Private Equity : Governance Arbitrage and Lessons for Public Corporate Governance

In this paper we test the proposition put forward by private equity practitioners that they undertake “governance arbitrage”. This proposition suggests that companies with higher agency costs are more likely to receive a bid from a PE firm.We find evidence that companies with higher agency costs are indeed more likely to receive a PE bid. PE is expected to make changes in the target company's governance, which would reduce these agency costs. We examine the aspects in their governance which make these target companies vulnerable to PE bids. The results may provide lessons for public corporate governance in highlighting areas where private governance expects to be more successful than contemporary public corporate governance. Additionally we find evidence of a spill-over effect in that public corporations are more likely to improve their governance during a period when there is increased private equity activity. In contrast to much of the debate on the merits of PE, we 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 PE activity. This conclusion in turn suggests that regulating changes to governance requires clear market goals and compelling empirical evidence to show how these goals can be realised. Companies also need to implement governance mechanisms that are optimal for their circumstances and desired goals. If we impose a uniform set of constraints to meet a set of desired public interest goals 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”