The Financial Times Thursday suggested that private equity might increasingly dominate the world’s capital markets, because it enabled a tighter rein to be kept on company management, and thus ensured better governance in the interests of shareholders. That’s why private equity values for companies are higher than public market values, according to the FT. If this is becoming the case, why would anybody bother investing in a public stock market at all?

The FT’s thesis is at first glance plausible even in Britain, where corporate governance was reformed by the Cadbury Report in 1992. It makes even more sense in the United States, where shareholders get to vote neither on what management gets paid nor (except purely as ratification) on the deal between management and the auditors. Even 15 years ago, the rash of poison pills adopted by companies, which brought to an end the contested takeover boom of the 1980s, demonstrated public company shareholders’ relative impotence in the face of serious threats to their financial wellbeing.

The problem with the FT’s view of the road ahead is that it begs the question of what stock markets are for. If the most efficient form of corporate ownership is through private equity funds, then public ownership becomes merely a transition stage between different private fund owners. Presumably the stock market eventually dies out since public companies are worth less than private ones and private owners can sell to each other without a stock market intermediary.

However, you then lose the stock market functions of price discovery and liquidity. In effect, you have gone back to the situation of 16th Century merchants owning stakes in each others’ ventures and trading them over the Rialto. While I yield to no man in my enthusiasm for returning to tried and tested financial methods, I can’t believe that undoing the last 400 years of financial history is likely to prove a gain in economic efficiency.

There’s another problem with the theory that private equity improves shareholder governance: in reality it simply moves the governance problem one step further back in the food chain. Whereas the management of the portfolio company has the joy of 28 year old MBAs crawling all over the company’s operations and making fatuous demands, the fund itself has very little responsibility to its own primarily institutional shareholders. Private equity fund managers are paid largely by a percentage of the profit from the fund, and are often able to use dubious means to revalue companies half way through the investment period (because who wants to wait 10 years for one’s yacht?) Hence they are motivated to engage in all kinds of valuation and accounting tricks to extract additional returns from their shareholders, and there’s very little shareholders can do about it.

Institutional investors should not deceive themselves for one minute that by investing in private equity funds they are in some magical way getting better governance than by investing directly in corporate America. In reality they’re investing only in fund managers with an outrageous sense of entitlement, and the ability to massage both the accounting and the operations of portfolio companies to maximize their own returns. While the fund manager pulls in tens of millions through adroit tricks with portfolio companies, the pension fund or insurance company executive generally earns a few hundred thousand only. Thus the man putting up the money is “little people” in the eyes of the fund manager — and generally gets treated as such.

As those with long memories will know, “alternative investments” become especially fashionable in periods like the present when money’s available from everywhere but the conventional stock market’s performance is mediocre. This appears about to change. If it does change, the bloodbath in private equity will be especially severe, because it has expanded so rapidly in this cycle.

Friday’s report of the Institute of Supply Management Index at 49.9, below the 50 level at which the economy is expanding, suggests that in spite of the lengthy pause by the Fed in its interest rate rises, the U.S. economy may be continuing to decelerate past the point at which expansion ceases. Far from achieving a conventional “soft landing” in which inflation begins to decline while the economy expands at a modest pace, Fed Chairman Ben Bernanke may be about to achieve something much more unpleasant.

Inflation shows no sign of decelerating below its current level of about 4% (why should it, since real interest rates are so low?) Indeed oil and gold prices have recently been strong, suggesting a possible further inflationary up-tick. On the other hand, Treasury bond yields have declined substantially in the last few months, to 4.43% on the 10 year bond Friday, well below short term rates and close to zero in real terms, without re-igniting the housing market. This suggests that the bond market sees further substantial economic declines ahead. Technically an equilibrium state in which inflation remains around 4% while growth decelerates to around minus 3% per annum may, by being achieved gradually, constitute a soft landing. In that case it may reasonably be objected however that the airplane has landed 30 feet under water.

