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Unformatted text preview: The business of making money Private equity’s strengths and its increasingly apparent weaknesses act: in the late 19805. the Financial Times carried a spoof story about a piannedhuy-out of General Motors. Now- adays the saie of such a giant would not be regarded as ajoke. Every day yet another company seems to succumb to the clutches of private equity. And this week saw what could be the biggest deal ever: a $43.5 billion offer by a consortium of in- vestors for ace. a Canadian telecoms group. it was swiftly followed by a poten- tial $2.2 billion bid for Virgin Media. a Brit- ish cabie—television company. and the $26 biliion purchase of Hilton Hotels. Even after those deals. the private~equ- ity titans have plenty of firepower left. AD cording to Private Equity Intelligence, a re- search group. the industry raised $240 billion in the first half of this year. leaving it weil placed to surpass last year’s record of $459 biliion. That compares with less than $10 billion raised in 1991. in the prev cess. private equity‘s share of mergers and acquisitions has grown massively (see chart on next page). Private equity has become a byword for money-making skills. "Why are we here attending conferences when we should be setting up private—equity firms?“ quippecl Niall Ferguson. a historian. at a conference held at the London Business School on July 2nd. But the industry’s wealth has also made it plenty of enemies. with trade unions and left-wing politi- cians calling for curbs on its activities and highertaxes on its earnings. The intellectual argument in favour of private equity has not changed much in 20 years. in 1989 Michael Jensen, of the Hat" vard Business School. wrote a paper" suggesting the public company had out- lived its usefulness. Economic develop» ments. in particular the recession of the early 19905. made that forecast seem pre- mature. But its underlying arguments have more force today. Public tedium Life is no longer much fun in a publicly quoted company. Executives have to suffer the slings and arrows of intrusive media coverage. the oppressive tedium of ”box- ticking” corporate-governance codes. the threats of activist investors and short sell» ers. and the scrutiny of singleminded po- litical campaigners. And what do companies get in return? Traditionally they have had three main reasons to list their shares on a stocltmark- ct. The first is to raise capital. either to ex- pand the business or to allow the founders to realise their Wealth. The second is to heip retain stali. who can be offered share options as an incentive to stay and work hard. The third involves prestige; custom- ers. sappiiers and potentiai employees maybe reassured (and attracted) by the ap- parent seal ol' approval given by a public listing. figwever. all three reasons seem to be less compelling than they used to be. Historically companies have got their equity capital from four sources: pension funds. insurance companies. mutual funds and retail investors. The first three groups faced iegal or regulatory impediments to buying unquoted shares. while the public naturaliy valued the liquidity a stockmar- ket listing could bring. In the absence of a public quote. com" panies often had only one financial alter- native: the banks. in some areas of the world this worked quite well. Banks were reliable partners to Germany’s Mittelstand of unquotecl companies and to Japan‘s in» dustrial empires. But in the Anglo—Saxon economies companies often felt nervous about being in hock to the banits. A change in lending policy. due to new manage- ment or an economic downturn. could lead to the sudden withdrawal of credit. Nowadays companies have many more options when it comes to raising money. Banks are much less important as a source of lending; they have been “disin- tennediated" by capital markets. Banks might arrange loans. but they quickly of— fload them to outside investors such as it t hedge funds. Bond markets are much more liquid than they used to be, and thanks to high-yield products even companies with a poor credit—rating can tap them. ' Then. of course. there is private equity. it can provide finance at an early stage (venture capital) or as an attractive alterna- tive for companies that have a public quote (the leveraged buyout). Whereas pension funds will be reluctant to hold a direct stake in an unouoted company, they are willing to pay hefty fees to private-equ~ ity firms to invest money on their behalf. - 50 companies have no difficulty in find- ing capital outside the public market these days. just as importantly. in recent years they have had little need to raise capital at all. Corporate profits have risen to a so year- high as a proportion of America‘s GDP. Companies have used the cashflow from those profits to buy back shares and pay down debt. Mr Motivator in the 19905 it seemed as though every» hody in America had a neighbour or a rela- tion who was about to become a million- aire through their stock options. Companies were handing them out like free newspapers on Piccadilly. Company boards were happy to offer options since accounting rules allowed them to pretend they had no cost. Employees were happy to take them in the belief that an evenris- ing stockmarket would allow them to buy the condominiums of their dreams. Com- panies without a listing seemed likely to fall behind in the race for talent. . But-the collapse of the dotcom bubble made lots of options worthless. These days many employees wouidjust as soon be rewarded with good old—fashioned cash. And now that options are properly accounted for. companies are just as happy to hand cash over. Besides, partnerships such as lawyers and accountants {not to mention hedge funds) have historically managed to offer very generous rewards to their top em- ployees without the need for a stockmarle et quote. And privaterequity groups have also been successful at retaining important staff by offering them potentially lucrative stakes. Indeed. top executives may prefer the private sector. For a start. private-equ- ity bosses can keep what they earn secret. while chief executives of quoted compa- nies find themselves the subject of imper- tinent comments from the media and ac- tivist