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8 Journal of Applied Corporate Finance • Volume 20 Number 3 A Morgan Stanley Publication • Summer 2008

Private Equity, Corporate Governance,

and the Reinvention of the Market for Corporate Control

* This article is based on a presentation given at the American Enterprise Institute,Conference on The History, Impact and Future of Private Equity: Ownership, Governanceand Firm Performance, November 27, 2007, Washington D.C. I would like to thank JohnChapman, Michael Jensen, Steve Kaplan, Josh Lerner and Annette Poulson, and espe-cially Don Chew for helpful discussion, questions, comments, and suggestions. Researchsupport from the Dice Center for Financial Research, the Fisher College of Business, andThe Ohio State University is gratefully acknowledged.

1. Source: Deal Journal, The Wall Street Journal, July 3, 2008, July 7, 2008, whichrelies on data from Dealogic, Private Equity Analyst, Standard & Poors, Moody’s InvestorServices, and FactSet MergeMetrics.

2. See for example, Peter Lattman, “Hunstman Sues Apollo in Texas Over BuyoutBattle, The Wall Street Journal, June 24, 2008.

3. Peter Lattman and Tamara Audi, “Wachovia, Deutsche Bank Bring End to PennNational Deal,” The Wall Street Journal, July 4, 2008.

4. Heidi Moore, “Private Equity Wins Again: BCE Buyout Proves the Customer is Al-ways Right,” The Wall Street Journal, July 7, 2008.

5. Allan Sloan and Katie Benner, “The Year of Vulture,” CNNMoney.com,

May 15, 2008.6. The incentives of dealmakers are a function of the payoffs they receive from fees,

carried interest, and so forth. As discussed at the end of this article, high levels of feesin relation to equity commitments are a prescription for overpriced (and thus too many)deals. For a discussion of the factors leading to boom-bust cycles in LBOs, see Jensen(1991), Kaplan and Stein (1993), Kaplan and Schoar (2005), Axelson, Jenkinson,Strömberg and Weisbach (2007). Full citations of all academic papers cited in this arti-cle can be found in the References at the end.

7. Kaplan and Schoar (2005) run an experiment for each buyout fund in their sample.They assess the value returned to investors by the buyout fund and compare it to thevalue that would have been returned to investors had they instead made the same invest-ment in the S&P 500. They nd that the S&P investment strategy would have been worth25% more on average. Moreover, to the extent the beta of private equity is greater thanone, the return to the S&P 500 understates the correct performance benchmark.

8. See Fleischer (2008).9. Henry Sender, “How Blackstone will Divvy up its Riches,” The Wall Street Journal,

June 12, 2007.

by Karen H. Wruck, Ohio State University*

The second hal o 2007 saw the end o the second wave o U.S. private equity and the beginningo a credit crunch that continues to work its way through the system. The volume o private equity

transactions has dropped dramatically. In the rst hal o 2007, global buyout volume totaled $527.7 billion. Through

mid-June o 2008, total buyouts were down to $124.7 billion,less than a quarter o the prior year’s volume. Buyouts over$1 billion in the rst hal o 2007 numbered 93; in the rsthal o 2008 there were 32. And the buyouts that are gettingdone are using notably less leverage, with debt averaging 4.9times EBITDA in the rst hal o 2008 as compared to 6.3times in the rst hal o 2007.

Another telling indicator o the change in the privateequity market is the rate at which agreed-upon buyouts arenow being “terminated”—that is, renegotiated or abandoned.Over 20% o the deals struck in 2007 are either rejected orreworked. (By comparison, the percentage o buyouts thus

terminated in previous years was 8.3% in 2006, 12.0% in2005, and 13.1% in 2004.1) Some terminated transactions,such as the $6.5 billion Hexion/Huntsman/Apollo deal, arebeing litigated.2 Others have avoided litigation, such as the$6.1 billion Penn National Deal in which the banks haveagreed to contribute $550 million in cash toward a $1.25billion out-o-court settlement.3 And still other deals have beensalvaged at lower prices and/or with less generous borrow-ing terms, including Clear Channel, Home Depot’s Supply Division, and the $52 billion buyout o Bell Canada.4

All this amounts to a sea change in the industry outlook. As late as mid-2007, Henry Kravis o KKR and others were

celebrating what they identied as the “golden age” o private

equity. But just six months later, at the World EconomicForum, David Rubenstein o the Carlyle Group stated thatthe golden age o private equity was over, and that the indus-try had entered a “purgatory age” in which it would be madeto atone or its sins.5

As we now know rom almost three decades o experi-

ence, private equity markets are prone to boom-bust cycles.Several actors have been identied as contributing to thesecycles, including relaxed credit market conditions, aggressivedeal pricing (refecting intense competition or deals), andthe incentives o many dealmakers to do overpriced deals.6 Viewed in this light, the sudden all o private equity doesnot come as a complete surprise. Even beore the end o thesecond wave in 2007, the perormance o private equity rms was being subjected to increased scrutiny and skepticism. Inact, while the unds put together by the top private equity rms have produced persistently strong returns over the years,one widely cited study reported that the average returns (net

o ees) produced by a large sample o private equity undsestablished between 1983 and 1997 ailed even to match thereturn to the S&P 500.7

At the same time their average returns were being calledinto question, private equity rms also began to come underattack or taking advantage o the provision o the U.S. taxcode that allows partnership earnings rom carried inter-est to be taxed at capital gains rates rather than as ordinary income.8 This tax controversy was ueled by detailed andmuch-publicized reports o the personal wealth being amassedby principals in private equity rms.9

Without understating the importance o the issues raised

above, I’d like to set them aside until the end o this paper.



9Journal of Applied Corporate Finance • Volume 20 Number 3 A Morgan Stanley Publication • Summer 2008

My primary goal in these pages is not to explore the causeso boom-bust cycles or other major controversies that now surround private equity. Nor do I claim any special ability to predict specic industry trends. Rather, my purpose is

to show how the private equity market, or all its problemsand cycles, has helped reinvent what economists reer to asthe “market or corporate control”—particularly in the U.S., which is home to the world’s largest such market. And by reinvigorating the U.S. corporate control market, privateequity has had prooundly positive eects on the governanceand perormance o U.S. public companies. Indeed, theseeects are important enough to warrant a new denitiono the market or corporate control—one that, as presentedbelow, emphasizes corporate governance and the benets o the competition or deals between private equity rms andpublic acquirers or, in industry parlance, between “nancial”

and “strategic” buyers. Along with improvements in governance, the early buyout

rms also pioneered a distinctive approach to reorganizingcompanies. Scholars and practitioners alike have recognizedthe combination o high leverage, strong governance, andincreased management equity ownership as a key contribu-tor to the success o LBOs.10 Less appreciated, however, isthe ability o early buyout rms such as Berkshire Partners,Clayton & Dubilier, Forstman Little, Hicks Muse, and KKR to develop what might be described as a new approach toreorganizing businesses or eciency and value.

