Does private equity create wealth? the effects of private equity and derivatives on corporate governance

University of Chicago Law Review

Volumn 76, Issue 1, 2009, Pages 219-259

  Masulis, Ronald W ^a   Thomas, Randall S ^a  

^a VANDERBILT UNIVERSITY   (United States)

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EID: 66249098556     PISSN: 00419494     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (170)

1. The earliest and best-known paper is Michael C. Jensen, Eclipse of the Public Corporation, 67 Harv Bus Rev 61, 67 (Sept/Oct 1989) (positing that private-equity-owned firms would do a better job of managing free cash flow than public companies). For further discussion of this literature, see Part II.
2. Derivatives are generally defined to include options, futures and forward contracts, and swaps, as well as financial products with derivative contracts embedded in them such as convertible securities, insurance, and reinsurance.
3. Dan Wilchins, Private Equity Is Viewed As a "Shock Absorber," Intl Herald Trib 17 (July 1, 2008) (stating that banks are in "dire need of capital" and suggesting that private equity may be able to provide it).
4. See Board of Governors of the Federal Reserve System, Policy Statement on Equity Investments in Banks and Bank Holding Companies 9-10 (Sept 22, 2008), to be codified at 12 CFR §online at http://www.federalreseive.gov/ newsevents/press/bcreg/bcreg20080922bl.pdf (visited Jan 11, 2009). In certain circumstances, the new rules permit investors to hold up to 15 percent of the voting power and 33 percent of the total equity without being deemed a controlling shareholder (and thereby being subject to regulation as a bank holding company).
5. See id at 10. They may also appoint one member of the board of directors.
6. Id at 6.
7. Peter Lattman, Flowers, Not His Firm, Buys a Bank, Wall St J C6 (Sept 24, 2008).
8. See Peter Lattman and Damian Paletta, Fed Gives Funds More Leeway to Buy Banks, Wall St J A1 (Sept 23, 2008) (discussing how the increased flexibility given to private-equity firms will enable them to "make investments in some bank holding companies where they had been reluctant to do so over the last few months");
9. The Lex Column, Beyond Buyouts, Fin Times 12 (Apr 9,2008) (describing a private-equity firm's "multi-billion dollar investment to recapitalize Washington Mutual" as indicating "where private equity's cash piles will go next").
10. Michael Jensen explains that this common practice is referred to as "strip financing," which Jensen defines as investors holding "roughly proportional 'strips' of all securities in the capital structure" and thereby reducing any conflicts of interest among the classes of claimants at firms. Michael C. Jensen, Corporate Control and the Politics of Finance, 4 J Applied Corp Fin 13, 25 (Summer 1991).
11. See Andrew Metrick and Ayako Yasuda, The Economics of Private Equity Funds *2 (University of Pennsylvania, The Wharton School, Department of Finance Working Paper, Sept 2007), online at http://finance.wharton.upenn. edu/∼rlwctr/papers/0717.pdf (visited Jan 11, 2009).
12. Id at *2.
13. Id at*3.
14. This is especially the case since existing investors have been identified as interested in private-equity investments and are most likely to become limited partners in future funds, provided they did well in prior funds.
15. Metrick and Yasuda, The Economics of Private Equity Funds at *6-13 (cited in note 8) (developing an expected-revenue model for private-equity firms).
16. James F. Cotter and Sarah W. Peck, The Structure of Debt and Active Equity Investors: The Case of the Buyout Specialist, 59 J Fm Econ 101,102-03 (2001) (discussing the various combinations of debt-subordinated, senior, long-term, and short-term-and third-party equity that leveraged buyout shops use to purchase the publicly held shares of target companies).
17. Id at 111-12 (finding that buyout specialists purchased a median 51.6 percent of the common stock of target companies in a sample of sixty-four LBOs, while target firm managers held 20 percent and third-party equity investors held the remaining 28.4 percent of the shares).
18. Steven N. Kaplan, The Effects of Management Buyouts on Operating Performance and Value, 24 J Fin Econ 217,246 (1989).
19. See also Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 Am Econ Rev 323, 326 (1986) ("Top-level managers frequently receive 15-20 percent of the equity.").
20. Michael C. Jensen, The Economic Case for Private Equity (and Some Concerns) *15 (Harvard NOM Research Paper No 07-02, Nov 2007), online at http://ssrn.com/abstract=963530 (visited Jan 11, 2009).
21. See Brian Cheffins and John Armour, The Eclipse of Private Equity, 33 Del J Corp L 1, 13-14 (2008).
22. Geoffrey Colvin and Ram Charan, Private Equity, Private Lives, Fortune 190 (Nov 27, 2006) (describing how private-equity-owned firms' boards are different from public company boards and "far more involved in assisting the company");
23. Cotter and Peck, 59 J Fin Econ at 137 (cited in note 13) ("Thus, buyout specialists are likely to more effectively monitor managers by having more seats on the board and by having smaller boards.").
