, and attracting better qualified, more financially sophisticated directors, who better understand the associated risks. Further, debt holders and institutional investors can further improve firm monitoring since they are also large investors (who frequently hold both debt and equity positions in private equity controlled firms), which gives them strong incentives to monitor and good access to proprietary firm information flows to accomplish this goal.
The paper is available here.
One Comment
Your point is well taken, that incentives tend to be aligned better when company’s are taken private. I appreciated the commentary on the debt tax shield, and the works cited on this topic, which I look forward to reading. This is a critical consideration in the use of debt, because as M&M point out, in a world free of taxes and default risk, the financing decision between using debt or using equity is not relevant.
However, there would be some difficulty with taking these types of financial institutions (that you mention in your paper) private with debt. The already highly leveraged nature of these institutions would make a deal in this space unlikely, or at least difficult to justify. So is there anything that can be done?
One way to get around this problem is to do what Goldman did, basically creating a publicly traded partnership, with partner managing directors that have large stakes in the company. So while not technically a partnership in the legal sense, the firm would have a “partnership” mindset that Warren Buffett speaks of in his letters to shareholders. Another way to create a more partnership oriented shareholder base is to avoid splitting shares to keep the share price, which is not an indicator of value, low. Buffett and Berkshire have also done this.