Michael Jensen: PE’s gonna take a hit
New York Times - September 16, 2007 http://select.nytimes.com/2007/09/16/business/16gret.html
It’s Just a Matter of Equity By GRETCHEN MORGENSON
The moribund private equity market stirred a bit last week as
Kohlberg Kravis Roberts dredged up some buyers for loans to finance
its $22 billion purchase of Alliance Boots, a British drugstore
chain. But lingering investor wariness toward private equity maestros
and their deals is far from the only problem facing the buyout
business. There are graver threats that are, no surprise, the
industry’s own making.
This is not just your humble research assistant talking. It is the
view of Michael C. Jensen, professor emeritus at the Harvard Business
School, leading scholar in finance and management, and the man whom
many consider to be the intellectual father of private equity. In
other words, a person uniquely qualified to opine on the matter.
“We are going to see bad deals that have been done that are not
publicly known as bad deals yet, we will have scandals, reputations
will decline and people are going to be left with a bad taste in
their mouths,” Mr. Jensen said in an interview last week. “The whole
sector will decline.”
Mr. Jensen was elaborating on the trenchant comments he made last
month in a forum on private equity convened by the Academy of
Management. There, he excoriated private equity titans who sell stock
in their companies to the public — a non sequitur in both language
and economics, he said — and warned that industry “innovations,” like
deal fees that encourage private equity managers to overpay for
companies, will destroy value at these firms, not create it.
He also said that private equity managers who sell overvalued company
shares to the public, whether in their own entities or in businesses
they have bought and are repeddling, are breaching their duties to
those buying the stocks.
“The owners who are selling the equity are in effect giving their
word to the market that the equity is really worth what it is being
priced at,” he said. “But the attitude on Wall Street is that there
is no responsibility to the buyers of the equity on the part of the
managers who are doing the selling. And that’s a recipe for
nonworkability and value destruction.”
Mr. Jensen’s interest in private equity goes back to 1989, when he
wrote a seminal article titled “Eclipse of the Public Corporation.”
In it he argued that new and more effective organizations were
emerging that unified the interests of managers and owners,
eliminating value-destroying practices so common at public companies.
These practices, examples of the so-called agency problem, are a
product of corporate structures that allow managers — i.e., agents —
to feather their own nests at the expense of owners — i.e., investors
— whose interests they are supposed to serve.
For years, private equity firms seemed superior to the public company
model, Mr. Jensen said. But recent developments, he said, have wiped
out many of the advantages in private equity’s original design.
Agency problems, precisely what private equity was supposed to
eliminate, are cropping up as a result of the disastrous changes made
by these firms, Mr. Jensen argues.
Raising permanent capital by issuing stock in a private equity firm
is a prime example, because it destroys powerful incentives that kept
these firms working hard for their investors, Mr. Jensen said. In
traditional form, private equity firms raise capital from investors
for a finite period of time, agreeing to pay them back, typically
after 3 to 13 years. This not only provides a reasonable time horizon
for gauging how well the firms perform, it also contains an implicit
threat that if they don’t produce for their partners then they won’t
be able to raise additional funds.
“This gives the capital markets a chance to say no,” Mr. Jensen said.
“When you liquidate a fund if you don’t have very good returns,
you’re going to have a tough time on the next fund. That’s a very,
very important constraint that has played a significant role in the
success of the private equity model.”
Mr. Jensen also deplores the newfangled fees that private equity
firms are levying on their clients. Among the worst? Deal fees that
rise in tandem with the size of the buyout, and special dividends
that go only to the private equity firm, not its investors.
“Deal fees that are going to pay them to do deals whether they are
good or not — now that’s nuts,” Mr. Jensen said. “And this notion of
taking special dividends out only for the private equity firm — you
can see the conflicts of interest that creates.”
Under the original model, private equity managers got annual
management fees, but their biggest payout was supposed to be on the
back end, based on the performance of the companies they had
operated. But waiting for a back-end payday is not enough for today’s
titans. They want their money up front.
“I can predict without a shred of doubt that these fees are going to
end up reducing the productivity of the model,” Mr. Jensen said. “And
it creates another wedge between the outsiders and insiders, which is
very, very serious. People are doing this out of some short-run focus
on increasing revenues, and not paying attention to what the
strengths of the model are.”
Who cares about the model when there’s a mountain of money to be made?
Short-term thinking like that can do genuine damage, and Mr. Jensen
fears such a result. “The sector is going to take a reputational hit
of nontrivial proportions,” he said. “Private equity is not going to
go away, but it’s going to take a hit.”
A sunny side to this dark view is that public company managers may
begin applying parts of the private equity model to their own
operations, according to Mr. Jensen.
“In principle, one ought to be able to duplicate virtually every
aspect of the private equity model in a public company, except the
actual going-private part,” he said. “It’s very difficult, but I
think public corporations may begin to think about running themselves
in this way.”
Now that’s something to hope for.