American Enterprise Institute

November 27, 2007

[Edited transcript from audio tapes]

Proceedings:

R. Glen Hubbard:  We are deliberately starting a little bit late to give everybody a chance to get settled, but start we need to do because, again, it is an excellent program.  I think yesterday’s introduction of the conference both as getting some facts on the table about the private equity business, a discussion of the economics, and Mike Jensen’s rendition of Jonathan Edward’s Sinners in the Hands of an Angry God last night, all of that, I think, was an important first day for the conference.

Today we are going to be burrowing in in three areas:  One in terms of the market for corporate control and entrepreneurship, the topic of the first session.  Second, to look at global developments as a tendency to think of this as principally an American phenomenon; historically, that was true but there are exciting developments around the world and they are different.  And third, to talk to practitioners about key issues they see, both business issues but, also, hopefully, policy issues regarding taxation and regulation.  The first panel, Karen Wruck will be the speaker and I will turn the program over to Alan Viard and to Karen.

Alan Viard:  Thank you all for coming out here.  It is always good to see so many people here so early in the morning.  I think we have a very interesting set of remarks ahead of us.  The topic of this particular session is how private equity has affected, reinvented, in our speaker’s terms, the market for corporate control.  We will have a speaker followed by two discussants. 

Karen Wruck is the associate dean of the MBA program at the Ohio State University, Fisher College of Business.  She is also the dean’s distinguished professor there.  Our first discussant will be Peter Klein, who is a professor in the Division of Applied Social Science at the University of Missouri, and the Associate Director of the Contracting and Organizations Research Institute.  Our second discussant is Annette Poulsen from the University of Georgia Terry College of Business where she is the head of the Banking and Finance Department and holds the Augustus H. "Billy" Sterne Chair.

So we will allot about 25 minutes for Professor Wruck, followed by ten minutes for each of the discussants.  And that will leave us some time for what I’m sure will be a number of questions.

Karen Wruck:  Thank you.  Good morning.  I want to make sure -- can everyone hear me?  Okay, super.  I’m very happy to be here today.  My charge is to talk about “Private Equity and the Market for Corporate Control.”  I’m going to call it a reinvention of the market for corporate control and I will tell you a little bit about why that is the case.  And it is one of the ways in which I think this private equity cycle is different than what we experienced in the 80s.

We have seen a lot of statistics over the last few sessions.  I will not reiterate or read mine but I will call your attention to the bottom line of my slide, which is really what I want to talk about.  There was an article not so long ago in the Wall Street Journal where Henry Cravis was quoted as referring to this period as the golden age of private equity.  And so one of the things that started me thinking about is what does it mean to have a golden age and is this really one of those?

So what is a golden age?  Just look it up - a standard definition: A period of great happiness.  Well, I think there are probably a lot of happy people in private equity out there.  Prosperity and achievement -- and the question I really focused on is what has been achieved.  If this is a golden age, we get the happiness and the prosperity part, but what has really been achieved?  My conclusion is it is not about the gold in the golden age.  Although, as people have talked about there has been plenty of gold created, and lots more to be created and spread around.  But there are really two achievements that I think are worthy of note.  And I’m going to spend a reasonable amount of my time talking about those.

The first is a reinvention of the market for corporate control which I think, again, is a distinguishing feature of this round of private equity from the last and is something that I think will be a permanent feature of the way the market for corporate control works here in the United States.  And the second, which I think is equally important, is what I’m calling the routinization of an approach to reorganizing for value creation. 

And one of the things, if you think back to some of the conversations we had yesterday, is this notion of private equity players being that bridge between capital markets and management and strategy.  Part of the way that is coming about is by having an influence on the way firms are reorganized.  And if you want to look to where you think there are going to be problems in deals in the future, it is where this capability to affect change on organizations is missing.  And I will talk more about that later as well.

I want to go back to the classic definition from a paper by Jensen and Ruback about what it is that we are calling this thing, the market for corporate control.  So this is the traditional definition that financial economists like to use to talk about the market for corporate control.  Stripped down to its essence, it just says, “This is the market where management teams compete for the right to manage corporate resources.”  And so, the market for corporate control is really an extension and augmentation of the managerial labor market.

The issues that have arisen, however, that I think have caused the market for corporate control to be reinvented are that there were some serious issues and some of those still remaining capital markets.  In particular, this inadvertent separation between risk bearing and the governance functions in the firm.  So what you had were too many situations where public shareholders where indeed specializing in bearing the risk, but their governance rights where essentially captured by managers. 

If you want to think about more theoretically how that would work - I’m sorry the pictures are not clearer - the notion here in an abstract sense is that there are three important functions that need to take place in a firm.  Someone needs to make decisions - the decision management function; someone needs to bear the residual risk of the organization, and someone has to have decision control or governance rights in the organization. 

And very broadly speaking, it is easy to see why I would want to separate the management rights from the governance rights.  In other words, I do not want risk bearers out there in the market place with no access to governance; I do not want managers capturing the governance process.  But in a sense, what ends up happening, particularly, pre-private equity is rather than having this separation between decision management and governance and risk bearing, you had what amounted to a situation where managers ran the firm and had captured the governance process, and shareholders are out there bearing residual risk with really no options but to vote with their feet.  And that could lead to substantial degradation and value.  And it puts a lot of firms and organizations in jeopardy. 

So how does the new market for corporate control solve that problem?  A new definition that I have just kind of thrown out there is the market in which the providers of capital compete for the rights to govern the corporation.  It is not a management-driven definition and it is not about the right to make decisions.  It is about the right to govern the company. 

What does that mean?  The governance rights succinctly summarize the rights to hire, fire and set the compensation of top managers; the right to veto or ratify major strategic initiatives, and to serve as internal consultants in developing the strategy and direction of the firm.  It is not a competition among management teams, although it does have very strong implications for how a firm is managed.

So take as an example -- you have a publicly treated target; you have two bidders.  One is a public corporation and one is a private equity firm.  In the ‘80s, the way we would think about that is we would say, well, there is a strategic buyer who has the potential for synergies with the target and the strategic buyer may be willing to pay a premium to capture those synergies.  And then, there is a financial buyer who is investing in the firm only because they are financially driven and looking for the returns; they do not particularly have operational expertise.  And so it is a competition between strategic buyer and financial buyer.

That distinction is really being blurred because of the way private equity shops are organizing themselves.  So the corporate bidder may have perceived synergies. And as anybody who has looked at the literature in mergers and acquisitions knows, it is extremely hard to capture those hoped-for synergies due to issues with post-merger integration.  It has to win the battle for the right to govern the firm first. 

And private equity shops, as Steve Kaplan pointed out yesterday, are developing what he calls this operational engineering capability.  But the good shops have always had that.  If you go back to the 1980s and look at, for example, Clayton and Dubilier, they always had operating partners that sat on the board of their portfolio companies and brought guidance and strategic direction to their portfolio companies.

So it is not a new idea but it is an idea that has permeated the market to a greater extent so that the private equity players can bring about operating improvements, synergies, and have shown a capability to put together more than one firm in an industry to exploit operating synergies.  So the distinction between a corporate buyer and a financial buyer -- very, very blurred at this point and which is one of the phenomenon, I think, we are going to have to deal with and live with in the market for corporate control.  It is no longer sufficient to say, “I’m a corporate bidder; I can over bid because I have synergies.”  Private equity guys can capture a lot of those as well.

So what does this look like in practice?  The way that I think about it is it essentially acknowledges the problems associated with traditional governance structure in U.S. publicly traded corporations; essentially, it admits defeat and says, “If you cannot beat them, join them.”  And so, what I’m going to do is I’m going to bundle risk-bearing with governance rights, and governance rights that actually work and stick.

So one way to think about it is in the Old World, you have a world where shareholders in theory had access to governance but in practice are easy to deflect.  In a private equity world, you have shareholders who are buying these shares because they intend to vigorously exercise their governance rights.  And so, this idea that we can peel those apart and function is not an issue; it is not going to happen anymore and everybody has going to have to deal with that.

There is an old quote that many of you are familiar with -- goes back to Adam Smith where he talks about the problems of joint stock companies.  And he says, “Being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance which the partners in a private co-partnery represent.” 

So one of my bullet points there is that it puts anxious vigilance back into the corporate governance process. And if you talk to managers who work with private equity partners on their board, I think that they will think that anxious vigilance can sometimes describe their world.  It is a much more intense process and it is more than just having a boss, right? 

It is having to engage in open dialogue in a very highly charged environment where performance is necessary: Are you doing a good job?  What is going on?  What are the short term implications?  What are the long term implications of your decisions?  And being open to challenge, which is something that many top managers, at least, historically, are not very good at. 

But it is something that you can think about it as kind of a personal trainings sort of analogy, right?  You could work out by yourself or you could hire a personal trainer.  If you hire a personal trainer, the reason you are hiring them is because they are going to push you to do things that you could not do by yourself or on your own.

And it is the same kind of concept in one of these aggressive governance environments.  While managers should welcome the opportunity to be pushed and coached, it is often a hard sell.  But it is becoming a reality and a way of life and resisting it could mean that you end up with an aggressive set of directors that do not have anything to do with the choices you might make.  So I think we are going to have to see the top management suites opening up to more aggressive inquisition by their directors or risk having it imposed upon them against their will.

