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Private Equity: Fact and Fiction
Fiction: Private equity funds and hedge funds are the same.
Fact: Private equity often is confused with hedge funds. But the two forms of investment differ in important ways. Private equity funds invest in companies with the intent of owning and operating them for several years or more. The goal is to grow them and turn them around, or otherwise strengthen their performance. Private equity firms typically create value by improving the operations, governance, capital structure, and strategic position of the companies in which they invest.
In contrast, hedge funds are a loosely-defined category of investment pools that, like a retail mutual fund, principally invest in publicly traded securities, currencies or commodities. While most mutual funds typically own “long” positions in securities, (that is, they own the security with the hope it will rise in value), a hedge fund may take “short” positions (betting that a company’s stock price will fall), and engage in many more complex trading strategies, including futures trading, swaps and derivative contracts.
Fiction: Private equity mainly benefits a small group of wealthy financiers.
Fact: Public and private pension funds, endowments and foundations account for 70 percent of the investments made with the top 100 private equity firms since 2005. Public pension funds alone made 45 percent of all top PE firm investments during that period.
The 20 largest public pension funds for which data is available (the California Public Employees Retirement System, the California State Teachers Retirement System, the New York State Common Retirement Fund, the Florida State Board of Administration, among others) have nearly $140 billion invested in private equity, delivering strong investment returns for the nearly 10 million beneficiaries.
These public and private pension funds, foundations and university endowments have chalked up returns from private equity investments that far exceed those available from the stock market. By 2008, the total net profits distributed to investors worldwide by private equity funds raised through 2007 amounted to $1.12 trillion. These returns translate into stronger public employee pension programs, more funds for college financial aid and scholarships and more funds for research and other causes supported by charitable foundations.
Fiction: Private equity firms have no commitment to growing companies.
Fact: Quite the contrary. The entire private equity business model is predicated on investing in and strengthening acquired companies so they are worth more when they are sold to another buyer or to the public markets. A 2007 study conducted by Ernst & Young found that the average value of businesses in the U.S. acquired by PE firms grew 83 percent over the course of private equity ownership.
The study also found that two-thirds of the earnings growth (before interest, taxes and capital expense) at PE-owned companies resulted from business expansion, with revenue growth from existing operations being the most significant factor.
Another study by Dr. Oliver Gottschalg on behalf of the European Union Parliament found that 91 percent of the private equity transactions studied produced growth-oriented initiatives at the companies that were acquired. That should not be surprising. To earn a profit on the transaction, private equity firms must make the companies more valuable by increasing earnings and cash flow. If the private equity firm strips a company bare, no one would want to buy it, much less pay a premium over the original purchase price.
Fiction: Private equity firms are “quick flip” artists that buy companies and then sell them to make a fast buck.
Fact: The “quick flip” claim is a canard. Private equity firms typically are long term investors, not quick flippers, because it takes time to strengthen companies so they are worth more to future buyers. According to a study conducted for the World Economic Forum by Harvard Business School Professor Josh Lerner, of all the companies acquired by PE firms between 1980 and 2007, 69 percent were still PE-owned by November 2007.
The study found that between 1970 and 2007, nearly 60 percent of 21,400 companies acquired by private equity investors remained under PE ownership for five or more years. And the EU Parliament study found that private equity investors after five years continue to be involved as majority shareholders in more than 45 percent of their investments, as opposed to publicly traded firms where the original investors have disappeared in 88 percent of the cases. The EU study found that only 16 percent of all PE exits take place in less than two years.
Fiction: Private equity firms weaken companies by stripping them of assets.
Fact: The notion that private equity firms strip valuable assets out of the firms they acquire defies common sense. In fact, the last three decades have seen private equity companies consistently adding value to portfolio companies. A 2008 study by The Boston Consulting Group found that operational improvement as a source of value increased two-fold between the 1980s and today to contribute more than a third of portfolio companies’ value growth.
There is a practical reason that so-called “asset stripping” is unwise. Private equity companies exit their investments in two ways: through an IPO or a sale to strategic investors. In an IPO, the public equity market places a value on the improvements made by the private equity owner. If the private equity firm has stripped assets and turned the company into a shell, the price will be steeply discounted. In a sale to strategic investors, the buyers are highly sophisticated businesses or institutions that understand how to read balance sheets. In both cases, given the many investment options available, investors would not put their dollars into companies that have been so weakened as to undermine their ability to profit from their investment.
Fiction: Private equity buyouts typically result in layoffs.
