American Enterprise Institute
November 27, 2007
[Edited transcript from audio tapes]
Proceedings:
Key Note Address: Michael C. Jensen
Michael C. Jensen: There are some slides but I will assume 70 percent of you cannot see them because that is probably accurate. Can you at least hear me when I’m standing comfortably? Can you hear me back there? Alright, if I start to mumble and you cannot hear me, just wave your hand. I promise not to call on you; I will just speak louder. Alright so I’m going to do this -- no, let’s do it this way.
So what I wanted to talk to you about tonight is my view of -– first of all, let me say, it is like déjà vu all over again as somebody said today. And my work on private equity was all about leveraged buyouts and what I call LBO associations back in the ‘80s when Steve Kaplan was my Ph.D. student and I learned everything I know about LBOs from him. And my colleagues Karen Wruck and George Baker and others who we had the privilege to work with and do work with private equity firms at that time were amazingly open, allowed us to film board of directors’ meetings; they really opened the [indiscernible]. At the same time, Bill Salomon was working -- doing his initial work on venture capital. And one of the things that eventually we got to talking to each other and seeing that these things were almost identical models; one being very intensively debt-oriented and the other, not. But the basic model was remarkably similar.
So, we saw the same dramatic success in the low growth sector of the market at that time in the leveraged buyouts and management buyouts, and in the high gross sector with the foundation of new firms in the venture capital market. So it was also very exciting times.
So what I want to do is review some of the work I did and that materialized in a congressional testimony in 1989 in a time that looked very much like it does today. And the story has not changed all that much and to the extent it has changed, it is probably changing for the not-so-good. And that is my concerns and cautions.
So I’m going to talk to you about private equity as a new and powerful model of general management. I do have to say that I failed absolutely in convincing my general management colleagues at the Harvard Business School that this had anything to do with general management. I retired in 2000; I do not get back there very much now but I’m guessing from my colleagues that are here now that there is much more attention being paid to it.
I’m going to summarize some important characteristics of private equity that contribute to its value creation and its new model of general management or governance; it is both of those. I’m going to talk to you a little bit about strategic value accountability in what I call SVA decision rights, which is the missing concept in corporate governance but something that PE generally does very, very well. I will talk to you a little bit about avoiding the out-of-integrity gaming and lying that dominates the relations between the firms and capital markets, and why that plays -- how that plays a role in the success of the private equity model. And then I’m going to end with some problematical trends and threats to this new model.
So, as I have said, since the 1980s I’m going to assume nobody can see that. So those of you who can look at it, this new model of general management basically applies to almost all organizations. There may be some exceptions in the long run; unless it is prohibited by law or regulation, I would not be shocked to find that the majority of now-publicly held companies go private because there are very, very large advantages to being in this model as long as the model does not get corrupted, and there is corruption going on and we will talk about that as we go along.
In my view, private equity enables the capture of the value destroyed by the agency problems in public firms due to the fact that the governance systems do not work very well. And the evidence from the growth of the private equity model -- when I wrote that paper that appeared in 1989, there was an outpouring of letters to the Harvard Business Review that were outraged. I did not choose the title, but it was called “The Eclipse of the Public Corporation,” which I did not like. But in some ways that is happening and there will be ups and downs, and unless it is prohibited by law, it will continue.
So, somewhere on the order of a trillion - some people say $2 trillion - is devoted to this activity now; I’m not going to argue about the amount of it. It has clearly been successful not only in the mature segment of the market but also in the venture capital segment. It is now applied in seemingly limitless places throughout the globe. And my concern is that this is going to be another example of the success-breeds-failure phenomenon, just something I have observed for the last 40 years.
That is, if you look at organizations, it was actually –- I’ll skip that -- if you look at organizations or at individuals, the moment they reach success - I mean, really big-time success - it seems to generate a set of forces that create failure almost inevitably. In organizations and individuals, if you care to look at it -- look at sports stars, look at rock stars, look at great companies. From the time they became great, they start to fail. And there is something very, very important that we do not understand about that, so we may be seeing that phenomenon going on here in this market.
So we have seen these Morgan Stanley estimates that there are 2,700 private equity firms representing 25 percent of global MNE activity, 50 percent of leveraged loan volume - this was a year ago - 33 percent of the high yield market, 33 percent of the IPO market, and the $40-billion buyouts represent new record levels.
Now, one of the things that puzzles me most is that almost all of these techniques that private equity uses to create value can be adopted by almost any public company without going private. And I have been unsuccessful as a consultant in making that happen in a public company. There are some that have; Karen Wruck wrote a wonderful article about Sealed Air, which is an example that did it without going private. But it is way too infrequent.
And I do not fully understand why that happens other than because it would avoid a whole set of cost - transactions costs and what not - other than the fact that CEOs basically do not want to put themselves in the situation of having a boss. So that is a big puzzle and it is another piece of evidence consistent with the notion that the agency problems, the agency costs associated with a publicly held firm are very large.
So what are the important characteristics of private equity that contribute to performance? And [indiscernible] interrelated and independent way. I’m going to compare them or ask you to think about a comparison with a typical conglomerate because that is where the old-style conglomerates -- because that is what they best compare to.
The corporate headquarters in a conglomerate in a PE firm is a partnership headquarters, not a corporate headquarters. The small size of the private equity headquarters staff is dramatically different. I remember looking at Goodyear Tire headquarters’ staff was 5,000 people. I was just talking to a major private equity firm whose name I will not reveal; they said that their current staff is measured in about a thousand and very different with 240 divisions, and most of them non-trivial.