So the nice thing about this system is that it does put anxious vigilance back in the governance process without requiring managers to own so much stock - a 100 percent of a large enterprise - that they are overwhelmed or cannot put together the capital.  And so you are able to have some efficiencies and risk bearing as you would have in a public corporation but also have a governance process that works much better than the process in a typical U.S. publicly traded company.

So what are the implications of that?  In a broad sense -and people have talked a lot about the evidence - more competitive liquid dynamic effective market for corporate control.  I think that is one of the big positive legacies of the private equity world and I think it is a great thing.  You are going to end up with more efficient organizations along a variety of dimensions and not just firms who have direct private equity interest.  Because the threat, the standard of behavior is a motivator, or an example, depending on how you would like to put that, in terms of what is going to work to supercharge an economy. 

If you have a competitor who has private equity as a significant owner and they are making huge improvements, you had better make similar improvements or you will not be competitive in your product markets either.  So it can have motivating effects even for firms that do not have direct private equity investors simply by changing the competitive dynamics in an industry.  And I think as you see private equity players take positions in industries and have bigger roles in industries, you will see them influencing the competitive dynamics of the product markets, which has an impact on everybody, okay?

So one of the questions -- and this came up last night: Is this the eclipse of the public corporation?  Has it arrived but only 20 years late?  So one of the things that Michael talked about yesterday at dinner was what is the future of the publicly-traded company?  I do not think it is an eclipse in the sense that we are never going to see -- we’re going to see a movement completely from public to private because predominantly, of the access to liquidity that public markets provide and they still serve an important role in terms of risk bearing.  They are, ironically, a desirable exit strategy or exit vehicle for private equity players. 

But the reality is that with big deep liquid pools of private capital, the public market is not as important as it used to be.  It is not the only kid on the block; it is not the only way to get residual risk born and, therefore, it will play a more limited role going forward.  And so how that gets dealt with, both in terms of the capital raising process and in terms of public policy is an interesting set of questions because there will be, I predict, less dependence on public markets.

So not exactly an eclipse but there is another classic article by Bennett Stewart that was called, Remaking The Public Corporation from Within.  It had a number of interesting ideas about how a public company could impose some of the discipline of a buyout on itself.  I think this is more a remaking from without, but you will see changes in public corporations brought about, I think, from pressures from this reinvented market for corporate control.

So that is sort of category one: Reinvention of the market for corporate control.  The other thing I want to talk about is this routinization of ways to organize for value creation.  While I have done large-sample empirical work in this area, as well, a lot of my time has been spent inside the black box of the organization, working with managers of firms, and studying managers of firms who are trying to figure out how to run their business under the new private equity regime.  So it is very difficult to do that for thousands and thousands of firms but you can do it for a number of firms. 

And so, part of my perspective is really driven by having spent time inside organizations two to three years, post-buyout or post-private equity, to try to understand where are these gains and operating profitability coming from.  What is really going on in terms of the management style and practices?  What do employees say about what their lives are like pre- and post- buyout?  Are they happy or are they unhappy?  And so on. 

So I want to talk a little bit about those kinds of issues.  And this is what I think is an apparent contradiction or, perhaps, the ultimate irony of private equity because on the surface it looks like a very market-oriented transaction driven world.  And, in fact, when it works well, it is a very relationship-oriented organizationally focused business.

And in that dichotomy really lies, I think, a way to understand what deals work and what deals do not work. Deals that are largely transactional in nature with no relationships that do not focus on the organizational dynamics or the management tend, I think, to be weaker than those that get it.  And I believe this is one of the things that distinguish the top players in the market from the B, C, and D players in the market on the private equity side.  And one of the reasons that I will think I will argue that it is very dangerous to invest with these B, C, and D players. 

So what do I mean by that?  Reorganizing for value creation.  What assets should remain with the organization?  When I buy an organization, what do I keep and what do I sell?  And how do I make that decision of a value-based proposition?  Public companies are very, very reluctant to reform themselves, except under crisis circumstances.  This is something private equity shops are very good at is looking at what is the core of this business. 

What can I unload to another buyer who could manage it better than I do?  And then, given what I keep, what should the internal rules of the game look like?  How should I allocate decision making rights?  How should I measure performance internally?  And how should I compensate managers in those organizations? 

These are the key organizational decisions and the thing that, I think, bridges this gap between the capital markets and the strategic management.  It is not that the private equity guys know how to run the business; it is that they know how to set up the business to tap managerial talent and knowledge, and provide them with incentives to make good decisions, which is one of the reasons it is so important for private equity players to buy firms either with very strong management teams or have the capability to replace those managers very quickly if they do poorly.

So what do we see in practice?  What we see are four pretty stylized facts about things that come up over and over again in terms of the way private equity guys work with operating managers to restructure organizations. 

Governance by small board -- Michael talked about that last night.  Decentralization of decision making -- so how do I get the decision rights for strategic decisions and other important decisions into the right hands of managers?  And when I give them high-powered incentives, I can afford to be more decentralized in the way decisions are made because I’m holding them accountable for outcomes.  I do not have to monitor their inputs as closely.  And that is a good thing because the private equity guys, a lot of times would not know what decisions ought to be made.  But they can help managers understand the value implications of their decisions and then let managers use their expertise to make decisions. 

And most of the managers that I have talked to, who stick around for the private equity guys, really enjoy working in that environment in the sense that they feel they have more autonomy, more authority, and more freedom than they did in their corporate environment or as CEOs of publicly traded companies. Probably, selection buyers there but performance measures that emphasize cash flow and long-run value creation, that should not be surprising; we know nothing about let’s grow earnings per share, we drop that completely.  And a new compensation package - higher level of compensation, bonuses based on cash flow measures, and significant equity ownership, but not crippling. 

Okay, so that is the organizational proposition.  What do I mean by routinization?  Well, once you get good at this, I mean, every company is different but the principles remain the same.  So if I have done four, five, six, ten, a hundred deals, I’m learning a lot about how to apply these principles of organizing in a variety of different circumstances. 

And this approach to organizing is really a technology.  Glenn talked in the introduction yesterday about the role of technology in driving growth in the economy.  It is appropriate, I believe, to think about ways of managing and organizing that are powerful as a technology because it does drive growth and value creation and this I think is one of those. 

The interesting thing about it is that it is not rocket science.  So one question is, is it a sustainable source of competitive advantage if you are good at it?  And the answer based on what we see from private equity returns and the fact that the top tier tends to significantly outperform the rest suggests to me that while it seems simple on the surface that it is, in fact, difficult to implement.  It appears to be difficult to replicate by new entrants into the private equity market and is certainly difficult, as Mike pointed out, apparently to implement in public companies, although again in principle, you could do this in a public company without going private.

So is this an organizational explanation for differences in performance across buyouts?  I think it is.  That is my speculation.  So to recap these two achievements, reinvention and routinization, I want to just spend a few minutes talking about one part of the private equity market that we have spent no time on, which is the private placements and pipes which are not buyouts but which are a huge part of the private equity market, by some estimates about $39 billion in ’07, headed towards $50 billion by the end of this year. 

We know very little about the impact of these transactions on value.  And the question is how do we think about them.  Are these more like seasoned offerings of equity but big blocks of equity?  Or are they more like buyouts but without the automatic access to governance and the ability to reorganize?  And I think it is very important that we start to try learn more about these transactions, and how they were not given the size of that market and the growth in that market.

And I will skip quickly through these.  So what is the relationship between [indiscernible] private equity investors and the firms in which they invest?  Talk briefly about a study that I have recently been involved in that looks at 2,000 private placements completed over a 10-year period and has the data on the placement contracts and the special filings.  So we know who the investor is and we know what their relationship is with the firm. 

And what we find is that 64 percent of the placements are made to investors that we would call relationship investors, either managers, key business partners, or people who are already block holders or directors of the firm.  We also find that most of these placements are associated with the formation of a new relationship, either a new directorship, a new management position, and so on.  And only eight percent of these placements are made to what we would call true outsiders. 

So what are the performance implications?  So what happens? For key business partners who invest in these private placements, they experience a very poor return at least over the six months following the placement after adjusting for risk and for market performance.  Why would that happen? 

We are not really sure but one of the speculations that we have is that, for key business partners, they are investing in the firm because they are already tied to the firm; perhaps their prospects are poor and it is better to invest than not invest.  So invest going in knowing it is going to be bad news but the alternative being to go down with the ship.

Outsiders without new relationship ties - and this is the one I really want to emphasize today - also do poorly.  So this suggests that even in pipes and private placements, the relationship connection, the governance access is important in terms of the performance of the investment after the fact.  Perhaps, not remarkably, managers who participate in private placements or pipes in their own firm do so at a substantial discounted experience and extremely positive return after the fact.  So they do demonstrate at least in our sample an uncanny ability to time the market.

But looking forward, in terms of private placements and pipes, a hypothesis is that in order to earn a decent return, private placement and pipe investors are going to have to adopt at least some of the private equity practices, gain some access to governance; otherwise they are going to end up being shut out and experience poor performance after the fact.  Looking forward in private equity overall, I want to talk about a few things that I consider to be bumps in the road and I will review in the time I have remaining.  So politics of finance, tax issues, ease of entry, which I think here is a problem and then a category of things that I’m going to call the necessity and importance of eating one’s own dog food.