24. Ronald J. Gilson and Charles K. Whitehead, Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets, 108 Colum L Rev 231, 259-60 (2008) (suggesting that private ownership increases the value of a firm in part through "reduced agency costs" resulting from a more active boarďof directors).
25. Jensen, Economic Case at *15 (cited in note 16).
26. See, for example, Viral V. Acharya and Conor Kehoe, Corporate Governance and Value Creation' Evidence from Private Equity *34 (London Business School Working Paper, May 2008), online at http://www.bvca.co. uk/pdf.php?id=901&filename=corporate-governance-and-value-creation: evidence-from-private-equity (visited Jan 11, 2009); Francesca Cornelli and Oguzhan Karakas,
27. Private Equity and Corporate Governance: Do LBOs Have More Effective Boards?, in Globalization of Alternative Investments Working Papers Volume 1: The Global Economic Impact of Private Equity Report 2008 65, 72 (World Economic Forum 2008), online at http://www.weforum.org/ pdf/cgi/pe/Full-Report.pdf (visited Jan 11, 2009);
28. Robert Gertner and Steven N. Kaplan, The Valuemaximizing Board *13 (NBER Working Paper, Dec 1996), online at http://faculty.chicagobooth. edu/steven.kaplan/research/gerkap.pdf (visited Jan 11, 2009).
29. See Cheffins and Armour, 33 Del J Corp L at 14 (cited in note 17).
30. Jensen, Economic Case at *16 (cited in note 16).
31. See Michael C. Jensen, The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, 48 J Fin 831, 863 (1993);
32. Jensen, Economic Case at *16 (cited in note 16).
33. These buyers would value any improvements in operating performance at the portfolio company created by the selling private-equity owners according to whether they believe that such gains will be temporary or permanent. This gives the private-equity seller an incentive to
34. ensure that the changes will persist. In the case of a strategic buyer, this would mean that the acquirer would have to be convinced that its management could replicate the private-equity firm's success in improving risk management or any other sources of the improved operating performance. In a reverse LBO, potential investors would need to see that the newly public firm could duplicate its past success with a less concentrated ownership structure. In this regard, these investors could take comfort from evidence that operating performance improvements at reverse LBO firms persist for at least several years after the firm returns to public ownership. See Gertner and Kaplan, The Value-maximizing Board at *17, table 1 (cited in note 21).
35. Daniel A. Wingerd, The Private Equity Market: History and Prospects, Investment Policy Mag 26, 30 (Sept/Oct 1997) (describing how the weak stock market and inadequate supply of qualified entrepreneurs led to poor conditions for venture capital in the 1970s).
36. See id at 30-32 (arguing that regulatory changes in 1980 meant that "outside managers of plan assets in the venture arena could now be paid proportionately to their success, a vital element in the venture capitalists' mode of doing business");
37. Valentine V. Craig, Merchant Banking: Past and Present, 14 FDIC Banking Review 29,30 (Sept 2001), online at http://www.fdic.gov/ bank/analytical/bankmg/2001sep/br2001vl4n1art2.pdf (visited Jan 11, 2009) (describing the history of the private-equity market in the United States from the 1800s to the present).
38. Viral V. Acharya, Julian Franks, and Henri Servaes, Private Equity: Boom or Bust?, 19 J Applied Corp Fm 44, 44 (Fall 2007) (describing how new private-equity or LBO transactions amounted to $500 billion globally, of which $200 billion was spent in the United States and $140 billion in Europe).
39. Steven Rattner, How the Levers Fell Off the Buyout Machine, Fin Tunes 13 (Mar 25, 2008) (noting how the value of leveraged buyouts announced between July 2007 and March 2008 equaled "less than half the amount achieved in June 2007 alone").
40. Acharya, Franks, and Servaes, 19 J Applied Corp Fin at 53 (cited in note 28).
41. See Serena Ng and Liz Rappaport, Is Debt Thaw on Borrowed Time? Buyout Bids, Stock Buybacks, Junk Issues Offer Hope, but Some See Short Window, Wall St J C1 (May 15, 2008) (summarizing leveraged-lending executives' worries that a March to May 2008 improvement in the credit markets was "a short-term window of opportunity for [private-equity] issuers").
42. Jensen, 67 Harv Bus Rev at 66-67 (cited in note 1) (noting how managers have "few incentives to distribute the funds").
43. See id at 67.
44. See id.
45. Luc Renneboog and Tomas Simons, Public-to-private Transactions: LBOs, MBOs, MBIs and IBOs *10 (ECGI Finance Working Paper No 94/2005, Aug 2005), online at http://ssrn.com/ abstract=796047 (visited Jan 11, 2009).