My own research on private equity—which includes

multiple case studies, interviews with buyout specialists andmanagers o rms acquired in buyouts, and large-sampleresearch on private equity markets and highly leveragedtransactions—has led me to identiy our principles o reorganization that help explain the success o the top buyoutrms. When applied eectively, these principles requiredchanges not only in corporate governance, but in day-to-day management decision-making and operating practices, in themeasures used internally to evaluate perormance, and in theincentive-and-reward structures used to motivate managersat all levels o the rm. (Leverage, on the other hand, plays asecondary role; the main role o debt in private equity transac-

tions, as I argue below, is to make possible the concentrationo ownership that is critical to eective governance and strongincentives.)

In addition to providing a source o competitive advan-tage or the top buyout rms, the management practicesthat derive rom these our principles o reorganization havebeen adopted by many public companies in their pursuit o shareholder value. In this sense, the impact o private equity

extends well beyond the thousands o companies worldwidethat have had direct dealings with private equity rms. AsI suggest in this paper, private equity’s most important andlasting consequence or the global economy may well be its

eects on the world’s public corporations—those companiesthat will continue to carry out the lion’s share o the world’sgrowth opportunities.

Development of the U.S. Market for Corporate Control With the rise o unsolicited (or “hostile”) takeovers in the late1970s and early 1980s, nance scholars, corporate manag-ers, and the press turned their attention to the eects onthe economy o mergers, acquisitions, and other “corporatecontrol” transactions. At this time, hostile deals were typi-cally decried by the press and corporate executives as drivenby greed and damaging to U.S. competitiveness, employees,

and local communities. And the creation o a high-yield debtmarket or new issues and the emergence o private equity inthe early ’80s meant that, or the rst time, even very largerms were vulnerable to “attacks” by “corporate raiders” likeBoone Pickens and Irwin Jacobs.

But nancial economists took a very dierent view o these new developments. A small but growing body o papers was reporting consistent evidence o shareholder gains inM&A transactions, particularly in hostile deals.11 And ina much-cited 1983 article that surveyed this new literature,nance proessors Michael Jensen and Richard Ruback cutthrough the controversy and rhetoric by introducing the

concept o a market or corporate control. Ater deningit as “the market in which alternative management teamscompete or the right to manage corporate resources,” Jensenand Ruback went on to call it “an important component o the managerial labor market.” In other words, by acquir-ing another rm (generally at a signicant premium over itscurrent market price), and then making improvements in itsperormance sucient to justiy the purchase premium, anacquirer’s managers were demonstrating their superiority tothe managers o not only the acquired rm, but o all actualor potential competitors or the same assets.

Viewing the market or corporate control as an exten-

sion o the managerial labor market was a new and powerulidea. I the management team o a large public company was clearly ailing to make the most o the investor capitaland other corporate resources at its disposal, the corporatecontrol market provided a means by which a more ecientand eective team—whether rom another public company or backed by unaliated investors—could buy the right tomanage those resources, thereby creating value or sharehold-

10. See for example, Kaplan (1997) and Kaplan and Holmstrom (2001), (2003).11. The evidence showed that most of the value gains accrue to target shareholders,

with bidder shareholders experiencing no gain or a small decline. The decline was at-tributed to a tendency by bidders to overpay in friendly deals. For example, in a study of47 hostile takeovers (larger than $100 million) attempted in 1985 and 1986, Bhide

(1989) reported that the targets of hostile deals tended to be low-growth, poorly per-forming, diversied companies with little management ownership. By contrast, the tar -gets of the 30 larger friendly deals transacted in the same period tended to be single-industry rms with strong performance and high insider ownership.




ers and the economy in general. The price or that right wasthe amount necessary to gain control o the underperorm-ing rm.

A primary contribution o the scholarly research and the

new denition o the market or corporate control was thusto change the tone o the debate, shiting the ocus away romthe greed o nanciers and the unortunate eects o somedeals on employees and local communities, and toward theimportance o improving the eciency o resource alloca-tion and use in public corporations. As a consequence, whileethical questions o greed and airness will always be withus, eciency and value are now widely accepted as the mostimportant social criterion in transactions involving changesin corporate control.

Viewed in the context o a well-unctioning market orcorporate control, underperorming public companies repre-

sent prot opportunities—opportunities that in turn providestrong incentives to mobilize capital, acquire underused assets,and nd ways to capture value by reversing underperormance.Such prot opportunities, and the resulting incentives, gaverise to the rst major wave o U.S. private equity transactionsin the early 1980s. And this rst wave o leveraged buyouts, when viewed together with hostile takeovers (also typically leveraged), can be seen as the beginning o the developmento an eective U.S. market or corporate control.

But it was only the beginning. At that time, the ability o potential acquirers—particularly unaliated raiders and privateequity rms—to prot rom corporate underperormance was

limited by the relatively small size o the high-yield and privatedebt markets, and by the size o the private equity market. Another critical constraint was the limited number o privateequity shops then capable o reorganizing underperormingrms. As a result, the U.S. market or corporate control market was under developed—and its lack o development was a majorcontributor to a governance system notably lacking in eitherinternal or external constraints on management.12

Inside U.S. public companies, corporate managers withminimal stock ownership or other equity incentives wereocused mainly on growth and diversication, oten at theexpense o protability and value. Take the case o General

Mills in the late 1970s. The company’s stated mission was tobecome “the all-weather growth company,” which it aimedto carry out by using the food o cash fow rom its corecereal businesses to diversiy into toys and games, specialty retail, travel services, and rare coins and stamps. The eventualoutcome o this diversication was a serious decline in prot-

ability and stock price—and it required a series o voluntary divestitures and spinos spanning more than a decade toundo the damage. Ater studying this situation, GordonDonaldson o the Harvard Business School concluded that

it “was a minor miracle that it [the voluntary restructuring]happened at all… [and it] cost ten years o opportunity toreap the benets.”13

In the case o another conglomerate, Beatrice Foods, ittook an LBO (completed in the ace o a hostile takeover oer)to bring about the needed restructuring. But unlike the caseo General Mills, the changes at Beatrice were made quickly.The company’s $8.1 billion LBO, which was sponsored by KKR, closed in late 1985. By the end o 1987, just two yearslater, the company had spun o or divested $6.55 billion inassets, retaining only the domestic ood operations. The neteect was signicant value added or KKR and its investors,

as well as a recovery o lost value by Beatrice shareholders inthe orm o the large purchase premium paid by KKR to gaincontrol o the rm.14

The diversiication strategies o General Mills andBeatrice Foods, while refecting management’s preerenceor growth over value, were at least tacitly supported by theirboards o directors. Although nominally representatives o theshareholder interest, corporate directors were generally hand-picked and dominated by the CEO (who also oten chairedthe board). And the underdeveloped state o the corporatecontrol market at that time meant that dissatised sharehold-ers had little recourse outside the rm. With hostile takeovers

still politically and socially unacceptable, and limited undingor the ew investors willing to bear the stigma o being a“corporate raider,” the external sources o control needed tocurb corporate managers’ pursuit o growth at all costs wereas yet in a ormative stage. As a result, tales o diversicationollowed by major “restructuring” were repeated countlesstimes in the ’70s and ’80s.15

But, as the history o the U.S. market or corporate controlalso makes clear, i the abysmal perormance o U.S. compa-nies in the late ’70s was the refection o ailed governance, italso became the catalyst or major governance reorm.

