What Lehman Could Learn From Private Equity

A guest column from John Carney, editor of DealBreaker.com.

Shares of Lehman Brothers got a lift yesterday when reports leaked that the management might be considering a take-private. In my day job over at DealBreaker, I’ve pointed out that it could be rough for Lehman to attempt going private. But it’s worth asking what kind of structure Lehman might have if it did.

Lehman spent most of its existence as private partnership, and at one point was one of Wall Street’s largest investment houses. The company was torn asunder in the mid-80s, then acquired by American Express and merged with Shearson. A decade later it was spun off—coming, for the first time, a publicly held company.

Returning Lehman to private partnership status might not mean reviving the partnership struggle they abandoned over a decade ago. These days even private partnerships are often more open than the partnerships in the past, and openness might be exactly what Lehman needs to survive.

University of Illinois law professor Larry Ribstein has been a pioneer in the study of how private partnerships have been used as alternatives to solving sticky problems of corporate management. Much of his work has centered on the problem of aligning managers’ and owners’ interests. He notes that the private partnership model popular in the private equity world might be very useful for Lehman here.

“So it might be back to the partnership for firms like Lehman,” Ribstein wrote on his Web site. “But it might not be the same partnership structure they left behind — it could be the beefed up private equity approach, plus SOX.”

Traditionally, private companies disclosed far less about performance and operations than their public counterparts. This was more evident in private investment houses, which operated almost as clandestine services. Even after Depression-era legislation introduced many reforms on the ways securities firms operated, they remained opaque institutions to most outsiders

But in a post-Bear Stearns era, when counter-party risk is on the mind of every risk manager worth his paycheck, opacity can be a serious handicap for a securities firm. Shareholder behavior provides important signaling for counter-parties about the financial health of a firm, while financial disclosure regulations force firms to divulge sometimes inconvenient truths about their performance. A sudden drop in a firm’s share price can signal to counterparties that shareholders have detected problems, for example.  If Lehman were to attempt to use a management buyout to “go dark,” relieving itself of the burdens of public disclosure, Sarbanes-Oxley compliance and the like, it could very well trigger the kind of flight of the counterparties—the equivalent of a run on the bank—that crippled Bear Stearns.

It seems far more likely that Lehman would borrow a page from private equity firms, going private with debt financing that requires registration under securities laws and carries with it stringent reporting requirements. Sarbanes-Oxley is often presented as the bane of corporate executives but for Lehman, its accounting demands could play the vital role of assuring counter-parties that Lehman is safe to do business with even without the oversight of public shareholders.

One irony not yet been noted is that reports of a plan to take Lehman private are popping up just over a year after the IPO of the Blackstone Group. Blackstone, of course, was co-founded by Peter Peterson after he retired as the chief executive of Lehman in the mid-1980s.

Reach John here.