For those who couldn’t attend, Per Strömberg, leading expert from the Stockholm School of Economics, delivered a presentation at the Inquire Europe Autumn Seminar 2024 in Valencia. His tutorial examined the connections between private equity (PE), governance, and liquidity, offering valuable insights into their effects on companies and the wider economy.
Growth and Evolution of Private Equity
Strömberg started by setting the context, highlighting the significant growth of the private equity market since the 1980s. Initially focused on leveraged buyouts (LBOs), PE has expanded to include real estate, infrastructure, and credit funds, now forming a $15 trillion private capital market. This growth has established PE as a central pillar of global finance. He noted that private equity is cyclical, with its activity levels affected by economic cycles that influence fundraising, valuations, and deals. Understanding these patterns is crucial for anticipating the sector’s performance.
Impact of Private Equity Ownership
Referencing Michael Jensen’s work, Strömberg argued that “that private equity ownership makes firms perform better and generate more shareholder value.”.
He explained the three main strategies PE firms use:
- Governance Engineering: Active control over boards, management recruitment, and incentive structures, contrasting with public firms’ passive governance.
- Financial Engineering: Use of leverage to optimize financial structures and amplify returns, despite the increased risk of distress.
- Operational Engineering: Expertise in M&A and internal improvements to streamline operations and enhance profitability.
Although PE ownership generally boosts productivity, profitability, and efficiency it can create stakeholder concerns, especially for employees. An other issue PE’s cyclical nature, affecting fundraising, buyouts, and valuations. While “private equity fund returns have exceeded historically public index returns”, Strömberg warned that past performance doesn’t guarantee future success, especially given changes in debt markets.
The Governance-Liquidity Trade-off
The central theme of the tutorial was the trade-off between governance and liquidity. Public markets offer liquidity and lower capital costs but lack strong governance structures. In that essence, Strömberg suggests that “there is a lot of tools in the corporate governance toolbox, but I would argue that the most effective way of getting better governance is having informed owners.[…] If the owners knew what management knew, then maybe they would understand what is the right thing to do“. Therefore “the perfect corporate governance form […] is having very concentrated ownership by one or a few controlling owners. But this requires that owners give up liquidity”. Hence, investors in private equity will require a liquidity premium. In addition, the PE fund managers, to whom institutions delegate this informed active ownership, require substantial compensation in the form of management fees and carried interest for managing their funds. Together, the liquidity premium and PE fund costs increase the cost of PE capital substantially compared to public equity.
Because of this, “you are going to find firms that could benefit from private equity ownership but not enough to make up for the fees and liquidity premium you need to generate. So not all firms are going to be optimally owned by private equity firms. So you are going to look for the worst governed or the public firms that are the most misunderstood or suffering the most from having uninformed, arm’s length public equity owners. You are going to look for corporate orphans of big companies that don’t get any attention or support or resources. You are going to look for private companies in need of management and financial support.”
Market Conditions and PE Success
In order to economize on expensive PE capital, PE funds will aim to finance their investment with debt to the extent possible. Higher leverage lowers overall cost of capital and makes more firms economically viable PE targets. As a result, “private equity activity will vary with conditions in debt markets, with liquidity related to willingness of investors to provide liquidity. You are going to get this cyclicality, this co-movement of debt markets with private equity activity. The second thing you are going to see is that for the private equity transactions that are still done in ‘cold markets’, the operating improvements in those deals will on average going to be substantially higher, because it is only those that are viable targets compared to the average deal done in normal market conditions.”
View the research in full via : https://www.inquire-europe.org/event/autumn-seminar-2024-valancia-spain/