A Closer Look at the Corporate Governance ProblemMost business journalists, and many nance scholars, tendto write about capital markets and corporate governance as i they were two distinct subjects. But the connection betweencapital markets and governance is undamental: how acompany chooses to raise its capital eectively determines

12. As Jensen summarized the situation, the managements of U.S. public companiesin the early ’80s could preside over the destruction of “up to a third of the value” of theirorganizations before “facing a serious threat of displacement” by either their boards oroutside investors. Michael Jensen, “Corporate Control and the Politics of Finance,” Jour-

nal of Applied Corporate Finance, Vol. 4 No. 2 (Summer 1991), p. 22.13. Donaldson (1990), pp.139.14. In 1990, the remaining operations were sold to ConAgra. And, according to cal-

culations made by George Baker, Beatrice’s shareholders recovered most if not all of thevalue lost through its poor diversication strategy in the $1 billion purchase premium

paid by KKR; and when this premium is added to the $1.2 billion ultimately realized byKKR and its investors, the net gains to all shareholders (buying as well as selling) fromBeatrice’s LBO were estimated at $2.2 billion. See Baker (1992). Today, perhaps themost notable remnant of Beatrice is the successor to Borden Chemicals, Hexion, a pri-vate specialty chemical rm controlled by Leon Black’s Apollo.

15. In his study of 28 successful hostile takeovers completed in 1985 and 1986(cited earlier in note 11), Bhide (1989) notes that, after the 28 deals closed, 81 busi-nesses were soon divested; and of the 81, as many as 78 had been previously acquiredrather than developed from within.




and payouts to investors. “Agency costs” consist partly o thedirect costs incurred in trying to manage these conficts—say, in the orm o auditing ees, and the costs associated withexecutive contracts and incentive comp plans. And, given the

impossibility o eliminating these conficts through contractsalone, agency costs also include the “residual loss in rmvalue” that results rom having limited governance and boardoversight over managers without signicant equity stakes. Forour purposes, what’s important to keep in mind is that suchagency costs are recognized, and refected in the stock priceso public companies, by outside investors who understand thelimits o their inormation and control.

The role o governance, then, is to give the shareholderssome degree o control over managers whose interests are notully consistent with their own. To put this in more ormalterms, in companies where managerial decision-making and

residual risk-bearing have been separated, the residual risk bearers must possess and be able to exercise what I will latercall “governance rights.” Moreover, they must be able toexercise such rights not only ater things have clearly gone wrong, but at critical points when companies are contem-plating new strategies or major organizational changes. When residual risk bearers have no governance rights—acondition that many nance scholars view as an accuratecharacterization o corporate America up through the early 1980s—agency problems lead predictably to widespreadunderperormance and value destruction.17

Effective Corporate Governance:The Private Equity ModelThe governance structure used by top private equity rms hasbeen the subject o considerable study by nance academics,and its main eatures are now well documented.18 The typicalboard o a private-equity controlled company has relatively ew (generally ve to eight) members, a non-managementchair, and only one management director. Among the non-management directors are nanciers and individuals withstrong management experience or industry expertise. Finally,and perhaps most important, the board o directors hassignicant equity-based incentives, either through direct

share ownership or an incentive structure whose payosare tightly linked to appreciation in share value (includingcarried interest).

A good example is the post-buyout governance structureo O.M. Scott, a lawn and plant care company that in 1986 was bought rom its conglomerate parent ITT by the buyout

the kind o governance system it will be subjected to.The objective o a governance system is to ensure that the

interests o a company’s managers are consistent with thoseo its shareholders. This raises the basic question o why, in

most large enterprises, the top managers are not the dominantshareholders. The answer has to do with comparative advan-tage in risk-bearing.

From economists’ vantage point, the principal advantageo the public corporation is its eciency in spreading risk among well-diversied investors, thereby providing the rm with a low-cost source o equity capital. In act, the publiccorporation can be thought o as an ingenious risk manage-ment device—a orm o organization that allows equity investors to specialize in bearing the residual risk o the rm without having to manage it, while at the same time allowingmanagers to run the rm without supplying the capital and

bearing the entire residual risk o the business. Consider thecase o General Electric. At the end o 2007, the rm’s marketcap stood at $374 billion16—an amount that had fuctuatedby an average o $3.7 billion per day during that year. It ishard to imagine an individual, or small group o individuals,having both the expertise to run GE and the capital and risk tolerance to bear the residual risk o such a huge enterprise.

But this separation o management and risk-bearing hasa downside: the need or corporate governance and incen-tive compensation to help ensure that the managers serve theinterests o the residual risk-bearing shareholders. In theirpathbreaking 1976 paper on “agency costs,” Jensen and his

colleague Bill Meckling identied and analyzed potentialconficts o interest between management and shareholdersas a “principal-agent” problem. As we saw earlier in the caseso General Mills and Beatrice Foods, managers place a highervalue on growth, size, and diversication than shareholders(who, o course, can diversiy their own portolios). And asthis managerial preerence or size and diversication suggests,investors also have greater tolerance or risk-taking, providedthe anticipated returns are high enough to justiy the risks. When the expected returns all below the cost o capital,investors would preer that the rm’s excess capital be paidout in the orm o dividends and stock repurchases—while

risk-averse managers, all else equal, would preer to keep thecash inside the rm.Corporate managers, then, when viewed as sel-inter-

ested and risk-averse agents or their shareholders, tend topreer more than the value-maximizing amount o growthand assets, and less than the optimal amount o risk-taking

16. According to the CIA Worldfact book, this is slightly greater than the 2007 ofcialexchange rate GPD of Sweden ($371.5 billion) and slightly less than the ofcial ex -change rate GDP of Switzerland ($386.8 billion)).

17. A defective governance structure is analogous to the non-surviving organizationalform identied by Fama and Jensen (1983 (a) and (b)). Adopting their terminology moreprecisely, a rm in which decision management rights are co-located with decision con -trol rights and at the same time separated from residual risk bearing cannot survive.Moreover, Jensen and his colleague Bill Meckling were sufciently pessimistic about theU.S. governance system in the early 1980s that they published an article called “Can the

Public Corporation Survive?” There they argued that U.S. policymakers and managers ofU.S. companies had so lost sight of their primary obligation to efciency and share-holder value that their future as competitive enterprises was in doubt. In other words,managers of public companies were failing to serve stockholders; and given the state ofthe stock and IPO markets, which reected such poor performance, competent ownersof private companies intent on maximizing value would simply choose to remain pri-vate.

18. See, for example, Jensen (1989) and Baker and Wruck (1990).




rm Clayton & Dubilier (C&D). Upon taking control o thecompany, C&D established a ve-person board o directors, with one management director, three C&D partners, andone outside director with extensive operating experience. One

C&D director served as Scott’s operating partner, working with managers to develop an eective strategy or improvingperormance. The C&D partners represented a 61.4% equity position—a position that, when combined with manage-ment’s and employees’ equity stake o 17.5%, is representativeo the highly concentrated ownership structure associated with buyouts.19

A comparison o Scott’s governance under C&D toits pre-buyout “governance” as part o ITT illustrates how private equity addresses the agency problems endemic tolarge, and especially diversied, public corporations. Priorto the buyout, Scott’s top executive was one o many division

managers in ITT’s consumer products group. He reporteda ew times a year to ITT headquarters and what “equity”he had consisted o stock options in ITT. ITT was itsel governed by an 11-member board whose equity ownershiptotaled 0.6% o the shares outstanding. Ater the buyout,Scott’s top manager was the CEO and 10% equityholder o a standalone company, reporting on a weekly (i not daily)basis to a ve-person board that included three partners o C&D, the 60% owner o his company’s stock.

