According to some, we should fear private equity because it operates in secret and is therefore more dangerous to society than public money. Does the argument hold water when it comes to FCPA compliance? Is PE bad for compliance? Let’s take a look.
Part of what makes private equity frightening is the scale of it. By 2021, PE had $6.3 trillion in assets under management and about $2 trillion in “dry powder” (uninvested cash on hand). Around 10,000 PE firms globally hold assets in 40,000 portfolio companies.
Private equity is cited as the reason why the number of public companies listed on U.S. stock exchanges is shrinking. That number declined from 8,000 in 1996 to fewer than 4,000 today, despite the economy growing by $20 trillion and adding 70 million in population.
Ironically, however, the biggest PE firms are themselves publicly traded companies, including Blackstone, Apollo, KKR, TPG, Carlyle, EQT, Ares Management, and Oaktree. They’re working under the same SEC and exchange disclosure requirements as other listed firms.
But that doesn’t quell the suspicions. A recent article in the Atlantic is typical. It talks about PE “devouring” public companies by taking them private.
“This is not a recipe for corporate responsibility or economic stability. A private economy is one in which companies can more easily get away with wrongdoing and an economic crisis can take everyone by surprise. And to a startling degree, a private economy is what we already have,” the article says. “The veil of secrecy makes all of this easier to execute and harder to stop.”
So, where’s the truth? Is private equity so big that it operates in public like other listed companies? Or, does private equity cloak itself in a “veil of secrecy” to avoid accountability and evade regulation?
Who has FCPA investigations? A good place to start an inquiry into PE and compliance is with companies that have disclosed ongoing (unresolved) FCPA investigations, according to data provided by FCPA Tracker.
I analyzed their ownership and found that 28 percent of them are either controlled by PE through majority ownership or at least heavily influenced through not less than 30 percent PE ownership. I excluded companies where PE ownership is 30 percent or more but where founders still control a working ownership majority.
PE firms now control at least 20 percent of all U.S. corporate equity. So their control of 28 percent of the companies listed on FCPA Tracker is roughly proportional to their role in the U.S. economy.
There’s no obvious anomaly there. PE-controlled companies aren’t performing substantially worse at FCPA compliance than other companies.
Let’s go beyond the math.
Proponents of PE point out that portfolio companies “operate on a longer time horizon than publicly traded companies do.” The average holding period for portfolio companies is now about five years — “which gives a [PE] and its handpicked CEOs ample time to make investments without the glare of quarterly earnings calls.”
Proponents argue that PE portfolio companies are also more “dynamic” and “flexible” and can generate better returns for shareholders.
In theory, then, the stability and longer-term perspective relieves acute pressures to crack new markets or make hasty acquisitions as ways to boost revenues. That should also create an environment where compliance professionals have space and time to design, implement, and execute effective programs.
But whatever the time horizon, there are structural problems with compliance at portfolio companies. Most PE investments are earmarked to create growth, usually by expanding into new markets.
That’s fine. Often, however, the compliance department at a portfolio company isn’t ready for the expansion. Compliance at smaller companies is commonly undersized and under-resourced, if it exists at all, and PE money isn’t likely to be allocated to enhance compliance.
That means the portfolio company’s business side and compliance function will be out of sync during the post-investment growth phase.
This might explain a common scenario among portfolio companies with FCPA issues. They move into a new market — China, say — either by hiring local agents or acquiring local businesses. Eventually, gaps in compliance lead to the discovery of behaviors (sometimes via whistleblowers) that trigger investigations.
Private equity firms are filled with sophisticated business people. They should know the damage compliance problems can inflict on reputations and financial performance. Naturally, they’ll want to avoid lapses that might jeopardize their investments and underlying business model, not to mention exposing themselves to personal culpability.
On the other hand, compliance professionals are expensive, and ambitious compliance programs might have the unintended consequence of impairing the agility advantage smaller portfolio companies enjoy. So PE has an incentive to keep the compliance burden light.
There’s the dilemma. How to promote growth without compromising compliance? It’s the same dilemma companies outside the PE world face every day.
The question of how private equity impacts compliance is complex and needs more attention. Will help come from the SEC? It is increasing the disclosure burden on PE firms so more investors will have information equivalent to investors at non-PE public companies. How much influence the new SEC rules will have on compliance at portfolio companies, if any, remains to be seen.
This starts our discussion about PE and compliance. It’s a big topic and needs more space, so let’s continue this in posts to come.