Ebook Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance
Does private equity create value when it acquires a company in a leveraged buyout (LBO)? If so, how? This question has fascinated scholars ever since the first big wave of buyouts occurred in the mid-1980s, but has yet to be resolved. A second, even larger wave of LBO transactions from 2003 to 2007, brought to a shuddering halt by the recent subprime mortgage crisis, has raised the question again as the current market for private-equity deals has collapsed. While many of the old arguments about underlying rationales for private-equity deals have survived this dramatic downturn, we offer an important new motivation for future deals: private-equity investors are better risk monitors with better incentives than public shareholders at firms with significant derivative trading activity and derivative contract positions.
As the subprime mortgage and 2008 banking crises have vividly illustrated, the growing use of, and trading in, derivative instruments by corporations has eroded the effectiveness of several critical corporate governance mechanisms—the board of directors, the financial accounting system, and oversight by regulatory authorities—because firms lack effective means of monitoring derivative risk exposure on a real-time basis. This change has increased the importance of attracting financially sophisticated, highly motivated corporate directors who can deliver intensive monitoring of corporate risk management strategies, who are capable of independently and effectively controlling firm management to regulate derivative exposure, and who set senior management financial incentives to ensure that these executives’ incentives and personal risk exposures are aligned with those of firm owners.
We argue that concentrated private-equity ownership is and will continue to be a very effective way of attaining the above objectives. Private-equity involvement strengthens board monitoring of derivative exposures by reducing board size, improving information flows to the board, increasing board control over managers, sharpening director financial incentives to monitor derivative exposure carefully, and attracting highly qualified, more financially sophisticated directors who are better able to understand the associated risks. It also creates incentives for managers to carefully evaluate risk-return tradeoffs. These strengths could be particularly important for financial firms that have experienced tremendous write-downs of their loan portfolios in recent months. In this regard, the Federal Reserve has relaxed its stringent regulations on private-equity investment in banks and bank holding companies to facilitate the flow of capital into banks. The Comptroller of the Currency has also permitted a private-equity fund manager to purchase a bank personally, rather than through the use of his fund, and thereby avoid having his fund classified as a bank holding company. These regulatory actions should facilitate greater investment in the sector by private-equity firms.
Large increases in debt also create strong managerial incentives to improve firm efficiency because they: (1) make stock prices much more sensitive to improvements in firm value; and (2) motivate managers to use firm cash conservatively and to eliminate underutilized assets so as to minimize the risk of bankruptcy, financial distress, and the accompanying forced management turnover. Moreover, debtholders and institutional investors can further improve firm risk monitoring since they are large investors who frequently hold both debt and equity positions in private equity-controlled firms. This gives them good access to and strong incentives to monitor proprietary firm information flows to accomplish this goal. Thus, the shift toward greater private-equity ownership in the economy can be viewed as a value-creating response to increased derivative activity and contract exposure levels, especially in less competitive industries where product market competition is a weaker alternative mechanism for motivating managers to improve firm efficiency and profitability.
This Article is structured as follows. In Part I, we explain the institutional details of private-equity investing in, and monitoring of, portfolio companies. Part II discusses prior theories explaining why private equity investing creates value. We then turn in Part III to the implications of the increased usage of derivative securities for corporate governance at public companies, arguing that it has created important new challenges at these corporations, especially for financial institutions. Part IV analyzes how private equity benefits investors through improved monitoring of their portfolio companies’ derivative risk management practices. We conclude with a brief summary and a discussion of future areas for private-equity investment.
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