The Economic Case For Private Equity

Comments Welcomed Nov.
27, 2007
Negotiations, Organizations and Markets

Research Papers
Harvard NOM Research Paper No. 07-02
The Economic Case For Private Equity (and Some

Concerns) — pdf of Keynote Slides
MICHAEL C. JENSEN
Jessie Isidor Straus Professor Emeritus, Harvard Business School
MJensen@hbs.edu
Senior Advisor, The Monitor Group
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Comments Welcomed Nov. 27, 2007
The Economic Case for Private Equity (and Some Concerns)

— pdf of Keynote Slides
Michael C. Jensen
Jesse Isidor Straus Professor of Business Administration Emeritus
Senior Advisor, The Monitor Group
MJensen@hbs.edu
Abstract
Presented at the Harvard Business School Centennial Conference on Private Equity, New York
City, Feb. 13, 2007 and the Swedish Institute for Financial Research Conference on The
Economics of the Private Equity Market, Aug. 30, 2007; American Enterprise Institute Conference
on The History, Impact, and Future of Private Equity Ownership, Governance, and Firm
Performance, Washington, DC, Nov. 27, 2007.
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Private Equity funds have grown from a tiny part of the financial market in the early 1980s to an
important global force today. Morgan Stanley estimated in 2007 that 2,700 Private equity funds
represented 25% of global mergers and acquisition activity, 50% of leverage loan volume, 33% of
the high yield bond market, and 33% of the initial public offerings market.
I present in these slides my belief, first argued in my 1989 Harvard Business Review paper
entitled "The Eclipse of the Public Corporation" that Private Equity is best thought of as a new and
powerful model of General Management. I also summarize some important characteristics of
Private Equity that contribute to value creation, how Private Equity generally implements
"Strategic Value Accountability" (what I have labelled the missing concept in corporate
governance) much better than the public corporation, and how Private Equity avoids much of the
out-of-integrity gaming and lying that dominates the relations between public firms and capital
markets. I close by summarizing some growing problematical trends and practices that threaten the
success of this new business model and the future of the Private Equity industry (in particular the
threat posed by the proliferation of non-equity based fees charged by Private Equity firms, and the
going public of the core management private equity company such as that by Fortress and
Blackstone and the raising of permanent public capital to substitute for the non-permanent limited
partnership capital).
© Copyright 2007. Michael C. Jensen. All rights reserved

The Economic Case for Private
Equity (and Some Concerns)
American Enterprise Institute

The History, Impact, and Future of Private Equity: Ownership,
Governance, and Firm Performance
Washington, DC, November 27, 2007
Michael C. Jensen
Jesse Isidor Straus Professor of Business, Emeritus,
Harvard Business School
Senior Advisor, Organizational Strategy Practice,
The Monitor Group
© Michael C. Jensen, 2007. All Rights Reserved

Topics
Private Equity (PE) as a new and powerful model of
general management.
Some Important Characteristics of Private Equity that
Contribute to Value Creation
Strategic Value Accountability: The missing concept in
corporate governance, but something that PE generally
does very well
Avoiding the out-of-integrity gaming and lying that
dominates the relations between firms and capital
markets
Some Problematical Trends and Threats To This New
Model
2
Private Equity as a New
Model of General Mgmt.
I’ve argued since the 1980’s that PE was a new
model of general management, applicable to
many, if not most firms and organizations.
PE enables the capture of value destroyed
by agency problems in public firms--
especially failures in governance
Evidence from the growth and success of the
PE sector is consistent with this.
Apparently somewhere over one trillion
dollars now in the PE Sector.
3
It has been successful in the mature segment
of the market with high free cash flows
(LBOs, MBOs)
And in the high growth segment of the

market (startups and venture capital
organizations).
Now being applied in seemingly limitless

places and has spread throughout the globe.
Will we see this as another example of the