Fact: According to a 2008 study of 5,000 transactions over 25 years commissioned by the World Economic Forum and led by Harvard Business School Professor Josh Lerner, private equity portfolio companies prior to their acquisition were, on average, losing jobs at existing facilities at a rate one to three percent faster than their competitors.
After private equity investment or acquisition, those same companies initially experienced a dip in employment but by year four under private equity ownership, employment rates rose to slightly above the industry average. The WEF study also concluded that in the first two years of investment, private equity firms increased the rate of job growth at new U.S. facilities built by their portfolio companies to six percent above the peer industry average.
A 2007 study conducted by Ernst & Young determined that in 80 percent of the cases studied, employment levels at PE-owned companies were the same as or higher at the conclusion of a PE investment than they were at the beginning. A 2008 study by Dr. Robert Shapiro and Dr. Nam D. Pham conducted for the Private Equity Council found that acquisitions of large companies by major, U.S.-based private equity firms between 2002 and 2005 resulted in a direct and positive impact on U.S. employment.
Across 42 companies studied, 26,214 net new jobs were created — an increase of 8.4 percent over their combined employment of 310,420 at the time of the acquisitions. Seventy-six percent of the sample recorded job gains, while less than 24 percent reduced employment. Among a subset of 26 companies providing data on U.S. employment, domestic jobs at private equity-backed firms increased 13.3 percent, compared to 5.5 percent for all U.S. businesses and 2.7 percent for large U.S. businesses.
Fiction: Private equity firms load up companies they buy with massive amounts of debt.
Fact: Private equity firms invest their own equity side-by-side with other investors, thus sharing in the risks and giving them very real incentives to make prudent investments, not highly speculative ones.
In fact, debt levels associated with private equity transactions generally have been decreasing over time. According to Standard & Poors data cited in M&A Quaterly Review, from 1987 through 1990, the average level of debt associated with a leveraged buyout transaction was 87.3 percent while the equity contribution was 12.7 percent.
The share of debt dropped to an average of 71.6 percent for the period from 1992 through 2000 and to 63.7 percent for the period from 2001 through 2007, while the equity contribution rose to 28.5 percent and then 36.5 percent. (Debt levels in the 2006-2007 period were higher because of the increased availability and decreased cost of credit.)
Fiction: Private equity firms have no incentive to improve the businesses they operate.
Fact: The goal of a private equity firm is to sell a company at a premium to the original purchase price — that’s strong incentive in and of itself. In the case of reverse LBOs (when a company is returned to the public markets), the private equity firms often remain a majority or large minority shareholder in the business.
In other words, destroying the business for short term gain would take money out of its own pocket by undermining the value of its own investment, or make the investment less attractive to a buyer, thus eroding its profit at sale. Either way, undermining a company’s strength is not a path to success in private equity investing.
Fiction: Private equity firms do nothing to improve the businesses they buy and operate; it’s all about financial legerdemain.
Fact: At one time, a strategy of simply adding more debt to an “underleveraged” balance sheet might have allowed private equity firms to recognize substantial gains with only modest business performance improvements. This approach no longer works. To succeed today, a private equity firm needs to bring much more to the table than financial creativity.
A 2008 study by The Boston Consulting Group found that operational improvement as a source of value creation increased two-fold between the 1980s and today to contribute more than a third of portfolio companies’ value growth, reflecting a long-term historical shift away from leverage, whose contribution to portfolio companies’ value creation has dropped to a quarter versus more than 50 percent in the 1980s.
A 2006 study by Harvard Business School Professor Josh Lerner and research associate Jerry X. Cao found that between 1980 and 2002, the stock price of companies PE firms brought back to market after operating them for more than a year rose faster than both the overall stock index and the share price of firms in the same sector not backed by private equity.
Finally, a 2007 independent study conducted by Ernst & Young found that the average value of businesses in the U.S. acquired by PE firms grew 83 percent over the course of PE ownership. Furthermore, the annual rate of business value growth achieved by the largest private equity-owned businesses outperformed equivalent public companies (in the same country, industry sector, and timeframe). Average annual business value growth rates were 33 percent compared to public company equivalents of 11 percent.
The same E&Y study concluded that two-thirds of the earnings growth (before taxes, interest and capital expense) at PE-owned portfolio companies came from business expansion, with organic revenue growth being the most significant element. This included the benefits of investment in sales and marketing and new product launches. Cost reductions accounted for only 23 percent of pre-tax earnings growth in U.S. companies and 31 percent in European companies. In short, asset stripping is not the way PE firms build value.
Fiction: Private equity firms stifle innovation by reducing expenditure on R&D in the portfolio companies they operate.