But that seems to be increasing over time and the question is, will private equity be able to avoid falling into the trap of the typical conglomerate? I think it will. A very important factor of the private firm’s success is the fact that the equity of the private equity firms has a finite life. As we heard today, it has to be paid back in 10 to 13 years. That is now being eroded, and I think it is a huge mistake. But let’s be careful, it does involve costs.
So it is that -- the horizon of that 10 to 13 years in which you have got to give the money back -- provides a natural totting-up [sounds like] point for everybody that is involved in the game. For the board, for the CEOs, for the managers of the private equity portfolio companies, it is very, very important. And I will mention it again later, but if you think it is not important just look at the history of closed-end investment companies; they all sell at a discount; very, very infrequently sell at a premium. And that is -- there are very good reasons for that.
We will talk more about the role of that horizon that comes from the limited length grant of the equity funding. Now there are some counterexamples. Berkshire Hathaway is a successful corporate counter-example that is run like a private equity firm. It has permanent equity. My cautions are for the market and investors to beware when Warren Buffett and Charlie Munger are gone because I did -- predicting that it will not be replicated.
Now, the other counterexample is Goldman Sachs, which for years I have said when they went public that it would be the end of Goldman Sachs; I was wrong. And I still do not understand that fully but I attribute a very important part of it to the culture of that firm, in the way it has evolved over a very, very long period of time. Will it continue? We do not know. It seems to be and it seems to be successful. And I’m sure there are other counter examples but they are scarce as hen’s teeth in the corporate world out there. So let’s be careful about that. And you will see how that is going to relate when we get to the end when I start to express my concerns about this with private equity firms that are now going public, both with their limited partnership funds and with the core partnership company itself. That is not a very good sign.
The reputations of the private equity partners are very important, and that importance gets driven by the necessity to raise the new funds that comes from this limited horizon grant of equity. The word used to be that too low return funds and you are done -- I’m not studying this in detail now, but I’m betting that it is one lure of low return fund and you are done at the current time.
What this does is make private equity partners excellent board members. It creates a very different board and governance system than what exists in the typical public corporation. And my simplest way of summarizing this is in private equity firms, the CEOs have a boss, unlike virtually all public corporations that exist in this country. The fact of the matter is that boards of directors in this country, even the -– and the members of those boards and, especially, the outside independent directors basically see themselves as the employees of the CEO; that is the fact of the matter.
Now, when does that change? It changes when the shit hits the fan enough so that their personal reputations are threatened. Then they become the boss of the CEO and decisions get made. But by that time, way too much value has been destroyed and way too much inefficiency has crept into the system. And as I think I have said earlier, that is the reason why I think it is so difficult to get the private equity model implemented voluntarily in public corporations because very few CEOs want a boss and that is what they get in this model.
And, well, some more characteristics. What is characterized today is financial engineering, the debt and equity -- private equity divisions are at the divisional level not at the corporate level; that is very important. The higher debt and equity in the private equity divisions than in the public conglomerates makes a big difference. We will talk a little bit -- I’ll show you a graph but you will not be able to see it so I will describe it.
The high debt plays a very important control function and it does lead to difficulties when you default on that stuff. But depending on the rules of the games surrounding that, the costs of that are way less than the cost of having unlevered firms. I’ll just talk more about that in a minute.
So let’s look at the typical conglomerate. You will not be able to see this picture but let me describe it for you for the -- the typical conglomerate as compared to the private equity firm. You have got at the level of the conglomerate as a whole -- at the Westinghouse, which no longer exists, you have got public equity in the form of stockholders that cannot get their money back; there is no way to get it out. The debt is generally at the corporate level, headed by a board of directors and a CEO in the corporate headquarters. And then you have got divisions.
Now if you look at the typical public equity firm of 30, 40, or 100 divisions, there is equity at the level of each division and there is debt at the level of each division, and the debt is very high. And how that debt gets set is a very important part of this whole function and we will say more about that in just a moment. But if you look at the top level, as I said, you get the equity given to the limited -– the equity is achieved -- is raised through limited partnerships, which have a definite horizon of 10 to 13 years. You have got to pay the money back, and you do not have that in the corporate form. That plays a very important role.
And when you recognize that -- because people that do not do a good job, do not get the money back. So recognizing that, you can begin to see that the enormous costs that are going to be imposed by making that capital permanent, by making it publicly tradable, permanent equity instead of the limited partnership finite life equity, as KKR did in the U.K. with their issuance of public limited partnership holdings with no finite payback period, that removes an enormous amount of the discipline. Then you get the equity claims of the partners at corporate headquarters -- a half a dozen; maybe it must getting larger now. Which when Steve Kaplan was doing his work [audio glitch] 20 times more equity interest than what you saw in the typical -- at the CEO level of the typical conglomerate, not at the divisional level.
So in this case, we are talking about at the divisional level the incentive compensation as measured by equity shares was, in his sample, $64 per thousand that they got as opposed to $3.25 per thousand that the CEO got, which is a factor of 10 to 20 different. Now, that has undoubtedly changed as the incentive compensation for CEOs and division managers has changed over the last 20 years.
Another very important point that goes on in the actual negotiation and creation of the buyout, what goes on in a typical conglomerate in terms of the annual budget games that go on, that gets settled pretty much once and for all when the deal is cut. And when the deal is done in a private equity firm, the managers of the firm and the private equity buyers probably know more about the details of the operation. They have more specific knowledge, to use John Chapman’s term - where is John? Yes, there he is - than existed from a very early time when that firm was an entrepreneurial organization.
