The effects of private equity investors on the governance of firms

Companies that receive external equity typically experience a separation of ownership and control, where owners who are not involved in the company (principals) have to rely on the management team (agents) for achieving expected goals and target levels. Theoretical literature argues that when ownership and control are separated, principals develop governance structures to reduce agency costs and align agents’ incentives (Berle and Means, 1932; Jensen and Meckling, 1976; Grossman and Hart, 1986; Zingales, 1995). Likewise, optimal financial structure design by financial intermediaries can effectively help to mitigate agency problems by identifying self-enforcing equilibria (Diamond, 1984; Fama and Jensen, 1985; Stiglitz, 1985; Bhattacharya and Thakor, 1993; Barry, 1994). In general terms, governance and financial devices can be thought of as either internal control mechanisms (such as the board) or external control mechanisms (such as the market for corporate control). An increasingly important external control mechanism affecting the governance of young and fast-growing companies worldwide is the emergence of institutional and private equity investors, as equity owners. Institutional investors have the potential to influence management’s activities directly through their ownership, and indirectly by trading their shares (Gillan and Starks, 2003). In this respect private equity investors are differentiated from institutional ones in the longer-term view and in the significantly more hands-on approach that they pursue when investing in a portfolio company. As a result, companies backed by private equity investors represent a fruitful environment to investigate the use and efficiency of a multitude of control mechanisms. The surge over the last 30 years in investment activity by private equity investors at large has given rise to an increased specialization of this class of investors conditional on the risk return profiles associated with different investment and firm life cycle stages. For instance, business angels supporting the archetypical ‘paper company’ start-up face a risk exposure that in terms of both magnitude and characteristics is significantly different from that incurred by a private equity investor acquiring control of a mature company. Yet, investors in this market share common traits such as a value maximization approach, risk‒return informed decisions, and a deep knowledge of governance mechanisms. As such their influence on portfolio company governance mechanisms is largely similar in terms of depth and breadth. In this chapter we aim at presenting an up-to-date review of the main theoretical contributions and empirical results in this active and growing field of research.