U.S. Corporate Governance: Accomplishments and Failings A Discussion with Michael Jensen and Robert Monks

Two of America's most prominent shareholder activists discuss three major issues surrounding the U.S. corporate governance system: (1) the case for increasing shareholder “democracy” by expanding investor access to the corporate proxy; (2) lessons for public companies in the success of private equity; and (3) the current level and design of CEO pay. On the first of the three subjects, Robert Monks suggests that the U.S. should adopt the British convention of the “extraordinary general meeting,” or “EGM,” which gives a majority of shareholders who attend the meeting the right to remove any or all of a company's directors “with or without cause.” Such shareholder meetings are permitted in virtually all developed economies outside the U.S. because, as Monks goes on to say, they represent “a far more efficient and effective solution than the idea of having shareholders nominate people for the simple reason that even very involved, financially sophisticated fiduciaries are not the best people to nominate directors.” Moreover, according to both Jensen and Monks, corporate boards in the U.K. do a better job than their U.S. counterparts of monitoring top management on behalf of shareholders. In contrast to the U.S., where the majority of companies continue to be run by CEO/Chairmen, over 90% of English companies are now chaired by outside directors, contributing to “a culture of independent‐minded chairmen capable of providing a high level of oversight.” In the U.S., by contrast, most corporate directors continue to view themselves as “employees of the CEO.” And, as a result, U.S. boards generally fail to exercise effective oversight and control until outside forces—often in the form of activist investors such as hedge funds and private equity—bring about a “crisis.” In companies owned and run by private equity firms, by contrast, top management is vigorously monitored and controlled by a board made up of the firm's largest investors. And the fact that the rewards to the operating heads of successful private equity‐controlled firms are typically multiples of those received by comparably effective public company CEOs suggests that the problem with U.S. CEO pay is not its level, but its lack of correlation with performance.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

Active Investors, LBOs, and the Privatization of Bankruptcy

In this testimony to the House Ways and Means Committee on February 1, 1989 (when LBOs and other highly leveraged transactions were under fierce attack by politicians and the media), the author identified “LBO associations” such as KKR and Forstmann Little as a valuable innovation in organizational form—a new model of management and governance that was competing directly with the headquarters of large public corporations, especially conglomerates. In the author's words, LBOs “substitute incentives provided by compensation and ownership plans for the direct monitoring and often centralized decision-making in the typical corporate bureaucracy.” In illustrating his point, the author noted that whereas the CEOs of U.S. companies during the '70s and '80s saw their personal wealth go up by only about $3 for every $1,000 increase in firm value, the average CEO in an LBO experienced a change of $64 per $1,000—and for the partners of the LBO firm, the closest equivalent to a conglomerate CEO, the change was about $200 per $1,000. Based on the performance of the first wave of LBOs to return to public ownership, such dramatic concentrations of equity ownership appear to have produced large gains in operating efficiency. (And since the author's testimony, these findings have been confirmed by subsequent studies of later periods and in other countries.) The heavy debt loads in these transactions, besides making possible the concentration of equity ownership, also perform an important control function, intensifying the search for efficiencies and discouraging reinvestment in low-return projects. For those LBOs that have trouble servicing their debt loads, the author argues that the costs of insolvency should turn out to be significantly lower than for traditional public companies because LBOs provide strong incentives to keep the process of reorganizing troubled companies out of the bankruptcy court (a prediction that, although proving wrong in the early‘90s, has turned out to be true of the most recent wave of private equity deals).     