shareholders. Perhaps as a result. managers can earn a lot more in the unquoted sector. The most famous example is Dave Calhoun. a top GE executive who turned down jobs at stint 500 companies for the chance to run privately owned VNU. a Dutch media group. for a reported $1oom package. Of course. such executives will take more risits and work hard for their money; private-equity partners can be tough taste masters. But at least there wili be only one set of masters and the goals will be clear. There is no need to worry about the oner- ous hits of the Sarbanes-Oxley law (in America). or shareholder resolutions sepa- rating the roles of chairman and chief ere ecutive (in Britain) or hedge funds deu mending that businesses he sold off (pretty much anywhere). Public compa- nies have to reveal a lot more than private ones. Pressure groups can pore over every detail of company policy from the use of child labour to carbon emissions. The danger is that executives running public companies and up spending so much time dealing with shareholders. reg- ulators and campaigners that they neglect the business. indeed, these different ”stakeholders" may well demand diffen cut. and irreconcilable. things. Entrepre~ nears, the type of people who like to "get things done“ may not want the hassle. There is another problem, identified by Professor Jensen almost two decades ago. The structure of a public company creates an inherent conflict between investors and the managers they hire to run the business. The main problem is what to do with free cashflow. the money left over after all prof- itable investment projects have been funded. In theory this money should be re- turned to shareholders. but managers may be reluctant to do so. Holding on to cash means they do not have to go cap in hand to capital markets. Professor iensen argued that borrow- ing imposed discipline on executives. They needed to generate cash to meet inw terest payments. And. if they wanted to fr- nance a project. they would have to con- vince investors that it was worthwhile. The result ought to be fewer unprofitable projects because cash is no longer left burning a hole in managers‘ poclrets. Private-equity firms apply this lesson in spadesThey gear up the balance sheets of companies they buy with more debt than public firms are willing to accept. Nearly so years of economic stability have led some to believe that even notoriously cy~ clical businesses. such as carmaking, can iii erg arid-acquisrti .de now hear higher levels of debt. In theory. executives working for priv— ateverjuity owners respond by cutting costs, weeding out unprofitable opera- tions and expanding those parts of the business where returns are highest. This is what generates charges of asset-stripping. But some of this occurs in most takeovers. whether public or private. Most takeovers are justified by "synergies”. which usually means sheddingjobs at head office. This is all part of the ”creative destruction” pro cess that allows capital to be allocated more efficiently. Academic studies have suggested that private~equity firms create jobs rather than destroy them. although a lot more research needs to be done before everybody will be convinced. Workers do have a legitimate concern about the security of their pensions. When a company takes on a lot of debt it undouhtedly maltes the “covenant“ be— tween a company and its pensions scheme less secure. For a start, it increases the risk that a company may go bust. and so may not be making contributions into the scheme in future. And in the short term ex- ecutives will concentrate on paying down debt rather than making additional pay- ments to close a pension deficit. It may well be that the shift away from quoted companies turns out to be detri- mental to worlcers’ pensions rights. How- ever. those rights were already being eroded. with many quoted-company schemes being closed to new members or to future accruals for existing employees. Private equity is not the main. or even a leading. cause of the pensions crisis. The conglomerate model Another potent criticism of private equity is the parallel with the conglomerates of the 197os and 19805. such as in. are and Hanson. Like private—equity firms. the con- glomerates used their financial muscle (in their case. highly rated shares rather than borrowed money) to construct diverse in~ dustrial empires. They argued. just as priv- ate equity does today. that they could im— prove the companies they owned through superior management. Eventually. those empires fell apart. Like a shark compelled to keep swimming forward to catch its prey, they needed ever- bigger acquisitions to make progress. in- vestors concluded that they could diver- sify on their own. by buying shares in dif- ferent sectors. They did not need a conglomerate to do thejob for them. Private~equity groups insist they will not run into the same problem. “We don‘t hang on to the businesses." says the leader of one. But that creates another potential problem: investing for growth. If a busi— ness is going to be sold within. say, five years, what incentive is there to approve the financing of projects that may take a decade or more to pay off? it Private-equity bosses maintain that it is not in their interest to ruin the companies they buy, because they want to sell them again. And it is also the case that the execu- tives of publicly quoted companies can sometimes skimp on capital expenditure, given that they are often under pressure to meet quarterly profits targets. Sup erior returns? In the end, the argument comes down to a simple one: if private~equity firms are or- ganising the assets of companies more em- ciently, then the founders of the industry deserve their billions (though not, per haps, all of their tax breaks). But it is hard to measure the efficiency of private'equity firms directly. The best that can be done is to look at their returns. Here, the evidence is murky. One much'cited study" found that average returns, net of fees, were roughly equal to that produced by the star 500 index between 1980 and 2001. That implies that private—equity firms do im— prove the businesses they own, since gross returns outperform the marltet. But inves- tors do not seem to benefit. ”Overall, re- turns have not been that special, espe- cially if you adjust for risk," says Richard Lambert. director~general of the Confeden ation of British industry, Britain’s main business lobby—group. The calculations can be complicated by the tortuous rca gun-ti g u: ..