One of the many myths aggressively promoted about private equity is that it allegedly has a better governance structure than public markets. There fat cat executives are insulted from the wrath of shareholders, who find it easier to sell their shares than wage the difficult battle of trying to hold executives accountable for overpaying themselves and/or poor performance. The key claims made about private equity fund managers is that they have better incentives than public company officers, and that those incentives are also aligned with those of investors.
Anyone who has been reading our coverage of private equity would know this is bunk. So it is gratifying to see an academic challenge the private equity party line in a well-researched article, which we have embedded at the end of this post.
If anything, law professor William Magnuson’s The Public Cost of Private Equity winds up being charitable by virtue of needing to speak to non-experts and thus cover only the main features, as in deficiencies, of the private equity governance model. As you’ll see from the summary Magnuson wrote for the Columbia Law School’s Blue Sky Blog, he is also concerned about why investors have allowed such a lop-sided relationship to persist. His paper also does a good high level job of covering the recent literature on private equity returns, concluding that generally, they aren’t what they are cracked up to be even before allowing for the greater risk of private equity. And some of those studies also suggest that the idea that private equity improves the performance of the companies they buy isn’t well founded.
First his recap, then some additional comments:
First, the compensation structure for private equity sponsors (the private equity firm itself) creates a classic situation of moral hazard: Sponsors capture much of the gain from any profits on their investments, but are largely insulated from any losses. The result is that private equity sponsors have financial incentives to take excessive risk in their investment strategies. Second, limited partners invest in private equity funds on significantly less advantageous terms than those offered typical investors in public companies. They have limited governance rights, little access to information, and few avenues for transferring or selling their equity interests in the fund. Finally, private equity funds treat investors differently, often giving better terms to favored investors. So, for example, an individual investor may enter into a side letter with a private equity fund to ensure that the preferred investor pays lower fees than other investors. Or a private equity fund may grant one investor a greater right to access information about company performance, or even a right to veto certain investments.
In sum, the private equity governance model creates a number of corporate governance costs that are endemic to the industry and are largely unrecognized as a potential source of conflict between private equity firms and their investors. This state of affairs presents a puzzle for traditional contract theories, under which agreements willingly entered into by arm’s-length parties should be expected to maximize joint wealth. In other words, if private equity’s governance terms substantially harm investors, why would investors agree to them, rather than negotiate for better terms or simply walk away?
The article argues that the persistence of private equity’s governance costs can be explained as a result of three related phenomena. First, private equity’s structure benefits from strong inertia (what scholars sometimes refer to as path dependency) that locks in the current structure even in the face of changes in external markets. Second, private equity investors face collective action problems on multiple levels that inhibit cooperation between investors and encourage opportunistic behavior by private equity firms. Third, the reputational constraints on private equity firm behavior have been systematically overestimated as a tool for aligning the interests of firms and investors.
Magnuson reaches his negative conclusions without even having to look at some of the bad practices we’ve discussed over the past few years. As Eileen Appelbaum and Rosemary Batt have mentioned, contrary to mistaken popular perceptions, close to 2/3 of the fund manager’s compensation at larger funds comes from fees that have nothing to do with performance. Even though he flags that private equity firms only have limited exposure to loss, typically by contributing 1% of the fund’s assets, it’s often even worse than this. That supposed 1% contribution often isn’t in the form of the money out of the pockets of the general partner staffers. Instead, a big chuck of that is often in the form of “management fee waivers,” in which management fees to be paid are instead treated as a contribution to the fun. This also happens to result in capital gains treatment of what otherwise would be ordinary income, and the IRS has targeted this an an abuse.
Magnuson does not flag practices like monitoring fees, which Oxford professor Ludovic Phalippou has called “money for nothing,” as an indicator of private equity managers engaging in purely extractive behavior.
