Private Equity Investors As Boosters of Corporate Performance
As company financing via private equity has increased dramatically in the past decade in Europe, it is interesting to note that these investors become much more involved in corporate governance than some family or large corporate shareholders. By keeping a tighter control on management and setting clear objectives, private equity firms increase company valuation.
Private equity has grown exponentially in the past decade, in the wake of the dot-com bubble, but there has been very little literature on the subject outside of the United States. Yet private equity is more than a source of financing for enterprises, its presence in the capital of a firm can also be viewed as a mechanism of corporate governance.
Indeed, it seems that private equity firms tend to be more involved than other shareholders in the way companies are run, defining and monitoring strategy, and working closely with management teams. This hands-on shareholder relationship supposedly reduces agency costs, which arise from the fact of having an agent (a manager) acting on behalf of a principal (a shareholder). These are mainly the cost of mechanisms destined to limit divergence of interests between agents and principals, such as internal audits, but also opportunity costs if, say, a CEO buys a jet as a company vehicle rather than redistributing the money as dividends. The issue of controlling agency problems is particularly relevant in the light of the financial scandals that rocked European companies such as Parmalat or Vivendi in the early 2000's, as Raul Barroso points out. "When Swissair went bankrupt in 2002, it was especially painful because the airline was a flagship for Switzerland," he says.
PRIVATE EQUITY FIRMS POSITIVELY IMPACT VALUE
In line with expectations, the main result of the study conducted by Raul Barroso and his colleagues at IESE and HEC Lausanne is that the presence of private equity has a significant and positive impact on firm valuation. Quite simply, this type of investor has substantial economic incentives to followits agentsmore carefully, thus monitoring and controlling the firm more closely. "The manager of a private equity firm invests a chunk of his own wealth; on top of that, he will have pressure from his partners to oversee the investment, a lot more so than themanager of a pension fund who simply receives his salary for managing other people's money," says Raul Barroso. In other terms, a private equity investor will reduce agency costs and improve performance by strongly involving himself in the governance of the company, by sitting on the board of directors, or even by appointing the managers himself, depending on how much executive power he has negotiated for himself when bringing capital. Evidently, as Raul Barroso points out, the company will benefit from the private equity investor's skills, for such a sophisticated investor will have expertise, the experience of managing a diverse portfolio of investments, and better access to funds than other types of shareholders.
FAMILIES AREN'T ALWAYS AS EFFICIENT AS PROFESSIONAL INVESTORS
Like a private equity firm, a family shareholder will have a certain amount of personal investment at stake and therefore a strong incentive to follow the company's performance, as in the case of watchmaker Swatch – whose shares have been doing well. Yet the presence of family shareholders is nowhere near as efficient as that of private equity investors when it comes to maximizing performance, on the contrary! The effect of "insider" family shareholders – who take an active part in management – is not statistically significant (which might just mean that private equity firms invest in companies with high growth potential), whereas that of "outsider" (not involved) family shareholders is actually negative. This suggests that professional managers may take advantage of the inactivity and lack of information of family owners to pursue their own goals. But these agency costs appear to be mitigated by the presence of a private equity investor alongside family shareholders, since companies with both types of stockholders have a higher valuation than merely family-owned ones.
LARGE CORPORATE INVESTORS NEED TO BE KEPT IN CHECK
Another casewhere private equity investors improves governance is when they are present in a firm's capital alongside large corporate or state investors. While there is a negative relation between corporate shareholders and firm value without private equity investors, valuation increases significantly when both types of investors hold shares. Indeed, an industrial or service company (or the state )may invest in another company for a number of strategic reasons that are not necessarily related tomaximization of shareholder value: it could be to diversify a portfolio, to enter a market, to secure a partnership. As Raul Barroso explains: "A large carmaker may invest in a steel supplier to control the value chain and stabilize its long-term supply, but may very well not get involved in day-to-day management and ultimately market valuation may suffer."
Furthermore, another risk of agency cost associated with a large corporate investor is that the corporation is in a position to extract a rent, unless they are kept in check by an active private equity investor.
Based on an interview with Raul Barroso and the article "Private Equity as a Governance Mechanism in a Context of Concentrated Ownership" (34th EAA Annual Congress, Rome, Italie, 2011), co-written with Antonio Dávila and Daniel Oyon.
IMPLICATIONS FOR MANAGERS
The study clearly points to better governance and ultimately higher market valuation when a private equity investor is involved in the governance of a publicly-listed company, as opposed to when only hands-off family or corporate shareholders are present. While the object of the study was Swiss companies, the results are likely applicable to most European firms, where ownership tends to be more concentrated than in the US, for example. The obvious implication for a potential investor seeking high returns is to look at who is already on the board of the company he wishes to invest in to get an idea of how tight a rein is kept on its managers. And while companies suffering from poor governance may consider opening to a private equity firm to improve performance, they must be aware that this type of investor may pursue aggressive investment policies, restructuring the company and refocusing on the most profitable activities, which is not necessarily in line with the values of a family enterprise.
This study focused on 116 firms (exclusive of banks and insurance companies) listed on the Swiss Stock Exchange, which is a sophisticated market with a high level of ownership concentration. By examining annual reports, about 1500 large shareholding observations were identified and their evolution traced over a six-year period, from 2002 to 2007, while tracking market and operational performance in parallel.