Okay, politics of finance.  It is clear that after a sector of any kind earns economic runs that there is an incentive to enter, and we have seen that in private equity.  But we also know that high economic rents [sounds like] attract political scrutiny.  You think about windfall profit, taxes in oil; it is not just about private equity.  It is about obscenely high profits in general. 

And there needs to be an understanding, and I think there is, that the political responses are not necessarily rational and they are not necessarily based on the overwhelming proportion of the scientific evidence on the topic.  So while we may have lots of scientific evidence that these are productive transactions for the economy, overall, that is not the same as addressing the political issue or the politics of it because sometimes legislative responses are driven on a handful of egregious examples. 

And there are people who would argue that Sarbanes-Oxley was a response to misbehavior by about six companies.  So thing to beware of:  We can have all the scientific evidence that we want but as I’m going to argue at the end, unless there is some effective educational process going on in the background to get the people to understand what the role of the sector is, all the evidence in the world may not be able to solve the problem.

This is just the tax angle.  One of the things that we need to just mention out there is that a big part of what drives these transactions are the tax deductibility of interest, which there are economists who think that is kind of silly proposition to begin with.  But just to beware that the tax man giveth, the tax man taketh it away. 

Ease of entry is a problem.  I do not know what your experience is, but almost every retired businessman that I meet these days is in private equity; many of my colleagues are also now in private equity.  So everybody is in private equity but they are not all Henry Cravis.  And therein lies the problem because if I’m right about the importance of that bridge between value and strategy, about the organizational restructuring that has to take place, then this disembodied third party investing will not work. 

So hedge funds are not going to do well here because somebody somewhere underneath all these financial structures and investment decisions has got to be actively engaged in governance or the value proposition disappears.  So if I’m a hedge fund investing in a private equity deal, I had better hope that somebody somewhere in there is doing the organizational and governance shtick because if they are not, then I got a problem.  And that is where I think, we are going to see some falling out in the sector.

So eating one’s own dog food -- so one of the things that I have been thinking a lot is some of the issues and concerns that have been raised about incentives in private equity and how those compare to what private equity managers ask the managers of their operating companies to do.  So I want to end by putting forward some of these examples.

So let’s just talk about non-performance-based fee structures; those came up last time.  So my question to the private equity world is:  Would you take your operating managers, buy them out of their equity stake, and leave them simply with options on the future upside?  Or would you take the managers of your operating firm, pay them a straight salary, and a bonus based on sales growth?  And if the answer to that is no, then you are not eating your own dog food when you pay yourself a largely fee-based compensation because you are asking managers to have pay at risk and you are not.

Investment through special dividends -- these are heads-I- win, tails-you-lose kind of contracts.  I understand that most of them are debt-financed and I understand that the bankers are big boys.  But what you are really doing is you are taking the sort of risk assessment and you are putting it back on the lenders.  And it is not just about the lenders, it is about the survival of the organization altogether. 

So if you took the analogy -- would be if you had your managers and you said, “Okay, you guys as a group own 15 percent of your stock.  I’m going to cash you out today at today’s prices and leave you with only upside potential.  And every time you make a dollar, your options values go up.  And when it goes down you are already cashed out, so no problem.”

And if you think this is not happening, I mean just take a look at Burger King, which is a great example of this.  It is a $388-million equity investment, a $400-million special dividend, $762 million out in the first couple IPO rounds.  They still own 58 percent of the firm and are thinking about doing another IPO.  So they are out of that company five times and still own over half the firm.  Now arguably, the firm has done well, but where is the downside?  There is none.  Right?  Because I’m clean many, many times over and that changes your incentives.  Any private equity person would tell it would certainly change management’s incentives if I wrote that contract.  

Going public, we have talked about that; Michael talked about that last night.  But think about the first picture that I showed at the very beginning of my talk, the problem that is associated with not separating decision management from decision control, letting managers capture the governance process.  If that is where private equity is creating its value by correcting that problem, then they should not be creating their own organization in the image of the problems that they are solving.  So if I go public and access public markets and give my residual claimants no access to governance, I’m creating the problem that I made money solving.  It is kind of ironic and, again, represents not practicing what you preach, if you will.

So I’m going to end with just a plea or a call to the challenge and importance of education here because the not eating one’s own dog food is what people are going to pay attention to.  If you are worried about policy issues that is where the policy is going to get made, and it is going to be very hard for all of the carefully done scientific evidence in the world to overwhelm the apparent egregiousness of some of the breakdowns in a small handful of firms.

So it is really important that not just Wall Street and policy makers, but that Main Street understand what the value of private equity is, the role in reinvention and the role in routinization of the way to organize.  That it is not about markets and transactions; it is about organizations and relationships.  And it is really incumbent upon the profession to take that mission seriously. 

If you look at even a company like Blackstone, they directly and indirectly employ 300,000 people.  It is a huge organization with huge impact, and people do not understand that.  And so the one major contribution would be to think about how to get that message across so that the sector can continue to create the value and do the good work on the economic and productivity side that it has done in the past.

Peter G. Klein:  Good morning.  It is a great pleasure to be here and to comment on Karen’s presentation, which I found extremely informative.  I think she did a terrific job laying out the basic issues associated with governance, with private equity as an organizational and governance phenomenon.  I recommend that you get a copy of the slides if you can, and I found in particular her “bumps on the road” section to be extremely informative and provocative. 

As we move from yesterday’s discussions to today’s, we have a little bit more of a micro economic focus, looking inside the black box, so to speak, of the organization and governance of the portfolio companies, and to a lesser degree of the private equity firms themselves. 

Karen’s presentation emphasizes the links between ownership, governance and organization.   And sort of her main take-aways are these twin ideas, that buyouts are best understood as a kind of reinvention of the market for corporate control and a routinization of a particular process for reorganizing the firm to increase value.  I will come back to the routinization point in just a moment.

Again, just to recap what I found as the most salient points in Karen’s presentation, this redefinition or reformulation of the basic corporate control problem that the market for corporate control is best understood not simply as a competition among management teams for the right to manage corporate assets but, rather, a competition among capital providers for the right to govern the firm.  So there is a critical distinction between management and governance that is sometimes lost in the practitioner literature on buyouts.

What does Karen mean by governance rights?  In this context, the right to hire, fire and set compensation for managers; the right to veto or ratify major strategic initiatives, and the performance of particular kind of services.  Karen describes the general partners as internal consultants providing particular governance expertise to their portfolio companies.  Or to summarize, the way Karen leaves us that this new market for corporate control is ultimately about organizations and relationships, not simply markets and transactions, and not simply tax advantages, for example, although those clearly play an important role as she just emphasized. 

So just as Mike Jensen reminded us last night that the private equity firm or the privately held portfolio company is ultimately a kind of an organizational structure, not merely a firm that has been through a particular kind of transaction.  I think it is critical that we try to understand the private equity phenomenon in this organizational and governance context, not merely in the transactional context.

There is a lot of support, both theoretical and empirical, for the view that private equity has reinvented the market for corporate control, as Karen explains.  Just yesterday some of the theoretical literature was discussed.  If we try to conceive the basic corporate governance problem as a kind of multi-level principal agent problem that you have the agency problem between shareholders and the firm, which is mitigated by the [indiscernible] the board so the board acts as an intermediary helping to alleviate some of the agency problems associated with managers.  But then, we have an additional agency problem between the shareholders and the board, given that the board is easily captured by management, as Karen explained in her slide with those little circles and the slashes.

If you think of private equity as simplifying or streamlining this contracting problem by turning the ultimate owners, the equity holder from what Mike Jensen calls, “passive investors” to what he calls, “active investors,” giving them an active relationship in governing the organizations.  Now, of course, there are some additional complications as Josh mentioned yesterday.  There is a potential agency relationship between the limited partners and the general partners.  And as Karen has just reminded us in a few cases like Blackstone where you have public equity holders on the table as well, there is certainly a potential agency relationship there. 

But there is lots of good theoretical work beginning with the basic principal agent problem suggesting that the creation of active investors through private equity transactions reduces agency costs in organizations.

There is a lot of good empirical work that has already been discussed, much of it by Karen herself and by others as well.  Providing strong evidence that buyouts do create value and the way they create value is through organizational redesign and restructuring, things like governance by a small board, decentralization of decision making, performance measures that emphasize cash flow and stronger pay-for-performance relationships or sensitivity of manager’s compensation packages.

A couple of challenges or things that we might think about in moving Karen’s view forward -- one has to do with the idea that I find intriguing that PE companies add value by making this particular kind of reorganization process a routine; that reorganization can be conceived as a process or a capability possessed by some but not all private equity companies, or possessed to a greater or lesser degree by some companies.  As Karen explained -- mentioned referring to work by Steve Kaplan that this may provide a good explanation for the variation that we observed in performance across PE companies. 

As Karen said, not everyone can be Henry Cravis.  As Steve mentioned yesterday, empirically that we see a lot of persistence or clustering of returns across funds or across investments within particular P.E. companies.  So some private equity firms have figured out a way to do this better than other firms.

