In the latest installment of the Salzburg Questions for Corporate Governance, Raj Gupta and Victoria Ivashina discuss the relationship between private equity and public ownership models and what they can both learn from one another
This article is part of the Salzburg Questions for Corporate Governance series by the Salzburg Global Corporate Governance Forum
The prevailing view of the past 15 years has been the secular decline in public ownership. However, the recent special purpose acquisition company (SPAC) frenzy with nearly 300 listings in 2020, and record valuations of IPOs, have brought back the question of whether—as eclipses go—the eclipse of public corporations was just a temporary phenomenon.
Importantly, it doesn’t really matter; the question of the domination of public or private models is in many ways outdated. The private equity and public ownership models are more similar today than ever, and they will continue converging. What ultimately separates the two models is not so much the governance or the managerial style, but the cost of capital and the operational agility of the private equity model that can be helpful at some point in the life of any public corporation.
Historically, the private equity asset class has been described as focused on either multiples arbitrage (buying low and selling high) or financial engineering. Early buyout deals painted a picture of an industry that pursues underperforming assets at low valuation multiples, leverages them up, strips costs, and exits through a sale or an IPO, thus booking high absolute returns. This picture might have been a reasonable description of the industry in its early years. However, the focus has since shifted toward operational improvements in the past two decades.
Two central factors contributed to this shift in focus of the industry. First, private equity has become large and highly competitive. Second, in the wake of corporate scandals of the early 2000s, the governance of public firms has undergone substantial scrutiny. This scrutiny was further accelerated by the increasing concentration of ownership structures of public companies with index funds and large institutional investors. Taken together, they have majority ownership in most public companies, and they are not a silent voice.
In this environment, the “right price” to sell a public firm is almost always the highest possible price. And might that not be the case, it is likely that an activist fund—another governance mechanism that roughly over the same period became a force to reckon with—will remind the board about it. Carl Icahn’s opposition to the 2013 Dell buyout is perhaps the most publicized example. In sum, today, a typical investment thesis of public-to-private buyouts assumes multiples will stay flat, or, simply put, one cannot systematically buy low in the public space.
A few words are needed on the controversial role of leverage: access to leverage is a commodity. Granted that private equity brings substantial sophistication to their use and management of leverage, but—to a large degree—this is not a differentiated skill among private equity investors. Accordingly, since access to cheap debt is widespread, the primary beneficiary of high debt levels are typically the sellers, as competition pushes the easier credit condition into higher valuations. This argument is supported by academic evidence pointing to the negative correlation between credit market expansion and private equity returns. Debt is often a necessary evil that allows private equity to gain a controlling position. Although, some recent structures, such as Blackstone Crocs investment, show debt is not a defining feature of the private equity value-add.
Against this background, operational improvements have become the center of value-add propositions of the mid to large-cap buyouts. Importantly, this process has led to a convergence in operational focus and standards and, increasingly, governance practices. Large buyout firms have in-house operational teams, but they also have been very active in recruiting proven CEOs and business executives as advisors, chairs, CEOs, and executives. In addition, the private boards, which traditionally were restricted to a few private equity partners, have been expanding and increasingly look like a public company board. Indeed, the eventual transition of the company into the public domain demands governance structures that continue beyond the investment horizon of a private equity firm.
Take an example of Avantor, Inc. (NYSE: AVTR), a leading supplier of specialty materials, equipment, and services to the health care industry. The firm was acquired by New Mountain Capital back in 2010 for $280 million in a spin-off from its parent, Covidien. Today, it is a Fortune 500 company with an enterprise value of $27 billion. Avantor’s journey is the case in point of operational levers that now are commonly deployed in the private equity space. This included recruiting an experienced and proven CEO and other core leadership positions, enlisting an active board with a deep understanding of the industry, and ultimately carefully executing a series of strategic acquisitions culminating in the 2019 IPO.
So what can a private model offer that a public model cannot? Or better put, when is the high cost of private equity justifiable? As pointed out earlier, the distinctive feature of the private equity model is that it is deeply informed and can quickly commit to an experimental and agile business plan. As a result, there are three sets of general situations where the private equity model is the best fit:
Overall, however, in mature private equity, the value-add is rooted in the strategic partnership between patient and smart capital and operational experts, including managerial talent and industry veterans. The effects of this partnership are long-lasting and essential to a successful trajectory of companies re-entering public markets. For example, the surge in IPOs and SPACSs over the last several months has reversed the long-term decline in a number of public companies. This is a great example that both will coexist – and that their models may indeed have converged.
Both need to rethink their purpose radically. Serving stakeholders (customers, employees, environment, and society) consistently leads to long-term value creation for shareholders.
Both need to set short-term, medium-term, and long-term goals and have the discipline not to sacrifice medium and long-term for the short-term.
Both need to be prepared to make bold decisions, understand the risks, make choices, and execute well. However, public companies have a bigger challenge.
Raj Gupta has been the chairman of APTIV plc since March 2015 (formerly Delphi Automotive plc). From 1999 - 2009, Raj was chairman and chief executive officer of Rohm and Haas. Raj held a variety of posts at the company beginning in 1971. He was elected a vice president of the company and was named director for the Pacific region in 1993. Early in 1996, Raj became one of six members of the Chairman's Committee and was given oversight responsibility for the company's electronic materials business group. In December 1998, Raj was elected to the board of directors and named vice chairman in January 1999. He became chairman and chief executive officer on October 1, 1999. Raj assumed the additional title of president in early 2005 and held that title until May 2008. Raj is a past chairman of the American Chemistry Council and the Society of Chemical Industry, America Section. He is the chairman of Avantor, Inc. He has also served on the boards of Dupont, Arconic (Howmet Aerospace Inc.), HP, IRI, The Vanguard Group, and Tyco International, amongst other companies, in the past. Raj holds a B.S. degree in mechanical engineering from the Indian Institute of Technology (1967), an M.S. degree in operations research from Cornell University (1969), and an M.B.A. in finance from Drexel University (1972).
Victoria Ivashina is the Lovett-Learned professor of finance and head of the finance unit at Harvard Business School. Her research spans multiple areas of financial intermediation, including corporate credit markets, global banking operations, asset allocation by pension funds and insurance companies, and value creation by private equity. Victoria is a research associate at the National Bureau of Economic Research (NBER) and a research fellow at the Center for Economic Policy Research (CEPR). She co-heads Harvard Business School’s Private Capital Initiative and Private Equity and Venture Capital (PEVC) executive education program. She is a co-author of Patient Capital: The Challenges and Promises of Long-Term Investing. Victoria serves as a department editor at Management Science and as a board member of the American Finance Association and Financial Intermediation Research Society. She holds a Ph.D. in finance from the NYU Stern School of Business.
The Salzburg Questions for Corporate Governance is an online discussion series introduced and led by Fellows of the Salzburg Global Corporate Governance Forum. The articles and comments represent opinions of the authors and commenters, and do not necessarily represent the views of their corporations or institutions, nor of Salzburg Global Seminar. Readers are welcome to address any questions about this series to Forum Director, Charles E. Ehrlich: cehrlich@salzburgglobal.org. To receive a notification of when the next article is published, follow Salzburg Global Seminar on LinkedIn or sign up for email notifications here: www.salzburgglobal.org/go/corpgov/newsletter