Viewpoint: Private Equity Benefit: Accountability American Banker | Friday, August 7, 2009

By David Haarmeyer

The Federal Deposit Insurance Corp.-proposed rules on private-equity investment in failed banks appear to be set on removing one of best means to bring capital and accountability to the crisis-riddled banking sector.

Already this year regulators have closed 69 banks, after the 28 they shut in 2008, and the FDIC expects bank failures to produce losses of $70 billion over next five years.

Requirements that private capital investors keep higher capital reserves than normal banks, backstop losses with other investments and hold on to acquired banks for three years are all in keeping for an investor class that gets little respect and is little understood. Private equity's real value-add is its ability to align management, investor and director incentives to foster accountability, engender trust and drive wealth creation.

More than $400 billion in "dry powder" could be allocated to bank recapitalization, reflecting the generally successful track record of private-equity firms in creating value.

The financial crisis has many causes, but an important one that has magnified its depth and breadth concerns a breakdown in governance, oversight and accountability at banks and other financial institutions.

Where there is no accountability, there is no trust and little or no wealth creation. To achieve these, free and prosperous societies require people to incur a cost — putting something meaningful at risk. Pledging a significant portion of personal wealth and reputation has proven to be amongst the most powerful of commitment devices. A brief historical view sheds light on this crucial tradition of capitalism.

Putting capital and reputation on the line binds individuals to their promises. Compared to cumbersome regulation, these devices are cheap, convenient and perhaps the oldest, most reliable form of personal and organizational governance.

This simple, far-reaching but little appreciated insight is crucial to the smooth functioning of capitalism. Government regulation in the form of clear, predictable and enforceable rules is

essential to ensure commitment and ownership incentives are credible, but in the end the integrity of the system requires that private parties be exposed to a clear and significant downside risk that both encourages them to uphold their promises and to fix the mistakes they will make.

The practice of relying on personal capital at risk has a long tradition dating from before Adam Smith. The 16th century Banco di San Giorgio, one of the oldest known banks, demonstrates the trust engendering the mechanism of capital at risk. Giuseppe Felloni, emeritus professor at the University of Genoa, discovered the bank's manual, which set out the rules for appointing treasurers. It is instructive: Candidates had to put up 16,000 lire (about $372,000 today) with the bank and give names of sponsors who would guarantee a further 90,000 lire.

At the turn of the 20th century, J.P. Morgan and his associates sat on the boards of the companies in which the bank invested. Indeed, Morgan was an early pioneer of this practice and of requiring that the companies he invested in provide periodic, accountant-certified financial reports to let the owners better monitor their assets. Economic research has shown that a company with a J.P. Morgan partner on the board was valued at a 30% premium to comparable companies.

Warren Buffett, a modern-day active investor, refers to his approach as "owner-capitalism." His 1999 Owner's Manual said, "Most of our directors have a major portion of their net worth invested in the company. We eat our own cooking."

Two decades ago, Michael Jensen, then a professor at Harvard Business School, predicted the "eclipse of the public corporation" due to its fundamental weakness — the conflict between small and dispersed shareholder "owners" and nonsignificant shareholding managers over the control and use of corporate resources. Jensen accurately predicted the rise of "LBO associations," or private-equity groups and active investors to address the ownership or commitment gap.

Jensen went on to highlight "strategic value accountability," or SVA, as the missing corporate governance driver that separates private equity from public companies. What the former do best is to clearly assign, measure and reward people for the long-run value affects of their strategic decisions. Notably, private-equity firms accomplish this in a clear and simple fashion — buyout partners assigned to the boards of companies going private benefit only when and by how much they create value at an IPO or sale of the company.

By contrast, without resolving assignment of SVA, public company and capital market relations are characterized by what Jensen called "out-of-integrity gaming and lying" — smoothing earnings and setting and managing quarterly earnings targets. Add to this the continual controversy over executive compensation and the push for proxy access by shareholders, and it is clear that accountability is more difficult to achieve at public companies.

Active investors such as private-equity firms are not immune from mistakes. Recently, a few have taken significant financial and reputational hits as portfolio companies like Chrysler, Washington Mutual, Linens 'n Things, and Tribune Co. failed. Yet some of these same companies are being reinvigorated by other private-equity groups that buy distressed debt at a

discount and ultimately become owners when equity is wiped out. More importantly, as a group, private equity has not experienced the scale or frequency of corporate governance scandals seen in the public market.

Economic research tells us why.

Harvard Prof. Sharon Katz has done research demonstrating that private-equity-backed firms tend to have higher earnings quality because, for example, they engage less in earnings management and report losses in a timelier manner than non-private-equity-backed companies. He points to the far greater demand for timely information from private-equity sponsor-owners and debtholders and the much greater care taken not to tarnish their reputations, given that they are repeat players in debt and IPO markets.

Thus, though private equity has capital to deploy, the real benefit it brings is aligning incentives that enhance accountability. This is accomplished best where ownership is clear and concentrated. Hence, "club deals" — encouraged by Federal Reserve rules restricting ownership by each private-equity firm to 24.9% — are counterproductive because they make it more costly and complicated to achieve accountability benefits.

In light of the recent massive failure of oversight at banking institutions, we should be very clear why they should not benefit from the discipline of a proven and powerful incentive-driven governance system. Indeed, it is worth noting that financial conglomerates such as the ones at the center of today's crisis are the very antithesis of the leaner, less complex and easier to govern (that is, make accountable) organizations private-equity groups build.

David Haarmeyer is an independent economic consultant and writer. He is the author of "The Revolution in Active Investing: Creating Wealth and Better Governance," published in Journal of Applied Corporate Finance. He can be reached at DHaarmeyer@gmail.com.

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