We should note sort of from a point of view of research design that when we describe the sort of explanation for differences in performance across P.E. companies, we really mean empirically that a sort of residual or kind of unobserved heterogeneity -- there is something about particular P.E. companies that we cannot quite put our fingers on that seems to make them perform better than others.  It is a residual, in other words; it is the part that we cannot explain by observable characteristics.

And that sort of suggests that it would be valuable to sort of flesh this capability out in greater detail.  In the management and strategy literature there is a great deal of emphasis on capabilities, routines, core competencies, and so on.  But the truth is we really do not understand them very well.  We have very weak micro foundations for the notion of the capability; it is something that we think we can identify when we see it but we cannot tell you exactly what it is ex ante, sort of like the famous definition of pornography. 

Can the kind of capabilities that Karen describes be purchased as services on the market?  If the ability to reorganize and restructure is ultimately a question of specific knowledge, as was mentioned yesterday, does that knowledge have to be bundled with a particular set of ownership claims?  Or can you simply hire consultants to come in and do these things? 

Mike Jensen mentioned last night that he has faced an uphill battle in trying to get public companies to adopt some of the organizational and managerial practices that are routinely imposed on portfolio companies by private equity firms.  Why is it so difficult to get public companies to do this?  In principle, consultants should be able to implement very similar kinds or at least some of the same restructuring attributes.

In other words, why not make what Karen calls “internal consultants?”  Why not make the general partners actual consultants simply by hiring them rather than giving them ownership claims?  Well, that suggests that there must be some relationship between management and governance.  In other words, the governance rights that Karen talks about must inextricably be linked somehow to ownership of assets.  This brings up the notion you get in Oliver Hart’s work on ownership as residual rights of control. 

In other words, in a world in which contracts are complete, if we can foresee possible contingencies and include them in contracts we designed, then, in principle, residual cash flow rights and residual ownership rights can be separated and these restrictions imposed on the managers of portfolio companies could be designated by contract.  The Hart model assumes a world of incomplete contracting.

In other words, there are particular contingencies that may arise but cannot be anticipated by the party’s drafting agreements, cannot be specified ex ante in contract.  Therefore, the role of ownership is to step in and fill in the gaps to make decisions under contingencies that were not covered by some prior agreement.  So I would be curious to hear Karen’s thoughts on how the governance rights that she talks about might relate to this notion of residual control rights under incomplete contracting.

Second point is when we look at the private equity company itself, we see some unusual characteristics of its portfolio.  Karen mentioned in the case like Blackstone and with some other firms, you have the problem that the P.E. company is not eating its own dog food, that it is not structured the same way it wants its portfolio companies to be structured. 

But sort of a related point is that, for example, P.E. companies are typically quite highly diversified.  This is some data that John Chapman and I collected a few years ago; this is data from 2000 on, certainly, a non-random sample of prominent P.E. firms.  As you can see, we counted how many portfolio companies they had.  This is a cross sectional analysis; this is in 2000 and how many different 2-digit S.I.C. industries their portfolio companies were in. 

As you can see, these guys are pretty highly diversified -  an average of about 15 and a half portfolio companies in some eleven two-digit S.I.C. industries where the average for public companies during this time is under three operating units or business segments and a little over one two-digit S.I.C. industry.  So P.E. firms tend to be much more highly diversified in the product space than the typical public company. 

Well, I have lots of examples, some of these from Karen’s own work.  It is sort of interesting as you look at the variety of different industries that some of the most important buyout firms have been in KKR [inaudible] counted 82 acquisitions in the late 1970s, 80s, and 90s and a huge range of different industries.

So one question this raises is:  Does governance routine or capability that Karen describes -- is a generalist skill in the sense that one does not need a great deal of operational expertise to pull it off?  It made me think of the old conglomerate-era management by the numbers technique associated with people like Herald Janine.  I did my dissertation research on conglomeration in the 1960s and sort of the conventional wisdom amongst scholars today is that the kind of unrelated diversification that proliferated in the ‘60s and early ‘70s on average did not add value to operating companies because there is a specific operational aspect to governance and management.      

If P.E. companies can do what they do, how is it similar to and different from the headquarters, the general managers of an old 1960s-style conglomerate - an ITT or Litton, or LTV?  Mike Jensen in his talk last night went over some of the key differences between a public conglomerate and a P.E. firm, but what strike me in looking at that comparison is not the differences but the similarities.

And there are many similarities that I think we have not tended to explain extremely well.  Is there a so called diversification discount, sort of a lively debate in the empirical corporate finance literature as to whether diversified firms traded at discount relative to more specialized firms controlling for selection and other complications? 

It would certainly be interesting.  And I have not seen anyone do this, looking for differences in the evaluation of P.E. firms themselves according to the degree of diversification.  And as Steve Kaplan mentioned yesterday that in the last few years, there has been a trend towards greater industry focus on the part of the P.E. firms themselves.  And think that is right, though I have not seen a lot of systematic evidence on this.  I think this overall question of to what degree operational expertise is required to make this routine of reorganization successful is an open question that deserves a little bit more research. 

Finally, going back to this question of whether public companies can adopt some of these features without themselves going private, one could imagine sort of a hybrid form of public company that has a small headquarters that gives managers substantial equity stakes in which the central management can somehow credibly commit not to subsidize across operating units.  One could imagine decentralization and appropriate performance-based compensation, and so on.  A public company that has a lot of private equity portfolio company characteristics. 

Mike suggested in his talk last night that the ultimate barrier in making that work is that CEOs in public companies do not want to have a boss and that is clearly an important barrier.  But one might also wonder:  Are the kinds of governance characteristics that we are describing and ownership in Oliver Hart’s notion of residual rights of control inextricably linked, such that all of these attributes go together in a bundle or a syndrome.  One cannot pick and choose just a few; one has to have all of them to make any of them work.  If so, then actually going private is the only option.

Okay, I will conclude with just a couple of comments about the relationship between the phenomenon we have been describing and entrepreneurship.  The term “entrepreneurship” has come up several times in our discussions.  I have been doing some work on entrepreneurship and innovation in recent years and I have the impression -- my sense is that the academic literature on entrepreneurship and innovation tends to focus too narrowly on the start-up company as the locus of entrepreneurship, and on a particular form of innovation, on technological innovation measured by patents and so on, rather than organizational innovation. 

On the other hand, when one looks at the classic contributions to the economic theory of entrepreneurship from Joseph Schumpeter, from Frank Knight, Israel Kershner [phonetic] and others, one finds a much broader notion of what the entrepreneurial act ultimately consists of.  If we think of entrepreneurship more broadly not as an occupational category, i.e. self-employment, nor as a particular firm or market structure - small firms, new firms - but rather as a function such as the bearing of uncertainty, the creation of innovation, alertness to proper opportunities, and so on, a function that is manifest in a variety of forms, not only start of the --establishment of new ventures but also the creation of new organizational forms, such as the P.E. Company itself. 

And this is something that John Chapman alluded to in his discussant remarks yesterday.  Though we can think of the private equity phenomenon, the emergence and establishment of this particular means of reorganization that Karen describes as itself an entrepreneurial innovation, a form of entrepreneurship that has added tremendous value to the economy. 

So thinking about it this way, emphasizes that we should look at governance not only at the level of the portfolio company and how the P.E. firm governs its particular holdings, but also at the level of the P.E. Company itself.  How is the P.E. Company structured and governed?  And it makes us think more broadly about the relationship between entrepreneurship, broadly defined, and the ownership that control of assets. 

I have a book coming out with Nicolai Foss next year on the relationship between entrepreneurship and the economic theory of the firm in which we argue, following Frank Knight, that entrepreneurship is always inextricably linked to particular rights of ownership over assets.  And then an entrepreneur is ultimately an owner and owners by necessity in a world of uncertainly must act entrepreneurly.

So I will close with that, thank you.

Alan Viard:  Annette?

Annette Poulsen:  I thank you all very much for the opportunity to be here.  I particularly thank John Chapman who has done an excellent job of setting up this conference today.  I came into this process because John asked me to talk about Karen’s talk, and Karen and Peter have both done an excellent job of talking about corporate control aspects and how the private equity process is changing that corporate control in portfolio firms.

If you look at the agenda for the day, the title of today’s topic was actually “Private Equity’s Impact:  Corporate Control, Capital Markets, and Entrepreneurship”.  So rather than spending too much time talking about the corporate control part that we have already heard quite a bit, I thought I would just talk a little bit about capital markets and entrepreneurship also. 

But to start of with corporate control, the eclipse of the public corporation was a topic that was broadly talked about in the late 1980s, and I think what we are seeing now is the modern eclipse of the public corporation that the process is still continuing.  There are lots of funds sitting in private equity firms that are able to go in and look at a corporation, decide if the organizational form that had existed for so many years was, in fact, the correct organization form.

So I think with these pockets of money or boatloads of money that are able to look at these companies, we are seeing companies that can go ahead and change that organizational structure as described by Karen and Peter and our speakers yesterday.  I think it is very -- I really liked Karen’s summary of -- this is about -- it is not about markets and transactions; rather, it is about organizations and relationships.  That what is changing is the organization; what is changing is the relationship, the way that the corporations are doing their business. 