46. See Kaplan, Effects of Management Buyouts, 24 J Fin Econ at 245 (cited in note 15) (positing that the adjusted distribution of equity interest could "suggest that new incentives for junior managers play an important role in buyouts").
47. This was demonstrated by Dan Galai and Ronald W. Masulis, The Option Pricing Model and the Risk Factor of Stock, 3 J Fin Econ 53,58-61 (1976) (concluding that "the systemic risk of the firm [ ] and of its equity [ ] is not only a positive function of its leverage ... but that it is a positive function of the face value of debt [as well as several other factors]");
48. Robert Merton, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, 29 J Fin 449, 466-67 (1974) (showing that until some inflection point, the return equity investors demand from a firm increases faster than the ratio of the firm's market debt to equity);
49. Mark E. Rubinstein, A Mean-variance Synthesis of Corporate Financial Theory, 28 J Fin 167, 176-77 (1973) (quantifying the effect of financial leverage on the risk of a firm and its corresponding expected equity rate of return).
50. Cotter and Peck, 59 J Fin Econ at 111-12 (cited in note 13) (comparing the incentives of the three types of controlling investors-management, buyout specialists, and outside investors).
51. Id.
52. Steven N. Kaplan and Per Strömberg, Leveraged Buyouts and Private Equity, 23 J Econ Perspectives (forthcoming 2009).
53. Acharya and Kehoe, Corporate Governance and Value Creation at *6 (cited in note 21) (reporting that one-third of CEOs are replaced within the first 100 days of an LBO and twothirds are gone within four years).
54. See Bengt Holmström and Steven N. Kaplan, Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s, 15 J Econ Persp 121, 136 (2001) (arguing that LBOs disappeared in the 1990s because "they were no longer needed").
55. Lucian Bebchuk has been an outspoken advocate of this position. See generally, for example, Lucian Bebchuk and Jesse Fried, Pay without Performance: The Unfulfilled Promise of Executive Compensation (Harvard 2004).
56. See, for example, id at 1-10.
57. Melvin Aron Eisenberg, The Structure of the Corporation: A Legal Analysis 146-48 (Little, Brown 1976). The increase in hedge fund shareholder activism over the past decade may be pushing boards to a more balanced weighing of shareholder and manager interests Hedge funds' high success rates in their activist endeavors have heightened director sensitivity to their interests.
58. See Alon Brav, et al, Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J Fin 1729, 1733 (2008) (arguing that because hedge funds occupy an "important middle ground" between internal monitoring by large shareholders and external monitoring by buyout firms, they are in a "potentially unique position to reduce the agency costs associated with the separation of ownership and control").
59. Sarbanes-Oxley Act of 2002, Pub L No 107-204, 116 Stat 745, codified at 15 USC §7201 et seq.
60. 15 USC §7262.
61. See, for example, Roberta Romano, The Sarbanes-Oxley Act and the Making of Quack Corporate Governance, 114 Yale L J 1521, 1588 (2005) (reporting that the cost of being public more than doubled after SOX and that it imposed a "far more significant burden" on small firms than on large companies).
62. Robert P. Bartlett III, Going Private but Staying Public: Reexamining the Effect of Sarbanes-Oxley on Firms' Going-private Decisions, 76 U Chi L Rev 7, 9 (2009) (discussing how most going-private transactions require the target firm to issue high-yield debt securities, which "effectively requires [the firm] to comply with SOX").
63. See Christian Leuz, Was the Sarbanes-Oxley Act of 2002 Really This Costly? A Discussion of Evidence from Event Studies and Going Private Decisions, 44 J Acct & Econ 146, 161 (2007).
64. See id.
65. Luc Renneboog, Tomas Simons, and Mike Wright, Why Do Public Firms Go Private in the UK?, 13 J Corp Fin 591, 597-98 (2007) (discussing how going private results in "the elimination of the direct and indirect costs associated with maintaining a stock exchange listing").
66. See Harry DeAngelo, Linda DeAngelo, and Edward M. Rice, Going Private: Minority Freezeouts and Stockholder Wealth, 27 J L & Econ 367, 400 (1984).
67. Renneboog and Simons, Public-to-private at *13 (cited in note 35) (estimating savings of $30,000 to $200,000 in service costs from going private).
68. Jana P. Fidrmuc, Peter Roosenboom, and Dick van Dijk, Do Private Equity Investors Take Firms Private for Different Reasons? *1 (Working Paper, Feb 2007), online at http://ssrn.com/ abstract=968101 (visited Jan 11, 2009).
