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Taking Companies Private

Taking Companies Private | Human Resource Executive Online Are private-equity firms the solution to better governance? That's been the prevailing conventional wisdom. But now, for the first time, a study comparing publicly held companies to those held by private-equity companies sheds doubt on that assumption.

Monday, April 27, 2009
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There has been a growing concern over the past few years about the basic operation of publicly held companies, those listed on the major stock exchanges and owned by the general investor community.

The complaints center on the fact that other forms of ownership seemed to perform better. Privately held companies, in particular, appear more able to plan and to take the long-term perspective.

Private-equity companies -- financial entities that own independent businesses -- seem to be especially favored, and popular accounts indicate that the smart money has been moving in their direction: Executives such as Bob Nardelli were bailing out of publicly held companies to take up positions running companies for private-equity firms, where they were paid a lot more money.

And the performance of those firms has seemed far better than anything achieved by equivalent publicly held companies. 

There are several arguments behind the idea that privately held firms are more efficient.

Conservatives argue that a big source of efficiency is that they are free from many of the regulations that burden publicly held companies, such as Sarbanes-Oxley requirements. Less regulation equals greater efficiency.

Shareholder advocates argue it is harder for executives in these companies to spend money on themselves because the owners pay more attention to the business and can discipline the executives more effectively.

Private-equity firms are seen as especially effective at turning around troubled businesses because, it is argued, they have the discipline to focus on the bottom line of financial performance. The executives running them are expected to have some of their own money at stake in ownership to create the commitment to improving company performance.

Then the big payoff will come when the companies are sold off, typically back into the public market, as leaner, more efficient, profit-maximizing machines.

These private-equity firms are known for having two distinctive operating features. The first is high levels of debt: They borrow money to buy the firms and take them private. The second is compensation for executives that is highly leveraged on performance.

The biggest of these firms, the Carlyle Group, raised $52 billion from 2003 to 2008. Cerberus Capital, which owns Chrysler, may be the most famous.

After the collapse of the financial industry this fall and the troublesome management at publicly held companies such as Bear Stearns and Lehman Brothers, the concern about the governance of publicly held companies increased again.

This time, the complaint is that the executives are able to manipulate business operations to pursue their own compensation interests, driven by short-term stock performance, and ignore basic risk-management issues.

Could privately held companies do better?

Into this debate comes the first serious study of how private-equity firms actually perform as compared to publicly held firms.

And the answer, according to Managerial Incentives and Value Creation: Evidence from Private Equity, an NBER Working Paper, by Phillip Leslie and Paul Oyer, is a surprise.

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As expected, these firms have much higher levels of debt as compared to publicly held firms -- that part isn't surprising. Neither is the second part: The compensation for their executives is much more heavily leveraged on performance than at equivalent publicly held firms. Their salaries are lower, but their bonuses and share price incentives are higher.

But here's the kicker: Performance of the private-equity firms -- as measured by profitability and operational efficiency -- is not better than that at publicly held companies. And once the individual operating companies are sold off -- going from private ownership by private-equity firms back to being publicly held companies -- they soon look much like they did before being taken over by the private-equity firms, at least in terms of ownership structure.

What do we make of this?

First, the idea that public ownership of companies is burdened by governance regulations isn't supported. If we got rid of Sarbanes-Oxley, there is no reason to think that companies would perform better.

Second, and more generally, the idea that if we could simply create bigger incentives for executives to run companies more profitably they would do so is not supported by the evidence.

Personally, I think the idea that an executive in charge of a company would simply goof off if paid a few million but would do the right thing if offered more millions is such a bizarre notion that only someone with no exposure to human nature could think it up. An accountant, perhaps, or an investment banker.

More generally, the belief that a simple change in governance structure would turn firms around seems to be misplaced. There may well be something wrong with the basic governance model based on public ownership of corporations, but the alternative doesn't seem to be any better.

Peter Cappelli is the George W. Taylor Professor of Management and director of the Center for Human Resources at the Wharton School of Business.

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