Just a few examples -- executive compensation tied to shareholder value.  This is something that has been emphasized and emphasized.  We have seen it in the public corporation but in the private corporation [indiscernible] able to move more directly to tying that executive compensation, an important aspect of what the P.E. firm is able to do.

Changing the board of directors -- so many studies have looked at boards of directors.  How involved are they in the company?  The directors are in six different boards; are they really involved?  Are they doing what needs to be done for that corporation?  When we have the private equity firms get involve, we see those direct investors on the board of directors; they are there at the meetings; they are participating; they are at the company more often; they are actively involved in the business activities. 

This has got to help with the organization -- Mike last night talked about that the CEO now has a boss; the CEO works for the board of directors rather than being the chairman of the board and the de facto board by his or herself.  So that is an important part of what is going on.  

And then it is not really the financing, the private equity, that is the key here; it is the involved nature of the new management team.  That capital is an important part of it but it is not the fact that it is private capital.  There is nothing distinct about private capital; it is rather that the organizational form has changed.

Karen’s evidence from the private placements of equity by public firms is a very nice complement to those private equity literature.  We tend to focus on the buyouts and that is clearly an important part.  But we can look around the financial sector and see other instances where the direct tying of the buyer’s relationship to the firm’s performance and showing that the related buyers, the ones that have a direct interest in the company -- that is where those performance improvements occur is very important.

Moving away from the corporate control, though, the capital markets have greatly benefited from the existence of the private equity firms.  The idea that the capital is out there for innovation, for entrepreneurship, the huge pools of money that are now available for new enterprises, for new technology, for entrepreneurship is clearly an important development that has come with private equity.  We spend a lot of time talking about corporate control but we cannot ignore that the financial markets and, therefore, the innovation markets are benefiting greatly from this phenomenon. 

This is the alternative source of capital, more than 500 billion dollars in private equity in 2007.  And with that private equity, we are getting the anxious vigilance; we are getting the routinization of how to run these firms.  So it is a huge part of what is going on in private equity that I do not think we have talked about too much.  Just the idea that if we have well-working liquid capital markets, we can do more in this country.

The private equity markets -- in some sense, we talked about Sarbanes-Oxley and trying to get out of the public market to avoid the regulation.  Being a former SEC economist, I know that that regulation can be burdensome.  But what private equity funds allow the investors to do -- they are investing in funds that are somewhat outside of the SEC regulation but it does not necessarily mean that the buyout firms are also outside of that regulation.  We have done some analysis looking at companies that have been bought out or companies that have gone private, not necessarily through private equity firms but have taken themselves out of the public equity market.

And you get into the question of what defines a public versus a private firm, if we say a private firm is one that does not have public equity, okay, that is one definition.  But we find that about 25 to 30 percent of the companies that go private, in a sense that they retire the public equity, whether through a sale to a public equity firm or just going dark, 25 percent of those companies are still filing SEC documents. 

So the private equity phenomenon is not necessarily about avoiding regulation.  There are still many firms; Toys “R” Us is still filing their 33 and 34 Act disclosures every quarter.  So the data are still there for many of these companies.  Not the data - that is the economist/academic talking - but rather, the regulatory burden is there for these companies.  They have not totally escaped that.

Private equity is taking an increasing role in the takeover of public firms.  In 2003, eight of 128 takeovers of public firms and that is defining them from SDC, at least $50 million public equity.  By 2006 that number had gone up to 52 of 222.  So the PE firms are there in the takeover of the public firms, and this is another point where the policy makers have started to get involved.

Yesterday, I think Josh mentioned the Department of Justice.  Is there clubbing?  Is there some collusion going on in the bidding for public targets by private equity firms, especially for the very largest takeovers of public companies by private equity firms?  We are seeing two or more private equity firms getting together and if you just simply look at the premiums that are paid for the stockholders in those companies, there is, in fact, a slightly lower premium than in other takeovers. 

Then, of course, the question arises:  Is there a collusion?  Colleagues of mine, Harold Mulherin and Audra Boone, have looked at some of these data and have found and confirmed that, yes, those premiums are somewhat lower.  But, in fact, once you control for the size of the target, for the industry of the target, for news releases before the target acquisition, that those premiums are essentially the same as in any other market.

So this is one of the ways that the Department of Justice or that the political machine can turn against private equity.  But if you look more deeply at the facts, you do not really see the evidence that there is collusion amongst these firms.

I think an important part that we have not talked about too much either is the role of private equity internationally.  That if we look at the developing markets, emerging Asia had 62 percent of the funds in private equity in 2006 were targeted towards developing countries.  And it is very important to get the capital there; it is a valuable source of capital for these firms.  What private equity can do is to help develop these international financial markets.  It is clearly important for the development of China, for the development of Brazil, for the development of Russia, to have well-functioning capital markets.  There is evidence that privatization of state-owned enterprises have helped to develop those markets. 

Private equity coming into these markets is going to encourage better exchanges, other markets, encourage liquidity in international markets.  It is going to encourage those governments that they want to have economic development to improve the rule of law, to improve the transparency of the corporate governance and the international markets.  So this is another valuable benefit that is coming along from private equity.

The third point that was in the title of our agenda for this session was entrepreneurship.  I think, again, Peter and Karen have talked about that very eloquently.  But just the idea that the PE firms are again going in to buy these firms, to sell them or turn them around in some way, that they are renovating, reorganizing, reenergizing, incentivizing management, streamlining, figuring out what you need to do to make these companies be more productive.

Yesterday, we talked about the industry specialization, the in-house consulting, the organizational engineering; all of those aspects are going to into the entrepreneurship that comes along with the PE firms.  I think Peter’s data on the diversity of the holdings of the buyout firms’ portfolio is very interesting.  We will see how that plays out.

At the bottom line, we have got this importance of the IPO market.  If we are going to turn around these firms, most of these buyout firms will be looking for the exit strategy.  Is it selling in the IPO market?  We have to keep our markets liquid and well-functioning to have that market work?  Or are we looking at selling to another company, selling to another PE firm?  Whatever, we have to get that turned around.

Basic strategies of the PE firms -- it is the concepts from every MBA class - use debt, watch cash flows, streamline the company, figure out what works and do it.  It is not rocket science to put it up on a slide; it is probably rocket science to get into the firm and do it and that is what the PE guys are helping us figure out.

In private equity markets internationally, again, the private equity is probably a little bit more like venture capital rather than traditional private equity going in and helping the starting firms.  But that is going to be very valuable.

So overall, private equity’s impact - corporate control, realignment of incentives, the routinization of the process, the idea that these are professionals coming in and running these companies.  Capital markets - raising capital in both the United States and overseas; helping to develop the capital markets, especially, overseas, I see that as tremendous impact to private equity.

And entrepreneurship -- we are going to have that emphasis on value maximization that needs to be there.  Thank you for your time.

Alan Viard:  Karen, if you would like to take 60 seconds to make a quick response, then we will get a few audience questions.

Karen H. Wruck:  I want to talk about Harold Geneen just for a minute because his name came up.  I think it is worth mentioning that the -- at least from my view, the organizational capability that I’m talking about is a general skill in the sense that it applies broadly to a wide variety of companies.  But I think it is worth noting that it creates value because it is the antithesis of the world of Harold Geneen for at least three reasons: One, because there is no cross-divisional [sounds like] subsidization. 

The second is because there is no horrifyingly painful and corrupt annual budgeting process of target setting and sandbagging.  Thirdly, because there is a serious degree of equity ownership and strong governance involved.  So it looks nothing like Harold Geneen and ITT managing by the numbers, and the fact that it does not look like that is where a lot of the power comes from.

Alan Viard:  Okay.  Let’s take audience questions or comments at this point.  If you can wait for the microphone to be brought to you, and give your name and your affiliation -- also, anyone over towards that end of the room, you may need to walk over into this section to make sure that I can see you.

Mark Wilser:  Hi.  It’s Mark Wilser with Global Capital Markets.  Karen, I found your data on the private placement and PIPE returns quite interesting and the fact that they were pretty negative in a six-month timeframe.  I was wondering whether there were any data that related to returns upon realization. 

The reason I ask that question is because most of these investments take place in non-common-stock-type formats.  So you have a whole bunch of attributes that are what I’ll call protected and preferred returning characteristics, liquidation preferences and the like that I think would enable them to, upon exit, probably have much higher returns than would be apparent if you look at them just after six months, and the presumption being that they had common-stock-type investments.

Karen H. Wruck:  Yeah.  A couple of things -- the returns that I presented were returns to the public shareholders after the placement was made, so they are not the returns to the investors.  So you do want to make that distinction if only because a lot of times, the investors get a different price than the market price; the shares are sold at a discount so the return to the investors is going to be higher.

It also focuses on a historic time period where the modern PIPEs are not really in the sample.  So the historical facts about private placements of uncommon stock is really -- the only place you can get the data in terms of performance are positive response to announcement, really negative post placement returns.  Whether that turns out to be the case in the more recent era of PIPEs, I think, is an interesting question.  I do not know of a study that tracks the non-common stock investments, but I agree with you that may be a different picture.