69. See Louis Lowenstein, Management Buyouts, 85 Colum L Rev 730, 780 (1985).
70. Brav, et al, 63 J Fin at 1742 (cited in note 45).
71. If a hostile offer is pending or imminent, however, it may be difficult to win a shareholder vote to approve a dual class recapitalization. Under these circumstances, an LBO or an MBO seems more likely to be a successful defense.
72. See Renneboog and Simons, Public-to-private at *16-17 (cited in note 35) (summarizing academic literature that found a positive correlation between potential tax savings and the likelihood of going private).
73. See Steven N. Kaplan, Management Buyouts: Evidence on Taxes As a Source of Value, 44 J Fin 611, 623-24 (1989) (estimating the potential value of the tax benefits involved in an MBO for companies facing a 15 percent and a 46 percent marginal tax rate, respectively). Kaplan estimates that a company receives even higher benefits if it elects to make a step-up in basis. See id.
74. George M. Frankfurter and Erdal Gunay, Management Buy-outs: The Sources and Sharing of Wealth between Insiders and Outside Shareholders, 32 Q Rev Econ & Fm 82, 93 (1992);
75. Lowenstein, 85 Colum L Rev at 731 (cited in note 56) ("Transactions of such suspiciously little economic and social value require reappraisal.").
76. See Renneboog and Simons, Public-to-private at *17 (cited in note 35) (arguing that going-private decisions by US firms in the 1980s were frequently motivated by "anti-takeover defense strategies" rather than the opportunity to appropriate tax benefits).
77. See Metropolitan Life Insurance Company v RJR Nabisco, 716 F Supp 1504, 1526 (SDNY 1989).
78. See Laurentius Marais, Katherine Schipper, and Abbie Smith, Wealth Effects of Going Private for Senior Securities, 23 J Fin Econ 155, 159 (1989) (indicating that a buyout may allow management to reduce other stakeholders' claims on a firm's cash flows by, for example, cutting back staff).
79. See Renneboog and Simons, Public-to-private at *10 (cited in note 35).
80. Marais, Schipper, and Smith, 23 J Fm Econ at 157 (cited in note 64) (finding "pervasive downgradings ... of Moody's debt ratings following successful buyout proposals" but indicating that there was insufficient evidence to generalize about the effects of a buyout on bond prices); Yakov Amihud, Leveraged Management Buyouts: Causes and Consequences 5 (Dow Jones-Irwin 1989).
81. See also Mark I. Weinstein, Bond Systematic Risk and the Option Pricing Model, 38 J Fm 1415, 1424-26 (1983).
82. See Arthur Warga and Ivo Welch, Bondholder Losses in Leveraged Buyouts, 6 Rev Fin Stud 959, 979 (1993) (concluding that in successful LBOs from 1985-1989, the typical bondholder lost 6 percent of the risk-adjusted value of his bonds within four months of the LBO announcement);
83. Paul Asquith and Thierry A. Wizman, Event Risk, Covenants, and Bondholder Returns in Leveraged Buyouts, 27 J Fin Econ 195, 212 (1990) (reporting that "[b]onds that contain covenants ... experience abnormal gains" while those "that do not... suffer abnormal losses").
84. See Andrei Shleifer and Lawrence H. Summers, Breach of Trust in Hostile Takeovers, in Alan J. Auerbach, ed, Corporate Takeovers: Their Causes and Consequence 33, 53 (Chicago 1988).
85. The evidence shows that post-LBO firms report small increases in employment levels, but fail to expand employment levels as fast as the rest of their industry. See Steve Thompson and Mike Wright, Corporate Governance: The Role of Restructuring Transactions, 105 Econ J 690, 697 (1995); Kaplan and Strömberg, J Econ Persp at 17-18 (cited in note 40).
86. See Jeffrey Pontiff, Andrei Shleifer, and Michael S. Weisbach, Reversions of Excess Pension Assets after Takeovers, 21 RAND J Econ 600, 601 (1990) (estimating that pension fund reversions account for approximately 11 percent of takeover wealth gains).
87. 17CFR 240.10b5-l.
88. In re Topps Co Shareholders Litigation, 924 A2d 951, 963 (Del Ch 2007) ("Few contexts are more important to stockholders than the pendency of a transaction in which they exchange their shares for cash and the company is taken private.").
89. See Robert C. Merton, Financial Innovation and the Management and Regulation of Financial Institutions, 19 J Banking & Fin 461, 462 (1995) (claiming that the "rise of derivative products could have just as easily been framed as greatly reducing risks in the system").
90. See also Gilson and Whitehead, 108 Colum L Rev at 235 (cited in note 19) (suggesting that "risk management [focused] at the firm level may be more efficient than broadband risk-bearing by diversified shareholders");
91. Myron S. Scholes, Derivatives in a Dynamic Environment, 88 Am Econ Rev 350, 364, 366-67 (1998) (characterizing equity as a "risk-management device").
