Why Private Equity Firms Have a Governance Advantage

Nicholas J Price
5 min read
With the increased scrutiny over public and private corporations and the failings of many of them, private equity firms have enjoyed a long stretch of success and respectability within the marketplace. On the whole, private equity firms have shown good returns over the last few decades and that's largely been due to their private equity governance advantage. They've seen a slight decline in recent years. In fact, their profitability is coming back in line with other companies.

Recent changes in the marketplace have also forced private equity firms to change the way they do business. Changing up their strategies has also changed their role in the marketplace and, at the same time, how others perceive them. With so many changes affecting them, private equity firms are looking for new niches to keep their craft alive and thriving.

Role of Private Equity Firms Evolving

When public and private companies began to fail in alarming numbers, private equity firms brought value back to the marketplace. Private equity firms quickly gained a reputation for being able to bring value back after it had been lost. As private equity firms stepped in, they optimized companies' operations and governance practices.

Struggling companies were low-hanging fruit for private equity firms for a long time. By threatening them with leveraged buyouts or following through on them, private equity firms helped to reform management practices. Private equity firms took advantage of opportunities to acquire fledgling companies by adding debt to their capital structures. After making some operational improvements, the private equity firm would either sell the company or take it public a few years after it could get itself back on its feet.

Opportunities for leveraged buyouts brought many new advantages. Sponsors could easily persuade companies to cut costs and replace their management teams. Companies had the benefit of being overseen by small incentivized boards that met frequently. Essentially, a leveraged buyout forced companies to become more self-disciplined. This arrangement was good for companies and private equity firms while it lasted.

Fewer Opportunities for Private Equity Firms as Times Change and Companies Fare Better

The pressure of leveraged buyouts has had a positive impact on most companies. Positive pressure is helping more companies to be successful. While that's great news for corporations, it's also created a situation for private equity firms where private equity firms have fewer underperforming companies to target and help get them back on their feet.

These events have brought a stronger sense of materialism into the marketplace, placing additional pressures on managers to perform. During the 2000s, the rise of institutional investors and hedge-fund activists also took management to task by keeping the pressure on corporations. The pressure on companies had a residual effect on most public firms as well, keeping them in line. Other incentives for companies to remain in the black were widespread acceptance of shareholder primacy and the thriving market for corporate control.

As corporations are regaining their footing, there is less of a need for private equity firms to bail them out. Private equity firms haven't been able to make as much of a mark by making small improvements in corporate governance. Many companies are now able to get ahead of the curve all on their own.

Targets for Private Equity Firms Are Evolving

Now that the low-hanging fruit is almost gone, private equity firms aren't able to grab as much of that business in flailing companies as they have in the past. Rather than growing organically, larger public companies are finding it easier to grow through acquisitions, and they're finding success in doing so. In light of this, companies are strategically grabbing their share of private firms, and private equity firms are missing out on those as well. Private equity firms are still having some luck with finding small private companies and family-owned businesses to aid. The question is who approaches them first.

In another arena, venture capital funds seem to be holding onto portfolio companies longer than in the past. In addition, they're gaining more expertise in debt financing, which is further distancing private equity funds.

What Does the Future Hold for Private Equity Companies?

While the economy faced the greatest instability in many decades, private equity firms played a strong role in helping the marketplace to re-stabilize by offering a cheap way to finance debt.

However, private equity firms have also had their failings in recent years. In today's marketplace, it's a combination of good corporate governance and good strategizing that's effective. Private equity firms have seen their fair share of failures, particularly in the retail industry. In the retail industry, private equity firms have used leverage, rather than strategy, to make changes. For example, they've failed to invest time and money in helping retail firms transition from physical stores to online stores, where the overhead is substantially less.

With their market changing, private equity firms have needed to use new tactics and go after asset classes like credit funds, real estate funds, alternative investment funds and hedge funds. These new asset classes may be more amenable to working with private equity firms because of their financial prowess and lucrative connections to financing sources. Perhaps the downside to going after these types of markets is that they're less likely to have an impact on social welfare than traditional governance optimization approaches. There is also a much greater risk of introducing conflicts of interest with these types of funds.

One of the main advantages of private equity firms is that they ensure that companies don't have divided loyalties. With the new roles that private equity companies are being forced to seek out, they may create new problems for them along the lines of attention and loyalty. Private equity is taking a few slow steps back from the acclaim of governance reforms. Private equity will continue to play a role in the foreseeable future in some manner. The exact role that it will play remains to be seen and is something to be monitored.