“success breeds failure phenomenon”?
4
Morgan Stanley estimated in the last year that
2,700 Private Equity funds represent:
25% of Global M&A activity
50% of leverage loan volume
33% of the high yield market
33% of the IPO market
and the $40 billion buyouts represent new
size records
5
Puzzling thing to me is that all of the
techniques that PE uses to accomplish its value
creation can be adopted by most any public
company
Except, of course, for the Going Private part
as Bennett Stewart, myself and others have
pointed out for a long time.
Yet it does not happen.
Seems to be due to the difficulty of changing
the mindset of managers and boards.
Given the huge gains possible it is still a puzzle
to me.
I interpret this failure as evidence of the agency
costs of the publicly held firm
6
Important Characteristics of
Private Equity
All of which contribute to high performance in an
interrelated, interdependent way
Compared to typical Corporate Conglomerate:
Corp. Headquarters in PE firm is a Partnership
Small size of PE Headquarters staff (caution:
seems to be increasing over time)
Limited Partnership equity of PE firm has finite
life
The horizon given by the temporary funding
generates a natural toting up point for the
board, CEO, and managers of the PE portfolio
companies.
Berkshire Hathaway is a successful corporate
counterexample: investors beware when Buffett
and Munger are gone 7 © Michael C. Jensen, 2007. All Rights Reserved
Private Equity (Continued)
Reputations of PE partners are very important
Necessity to raise new funds makes mediocre
returns a disaster--Two low-return funds & you are
“out”
Makes PE partners excellent board members
Creates a very different board & governance
system than in the typical public corporation
In PE firms CEOs have a boss--unlike almost all
public corporations
Where directors generally see themselves as
employees of the CEO--except in crises
8
Financial Strategy
Debt and Equity of PE “divisions” are at the
divisional level
Higher Debt/Equity in PE divisions than in public
Conglomerates
Control Function of Debt plays a very important
but often unrecognized role
Let’s take a quick and somewhat oversimplified
look at the overall structure of PE firms vs. the
typical conglomerate
9
TYPICAL DIVERSIFIED FIRM
Director Pay/performance sensitivity small Stockholders Perpetual Commitment

Board
of
Directors
Staff measured in 1,000s Debtholders
CEO Pay/performance sensitivity small,
$3.25 per 1000
CEO,
Corporate
Hdqtrs.
CEO Pay/performance
sensitivity tiny
BUS UNIT 1 BUS UNIT 2 BUS UNIT 3 BUS UNIT 4
Low Debt to Equity Ratio
TYPICAL LBO ASSOCIATION

(KKR, Forstman Little)
Staff measured in 10s

CEO Pay/performance sensitivity huge
Partnership General Limited Partnership

Buyout Funds 7-10 Year Commitment
CEO Pay/performance
Hdqtrs. Partners
sensitivity large,
$64 per 1000
LBO 1 LBO 2 LBO 3 LBO 4
Debt Debt Debt Debt
Stock Stock Stock Stock
High Debt to Equity Ratio

Control & Incentive effects of Debt
Firm Value
Debt Value
$mm
Going Concern Value = $100

100
90
Bad Times Value of Firm Debt/Value=85%
80 Insolvency Point
Works well as long as

70
private restructuring is
60
allowed and strip
50 financing is used for
40 mezzanine financing
Value at
Risk
30
in
Debt/Value=20%
Bankruptcy Local tax & bankruptcy
20
Insolvency Point
laws are important
Bad Times Value of Firm
10
Liquidation
Value=10 mm
0
Traditional New
Leverage Leverage
Model Model11
New Management Model
Missing the debt service obligations becomes a
big deal compared to missing your budget in
the typical firm (Control Function of Debt)
Bankruptcy, restructuring, loss of equity
Done right very few LBOs ever went into
bankruptcy even though leveraged to 95% or
higher--until change in tax code in about 1990
Why?
Control & Incentive effects of high Debt
Strip Financing
12
More on PE boards:
Boards of Directors are small in size
Generally CEO is the only manager on the board and
is not the chairman
Other managers are ex-officio and active
PE partners are “Active Investors” in a true sense
Active Investors have substantial equity (and or
debt position) and are actively involved in the
strategic direction of the company
Active investors are generally barred from
public boards by insider trading and other
regulations
No cross-subsidization between PE divisions
13
Far greater and better information at the top
management and board level
As a result of extensive due diligence at the time of
the deal there is generally more information in the
hands of board and top management about the
company than ever before.
Compensation
CEO and other top managers have more equity
interest than typical public company managers
Used to be by a factor of 10 or 20. Kaplan (1989)
Social customs on boards are very different and
forthright. Far fewer “undiscussables”
14
Management Model
Self selection of those who believe in the
strategy generated by necessity to purchase
equity in the deal
Clear focus on value as the score for what
determines “better”
To Repeat: No ability to transfer moneys
between businesses in the Private Equity
model--ends the cross-subsidization in the
conglomerate
Funds must be sent back to limited
partners
15
Management Model
Externalization of the budget process (in

