Friday, May 25, 2007

The Eclipse of the Public Corporation

Nearly two decades ago, Michael Jensen was criticized by many people, including many of his academic colleagues, for his thought-provoking article, The Eclipse of the Public Corporation, published in Harvard Business Review. People dismissed him when the LBO boom of the 1980s faded. They laughed when he wrote, "By the turn of the century, the primacy of public stock ownership in the United States may have all but disappeared." Well, in January 2000, with the dot com bubble raging, Jensen's far-reaching prognostications did seem completely off base. What about today? The dramatic expansion of private equity has validated Jensen's predictions from 18 years ago. Private equity has expanded rapidly, in part because it does solve some of the governance problems posed by the large publicly traded corporation, with its separation of ownership and control.

It's worth revisiting Jensen's arguments for a moment. At the time, Jensen argued that the public corporation's "decline is real, enduring, and highly productive." He explained the benefits of private equity and leveraged buyouts using agency theory, of which he was one of the founding fathers. Jensen wrote, "By solving the central weakness of the public corporation - the conflict between owners and managers over the control and use of corporate resources - these new organizations are making remarkable gains in operating efficiency, employee productivity, and shareholder value."

I can recall being one of Michael Jensen's students back in the early 1990s, long before I became his colleague on the HBS faculty. His class was the most popular elective at HBS back then. Not everyone agreed with him, but he offered thought-provoking theories, and he sparked some wonderful debates. This article, in particular, resonated with me and many of my peers back then, and it sure does seem quite prescient looking back today.

5 comments:

Andrew said...

Hi Professor Roberto!

I just found your blog here and thought I'd comment...

First, I understand agency theory says that LBO targets will have a much more focused owner group, which could reduce some of the agency costs of split ownership/management. But how does this fit in with MBOs? The PE group trusts current management enough to let it stay on, and management seems to get compensated even more - Burroughs and Helyar's description of Donald Kelly's attitude toward the Beatrice LBO is that you do the same job, but you get paid a lot more. Is it just that management's "wasteful" spending is to be checked by more careful oversight? If the PE group gives management even greater compensation and leeway in running the company, how are agency costs reduced?

Second, how much do you think the current private equity "boom" had to do with low rates and low spreads on low-quality debt?

I hope RI is treating you well!

-Andy MacNamara

Michael Roberto said...

Good questions, Andy. With regard to MBOs, the key is watch what form the compensation takes, rather than simply focusing on the level of pay. Is it simply more money, or is a compensation scheme that more closely ties pay to performance. In most cases, I believe private equity firms do a better job than the boards of publicly traded companies of tying pay to performance. In that way, they control agency problems more effectively than many publicly traded firms. Of course, in return for asking managers to take on more risk in their compensation schemes, they tend to pay more in absolute terms. More risk-more reward. It's not surprising to me that the overall level of compensation often increases. Remember, though, that management's feet will definitely be held to the fire, and their personal wealth will be more dependent on how the firm does than ever before. As for your second question, there is no question that the low cost of debt has helped to fuel the buyout boom of recent years. However, I do believe that there are structural reasons for the private equity boom, beyond simply the cyclical downturn in interest rates. Specifically, concerns about governance have fueled the buyout boom, as well as to some extent the effect of SOX regulations.

ilanit said...

A broker in commodity based derivatives working mainly with financial counterparty will have less issues implementing the directive. Their business is basically a Los Angeles business investment business and some of the principles behind the details of MiFID and CRD clearly apply to them.

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