As the eatures o the Scott deal are meant to suggest,private equity rms combine signicant and concentratedshare ownership with eective board oversight, thereby

reuniting the corporate risk-bearing and governanceunctions that are separated when companies go public. Andthe results o such changes in ownership and governancehave been impressive. Within two years o being acquired by C&D, or example, Scott had increased its sales by 25% andits earnings beore interest and taxes (EBIT) by over 50%. And these earnings increases, which were achieved whileraising spending on R&D and marketing and distribution,are consistent with those reported or large samples o privateequity buyouts. For example, two separate studies o largesamples o LBOs in the 1980s both reported 40% averageincreases in operating income during a two-year period

ollowing the buyouts.20

Another study o LBO compa-nies that eventually went public through IPOs (known as“reverse LBOs”) showed that these rms not only becamemore protable ater going private, but continued to be more

protable than their industry peers during the rst two yearsater their IPOs .21

Costs of Going Private

But, as the decision by some LBO companies to return topublic ownership suggests, there is also a major cost to concen-trating ownership: at bottom, the decision to go private meansorgoing the risk-bearing economies and the resulting lowercost o equity capital provided by equity public markets. Inother words, the benets o better corporate governance andstronger incentives that are made possible by concentratingequity ownership come at the cost o restricting sharehold-ers’ access to liquidity and their ability to diversiy risk. Inthis sense, going private represents a decision to trade o e-ciencies in risk-bearing and lower-cost equity or the gainsassociated with concentrated equity ownership and the stron-

ger governance and incentives that come with it.22

And it is these costs o going private that ensure thatthe governance structures implemented by private equity rms in most o their individual portolio companies are not“permanent.” At some point, private equity deals seek a major“liquidity event” that allows investors to sell all or part o theirinvestment. Indeed, the nite lie o the limited partnershipstructure underlying private equity, typically seven to tenyears, eventually orces the occurrence o such an event.23

One possible liquidity event is that the portolio company is sold to another private equity group (or, alternatively, pays aliquidating dividend to its current owners and is recapitalized,

with some changes in ownership). In such cases, although thecast o characters may change, the company stays private andthe basic governance and equity ownership structure likely remains the same. Another common outcome is sale o the rmto another corporation, public or private, in which case therm becomes subject to the governance system o the buyer. A third possibility—limited mainly to larger buyouts by themost reputable buyout private equity rms—is public owner-ship through an IPO. In the case o such reverse LBOs, therm’s managers and investors sell part o their equity stake,thereby diluting ownership concentration; and the inusion o new equity has the eect o reducing leverage. And ater the

IPOs, the debt o reverse LBO rms continues to all, and thestructure o their boards and their management incentive plansbegin to look more like those o “typical” public companies.

But somewhat surprisingly, in light o these post-IPO

19. Over the next few years, three new directors were added. One was an academicturf-expert, one was a consumer products expert, and one was the president of a com-pany Scott acquired after its buyout. Each of these directors received signicant compen-sation in the form of stock options.

20. Kaplan (1989), Smith (1990).21. Cao (2008), Cao and Lerner (2007).22. To see the tradeoff more clearly, recall that the main advantage of diffuse owner-

ship is the relatively low cost of equity that results from providing investors with liquidityand the opportunity to diversify away rm-specic risk. In a private equity structure,managers are exposed to rm-specic risk through their human capital and share owner -ship, but have strong incentives to maximize value. General partners are less exposed torm-specic risk since they invest in a number of portfolio companies and may have

well-diversied personal portfolios. Nevertheless they bear more rm-specic risk thanwell-diversied, passive equity investors because of the illiquidity of their investmentsand the potentially large effects of deal outcomes on their reputations and human capital.Limited partners, by contrast, have the greatest opportunity to hold well-diversied port -folios. They are generally, although not always, large institutional investors with only aportion of their assets allocated to alternative investments such as private equity.

23. According a study by Steve Kaplan of 183 LBOs larger than $100 million thatwere closed during the period 1979-1986, 62% of the LBO rms remained privatelyowned four or more years after their buyout, another 24% were owned by public compa-nies, and 14% were independent publicly traded rms. Of the LBO rms that remainedprivate, some continued to be owned by the original buyout rm, but others had beenpurchased by other private rms.




changes in ownership and capital structure, a recent study by Jerry Cao and Josh Lerner o more than 500 reverse LBOsthat went private during the period 1983-2001 reports thatsuch companies outperormed both the broad stock market

and other IPOs or several years after their return to publicownership.24 This perormance suggests that, having experi-enced the benets o private equity-style governance andmanagement, public companies do not completely revert totheir pre-buyout ways. In other words, we may have evidenceo “permanent” organizational change and learning (a pointI will come back to).

A New Approach to Reorganizing for ValueIn addition to a superior governance model, private equity can be credited with a second major contribution: the devel-opment o a systematic approach to reorganizing companies

or eciency and value. Perennially successul buyout rmshave used this approach to increase the productivity o many portolio companies, in most cases without changingtop management or the rm’s core assets. In the process,they have developed specic knowledge and skills that allow them to tackle the challenges posed by the next portoliorm quickly and eectively. In other words, the reorganiza-tion process becomes suciently routine to the point whereit can be thought o as a reorganizing “technology,” a sourceo competitive advantage and value in itsel.

In any reorganization eort, there are two primary questions that must be addressed. One is which assets should

remain with the organization—and which should be sold orshut down? The second is what is the best “organizational struc-ture” or a given enterprise? Private equity rms decide whichassets should remain based on their contribution to rm value;assets that cannot earn their required rate o return on capitalunder private equity’s ownership are sold or shut down.

In discussing the approach o private equity to reorganiza-tion, I nd it useul to begin with a corporate “coordinationand control” ramework that was developed by Jensen andMeckling to address the dual problem o managing inorma-tion and incentives in large organizations.25 The ramework identies three critical elements o organizational structure:

1. The allocation o decision rights—that is, who gets tomake what decisions?2. Internal perormance measurement—how is success

dened or the rm, or business units, and or individuals?3. Reward and punishment systems, including promotion

and compensation systems.Note that although compensation gets a lot o attention,

it is only part o the story. And because o the diculty o getting inormation—particularly in private rms—about

internal decision-making structures and perormancemeasurement systems, these rst two elements o organiza-tional design are oten overlooked. But, as documented by a body o case studies and other “eld” research, buyoutsby private equity rms tend to be ollowed by dramaticchanges in both decision-making authority and perormancemeasures.26

To oer one example, while visiting Sterling Chemicalsover a several-year period ater its 1986 buyout by GordonCain, I ound clear evidence o the potential value romdecentralizing decision-making. In the case o Sterling,decentralization was the outcome o a rm-wide quality

management program that aimed to exploit the “specicknowledge” o managers and employees throughout the rmby expanding their decision rights. And this “empowering” o employees was accompanied by major changes in the rm’sperormance measurement and reward systems. Especially notable among such changes was the adoption o prot-sharing and employee stock ownership plans or Sterling’shighly unionized workorce. This combination o changesprovided employees with both the decision-making autonomy and the incentives to put their accumulated specic knowl-edge to work in ways that improved perormance. And, asI reported in my study, the result was a signicant increase

in value.27

Another reorganization I observed at close quarters wasSaeway. In 1985, Saeway was the largest public grocery storechain in the U.S. Faced with a number o challenges, includ-ing an inability to compete with strong regional chains thatused non-union labor, the company became the target o a hostile takeover oer. In response, management took thecompany private in a $4.3 billion LBO sponsored by KKR.

