Do you need Private Equity to be disciplined?

According to Michael Jensen (Harvard) private equity is a new model for general management. The reason for this is that of the three governance mechanisms, product markets, governance by non-executives and the capital market, product markets and governance by non-executives have failed to discipline executives of public firms. Executives tend to mismanage the free cash flows of the operations of their firm, tend to choose for growth or market share, not for growth of return on investment or shareholder value, and pursue self aggrandizement by status instead of value created. The professors Arnoud Boot and Cees Cools concur with Jensen in writing that the role of private equity is to discipline underperforming executives with respect to choosing the right strategy, to correct wrong acquisitions and bad execution of strategies.

Jensen has argued convincingly that the short term strategies of private equity investors has no adverse effects on labor productivity, nor on competitive position of firms led by private equity, nor on innovation (in the USA). In his 1989 HBR article Jensen wrote that especially in declining industries, with low growth and plenty of cash, executives have wasted billions of cash in wrong investments.

This is where private equity firms have stepped in, since the eighties of the twentieth century. These firms created shareholder value by making hidden reserves, unused cash and under utilized resources liquid for shareholders (and themselves). According to Jensen the stunning fact is that the methods private equity investors use to create shareholder value are available and can be adopted by basically any public firms, their supervisory boards and their executives. So the question is what is it why executives of public firms do not use the data, the analysis and the tools to create shareholder value like the private equity investors do? Is the issue satisfying behavior, as Jensen and private equity investors will have it, or have executives different objectives functions? Why is it that only through debt obligations appropriate executive behavior can be elicited? Are only corporate finance and private equity able to discipline executive behavior?

Michael Jensen provides us with a biased view on executives. He is right that private equity disciplines underperforming executives, but from that should not be concluded that all those executives who do not under perform do so for being disciplined by private equity. The issue is that the principal-agency theory underlying Jensen’s thinking on corporate governance and the role of private equity, carries a specific, negative model of the CEO. Berle & Means distinguished three types of managers (CEOs). The first type is the managerial trusteeship; that is the CEO who functions like a trustee for stockholders. The second type is managerial entrenchment; these are CEOs who are self serving and utilizing the corporate organization form to exploit other constituencies. The third type is managerial professionalism, these are CEOs that use their discretion not narrowly for their own or for stockholders interests only, but for the interests of society as a whole.

Actually, this third type of executive category answers Jensen’s remark that the real objective function of the firm is not to maximize shareholder value, but the real question is what corporate behavior gets the most out of society’s limited resources? Private equity is a useful force in the market, but it would be wrong to use them as a lender of the last resort to discipline CEO’s. To say that Private Equity is the new general management model denies that many CEO work on basis of due stewardship entrusted to them.

Besides, the question should be asked: who or what disciplines private equity? It is not without reason that the power of private equity in the USA in 1990 was curtailed in the interest of society. Having private equity discipline executives is like having your confession heard by a policeman instead of a priest. True disciplined behavior only can be the result of an internalized sense of responsibility for the community. This is the basis attitude of most executives, even if they are somewhat autocratic. It may be true that executives in a number of cases wasted free cash flow. This was not because they wanted to do so, but because in their drive to produce results, these executives were ill advised on changes in the economy, technology and society, as a result of which they rode the wrong, usually worn out track.

The discipline enforced by private equity certainly is needed in a number of cases, but we should be aware that their way to discipline executives is by pressing down the accelerator more deeply only, not by taking the fundamentally different courses which are necessary to achieve intrinsic new levels of growth in productivity. That is what society needs.