Private Equity's Three Lessons for Agency Theory

Abstract

It is time to consider the lessons to be learned from the recent boom in private equity buyouts, not least in view of its abrupt termination in the wake of tightened credit. In the past, such inquiries have been undertaken in the context of agency theory and have focused on the buyout's implications for solving the problem of separation of ownership and control. This article reverses the pattern of inquiry to consider the buyout's implications for agency theory, pointing to three lessons. The first lesson addresses agency theory's three-way association among control transfers, governance discipline and hostile takeovers, suggesting that this triptych needs to be unbundled and reconsidered. The buyout's recent salience implies that we need no longer assume that hostility is the acquisition mode best suited to post-merger disciplinary governance. The second lesson concerns agency theory's account of buyout motivations. The theory posits a world where agency cost reduction determines control outcomes at the transactional margin. On first inspection, private equity buyouts neatly fit this picture. But a deeper examination shows that buyouts are driven by the economics of leverage, with agency cost reduction taking only a secondary motivational role. The third lesson follows from financial returns. Even as buyouts ameliorate the agency costs of separated ownership and control, buyout structures implicate their own agency costs in the form of fees paid to buyout firms. Studies show that buyout firms take so much of the gain that the institutions investing in buyout funds would be better off investing in market indices. There result questions for the line of agency theory that looks to institutional investors as agency cost-reducing monitors. There also result questions respecting buyouts' incentive compatibility, questions raising doubts as to whether buyout governance structures hold out a template for improving corporate governance generally, even as a matter of agency theory.