Private Equity: Another Investment to Cross off Your List.

According to Michael C. Jenson, professor emeritus at the Harvard Business School, “We are going to see bad deals 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.”

The quote above is from Gretchen Morgenson’s column on page 20 of the September 16, 2007 New York Times.  Professor Jenson is considered by many the godfather of the Private Equity industry.  He is considered such because in 1989 he wrote an article titled, “Eclipse of the Public Corporation” in which he argued that “agency” problems were preventing public corporations from performing and that other forms of control could do better.  By “agency” problem, he meant that corporations were structured so that corporate management acted in their own best interests, not in the interest of their shareholders, not in your best interests.  The solution or one solution was the private equity fund.  By structuring businesses so that management’s interests were the same as the owners, private equity produced great leaps in productivity and profit and, not incidentally, made billions for many owners and management.

The problem now, according to Mr. Jenson, is that private equity is rotten with agency problems of its own.  Mr. Jenson is horrified by the fact that private equity firms are going public and he is horrified by fee structures that pay off for the PE firms whether or not their investment portfolios make money.  Mr. Jenson is also horrified by fees that scale up with the size of the buyout and dividends that go to private equity management, not investors, not you.

Mr. Jenson is correct, of course.  And to the extent the trends that horrify him continue, private equity will become just another rotten investment.  In an important sense, however, private equity has always been a rotten investment.  Private equity is one solution to agency problems, but it is a solution based on theft.  Those billions that private equity managers acquired should have gone to the stockholders. Private equity firms do nothing that strong corporate boards cannot do.

Another solution to the same problem is activist investing.  In activist investing, investors take over boards of directors and force corporate management to do their job.  But LBOs, the primary tool of private equity firms are easy, while activist investing is hard.  In most LBOs, the private equity firm buys management off, which is obviously easier than trying to take over a corporate board while management fights you for every inch of control.  On the plus side, however, activist investors make all of the money, and they pay no blood money, excuse me, fees to corporate or private equity management, which is exactly the way it should be.