92. Merton, 19 J Banking & Fin at 465 (cited in note 73).
93. Id at 466.
94. Id.
95. Id. See also Scholes, 88 Am Econ Rev at 366 (cited in note 73) ("Ways will be found through financial engineering to provide private entities with the advantages of the public market-risk sharing, liquidity, and pricing signals-while retaining the advantages of the private market-lower disclosure and agency costs.").
96. Many studies find that SOX has led many small US firms to go private. See, for example, Ellen Engel, Rachel M. Hayes, and Xue Wang, The Sarbanes-Oxley Act and Firms' Going-private Decisions, 44 J Acct & Econ 116, 118 (2007). Another study documents that many LBO firms were small and had IPOs in the prior five years.
97. See Hamid Mehran and Stavros Peristiani, Financial Visibility and the Decision to Go Private *3-4 (Federal Reserve Bank of New York Working Paper, July 2007), online at http://www.newyorkfed.org/research/economists/ peristiani/ mehran-peristiani.pdf (visited Jan 11, 2009).
98. See, for example, David J. Denis and Diane K. Denis, Leveraged Recaps and the Curbing of Corporate Overinvestment, in Donald H. Chew and Stuart L. Gillan, eds, Corporate Governance at the Crossroads 318, 320 (McGraw-Hill 2005) (surveying twenty-nine leveraged recapitalizations completed between 1984 and 1988, and concluding that these companies outperformed the market by 26 percent, on average);
99. Anju Seth and John Easterwood, Strategic Redirection in Large Management Buyouts: The Evidence from Post-buyout Restructuring Activity, 14 Strategic Mgmt J 251, 258 (1993) (describing how conglomerates and other firms with unrelated divisions divested assets post-buyout in order to focus on their core businesses);
100. Kaplan, 24 J Fin Econ at 251 (cited in note 15) (stating that empirical evidence "supports the hypothesis that management buyouts experience post-buyout operating improvements and value increases [that] appear to be generated by improved incentives").
101. See Galai and Masulis, 3 J Fin Econ at 57 (cited in note 37) (analogizing an optionholder who has "claim to the slice of a stock's price distribution to the right of the exercise price at maturity date" to a firm's stockholder who has a "claim to the slice of the firm's price distribution to the right of the face value of the firm's debt at its maturity date").
102. See also Fischer Black and Myron Scholes, The Pricing of Options and Corporate Liabilities, 81 J Pol Econ 637, 637 (1973) (defining a "European option" as a "security giving the right to buy or sell an asset, subject to certain conditions,... on a specified future date").
103. As we noted in Part II.H, an LBO may create increased conflicts of interest among the firm's debt and equity holders. When private-equity firms purchase both debt and equity interests in their portfolio firm, especially if they do so in a strip financing investment, see note 7, this will better align the private-equity firm's interests with those of both debt and equity investors in the post-buyout company.
104. See Acharya, Franks, and Servaes, 19 J Applied Corp Fin at 52 (cited in note 28);
105. Gregor Andrade and Steven N. Kaplan, How Costly Is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions That Became Distressed, 53 J Fin 1443, 1483 (1998);
106. Steven N. Kaplan and Jeremy C. Stein, The Evolution of Buyout Pricing and Financial Structure in the 1980s. 108 Q J Econ 313, 313-14 (1993) (finding that fees taken by buyout shops, investment banks, and lenders trended upwards during the boom in buyouts during the late 1980s growing from between 2.05 percent and 2.66 percent before 1985 to between 3.69 percent and 5.97 percent in 1988).
107. Evidence that this concern is not economically important has been found by Gregor Andrade and Steven Kaplan. They studied a sample of highly leveraged transactions that subsequently became financially distressed and estimated the effects of distress on firm value. They report that "[f]rom pretransaction to distress resolution, the sample firms experience a small increase in value. In other words, the net effect of the [highly leveraged transaction] and distress is to leave value slightly higher." Andrade and Kaplan, 53 J Fin at 1487 (cited in note 82) (arguing that this evidence "strongly suggests" that highly leveraged transactions earned positive risk-adjusted returns).
108. Recent research suggests that these club deals may result in private-equity firms paying lower prices when acquiring firms unless the targeted firm has high institutional stock ownership. See generally Micah S. Officer, Oguzhan Ozbas, and Berk A. Sensoy, Club Deals in Leveraged Buyouts *2 (USC Marshall School of Business Working Paper MKT 10-08, July 2008), online at http://ssrn. com/abstract=1128404 (visited Jan 11, 2009) (finding that target shareholders received on average 10 percent less in club deals and suggesting that these findings are "consistent with the view that club deals may be detrimental to passive, dispersed shareholders of publicly-traded corporations").