As part o its reorganization under KKR, Saeway madea simple but important change in its perormance measure-ment systems. Beore the buyout, Saeway’s key perormancemeasures were based on sales and net income benchmarked

against those o other national grocery chains—which, itturns out, were not its ercest competitors. Ater the LBO,Saeway developed a perormance measure called return onmarket value , or ROMV. ROMV was the ratio o annualoperating cash fow to the estimated market value o assets

24. Cao and Lerner also found that the buyout sponsors owned an average of about55% of the equity in their portfolio rms just before the IPOs. After the IPOs, their aver-age ownership stake dropped to about 38%. Leslie and Oyer (2008) nd that differencesin debt and in management compensation between LBO and public companies tend tonarrow (and then disappear) during the two years following the IPO.

25. See Jensen and Meckling (1995).26. See, for example, Baker and Wruck (1990), and Wruck (1991, 1994, 1997a

and 1997b) .

27. Between 1987 and 1988, Sterling’s sales increased from $413.2 million to$699.0 million, and EBITDA increased from $129.0 million to $340.1 million. Theoutstanding performance in 1988 was in part due to increases in operational efciencyand in part due to a substantial increase in the the world price of styrene monomer,which increased Sterling’s margins because styrene was a major product. By the end of1988, the company had reduced its debt to $90.8 million from $200.5 million at thetime of the buyout, and paid $190.3 million in dividends. The dividend payout was al-most 28 times the $6.8 million equity investment made at the time of the buyout. Formore detail see Wruck and Jensen (1994).




(and hence the amount that could be realized by selling thoseassets). The market value o assets was determined primarily through the appraisal o Saeway’s real estate holdings, which were then “marked to market.” ROMV was calculated at both

the divisional and corporate level, and management bonuses were tied to achieving a 20% target ROMV.

With the help o ROMV, Saeway’s managers identiedstores and divisions with substandard perormance. I they could not be made competitive, they were marked or sale orclosure. And the act that, ater the buyout, Saeway’s manag-ers owned 10% o the company’s common stock ensured thatthey had strong incentives to make such dicult decisions.(Beore the LBO, Saeway’s managers and directors as a groupowned just 0.6% o its common stock.)

Following these changes in perormance measurementand compensation, the company sold $1.8 billion in assets. In

the process, they were able to renegotiate about hal o their1,300 labor union contracts. Management’s ocus then turnedto improving the perormance o the stores that remained. And improve it did: Ater running or ve years under itsrevamped perormance measurement and compensationsystems, the company had increased its enterprise value by $1.6 billion—an increase that came ater, and on top o,KKR’s payment o a $1.8 billion takeover premium to buy the company rom Saeway’s public shareholders.

Four Principles and a Question ofCompetitive Advantage.

To sum up, then, my synthesis o a large and growing body o research points to a set o our principles that can be viewedas the oundation o the reorganizing approach taken by thebest private equity rms:

1. Governance by a small board o directors withsignicant equity ownership;

2. Decentralization o decision-making;3. Adoption o new perormance measures that

emphasize cash fow and long-run value; and4. Adoption o a new management compensation

system that includes:a. Higher levels o compensation, with more pay

at risk,b. Bonuses based on cash fow and/or valuemetrics, and

c. Signicant percentage management equity ownership.

The bottom line here is that a major part o the long-runsuccess o private equity can be attributed to its ability toreorganize companies in a way that makes the most o theirexisting knowledge, managerial expertise, and assets. This iscrucial when it comes to day-to-day decision-making, detailedproblem-solving, and issues o implementation. In other

words, I would argue that, although the best buyout rms

have the ability to govern their operating companies, they donot generally have the ability to manage them. And while it’strue that many buyout rms have added “operating” capabil-ity in the orm o experienced corporate managers (many o

them ormer CEOs) to their own stas, this capability is nota substitute or eective management and reorganization atthe portolio rm level. This makes reorganization based oneective decentralization and perormance measurement-and-reward systems a critical part o the private equity successstory. A schematic o the process is presented in Figure 1.

An important question, then, is the extent to which theseour reorganizing principles constitute a source o sustainablecompetitive advantage. The answer is not obvious; ater all,the principles identied above are not “rocket science.” Butthey may be hard to put into practice. As one example, thereis no shortage o public inormation documenting South-

west Airline’s business strategy, organization structure, andmanagement practices, yet no other airline seems to be willingand able to replicate its success.

The Secondary Role of Debt. Also worth noting here isthat substantial debt or high leverage is not one o the ourprinciples. This is not because debt is unimportant in buyouttransactions, but rather because, in an organizational andmanagement sense, its role is a secondary one. Set aside ora moment the tax benets o debt, and the higher returnsassociated with leveraged equity. From an organizationalperspective, the primary role o debt nancing is to make possible the creation o the concentrated equity ownership struc-

ture that is undamental to the eective governance and strong incentives associated with buyouts. Leverage accomplishes thisconcentration o ownership by “shrinking” the dollar amounto equity required to buy the portolio rm to the point wheremanagers can own a signicant percentage equity interest andprivate equity investors can own the rest.

In tight credit market conditions like today’s, private equity transactions will be done with less leverage, and hence produceewer tax benets and less leveraged (and thus lower) equity returns. Even so, today’s credit market conditions should notprevent private equity rms rom eectively reorganizing thoseportolio rms they do manage to acquire. Indeed, tight credit

markets and a sot economy are likely to make reorganizingcapabilities even more important since there are ewer alterna-tive sources o value to exploit. Finally, to the extent that easy credit encouraged the entry o private equity rms that wereless skilled at governance and reorganization, current condi-tions will expose their limitations, identiy them as “marginal”players, and orce them to shrink or exit.