The State of the Public Corporation: Not So Much an Eclipse as an Evolution

By some measures, the U.S. public corporation appears to be in the midst of a significant decline, as Michael Jensen predicted 25 years ago in a Harvard Business Review article called “The Eclipse of the Public Corporation.” Based on an analysis of ten industries during the 48‐year period from 1966 through the end of 2013, the author reports a 60% drop in the number of publicly traded U.S. companies, as measured from each of the industry peaks to the end of 2013. Mergers and acquisitions, together with the private‐equity transactions hailed by Jensen in his 1989 HBR article, have contributed significantly to this reduction in numbers. But so has the remarkable growth of “uncorporate” (or pass‐through) structures such as Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (REITs), both of which address governance as well as tax problems faced by public C‐corporations. But along with this drop in numbers, the author's analysis of the performance of U.S. public companies—as measured both by operating returns on equity and Tobin's Q ratios—also shows a growing separation of the “best” from the “rest” over time. Intense global product market competition, the growing benefits (and urgency) of achieving efficient scope and scale, high U.S. corporate income tax rates, and a vigorous market for corporate control are all significantly “thinning the herd” of public corporations. The “winners” have been emerging as larger, more efficient, and more influential enterprises than ever before, as the rise of massive U.S. multinationals (and, in countries outside the U.S., state‐owned enterprises) over the past two decades has increasingly blurred the line between private business and government. Viewed in this light, the overall trends, both in the U.S. and abroad, suggest an evolution rather than an eclipse of the public corporation. Such trends also suggest that over the next 25 years, the success of the public corporation will increasingly depend on issues such as its ability to resolve conflicts between controlling shareholders (including sovereign governments) and minority shareholders, regulatory (in particular, antitrust) policy, and the role (and investment horizons) of activist shareholders.     

Morgan Stanley Roundtable on Private Equity and Its Import for Public Companies

The role of private equity in global capital markets appears to be expanding at an extraordinary rate. Morgan Stanley estimates that there are now some 2,700 private equity funds that either have raised, or are in the process of raising, a total of $500 billion. With this abundance of available equity capital, the willingness of private equity firms to participate in “club” deals, and the leverage that can be put on top of the equity, private equity buyers now appear able and willing to pay higher prices for assets than ever before. And thanks in part to this new purchasing power, private equity transactions reportedly account for a quarter of all global M&A activity as well as a third of the high yield and IPO markets. The stock of capital now devoted to private equity reflects the demonstrated ability of at least the most reputable buyout firms to produce consistently high rates of returns for their limited partners. Although a talent for identifying and purchasing undervalued assets may be part of the story, the ability to produce such returns on a consistent basis implies an ability to add value, to improve the performance of the operating companies they invest in and control. And in this round‐table, a small group of academics and practitioners address two main questions: How does private equity add value? And are there lessons for public companies in the success of private companies? According to the panelists, the answer to the first question appears to have changed somewhat over time. The consensus was that most of the value added by the LBO firms of the‘80s was created during the initial structuring of the deals, a process described by Steve Kaplan as “financial and governance engineering,” which includes not only aggressive use of leverage and powerful equity incentives for operating managements, but active oversight by a small, intensely interested board of directors. In the past ten years, however, these standard LBO features have been complemented by increased attention to “operational engineering,” to the point where today's buyout firms feel obligated, like classic venture capitalists, to acquire and tout their own operating expertise. In response to the second of the two questions, Michael Jensen argues that much of the approach and benefits of private equity‐particularly the adjustments of financial policies and stronger managerial incentives‐can be replicated by public companies. And although some of these benefits have already been realized, much more remains to be done. Perhaps the biggest challenge, however, is finding a way to transfer to public companies the board‐level expertise, incentives, and degree of engagement that characterize companies run by private equity investors.     

New Corporate Forms: One Viable Solution to Advancing Environmental Sustainability

There is a clear trend in corporate governance toward increased attention to the environmental and social impacts of business operations. Major consulting firms are advising Fortune 500 companies on how to become more environmentally sustainable, private equity and “impact” investors are measuring environmental, social, and governance (ESG) factors, and voluntary reporting and shareholder resolutions on issues of environmental sustainability are on the rise. While traditional corporate forms allow companies to embrace social and environmental responsibility with some measure of success, various real and perceived risks encourage directors to focus on short‐term profitability. Even if a company has a strong social mission at inception, founders often have difficulty “anchoring their mission” over time. And the lack of required disclosure of social and environmental performance makes it more difficult for investors to evaluate and compare companies. Many believe that the institutionalized mispricing of natural resources and the continued failure to price externalities, combined with the progressive nature of climate change, require the transformation of both business and law. This article discusses social and environmental sustainability within the traditional corporate form and then explores three emerging alternatives that are now being used by businesses in California: limited liability corporations (LLCs); benefit corporations (B corps); and flexible purpose corporations (FPCs). Of these three alternatives, FPCs—a corporate form that requires shareholders to agree on one or more social missions with management and the board—may be best suited to meet the needs of the many small private firms (as well as some large public companies) that, whether for purely economic or altruistic reasons, plan to integrate ESG into their operations.     

