My article, Private Equity Firms as Gatekeepers, identifies an important and overlooked way in which private equity creates value: private equity firms act as gatekeepers in the debt markets. As repeat players, private equity firms establish reputations with lenders that are tied to the credit performance of the companies that they acquire and manage. In turn, private equity firms use their reputations both to certify the creditworthiness of their companies ex ante and to bond against misconduct or poor performance by their companies ex post. Private equity firms thereby mitigate the problems of borrower adverse selection and moral hazard that plague the debt markets. These certification and bonding functions of private equity are best understood as gatekeeping: by causing companies to behave better toward creditors than they otherwise would, private equity firms afford companies access to more capital, and on better terms, than they could otherwise get. The article provides both conceptual and formal proofs of this gatekeeping hypothesis.

The most obvious benefit from private equity’s gatekeeping role is that, all else being equal, it should allow private equity-owned companies to borrow money on better terms than other companies. And crucially, this role will become increasingly valuable in light of sweeping changes in the corporate loan markets. Lenders’ traditional methods of controlling borrower adverse selection and moral hazard – screening, monitoring, and covenants – are in sharp decline. This decline is due to the major shift from relationship banking, in which a company borrows from a single bank that holds the loan until maturity, to syndicated lending. Syndicated loans are funded by large numbers of unrelated creditors and may be traded or securitized to reach still more creditors. As the chain from the borrowing companies to their ultimate creditors lengthens, the information gap between them increases significantly, while creditors’ incentives to monitor their borrowers decline. If private equity firms can credibly fill the void in monitoring left by lenders, their companies will get significantly better financing than other companies.

…continue reading: Private Equity Firms as Gatekeepers

Overview

Schulte Roth & Zabel regularly conducts studies on private equity buyer acquisitions of U.S. public companies with enterprise values in the $100 million to $500 million range (“middle market” deals) and greater than $500 million (“large market” deals) to monitor market practice and deal trends reflected by these transactions. During the period from January 2010 to Dec. 31, 2012, there were a total of 40 middle market deals and 50 large market deals that met these parameters.

…continue reading: Large and Middle Market PE/Public Target Deals: 2012 Review

In our paper, CEO Contract Design: How Do Strong Principals Do It?, forthcoming in the Journal of Financial Economics, we contribute a new perspective on executive compensation research by studying changes to CEO employment contracts implemented by some of the most sophisticated and financially savvy principals in U.S. capital markets: private equity sponsors. If the changes in a firm’s governance structure following a leveraged buyout (LBO) allow for arm’s-length bargaining between private equity (PE) sponsors, as ‘‘strong principals,’’ and the CEOs of the portfolio companies as their agents, we may observe changes to contract features of importance to the private equity sponsors.

Our objective in this paper is to answer three questions. First, do the strong principals redesign CEO contracts? If they do, which contract features do they change? We examine a comprehensive set of features of CEO contracts in addition to cash pay, such as perquisites, equity incentives, vesting conditions, and severance pay. Second, how do the CEO contracts designed by PE sponsors square with contracting theories? Finally, do the CEO contracts we study avoid some of the most criticized compensation practices in U.S. public firms? Regulators and shareholder interest groups should be interested in whether their proposals differ markedly from contracts where a shareholder with significant ownership and financial expertise bargains with a CEO.

…continue reading: CEO Contract Design: How Do Strong Principals Do It?

I have had the great pleasure over the last year or so to work with Dana [Fleischman, Chair of the Trading and Markets Subcommittee] and other members of the Trading and Markets Subcommittee and other ABA groups on a number of initiatives surrounding one broad and oftentimes tricky question: when is a person required to register with the SEC as a broker-dealer? Not exactly a prime subject for a TED Talk, but this group knows how vitally important it is to settle some of the questions that have been open for a decade or more about who needs to register with the SEC as a broker-dealer.

I and my staff have already begun talking with you about such perennial hits as placement agents, so-called “finders,” and business or M&A brokers. Most recently, we have had lengthy discussions with various members of this subcommittee about Rule 15a-6, the rule exempting from registration certain non-U.S. resident persons engaged in business as a broker or dealer entirely outside the U.S. These discussions led the staff to publish responses to frequently asked questions about the rule to address some of the issues that you have told us have been a source of confusion. [1] We view the FAQs as an initial set of staff guidance about issues that commonly arise under Rule 15a-6. They do not break new ground, but I believe they are important to ensuring that regulators and market participants are operating under a common understanding of how the rule works. We are very much open to exploring opportunities for additional guidance through subsequent FAQs.

…continue reading: A Few Observations in the Private Fund Space

A recent book by Josh Lerner and a recent article in the Journal of Public Economics has asserted that government venture capital programs in Europe have displaced or crowded out private venture capital. The result of work such as this has been to place pressure on government bodies around the world to remove or replace their existing governmental programs. In the aftermath of the financial crisis, venture capital markets around the world themselves have been in crisis. So, it is particularly timely to address the issue of whether or not government venture capital programs in regions such as Europe really have in fact crowded out private venture capital programs.

