The Economic Case For Private Equity

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Nov. 27, 2007

Negotiations, Organizations and Markets Research Papers Harvard NOM Research Paper No. 07-02

The Economic Case For Private Equity (and Some Concerns) — pdf of Keynote Slides

MICHAEL C. JENSEN Jessie Isidor Straus Professor Emeritus, Harvard Business School [email protected] Senior Advisor, The Monitor Group

Fair Use: You may redistribute this document freely, but please do not post the electronic file on the web. I welcome web links to this document at: http://ssrn.com/abstract=963530 I revise my papers regularly, and providing a link to this original URL ensures that readers will receive the most recent version. Thank you, Michael C. Jensen

Comments Welcomed

Nov. 27, 2007

The Economic Case for Private Equity (and Some Concerns) — pdf of Keynote Slides

Michael C. Jensen Jesse Isidor Straus Professor of Business Administration Emeritus Senior Advisor, The Monitor Group [email protected]

Abstract Presented at the Harvard Business School Centennial Conference on Private Equity, New York City, Feb. 13, 2007 and the Swedish Institute for Financial Research Conference on The Economics of the Private Equity Market, Aug. 30, 2007; American Enterprise Institute Conference on The History, Impact, and Future of Private Equity Ownership, Governance, and Firm Performance, Washington, DC, Nov. 27, 2007. Note: SSRN is experimenting with enabling the distribution of different types of files: slides, spreadsheets, video, etc. We are interested in our users desires to distribute files that go beyond word processing text files. You can communicate with me on these issues via my email address below. We invite you to submit your own presentation slides. Private Equity funds have grown from a tiny part of the financial market in the early 1980s to an important global force today. Morgan Stanley estimated in 2007 that 2,700 Private equity funds represented 25% of global mergers and acquisition activity, 50% of leverage loan volume, 33% of the high yield bond market, and 33% of the initial public offerings market. I present in these slides my belief, first argued in my 1989 Harvard Business Review paper entitled "The Eclipse of the Public Corporation" that Private Equity is best thought of as a new and powerful model of General Management. I also summarize some important characteristics of Private Equity that contribute to value creation, how Private Equity generally implements "Strategic Value Accountability" (what I have labelled the missing concept in corporate governance) much better than the public corporation, and how Private Equity avoids much of the out-of-integrity gaming and lying that dominates the relations between public firms and capital markets. I close by summarizing some growing problematical trends and practices that threaten the success of this new business model and the future of the Private Equity industry (in particular the threat posed by the proliferation of non-equity based fees charged by Private Equity firms, and the going public of the core management private equity company such as that by Fortress and Blackstone and the raising of permanent public capital to substitute for the non-permanent limited partnership capital). © Copyright 2007. Michael C. Jensen. All rights reserved

The Economic Case for Private Equity (and Some Concerns) American Enterprise Institute

The History, Impact, and Future of Private Equity: Ownership, Governance, and Firm Performance Washington, DC, November 27, 2007

Michael C. Jensen Jesse Isidor Straus Professor of Business, Emeritus, Harvard Business School Senior Advisor, Organizational Strategy Practice, The Monitor Group

© Michael C. Jensen, 2007. All Rights Reserved

Topics Private Equity (PE) as a new and powerful model of general management. Some Important Characteristics of Private Equity that Contribute to Value Creation Strategic Value Accountability: The missing concept in corporate governance, but something that PE generally does very well Avoiding the out-of-integrity gaming and lying that dominates the relations between firms and capital markets Some Problematical Trends and Threats To This New Model

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© Michael C. Jensen, 2007. All Rights Reserved

Private Equity as a New Model of General Mgmt. I’ve argued since the 1980’s that PE was a new model of general management, applicable to many, if not most firms and organizations. PE enables the capture of value destroyed by agency problems in public firms-especially failures in governance Evidence from the growth and success of the PE sector is consistent with this. Apparently somewhere over one trillion dollars now in the PE Sector. 3

© Michael C. Jensen, 2007. All Rights Reserved

Private Equity as a New Model of General Mgmt. It has been successful in the mature segment of the market with high free cash flows (LBOs, MBOs) And in the high growth segment of the market (startups and venture capital organizations). Now being applied in seemingly limitless places and has spread throughout the globe. Will we see this as another example of the “success breeds failure phenomenon”? 4

