After the storm: unmasking publicly-traded private equity firms to create value through shareholder democracy.

• Author: Gomberg, Trevor M.

1. INTRODUCTION

   On June 21, 2007, The Blackstone Group L.P. ("Blackstone"), a prominent private equity firm, conducted its initial public offering ("IPO") of 133.3 million shares of "common units representing limited partner interests," raising $4.133 billion from public investors. (1) Within two weeks of Blackstone's IPO, Kohlberg, Kravis, Roberts & Co. L.P. CKKR"), another reputable private equity firm, filed a registration statement with the U.S. Securities and Exchange Commission CSEC"), intending to raise cash from the public markets. (2)

   Investment banks and journalists reacted in an overwhelmingly positive way to Blackstone's IPO. Wall Street analysts "positively gushed" over the prospect of Blackstone trading publicly; the strength of its portfolio holdings makes the firm a great investment. (3) "Wall Street firms rushed in to advise investors to buy, buy, buy ... [as] most of the underwriters came out with positive ratings." (4) Analysts in particular noted Blackstone's ability to remain profitable even during down markets. (5) With a stellar reputation and analyst praise, the IPO may have a far-reaching impact on an industry thrust in the spotlight.

   Private equity firms, defined and discussed in Part II of this comment, play an important role in business today. They can purchase stock in public companies, take a public company private, or take ownership positions in privately-held companies. Whereas private equity firms change management and operations to maximize value in portfolio companies, hedge funds are trading-oriented. (6) Private equity firms are commonly organized as partnerships (7) and, as such, traditionally have only had to answer to few outsiders. The firms are typically flush with cash, whether it is their own or borrowed from other sources.

   The Blackstone IPO provides a window of opportunity to observe the malleability of a private equity firm as it attempts to develop a relationship with new public owners and comply with demanding regulation. For instance, the SEC requires that publicly-traded companies disclose information that they otherwise would not need to as private entities. (8) Private equity firms are secretive about the way they do business--in an aggressive industry, specific business decisions are understandably "competitively sensitive." (9) Part III, describes some unique challenges Blackstone, as a public company, must face as it navigates uncharted waters.

   On the other hand, a firm in this industry cannot underestimate the benefits of seeking public ownership. A publicly-traded company has the chance to gain access to greater pools of capital from the investing public and consequently reduce reliance on borrowed funds. Decentralized decision-making for the benefit of new limited partners and disclosure of information pertinent to their investments can create value for post-IPO firms. Part IV presents Professor Lucian Bebchuk's theoretical approach and Professor Gompers's empirical approach, which both demonstrate that adoption of shareholder democracy principles by a post-IPO private equity firm can create value. Part V shows that private equity firms such as Blackstone and KKR do not intend to implement shareholder democracy concepts, as evidenced by their respective registration statements. This stance does not, however, foreclose them from the opportunity to do so.

   Part VI compares the management styles and disclosure policies of Blackstone and KKR, on the one hand, with Google Inc. ("Google"), on the other, to show that shareholder-driven governance mechanisms can be effective. Finally, this comment concludes that private equity firms which choose to conduct ah IPO should implement shareholder democracy--which, for the purpose of this paper is a function of shareholders' access to information and power to make decisions--and realize that doing so will likely have a positive effect toward maximizing both firm value and shareholder wealth.

2. WHAT PRIVATE EQUITY FIRMS ARE; WHAT THEY DO; HOW HEDGE FUNDS DIFFER

   Private equity firms lack a commonly-accepted legal definition. Private equity is an "umbrella term" consisting of venture capital financing for start-ups and private buyouts of existing companies. (10) This paper focuses on the latter application of the term. Private buyout firms commonly invest in mature life-cycle companies, often through leveraged buyout transactions or other related financing methods. (11) Leverage "refers to the advantages that may accrue to a business through the use of debt obtained from third persons (e.g. banks or outside investors) in lieu of contributed capital." (12)

   A private equity firm is really a dual-layered organization. On the outside, a private equity firm maintains a fund or funds which invest in a portfolio of companies. Underneath is a management company, employing "knowledgeable investment professionals" which provide "management expertise" to the portfolio companies. (13) The goal of private equity is to create value through investments in unproven or mismanaged companies which likely need help in order to become profitable. (14) Private equity firms typically divest ownership in these companies to realize the returns that they have generated by way of managerial and operational changes.