Corporate Governance,Valuation, and Performance: Evidence from a Voluntary Market Reform in Brazil

In December 2000, the São Paulo Stock Exchange launched a new premium market segment for companies that voluntarily commit to “good practices of corporate governance.” We construct a composite index (NM6) that combines six proxies for the main governance practices targeted by Bovespa's reform. We find that higher scores for our index are related to greater market value but not to better operating performance. An investment strategy that purchased stocks of firms with high NM6 and sold stocks of firms with low NM6 would have earned abnormal returns of 10.68% per year from 2001 to 2005.     

The Capital Structure of PE‐Funded Companies (and How New Debt Instruments and Investors Are Expanding Their Debt Capacity)

The capital structures and financial policies of companies controlled by private equity firms are notably different from those of public companies. The concentration of ownership and intense monitoring of leveraged buyouts by their largest investors (that is, the partners of the PE firms who sit on their boards), along with the contractual requirement of PE funds to return their capital within seven to ten years, have resulted in capital structures that are far more leveraged than those of their publicly traded counterparts, but also considerably more provisional and “opportunistic.” Whereas the average U.S. public company has long operated with roughly 30% debt and 70% equity, today's typical private‐equity sponsored company is initially capitalized with an “upside‐down” structure of 70% debt and just 30% equity, and then often charged with working down its debt as quickly as possible. Although banks supplied most of the debt for the first wave of LBOs in the 1980s, the remarkable growth of the private equity industry in the past 25 years has been supported by the parallel development of a new leveraged acquisition finance market. This financing innovation has led to a general movement away from a bankcentered funding base to one comprising a relatively new set of institutional investors, including business development corporations and hedge funds. Such investors have shown a strong appetite for new debt instruments and risks that banks have been unwilling or, thanks to increased capital requirements and other regulatory burdens, prohibited from taking on. Notable among these new instruments are second‐lien loans and uni‐tranche debt—instruments that, by shifting the allocation of claims on the debtor's cash flow and assets in ways consistent with the preferences of these new investors, have had the effect of increasing the debt capacity of their portfolio companies. And such increases in debt capacity have in turn enabled private equity funds—now sitting on near‐record amounts of capital from their limited partners—to bid higher prices and compete more effectively in today's intensely competitive M&A market, in which high target acquisition purchase prices are being fueled by a strong stock market and increased competition from corporate acquirers.     

FMA Roundtable on New Developments in European Corporate Governance

In this discussion that took place in Helsinki last June, three European financial economists and a leading authority on U.S. corporate governance consider the relative strengths and weaknesses of the world's two main corporate financing and governance systems: the Anglo‐American market‐based system, with its dispersed share ownership, lots of takeovers, and an otherwise vigorous market for corporate control; and the relationship‐based, or “main bank,” system associated with Japan, Germany, and continental Europe generally. The distinguishing features of the relationship‐based system are large controlling shareholders, including the main banks themselves, and few takeovers or other signs of a well‐functioning corporate control market. Given the steady increase in the globalization of business and international diversification by large institutional investors, the panelists were asked to address the question: can we expect one of these two systems to prevail over time, or will both systems continue to coexist, while seeking to adopt some of the most valuable aspects of the other? The consensus was that, in Germany as well as continental Europe, corporate financing and governance practices have already begun to look much like those in the U.S. and U.K., with much less reliance on bank loans and greater use of bonds and public equity. And these financing changes have resulted in major changes in ownership structures that have seen local main banks largely supplanted by foreign institutional investors—some of whom have demanded a greater voice in how companies are run. Moreover, Finnish economist Tom Berglund may well have provided a blueprint for the dominant European governance system of the future in describing the “Nordic model” as

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Do Private Equity Funds Increase Firm Value? Evidence from Japanese Leveraged Buyouts

