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Comment: Will private equity defy its critics?

Chris Higson, associate professor of accounting at London Business School, examines the powerful challenge posed by private equity to existing orthodoxy on governance, management and ac

Chris Higson, associate professor of accounting at London Business School, examines the powerful challenge posed by private equity to existing orthodoxy on governance, management and accountability.

In 2005, takeover markets were booming and private equity acquirers were targeting big companies. Then, in 2007, the industry was suddenly engulfed by a storm of hostility from unions, politicians and the media. There was alarm that men in grey suits were getting very rich by stripping assets and sacking workers, and would soon take over the world.

Shortly afterwards, though, credit markets froze and private equity activity fell sharply. In the year to mid-November 2008, Canadian and US deal values dropped by 85 per cent. Suddenly the people who confidently predicted private equity taking over the world were describing it as just a product of the credit bubble, and doomed.

However, one should be wary of subscribing to either of these apocalyptic views. Instead, we need to take private equity more seriously. There is a need to understand exactly what the private equity industry is, what it does, and how it makes money. This in turn will help to explain its place in the modern economy and provide an insight into what its future might hold. Like any other industry, the challenge for private equity is to maintain its competitive advantage. The real question, then, is what is private equity’s competitive advantage in acquiring businesses and increasing their value?

Private equity’s record

The private equity industry in its current form is quite young, so it is only recently that we have started to have serious research on how it creates value. Ludovic Phalippou of the University of Amsterdam and his colleagues looked at the performance, gross of fees, of a very large sample of buyouts dating back to the early 1980s.

They found that the median investment roughly doubled its money, earning an internal rate of return of 21 per cent, whilst the bottom quartile lost money, returning less than 90 per cent of the initial investment. The top quartile, however, returned more than 3.5 times their investment and the very top five per cent earned an IRR in excess of 190 per cent per annum.

Private equity funds, therefore, have tended to create value from their acquisitions and blue-chip private equity firms have been consistently successful in generating very high returns. The evidence on those returns to outside investors – limited partners – is intriguing. The most skilled private equity investors are university endowment funds, while banks have been the worst performers and overall earn from private equity what they would have got from investing in public equity markets. A lot of the value created by private equity finishes up in the pockets of the general partners, and in fees to advisers.

Does private equity depend on cheap credit?

Critics of private equity tend to focus on the ‘leverage’ part of leveraged buyouts. Almost the first thing private equity does is increase the borrowings of the acquired firm mightily, sometimes immediately extracting the proceeds through an early distribution to the shareholders. So is private equity a product of the credit cycle? Looking at its short history, you might think so.

Understanding the role of leverage for private equity is key. Leveraging the acquired firm has major attractions to investors – when private equity leverages an acquired firm, interest on the debt is tax deductible. Burdening the acquired firm with debt then also provides management with powerful incentives to improve margin and cash flow.

Most fundamentally, high leverage shares the risks and rewards to business in a way that is apparently very favourable to the owners. It channels the upside to equity and the downside to other stakeholders so that if the business thrives the shareholders take the upside; if the business fails they walk away. In the case of workers, it is implausible that they are able to compensate themselves as leverage increases their risk.

However, private equity’s enduring competitive advantage isn’t leverage. ‘Borrowing a lot’ isn’t rocket science. Leveraging is one of the easiest tools to replicate outside the immediate confines of the private equity industry. Cheap credit was on the table and private equity picked it up, but they were not the only ones to take advantage.

Some fascinating research evidence shows that private equity does better during periods of tight credit. When credit spreads are low and credit is plentiful, acquirers tend to pay higher prices and underperform. While some marginal deals might therefore have depended on cheap credit, these were the deals that private equity should have been avoiding.

Private equity is waiting for credit markets to be open and functioning, but the whole economy depends on this. Higson believes that many private equity deals are sufficiently profitable that they would be worth doing without debt finance. Whether the industry is willing to change the habits of a lifetime and manage without leverage, however, is a different matter entirely.

Private equity’s governance model

Most economists would argue that governance is what distinguishes private equity’s model. In publicly quoted firms, ownership and control are separate. Economics has long understood the incentive and efficiency problems this creates, the ‘agency’ problem. The beauty of private equity governance is that it resolves the agency problem and aligns the interests of owners and managers extremely closely – in essence, raw capitalism stripped bare.

Investors arrive with a very clear and detailed plan on turning the business around. They sit on the shoulders of management to get it done, demanding a high level of reporting. If further incentive was needed, the burden of debt financing yokes management to focus on cost reduction and generating cash flow.

Private equity motivates managers using a large carrot, and a large stick. Recent research from Viral Acharya at London Business School suggests that the chief executive in a buyout was granted, on average, 5.4 per cent of the equity in the business, and the senior team 16 per cent. That is the carrot, but the firing statistics are startling. Private equity fired a third of CEOs within the first 100 days, and two-thirds over four years of ownership. The finite life of the funds means intense pressure for performance.

Private equity’s governance story is compelling, but there is a danger of exaggerating the agency problem in public companies. Everyone has war stories about incompetently, even fraudulently managed public companies, but the Enrons of the world are extreme outliers.

The public face of private equity has endured a high-profile battering in the press due to a handful of controversial buyouts, but it is important to remember that these represent just a tiny fraction of private equity deals. What is also less appreciated is that none of the major corporate scandals in the past three decades have emerged from private equity-owned companies. That is down to the very close control that private equity has. You’re not likely to see a private equity-backed Enron.

One distinct advantage of private equity is its attractive tax structure. A private equity partnership receives a distinctly relaxed treatment from the law. Profits are usually treated as capital gains rather than income, and such a structure does not generally compel any presentation of accounts, meaning public accountability is less demanding.

For example, Alliance Boots, now owned by private equity group Kohlberg Kravis Roberts, has to file accounts as long as it remains a corporation, but the actual accounts of Kohlberg Kravis Roberts remain private. The tax structure of private equity partners has, however, come under increasing scrutiny in the media, with accusations that private equity executives frequently pay less tax than their cleaners.

Hardcore skills remain tough to copy

Many outsiders will certainly be tempted to replicate aspects of the private equity model, such as leveraging. But what will be harder to replicate over the long term will be the hardcore operational and strategic skills that private equity partners have deployed in the past.

Some non-private equity operators are probably already tempted to give this a go, despite a lack of experience. An insurance company, pension fund or sovereign wealth fund investing in private equity funds might well conclude: ‘This doesn’t look like rocket science, let’s do this in-house and save ourselves the 20 per cent carry.’ Replication of the model is therefore likely to emerge, though operational quality means results will be highly variable.

The private equity model enables people with certain skills to capture the economic rent from various businesses, and extreme leverage means rents now flow to people with human rather than financial capital. The predictable implications are that successful private equity firms will increasingly deploy strategic and operational, rather than financial, skills.

The future

Over the long term, it is tricky to predict what impact credit anxiety will have on private equity. Recovery from the current distress won’t be quick, and private equity also has its own issues to deal with. Many large firms, such as 3i Group, have seen revenues fall steeply, making it difficult for them to sell companies they have invested in. Stuck between a rock and a hard place, some private equity-owned companies are reportedly close to breaching banking covenants. The outlook for 2009-10 remains difficult.

But if the private equity industry is currently quiet, this is likely to be temporary. The world still contains opportunities for private equity and there will be no shortage of funds for firms with a proven ability to generate the elusive alpha for their investors. It is possible that the private equity industry could emerge from the current crisis as strong as, and more influential than, when it entered.

Chris Higson is associate professor of accounting at London Business School, where he teaches the Masters in Finance and Corporate Finance programmes

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