Private equity firms are not the “barbarians at the gate” that the media would have you believe, says Mehlman.

Question: How does private equity benefit society?

Ken Mehlman: Private equity started off as a solution to some challenges that American companies had back in the mid '70s. And the challenge that a lot of companies had was that the management of those companies thought of themselves separately from how the owners of companies might think. They got paid whether the company did well or didn’t do well. They didn’t have skin in the game.

Also a problem in a lot of companies was the fact that they though short term and not long term. They thought quarter-to-quarter, and because they depended for their capital in public markets, what their stock traded at each quarter was critically important. What private equity does is it tries to deal with those and some other problems, too.

First, when we buy a company, the management of that company, and the board of that company, are paid like we are, the owners of that company. We’re paid on whether it grows over the long term, not the short term. So if you’re the CEO, you’re not going to be jetting around the company on a company plane regardless of whether the company’s doing well, because that’s your money that you’re spending and that you’re not being efficient with respect to. And that’s really important. So, one, you deal with the, some might call the agency problem, you make company owners think like—company managers, excuse me, think like owners. Not simply like agents.

The second thing that we are able to do, we own companies for an average of seven years. If your horizon is, how do you grow a company over seven years, not simply what’s the stock trading each day, then you’re a lot more likely to focus on things like, “How do I grow into a new market, even if that’s going to cost us something over the initial period." You think about how do you expand, for example, cap X. How do you make companies think more long term than short term?

The second area that’s important from private equity, is if you think about it, the people that invest in private equity. We look at our recent funds. There are 9 million retirees. A lot of them were once teachers, they were once firemen or police. They are folks that have worked very hard all their lives. And because their state pension fund chose to invest in private equity, their returns are better and their retirement is more secure. And what that means is that the communities in which they operate, which otherwise might have to divert resources away from public services or education to pay for the retirement, they don’t have to.

Recorded November 22, 2010
Interviewed by Max Miller