109. See Audra L. Boone and J. Harold Mulherin, Do Private Equity Consortiums Impede Takeover Competition? *7 (AFA 2009 San Francisco Meetings Paper, May 2008), online at http:// ssrn.com/abstract=1104224 (visited Jan 11, 2009) (reporting that the median number of bidders in consortium deals is 2.84). Boone and Mulherin estimate that target returns for "private equity consortium bidders" from sixty-three days before the takeover until completion were "not measurably different" than for private-equity firms bidding alone.
110. Id at *19-20.
111. See Viral V. Acharya and Timothy C. Johnson, More Insiders, More Insider Trading: Evidence from Private Equity Buyouts *1 (London Business School Working Paper, Nov 2007), online at http://facultyresearch. london.edu/docs/Acharya-Johnson-Insider-Trading-Takeoverspdf (visited Jan 11, 2009).
112. To see a measure of the rapid growth of derivatives trading and outstanding contracts, see the summaries of annual levels of exchange-traded and over-the-counter (OTC) derivative contracts reported by the International Swaps and Derivatives Association, Summaries of Market Survey Results, online at http://www.isda.org/statistics/recent.html (visited Jan 11, 2009). For US bank derivatives activity,
113. see Comptroller of the Currency Administrator of National Banks, OCC's Quarterly Report on Bank Derivatives Activities, online at http://www.occtreas.gov/deriv/deriv.htm (visited Jan 11, 2009).
114. See Merton, 19 J Banking & Fin at 471 (cited in note 73) (contrasting innovations in derivative products, which can be implemented quickly, with changes in financial regulation, which take longer and require more coordination to implement).
115. Companies have between sixty and ninety days after the end of their fiscal year to file their Form 10-K and between forty and forty-five days after the end of each fiscal quarter to file their Form 10-Q. See Form 10-K, "General Instructions" A(2), online at http://www.sec.gov/about/ forms/form10-k.pdf (visited Jan 11, 2009);
116. Form 10-Q, "General Instructions" A(1), online at http://www.sec.gov/about/forms/form10-q.pdf (visited Jan 11, 2009).
117. Merton, 19 J Banking & Fin at 470 (cited in note 73) (arguing that the current accounting system only looks at value allocations and is, "therefore, an ineffective structure for identifying risk allocations");
118. Scholes, 88 Am Econ Rev at 367 (cited in note 73) (noting how standard accounting does not "decompose profitability into profits from market forces and profits from managerial efforts, nor does it describe the sensitivities of the firm's profit and loss to market factors"). In an earlier paper, Scholes states, "A whole new system of risk accounting must be developed. Current accounting systems concentrate on static valuations Swaps, foreign exchange contracts, and other OTC derivatives have no initial value. As a result, they are 'off balance sheet.' There is no place for them in the current accounting world."
119. Myron S Scholes, Global Financial Markets, Derivative Securities, and Systemic Risks, 12 J Risk & Uncertainty 271, 284 (1996).
120. Merton, 19 J Banking & Fin at 470 (cited in note 73).
121. Id.
122. See note 89 for a discussion of the time lags for filing Forms 10-K and 10-Q.
123. For example, the changing composition of mortgage pools, which many mortgage-backed securities allow, increases the difficulty of valuing these pools on a mark-to-market basis.
124. This is the one good reason for relying on an exchange-clearing corporation to be the counterparty in all trades. Unfortunately, most derivative trades occur off the floors of derivative exchanges. See International Swaps and Derivatives Association, Summaries of Market Survey Results (2008), online at http://www.isda.org/statistics/recent.html (visited Jan 11, 2009) (cited in note 87) (reporting that by mid-2008, the notional amount of off-exchange interest rate derivatives had grown to $464.7 trillion).
125. Brian W. Nocco and René M. Stulz, Enterprise Risk Management: Theory and Practice, 18 J Applied Corp Fin 8, 15 (2006).
126. See Lisa K. Meulbroek, A Senior Manager's Guide to Integrated Risk Management, 14 J Applied Corp Fin 56, 61 (Winter 2002).
127. Merton, 19 J Banking & Fin at 472 (cited in note 73); Scholes, 88 Am Econ Rev at 364 (cited in note 73).
128. See, for example, Andrew S. Grove, Stigmatizing Business, Wash Post A23 (July 17, 2002) ("[S]tock exchanges should require that boards of directors be predominantly made up of independent members having no financial relationship with the company.").