The author summarizes the findings of his recent study of 62 buyouts of listed Japanese companies by both Japanese and “foreign” private equity funds that were transacted between 2000 and 2007. Roughly half of the author's sample of transactions were accomplished by means of takeover bids by PE funds, and such deals were transacted at prices that represented a premium (of roughly 12%) to current market values. Most of the other PE transactions were privately negotiated deals in which the purchase prices involved discounts (of about 15% on average) to current value. For both sets of deals, however, the announcements of such buyouts were associated, on average, with a significantly positive stock market reaction. By the cutoff date of the study (May 2010), 30 of the 62 acquired firms had realized “exits.” Those companies (though not the others) experienced significant average improvements in operating performance; and the extent of such improvements were roughly consistent with the size of the positive market reaction to the buyout announcements. The test results suggest that the value increases can be attributed to the more efficient use of assets and reduction of operating costs. Meanwhile, there was no evidence suggesting that the acquired firms cut back on their research and development, capital investments, or employee wages and growth. What's more, examination of the operating performance of the 30 companies after their exits showed no deterioration in profitability or investment spending.     

Columbia Law School Roundtable on A Governance Research Agenda for the Academy

Since Jensen and Meckling's formulation of the theory of “agency costs” in 1976, corporate finance and governance scholars have produced a large body of research that attempts to identify the most important features and practices of effective corporate governance systems. But for all the research that has been done in the past 40 years, many practitioners continue to see a disconnect between theory and practice, between the questions researched and the questions that need to be answered. In this roundtable, Martijn Cremers begins by challenging the conventional view that limiting “agency costs” is the main challenge confronted by boards of directors in representing shareholder interests and, hence, the proper focus of most governance scholarship. Especially in today's economy, with the high values assigned to growth companies, the most important function of corporate governance may instead be to overcome the problem of American “short termism” that he attributes to “inadequate shareholder commitment to long‐term cooperation.” And he buttresses his argument with the findings of his own recent research suggesting that obstacles to the workings of the corporate control market like staggered boards and supermajority voting requirements may actually improve long‐run corporate performance by lengthening the decision‐making horizon of boards and the managements they supervise. Vik Khanna discusses Indian Corporate Social Responsibility (CSR) spending and its effects in light of a recent law requiring Indian companies of a certain size to devote at least 2% of their after‐tax profit to CSR initiatives. One unintended effect of this mandate, which took effect in 2010, was that all Indian companies that were spending more than the prescribed 2% of profits cut their expenditure back to that minimum, suggesting that CSR and advertising are substitutes to some extent, and that such legal mandates can discourage CSR spending by early adapters or “leaders.” Nevertheless, Khanna also found evidence of social norms developing in support of CSR, including a spreading perception that such spending can help some companies achieve strategic goals. Jeff Gordon closes by arguing that, to the extent investors are short‐sighted, their short‐sightedness is likely to be justified by their recognition that public company directors have neither the information nor the incentives to do an effective job of monitoring corporate managements. The best solution to the problems with U.S. corporate governance is to replace today's “thinly informed” directors with “activist” directors who more closely resemble the directors of private‐equity owned firms. Such directors would spend far more time with, and be much more knowledgeable about, corporate management and operations—and they would have much more of their personal wealth at stake in the form of company stock.     

Baylor University Roundtable on The Corporate Mission, CEO Pay, and Improving the Dialogue with Investors

A small group of academics and practitioners discusses four major controversies in the theory and practice of corporate finance:

• • What is the social purpose of the public corporation? Should corporate managements aim to maximize the profitability and value of their companies, or should they instead try to balance the interests of their shareholders against those of “stakeholder” groups, such as employees, customers, and local communities?
• • Should corporate executives consider ending the common practice of earnings guidance? Are there other ways of shifting the focus of the public dialogue between management and investors away from near-term earnings and toward longer-run corporate strategies, policies, and goals? And can companies influence the kinds of investors who buy their shares?
• • Are U.S. CEOs overpaid? What role have equity ownership and financial incentives played in the past performance of U.S. companies? And are there ways of improving the design of U.S. executive pay?
• • Can the principles of corporate governance and financial management at the core of the private equity model—notably, equity incentives, high leverage, and active participation by large investors—be used to increase the values of U.S. public companies?