Tully Friedman:  Tully Friedman, Friedman Fleischer & Lowe.  Karen, I thought that was a very good presentation.  I think based upon a couple of decades of experience, I agree with the bulk of it.  There was one point you made that I think I do not agree with, which is your notion that recaps and IPOs somehow violate the model or violate the compact.  The deal is investors, you have private equity [inaudible] money; it is locked up for 10 years and the idea is to balance risk and return and get appropriate returns.  Recaps are part of that.

So I’m going to take it in pieces.  So two, three, four years into an investment, in our case the company has improved.  There is an ability to raise additional debt or recap existing debt and add some, and it makes sense.  That does not change the risk-reward profile in terms of how we think of our ownership.  It does take money off the table.  Yeah, it buffers the risk but there is nothing wrong with that; it is part of the deal. 

Taking it public actually is worse than you think because, guess what?  We are on our way out.  We are working as hard as possible, as fast as possible to get 100 percent liquidity but I do not think that is a violation of the model either.  I think that is part of it.  So either explicitly or implicitly, you present this as a negative series of actions.  It is intrinsic to the business, and neither the LPs nor the GPs would view it as unusual or wrong.

Karen H. Wruck:  My position would not be that it is wrong in general, but that it is dangerous in the sense that you can on the margin really have some issues with having cashed out your equity position, leaving the carcass of the firm to the banks if the firm collapses.  Whereas if you have money on the table, at least it is there if something happens in the extreme.  So I understand access to liquidity is important, and that is a way to get access to liquidity and to get out of the investment.  But I think there is an incentive concern there.

Tully Friedman:  Well, I agree with that statement, but it is a real value judgment that does not comport with reality.  You took Burger King.  So the recap if they take it public, they only have 58 percent of the company left.  I guess if they got down to zero, it would be really bad.  It is just not the way things work.

Karen H. Wruck:  In what sense?

Tully Friedman:  The deal is not that you are locked in indefinitely to take the risk.

Karen H. Wruck:  I know.  I understand.

Tully Friedman:  The deal is you do whatever you do for a set number of years.  You deliver to your investors, hopefully, what they expect.  You take a return yourself and then you go on to the next thing.  So there is this very explicit, I guess, idea that there is something wrong with that.  I do not understand -- I hear the words; I just do not get why that is--

Karen H. Wruck:  Yeah.  Well, would you agree -- so let’s see if there is a class of situations where we would agree that it was a bad idea.  So, for example, if you were in a world where the equity were overvalued and you were borrowing and paying out cash at too high a price, would you agree that was problematic?

Tully Friedman:  Yeah, but that is a risk you take.  Whereas, when we look at it we essentially re-underwrite [sounds like] the position; think about what the business will do over the next five years; think about a sensible level of debt.  And then if it makes sense, we will recap it.  We do not say, “Hey, the lenders will lend us too much.  Let’s go out and get as much as we can and the devil take the hindmost,” which is a situation you are talking about.  But, yeah, I would agree with you.

Karen H. Wruck:  Okay.  All right.  So we can agree on that small subset.

Tully Friedman:  Yeah.

Karen H. Wruck:  I understand.

Tully Friedman:  Okay.

Karen H. Wruck:  I understand your point.

Tully Friedman:  I understand your point.

Karen H. Wruck:  I’m concerned.  Okay.  That is fair.

Alan Viard:  We have time for one last question.

Male Voice:  Just a shortcoming.  It seems to me that the issue here is not the recapitalization and taking down the equity; it is taking it out in a way that is not proportional to all of the equity interests.

Karen H. Wruck:  But he does not do that.  That is [cross-talking].

Male Voice:  I understand, but that is what I heard Karen objecting to most strongly.  And that is a really big deal.

Alan Viard:  Well, I do not think we have exhausted everything that could be said about this important topic, but we have exhausted the time that has been allotted to us on today’s tight schedule.  So I hope you will all join me in thanking the panel.

Panel Four:  European and Global Developments in Private Equity

Nick Schulz:  Good morning.  Thank you for joining us today.  My name is Nick Schulz.  I’m a research fellow here at the American Enterprise Institute.  I’m also the senior editor of AEI’s flagship business and economics magazine, so I’ll give a plug for that right now; it is called The American.  We should have copies widely available around here.  So while you are here enjoying the conference, if you would like to pick up a copy, please let me know or let any of the AEI staffers know.

I’m delighted to be moderating what will be, I’m sure, a most interesting panel today.  Our focus at this conference yesterday and the first part of today has mostly been about the domestic private equity industry.  But now we want to take some time to turn our gaze overseas and we are gathered to discuss European and global developments in private equity.

We are happy to have with us today as our presenter, Mike Wright.  Mike is a professor of financial studies and director of the Centre for Management Buy-out Research at Nottingham University Business School.  He has written over 25 books and more than 250 papers in academic and professional journals on management buyouts, venture capital, corporate governance and related topics.  He served two terms as an editor of Entrepreneurship Theory and Practice and is currently a joint editor of the Journal of Management Studies.  Mike, thanks for being with us.  I’m going to introduce our other guests first before calling Mike up here.

Our discussants today are David Ravenscraft.  David is the Julian Price Distinguished Professor of Finance at the University of North Carolina Business School.  He is the associate dean of the Bachelor of Science in business administration program and the former associate dean of OneMBA, the innovative global executive master of business administration program offered in partnership with top schools in Europe, Asia and Latin America.  Mr. Ravenscraft’s research interests include mergers and acquisitions, antitrust, game theory and hedge funds.  He has served seven years at the Federal Trade Commission.

After David, we will hear from Adam Lerrick.  Adam is a visiting scholar here at AEI and a Professor of Economics at Carnegie Mellon University Tepper School of Business.  He is studying international capital markets, particularly the role of hedge funds, international financial crises, sovereign debt restructuring, and economic development, including the impact of aid and the role of multilateral institutions. 

Adam is an adviser to the Congressional Joint Economic Committee.  He served as the senior adviser to the chairman of the International Financial Institution Advisory Commission where he analyzed the workings of the World Bank and reassessed its role in the global economy.  Previously, he was an investment banker with Salomon Brothers and Credit Suisse First Boston.

Just a quick note about ground rules before we get going, Mike will present for about 20 minutes followed by 10 minutes or so of discussion from David and then another 10 minutes or so from Adam.  We have a very tight schedule so we hope once that is said and done, we will have some time for Q&A.  With that, Mike, the floor is yours.

Mike Wright:  Okay.  Nick, thank you very much.  Thank you for inviting me.  Thank you, John, for organizing this splendid conference.  To speak for 20 minutes about the globe is a bit like Monty Python summarizing Marsel Proust in two minutes, but I shall attempt to do that.  This is the history of the universe in 20 minutes.

There is a paper that is based around this.  You will see our website address on the slide there.  The lengthy version was a report we did for the OECD, which you can all get from our website or from the OECD website.  And there is a more focused presentation that, if you want, I can send it to you. 

Just a very brief word on those; I’m not going to into detail.  We have been around since 1981.  We organized the first conference on buyouts in the U.K..  In those days, my head of department told me - he is a very junior faculty member - that I was wasting my academic career on this.  So I followed his every word, as you can see.  In those days, it was very much saving jobs and entrepreneurship in the U.K. context.  So how we got to this, I do not know.  But we have a database of over 25,000 buyouts, and that is what I’m going to try and base my talk on.

I’ll kick it off with some discussion of international trends, just basic numbers and values and where these deals come from because I think it is useful to see some contrast with the U.S. position.  I’ll say a little bit about the structuring and pricing as well as changes in types [sounds like] of exits.  We have been mentioning IPOs and the exit form [sounds like] the last day or so.  In Europe, an IPO on exit [sounds like] is pretty remarkable.  Then, I’ll look at some of the evidence and draw some comparisons relating to some particular issues that have exercises [sounds like] in Europe.

As you know, it has become a worldwide phenomenon; we have done this various work on summarizing that as I mentioned.  Much of the debate of the European context has been based on some pretty, shall we say, unusual anecdotal examples, some of which have been somewhat misrepresented even as regards the employment factors.  We have had locus [sounds like], as we heard yesterday.  We have had unions parading in front of the church with the head of Permira with a camel and a needle - make you work out the biblical reference there. 

I believe a firm in Germany has a crucified locust hanging outside its factory gate.  The chairman of the TUC in the U.K. has referred to private equity as amoral asset-strippers; amoral is probably better than immoral, so that is all right.  We had a senior executive of one private equity firm boasting that he paid less tax than his cleaner which goes down to British history as a [indiscernible] moment which I can explain later on.

So in that context, let me try and get a handle on some of the recent evidence.  You can see from the charts, the top one is the U.S. numbers of private equity in buyouts; the bottom one relates to Europe.  And you can see that the value chart which is the black line follows a similar kind of pattern.  The numbers, again, have been growing over the last few years.  But it is this last year that is most important.  The numbers do not fall off the cliff because it -- has fallen off the cliff; it is just that it is the first half of 2007.  If you actually take it to the end of 2007, the total will be bigger than last year.

Within Europe -- and I’m afraid from a distance that is probably quite difficult to see the chart.  But we see a considerable variation between countries; the U.K. is by far the largest.  And I think for this purpose I’ll assume that we are part of Europe, although do not quote me in England for saying that.  Within Europe then, we have France and Germany and the Netherlands as pretty significant markets.  But then, as my soccer team did last week, it fell away from home, and the numbers fall away after that.

