Friday, 21 December 2007

Private equity and governance

Back on the private equity issue (topic of the year really) the bit below is from an interesting opinion piece by the editor of Financial News, a publication which is always worth a read as it's effectively the trade mag for the City.

Perhaps the best indicator of the systemic failure in governance is the dramatic rise of hedge funds and private equity firms – the second category that can be termed "investor governance" in the sense that they act more as owners of companies instead of just holders of their securities. The jury may be out on the claims that they are a force for moral or social good, but there is little question that they are a positive economic force. They act like "good" bacteria in attacking inefficiencies with a superior governance model and bridging the agency gap. Their rise has not been an accident. Poor governance has left the door open for them.

This is an increasingly common argument in favour of private equity as an ownership model. It is supposed to get over the agency problem of the separation of ownership and management in listed companies. And there is clearly some validity in the critique of public companies. Many investors - and I'm talking about fund managers here, not the real shareholders (us) - are very focused on short-term performance, because it is what they themselves are judged on. They are also trying to oversee hundreds of companies, so they are always a long way removed from the action (look at how many got burnt in Northern Rock). I have heard directors of public companies moan many times about how little investors understand their businesses, and how they have to manage news to suit how analysts react.

In contrast private equity funds invest in a small number of companies and the general partners are far more 'hands on' than even a large institutional investor will be in respect of a public company. In addition, private equity will typically 'own' a company for several years before selling it on, whereas the average length of ownership of shares is now under a year I think (although this doesn't actually tell you as much as many people make out). So, clearly, private equity as an ownership structure has some theoretical advantages over public companies.

But, and this is a big but, governance structures only get you so far. What matters much more is how people behave within those structures. As many have said before, good governance structures don't create good managers, and this is as true for private equity as it is for public companies. Cases like the AA demonstrate that actually private equity owners can be pretty clueless. And flip it around, are we really to believe that all those managers in public companies are performing sub-optimally, simply because the ownership structure is different? What sounds good at a theoretical level, sounds odd when you think about it in the real world.

Isn't it therefore far more realistic to view private equity as a bacteria alright, but one that principally attacks companies' capital, rather than governance, structure? In this view the success of private equity is really about arbitraging 'inefficiencies' in companies' use of capital - ie get the most out of debt while it is cheap. Arguably public companies were slow to make use of leverage, though it is clearly a strategy that has limitations and dangers.

My feeling is that the next couple of years will really see whether private equity can deliver the goods, as it won't be able to use leverage to turbo-charge its returns as it has done in recent years. The industry has taken out some big public companies, and how they perform will tell us a lot about what private equity actually does. The industry's pitch is that they run companies more efficiently AND create jobs. It will be interesting to see whether they can back these significant claims up. If they can, maybe the governance argument deserves some further scutiny. If they can't then maybe they were just another group of people who got excited by cheap money.

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