Has Private Equity Lost Its Original Purpose?

A Duke University professor cautions against the business school “tale” of the private equity “knight in shining armor.”

Illustration by II

Illustration by II

Private equity is moving away from the “corporate governance revolution” that was central to its rise in the 1980s, according to Duke University research.

Business school students in the U.S. have all heard a version of the same “tale” that private equity ownership is superior to the governance model of public companies, Duke University law professor Elisabeth de Fontenay wrote in a paper posted this month on SSRN’s website. As the “tale” goes, she said, public companies with “entrenched, lazy, and cash-hoarding management went unchecked” in the “bad old days” before the 1980s.

“But lo, private equity emerged as a knight in shining armor, reuniting ownership and control in corporate America and turning bloated, inefficient companies into slimmed-down cash machines,” de Fontenay said in the paper, which SSRN indicates was written in April.

But public companies have changed since the rise of leveraged buyouts decades ago, as they’re now dogged by activist hedge funds and other “empowered” shareholders looking for “any sign of slack,” according to the paper. The private equity industry has also evolved as it continues to expand, de Fontenay wrote, and its main contribution to U.S. companies may now be “cheap debt financing, rather than governance, strategy, and operations.”

“Private equity is shifting its center of gravity away from governance reform, towards a dizzying array of new tactics and new asset classes,” she said in her paper. “Large private equity firms now simultaneously run leveraged buyout funds, credit funds, real estate funds, alternative investments funds, and even hedge funds.”

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Some of the “new money-making strategies” at private equity firms aren’t as likely to build value the way strengthening governance and operations can, according to the paper. The author argued that the strategies introduce conflicts of interest and complexities, pointing to the possibility of a private equity firm holding equity and debt positions in the same company.

“Private equity’s governance advantage has always been to ensure that companies are the servant of only one master,” de Fontenay wrote. “Yet today the master itself may have divided loyalties and attention.”

Meanwhile, the traditional LBO model is being “squeezed,” as there’s less room to make gains from cutting costs, replacing management, and ensuring a watchful board at the “newly reformed crop of public companies,” according to the paper.

“Activist hedge funds and other institutional investors have already done the heavy lifting,” de Fontenay wrote. She also suggested that it’s becoming harder for private equity firms to buy and improve unlisted companies because of increased competition in a buyout industry “awash” in cash.

“Valuations are soaring, making it less likely that private equity will find attractive targets and that its returns will remain high for much longer,” she said.

The “decline of the traditional private equity approach” is most obvious in the retail industry, the Duke law professor said, citing the leveraged buyout of Toys “R” Us that culminated in bankruptcy in 2017. “In lieu of making the major investments needed to transition brick-and-mortar retailers into the e-commerce age, private equity funds combatted their lower prospects of generating returns by doubling down on the use of leverage,” she said in the paper.

For their own part, private equity firms appear to be adjusting to their newly competitive environment by “switching to tactics to drive returns” and expanding into new asset classes, rather than increasing their efforts at governance, according to de Fontenay.

The industry’s expansion has soared through fundraising, taking it well beyond its “halcyon days as a small, select club of sponsors” that could easily make money from traditional LBOs, her paper said. Private equity firms today also often have a “considerably larger” workforce that includes non-investment professionals in areas such as compliance, human resources, and government relations, de Fontenay wrote.

With all but the smallest private equity firms now required to register with the Securities and Exchange Commission as investment advisers, major firms now look less like the “small, scrappy teams of yore” than like the big mutual fund managers and investment banks, according to the paper.

“Private equity is not going anywhere — it will remain influential and a powerful draw for capital for the foreseeable future,” de Fontenay wrote. “Yet its influence will be felt in areas other than corporate governance.”