© Michael C. Jensen, 2007. All Rights Reserved

Private Equity as a New Model of General Mgmt. Morgan Stanley estimated in the last year that 2,700 Private Equity funds represent: 25% of Global M&A activity 50% of leverage loan volume 33% of the high yield market 33% of the IPO market and the $40 billion buyouts represent new size records

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© Michael C. Jensen, 2007. All Rights Reserved

Private Equity as a New Model of General Mgmt. Puzzling thing to me is that all of the techniques that PE uses to accomplish its value creation can be adopted by most any public company Except, of course, for the Going Private part as Bennett Stewart, myself and others have pointed out for a long time. Yet it does not happen. Seems to be due to the difficulty of changing the mindset of managers and boards. Given the huge gains possible it is still a puzzle to me. I interpret this failure as evidence of the agency costs of the publicly held firm 6

© Michael C. Jensen, 2007. All Rights Reserved

Important Characteristics of Private Equity All of which contribute to high performance in an interrelated, interdependent way Compared to typical Corporate Conglomerate: Corp. Headquarters in PE firm is a Partnership Small size of PE Headquarters staff (caution: seems to be increasing over time) Limited Partnership equity of PE firm has finite life The horizon given by the temporary funding generates a natural toting up point for the board, CEO, and managers of the PE portfolio companies. Berkshire Hathaway is a successful corporate counterexample: investors beware when Buffett © Michael C. Jensen, 2007. All Rights Reserved and Munger are gone 7

Important Characteristics of Private Equity (Continued) Reputations of PE partners are very important Necessity to raise new funds makes mediocre returns a disaster--Two low-return funds & you are “out” Makes PE partners excellent board members Creates a very different board & governance system than in the typical public corporation In PE firms CEOs have a boss--unlike almost all public corporations Where directors generally see themselves as employees of the CEO--except in crises 8

© Michael C. Jensen, 2007. All Rights Reserved

Important Characteristics of Private Equity (Continued) Financial Strategy Debt and Equity of PE “divisions” are at the divisional level Higher Debt/Equity in PE divisions than in public Conglomerates Control Function of Debt plays a very important but often unrecognized role Let’s take a quick and somewhat oversimplified look at the overall structure of PE firms vs. the typical conglomerate

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© Michael C. Jensen, 2007. All Rights Reserved

TYPICAL DIVERSIFIED FIRM

Director Pay/performance sensitivity small

Stockholders

Board of Directors

Staff measured in 1,000s CEO Pay/performance sensitivity small, $3.25 per 1000

Perpetual Commitment

Debtholders

CEO, Corporate Hdqtrs. CEO Pay/performance sensitivity tiny

BUS UNIT 1

BUS UNIT 2

BUS UNIT 3

BUS UNIT 4

Low Debt to Equity Ratio

TYPICAL LBO ASSOCIATION (KKR, Forstman Little) Staff measured in 10s CEO Pay/performance sensitivity huge

Partnership Hdqtrs.

CEO Pay/performance sensitivity large, $64 per 1000

LBO 1

LBO 2

Debt

Debt Stock

Stock

Limited Partnership Buyout Funds

General Partners

LBO 3

LBO 4

Debt

Debt

Stock

High Debt to Equity Ratio

Stock

7-10 Year Commitment

Control & Incentive effects of Debt Firm Value Debt Value $mm

Going Concern Value = $100

100

90 Debt/Value=85% Insolvency Point

Bad Times Value of Firm 80

Works well as long as private restructuring is allowed and strip financing is used for mezzanine financing

70

60

50

40

Value at Risk in Bankruptcy

30

20

10

Debt/Value=20% Insolvency Point

Local tax & bankruptcy laws are important

Bad Times Value of Firm Liquidation Value=10 mm

0

Traditional Leverage Model

New Leverage Model11

Private Equity as a New New Management Model Missing the debt service obligations becomes a big deal compared to missing your budget in the typical firm (Control Function of Debt) Bankruptcy, restructuring, loss of equity Done right very few LBOs ever went into bankruptcy even though leveraged to 95% or higher--until change in tax code in about 1990 Why? Control & Incentive effects of high Debt Strip Financing 12

Important Characteristics of Private Equity (Continued) More on PE boards: Boards of Directors are small in size Generally CEO is the only manager on the board and is not the chairman Other managers are ex-officio and active PE partners are “Active Investors” in a true sense Active Investors have substantial equity (and or debt position) and are actively involved in the strategic direction of the company Active investors are generally barred from public boards by insider trading and other regulations No cross-subsidization between PE divisions 13