     

Board 3.0: What the Private‐Equity Governance Model Can Offer Public Companies∗

The authors view board structures as an adaptive institution that responds to the key challenges faced by public companies: helping management solve the problems of production and organization of large‐scale enterprise; limiting managerial agency costs; serving as a delegated monitor of the firm's compliance obligations; and responding to the governance environment of changing shareholder ownership patterns. U.S. company board structures are shown to have evolved over time, often through discontinuous lurches, as particular functions have waxed and waned in importance. This article is part of a larger project that traces two iterations of the public company board, what the authors call Board 1.0 (the “advisory board”) and Board 2.0 (the “monitoring board”). The authors argue in particular that Board 2.0, as embedded in both current practice and regulation, now fails the functional fit test for many companies. First, it does not scale to match the dramatic increase in the size and complexity of many modern public corporations. Second, at a time of reconcentrated ownership achieved through institutional investors and increased activism, it does not have the expertise and commitment needed to resolve the tension between managerial or market myopia, or “short‐termism,” and managerial “hyperopia.” This article holds out an optional alternative, Board 3.0, which would bring to the public company board some strategies used by private equity firms for their portfolio company boards. Such “Portco” boards consist of directors who are “thickly informed,” “heavily resourced,” and “intensely interested.” Bringing such “empowered directors” to public company boards could facilitate evolution of the public company board model in response to dramatic changes in the corporate business environment. The authors also suggest possible routes for implementing Board 3.0, including the enlisting of PE firms as “relational investors” that would have both capacity and incentives to engineer changes in board structure.     

Leveraged Buyouts in the U.K. and Continental Europe: Retrospect and Prospect

The markets for management buyouts in the U.K. and continental Europe have experienced dramatic growth in the past ten years. In the U.K., buyouts accounted for half of the total M&A activity (measured by value) in 2005. And as in the U.S. during the‘80s, the greatest number of U.K. buyouts in recent years have been management‐ and investor‐led acquisitions of divisions of large corporations. In continental Europe, by contrast, the largest fraction of deals has involved the purchase of family‐owned private businesses. But in recent years, increased pressure for shareholder value in countries like France, Netherlands, and even Germany has led to a growing number of buyouts of divisions of listed companies. Like the U.K., continental Europe has also seen a small but growing number of purchases of entire public companies (known as private‐to‐public transactions, or PTPs), including the largest ever buyout in Europe, the €13 billion purchase this year of the Danish corporation TDC. In view of the record levels of capital raised by European private equity funds in recent years‐which, until 2005, exceeded the amounts invested in any given year‐we can expect more growth in private equity investment in the near future. In continental Europe, the prospects for buyouts remain especially strong, given both the pressure from investors to restructure larger corporations and the possibilities for adding value in family‐owned firms. But, as the authors note, today's private equity firms face a number of challenges in earning adequate returns for their investors. One is increased competition. In addition to the increased activity of U.S. private equity firms, local private equity investors are also facing competition from hedge funds and new entrants such as government‐sponsored operators, family offices, and wealthy entrepreneurs. Another major challenge is finding value‐preserving exit vehicles. Although an IPO is an option for the largest buyouts with growth prospects, most buyout investments are harvested either through sales to other companies or, increasingly, other private equity firms. The latter transactions, known as “secondary” buyouts, now account for a significant share of new funds invested by private equity firms across Europe.     

Public vs. Private Equity*

Many corporate executives view private equity as a last resort, as expensive capital that should be tapped only by companies that don't have access to presumably cheaper public equity. The reality of private equity, however, is more complex, and potentially quite rewarding, for both shareholders and management. This paper surveys some of the academic work on the costs and benefits of public vs. private equity, contrasting the private equity investment process with its public counterpart and exploring how such a process may add value. The importance of public equity, particularly for very large companies and growth companies with large capital requirements, is indisputable. But as investment bankers and other practitioners have noted, under certain circumstances the public markets effectively become “closed” to some public companies. Moreover, the cost of equity raised in public markets involves much more than the direct costs of underwriters, attorneys, and accountants. Some indication of the indirect costs is provided by the market's typically negative reaction to announcements of seasoned equity offerings. Although the negative reaction averages about 3%, in some cases stock prices drop by as much as 10%, thereby diluting the value of existing stockholders. Most academics attribute this reaction to the informational disadvantage of public stockholders. Private equity is designed in large part to overcome this information problem by replacing the monitoring performed by the typical public company board with the oversight of better informed and more highly motivated owners. A growing body of academic research suggests that private equity investors add value to the companies they invest in, and that the best investors are consistently effective in so doing. What's more, even public companies that tap private equity seem to benefit. As the author found in his own research on PIPES (Private Investment in Public Equity Securities) transactions, even though such securities are issued to private equity investors at a discount to the prevailing market price, the average market response to the announcement of such transactions is a positive 10%. In short, the participation of private equity investors is perceived to create value, and some of this value is shared with the rest of the market.     