Fact: A PE-focused innovation study conducted under the leadership of Professor Lerner for the World Economic Forum and released in 2008 refuted claims that private equity firms generate profits by sacrificing long-run investments. The researchers found that the PE investment led to a “beneficial refocusing” of the portfolio companies’ innovative portfolios.
Specifically, PE-owned companies pursued more economically important innovations than non-PE owned companies, as measured by patent citations, the most commonly used and accepted measure of the economic impact of innovation, and the study observed a clear increase in the average number of citations for the PE-backed firms.
Further breakdowns of the patenting patterns suggested that the areas where portfolio companies concentrated their patenting after the PE involvement, and the historical core strengths of the company, tend to be areas where the technological and economic impact is particularly great.
Fiction: If a few mega deals fail, the effect will ripple across the world, causing a severe crisis in global capital markets.
Fact: The relatively limited size and diverse holdings of private equity make it highly unlikely that problems with some investments could lead to systemic problems in capital markets. The direct capital at risk in private equity holdings in any recent year has remained a very small fraction of the value of all U.S. public companies equal to less than one percent and the total value of all private equity holdings is equivalent to just 2.6 percent to 4.3 percent of all corporate stocks and 3.1 percent to 5.3 percent of GDP.
In sum, private equity funds occupy a place in the capital markets that is likely too small to trigger broad, cascading financial market problems. Further, unlike the systemic risks presented by subprime mortgage-based securities or the dot-com bubble, the assets of private equity funds are highly diversified across nearly every major industry and sector.
While large, privately-held companies sometimes fail, their failures do not usually occur suddenly; and a private equity fund holding such a company can take steps to protect its solvency and overall investing activities. Further, when such a company fails, the value of many of its physical assets may be unaffected and can be sold to limit the fund’s losses.
Also, the investments of private equity funds in individual companies limit their exposure to no more than the value of the investment, its leverage or loans to complete the purchase, and the acquired firm’s liabilities net of the value of its cash and other assets. These potential losses are known by the funds with some certainty and are much less subject to the sharp and sudden shifts in value associated with speculation in interest rates, currency values, and housing prices following a bubble.
Finally, a November 2007 study by Dr. Oliver Gottschalg on behalf of the EU Parliament refuted the claim that private equity activity has any substantial negative effect on economic or financial stability. The study, Gottschalg wrote, “…does not support the claim that buyout activity makes the financial system substantially less stable.”
Fiction: Pension fund investments in private equity partnerships endanger the retirement security of tens of millions of Americans. If one of these deals fails, retirees will lose millions.
Fact: The truth is quite the opposite. Private equity investments historically have been among the best performing investments for the nation’s public pension funds, with annual returns from top-quartile firms averaging 39 percent over the past 25 years. In any case, pension funds have strict limits on the amount of assets they can allocate to private equity and other alternative investments.
In many cases, this allocation is less than 10 percent. And when they do make these investments, they have positions in several funds that collectively might own 50 or more businesses. In short, the amount of assets invested is strictly controlled and the diversification of the portfolio means that a bankruptcy in a single portfolio would have virtually no impact on a pensioner’s benefits.
Fiction: Private equity firms operate in a secretive and opaque world. No one really knows what they’re up to.
Fact: There is substantial disclosure involving private equity investments; arguably, investors know more about their PE investments than average investors know about their mutual fund or stock market holdings.
PE firms engage in extensive, thorough disclosure to their limited partners, including detailed performance and return information, as well as substantial detail about each company they own and operate. Further, the majority of large PE portfolio companies issue public debt. As a result, these companies are obligated to file the same 10k report as public companies, with the same level of detail, all readily available on the SEC’s website.
Fiction: When public companies go private, the transactions are riddled with conflicts. As a result, shareholders rarely get a fair price when the company is sold.
Fact: When a public company is a candidate for going private, the process is similar to that involving any other merger. If the management is approached by a private equity firm, management is legally obligated to report this to the Board of Directors, which in turn is required to set up a special committee made up only of independent directors.
Once the company is seriously considering a buyout, all normal SEC disclosure laws are triggered. That means management is required to file proxy statements and obtain fairness opinions, which must be reviewed by the SEC. As in all other acquisitions, the Board of Directors has a fiduciary obligation to act in shareholders’ interest.
Finally, institutional shareholders have demonstrated in several high-profile private equity bids that they hold tremendous power and perform a watchdog function to prevent shareholders from being denied a fair price. It is now typical in most PE transactions for the company to insist on provisions allowing the board to shop the private equity firm’s offer to others to ensure that the bid on the table is the best available option.
July 2008