-d to calculate the private—e- 2-1.1?” ind- retry s returns. A re- cent studyi suggests um. the residual val- ues of companies that remain in private- equity portfolios may have been over stated. Allowing for this cuts the average net return to three percentage points be- low that of the star 500 index. However, analysis does suggest that a small proportion of private-equity groups has consistently achieved superior re- turns. And a study by three American aca» demicstir found that the results achieved by end-investors (such as pension funds and private banks} differed widely; college endowments earned returns that were 14 percentage points better than average. This suggests that a headlong rush by pension funds into the sector in pursuit of diversi» fieci returns from “alternative assets“ might leave many disappointed. Going private Could the private-equity model become the norm, replacing the public company? And would that be a good thing? What might be logical for an individual corn» pany might not be best for the economy overall. If all companies were to substitute debt for equity on the scale that private- equity firms have, there would be an in- crease in the cost of debt. Thatvvoulcl make superior equity returns hard to achieve. in addition, private—equity firms need an exit route to sell their investments. Al- though there is a growing trend forsecond- ary deals. where one group sells a firm it has bought to another, there must be a limit to which further efficiencies can be squeezed out of any particular business. In the end, a public market will be needed for someone to realise their profit. Indeed. the need for an exit route was neatly demonstrated by the recent flota— tion of Blackstone. one of the largest priv» ate-equity groups, on the New York stocl — market and the decision this week by Kohlberg Kravis Roberts, another of the in- dustry's titans, to follow suit. it does seem a bithypocritical for these firms,who regu— larly tout the benefits of the private model, to head for the public markets-but what other route could they take? They could hardly agree to be bought by each other. A bigger role for private equity might matte the economy more vulnerable. His- torically, recessions have often occurred when rising interest rates have cut into cor— porate profits, causing firms to slash em- ployment and capital expenditure. in a world where most companies carried priv- ate—equitynstyle debt levels. companies would be much more vulnerable and re cessions might become much more fre quent. Monetary policy would become more difficult, with even small changes in interest rates having the potential to cause massive damage to business. And govern— ment revenues might be affected if large portions of industry were financed by tax- deductible debt. But private equity still accounts for only a small proportion of corporate owner- ship. Much of the industry’s activity is among small and medium—sized compa— nies. There is still plenty of scope for priv- ate—equity firms to expand. It may well be, however, that the peak of the cycle is close at hand. Private equity is inevitably a "feast and famine" business: when one fund can raise a lot of capital, they all can. Competition to buy compa- nies then pushes up the price of doing deals, increasing the interest burden and reducing the returns for equity holders. More deals will be done this year, but they may not deliver the kind of returns that in- vestors are hoping for,just as the late 19805 buy-out of are Nabisco, the emblematic deal of the era, proved a disappointment. Since 2003 conditions have been al- most icleal for private»equity firms, with low interest rates, lots of liquidity and ris— ing asset prices. But recent events have been moving against them. Bond yields have been rising, making takeovers (which replace equity with debt) more expensive. The high level of corporate profits suggests that there may not be much more to be wrung out of businesses. And the relent- less campaign against private-equity tax privileges has made the groups look like easy targets for finance ministers, It may be symbolic that Blackstone's shares quickly slid below the offer price. Bad debts Investors also seem to have woken up to the potential risks, perhaps alerted by the losses being suffered in another part of the credit universewsubprime mortgages. They had previously been happy to extend credit on easy terms, such as “covenant- lite" loans (debts with few checks on op— erating performance) or paymentmin—kind notes, where borrowers can substitute more debt for interest payments. Now they are starting to turn down deals where private—equity firms push their lucit too far. Banks are getting reluctant to provide the "blank cheques“ that private-equity groups were demanding for the bridge fi- nancing of deals. in addition, exits may be becoming more difficult: the sale of New Look, a British retailer. collapsed when the last two remaining bidders pulled out. It is important, however, to distinguish between the cyclical and structural tides. The 19805 private-equity boom ended in the face of rising interestrates and a slump- ing economy. The same combination might cause another retreat over the next few years. But after that tide has ebbed. more businesses will be in private hands. And when interest rates inevitably fall again, the private-equity wave will once again capture new ground. ........ .......4.nu.nun-nun”.....n..nunnuunu-uuu "Eclipse of the Public Corporation", by Michael Season. Harvard Business Review, Sap-Oct :989. ”"Pn'vate fiquéty Performance: Returns, Persistence and Capital Flows", by Steven Kepler: and Antoinette Schoar, Journal of Finance, August 2035. 1"The Performance of Private Equity Funds", by Ludavic Phaiippou and Oliver Gottschalg, http://ssrn.com/abstract=6857az April 2057. “Smart Institutions, Foolish Uioices? The Limited Partner Performance Puzzle". by Josh Lerner, Antoinette Scltoar anti Wan Wong, MIT Sloan Research Paper 4523-05, January 2005 ...
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