I have a new paper with John Chapman and Mario Mondelli, “Private Equity and Entrepreneurial Governance: Time for a Balanced View,” in the February 2013 issue of the Academy of Management Perspectives. (Ungated SSRN version here.) The paper is part of a symposium called “Private Equity: Managerial and Policy Implications.” Our paper builds on the “judgment-based view” of entrepreneurship that builds on Mises and Frank Knight and evaluates how judgment rights are assigned between private equity investors and companies receiving private equity funding. Here’s an excerpt:
Judgment refers to decision making that cannot be represented by formal models or decision rules, but is nonetheless different from luck or chance. Unlike other entrepreneurial attributes such as alertness (Kirzner, 1973), judgment is manifest in the ownership of productive assets. It reflects ultimate decision authority—residual rights of control, in Grossman and Hart’s (1986) terminology—about the deployment and use of valuable resources under conditions of uncertainty. Entrepreneurs act to combine and recombine heterogeneous capital resources, whose attributes are subjectively perceived, to pursue financial or other gain. As Lachmann (1956, p. 16) put it: “We are living in a world of unexpected change; hence capital combinations … will be ever changing, will be dissolved and reformed. In this activity, we find the real function of the entrepreneur.”
Are PE firms more entrepreneurial, in this sense, than publicly traded firms? Yes and no. Both theory and the empirical evidence, summarized below, support a balanced view in which PE is best regarded as a governance structure that, like all forms of organization, has benefits and costs that vary according to circumstances. As Jensen (1989) famously argued, PE has substantial potential governance benefits over public equity due to a closer alignment of ownership and control. The high-powered incentives associated with ownership can lead to what Wright, Hoskisson, Busenitz, and Dial (2000) termed a “change in managerial mindset” that prefers long-range, strategic, holistic thinking over a short-term focus on quantitative performance metrics. At the same time, however, privately held firms are often constrained from pursuing potentially attractive profit opportunities by the nature of their debt obligations. Put succinctly, PE favors management by fixed rules while public equity allows a greater degree of managerial discretion, and both rules and discretion have benefits and costs.