© Michael C. Jensen, 2007. All Rights Reserved

Important Characteristics of Private Equity (Continued) Far greater and better information at the top management and board level As a result of extensive due diligence at the time of the deal there is generally more information in the hands of board and top management about the company than ever before. Compensation CEO and other top managers have more equity interest than typical public company managers Used to be by a factor of 10 or 20. Kaplan (1989) Social customs on boards are very different and forthright. Far fewer “undiscussables” 14

© Michael C. Jensen, 2007. All Rights Reserved

Private Equity as a New Management Model Self selection of those who believe in the strategy generated by necessity to purchase equity in the deal Clear focus on value as the score for what determines “better” To Repeat: No ability to transfer moneys between businesses in the Private Equity model--ends the cross-subsidization in the conglomerate Funds must be sent back to limited partners 15

Private Equity as a New Management Model Externalization of the budget process (in negotiations with the suppliers of debt) Think of the committed debt service obligations as the performance target beyond which bonuses start to be earned

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Private Equity as a New New Management Model In slow growing businesses high leverage is appropriate Creates mgmt. focus on cash flow to pay the debt, and this is very productive Management shifts from growing the business to growing the equity--and this can be very profitable 17

Private Equity as a New New Management Model In fast growing businesses high leverage is not appropriate and venture capitalists substitute staged investments Entrepreneur does not get enough money to do the entire development Has to return for more, and this creates control opportunity and limits losses VCs often require another firm to participate in the next stage to limit them from falling in love with their deals--even if bad 18

Strategic Value Accountability: The Missing Concept in Governance Task is to bridge the gap between the markets and the managerial organization A critical function in every firm. What is it? Consider the situation where the management team is creating a strategic plan. How do they decide on the multitude of tradeoffs that must be made and how are they are to be compensated for achieving it. Managers want to be measured on results they can “control”, say number of new products or sales, or cost reductions, etc. Virtually no manager wants to be measured on how the market values the firm. But value is what it is all about. 19

© Michael C. Jensen, 2007. All Rights Reserved

Strategic Value Accountability: The Missing Concept in Governance SVA often gets assigned by default to CFO and Investor Relations Manager in Public Firms Who do not have the appropriate decision rights to properly exercise this function Has to be either the CEO and/or a group of senior managers or the Board In Private Equity it is effectively assigned to and exercised by the Private Equity Partners on the board and the CEO And this means those involved must be rewarded based on the market value of the results Historically PE has accomplished this through the carry and/or equity interests. 20

© Michael C. Jensen, 2007. All Rights Reserved

Strategic Value Accountability: The Missing Concept in Governance It takes very special talent to bridge the gap between the mindset and knowledge of the operating manager and the deep knowledge of what will be valued and how by the capital markets. Yet, this talent is seldom found in public corporations Viewed from this angle it is not hard to see why PE firms tend to be founded and populated by people who have deep knowledge and experience in the capital markets and they combine this with managerial knowhow in many ways It is extremely difficult for public corporations to hire and retain this talent at the upper levels of management. Their opportunity costs are “too high”. But they make great PE partners. 21 © Michael C. Jensen, 2007. All Rights Reserved

Strategic Value Accountability: The Missing Concept in Governance The importance of this special knowledge of value and capital markets becomes even more salient when viewed in light of the widespread ignorance of top managers about what actually creates value in their firms. The recent disastrous reign of Nardelli at Home Depot is a good example. In his mind he was a success, but value was destroyed. Not the sort of manager you want to be in possession of the SVA Decision rights, And especially if you do not evaluate & reward him on actual value created (or in this case destroyed). Very simply, this scandal would never have been allowed to happen in the typical PE firm. 22 Unfortunately this example is not rare in public firms. © Michael C. Jensen, 2007. All Rights Reserved

Avoiding the Out-Of-Integrity Gaming with the Capital Markets Clear focus on value creation as the score for success An ability to short circuit (for a while) the highly counterproductive and out-of-integrity game that goes on between managers and capital markets. By this I mean the gaming and lying that dominates the relations between managers and markets. Smoothing earnings, managing expectations, meeting the street’s forecast, and on and on. When managers decisions are driven by anything other than creating long-term value they are lying And this well documented process destroys value Being out of this out-of-integrity process provides opportunity for value creation, another source of 23 PE value © Michael C. Jensen, 2007. All Rights Reserved