Remember, early when I got involved in this, I met Carl Ferenbach, who is a managing partner at Berkshire Partners, at an evening session like this; it was again close to 20 years ago and we got to chatting at the dinner table. He was telling me -- this was in January and we were in New York and he had just come back from spending a week or two in Northern Wisconsin running around on a railroad car interviewing both customers and employees of the Wisconsin Central Railway. And he was the chairman of the board of this company.
I said, “This is really interesting. When was the last time I heard a story of a chairman of the board of a railroad company running around on a railroad car talking to customers and clients?” But that was what he was doing and they made a lot of money on that deal. They took a money-losing railway - 2,000 miles that they bought from a Canadian railway; I forgot the name of it right now - and turned it into a very profitable venture.
So that is a brief outline of the differences between those things and they are very, very great and they matter. Now, a little bit -– I’m not going to go into too much detail on this, on the control function of debt. When a company goes into bankruptcy, people generally think the world has come to an end; that is not true. All that needs to happen at that point in time is that the contracts between the various levels of debt and equity holders need to get renegotiated. But, very importantly, the contracts with the management need to get renegotiated.
When you have very low levels of debt - just let me go back - what really matters is what the liquidation value of the firm is. So if you take two firms with a value of 100 and liquidation values of, let’s say -- I used 10 over there on the graph. Then if there is no debt, if there is no debt, you have a completely unlevered firm. Then the management of the unlevered firm, hold the capital markets aside, can engage in value-destroying activities all the way down to 10 before it [inaudible] supposedly, even at $10 million worth of debt before they run into difficulty and then things get into trouble.
If, on the other hand, there is an 80 percent debt-to-value ratio, then the managers of that company can only destroy value, control market aside, down to the level of 80 percent or $80 million. So they can destroy $20 million worth of value without changes in the decision rights taking place through the bankruptcy courts or the threat of bankruptcy.
Most firms -– we changed the bankruptcy laws in the late 1980s, early 1990s. That made it much less efficient to have high [audio glitch] than it did before. When Mike Milken was around and Drexel, and under the bankruptcy laws very few of those firms that were levered to 90, 95 percent ever actually formally went into bankruptcy. They got reorganized outside of bankruptcy. We changed the tax provisions and we changed a number of other provisions of the bankruptcy laws so that is almost impossible now. So we have invented what are called prepackaged bankruptcies to reduce the cost of bankruptcy. High debt is still desirable but not as high as it used to be under the new rules of the game and we have got to be careful not to forget that.
So this is just a summary of what I said. Let me skip through it. Strip financing was important in those days; we do not see that much anymore because of the fact that you are forced to do it in the context of the bankruptcy courts anyway.
A little bit more on the private equity boards of directors - the boards of directors, at least all the ones that I have seen, are small in size. Generally, the CEO is the only manager on the board - and I’m sure there are violations of this now - and is not the chairman of the board. Now I have not seen a single case and if there are any, I would be shocked. At least when a private equity firm is bought, bought the entire firm. The other managers are there but they are ex-officio and active but they do not vote.
The private equity partners are active investors in the true sense that I have defined that word; that is, active investors are investors that have substantial holdings in both the equity and for the debt position of the firm and are actively involved in the strategic direction of the firm.
You can see why that plays -- makes a very big difference. Active investors are generally [audio glitch] from public boards by insider trading and other regulations that have made the role of JPMorgan simply impossible to perform now without this unique organizational form that we call private equity. Other very important provision of private equity firms is that every single contract that I have looked at - there may be exceptions but I do not know of any - prohibits the cross subsidization of divisions; you cannot take money from one division in cash and hand it to another one as goes on in the typical public conglomerate and the source of massive amounts of waste.
So that is another very, very important part of this, you see. Money that comes out of any private equity division has got to go back to the limited partners and then you get to ask for it back. I want you to pay careful attention to the control aspects of that; it is very important.
I have mentioned before there is far better information at the top management than the board level, at least when it starts out in a typical private equity deal than there has ever been, except when it goes [audio glitch] you go take it back to an entrepreneurial firm, and that comes from the due diligence.
The compensation - we have talked about that so I do not need to go through that. A very important element -– it is a little hard for me to say how important this is nowadays, but when I was studying it actively, it became general practice to ask the managers of the private equity division that is being bought out to invest some of their own money in the deal. That is actually very, very important because you are going to give them a big chunk of the equity; they need to have some skin in the game.
And I certainly saw in the cases we worked with in which important top-level managers left because they did not think the deal was going to work. We do not want those people; they did not want to invest their money in the deal. You do not want them executing the strategy that they do not think can work. And there is no way you can get that information other than asking them to put up some of their own money in return for getting the equity position they did; very, very important.
Private equity firms have very clear, because of these limited horizons, understanding of what the score is. I’m not talking about the scorecard; I’m talking about what is on the scorecard in the bottom line and its value. And its value is somewhere between three years and 13 years from now; that makes a huge difference. I cannot tell you the number of times I have seen organizations and firms where the management is tied up in knots and cannot agree on a strategy because they cannot agree on what they are doing, what the score is on the scorecard. In these firms, it is value. Now you might quarrel about that; you might say it should be something else. I happen to think it is the right measure although it is not perfect. But one thing these firms do, everybody is focused on value. So we know what better is and what worse is.
So you can think about the negotiation process that leads to the private equity deal with the banks and the providers of the debt as substituting as I have mentioned very briefly earlier -- as substituting for the annual budget negotiation process. In this case, it gets set once. This is the debt we are taking on; this is the debt service levels that we are obligated for and we have to meet that. And then, if and when we meet it, then there could be bonuses and all of the rest of the stuff that comes with that.
