Private Equity As The Solution To Bad Corporate Governance

As a result of Alan Murray's Wall Street Journal column and appearance on CNBC yesterday morning, I have a developed, literally overnight, a different view of the private equity phenomenon. Alan is a managing editor of the paper, and a very shrewd, insightful writer with typically free market-leaning opinions, usually supported by evidence.

I've thought, for some time now, that the concept of shareholder 'democracy,' as currently bandied about, is wrong. For instance, I am listening to Congressman, Barney Frank, the new House Finance chairman with dubious credentials, on CNBC right now, as I write this. His verbiage is a good example of what I mean. Contrary to Frank, and others, I don't think the publicly-held company model was ever intended to raise the marginal shareholder to the level of voting on the CEO's compensation package, or similar "rights."

Previously, I've written in my blog that corporate structures of the 1890s were probably more effective than today's corporate model. Blogger is misbehaving this morning, so I cannot search for the post and link to it. In those days, however, a few men who actually knew how to create value and run a business, and make money. The public was allowed in because, ultimately, the barons needed more capital. With regulation of the capital markets over time, it worked. Boards were largely composed of wealthy, successful capitalists. The marginal public shareholder received the same financial benefit of ownership as the barons, without needing the skill or knowledge of the latter. A sort of asymmetric, one-way shareholder 'democracy.'

After some reflection, I realized that Murray's comments on private equity demonstrate that it is the new version of that old model. Successful businessmen use other's money, but now, in a smart twist, not for equity, but debt. So they don't give an unwanted vote/voice to the masses of small capitalists, or even concentration vehicles for funds, such as pension funds. Very astute, really. Take the public's money, but in a non-voting manner, without any reporting requirements.

Is this not new-style 1890s capitalism? I now think private equity is the, if not merely a, response to bad corporate governance.

In his excellent piece yesterday, Alan Murray wrote, in part,

"Increasingly, shareholders and directors are asking a fundamental question: If managers can create so much wealth for private owners, why can't they do the same for public shareholders?

Christobal Conde, chief executive officer of software company SunGard Data Systems, thinks he has an answer to that question. He was also in Davos last week and happy to tell his story to anyone who asked. As a public-company CEO, he was skeptical when Silver Lake's Mr. Hutchins first approached him two years ago about leading a buyout of his company. He thought private-equity firms made their money mostly through financial engineering, loading the target company with debt. But since then, he has learned otherwise. The buyout, he says, made SunGard a better company.

First, "it allowed us to push an enormous amount of change through the organization," Mr. Conde says. "It made everyone more receptive." That is particularly true of top managers, who were given twice the ownership stake in the company that they had when it was public. By boosting the company's debt, the buyout also ensured the value of those ownership stakes would skyrocket if the managers met their goals.

Second, he says his new private-equity partners -- which include Silver Lake, Blackstone, Bain Capital, Goldman Sachs Group, Kohlberg Kravis Roberts, Providence Equity and Texas Pacific Group -- have taught the company a great deal about improving the business in areas like purchasing.

"Like any company, we were very inbred," Mr. Conde says. But the private-equity partners operate across companies and industries, and were able to bring new knowledge to the firm "that has helped us enormously."

Finally, he says, his private-equity partners aren't obsessed with quarterly earnings. They understand a company's earnings may be volatile, and instead they focus on longer-term goals.

"I spend more time with my new private-equity shareholders than I did with the old ones," he says. "But I get so much more of it."

Mr. Conde says SunGard is still owned by many of the same pension funds that owned it before. That is the ultimate irony behind the new financial alchemy. Pension funds are paying hefty fees to private-equity firms -- which generally charge 2% of funds under management, plus 20% of the profit -- to make investments that the pension funds used to make by themselves.

Shareholders are right to be concerned about this trend. But the fault lies less with a private-equity market that is generating superior returns than with a public-company market that is generating lousy ones. Investors would be better off if public companies could clean up their own houses, and get rid of the high-priced middleman."

Look at what Mr. Conde is describing! Old-style, 'robber baron' capitalism. Isn't this what a board is supposed to do? In effect, these private equtiy titans buy choice, undervalued assets, and then reap equity rewards for overseeing their operations. They add as much value as the CEOs do, because they create the proper environment, goals, and long-term perspective for the eventual realization of the firm's value.

Is it not ironic that Conde points out how many pension funds invest in him via what Murray calls "middleman?" In fact, this is the answer to the claim that business doesn't care about the poor blue-collar worker, or compensation inequities. If the blue-collar worker's pension is invested with a fund that invests in private equity, then the lower-paid masses are, in fact, capable of reaping equity returns via the very deals which some feel disenfranchise or underpay them. Wages down, portfolio value up!

Here's another insight. If, as I wrote last summer as a solution to America's corporate governance problems, board members were required to "run" for the post, and invest significant assets of their own in the company, thus clearly aligning their financial interests with those of shareholders, it might improve corporate board oversight and involvement in the operation of companies.

Suppose private equity firm partners offered their services to a publicly-held company. Would they not, in effect, take board positions, in exchange for options to own much of the firm, or be paid a percentage of the value they created over, say, a function of the firm's prior total returns, relative to the S&P500? In effect, like my idea, they'd commit their financial fortunes to, and align them with those of the firm's. But what mechanism exists for shareholders to do this? None.

It would, in fact, be a sort of return to the days of the original form of shareholder capitalism. A few wealthy, skilled owners running the boards of large companies. Since, instead, many boards are infested with lesser lights, faded failures of other boards (look at Microsoft for a great example of this tendency), or "politically correct" members with absolutely no business skills, corporate performances are often appallingly bad, while CEOs and board members are still handsomely compensated.

Faced with this situation, private equity partners have followed Gresham's Law. They have, a la Ayn Rand, withheld their services from the poorly-paying public market for their services and, instead, gone private. In their private world, they are the new Morgans, Goulds and Schiffs. They invite investors to participate in a limited manner, with no vote. Just a financial reward.

Is this not the best solution smart, competent businessmen can effect in today's market? Since the publicly-held companies can't organize themselves to hire private equity partners as new, more-effective board members, these skilled operators simply created their own 'private' equity market, in which they can do the same job, for appropriate, risk-adjusted rewards.

Publicly-held company shareholders miss this source of premium returns because they are forced to invest via a broken, ineffective model which espouses "shareholder democracy," as if the marginal $10,000 investor in, say, Boeing, knows anything about how much the CEO should earn, or which board members, from a pre-selected slate, can properly and profitably oversee the firm's CEO and senior executive team.

Now, for a prediction as to a form of solution which may develop. What is to stop private equity firms from issuing securities of participation in their ventures, in small denominations, as limited equity partners? Would not brands such as Texas Pacific, KKR, and Silverlake command a premium in the market? By attracting investor capital to their privately-held efforts, these partnerships could effectively begin to drain capital from poorly-run public firms, and then slowly, inexorably, pull them into the private equity world, where the value they add would accrue to the small, limited partner.

Truth is, the worst part of the structure of today's publicly-traded firms is that the board-CEO governance mechanism mitigates against the effective management of the firm for consistently superior total returns. Read Murray's passage quoting Mr. Conde of Sungard. Conde essentially says that he could not run the company 'right' in the public markets. So the small investor has no chance, currently, to enjoy the fruits of really top-notch corporate management or governance.

Maybe they'll get a break, when some of the better private equity firms begin to add investment vehicles for the smaller investor.