In praise of private equity
Oct. 19, 2006
The buyout funds managed by these companies raise billions from professional investors to buy undervalued companies, often from the stock market, which are “turned around” and sold a few years later. Their latest big deal came on Monday, when Australia’s Macquarie fought off stiff competition from other funds to buy Thames Water for £8bn.
Like most other successful industries, from supermarkets to pharmaceutical giants, success has brought envy, jealously and, all too predictably, increasingly vocal attacks against private equity firms in the media. They have been accused of all the usual sins from which capitalist entrepreneurs supposedly suffer: short-termism, asset stripping, greed and excessively secrecy. Of course, there are rogues in this industry, as in all other walks of life; but private equity remains overwhelmingly a force for good. In many ways it has prospered as a reaction to widespread inefficiencies and distortions in the stock market – and because of excessive government red tape and taxation.
The higher volumes of debt generated by private equity (it borrows to buy) and its cyclical nature do increase the threat to the global economy in the case of a downturn. But central banks should be blamed if credit is too cheap, not those who make the most of it. By continuing to spot undervalued assets neglected by the capital markets, private equity investors provide an important service by increasing the economy’s efficient allocation of resources. Owners of infrastructure assets, for example, suffered for years from faddish stock markets too bored by their businesses to value them properly. Now British water assets and other infrastructure companies such as airports attract high valuations from specialist infrastructure bidders because they offer stable returns that can match the funds’ liabilities.
The value of buyouts announced worldwide this year already stands at almost $450bn, well ahead of the record $250bn for the whole of last year, according to Thomson Financial. The business is increasingly profitable: private equity firms have made about £152bn in gains on selling off assets in the past year, an astonishing and unprecedented bonanza, compared with the $354bn of gains made during the previous 15 years.
After raising more than $200bn from investors last year, the industry is now attempting to raise a further $342bn from investors in 700 new funds, a task made easier by huge amounts of petrodollars looking for a profitable home. Much of this activity is being conducted out of London. The City is the second largest global center – and by far the biggest in Europe – for private equity. According to one measure, 22% of new investments made globally and a quarter of funds raised last year were managed from Britain; its share of the global private equity market more than tripled between 2000 and 2005.
While publicly-quoted stocks will obviously always remain the dominant corporate structure, economists are beginning to wonder whether private ownership is not often more efficient, at least in some respects and in some kinds of industries, than the traditional stock-market listed corporation. Private equity companies, after all, have managed to solve the principal-agent problem that has been the downfall of many a public company. Whenever there is a split between the ownership and the management of a company, owners must find ways of monitoring those running the firm on their behalf. This is difficult to do effectively in public companies because their shareholder base is so fragmented, making it hard for shareholders to cooperate and work together. Most shareholders hope others will make the effort; typically, everyone seeks to free-ride and the management ends up getting away with running the firm in its, rather than shareholders’, interests. One consequence has been that the remuneration of top mangers has increased to ridiculous levels, way out of line with performance.
Such pitfalls are largely resolved under private equity as the firm’s management works directly for a representative of the owners, who fixes their salaries and all the details of their contracts. In exchange for giving up the autonomy and high profile enjoyed by CEOs of public companies, the management of privately-owned firms enjoy complete privacy, a deregulated environment, the absence of quarterly reporting, fewer owners who actually understand the business and are willing to plan for longer periods of time, and huge financial rewards based on results.
Because they are usually preparing a company to be sold, private-equity owners tend to be far more efficient at disposing of underperforming assets. They ruthlessly make sure that their business is at all times worth more together than the sum of its parts, or they break it up. Their aim is to maximise at all times the net present value of their holdings, which means that it makes no sense to starve a company of investment or to take other measures to damage its prospects, especially with investment horizons of several years.
Private equity corporate structures can compete against public companies for another reason. In today’s professional and highly liquid environment, the main advantage of the stock market – that it taps into huge pools of cash from large numbers of investors and provides a place where those seeking capital are matched with those wanting to invest – is replicated in private equity with investors prepared to pour their cash into private equity funds. While such funds are less democratic than the stock exchange – and often require large incomes and liquid wealth – there is little difference in liquidity terms; and the number of vehicles open to the public, including smaller shareholders, that invest in private equity funds continues to grow.
It is untrue to claim that private equity companies are excessively short-termist. Most investments last between three and seven years and sometimes even longer; increasingly, they are then sold on to other private equity firms. Short-termism is much more of a problem for quoted companies. Many of the blunt devices used to fight the principal-agent problem in PLCs, such as the publication of ever more frequent earnings and revenue numbers (now often every quarter) and stock options (which create all manner of problems), have made executives far more obsessed with managing short-term results expectations and smoothing share prices than private companies, which do not have to care about any of this.
Another criticism leveled at the private equity industry is that it is too unaccountable, especially now that it owns a fifth of the economy. But private equity-owned companies are only ruthlessly focused investors; their power, in as much as it exists at all, is strictly contained by market forces. Private companies have always retained the right to privacy; this is the way it should remain. But it would make commercial sense for the largest private equity funds to divulge more information about themselves in more accessible ways; it would even help attract a new generation of investors.
A key reason why so many senior executives are now attracted to private equity is that the red tape and restrictions that accompany public companies have become far too onerous. The dynamism of the unregulated private sector has been a key driver in the essential process of capitalist creative destruction in recent years; those who wish to regulate the industry could end up taming it and hence robbing the economy of its biggest force for productivity improvements and wealth creation. Chancellor Gordon Brown claimed again this week to recognize these realities (see page 32); but he continues to do nothing about it.
Other, more serious allegations have been made against private equity. Last week, the US Department of Justice launched an investigation into possible collusion among leading private equity firms to keep down the prices they pay for companies. This will be hard to prove. It is true that management buyouts – as distinct from those private equity deals not involving the target company’s executives – can sometimes create problems. While the managers that are buying the company retain their fiduciary duty to get the best possible price for their company, there can be a conflict because they personally stand to gain from not fully rewarding the original shareholders. But the answer to such situations must be caveat emptor: shareholders should be treated as adults who are well aware of this temptation and who therefore only choose to sell up if they think the price is right.
The growth of private equity has been helped by one government-created market distortion: interest payments are tax-deductible, while dividends are not. This favors a capital structure made out of debt rather than equity; it also means that the tax shield created by a purchaser using only debt can allow private equity companies to pay a higher price for an asset than public companies. Private equity deals usually gear up companies five to seven times earnings before tax, depreciation and interest, against two or three times for quoted vehicles.
This tax-related distortion is a problem and at least a partial explanation for the current debt-fuelled buyout bonanza, which could prove catastrophic if the global economy tanks, triggering mass defaults. Britain’s Financial Services Authority is looking at whether private equity poses a threat to markets and at the exposure of the banks to the sector. But rather than trying to curtail private equity, the answer is to cut the overall corporation tax rate, a move which makes sense in any case to retain Britain’s competitive advantage. If it were just 12.5%, as in Ireland, rather the current 30% in Britain, the tax advantage of making interest deductible would be dramatically reduced.
The real danger is that, having already picked off all the low hanging and undervalued fruit, it will become increasingly difficult for the hundreds of billions being raised for private equity funds to find a worthwhile home. If they cease to deliver the double digit annual returns, private equity funds will become a victim of their own success and investors will simply vote with their feet. That, rather than any external pressure, is what should -- and will -- keep the industry in check.