Why do PE-backed firms have poor governance?

Posted by Marc Hodak on June 14, 2009 under Executive compensation, Reporting on pay |

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.

http://hodakvalue.com/blog/?p=1441