Once such a “landing” has occurred, it’s difficult to see how the Fed and the Administration get out of it. The Federal budget deficit in such circumstances would spiral rapidly upwards, quickly attaining the level of around 6% of GDP ($800 billion currently) at which it becomes difficult to finance. The payments deficit, on the other hand, might improve, although the even larger level of US dis-saving (from the budget deficit and from laid off workers maxing out their credit cards) would put pressure on the dollar, which would cause further inflation. Effectively we would be in late 1974, but maybe without the bell-bottoms and the “Whip Inflation Now” buttons.

In such a situation, with the Treasury borrowing heavily and corporate profits deeply depressed, the stock market would lurch downwards and private equity’s takeout window, the Initial Public Offerings market, would snap shut. At that point, investors in private equity would discover by default what the stock market’s for; they would have no way of recovering cash from their private equity investments, and would be locked into them until prosperity returned.

This hasn’t happened in the U.S. since the Great Depression. It happened in Britain in 1974-75. In that case, the private equity investors such as Jessel Securities and Slater Walker ALL went bankrupt, along with most of the second tier banks which had lent to them. The British economy recovered quite well in the end, but there was no private equity boom in the 1980s similar to that in the United States; it took until the end of the decade, 15 years after the crash, for British investors to begin placing bets on private equity once again.

Once the crash has happened, a chastened pension fund and insurance company industry will realize that it cannot rely on private equity investment to ensure better corporate governance. At that point, if institutional investors act intelligently, investor associations will spring up. These will have the purpose of monitoring public company management, ensuring it does not pay itself too much, that it reports with properly conservative accounting to shareholders, and that it manages the company’s assets with shareholders’ interests paramount, as they should be. Whereas an individual pension fund may own only 3-5% of a public company, pension funds as a class will often own a majority of it; thus a pension fund investors’ association will have all the power it needs to ensure management’s compliance.

At first sight, it’s surprising that such associations have not been active in the past, though the Council of Foreign Bondholders, formed in London in 1868 to exert pressure on defaulting countries and wound up only in 1988, offers a useful precedent as to how such an association would work. Indeed the Council of Foreign Bondholders’ instigation of the British bombardment of Alexandria in 1882 is a useful precedent should direct action be needed against some of the more recalcitrant managers in the tech sector – a good thing Silicon Valley’s close to the coast!

The surprising failure of U.S. institutional investors to form such associations with real power is probably the fault of the counterproductive focus by U.S. investors and their advisors on short term performance, with investors being ranked in “quartiles” according to that performance. If you’re being ranked against your colleagues in quartiles, you naturally assume that they are your competitors, and that your interests are antagonistic to theirs.

In reality, company management, not other investment institutions, is the enemy of institutional investors. Organizing an investor association to discipline management is a positive sum game. By such an association management remuneration can be squeezed down and management malfeasance stamped out, to the benefit of all shareholders.

It matters little in what quartile of investor returns your pension fund or insurance company ranks, if by squeezing and disciplining corporate management returns can be improved for all investors. Higher returns for beneficiaries, not better performance against other managers, should be institutional managers’ chief objective. Investment manager selection procedures need to be restructured accordingly, to choose not the best relative performers in the short term, but the most rigorous enforcers of shareholders’ rights against management.

There are a number of regulatory improvements which should be made, to ensure shareholder control is truly effective. One is for management’s pay to be put to a binding resolution of shareholders (in Britain, it’s put to shareholders, but only in a non-binding fashion.) Another is for all audit proposals to be put to shareholders, who annually will choose the auditor – by this means auditors will become truly independent of management, since it will have no voice in appointing them, beyond an advisory role.

Capitalism is a truly wonderful economic system, but it depends on shareholders controlling the allocation of resources, and on hired management acting in their interests. As the FT points out, it is indeed high time this necessary discipline was strongly re-asserted. Private equity funds, however, are not a useful mechanism for doing so.

-0-

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)