129. See, for example, Lucian Bebchuk and Yaniv Grinstein, The Growth of Executive Pay, 21 Oxford Rev Econ Policy 283, 284 (2005) (finding that compensation growth cannot be explained by changes in firm size, performance, or industry mix);
130. Michael C. Jensen and Kevin Murphy. Remuneration: Where We've Been, How We Got to Here, What Are the Problems, and How to Fix Them *29 (Harvard Business School Working Paper No 04-28, ECGI Finance Working Paper No 44/2004, July 2004), online at http://ssrn.com/abstract=561305 (visited Jan 11, 2009) (discussing how giving large compensation packages despite poor performance is not in the best interests of the firm);
131. Jensen, 48 J Fin at 866-67 (cited in note 24) ("Without the direction of an independent leader, it is much more difficult for [a] board to perform its critical function.").
132. See Byoung-Hyoun Hwang and Seoyoung Kim, It Pays to Have Friends. J Fin Econ (forthcoming 2009), online at http://ssrn.com/abstract=1195313 (visited Jan 11, 2009) (finding that from 1996 to 2005, 87 percent of Fortune 100 boards could be classified as "conventionally independent," whereas only 62 percent could be classified as "socially independent").
133. Ronald Masulis and Shawn Mobbs find that given their firm-specific knowledge, inside directors can be very beneficial to board decisionmaking, especially when they have some independence and serve on the boards of high-tech and other information-intensive firms. See Ronald W. Masulls and Shawn Mobbs, Are All Inside Directors the Same? CEO Entrenchment or Board Enhancement *3 (Third Annual Conference on Empirical Studies Paper, American Finance Association 2009 San Francisco Meetings Paper, Mar 2008), online at http://ssrn.com/abstract= 1108036 (visited Jan 11, 2009).
134. For evidence of LBO board activity, see generally Acharya and Kehoe, Corporate Governance and Value Creation: Evidence from Private Equity (cited in note 21) (finding that evidence from private-equity transactions in the United Kingdom from 1996 to 2004 indicates that buyout firms take an active stance on firm ownership and governance);
135. Cornelli and Karakas, Private Equity and Corporate Governance: Do LBOs Have More Effective Boards? (cited in note 21) (finding that private-equity board members are more actively involved in complex transactions than board members backed by nonfinancial sponsors);
136. Gertner and Kaplan, The Valuemaximizing Board (cited in note 21) (finding that as compared to public companies, the boards of private-equity-controlled firms are smaller, control larger equity stakes, and meet less frequently, while directors are younger and have shorter tenures).
137. One implication of this is that FIs are unlikely to be serious competitors to the privateequity firms. This is especially true given the various regulatory constraints they face in holding significant amounts of equity in illiquid, privately held firms. The one exception to this statement is the creation of venture capital subsidiaries by some major commercial banks.
138. Scholes, 88 Am Econ Rev at 360 (cited in note 73).
139. It is surprising that banking authorities have not required banks to move this derivatives market-making activity to a centralized exchange where transparency is enhanced and bank exposure to counterparty default risk is greatly reduced.
140. Merton, 19 J Banking & Fin at 462 (cited in note 73).
141. Id.
142. Id at 477 (predicting that central banks and other government policymakers are "likely to become increasingly familiar" with derivatives and the "advanced financial technology" used by financial institutions).
143. Scholes, 12 J Risk & Uncertainty at 284 (cited in note 90) (noting that, given the growth and evolution in derivative contracting, "[t]he speed of institutional change has increased in recent years. As new financial innovations have succeeded, regulatory conventions have become obsolete, or lagged behind the new innovations").
144. For a detailed discussion of the accounting treatment of derivatives, see generally Mark A.Trombley, Accounting for Derivatives and Hedging (McGraw-Hill 2003).
145. See General Accounting Office (GAO), Financial Derivatives: Actions Needed to Protect the Financial System, Report No GAO/GGD-94-133 to Congressional Requesters 12 (May 1994), online at http://archive.gao.gov/ t2pbat3/151647.pdf (visited Jan 11, 2009), which earlier raised these concerns, and Scholes, 12 J Risk & Uncertainty at 273 (cited in note 90), which gave a critical response to the GAO report.
146. More recently, see International Monetary Fund, Global Financial Stability Report: Containing Systemic Risks and Restoring Financial Soundness 87 (Apr 2008), online at http://www.imf.org/External/Pubs/FT/GFSR/ 2008/01/pdf/text.pdf (visited Jan 11, 2009) (summarizing evidence that from July 2007 to April 2008, increased market volatility and higher default risks of potential counterparties made prices so unreliable that "no trading took place at those prices").
147. Kenneth Scott argues that this trend is driven in part by legal liability from the In re Caremark decision of the Delaware Chancery Court and SOX's emphasis on internal controls and audit committees, but perhaps more importantly by the financial advantages to firms from adopting risk management. See Kenneth E. Scott, The Role of Corporate Governance in Coping with Risks and Unknowns *7-8 (Stanford Law and Economics Olin Working Paper No 356, Apr 2008), online at http://www.law.stanford.edu/publications/details/3993 (visited Jan 11, 2009),
148. citing In re Caremark International Inc Derivative Litigation, 698 A2d 959 (Del Ch 1996). See also Gilson and Whitehead, 108 Colum L Rev at 249 (cited in note 19) (stating that corporate risk management has only emerged in the last thirty years).
