Governance Arbitrage by Private Equity and Why it Occurs

In this paper I test the proposition put forward by private equity players that they undertake “governance arbitrage”. This proposition suggests that public companies with weak governance are more likely to receive a buyout bid from a private equity (PE) firm.I find evidence that companies with ineffective governance are indeed more likely to receive a PE bid. In contrast, synergistic bids are significantly less likely to be motivated by governance factors. PE is expected to make changes in the target company's governance, which would reduce the costs arising from ineffective governance. I therefore examine the governance in target companies which make them more vulnerable to PE bids. The results highlight areas where private governance expects to be more successful than contemporary corporate governance of a public corporation. As an extension I examine how the findings vary with a company's moral setting. The results highlight how arbitrage opportunities are contingent on the moral hazards facing a company and these affect the board's cost of information discovery.In contrast to much of the debate on the merits of PE, I highlight that the current state of public corporate governance is itself a driver for the existence of PE in that the need to address ineffective governance underlies some of PE's activity. Companies need to implement governance mechanisms that are optimal for their circumstances. When we impose a uniform set of constraints to meet desired public interest goals for public corporations then it seems likely that we also need a complementary mechanism to support a market for corporate control. In this sense PE is a desirable “player in the field” in that an economy is generally better off with, rather than without, “buyout governance”