HEC Paris Associate Professor and TRIUM’s Academic Dean Oliver Gottschalg talks to World Finance Magazine (p.168) about private equity governance and political governance.
The recent rise in private equity deals has brought renewed scrutiny to governance in the PE context. I recently gave a lecture to the current TRIUM Global EMBA class on this question. The TRIUM student population is exceptionally diverse, senior and experienced. Many participants have already worked in businesses with different forms of governance or run their own companies. It is not uncommon for our graduates to go on to serve on boards of businesses or create new business ventures, so they have a particularly clear interest in understanding the implications. The pros and cons of the PE corporate governance structures was at the centre of my recent TRIUM lecture on Private Equity (PE) Strategies, where I outlined some of the differentiating features of the this form of governance, including the fact that the investors (“LPs”, often representing pension payers etc.) give a mandate to highly specialized and capable representatives (the fund managers, “GPs”) to manage their money for a limited time horizon, based on an incentive structure (the carried interest and a desire to receive a follow-on mandate) that motivates them to seek to make only the best decisions, in terms of selecting management teams and companies for investment and supervising and guiding them in the execution of their strategy.
The class generated lively discussion. After class, a classic “TRIUM conversation” ensued. One student picked up on my remarks and related them to some background reading she had done around earlier TRIUM classes on political economy at the London School of Economics and Political Science: “So PE governance really is for businesses what a representative democracy form of government is for countries. GPs are like Members of Parliament who are elected by the investors to represent them (for an election period) charged with the responsibility of acting in the investor’s interest; not as their proxy representatives nor necessarily always according to their wishes, but with enough authority to exercise swift and resolute initiative in the face of changing circumstances. In this function, the GPs select management teams (like parliaments elect governments), define strategies and set budgets for them and oversee the executions of these strategies (like parliaments pass laws and control governments).”
Her analogy made perfect sense to me: “Yes, precisely. And PE Governance is just as different from the traditional publicly listed corporation as a representative democracy is from a direct democracy. Direct democracy often does not function well as the exact implications of complex political decisions are too difficult to assess for many individual voters. Similarly, it is often not effective to let individual investors vote on complex business decisions as they may not have the time or knowledge to fully understand their implications. In the publicly listed corporation, individual investors rely on management, as the equivalent of a national government, to act in their best interest. What is missing, however, is an overseeing authority, which would be equivalent in its function to that of parliament in a representative democracy. External board members of public corporations could in theory perform these functions but are probably as limited in their power as the Members of Parliament in a direct democracy. There is much research on the fact that external board members are structurally in a less powerful position to perform this role than PE fund managers. The latter are in fact acting as “active owners” with more powerful incentives, direct influence on top management and better and timely access to critical information.”
The student pushed the analogy one step further: Then what about other privately owned firms … or family owned firms? Their owners also have full control over their business and in theory there should be no agency conflict.”
An intriguing argument, I thought, and replied: “Well, these would probably be the equivalent of a monarchy or dictatorship. Without a doubt very often a benevolent dictatorship, in which the private owners exercise their power responsibly and for the benefit of the whole company with all its stakeholders. But there is always the risk that at some point, the private owners or their successors start to abuse this power and harm the business.”
She looked puzzled and said: “Well, let’s hope that the chances of private business owners being and remaining benevolent are greater than in politics, where benevolent dictators are more the exception than the rule– after all, how many Lee Kuan Yews have we seen recently… ?”
I concluded “Very true. Ultimately, the question of which form of governance is best for a given business depends a lot on the nature of the business, its competitive context at a given point in time and the people available to govern it under alternative forms of governance – just as it is the case with political forms of governance. In some situations PE governance may not be effective for a business, just as much as sometimes there are difficulties in representative democracies. Some GPs may not be performing their role as well as one would hope … just as it can be the case for some politicians. And in some aspects, the incentives in PE may be far from perfect, which is why the PE governance structures need to constantly evolve and improve based on investor input, just as specific rules of governance in a representative democracy are not written in stone but adjusted and improved over time.“
Her final question was “But then why do so many people criticize PE?”
At this point I could only reply with a variation of Churchill’s classic quote: “Surely, it is because without a doubt PE as it stands today is the worst possible form of governance … .except all those other forms that have been tried from time to time.”
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