The more successful it becomes, the more private equity is coming under scrutiny. This month, Britain's Financial Services Authority warned of the growing riskiness of the industry as private equity firms set their sights on ever bigger targets and take on ever higher debt in the process. Some firms may well discover they have bitten off more than they can chew. But there are no signs that the challenge posed by private equity firms to the public equity model is about to ease.
The top 25 per cent of private equity firms outperform the relevant stock market index over time. Moreover, they do so by some distance and, unlike in other areas of finance, the same group of firms manages to do so persistently.
The source of their success is the governance model they apply to the companies they own. It is an advantage that public companies find hard to emulate. The top private equity firms have created a means to exert ownership control over management that can create sustainable above–average performance. The contrast in governance style is particularly striking when these firms are measured against traditional public companies, with their typically diffuse shareholder bases, powerful chief executives and under–resourced non–executive directors.
Top private equity firms are much more committed to effective oversight of their investments. True, they use high levels of compensation to align managers' interests with their own. They have longer time horizons than the quarterly earnings treadmill of public markets. But they tend quickly to bring in new management where needed (including the chief executive) when they acquire a company. They also commit much time to influencing the effectiveness of the board and researching their view on the direction the company should take, using their block vote to speed up decision–making. This assertion of ownership is the crucial difference between theirs and ordinary corporate governance.
Successful private equity firms exploit what might be called "governance arbitrage". They are able to find and successfully realign companies whose governing structures (owners and managers) have become sub–optimal. So big is the opportunity for this type of transaction that private equity is likely to maintain, and perhaps to grow, its presence as a parallel system to established public markets. It would only revert to marginal status if governance in public markets were to undergo a dramatic improvement.
Some might argue that governance has been greatly improved in public markets, notably since the clean–ups that followed high–profile corporate scandals. But the overwhelming effort has been directed not at governance that creates value, but at compliance – ensuring no codes are breached.
This is reinforced by the structure of incentives – non–executive directors do not usually enjoy great financial gain if their company is successful, but stand to lose if there are lapses in compliance. Lawsuits may ensue. Further, non–execs are often drawn from the ranks of professional managers, so they may empathise more with management than with owner–shareholders. They have little share–voting power and few staff resources to support their contributions to board deliberations.
Of course, the private equity system is not perfect. The management fee in large funds may now be so great that it will blunt the hunger to create returns – large funds may be generating annual revenues of Dollars 1m–Dollars 2m per professional from fees alone. As funds grow in size, they may outstrip firms' skills – a Dollars 40bn company may require different governance skills to a Dollars 400m company. Some firms, eager to avoid endless fundraising visits, are seeking "evergreen capital" from stock market issuance, but this might reduce their attention to investors' needs. Finally, although only the top 25 per cent of funds create convincing value for investors, the other 75 per cent get funded, usually on the same terms as the better performers. Their weakness could threaten the industry's sustainability.
Nevertheless, public equity markets still face a real challenge from private equity: not from its technocratic excellence or its sometimes giddy use of financial leverage. Rather, the challenge comes from private equity's ability to align owners and managers far more effectively. Those in charge of public companies will need to raise their game if they want to compete against the best that private equity has to offer.
Andreas Beroutsos is a director in the New York office of McKinsey & Company and Conor Kehoe is a director in the London office.