So it gets set for the next three, seven, ten years, depending on how long. And we get out of this annual budget negotiation cycle with bonuses that are attributed to it. It is well-known what the damaging effects of that are, at least amongst accountants; I wrote a paper on it a number of years ago that I entitled “Paying People to Lie.” And eliminating that process alone can result in increases in productivity of easily 100 percent in most firms and that, by and large, gets eliminated in these firms.
Back to the debt levels, slow growing businesses, high leverage is appropriate, creates management cash -– focus on cash flow to pay the debt and that is productive on the management stops [sounds like] thinking about growing the company in a world in which they got paid based on the size of the company or its annual sales or its total assets, and shifts it to growing the equity which can make a world of difference in creating value and efficiency for society.
So in the venture capital end of the market that is not appropriate; you do not see high debt there; you do not see much debt at all; you get staged capital commitments. If you do not perform well with the first or second stage, you do not get more. VCs often bring in -- ask for another venture capitalist to come in on second or third or fourth stage financing so that they do not fall in love with their deals. I want to skip this strategic value accountability. A brief summary and then I will skip through it.
In every organization -- this is what I call the missing concept in corporate governance. In every organization, somebody has to bridge the gap between the markets and the managerial organization. It is where -– think about a situation where a management team is putting together a new strategy; they are making thousands, maybe, tens of thousands of decisions; there is great uncertainty of what the impact of those decisions are going to be from society’s standpoint.
I argue, and many economists would argue as well, that the important thing is how those decisions are valued in the market by consumers and suppliers in the communities, and that is going to get reflected in the value of the company. That is a very, very complicated problem and no CEO -- almost no CEO wants to be held accountable for the value implications of the decisions they are making. They want to be held accountable for things like the number of new products, the amount of cash flow they generate, that kind of stuff.
So what has generally been true in American corporations, and I would say true in corporations throughout the world, is that the strategic value accountability decision rights - that is, to make those decisions so that the value consequences of them are maximized - are basically unallocated in most corporations. It takes very sophisticated knowledge of the financial markets to bridge that gap. And corporations generally are unwilling and unable to hire that kind of talent. What you see over and over again in every successful private equity firm that I know of, in every successful venture capital there is always a coterie of people at the top, oftentimes at the very top of the organization, who come from investment banking. They understand stock markets and debt markets; they understand the linkage between the managerial decisions, the strategic decisions and what value is going to be materialized three, five, or seven or 10 years down the road.
That almost does not exist in most corporations in this country. I am astounded when I work with companies about how ignorant most managers are about the value consequences of their decisions, and how value actually gets created in their company. That does not occur in successful private equity firms. I have sat in those board meetings; I have listened to amazingly sophisticated conversations when you blend the managerial viewpoint with the knowledge of markets and how value is determined and price earnings ratios - amazing things happen. This is, again, the kind of specific knowledge that John was talking about; it is very, very important.
Enough said about that. Let me skip through these slides. It is generally done badly in every organization - a typical corporate organization - and done well in all of the successful private equity firms that I know of. A good example that happens be on this slide is the disastrous reign of Nardelli at Home Depot. By his standards and what he thought performance was, he was a big success; he was an utter failure because value was destroyed during his tenure. And when he got fired because of the nature of the contract he left with he got -- what? Is it $220 or a $240 million? He got paid more from being fired than he would have if he would have stayed and finished his contract.
Now it is very interesting that he gets a chance to recoup his reputation by working for Cerebus where he is going to have a real boss in running Chrysler, and we will see how that comes up. He does not make the grade within a year or two, he will be gone because he has got a boss now and he will not leave with $200 million is my prediction.
So, it is too long, given how late it is in the evening, to go through this. Let me just say that in terms of the equilibrium that has arisen between corporations, virtually all of them -- not all; Warren Buffett does not do this and there are a few others. But the annual and quarterly earnings management gain that goes on between corporate managers and the capital markets and the analysts is a game that is out of integrity on both sides big time, and it is very, very destructive of value creation.
There is a general tendency to see the results of all that in terms of a frame that has to do with short-term value maximizing versus long-term value maximizing. Since I have spent this time -- spent a lot of time in the last couple of years thinking about integrity, I now see and someday I will convince all of you but there is not time tonight that that is the wrong way to look at that problem. It is not productive; it does not give you access to anything; it does not have to do with the horizon. It has to do with the lack of integrity versus integrity. And what I mean by integrity is a case -- it is simply that you honor your word. And when you make reports to the market, those would be accurate reports.
Anyway, when you take it private and if you stay private, that whole game goes away and that can result in huge increases in value. So some problematic trends -- the growth in the non-equity-based fees to PE management companies is a big problem for me. I mean I do not object to anybody making a lot of money, but one of the things that matters to me in the world is efficiency -- one of the four things. And what happens is what we are seeing with people taking out special dividends, people taking -- the private equity firms taking out payments that are not proportional to equity -- to the equity holdings. This is a disaster for the structure of this model.
Go ahead and take more money out but do not take it out in a way that treats you as an equity holder different from anybody else. And that is what is happening in some cases; I hope it does not continue. It creates major conflicts of interest with the limited partners and value destruction, I guarantee you, in the long run will result. So do not confuse the ability to charge more with charging more in the wrong ways and this is the wrong way to do it. There are some funds -- I got a prospectus in the mail three, four weeks ago of an organization that does it all on [indiscernible]. There are no deal fees; there are no monitoring fees. Those should all disappear or they should be de minimus if you want this model to succeed.