   Although a private equity firm may choose to organize as a corporation or limited liability company, the most common form of entity is a partnership. (15) The benefit of the partnership form is that it enjoys "flow-through" taxation, meaning that the entity is exempt from paying federal income tax. (16) From a tax perspective, this entity is preferred over a corporation, which is exposed to "double taxation": both the corporation itself and the owners of the corporations (its shareholders) are taxed. (17) Aside from favorable tax treatment, private equity firms limit liability by organizing as a limited partnership, with one general partner and several limited partner shares; the limited partner interests are given to individual investors and institutions in consideration for the capital they provide to the firm. (18) In the case of Blackstone, investors became limited partners ("unitholders") in the public firm.

   Hedge funds, another private, pooled investment vehicle, similarly lack a universal definition. (19) The SEC has classified a hedge fund as "an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company under the Investment Company Act [of 1940]." (20) Hedge funds adopt aggressive investment techniques and create portfolios of varied investments for their shareholders, with the goal to generate superior returns. One trade group defines a hedge fund as "a privately offered fund ... [with the] ability to hedge the value of the assets it holds.... However, some hedge funds engage only in 'buy and hold' strategies or other strategies that do not involve hedging in the traditional sense." (21) Ina hedge fund, the focus is more on trading strategy than governance strategy; hedge funds seek "absolute returns" on their investments, with "little or no correlation" to the momentum of other stocks and bonds. (22) Some of the strategies that funds have adopted include "event-driven strategies" based on expectations of the market, strategies which focus on certain geographic areas, and industry-targeted strategies to specific business sectors. (23)

   Private equity firms and hedge funds are similar in that they are not held to the same standard of regulation by the SEC as are other investment vehicles such as mutual funds. Instead, they qualify for several exemptions to otherwise necessary registration under the securities laws. (24) Due to these statutory exemptions, wealthy individuals and institutions traditionally have been the only investors qualifying to invest.

   Perhaps the most profound distinction between private equity firms and hedge funds is that hedge funds traditionally have not played as active of a role as private equity firms in transforming unproven or struggling companies to generate returns. While the recent trend may suggest that "'hungry' hedge funds with outsized war chests and egos to match are ... the 'new raiders,' or even the 'new sheriffs of the boardroom,'" (25) the focus of hedge funds is primarily in trading activity. Private equity activity, on the other hand, traditionally involves more strategic decisions over portfolio companies. It is not surprising, then, that Thomas W. Briggs identifies hedge funds' deference to management in the governance of their portfolio companies as follows:

   Lined up on one side are those who believe that shareholders actually own corporations and should have a greater say in how they are run. Shareholders, according to this view, should have direct input [to make] major corporate decisions.... Against them stand those who distrust shareholders ... and believe that companies are best run by directors who supervise professional managers. (26) III. THE PUBLIC, PRIVATE EQUITY FIRM--AN OXYMORON?

   The prospect of public ownership is a double-edged sword for private equity firms: while public ownership allows these firms to raise cash from individuals and institutions, they are also subject to closer scrutiny by regulators. Under federal securities law, an IPO requires firms to disclose certain material information that they would not need to as private entities. (27) When a company wants to sell its securities in the public markets, it must file a registration statement with the SEC. (28) By disclosing certain information--such as investment strategy--a post-IPO private equity firm would be acting inconsistent with its traditional operations. As private entities, their "scrappy" operations are not transparent to the investing public. (29) Unitholders will demand greater disclosure and input in business decisions than the private firms have ever provided.

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