Magunuson describes at some length how little say limited partners have. Readers new to this terrain will find this to be an eye-opener:
For example, investors typically have no right to vote on the sale of portfolio companies, even if those companies form a substantial part of the fund’s assets. That decision resides solely within the discretion of the private equity firm. They typically have no right to vote on the board of directors with managerial authority for the fund. Managerial authority is vested in the private equity firm. They typically have no right to vote on the compensation of executives. That decision also rests with the private equity firm in its sole discretion. These are all rights that, in some form or other, shareholders in public corporations are guaranteed, but that very few private equity investors have.
What rights investors do have in the governance of private equity funds are typically rigorously circumscribed. One common voting right that investors do have is the right to remove the private
equity firm from its position as general partner of the fund. But that right is far from absolute. First, it typically must be “for cause,” meaning that investors can only remove the private equity firm if it misbehaves. This provision, on its face, would seem an unobjectionable way of aligning the interests of private equity firms and investors: the investors promise to keep the firm in place as long as it acts in the interests of the investors, but have the power to remove it if it doesn’t. But limited partnership agreements commonly define “cause” so narrowly that it can only be invoked in the most extreme cases, such as fraud, willful misconduct, violations of law, felony convictions or bad
faith. Some agreements go even further, requiring there to be a final court determination confirming the general partner’s misbehavior before investors can remove the firm. And, adding yet another obstacle, the voting threshold for invoking a “for cause” removal is often set at prohibitively high levels—as high as 85% to 95% of the vote.
Put together, these restrictions and limitations effectively eliminate the ability of private equity investors to voice their opinions and participate in essential business decisions of the funds that they own. Near total control is vested in the private equity firm itself.
Recall that the investors also cannot do an effective job of overseeing portfolio company investments, since they have no right to see portfolio company financials and receive only limited data. But in light of their inability to do anything if they saw information they didn’t like, the lack of disclosure is part of a consistent, if ugly, pattern.
The overview of why limited partners can’t do much to change this situation is solid. The model for private equity investing was set in the 1970s and early 1980s. Fund returns were regularly 30% to 40% due to the number of overdiversified firms trading at a conglomerate discount. Making money in leveraged buyouts then was like shooting fish in a barrel, provided you could hire an investment bank to run a hostile takeover. Simply buying the company with a ton of debt (and achievable leverage levels were also higher back then, amping up returns), breaking it up and selling off the parts was an easy winner.
And the initial investors in private equity were wealthy individuals, who were “take it or leave it” investors. The early institutions who invested in leveraged buyouts were so keen to get in that they didn’t push back on such one-sided terms.
And as CalPERS described at some length in its November 2015 private equity workshop, the barriers to limited partners getting better terms are considerable. First, anti-trust rules severely constrain the ability of limited partners to team up and negotiate as a group. But second, and even more important, the limited partners often aren’t on the same page on many issues. For instance, endowments like Harvard and Yale fancy themselves as being from the same class as the private equity kingpins and weirdly make it a point of pride not to make a fuss. Moreover, since all these endowments are chasing wealthy alumni or other prospects, being difficult about private equity could turn off potential big donors. Magnuson argues, the private equity managers already discriminate in favor of endowments due to their prestige value:
Given the differential treatment of investors, it is not surprising that limited partner investors in private equity receive widely varying returns from their investments. One study found that endowments, a group that is generally viewed as a preferred investor by private equity firms, receive 14% greater returns than the average return for all investors in private equity funds. And even within the same fund, investors can receive significantly different returns, based on management fee discounts and rebates.
Despite this dreary picture, Magunson offers some sound ideas for reform and calls for more regulation and more investor cooperation on governance issues, since outside the transaction context, the anti-trust issues would not be an impediment. As we’ve seen in California, state level legislation, particularly if parallel legislation is introduced in key states, is another avenue.
But none of this will happen until the many misrepresentations about private equity’s operations are results are exposes. So this article in and of itself is a step in the right direction.Magnuson on Private Equity's Deficient Governance