The hedge funds -- talk about hedge funds entering the PE business. This is a governance business; it is not a transaction business. Unless the hedge funds change dramatically - what their talent [sounds like] and their world view is - they will fail at it. Karen Wruck, when we were colleagues at Harvard, wrote a wonderful case study of the disastrous leveraged Revco buyout by Salomon Brothers, which was a Lerner private equity firm at that time. They lost their shirt and, to my knowledge, they were never able to do another deal by themselves.
Private equity firms going public -- the publicly held private equity firm is a non-sequitur in my world, both in language and in economics, and I said that Berkshire Hathaway is a counterexample. But permanent capital in the form of publicly-held stock replacing some or all of the funding provided by the finite rise in limited partnership funds as KKR did in the U.K. is going to create more agency costs. And as I said earlier, just think about the closed-end discounts. And I'm sure that KKR Company will do just fine for a year or two or maybe three or four.
But I guarantee you because of what I believe I understand about human nature, is that you substitute permanent capital for that temporary capital and it will generate -- it will evolve companies that move towards the old conglomerate. And when they got reorganized in the '70s and '80s, when all of that started, roughly half of the entire value of the American corporate sector was being destroyed by that inefficiency. So these are not trivial numbers.
So this business of reputations is very important and it relates to this finite live contracts. They have got big incentives when they have got to give the money back to do good deals, and when they do a bad deal, to make them work, to stick with them. They simply cannot walk away from it, which is in the end what Salomon Brothers did, and that is very important.
Now, what if the -- let me skip this. So now, think about what happens when you take the partnership headquarters organization public as Blackstone and Fortress and a couple of others have done. Now, you have re-entered the whole game in this out-of-integrity relationship with the capital markets and [audio glitch] this is a case where transparency is highly counterproductive. And this is a conviction on my part; it is a prediction as well and we will see how it works out. But it puts at risk -- when you take this part of it public, it puts at risk another of the major competitive advantages that the private equity firm has.
In Blackstone's case, I do not know; I have not read the prospectuses on the others but I did check this one. The new public holders of the limited partnership have virtually no say in the governance of the enterprise - virtually none. This is insanity. I mean, who would put their money into this deal? You can count me on record as saying this is insanity. It is going to be -- have bad results. And I know there are Goldman and there are Berkshire Hathaway as counterexamples; I do not think that is going to happen at Blackstone.
So having given up many of the private equity controls, I'm going to read you from the prospectus of Blackstone what they provide: "The Blackstone Group limited partnership is managed by our general partner, which is owned by our senior managing directors. Our common unit holders will have only limited voting rights and will have no rights to elect our general partner or its directors.” They have literally no role in the governance. "Immediately following this offering, our existing owners will generally have sufficient voting power to determine the outcome of those few matters that may be submitted for a vote of our limited partners, including any attempt to remove our general partner."
Being very frank about it, at least in integrity. "The partnership agreement of the Blackstone Group LP limits the liability of, and reduces or eliminates the duties, including the fiduciary duties owed by our general partner to our common unit holders and restricts the remedies available to common unit holders for actions that might otherwise constitute breaches of our general partner’s duty." This is insanity.
Now you take a sample of 100 firms like this and there may be two that turned out to be Goldman Sachs or Berkshires. But 98 of them are going to turn out the other way. This is Daniel Gross in his article in Slate on Schwarzman: “And now Schwarzman may pay for his antics” -- I have not quoted the rest of it. “He is like an NBA player who, having gone the length of the court for a slam dunk with the game already put away, starts trash-talking, jumps atop of the scorer’s table, gestures obscenely at opposing fans, pinches a cheerleader, chest-bumps the referee, sticks his tongue out at the camera, all while grabbing his crotch and yelling loudly that he is the man.”
This is not me saying this. That would certainly get the attention of the ordinarily forgiving disciplinarians in the league office. The article is entitled “The Golden Ass: How Blackstone CEO Steve Schwarzman’s Antics May Cost Him and His Colleagues Billions of Dollars” - June 19th.
So my guess is that Steve has personally imposed billions of dollars worth of costs on this industry. It did not have to happen. The Japanese have a saying: “The nail that sticks up gets hammered down.” And something happened in this process. This industry has behaved remarkably well and the people in this industry have behaved remarkably well. It is a shame to see what is happening. And the danger is that real increases in welfare can be stifled or stopped as a result of these unfortunate trends and tendencies.
We are going through another period like when I gave that congressional testimony back in 1989. Private equity firms are going to have to manage this very well, and Steve is not helping. Notice I read today about his latest speech and it seems like he has begun to become aware of the fact that he has caused some ripples that may not be desirable. This is particularly a problem, given the fact that the private equity industry has been overvalued for the last few years, and I have been saying it for a long time. Why is that a concern?
A couple of years ago –- a number of years ago I wrote a paper entitled “The Agency Cost of Overvalued Equity.” And the purpose of that paper was to explain to my colleagues who like me taught finance for years and that the fact that what we wanted to do to maximize social welfare was to maximize the value of the firm. What became clear to me back in about 2001 was that that does not mean that you should have as high an equity price as possible. Because if your equity becomes substantially overvalued – now, I do not mean by 5 or 10 percent; I mean by 50 percent or 100 percent or even more - I’m guaranteeing you that will release a set of forces inside your firm that will destroy value and may well destroy all of the value of your company. That is what happened to Enron; that is what happened to Xerox; that is what happened to WorldCom.