negotiations with the suppliers of debt)
Think of the committed debt service
obligations as the performance target
beyond which bonuses start to be earned
16
In slow growing businesses high leverage is

appropriate
Creates mgmt. focus on cash flow to pay

the debt, and this is very productive
Management shifts from growing the

business to growing the equity--and this
can be very profitable
17
In fast growing businesses high leverage is not
appropriate and venture capitalists substitute
staged investments
Entrepreneur does not get enough money to do

the entire development
Has to return for more, and this creates control

opportunity and limits losses
VCs often require another firm to participate in

the next stage to limit them from falling in love
with their deals--even if bad
18
Strategic Value Accountability:
The Missing Concept in Governance
Task is to bridge the gap between the markets and the
managerial organization
A critical function in every firm. What is it?
Consider the situation where the management team
is creating a strategic plan. How do they decide on
the multitude of tradeoffs that must be made and
how are they are to be compensated for achieving it.
Managers want to be measured on results they can
“control”, say number of new products or sales, or
cost reductions, etc.
Virtually no manager wants to be measured on
how the market values the firm.
But value is what it is all about.
19
SVA often gets assigned by default to CFO and
Investor Relations Manager in Public Firms
Who do not have the appropriate decision rights
to properly exercise this function
Has to be either the CEO and/or a group of senior
managers or the Board
In Private Equity it is effectively assigned to and
exercised by the Private Equity Partners on the board
and the CEO
And this means those involved must be rewarded
based on the market value of the results
Historically PE has accomplished this through the
carry and/or equity interests.
20
It takes very special talent to bridge the gap between
the mindset and knowledge of the operating manager
and the deep knowledge of what will be valued and
how by the capital markets.
Yet, this talent is seldom found in public corporations
Viewed from this angle it is not hard to see why PE
firms tend to be founded and populated by people
who have deep knowledge and experience in the
capital markets and they combine this with
managerial knowhow in many ways
It is extremely difficult for public corporations to hire
and retain this talent at the upper levels of
management.
Their opportunity costs are “too high”. But they make
great PE partners. 21
The importance of this special knowledge of value
and capital markets becomes even more salient when
viewed in light of the widespread ignorance of top
managers about what actually creates value in their
firms.
The recent disastrous reign of Nardelli at Home
Depot is a good example. In his mind he was a
success, but value was destroyed.
Not the sort of manager you want to be in
possession of the SVA Decision rights,
And especially if you do not evaluate & reward him
on actual value created (or in this case destroyed).
Very simply, this scandal would never have been
allowed to happen in the typical PE firm.
Unfortunately this example
22 is not rare in public firms.
Avoiding the Out-Of-Integrity
Gaming with the Capital Markets
Clear focus on value creation as the score for success
An ability to short circuit (for a while) the highly
counterproductive and out-of-integrity game that
goes on between managers and capital markets.
By this I mean the gaming and lying that
dominates the relations between managers and
markets.
Smoothing earnings, managing expectations,
meeting the street’s forecast, and on and on.
When managers decisions are driven by anything
other than creating long-term value they are lying
And this well documented process destroys value
Being out of this out-of-integrity process provides
opportunity for value creation, another source of
PE value 23
Some Problematic Trends
Growth in non-equity based fees to PE management
company
Create major conflicts of interest with limited
partners & value destruction will result
Hedge funds entering PE business
This is a governance business, not a transaction
business
Example: Disastrous Revco buyout by Salomon Bros.
PE firms going public
The Publicly Held Private Equity firm is a non-
sequitur both in language and in economics:
Berkshire Hathaway is a counter example
Permanent Capital in the form of publicly held stock
replacing some of all of the funding provided by the
finite horizon Ltd. Partnership Funds (KKR) will
create more agency costs--think of closed end fund
discounts. 24
A Word About the Incentives
of Private Equity Firms
Private equity firms have their reputations on
the line.
They have to pay out the proceeds to the
limited partners by the end of the contract
period
If they want to raise another fund they must
show good performance in earlier funds
This means they are unlikely to simply walk
away from a bad deal
They have big incentives to do good deals and
make them work
25
The Dangers of Giving PE
Permanent Public Capital
What if the typical large public firm board and top
management changed their mindset from managing
businesses to managing governance systems that
manage businesses?
They still don’t have the requirement to divest the
businesses, realize a valuation, pay off those who gave
them capital, and ask for more back again.
One reason I think it is a mistake to give the Private
Equity Firm permanent publicly held capital (as KKR
did in Europe)
26
The Dangers of Taking the
PE Mgmt. Company Public
When Fortress and Blackstone and others take the

