Private Equity’s Governance Advantage: A Requiem

Elisabeth de Fontenay is Professor of Law at Duke University School of Law. This post is based on her article, recently published in the Boston University Law Review.

Is private equity still special? Although the industry’s returns have been envied for decades, recent studies show that they have declined over time and converged with public-market returns. In Private Equity’s Governance Advantage: A Requiem, I document that the means by which private equity generates those returns have changed as well.

Private equity’s original value proposition was optimizing companies’ governance and operations. Reuniting ownership and control in corporate America, the leveraged buyout (or the mere threat thereof) undoubtedly helped reform management practices in a broad swath of U.S. companies. In a leveraged buyout, the private equity fund acquires a public or private company, adds a heavy debt load to its capital structure, makes operational improvements, and then sells the company or takes it public after a few years. The potential governance advantages of LBOs are many, including the sponsors’ willingness to cut costs and replace management, the disciplining effect of high leverage, and the careful monitoring provided by a small, incentivized board that meets frequently.

Due to mounting competitive pressures, however, private equity is finding fewer underperforming companies to fix. This is particularly true of its potential public-company targets. The rise of institutional investors, the widespread acceptance of shareholder primacy, and the flourishing market for corporate control have put a stake in unrepentant managerialism. Most visibly, hedge fund activists began seriously taking American management to task in the 2000s and never looked back. The threat of activist campaigns has altered management practices not only at the firms they target, but at most public firms. As a result, the low-hanging fruit for LBOs has all but disappeared. As other scholars have noted, there are diminishing marginal returns for corporate governance improvements in any given firm, and for most public companies, it appears that we are already at the plateau.

Private equity is also struggling to find private targets to acquire and improve. Large companies today are finding it easier to grow through acquisitions than organically. These “strategic” acquirers are snatching up private firms eager for capital that in the past would have been ideal candidates for private equity acquisitions. Separately, venture capital funds are holding onto portfolio companies for longer and even becoming comfortable with debt financing, further crowding out private equity. Unlike with its public-company targets, private equity surely still shines at improving governance and operations in small, private companies—particularly family-owned businesses. The question is whether these firms can be reached before others swoop in. While private equity today is awash (and perhaps drowning) in cash, so is everyone else. Firm valuations are soaring as a result, making it less likely that private equity will find attractive targets.

These competitive pressures are already manifesting in the data. A growing body of empirical studies finds that private equity returns are substantially lower than the industry generally claims, and are now no better than public-market returns. Simply put, private equity’s primary contribution to U.S. firms today appears to be cheap debt financing, rather than governance, strategy, and operations. Nowhere is the decline of the traditional private equity approach more obvious than in its failures in the retail industry. In lieu of making the major investments and operational changes needed to transition brick-and-mortar retailers into the e-commerce age, private equity funds combatted their lower prospects of generating returns by doubling down on the use of leverage, with poor results.

In response to the increased competition, private equity is shifting its center of gravity away from governance reform, towards a dizzying array of new tactics and new asset classes. Large private equity firms now simultaneously run leveraged buyout funds, credit funds, real estate funds, alternative investments funds, and even hedge funds. Ironically, in comparison to governance and operational improvements, these new strategies may in fact play better to the built-in advantages of the larger private equity firms: extraordinary financial sophistication; deep and lucrative connections to financing sources; and, perhaps, the ability to time markets.

The difficulty is that the new money-making strategies are less likely to increase social welfare than the traditional governance optimization approach. Moreover, they introduce new conflicts of interest and complexities that alter private equity’s role in corporate governance. Private equity’s governance advantage has always been to ensure that companies are the servant of only one master. Yet today the master itself may have divided loyalties and attention. With few gains left to be had from governance reforms, private equity is quietly distancing itself from the corporate governance revolution that it helped bring about. To be sure, private equity is not going anywhere—it will remain influential and a powerful draw for capital for the foreseeable future. Yet its influence will be felt in areas other than corporate governance.

The complete article is available for download here.

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