In a brief argument about how that happens is that if your equity becomes substantially overvalued, it is like heroin to a drug addict - it feels really great when it starts. You are on TV; if you have got any options or equity-based compensation, your wealth is rising. You are a star. But let’s be careful. If you are overvalued then, by definition, you will not be able to produce the financial report performance that the market is expecting to justify that value. That is what we mean by overvalue. And that will dawn on you that all of that fame and glory and wealth is going to go away because the market is beginning to be more and more demanding about these financial reports.
People do all kinds of things; they make decisions in the gray area of accounting. But eventually what we have seen is they know they are overvalued when they walk around the corner and commit fraud, which is what happened at Enron and a lot of other companies.
Now, the private equity industry has been overvalued for a number of years. Now values, except for the recent counterexamples, did not exist in that business. So how does the overvaluation represent itself? With way too much capital coming in, it represents itself not in the price dimension but in the quantity dimension. That results in the overinvestment, bidding up of prices and deals; Lerners coming into the market; low returns. We had several summaries of that cycle today.
So you add that on to the other things that are going on right now and private equity is going to go through some very challenging times. And then you get the public surveys documenting the earnings of private equity partners and hedge funds; you get the actual revelation of those earnings through the prospectuses of those firms going public. My question is why in the world would any private equity manager, partner, or a hedge fund partner for that matter, in the political environment of today want their earnings to be publicly known?
This is one of the worst parts of human beings - jealousy. And it is beyond me to understand why people would rush to have this information released because the result is not going to be good; it is exactly as the Japanese motto says. And I do not care about whether they get wealth taken away from them. What I care about is we are destroying, or there is a danger of destroying, a very productive system. And mark my words, there is a lot of people out there in the corporate sector who have not yet figured out that it might be nice to be private, who will be happy along with a lot of others to pile on and establish rules of the game that substantially penalize this system.
I’m not at all surprised that the tax rules on private equity income may be changed. And maybe they should but they should not be changed for this reason. Why would Steven Schwarzman allow his picture to be on the front cover of Fortune Magazine in an article where he says very clearly how he sees all of this as war? It does not bode well for public relations and neither does the public offering.
So when I gave a first version of this talk at the Harvard Business School birthday party for its 100th year that a number of my colleagues invited me to give in New York City in early February, what I said at that time is that private equity is going to have its reputation tarnished; it is going to be damaged. But it will survive, I believe. It may be crippled, but it will survive. So that is all I have to say. We can take questions if there are any. [Applause]
Yes, I would be happy to call in [sounds like]. Any questions, disagreements, agreements? Yes?
Male Voice: [Inaudible] question of behavior and horizon within the firms themselves between a senior and the less senior people and how that drives decisions and --
Michael C. Jensen: Yes, I know, it is okay. I was thinking of asking for a clarification in -- are you talking about the private equity management company? Or are you talking about --?
Male Voice: Yes, yes. And the other is has anyone taken a look at the other side of it and how, for want of a better word, the bureaucrats and the big institutional LPs think about their job, their horizon, and their objectives? Because this is not all [sounds like] being done to them; they are doing it to themselves to some extent.
Michael C. Jensen: Right. I cannot answer those questions because I have not done that work. Is there any of my colleagues or anybody else in the audience who can answer them?
Male Voice: [Inaudible]
Michael C. Jensen: Yes. There is this very interesting phenomenon. There are people beginning to look at and look pretty carefully at the fund of funds kinds of thing, if you look at the buy-side. And that is a real puzzle to understand because as Steve Kaplan explained very carefully -- I think it was Steve -- today that is just an additional load on the system -- additional drag. Sorry, I cannot provide you any brilliant insights to that. Any other questions? Yes? Oh, I think maybe he is ordering coffee. There we are, back in the corner.
Male Voice: My question, Mike, is how does the average American earn a significant investment return in a private equity context? It seems to me that it is open to well-fixed people and I'm trying to figure out from a political standpoint -- my concern is what politicians will do to something like this. How it plays out for, you know, the little guy, if you will?
Michael C. Jensen: My guess on this is that the holdings of individual people are, in fact, quite substantial but they are indirect. They occur through pension funds as was mentioned today; they occur through endowment funds; they occur through insurance contracts, and all of that is indirect. But all of those institutions are big players in this market. And as far as I know, nobody has ever documented that, nor have we had documented just how much money is directly invested by private individuals who are very, very wealthy. I’m guessing that if you look at the total pie, the total size of those investments, that that amount is very small relative to the institutional money that goes in to finance this.
That is just a guess but it is a very good thing -- a very good question to answer. At least it would help resolve some political issues. Yes, sir?
Male Voice: I would venture to complement your answer by saying that the private equity industry provides an exit strategy for small- and medium-sized business owners that may not exist otherwise and, therefore, it helps out average or even slightly above-average Americans who are the owners of these businesses.
Michael C. Jensen: Absolutely. And I know a couple of private-equity firms that specialize in exactly that kind of middle-market transaction where there is no obvious successor to the CEO family ownership and they provide a professional bridge to professional management and do, not only those people a big service, but the economy by providing a new growth opportunity for those firms instead of no management; very, very important phenomenon. As far as I know, it has not been studied. Thank you for the question. Yes?
Rob Colerina [phonetic]: Thank you. Rob Colerina. Professor Jensen, two questions. One is, any thoughts and comments on private equity in the emerging markets? Having spent time in both Asia and Eastern Europe, how that may in fact bring new markets to the table, discipline and greater transparency? And then as a follow-up on the topic of hedge funds, a speaker at the U.S. chamber - he was part of the Council on Foreign Relations - described some hedge funds taking positions as firefighters where, in fact, banks or private equity groups would not even go there but were able to create value, sustain jobs and the like. So I would appreciate your comments on both.
