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How Private Equity Can Boost Company Performance - Ideas for Leaders
Idea #100

How Private Equity Can Boost Company Performance

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KEY CONCEPT

Companies with private equity investors have several advantages over those with only hands-off family or corporate shareholders. Private equity investors become more involved in company strategy and governance than some family or large corporate shareholders, and by keeping a tight control on management and setting clear objectives, these investors can help companies achieve higher market valuations. 


IDEA SUMMARY

Private equity investment, which has grown exponentially in Europe in the past decade, is more than a source of financing for enterprises, its presence in the capital of a company can also be viewed as a mechanism of corporate governance. Private equity firms tend to be more involved than other shareholders in the way companies are run, defining and monitoring strategy, and working closely with management teams. This hands-on shareholder relationship reduces ‘agency’ costs – the cost of having an agent (a manager) acting on behalf of a principal (a shareholder); reducing the cost of mechanisms destined to limit divergence of interests between agents and principals (e.g. internal audits, but also opportunity costs). The need to control agents is particularly relevant in the light of recent corporate and financial scandals.

PRIVATE EQUITY FIRMS POSITIVELY IMPACT VALUE
In line with expectations, the main result of the study conducted by Raul Barroso and his colleagues was that private equity investors have a significant and positive impact on company valuations. Private equity investors have substantial economic incentives to follow agents carefully, thus monitoring and controlling the firm more closely. A private equity investor risks a chunk of her own wealth and will have pressure from her partners to oversee the investment, far more so than the manager of a pension fund who simply receives his salary for managing other people’s money. Private equity investors improve performance by involving themselves in the governance of a company, by sitting on the board of directors, or even by appointing the managers. Furthermore their involvement as sophisticated investors, with expertise and the experience of managing a diverse portfolio of investments, and better access to funds than other types of shareholders, can also be a major benefit to companies.

FAMILIES AREN’T ALWAYS AS EFFICIENT AS PROFESSIONAL INVESTORS
Family shareholders will have a certain amount of personal investment at stake and therefore a strong incentive to follow a company’s performance. Yet this research suggests that family shareholders are much less efficient than private equity investors when it comes to maximizing performance. In fact the effect of ‘insider’ family shareholders — who take an active part in management is not statistically significant, whereas that of ‘outsider’ (not involved) family shareholders is actually negative. This suggests that professional managers may take advantage of the inactivity and lack of information of family owners to pursue their own goals. But these agency costs appear to be mitigated by the presence of a private equity investor alongside family shareholders, since companies with both types of shareholders have a higher valuation than merely family-owned ones.

LARGE CORPORATE INVESTORS NEED TO BE KEPT IN CHECK
Private equity investors also improve governance when they are present alongside large corporate or institutional investors. Company valuations increase significantly when both types of investors hold shares. Indeed, an industrial or service company (or the state) may invest in another company for a number of strategic reasons that are not necessarily related to maximizing shareholder value: it could be to diversify a portfolio, to enter a market, or to secure a partnership. Another risk of agency cost associated with large corporate investors is that the corporation may be in a position to extract a rent, unless they are kept in check by an active private equity investor. 

Methodology
Raul Barroso’s study focused on 116 firms (exclusive of banks and insurance companies) listed on the Swiss Stock Exchange, which is a sophisticated market with a high level of ownership concentration. By examining annual reports, about 1,500 large shareholding observations were identified and their evolution traced over a six-year period, from 2002 to 2007, while tracking market and operational performance in parallel.


BUSINESS APPLICATION

While this study focused on publicly listed Swiss companies, the results are likely applicable to most European firms, where ownership tends to be more concentrated than in the US. The obvious implications are:

  1. For potential investors: Look at who is on the board of the company rather than just at the management team to get an idea of how tight a rein is kept on governance. If a board has members from private equity firms that is a good sign.
  2. For companies suffering from poor governance: Consider offering shares to a private equity firm to improve performance. But be aware this type of investor may pursue aggressive investment policies, which may not be in line with the values of a family enterprise.
  3. For companies without private equity investors: To keep up with your hard-driven private equity controlled competitors, try to learn from their aggressive approach to governance and controlling agency costs.

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Idea conceived

January 1, 2012

Idea posted

Feb 2013
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