149. Meulbroek, 14 J Applied Corp Fin at 64 (cited in note 97).
150. Nocco and Stulz, 18 J Applied Corp Fin at 8 (cited in note 96).
151. Id.
152. Id at 10.
153. us See Ont Gadiesh and Hugh MacArthur, Lessons from Private Equity Any Company Can Use 62-67 (Harvard Business 2008) (discussing how private-equity investors focus on forward-looking operational metrics such as revenue churn, retention rates, and return on invested capital);
154. Thompson and Wright, 105 Econ J at 701 (cited in note 69) (evaluating the extent that LBOs are an innovation in corporate governance and how far they remedy the agency problems associated with diffuse shareholdings and management control).
155. For the pathbreaking article on this point, see Bengt Holmström, Moral Hazard and Observability, 10 Bell J Econ 74, 75-80 (1979) (developing a model of optimal risk-sharing between principals and agents when the principal can monitor only the outcome of the agent's actions).
156. It is worth noting that a small board reduces the financial cost of creating good director incentives.
157. An interesting issue worthy of empirical documentation is the percentage of privateequity directors who have substantial financial expertise.
158. Editorial, The Banks and Private Equity, NY Tunes WK9 (Aug 3, 2008) (indicating that the previous rules discouraged private-equity investment in the financial sector because privateequity firms could not gain control over target banks).
159. See text accompanying note 4 for a discussion of this change.
160. The most likely reason for this is that private-equity firms are unwilling to be regulated by the Federal Reserve as financial holding companies, which would be one result of them acquiring an FI. If this is correct, then the Federal Reserve needs to consider relaxing this rule. Presumably it would make its decision by weighing the cost-benefit tradeoffs of allowing large, loosely regulated capital injections from private-equity firms and closer risk monitoring versus the potentially negative impact of a reduction in federal oversight of these institutions.
161. Given the federal government's decision to become a large stakeholder in many FIs through its recent investments in those firms under the Troubled Assets Relief Program (TARP), it is interesting to speculate over whether the Federal Reserve should have considered creating much greater incentives for private-equity investors to invest in FIs. Presumably the privateequity firms would create stronger forward-looking risk monitoring controls at FIs (as well as better monitoring of compensation levels) than what the federal government has been able to do as of the time that this Article went to press.
162. James Cotter and Sarah Peck find that sophisticated buyout shops use less short-term debt and need less senior debt because these private-equity investors do a better job of monitoring their portfolio companies. See Cotter and Peck, 59 J Fin Econ at 123-24 (cited in note 13).
163. See Charles K. Whitehead, The Evolution of Debt: Covenants, the Credit Market and Corporate Governance *23-24 (Boston University School of Law Working Paper No 8-26, Jan 2009), online at http://www.bu.edu/law/faculty/ scholarship/workingpapers/documents/WhiteheadC090208.pdf (visited Jan 11, 2009).
164. One seemingly contradictory piece of evidence is the recent popularity of covenant-lite debt when institutional investors were competing to lend to private-equity borrowers. This appears to represent a serious failure in the commercial bank decisionmaking process that has had adverse consequences See Acharya, Franks, and Servaes, 19 J Applied Corp Fin at 52 (cited in note 28) (characterizing covenant-lite loans as "a manifestation of weak lending standards and incentives to monitor").
165. Thompson and Wright, 105 Econ J at 692-93 (cited in note 69).
166. See, for example, Nishant Dass and Massimo Massa, The Bank-firm Relationships Tradeoff between Better Governance and Greater Information Asymmetry *4 (INSEAD Working Paper, Sept 2008), online at http://fic.wharton.upenn.edu/fic/corporate%20finance%202006/Massa.pdf (visited Jan 11, 2009) (finding that public firms that have a more exclusive relationship with their lending banks experience roughly a 1 percent increase in information asymmetry (insider trading) for every 10 percent increase in exclusivity).
167. See Robert A.G. Monks and Nell Minnow, Corporate Governance 132 (Wiley 4th ed 2008).
168. See, for example, Martin Arnold, USS Commits to US Buy-out Fund, Fin Times 21 (June 18, 2008) (describing UK pension funds joining the trend of US and Canadian pension funds by investing in private-equity buyout funds).
169. See id.
170. See Board of Governors of the Federal Reserve System, Policy Statement on Equity Investments in Banks and Bank Holding Companies at 7 (cited in note 4).