The bottom chart, I think, is quite interesting because it shows that while we have some pretty big economies like Germany, Italy, Spain, the size of the buyout markets are relatively underdeveloped given the size of the economy.  In some other countries like Netherlands, Sweden have rather more developed markets.  Denmark, which [inaudible] small economy, seized a few big deals and that changes the rankings.  So it is a picture of undeveloped markets, institutional constraints affecting some of those factors.

Nevertheless, we have seen this big increase in large deals over the last decade.  The data we put together gives you some idea of how these -- for this purpose, 500 million euros, we would describe as big in a European context.  You can see how that has grown.

Just to try and encapsulate the whole raft of factors influencing the emergence of the market, which are in the papers, you can see that if you take a 20-year run, then it has been a gradual process of erodings [sounds like], if you like, some of the resistance to private equity deals in terms of the deal supplier at the bottom, encouraging people to consider succession in family firms, which is a big issue in Europe I have come on to.  Privatization, particularly in the U.K., and then stimulating the demand but it is the willingness of managers to buyout these firms.  There has been a considerable resistance until fairly recently in some countries, Germany being a particular example.

Then, you can see at the top there is a whole raft of relaxations of regimes to facilitate these transactions and to deal with the incoming [sounds like] of debt and so on and so forth.  This kind of concept - this [indiscernible] context and notions of locusts and so on in an environment where there has been a traditional resistance perhaps to the market for corporate control, let alone venture capitalists and private equity firms.

Again, just where these deals come from -- again, this is probably difficult to see at a distance but the most important source of transactions in Europe are either from succession in family firms or private firms or divestments by corporate groups in numbers term.  In value terms, divestments from corporate groups become most important.  The small number of public-to- private transactions which has been increasing becomes important.

But what has really emerged - and we have not talked about this really - is secondary buyouts have been one of the most important source of transactions in the European market.  So you do the first private equity deal.  You then re-leverage [sounds like] it with the first private equity firm exiting and another one coming in.  I think that is also pretty important in the U.S. as well and that, I think, raises particular issues about prolonging the private equity model.  It also raises issues about how you continue to get the gains in those transactions.  I’ll come back to that.

These four charts just give you an idea of the growth of public to privates globally.  The top left is the U.S.  The top right is the U.K..  Then, bottom left, Europe and then the bottom right is Japan, which, perhaps, surprisingly, has seen these public to private equity transactions.

The European context there, again, is pretty erratic perhaps because big capital markets, stock markets, rather than develop compared to, certainly, the U.K.  If you actually went back, it starts in 1985.  In fact, if you think this is a recent phenomenon, if you actually go back to the 19th century, you can identify public to privates, but that is another story.

The pricing and structuring-- what we have seen -- this is European data.  In the top and in the bottom in terms of structuring is a general trend over the last 16 years in pricing multiples.  I have shown there that -- what we call the mid-market and the upper parts of the market; the red line is the mid-market.  [indiscernible] really too much about the precise figures, but pricing multiples have increased by probably between a third and a half over that period.

The structuring -- the leverage part of it is very much in the European context focused on these larger deals where we see probably two-thirds to 70 percent debt in the structures.  If you go below that, then the debt is probably around about 50-55 percent.  So it is quite a different market.  That is important to bring out that we have quite a segmented market between these very few large deals at the top 10 and this raft of several hundred at mid-market transactions.

[indiscernible] I touched on a few minutes ago.  The top charts break it down by five-year periods from the mid ‘80s.  You can see that there has been quite a shift in exiting patterns over that period.  The IPOs in the U.K. [indiscernible]  in the mid to late ‘80s, we saw a lot of IPOs and buyouts, mid-market deals and so on.  By now, the current period, very difficult to IPO a buyout.  They do occur but very few of them in the European context.

Strategic sales -- pretty important, as you can see; in fact, the most single important source.  But what has come through from being fairly obscure in the mid-‘80s are these secondary buyouts.  Private equity firms selling to each other.  That is emphasized by the bottom chart where, again, you can see this growth, not just in trade sales but secondary buyouts and the IPOs are virtually disappearing.

Just a very quick thumbnail sketch of the market.  Let me just try to say a little bit about some of the evidence from a European context.  You can perhaps relate that to some of the evidence that Josh and Steve were presenting yesterday, primarily in relation to the U.S.

From a funds level basis in terms of returns, there is rather less evidence in Europe.  But what evidence there is broadly tends to confirm this notion of the experience of fund managers being extremely important in driving the returns.  But within Europe and further afield, the returns [indiscernible] the coming that -- then you get returns depending on the strength of the legal conditions in different countries.  So all markets are not created equal in that context, and that feeds back to what I was saying earlier about the growth of the markets which these legal factors which determine access to information as well as getting security and enforcement of contracts and so on do very quite considerably across markets.

Looking to public to private conditions then, the premier that we are seeing is pretty much in line with the U.S. figure. But we do see a little bit of difference in some of the rationale.  Undervaluation, in particular, is being seen as one of the major factors driving the public to private activity, both the premier and the rationale for going private.  What we see is that although the board composition of outside directors is not out of line with companies that remain on the market, we do see less separation, if you like, more duality of the CEO and the chair. 

This is a corporate governance issue, and that is associated with higher CEO stockholdings prior to the buyout and more significant outsider block holdings.  Part of that, I think, is a frustration on the part of institutional investors investing in firms with relatively illiquid markets in those shares and the private equity deal is a way to get out, and so on.

What we also see is that these deals have better asset collateralization, less debt prior to the deal, and to be more diversified.  But not in the U.K. context [indiscernible] R&D expenditure.

Profitability and productivity -- again, like the U.S., studies generally, we see this growth in profitability and cash flow post [sounds like] the transaction.  Industry specialization and deals specialization or deal experience by private equity firms driving some of those deals - both the study by Bob Cressy there and also some of our own work tends to support that.  And that term is not just in the U.K..  You see that elsewhere in Europe, in France and the Netherlands.

Doug mentioned in his discussion yesterday the study we did on productivity.  But just to emphasize, we see the significant increase in productivity.  Entrepreneurship was mentioned quite a bit in the last session.  Entrepreneurship, to my mind, is an [indiscernible] ET&P tells me something about not just value creation but value creation through innovation and product introduction and so on.  I think it is sometimes forgotten that in buyout private equity deals, it is not just about improving efficiency, but you do see evidence of new product development, new market development, that could not have occurred prior to the transaction.

We did some work back in the ‘80s, and there is some American work in the entrepreneurship literature on that.  More recently, we also see this improvement in new product development.  That is important to generate some of these gains as we are now late in the maturity of the industry when perhaps cost efficiencies perhaps cannot deliver the gains that one is looking for.

Employment and wages -- this was again referred to yesterday.  I think that the key point here, particularly [sounds like] points first of all is that in the U.K., we tend to see an initial dip [sounds like] in employment in the first year after buyout, and then a recovery.  I think the data that Steve Davis was showing, you tend to get this longer delay before you get to recovery.

Secondly is this importance of recognizing the difference between insider-driven buyouts, management buyouts, and outsider driven deals; what we would call the management buy-in, where the circumstances leading up to the deal are quite different.  I think it is very important to understand the debate to key into that difference, which may be a rather abstruse notion.  But we did manage in the U.K. to get radio and television programs to actually be making this distinction to get away from the rather lurid claims that all private equity is bad for employment.  I think it then began to realize the world growth stories that were restructuring stories.  And it was that [indiscernible] to understand what was going on behind them.

Exited deal returns at the firm level -- Ernst & Young just published a study on some of the larger exits showing the growth.  We also did a study based on all the exits we could identify from our database, looking at both the equity return and the enterprise value return.  Even at the enterprise value return adjusting for stock market changes, we do see quite a significant return.

IPOs, not surprisingly, outperformed.  The secondary buyout returns were the worst of the three forms of exit, perhaps illustrating that whilst these have grown quite significantly, generating those actual returns once the first round investors have been there is quite difficult.  Larger deals, that is important, and management equity stakes being very important in driving those returns.  There is upside incentive on management.

We have not heard much about the failure risk, although [inaudible] to talk about.  From our data, about 12 percent of deals have ended -- in the U.K. we call it receivership or the bankruptcy process over that period.  The peak here for deals completed but then failed was the late ‘80s, which was the last boom and where there were a lot of high-priced deals done and so on.

We did a separate study and we find that high leverage is associated with a higher probability of failure.  And then in terms of looking at what the secured lenders get out of these things when they went to bankruptcy, on average they get about 62 percent of their secured loans back, but yet, 30 percent of these deals are sold as going concerns.

[indiscernible] accusations that have been made about private equity is that they are just short-term flippers of assets.  What we see from this data from our database is that if you take a 20-year run, on average the average exit time is for those that have exited somewhere between four and five years and on average that has been increasing over time.  In the late ‘80s, there was a much shorter period to exit.  That is on average. 

Clearly, some deals do exit quite quickly, and some take a much longer time, but it is very difficult to sustain this flipping argument, as one might say.  It is the IPOs that tend to exit sooner.  The secondary buyouts take longer as at the bottom chart.