As pointed out in this Economist article and in my recent commentary and my review article, the idea that government programs crowding out private venture capital in Josh Lerner’s book and in the Journal of Public Economics is based on empirical measures that are completely flawed. The empirical tests supporting crowding out are based on methodologies that rank the Austrian and Hungarian venture capital markets as being the best in the Europe, and the U.K. venture capital market as being the worst in Europe (I am not kidding).

…continue reading: Measuring the Effectiveness of Public Policy Towards Venture Capital

The Delaware bar has recently proposed an amendment to the Delaware General Corporation Law that is likely to facilitate the use of tender offer structures, especially in private equity deals. The new proposed Section 251(h), which is expected to be approved by the legislature and governor with an effective date of August 1, would permit inclusion of a provision in a merger agreement eliminating the need for a stockholder meeting to approve a second-step merger following a tender offer, so long as the buyer acquires sufficient shares in the tender offer to approve the merger (i.e., 50% of the outstanding shares, unless the company’s charter provides a higher threshold).

…continue reading: Proposed Amendments to Delaware Law Would Facilitate Tender Offer Structures

There are arguably two broad objectives to the governance of any entity including private equity (PE) funds: i) effective and accountable decision-making and ii) aligning interests of different stakeholders. This article focuses on the second of these objectives describing in more detail the difficulties in aligning interests between a general partner (GP) and a limited partner (LP) in a PE fund.

The governance of PE funds is increasingly coming into the spotlight. The Institutional Limited Partners Association (ILPA) revised its Private Equity Principles in 2011 to establish a set of best practices to govern the relationship between GPs and LPs. Also, the UNEP Finance Initiative for Responsible Investment (UNPRI) issued a second version of its guide for LPs in 2011. There are contributions from the European Private Equity and Venture Capital Association (EVCA), the Australian Private Equity & Venture Capital Association Limited (AVCAL), as well as most recently from the International Corporate Governance Network (ICGN)—all on the same topic.

…continue reading: Alignment of General and Limited Partner Interests in PE Funds

Since the modification of the “Prudent Man” rule in 1978 that allowed institutional investors to allocate part of their portfolios to alternative assets, the private equity industry has changed substantially. In 1980, the largest fund raised was the Golder-Thoma $60 million dollar fund that invested in many different kinds of deals, including both venture capital and buyouts. At the time, institutional investors were somewhat skeptical of the industry, GPs, LPs and portfolio firms were experimenting with different contractual structures, and indeed “private equity” itself was not an accepted term. By the time of the 2008 Financial Crisis, individual funds of over $20 billion were being raised, funds became specialized in particular types of investments so that “renewable energy” or “infrastructure” funds were commonplace, contracts have become standardized, and private equity has become an accepted part of the financial world in which most major business schools teach courses, and is even a topic for debate in presidential campaigns.

It is natural that such maturing of an industry can lead to changes in the fundamental relationships between participants. In the private equity industry, the major participants are the limited partners (LPs), the general partners (GPs), and the portfolio companies. In the paper, Limited Partner Performance and the Maturing of the Private Equity Industry, which was recently made publicly available on SSRN, my co-authors (Berk Sensoy and Yingdi Wang) and I explore the relationship between limited partners and general partners by focusing on access to funds, and the way in which it has changed over recent years. An overarching hypothesis is that the fundamental changes brought on by the maturing of the private equity industry have changed the nature of relationship between limited partners and general partners in private equity.

…continue reading: Limited Partner Performance and Maturing of the Private Equity Industry

In the paper, Does Target CEO Retention in Acquisitions Involving Private Equity Acquirers Harm Target Shareholders?, which was recently made publicly available on SSRN, we examine whether target shareholders are affected adversely when the target CEO is retained by the acquirer and if the effect differs when the acquisition involves a private equity firm. We find that private equity acquirers are more likely to retain target CEOs, and, given an acquisition is made by a private equity firm, target shareholders receive a higher premium when the CEO is retained. The difference in premium is economically large as it corresponds to 10% to 23% of pre-acquisition firm value.

The reason for this higher premium is that the CEOs retained by private equity acquirers appear to be CEOs who have performed better and hence can add more value to the firm that results from the acquisition. Further, a CEO who is retained cannot compete with her former firm and we show that the premium paid if a CEO is not retained falls with the ease with which that CEO can compete with her former firm. The fact that better CEOs are more likely to be retained and that targets receive higher premiums when the CEO is retained is inconsistent with the view that the target CEO conflict of interest leads to inefficient retention of CEOs in exchange of lower premiums.

…continue reading: Target CEO Retention in Acquisitions Involving Private Equity Acquirers

We wish we could tell you something fascinating about what happened to the private equity industry in 2012. But it was just not that kind of year. Private equity deal volume was flat compared with 2011. New funds continued to be raised at a modest pace. There were no particularly interesting new developments in the deal market.

However, private equity, despite the challenges facing the industry and the harsh spotlight put on it by the presidential campaign, continued to thrive. This post looks back on some of the trends that we saw in the industry in 2012 and some predictions as to what awaits it in 2013 and beyond.

Trends in 2012

Some of the trends that we saw in the private equity industry in 2012 included:

…continue reading: Private Equity Trends in 2012