Private Equity Markets and the Contest for“Governance Rights”The last 20 years have seen the evolution o a more compet-itive and dynamic market or corporate control, not only in

the U.S., but in the U.K. and increasingly in continental




Europe and Asia. And one predictable eect o this devel-opment has been to strengthen the governance systems andimprove the perormance o public companies, even thosethat have not been parties to private equity or any kind o

control transactions.28

To illustrate these “indirect” benets o a well-unctioningcorporate control market, one common response by publiccompanies to the potential threat posed by hostile takeoversand LBOs in the 1980s (as we saw in the case o GeneralMills) was to sell “non-core” businesses worth more in thehands o other companies or investors. Another response,oten combined with such asset sales, was to borrow (oruse the proceeds rom the sales) to buy back shares in whatbecame known as “leveraged recaps.”29 As these examplesare meant to suggest, many companies recognized that thebest way to protect themselves rom the threat o takeover

was to anticipate the acquirers’ action and do it themselves.But a more undamental solution, as many companies alsolearned, was to adopt at least some aspects o the more eec-tive governance and management processes o their would-beacquirers—those processes that were leading companies tovolunteer to sell underused assets and to distribute excesscapital.30

Much o this restructuring activity came to a halt in theearly ’90s when the market or leveraged (and hence mosthostile) transactions was essentially shut down, in large partthrough regulatory overreaction.31 At that point, large insti-tutional investors responded to the resulting governance

“vacuum” by using their new clout to become more activein conronting the boards o underperorming companies,taking advantage o relaxed restrictions on proxy ghts,and encouraging companies to provide top executives withmore generous equity incentives, mainly in the orm o stock options.32

But when leveraged nancing markets began to recoverin the mid-’90s, the U.S. private equity markets made adramatic comeback. The volume o U.S. private equity dealssoared rom $35 billion in 1996 to $782 billion in 2007. Andprivate equity played a growing role in M&A transactions,participating in over 20% o total deals in 2007’s $4.4 trillion

28. In addition to the “private” market-based solutions discussed below, some of themore recent improvements have been attributed to the regulatory response to highlypublicized governance failures such as Enron and WorldCom. The Sarbanes-Oxley (SOX)Act, passed in 2002, and the adoption of governance rules and guidelines by stock ex-changes, made certain governance practices mandatory. SOX places restrictions on in-sider trading and emphasizes the independence of the audit committee, focusing on in-ternal controls and transparency in reporting. NYSE rules and guidelines, adopted in late2003, require that the majority of directors be independent, that the compensation andnominating committees be comprised of independent directors, that non-managementdirectors meet regularly without managers present, that shareholders vote on the adop-tion of new equity compensation plans and on material revisions to existing plans, andthat companies make their corporate governance guidelines available.

29. See Wruck (1991) for a discussion of the governance, organizational and valuechanges associated with Sealed Air Corporations’ leveraged recapitalization. See alsoPalepu and Wruck (1992), who show that companies undertaking recapitalizations as adefensive measure underperform other recap rms following the transactions.

30. A recent example of a very large public company taking such steps is IBM, which,

after increasing its quarterly dividend by 50% in April 2006, sold its printer division intoa joint venture arrangement in January 2007, and announced a $15 billion share repur-chase plan in April 2007. It’s also interesting to note that, at around the same time, anumber of technology rms became private equity targets and IBM’s former chairmanLou Gerstner became Chairman of the private equity rm The Carlyle Group, promptingrumors of IBM as a possible target.

31. See Jensen (1991), “Corporate Control and the Politics of Finance.”32. Holmstrom and Kaplan (2001, 2003) identify a number of important causal fac-

tors that helped bring about improved governance. Among them are the dramatic increasein the fraction of shares held by institutional investors and 1992 changes to SEC rulesreducing the cost of mounting a proxy ght; these combined to increase shareholder activ -ism. Consistent with increased activism is evidence of an increase equity-based compen-sation for executives and directors, some evidence of a reduction in the size of boards, andan increase of the sensitivity of CEO turnover to performance (Kaplan and Minton (2008)).While there have been improvements, longstanding governance critics like Michael Jen-sen and Robert Monks argue that there are still major problems in need of reform. ( JACF Roundtable Discussion on Corporate Governance (Winter 2008)).

Figure 1 Reorganizing the Firm for Value

Weak Corporate Governance

Focus on size and growth rather than value, weak internal capital markets

Pressure from the Market for Corporate Control

Hostile Takeover Offer, LBO as an Alternative

Underperformance

Improved Strategy and Decision-making

Utilizing valuable specific knowledge through effective

decentralization allocating capital more efficiently

Asset Sales, if necessary

Private Equity-Style Governance

high leverage facilitates concentrated equity ownership

Changes in Organizational “Rules of the Game”

1) Decision rights decentralized

2) New Performance Measures focus on cash-flow rather than EPS

and on firm value rather than size or growth

3) Rewards that align incentives with bonuses based on new per formance

measures and management-equity ownership

Improved Performance and Value Creation




M&A market (as compared to just 3.1% in 1996).33 Privateequity also became a global phenomenon, with substantialgrowth in the U.K., continental Europe, and other parts o the world. Between 2001 and 2007, 12% o all global LBO

transactions were done outside North America and WesternEurope.34

A New Denition of the Market for Control

In light o private equity’s increased share o the global M&A market—and o its positive eects on control markets andcorporate governance generally—I propose the ollowingvariation on Jensen and Ruback’s denition o the marketor corporate control:

The market for corporate control is the market in which providers o capital, or their representatives, compete or the right

to govern the corporation. Governance rights include the right to establish governance structures and processes, to hire, fre and set the compensation of top managers, to veto or ratify major strategic initiatives, and to serve as “internal consultants” tomanagers.35

By “providers o capital” I mean not only investors andinvestment rms, but also corporations seeking to invest in orbuy the operations o other companies. While this denitiondoes not mention the managerial labor market, it has strongimplications or how that market unctions. For example,through the exercise o its “governance rights” (as just dened),

a buyer can retain or re incumbent managers, or change thestructure o its executive compensation contracts.

When the corporate control market is redened in this way, the importance o private equity, both or the controlmarket and the governance o public companies, becomesmore clear. Think about what happens when a private equity rm and public company bid or the same business. Corpo-rate bidders bring to the table the risk-bearing benets o diuse ownership along with the value o any operational orother synergies between the bidder and target. But set againstthe value o those advantages are the costs o the compa-nies’ less eective governance and incentives. Even i they

adopt some o the governance and incentive characteristicso private equity, corporate bidders cannot perectly replicatethe structure because o their inability (or unwillingness) toconcentrate ownership. Private equity rms, on the otherhand, bring the benets o strong governance and incentives while lacking the benets o ecient risk-bearing and thepossibility o synergies.

Now, i we assume that all bidders are “rational” (inthe sense o being unwilling to overpay), a public company

suitor will win the contest or control whenever the benetso public-market risk-bearing and the synergies associated with the specic business combination outweigh the expectedvalue o the stronger governance and incentives associated

with private equity. As a general rule, this is likely to be truein riskier industries with signicant economies o scale andgrowth opportunities requiring large, ongoing investmentand inusions o equity. Private equity rms are likely to win the contest under the opposite circumstances—that is,relatively stable cash fows and limited growth opportuni-ties (though buyout rms have placed increased emphasis ongrowth in recent years) and modest ongoing investment andcapital-raising requirements.

But having oered this generalization, with publiccompanies adopting stronger governance practices, andprivate equity rms gaining access to increasingly large pools

o capital and acquiring management and operating exper-tise in particular industries, the distinctions between the twotypes o bidders have begun to blur. This “convergence” o public and private equity practices has at least three impor-tant implications: First, private equity will increasingly beviewed as mainstream, as opposed to an “alternative,” sourceo capital. Second, the returns to private equity are likely to become more pedestrian, with lower expectations on thepart o investors and lower actual returns. Third, strongergovernance in public companies implies that we will see ewercases o the excessive bidding and overpayment by publicacquirers—as in the case o Time Warner’s purchase o AOL

and the Daimler-Chrysler merger—that resulted in massiveshareholder losses during the late 1990s and early 2000s.