GOLBALIZATION, CORPORATE FINANCE, AND THE COST OF CAPITAL

International financial markets are progressively becoming one huge, integrated, global capital market—a development that is contributing to higher stock prices in developed as well as developing economies. For companies that are large and visible enough to attract global investors, having a global shareholder base means having a lower cost of capital and hence a greater equity value for two main reasons: First, because the risks of equity are shared among more investors with different portfolio exposures and hence a different “appetite” for bearing certain risks, equity market risk premiums should fall for all companies in countries with access to global markets. Although the largest reductions in cost of capital resulting from globalization will be experienced by companies in liberalizing economies that are gaining access to the global markets for the first time, risk premiums can also be expected to fall for firms in long-integrated markets as well. Second, when firms in countries with less-developed capital markets raise capital in the public markets of countries (like the U.S.) with highly developed markets, they get more than lower-cost capital; they also import at least aspects of the corporate governance systems that prevail in those markets. For companies accustomed to less-developed markets, raising capital overseas is likely to mean that more sophisticated investors, armed with more advanced technologies, will participate in monitoring their performance and management. And, in a virtuous cycle, more effective monitoring increases investor confidence in the future performance of those companies and so improves the terms on which they raise capital. Besides reducing market risk premiums and improving corporate governance, globalization also affects the systematic risk, or “beta,” of individual companies. In global markets, the beta of a firm's equity depends on how the stock contributes to the volatility not of the home market portfolio, but of the world market portfolio. For companies with access to global capital markets whose profitability is tied more closely to the local than to the global economy, use of the traditional Capital Asset Pricing Model (CAPM) will overstate the cost of capital because risks that are not diversifiable within a national economy can be diversified by holding a global portfolio. Thus, to reflect the new reality of a globally determined cost of capital, all companies with access to global markets should consider using a global CAPM that views a company as part of the global portfolio of stocks. In making this argument, the article reviews the growing body of academic studies that provide evidence of the predictive power of the global CAPM as well as the reduction in world risk premiums.     

How Corporate Diversity and Size Influence Spinoffs and Other Breakups

In recent months, the list of large diversified companies that have decided they would be worth more as several smaller, focused companies has grown sharply. In many of these cases, it has been outside pressure from activist investors that has motivated these actions by management—and with some pretty favorable results. But what is driving these strategic actions and what is most important in determining whether breakups create value? To answer this fundamental questions, it is critical to decide whether large, diversified companies have a value recognition problem or a value creation problem. In this article, the authors present and try to integrate the findings of two separate but related research studies on business diversity and size with the aim of identifying their implications for corporate strategy and helping company executives create more value for their investors. The specific reasons for underperformance by large diverse companies vary greatly, but there are a number of potential problems discussed in this article, including organizational “distance,” capital allocation, human capital allocation, cross subsidies, and ineffective governance. Instead of waiting for activist investors to demand a breakup, executives of large diverse companies should be proactive in addressing the potential weaknesses of their organizations. Private equity firms understand how to make diversification work and many of today's executives could learn some valuable lessons from these firms. Large diverse businesses should embrace “Internal Capitalism,” a corporate culture and set of practices that emphasizes the importance of strategic decision‐making that is linked through continuous performance assessment to the corporate goals of boosting efficiency and sustainable growth.     

Private Equity and Investment in Innovation: Evidence from Patents

The authors' analysis of the patenting activity of 472 companies that received private equity investments between 1986 and 2005 provides suggestive evidence of an increase in the effectiveness (though not necessarily the quantity) of their innovative activities. After such companies received private equity backing, the patents they applied for received more frequent citations than patents awarded before the involvement of PE firms. Companies acquired by private equity also show no sign of deterioration in patent “originality” and “generality,” which have been shown to be fairly reliable indicators of the fundamental nature of the research. And while there is no clear pattern of change in the level of patenting activity, corporate patent portfolios become more focused in the years after the private equity investments. The increases in our measure of patent “impact” are greatest in the areas that constitute the companies' historical core strengths. These findings are likely to prove increasingly important as private equity continues its incursions into growth areas of the economy.