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Does Private Equity Create Wealth?

By Harvard Law School Program on Corporate Governance

Does private equity create value when it acquires a company in a leveraged buyout? If so, how? This question has fascinated scholars ever since the first big wave of buyouts occurred in the mid-1980’s, but has yet to be resolved. A second, even bigger wave of LBO transactions in 2003-2007, brought to a shuddering halt by the recent sub-prime mortgage crisis, has raised the question again even more forcefully as the current market for private equity deals has collapsed. In our recent article “Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance,” Ronald W. Masulis and I offer an important new motivation for private equity deals in the future: private equity firms and managers can do a better job of monitoring of derivative transactions and derivative contract positions than their public company counterparts.

As the subprime crisis has illustrated vividly, 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 as part of regulating derivative exposure and who will make the appropriate choices in creating managers’ financial incentives to insure that these executives’ personal risk exposures are aligned with the interests of the firm.

In this paper, we argue that private equity concentrated ownership is now, and will continue to be in the future, a very effective way of attaining all of these objectives. Private equity involvement strengthens boards monitoring of derivative exposures by reducing board size, increasing boards’ control over managers, improving information flows to the board, sharpening director financial incentives to monitor derivative exposure carefully, and attracting better qualified, more financially sophisticated directors, who better understand the associated risks. Further, debt holders and institutional investors can further improve firm monitoring since they are also large investors (who frequently hold both debt and equity positions in private equity controlled firms), which gives them strong incentives to monitor and good access to proprietary firm information flows to accomplish this goal.

The paper is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on November 25, 2008 (boomark / email).