The Import of PIPEs and Other Private PlacementsOne o the most visible and striking orms o the convergenceo private and public equity markets is the recent growth o private placements o equity, and o a more liquid kind o private placement known as a PIPE (short or “private invest-ment in public equity”). A private placement is the sale o ablock o newly issued stock in a publicly traded company toa single or small group o sophisticated (or at least “quali-ed”) investors. The shares are oten unregistered at the time

o issuance; and unless the issuer les a registration state-ment, they cannot be traded until held or two years. PIPEs,by contrast, are registered with the SEC within 30 days o issuance and can be publicly traded as soon as the registra-tion becomes eective. Between 1995 and 2007, the numbero private placements o equity increased rom 127 to 2,430, with aggregate proceeds soaring rom less than $2 billion toalmost $145 billion. And o the $145 billion raised in 2007,$50 billion, or over a third, took the orm o PIPEs.36

33. Between 2001 and 2007, 12% of all global LBO transactions were done outsideNorth America and Western Europe. For an overview of the Global Impact of PrivateEquity, see the Executive Summary of the World Economic Forum (2008) Report. Itprovides references to more detailed research done as part of the forum.

34. Sources: Thompson Financial and Dealogic.35. What I call governance rights include the top-level control rights that Fama and

Jensen (1983a and b) and Fuller and Jensen (2002) identify as rights that must be al-located to the board of the directors for governance to be effective.




A simple or traditional PIPE involves the issuance o common stock at a xed price, or convertible preerred stock at a xed price with a xed conversion ratio. More complexor structured PIPEs involve “contingent” (or option-like)

pricing arrangements, variable conversion ratios, and a variety o other contractual provisions.

One recent study o PIPEs reported that they tend to beissued by poorly perorming companies, and that contingentpricing provisions tend to be used in cases o “extreme uncer-tainty” to allow investors to earn appropriate risk-adjustedreturns.37 Consistent with and adding to this picture, anotherstudy ound that among PIPE investors, hedge unds tend tobe attracted to weaker issuers and to protect their returns by using contingent contracting terms.38

But this leaves a number o important questionsunanswered. For example, are PIPEs and private placements

generally best characterized as “partial buyouts,” but withoutthe access to governance and reorganization rights provided by a typical private equity purchase o an entire rm? Do privateplacement and PIPE investors become actively involved in theaairs o the issuer? I so, what role do they play and what isthe eect o these relationships on perormance?

In a recent study, 39 Yilin Wu and I put together a sampleo 1,976 private placements o common stock spanning theten-year period rom 1989 to 1999 (ending just beore theburst o the NASDAQ bubble, when the number o suchtransactions ell o sharply) and then “hand-collected” dataon placement terms and investor identity. Although our

primary source o data was the private placement contracts, we also used other sources to help identiy “relationships”between issuers and investors, and to classiy such relation-ships as either “pre-existing” or “new.” Our study showed,rst o all, that almost two-thirds (64%) o the issuers in oursample placed at least some shares with investors with whomthey had a pre-placement relationship—that is, with currentmanagers, key business partners, current 5% or greater block-holders, or current directors. In addition, in many privateplacements, new relationships, mainly in the orm o new directorships, were created as part o the placement agree-ment. Taking both pre-existing and new relationships into

account, we ound that only 8% o placements were issuedentirely to complete “outsiders” with no current or previousties to the rm.

Our study also urnished evidence that “relationshipinvestors” (as dened above) provide issuers with access tolarger amounts o capital and gain greater governance infu-

ence than outside investors. But our most powerul andpersistent nding was a strong, positive association betweennew relationships formed as part of the placement agreement and the issuer’s stock returns and operating proftability over the

ollowing two-to-three years. And given that the vast majority o new relationships are governance-related, involving board seats and/or new 5% or greater blocks, this fnding constitutes persua-sive evidence that the increased monitoring and better governance acilitated by some private placements can create signifcant value or all investors, passive as well as active.

To test the extent to which non-participating public inves-tors benet rom the relationships between private placementinvestors and issuing rms, we also estimated the “alphas” (orexcess returns) rom a variety o simulated trading strategiesthat were all based on the use o only publicly available inor-mation. Depending on the type o relationship involved in

the private placement, the issuer’s stock was either purchasedor sold short on the day ater announcement and held or two(or three) years. For example, one o our trading strategies was to buy the stock o issuers selling stock to investors with whom they already have a relationship and to short the issuersselling stock only to outsiders. Ater controlling or marketmovements, the rm size and book-to-market actors, andmomentum, this strategy yielded a two-year excess return o almost 17%—striking evidence o the value o relationshipsto non-participating public investors.40

In sum, our ndings suggest that PIPEs and privateplacements provide an opportunity or productive collabo-

ration between private and public equity. But to make it work, investors must have a relationship that provides them with governance rights or some other means o exertinginfuence on the issuing rm. In such situations, the privateplacement can create a partnership in which active investorssupply governance expertise while public investors continueto urnish most o the equity capital and bear most o theresidual risk. (What’s more, the governance benets o PIPEScan be realized without debt nancing, an attractive eaturein today’s environment.)

Bumps in the Road

While we have clearly passed the peak o the second major waveo U.S. leveraged buyouts, it seems equally clear that privateequity has established itsel as a permanent and signicanteature o capital markets and the market or corporate control. As discussed earlier, private equity has been a major orce inreinvigorating the U.S. corporate control market and strength-

36. The source is Sagient Research (http://www.sagientresearch.com). Private place-ments include private investments in public equity (PIPE), 144-A placements and Regu-lation S transactions.

37. Chaplinsky and Haushalter (2007).38. Brophy, Ouimet and Sialm (2007).39. Wruck and Wu (2008).40. One nding that came as a bit of a surprise was the poor performance of compa -

nies making private placements to key business partners where no new relationshipswere formed as part of the placement agreement. This is conrmed by the estimated

excess returns to the trading strategy of shorting the stock of all issuers selling to “keybusiness partners” in which no new relationships are formed, and going long in the rest.The returns of this strategy ranged from 17.2% to 29.0%. Our explanation of this ndingis that key business partners tend to have pre-placement relationships with the rm thatinvolve some kind of rm-specic investment (consider, for example, an OEM that hasinvested to become a primary supplier to a specic automobile company). Such investorsoften nd themselves hostage to the fortunes of the issuer, forced to share the pain byvirtue of their relationships.




ening the governance o U.S. public companies. In addition,the principles o reorganization that govern the practice o thetop buyout rms have also clearly infuenced management prac-tices in a broad range o companies, public as well as private.

But there are nevertheless a number o important and contro-versial issues that have raised bumps in the road.

Tax Angles. One policy area o particular concern is thetax code. While some have objected that buyout rms benetrom the tax deductibility o interest, this benet accruesto all companies, public as well as private, that use debtnancing—and thus interest deductibility is unlikely to bea target o policy change. But the same cannot be said aboutthe preerential tax treatment o partnership prots. Morespecically, earnings received in the orm o “carried interest”are taxed at the capital gains rate rather than at the higherordinary income rate. And a number o scholars, politicians,

and others view this as a loophole that is being aggressively and unairly exploited by private equity partners.41

The threat o a change to the tax code that more thandoubles the eective tax rate on partnership carried interest isvery real. With the subprime crisis, the weak economy, and anupcoming presidential election, it has received less attentionrecently, but will likely come up again.