core management company public they have put at
risk another of the major competitive advantage the
PE firm has
In Blackstone’s case the new public holders of the
limited partnership have virtually no say in the
governance of the enterprise.
27
Having Given Up Many PE Controls,
Here is what Blackstone Provides:
“The Blackstone Group L.P. is managed by our general
partner, which is owned by our senior managing directors.
Our common unitholders will have only limited voting
rights and will have no right to elect our general
partner or its directors.
Immediately following this offering, our existing
owners will generally have sufficient voting power to
determine the outcome of those few matters that
may be submitted for a vote of our limited partners,
including any attempt to remove our general partner.
The partnership agreement of The Blackstone Group L.P.
limits the liability of, and reduces or eliminates the
duties (including fiduciary duties) owed by, our
general partner to our common unitholders and restricts
the remedies available to common unitholders for actions
that might otherwise constitute breaches of our general
partner's duties.” Blackstone Prospectus, 2007
28
Daniel Gross on Schwarzman:
And now Schwarzman may pay for his antics. He's

like an NBA player who, having gone the length of a
court for a slam-dunk with the game already put away,
starts trash-talking, jumps atop the scorers' table,
gestures obscenely at opposing fans, pinches a
cheerleader, chest-bumps the referee, sticks his
tongue out at the camera, all while grabbing his
crotch and yelling loudly that he's the man. That
would certainly get the attention of the ordinarily
forgiving disciplinarians in the league office.
Slate, “The Golden Ass: How Blackstone CEO Steve
Schwarzman’s Antics May Cost Him and His Co"eagues
Bi"ions of Do"ars”, June 19, 2007
29
As Private Equity grows in influence, size and
visibility, the limited public understanding of what PE
firms do will create problems and further destroy
value.
PE firms will have to manage this well.
This is particularly a problem given the
“overvaluation” that has existed and is being resolved
at this time. And since with the exception of the
recent public issues (Fortress & Blackstone) prices for
PE management companies do not exist, most of the
adjustment comes out in increased cash inflows to the
industry and all that implies for higher deal prices,
lower returns, etc.
I’ve argued elsewhere that the Agency Costs of
Overvaluation, once put in motion, are almost certain
to destroy part, or even in some cases, all the real
value of such companies. Beware.
30
Public surveys documenting the earnings of PE partners
do not bode well for the industry.
Why would any PE manager, knowing the sensitivity of
the public and political process to high earnings allow
their personal earnings be made public (especially if they
were over $1 billion last year)?
Is it a surprise that the tax rules on PE may be changed?
Why would Stephen Schwarzman allow his picture to be
on the front cover of Fortune Magazine?
Does not bode well for public relations, and neither does
their public offering. Blackstone has created a negative
externality for the entire PE industry.
I said in early Feb. 2007 that PE is going to have its
reputation tarnished. It will be damaged but will survive
31
END
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Comments Welcomed Nov.

Negotiations, Organizations and Markets

Harvard NOM Research Paper No. 07-02

The Economic Case For Private Equity (and Some

Senior Advisor, The Monitor Group

The Economic Case for Private Equity (and Some Concerns)

Jesse Isidor Straus Professor of Business Administration Emeritus

Senior Advisor, The Monitor Group

© Copyright 2007. Michael C. Jensen. All rights reserved

American Enterprise Institute

© Michael C. Jensen, 2007. All Rights Reserved

And in the high growth segment of the

Now being applied in seemingly limitless

Will we see this as another example of the

Director Pay/performance sensitivity small Stockholders Perpetual Commitment

BUS UNIT 1 BUS UNIT 2 BUS UNIT 3 BUS UNIT 4

Low Debt to Equity Ratio

TYPICAL LBO ASSOCIATION

Staff measured in 10s

Partnership General Limited Partnership

LBO 1 LBO 2 LBO 3 LBO 4

Debt Debt Debt Debt

Stock Stock Stock Stock

High Debt to Equity Ratio

Going Concern Value = $100

Works well as long as

Externalization of the budget process (in

In slow growing businesses high leverage is

Creates mgmt. focus on cash flow to pay

Management shifts from growing the

Entrepreneur does not get enough money to do

Has to return for more, and this creates control

VCs often require another firm to participate in

When Fortress and Blackstone and others take the

And now Schwarzman may pay for his antics. He's

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