Intellectual father of the private-equity industry offers a scathing assessment of its current trends
August 1, 2007
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He may be widely regarded as the intellectual father of private equity. But, when Harvard Business School's Michael C. Jensen addressed an audience of management scholars recently, he had few kind words about the current direction of the industry.
Participating in the annual meeting of the Academy of Management (Philadelphia, Aug. 3-8), Prof. Jensen was scathing about private-equity firms' going public as well as about the celebrity that some of the industry's most prominent practitioners have seemed recently to pursue.
Although private equity has increasingly been described as a bubble, Jensen chose a different metaphor during the Academy of Management symposium, which was chaired by Prof. Margarethe Wiersema of the University of California Irvine.
"There's an old Japanese saying that the nail that sticks up gets hammered down," Jensen told the gathering. "And in this case it isn't going to be just one or two people; it's going to be a big chunk of the industry."
The prodigious growth in non-equity based fees by Blackstone and others "is an utter disaster," he said, citing in particular the levying of deal fees, which he argued, do violence to the greatest strength of private equity -- a unity of purpose between owners and managers which, in Jensen's view, is commonly lacking in public corporations. Management scholars refer to this lack as the agency problem.
"Raise the fees, but don't take them out in this way," Jensen said. "These are major agency problems arising because the general partners are taking special dividends out that don't go to the outside equity holders. It's a disaster -- shortsighted -- and it's going to come back to haunt them. There will be scandals. The sector is going to take a reputational hit of nontrivial proportions. Private equity is not going to go away, but it's going to take a hit."
Equally misguided, he continued, was for private equity firms to be going public. "A publicly held private-equity firm is a non sequitur, both in language and in economics. It doesn't make sense, and it won't work. When you take the core public, as Blackstone and Fortress have done and KKR is talking about doing, you've gutted the business."
Seasoned investor and Home Depot cofounder Ken Langone, who shared the podium with Jensen and Wharton School finance professor Andrew Metrick, seemed more inclined than the Harvard professor emeritus, to shrug off the proliferation of fees. "As long as greed is around, people will find ways to squeeze juice out of the lemon," is how he put it. "I wouldn't take out these dividends in the businesses I ran, because I'd rather have it back in the business. But the investors in these funds keep coming back; it's all arm's length, it's fully revealed."
Langone saved his harshest criticism for the labor unions and pension funds that constitute a large part of the investors in private equity. "The unions are wringing their hands about job layoffs in companies that go private, and here they're pouring money into the funds that [take those firms private]. When I was on the board of General Electric, the state pension funds would raise hell about what we were paying the executives there; now the sky's the limit when it comes to paying CEOs of companies that have been taken private with money from these same state funds."
But Jensen argued that it was a strength of private companies that they rewarded CEOs handsomely for value added. He also took exception to Langone's repeated contention that the essence of the private equity was, as the veteran businessman put it, "nothing more than simple mathematics."
"Take the mystique out of it," Langone urged at several points. "If it doesn't work out on a single sheet of paper, it isn't going to work."
Noting that he had been studying private equity since the 1980s, Jensen recalled that "it was very clear to me that this was not simply a game of arithmetic. For me, private equity was a new and very powerful model of general management. It takes companies out of the capital markets, out of this highly counterproductive game in which managers are lying to the capital markets and the analysts are lying to the managers and both are manipulating each other -- in short, a game that destroys value."
"There are remarkable lessons here for learning about public companies and how to make them better," he concluded. "The model will survive, although it's going to go through a bad reputation. But even if it gets destroyed, we can still implement its lessons in public firms."
Jensen joined the faculty of Harvard Business School in 1985 after a distinguished career at the University of Rochester. His 1976 paper with William H. Meckling ("Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal of Financial Economics) is universally regarded as a landmark in agency-theory research, and his 1989 article in the Harvard Business Review , "Eclipse of the Public Corporation," is widely considered the intellectual precursor of the current private-equity movement.
A former board member of GE and the New York Stock Exchange, where he was a staunch supporter of Richard Grasso's $190 million pay package, Mr. Langone continues to serve on the board of Home Depot and Yum Brands; runs Invemed Associates, a small investment bank he founded; and serves as the chairman of the board of New York University Medical Center, one of the leading such centers in the country.
The forum on private equity was a highlight of the Academy of Management annual meeting. Founded in 1936, the Academy is the largest organization in the world devoted to management research and teaching. It has about 18,000 members in 100 countries, including some 10,000 in the United States. This year's meeting drew about 8,000 scholars and practitioners to Philadelphia from August 3rd to 8th for nearly 1,700 sessions on a host of subjects relating to corporate organization and investment, the workplace, technology development, and other management-related topics.
- Media Coverage:
- The New York Times. It's Just a Matter of Equity. (Sunday, September 16, 2007).