Private Equity Markets & Corporate Governance – A question of Scale

In “Private Equity, Corporate Governance and the Reinvention of the Market for Corporate Control”, Karen Wruck asserts that the reinvigorated U.S. corporate control market has had “profoundly positive effects on governance and performance of U.S. public companies.” In doing so Wruck provides us with a different perspective on the heated acquisition market of the “Go-Go” eighties. Rather than a period of greed and corporate excess, Wruck cites research suggesting that this was a market for corporate control – “an important component of the managerial labor market.”

As such, the opportunity to direct a corporation is viewed as a resource to be “sold” to the managerial team with greatest know-how, that was able to make the best use of this resource; the takeover market was the venue in which roving bands of managers bid for underutilized corporate resources on which they could work their magic, returning the enhanced value that would have been tragically lost.

This view steps neatly around several issues. For example, to whom does this marvelously recovered value returned? It is returned to the equity stakeholders, shareholders, and to the deal-makers.

We are told to set aside the issue of leverage as having a secondary role from the perspective of the organization and management of the resulting firms. The enormous amount of leverage is seen as a tool that allows the concentration of equity ownership that is “fundamental to the effective governance.” However, this kind of leverage typically places serious constraints on how the firm can be managed, and, coupled with the incentives, fees and so on that are incorporated into the costs of going private, demands high returns on capital. Perhaps the increased profitability is inherent in the firm, waiting to be exposed and enhanced by the new management, but rather is forced as a necessary part of the deal, and comes at a cost.

Wruck hints at this tradeoff when she mentions that this research – the research resulting in a more benign view of the private equity market – shifts the focus away from “… the unfortunate effects of some deals on employees and local communities …” Further on in the same paragraph we are told that “while questions of greed and fairness will always be with us, efficiency and value are now widely accepted as the most important social criterion in transactions involving corporate control.” So not only does this enhanced value accrue in dollar terms to those close to the deal, but it accrues generally to society in the form of “efficiency and value” – unless, of course you are one of those unfortunate employees or a stray local community or two.

To be fair, Wruck does identify a critical issue in corporate governance, a feature that allowed corporations to be the vehicle that successfully achieved the material abundance that our society enjoys, to be the victorious troops of the industrial revolution. This is the development of an organizational structure that efficiently spread risk, providing firms with the ability to access diffuse, cheap sources of equity capital.

The problem with this form of governance, in terms of building a sustainable economy based on an ecosystems of sustainable firms, is the very flaw that Wruck points out – with equity separated from managerial control, the values of the owners and the values of the managers diverge. You can think of it this way – as ownership gets diffuse, so does responsibility – and with responsibility, the ability of the owners to be held accountable for the consequences of the acts the corporation conducts.

Wruck proposes that the equity market provides us with a solution to this problem, by supplying a mechanism that concentrates equity ownership to the point where effective governance – closing the gap between the owner’s values and the manager’s values – can take place.

There are several problems with this solution from the perspective of sustainability, and the most apparent one is that of scale.

Let us back up for a moment, and consider another approach to merging equity ownership and managerial control – that of the employee owned firm. Here, we have completely merged the two, and solved the governance problem of the “gap” between owner and manager values. And, as the owners of these firms are close to the employees – they are the employees! – as well as are generally close to their local community, social, human and environmental values are more easily incorporated into the firm’s mission. Because they are “close to the ground”, it is difficult for the owners to escape the consequences of their actions.

The problem with this solution is that it does not work for large numbers of owners. This type of management structure is inefficient, and quickly becomes unwieldy as owners are added. This type of combined ownership/management structure is simply not possible for the size of firms that Wruck is considering.

It seems then, we are trapped. To hold to values, and to govern effectively at a human scale, we require a relatively small number of persons with equity control. But, this handful of owners cannot raise enough capital without enormous leverage, leverage who’s risk demands returns that distort values, create incentives that place profit ahead of social and environmental values.

The way out of this trap is clear. It is to reduce the scale of the enterprise. Rather than try to scale up the financing to handle these mega-deals, to be developing private equity markets that externalize the social and ethical costs of profitable ownership, we should be scaling down the size of the firms so that 100% employee ownership becomes feasible.

But don’t we need these large enterprises to continue bringing us the material abundance we are used to, allocate resources efficiently so as to preserve our quality of life? Perhaps.

Let me hold out another question – when nature wants to provide for the well being of a large community, does she build one gigantic organism? Or does she build an ecosystem that provides a framework for a unimaginable number of appropriately sized organisms to interact in an integrated fashion? This is the challenge of sustainability – to envision an economy as an ecosystem of firms that are appropriately sized – small enough to hold ethical and environmental values – plentiful, and through integration abundant enough to provide for our material well-being.

[originally posted at cosmo.marlboro.edu/wrobb – an E Portfolio]

About William Robb

William Robb, AKA OtherWill - no not the Will you are thinking of just now, that other one - is the main contributor to this blog
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