Entry, Exit, and Shifting Markets. Because high protsattract entry, new private equity rms enter the industry during boom times. Other than the ability to raise unds orinvestment, which is relatively easy during booms, there areew real barriers to entry in private equity. Indeed in 2006, a

record 2,700 private equity rms raised over $220 billion orinvestment, and over 170 unds had over $1 billion in assetsunder management. But, at the end o a boom cycle, suchease o entry creates potential problems.

One problem is that, ollowing a period o rampant entry,many private equity rms lack the experience and expertisein governing and reorganizing portolio rms required tomanage their investments eectively through boom andbust. To the extent active engagement in governance andorganizational redesign are undamental parts o privateequity’s value proposition, “passive” approaches to privateequity are unlikely to yield adequate returns or the risk

borne. When the market contracts, investors in the undso many o the private equity rms that were able to makemoney in easier times will experience poor returns. And asa result, the rms themselves will become marginal players,unable to raise new unds. A substantial number o suchailures could tarnish the reputation o the industry.

Moreover, deals-in-progress that are caught in shitingmarket conditions will either all apart or require renegotiat-ing. As mentioned earlier, an unusually high percentage o buyout agreements have been “terminated” in 2008, with a

number o such deals being re-struck at lower prices and/or with tighter credit terms. The allout rom such terminationsmay be increased reluctance on the part o target managers toenter into riendly deals with private equity, which could reducethe opportunity set o viable private equity transactions.

Incentive Dilution. A potential agency problem that hasreceived little emphasis to date results rom conficts o interestbetween general partners (GPs) and limited partners (LPs). Itis critical that their incentives are aligned i the private equity market is to unction eectively.

Under the typical “2 and 20” payout structure, GPsreceive a ee o 2% o assets under management annually and

20% o the prot (the “carried interest”) rom the und. GPsoten invest in the und alongside LPs, typically contributing1% to 5% o the total. The carried interest, along with theGPs’ investment in the und, work to align the incentives o GPs and LPs. But because management ees are paid regard-less o perormance, they do nothing to align incentives.In addition to management ees, GPs oten receive uprontdeal ees and monitoring ees, which are also independent o perormance.

As deals get larger, the management ee, which is eec-tively a percentage o deal size, becomes substantial. And when the bulk o the rewards rom a deal come rom “non-

contingent” payouts rather than those based on protability or share value, GPs have an incentive to close the deal even when the expected returns are inadequate rom a risk-returnstandpoint. This is a clear prescription or too many deals—or, more precisely, deals transacted at prices that are likely toturn out to be too high.42

There are also potential incentive problems when privateequity rms tap public equity markets. Raising unds througha limited partnership structure imposes a time constraint (thelimited lie o the partnership) and discipline with respect tohow the money can be deployed. In contrast, money raisedin public equity markets is permanent capital and imposes ar

ewer constraints on the issuing rm. Thus, when a privateequity rm goes public, the strength o the alignment betweenpartner and investor interests is diminished.

The Politics of Finance. The private equity industry would be well-served by considering the potential damagethat can be imposed on a sector by what nancial econo-

41. For example, Fleischer (2008), a legal scholar, states: “Partnership prot interestsare treated more favorably than other economically similar methods of compensation,such as partnership capital interests, restricted stock, or at-the-money non-qualiedstock options (the corporate equivalent of a partnership prot interest). The tax treatmentof carry is roughly equivalent to that of Incentive Stock Options or ISOs. Congress haslimited ISO treatment to relatively modest amounts; the tax subsidy for partnership prof-its interests is not similarly limited. A partnership prot interest is, under current law, thesingle most tax-efcient form of compensation available without limitation to highly-paid

executives.” Fleischer (2008), page 2.42. In my case study of Revco’s failed buyout in the late 80s (see Wruck (1991)), I

found that, with the exception of one outside investor, all the parties to the transactionreceived more in fees than they invested in equity, meaning that, even if the equity turnedout to be worthless, they still made money. And there is some new evidence that sug-gests that this could be a problem. Metrick and Yasuda (2007) nds that 60% of thetypical partner compensation in their sample of private equity rms comes from fees,with the remainder coming from carried interest.




mists now reer to as the “politics o nance.” 43 Unusually high protability attracts not only attention in the press, butalso scrutiny by politicians and regulators. The attack on“windall prots” when oil prices rise dramatically is one

good example. Another is the press and regulatory attack on the high yield market in the early 1990s. In short, thereis abundant historical precedent or political and regulatory responses to situations perceived to be “unair” and protsand earnings that are viewed as “excessive.”

But, as those who have been on the receiving end o suchresponses are aware, there is no requirement that the politicalor regulatory responses be based on scientic evidence—thatis, on the “central tendencies,” or representative cases, thatresearch helps us to identiy. Instead, they are likely to be areaction to a relatively small number o sensational and highly politicized examples. For example, many legal and nance

scholars view at least parts o Sarbanes Oxley as an overreach-ing and costly regulatory response to a very small number o highly visible and egregious breakdowns in governance.44

The highly publicized payouts that ollowed Blackstone’sIPO, and similarly detailed reports o payouts to other privateequity players, have the potential to damage the entire sector.Given the negative allout that can result rom this type o media attention, it probably makes sense to award substantialpayouts with as little publicity as possible.

From Avant Garde to Mainstream?Private equity has evolved rom an avant garde , boutique

business to an important orce in capital markets and in theeconomy. But i private equity is to be ully accepted, MainStreet must be given a better understanding o its role in

acilitating economic growth and creating or sustaining jobs.This will not happen unless the industry communicates itsmessage.

People know that General Motors and General Electric

are large and important companies. They do not know thatthe same is true o Blackstone, KKR, TPG, and others.In 2006, taken as a whole, Blackstone’s 35 to 40 porto-lio companies generated over $50 billion in revenues andemployed over 300,000 people, making it the equivalento a top 20 company in the Fortune 500. TPG’s portoliocompanies generated $41 billion in revenues and employed255,000. And Carlyle’s portolio companies generated $31billion in revenues and employed 150,000. People know thattheir welare in retirement depends on the perormance o thestock market, but most do not understand that it also dependson the perormance o private equity investments—and that

this dependence is likely to grow.Leaders in the private equity arena are more like success-

ul entrepreneurs than successul investment banker ortraders—more like Bill Gates, the ounder o sotware giantMicrosot, than like Bill Gross, ounder o asset manage-ment titan Pacic Investment Management. They are theowners and leaders o major businesses, with all the attendantchallenges and responsibilities. Addressing these challengespublicly and proactively could make a big dierence or boththe industry and the economy.

karen hopper wruck is Dean’s Distinguished Professor, FinanceDepartment at Ohio State University’s Fisher College of Business

43. Jensen (1991) coined this phrase in describing the fall of the junk bond marketin the late 1990s.

44. See, for example, Romano (2004).




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read - pe, corp governance, and reinvention of market for corp control

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