Why do PE-backed firms have poor governance?

Posted by Marc Hodak on June 14, 2009 under Executive compensation, Reporting on pay | Read the First Comment

Apparently, the answer is:  just because the Corporate Library said so.

In a recent report called “What is the Impact of PE on Corporate Governance,” the corporate library concluded that their analysis:

…does not support the private equity claim to superior corporate governance as the companies enter the public markets.  On the contrary, it indicates that buyout-fund-backed companies exhibit, in higher proportion than average, a number of features that have the potential to benefit executives at the expense of shareholders, including takeover defenses and boards whose independence may be compromised.  In addition, the often-made assertion that private equity firms design compensation packages well suited to link pay to performance is not supported by this study.  The companies lacked the key compensation structures that are widely believed to link pay to performance.

As someone who designs compensation packages for PE firms, and has often asserted that the designs were especially well suited to link pay for performance,  I was interested in the basis for their conclusions.  What key compensation structures were PE-backed firms lacking?  Who are all those people who believed in them?

The report ended up offering a hopelessly muddled approach to compensation unsupported by any empirical analysis.

An example of their muddled approach was their citing the propensity of PE-backed firms to increase long-term compensation post-IPO, especially in the form of restricted stock.  They derided restricted stock as “pay for pulse” because stock retains some of its value even if the share price declines.  Later, they note that non-PE backed firms were more likely to “increase salary significantly” post-IPO.

It turns out that the Corporate Library did not examine changes in total compensation to see if the difference they cited were simply differences in pay mix versus value.  If one decides to increase total compensation, is there greater virtue in offering more salary versus more stock?  Deriding stock as “pay for pulse” won’t do since it is, in fact, much less so than salary.

Beyond the pot-shot nature of the Corporate Library’s approach was their willingness to substitute opinion for empiricism about each of the pay elements they criticized.  For example, it turns out that PE-backed firms tend to concentrate on a “narrow spectrum of earnings” rather than a “greater diversity” of performance metrics.  The study concluded that the non-PE backed firms may be “making more careful efforts to reward executives based on achievements.”  This curious speculation assumes that the good guys lived in the “greater diversity” camp, which is simply an assertion of opinion that runs counter to empirical evidence.

I’ve always taught that the standard of good governance is the benefit of the owners.  If a particular policy or practice does not actually lead to higher shareholder value, either in principle or in practice, then it’s difficult to claim that it’s good governance.

Well, in principle private equity owners should wish to maximize their value from IPOs.  That is more or less the raison d’etre of PE firms.  Why does the Corporate Library think that they would care more about shareholder value than the PE firms that actually own the firms, even after the IPO?  The Corporate Library says it’s because the PE firms wish to “reward company managers…to ensure their own access to future buyout deals.”  Uh huh.  This from a critic that often impales investors for being too short-term focused.

What about in practice:  how do PE-back firms actually perform versus non-PE backed firms?  The Corporate Library says, “We did not examine either operational performance or total shareholder return for the companies in this study, and we are making no claims about the actual achievements of their executives.”

So, it’s all just opinion and speculation against a personal standard of what constitutes good governance.

HT:  Larry Ribstein