Some Problematic Trends Growth in non-equity based fees to PE management company Create major conflicts of interest with limited partners & value destruction will result Hedge funds entering PE business This is a governance business, not a transaction business Example: Disastrous Revco buyout by Salomon Bros. PE firms going public The Publicly Held Private Equity firm is a nonsequitur both in language and in economics: Berkshire Hathaway is a counter example Permanent Capital in the form of publicly held stock replacing some of all of the funding provided by the finite horizon Ltd. Partnership Funds (KKR) will create more agency costs--think of closed end fund discounts. 24

© Michael C. Jensen, 2007. All Rights Reserved

A Word About the Incentives of Private Equity Firms Private equity firms have their reputations on the line. They have to pay out the proceeds to the limited partners by the end of the contract period If they want to raise another fund they must show good performance in earlier funds This means they are unlikely to simply walk away from a bad deal They have big incentives to do good deals and make them work 25

The Dangers of Giving PE Permanent Public Capital What if the typical large public firm board and top management changed their mindset from managing businesses to managing governance systems that manage businesses? They still don’t have the requirement to divest the businesses, realize a valuation, pay off those who gave them capital, and ask for more back again. One reason I think it is a mistake to give the Private Equity Firm permanent publicly held capital (as KKR did in Europe)

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The Dangers of Taking the PE Mgmt. Company Public When Fortress and Blackstone and others take the core management company public they have put at risk another of the major competitive advantage the PE firm has In Blackstone’s case the new public holders of the limited partnership have virtually no say in the governance of the enterprise.

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Having Given Up Many PE Controls, Here is what Blackstone Provides: “The Blackstone Group L.P. is managed by our general partner, which is owned by our senior managing directors. Our common unitholders will have only limited voting rights and will have no right to elect our general partner or its directors. Immediately following this offering, our existing owners will generally have sufficient voting power to determine the outcome of those few matters that may be submitted for a vote of our limited partners, including any attempt to remove our general partner. The partnership agreement of The Blackstone Group L.P. limits the liability of, and reduces or eliminates the duties (including fiduciary duties) owed by, our general partner to our common unitholders and restricts the remedies available to common unitholders for actions that might otherwise constitute breaches of our general partner's duties.” Blackstone Prospectus, 2007 28

Daniel Gross on Schwarzman: And now Schwarzman may pay for his antics. He's like an NBA player who, having gone the length of a court for a slam-dunk with the game already put away, starts trash-talking, jumps atop the scorers' table, gestures obscenely at opposing fans, pinches a cheerleader, chest-bumps the referee, sticks his tongue out at the camera, all while grabbing his crotch and yelling loudly that he's the man. That would certainly get the attention of the ordinarily forgiving disciplinarians in the league office. Slate, “The Golden Ass: How Blackstone CEO Steve Schwarzman’s Antics May Cost Him and His Co"eagues Bi"ions of Do"ars”, June 19, 2007

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Some Problematic Trends As Private Equity grows in influence, size and visibility, the limited public understanding of what PE firms do will create problems and further destroy value. PE firms will have to manage this well. This is particularly a problem given the “overvaluation” that has existed and is being resolved at this time. And since with the exception of the recent public issues (Fortress & Blackstone) prices for PE management companies do not exist, most of the adjustment comes out in increased cash inflows to the industry and all that implies for higher deal prices, lower returns, etc. I’ve argued elsewhere that the Agency Costs of Overvaluation, once put in motion, are almost certain to destroy part, or even in some cases, all the real value of such companies. Beware. 30

© Michael C. Jensen, 2007. All Rights Reserved

Some Problematic Trends Public surveys documenting the earnings of PE partners do not bode well for the industry. Why would any PE manager, knowing the sensitivity of the public and political process to high earnings allow their personal earnings be made public (especially if they were over $1 billion last year)? Is it a surprise that the tax rules on PE may be changed? Why would Stephen Schwarzman allow his picture to be on the front cover of Fortune Magazine? Does not bode well for public relations, and neither does their public offering. Blackstone has created a negative externality for the entire PE industry. I said in early Feb. 2007 that PE is going to have its reputation tarnished. It will be damaged but will survive 31

© Michael C. Jensen, 2007. All Rights Reserved

END

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© Michael C. Jensen, 2007. All Rights Reserved