The amoral asset stripper bit -- if you actually look at the amount of partial sales activity both in the U.K. and Continental Europe on this chart, then the number of partial sales -- obviously, it occurs.  You can see there is quite a bit of activity, but compared to the overall new transaction activity that is going on, then it is actually a relatively small part.  So there are certain parts of the sector you see it once you get into the mid-market, then there is relatively little asset restructuring in this context.

So just to finish, if I might just summarize some of the key differences in the U.S. context versus the non-U.S. context, I think in the U.S. one can portray it as public to private large [sounds like] divisional [sounds like] deals.  In Europe and perhaps elsewhere, buyouts of family firms and mid-size divisions have dominated the market, although at the top end we see that changing.  U.S. has matured but elsewhere, considerable variety. 

The premier in public to privates in the U.S. reflects the different factors compared to Europe.  Undervaluation has been a much more important factor with much larger equity stakes held by management.  There is some evidence in the U.S. that distress costs have frustrated deals going private.  Evidence from the U.K. suggests that it is almost the opposite, restructuring troubled deals.

In terms of productivity, evidence from Don Siegel and Frank Lichtenberg a few years ago suggests that prior to the deal, productivity in U.S. establishments was not underperforming.  In the U.K., we see this underperformance at that sector.

There is a lot more debate about the CAPEX R&D picture.  In Europe, I think because the industry is traditionally being seen as part of the venture capital industry and perhaps because we have relatively little venture capital, but [indiscernible] been aligned with that industry, then I think we have seen generally lower leverage, more upside growth attempt, particularly in divisions that have been frustrated by their former ownership.  So I think we tend to see a more general growth story.

The employment effect, I mentioned -- important to appreciate this difference.  The second is longevity; it is heterogeneous in the two countries, U.S. and elsewhere.  I think the secondary buyout route is becoming one of the most important factors, which raises a number of issues both for private equity firms achieving their returns.  I think it also raises issues for LPs investing in the -- one fund invests in the first deal and then invests in another fund that invests in the second round deal. 

And that raises certain issues about returns and pricing and so on, which has perhaps been on the scope of what I wanted to say today.  But for the market going forward and sustaining the market, then I think there are also some issues there that we have yet to work through.  So I’ll stop there.  Thank you for your attention, and I’ll take some questions.

Nick Shulz:  Thank you, Mike.  Thank you for your brevity.  Next, we have David Ravenscraft.

David Ravenscraft:  Thank you.  It was a pleasure to read Mike’s paper; I have been a fan of his work for a long time.  There is really no one more qualified to look at global private equity than Mike.  It is a wonderful paper.  I encourage you strongly to read it.  It covers three decades and many countries, and it has more tables than most empirical dissertations I have seen.

The fundamental conclusion you get from it as you read from it is that - and Mike talked about this - private equity is very heterogeneous.  I agree with that; I think it is well supported in the paper.  What is a little disturbing about that conclusion is that it is very understated.  Just look at the main research tables where he summarizes 46 non-U.S. studies; 35 of them are from the U.K.; five are multi-country studies pretty much dominated by U.S. and U.K.; six are from Australia, Holland and France.  So only six out of the 46 do not involve the U.S. and U.K., and yet we get a tremendous amount of heterogeneity.  Just imagine what we would get if we studied the whole world because the part he is talking about is not that different compared to Asia and Latin America.

So I think the first thing that comes out of the paper is there is really a need for more research in Latin America and Asia.  And if anybody in this room can do that or could help researchers do that, I would strongly encourage you.  We have a huge need there.  My concern is that if we do those studies, we are going to find that the world is more heterogeneous.  Then, you begin to say, “What can we say because this study says that and that study says this?”  And it starts getting confusing. 

I think, the more complex the world is, the more our job is to try to simplify it; if things were simple, we can make it complex.  But this is very complex.  So I think that is our job - it is to try to make it a little more simple. 

I read through the paper trying to get out some of those more simplistic ideas.  I think one of them, if you just look at the data that he gives you across countries, you get that buyouts come in waves.  You have seen that data here with the United States.

I think he gives a lot of reasons for it but I would like to summarize it more simplistically.  It is really availability of funding, the need to restructure and changes in government policy that drive those ways across different countries.  The latter one, changes in government policy, I think, is very important for this conference.  If you look at the data, it strongly suggests that government policy can affect either positively or negatively private equity deals.  It is a little disturbing that is true because you would hope they were a little more robust, but I think that there are two reasons. 

One, a lot of times the public policy focuses directly on private equity; it is very targeted.  Secondly, private equity involves a lot of leverage.  If you have ever done valuation with a lot of leverage, a small change in the cash flows can make a huge difference in the returns.  So I guess it is not surprising that government policy really affects private equity.

You should talk about the idiosyncratic patterns as well.  Privatizations [sounds like] are certainly an [sounds like] aside [sounds like] to say that is a driver.  What ends these waves is, I think, equally simple.  It is a reversal of these factors that started as well as recession, and recession is really the key.  You see a lot of them just drop off when you hit a recession.

I also think there are some universal findings.  One of the ones that is most important that you heard Steve Kaplan emphasize, and Mike emphasize to some extent, is that pretty much across the board, you see improvements and post buyout performance.  I think that is a very important and powerful conclusion.

The problem is -- that I just said and Mike said -- everything is heterogeneous.  Then, we say, “It is all good.”  That is a little bit bothersome, so how do we interpret that?  One way is the heterogeneity does not matter and buyouts just find a way to work.

The other extreme -- and I do not know if this is a right interpretation, Mike, of what you said last night.  But there is a lot of things that LBO companies get right, and it is really the whole package that matters.  That is the other extreme but, obviously, all countries do not have the whole package.  So I think that somewhere in between, and what I would like to see a lot more work on, is what buyout characteristics really matter.  What is really important about Mike’s paper is it provides the foundation for that.

There are a couple of studies in there that actually address that directly.  For example, the one that shows the relationship between legal structure and return is the kind of thing I really would like to see a lot more of.  For example, throughout the paper, it is just -- here are these differences between these countries.  And I kept saying that is interesting, but does it matter?  Is it important?  To me, “does it matter” means, “How does it affect performance?”

So I have that particular bias.  But one of them that was striking is that in Europe, private equity tends to be more associated with banks and insurance companies than independent companies as in the U.S. and U.K..  I got to believe that one matters, and that performance is going to be different between those kinds of buyouts.  That is the kind of stuff I would really like to see Mike’s paper taking and focus on those key differences so we can understand what types of characteristics matter with respect to buyout performance. 

John Chapman asked me to make comments on the paper and also make some general comments.  I think part of it was he was hoping that I would spend a little time to represent the anti-buyout perspective.  I have historically been associated with the anti-merger perspective but the truth of the matter is if you go and look at my work, it was that conglomerates did not work, which I think is now well-accepted.  Unfortunately, I told John -- I said, “My work on buyouts would be along [sounds like] in the 1980s.”  It was generally pretty positive on buyouts.

I think I would like to take -- attempt [sounds like] at that anyway.  I should say that I think from Josh to Steve to Mike’s talk last night, to Karen’s, there has been a lot of balance there, a lot of, “Here are some concerns as well.  This is what is working.”  But I have some real concerns with them, so maybe I’m just adding to those list of concerns.

The first one I do not think got enough attention is that, yes, post buyout performance improves but maybe much of the evidence suggests that that is only short-term, that those performance improvements decline over time.  To some extent, if you put on your strategy hat -- I mean, strategies, that does not concern them at all; strategy thinks returns are never sustainable.  The trouble when you put on your finance hat, you do valuation.  If you try to do valuation where returns are not sustainable, where they decline over time, you cannot get anything like 20 or 30 percent premiums.  So there is really a conflict between that to get those premiums to justify the kind of price we need to have sustainable returns.  So that is problem.

Part of it, as you heard, that private equity characteristics change over time -- they go public; the debt gets paid off over time.  So when we expect the returns to decline -- but still that says, “Well, these are short-term effects.”  That is somewhat bothersome.

Something that would be more bothersome is that Jensen’s free cash flow -- and I think a lot of evidence in the U.S. suggests that there are cutbacks in capital investment and R&D.  The question, I think, there is really important:  Are those cutbacks leading to those short-term gains and therefore will impact long-term gains in the future?

My work with Bill Long looked at that in particular.  It was my most -- if I can use this Jensenesque paper that I wrote -- and it is in the Strategy Journal, unfortunately.  But what it found is that, in fact, when they do leverage buyouts in the ‘80s, they cut R&D by half.  That is somewhat disturbing, but they targeted low R&D firms to begin with.  And, furthermore - and I think this is the important part - what we did -- it was not great but we looked at cutbacks in R&D and then looked out two or three years and see if there was any impact on long-term performance, and there was not.  So I think there needs to be more of that to look at these cutbacks in investment and see if it affects long-term performance.

That leads me to another concern about the research is while we are saying the ‘80s and the current period is similar,  there are lots of differences.  I’m doing a study with Fernando Chaddad, and we are just starting it.  And it is going to be a very complementary study to the one you heard with Steve Davis yesterday.  We are going to use QFR [phonetic] data and whole company data.&nbs