Michael C. Jensen: Let me deal with the hedge fund issue first. I have no doubt that on occasion they contribute good things. They are not set up to do private equity deals. It requires dramatic change and how they think about themselves, what their horizons are, a shift from thinking about this as a transaction-hedging business to a governance business, which is not about hedging. It is very, very different. And you have got to have operating people involved as well as people who understand pricing in the capital markets and value at a very deep level.
I think there is -- again, I have not studied it, but from a distance, you know, I have always believed that private equity -- the private equity model, to the extent that it is allowed by the rules and regulations in developing countries, in Asian countries, in Europe, has an enormous amount to offer. It is way more efficient than the typical family firms that you find in Asia and in Europe of old, at least, because you got people who are focused on value. And when I say efficient, I take that value as representing what is being contributed by that firm into society.
So it makes -- I have no doubt that -- you know, there was a time during the ‘70s and ‘80s where there was a malaise. And about the time I went to the Harvard Business School in ’84 that the Japanese were simply going to destroy American industry. And what was going on in the takeover market and in the market for corporate control, and when the private equity market played a very big role here in creating a lean and mean corporate environment, by no means done. And I think that can happen overseas in developing countries as well.
It is going to depend on the rules of the game being set up so that these kinds of things and customs and a tolerance for a new way of doing business to occur. But I do not have any doubt that they are much more efficient than the typical family operation that you see, for example, in Asia or in Europe. Yes, sir? Chris?
Chris: One way to interpret the theme that went throughout your talk is that the agency problem really has no solution.
Michael C. Jensen: Yeah, it will never go away.
Chris: They are just temporary solutions. But what they really do is displace it so that the private equity phenomenon has solved in a very substantial way some very serious agency problems, but in effect have really displaced it to another level so that we can say that what Steve Schwarzman needs is a boss, right?
Michael C. Jensen: Right.
Chris: So we need, you know, another --
Michael C. Jensen: Or a mother.
Chris: He does not want a boss; he needs a boss, right? And so there is no ultimate solution. But, you know, we keep -- opportunities open up, new phenomena come in to try to solve it. I'm just wondering if one approach within the current industrial -- within the current organizational context of private equity would be through some contracting approach where a private equity firm would commit itself over some substantial amount of time, like the 12 or 13 years that a given investor would care about, not to defect; you know, not to exploit the opportunities that this mechanism has created to do new things like, you know, have a public offering, engage in several of the activities that you have mentioned. As the markets tend to learn about how these opportunities get taken advantage of, one thing you have to do is to tie yourself to the mast and say, “I'm not going to do it.”
Michael C. Jensen: Right. I'm not optimistic about that solution working. You are right - the agency problems are never going to go away. They are universal. They arise out of two reasons: Human beings are self-interested and, secondly, we are irrational -- non-rational. That is a longer discussion that I’ll postpone but as Dick Taylor [phonetic] and others had come to place it, and I think it puts a good way, we have agency problems with ourselves. We take actions that hurt ourselves, hurt our loved ones, hurt our companies, and we refuse to learn about those. Steve is a good example. This is not making -- this behavior is not making him better off. Maybe he has learned; maybe he has not.
So they will be displaced or we can reduce the cost of them, of these agency problems, but they are never going to get reduced to zero. That is just a fact of life. So, I do not have any doubt that we are a lot better off today than we were when I was a young faculty member, where CEOs were being paid mostly on the basis of the size of their organizations. We had these large, bloated conglomerates destroying massive amounts of value. Now, we got a new set of problems. They are nowhere near as costly but they are costly. And so we are right to be upset about them, whether it is the latest things going on in the private equity market or what is going on in the corporate sector with CEO compensation.
It will get solved in the long run. Investors will learn that, entering into contracts like I just read you, when you have given up all these very important control mechanisms or a very large fraction of them does not make a lot of sense. Now, I'm not saying it is going to fall apart in the next year or two; it might. But I'm really looking forward to 10 or 20 years into the future and I guarantee you it is not going to work. I think I understand human beings well enough to know that if you take a reasonably large sample like 100 or 200 of these, 90 percent of them under this new structure are going to fail like closed-end investment funds did. Nevertheless, they got started; some suckers bought into it.
I witnessed when I went to Harvard -- I had the great fortune of having a couple of dinners with Marvin Bower. He was retired from McKinsey at that time, I believe, or he was just retiring; that was in 1984. An amazing man. I do not fully understand the role he played at McKinsey in putting it together, but I'm told by people who were part of that that he was like the founder.
Marvin, when he retired, had enough sense to understand that if he tried to capitalize on the value of his equity, he would, if not destroy McKinsey, seriously damage it. I believe -- he did not tell me this but I believe he understood that. And when he retired, he turned all of his equity over to his partners. I did not understand it in those days, but I do understand it in the context of this problem. And I understand the choice; kind of a Hobbesian choice that Henry Kravis and Steve Schwarzman are looking at. They have the opportunity in the short run to take that management company public and bank $650 million in cash and another $3 billion, or whatever it is, in current value.
Somebody that was in Stockholm when I gave this talk -- one of my colleague-friends said, you know, “Why should he just give that away?” And my answer is, “It does not exist.” He thinks it exists because he is not wise like Marvin Bower. If he cared about his firm, he would not do what he did because it is not his to give away; it is not there. Under the new structure, it is not there. He can steal it from naïve public investors. And it was very unseemly, the way he rushed to get this company public, knowing, I believe, that it was overvalued and that there was a threat of tax action or turndown in the credit markets. And we are all aware of how rapidly that thing was accelerated.
Now you are creating a fiduciary responsibility when you take your company public. If you have integrity, the process of taking your company public, which creates those fiduciary responsibilities in my opinion, has to be done with the same level of integrity as those responsibilities would require when you are public. He did not do that and that is out-of-integrity behavior. This is another paper that I'm not giving tonight, but it creates non-workability.
And what I'm forecasting right now, we will never read it in the newspapers but his life is going to be dramatically and negatively affected by those decisions because it will become obvious, if I'm right, that he fleeced a bunch of people. And he set about a set of forces that will result in the damage if not destruction of a wonderful organization. I do not think necessarily that he thought this through. And Henry Kravis and company whom I have a great deal of respect for are going through those same agonizing decisions.
My analysis is it is not their money; it does not exist; it is only a chimera. And in the process of doing that -- I did a case on Sterling Chemicals. A wonderful man, Gordon Cain. Shortly after I got to Harvard Business School and Gordon came up. He did -- it was Sterling Chemicals and a number of other companies. He was an amazing man. And I remember when he came to class to talk about the Cain Chemical case, how personally embarrassed and hurt he was that the company he had taken public was a leveraged buyout, a year earlier was selling for something like 20 percent less than what he sold it for. It had dramatically reduced his level of welfare. He took it very seriously.
I believe there were all kinds of things around that. It was not purely his own standards that his life was affected. So those who do this and take the short-run optimizing action, especially if they take it in an out-of-integrity way, are not going to find that their lives are as great as they thought it might be.
Because I think pretty much everybody in this room understands that wealth -- we have all got enough. Wealth does not bring happiness. And yet we oftentimes do not face up to that. And in a misled attempt to get more wealth, we create [audio glitch] in our lives a mess that is very hard to get undone. That is my forecast of what is going to happen in that situation. But I'm way out on a limb. Ten more years and then we will know whether I'm right or not. Yes, sir?
Matt: Thanks a lot, Mike. Matt [indiscernible] from the OECD in Paris. One of the reasons why private equity firms can perform what they do is that there is another complement of shareholders that are not doing their job, right? There is a vast majority of shareholders that are out there being very anonymous [sounds like] and passive and just not living up to what it is all about being a shareholder, and that is why this arbitrage can take place, right?
And while we are having this wonderful event talking about the virtues of private equity and all the good things that they are doing, there are similar events going on organized by pension funds who say that they are their future owners; they are the ones with workers’ capital and they are going to go in and they are going to be active and they are going to be relational and they are going to do all these good things. It seems that they are a little bit of a less of a profile now because they are doing most of their investments through the private equity funds.
But still, where is the jury on this now? Because this comes in waves and for the last 10 years, there has been a lot of discussions about the Hermes and the CalPERS and whatever focus funds or whatever that are going to do all this wonderful job of being active and informed investors. And on the one side, you have the private equity industry that is actually doing it, not talking about it so much.
Do you think that this vast ocean of owners in terms of, for example, public pension funds ever will get their act together? Or are they just too constrained by their political and institutional environment to be able to live up to the role of an active and informed investor?
Michael C. Jensen: Yes, I think they will fail.
Male Voice: [Inaudible]
Michael C. Jensen: Right. The incentives are not right; the knowledge is not there; the possibility that the move to more activism on the part of money managers will make things worse, not better. As unions, for example -- I mean, the worst thing in the world would be to have the board of directors and the public firm politicized. And yet I can see a set of circumstances in which that could happen. And the easiest place to start, it is not -- it would not end there, but is with the union funds. And there is actually some empirical evidence indicating that. So they are interested in not maximizing the value of the organization, but maximizing their own members’ interests.
The free-rider problem is a huge problem that is not easily solved. What has struck me as I learned about the structure of the private-equity end of the business, whether it is venture capital or in the slow-growth end of the market, the leveraged buyout sector, is -- I do not know -- somehow, by luck, a bunch of people ended up evolving an organizational structure that both worked legally that allowed them to be active investors after the 1940 Act basically banned the JPMorgans and other active investors. And has in it -- it is not perfect but a remarkably consistent set of incentives that has enabled them to kind of thread the needle and create a mini miracle, so to speak.
I do not see that on the part of institutional activism. It can be misused as easily as it can be used for good. So I'm not optimistic, given the current rules of the game. And I just spent a day up at the Tuck School talking with 30 or 40 major funds and major players from around the world who are interested in doing exactly what you say. But I do not think they will ever be able to effectively get their act together to do this, to pay people -- the people who have this kind of talent to bridge the gap between the capital markets and the managerial organization, to communicate across that bridge, are very rare. And it takes an enormous amount of knowledge and talent and you cannot get that kind of person.
If we look at the General Electrics and the IBMs, we are looking at very successful corporate organizations. They do not have this talent there because they cannot afford to pay for it or they cannot stand to have it in - one of those reasons or maybe both of them. So what is the likelihood if you cannot get it hired into an IBM or a Hewlett-Packard or General Electric? How in the world are you ever going to get it hired into a pension fund?
These are very rare talents. And it is not just knowledge of the capital markets; it is also an ability to communicate with managers and to actually get over to that side of the strategy equation so that those two things can be brought together. And that kind of talent does not come cheap. And most organizations -- you know, Warren Buffet is one that has that talent. He gets paid by owning 45 percent or whatever it is of Berkshire.
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