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Private Equity: Frequently Asked Questions
“Here’s what private equity firms have figured out how to do: attract and keep the world’s best managers, focus them extraordinarily well, provide strong incentives, free them from distractions, give them all the help they can use, and let them do what they can do. No wonder these companies tend to be outstanding performers.” Fortune
Introduction
Private equity has been much in the news lately. According to Private Equity Intelligence, the value of private equity transactions in 2007 topped $721 billion. Private equity firms and their investors contributed $234 billion in equity to those transactions.
Once considered an esoteric form of “financial engineering,” PE in recent years has become an important tool for driving growth and improving performance at hundreds of companies across the country and around the world.
In addition to transforming the companies they acquire, private equity firms have delivered superior returns to scores of public and private pension funds, university endowments, charitable foundations and other investors.
By 2008, the total net profits distributed to investors worldwide by private equity funds raised through 2007 were $1.12 trillion, according to the research firm Private Equity Intelligence. Seventy percent of the funds invested with the top 100 PE firms since 2005 have come from public and private pension funds, foundations and endowments.
In a nutshell, PE is an ownership structure that enables a private equity firm and its investors to acquire companies – either public or private – that have significant potential for growth. They may be, for example, an “orphan” division of a large conglomerate that is focused on other lines of business; a family business that needs an infusion of capital to compete at a higher level; or a private company in need of a new marketing strategy or management team. The PE firm invests time, energy, talent and capital to improve the company’s performance and its prospects.
After several years — the average holding period is about five years — the PE firm sells the company, hopefully at a premium to the purchase price. Typically, 80 percent of the profits go to the limited partner investors, which include public and private pension funds, university endowments and charitable foundations.
For the past 20 years, private equity activity has ebbed and flowed depending on underlying economic and capital market conditions.
Q: What is private equity?
A: The term “private equity” refers to a range of investments that are not freely tradable on public stock markets. Private equity firms raise money for two types of funds: venture capital funds and buyout/growth funds, although in recent years, the distinction between venture capital and buyout/growth funds has blurred considerable.
At its core, private equity is simple: PE firms establish funds that raise capital from investors – who are referred to as limited partners, or LPs. The private equity firms – known as general partners, or GPs – invest their own capital along with the capital raised from investors. They borrow additional funds from banks and other lenders. With the combination of equity and the borrowed funds, the general partners buy companies that they believe could achieve significantly greater growth and profitability with the right infusion of talent and capital.
Private equity GPs typically hold companies for about five years, and then sell them, hoping to realize a gain on the sale as a result of the increased value they have created during their period of ownership. The general partners cannot recover any of their money until and unless they return to investors their principal plus the first eight to 10 percent of partnership profits. If there are no profits, PE partners not only make no money, they lose their own equity investment.
The size of the capital gain directly relates to the increase in value the PE firm has created. Typically, 80 percent of the profits are distributed to limited partner investors.
Q: Who benefits from private equity?
A: The big winners are public and private pension funds, endowments and foundations. Together, these institutions account for 70 percent of the funds invested with the top 100 PE firms since 2005, according to Private Equity Intelligence. As noted earlier, investors in private equity funds, including the pension funds, endowments and foundations, have received net profits of $1.12 trillion from private equity funds raised through 2007.
Between 1980 and 2005, top-quartile private equity firms delivered 39.1 percent in average, annualized net returns to pension funds, endowments, foundations and other private equity investors, significantly beating the S&P 500 and other public market indices. Those superior returns helped strengthen major public, union and private pension funds, charitable foundations and university endowments.
The 20 largest public pension funds for which data is available (including the California Public Employees Retirement System, the California State Teachers Retirement System, the New York State Common Retirement Fund, and the Florida State Board of Administration) have invested nearly $140 billion in private equity, delivering strong investment returns to their nearly 10 million beneficiaries.
A survey of 150 public pension plans, conducted by the Bear Stearns Pension, Endowment and Foundation Services Group and the Government Finance Officers Association, found that 52 percent have or plan investments in alternative assets over the next year. At 60 percent, private equity was second only to real estate (85 percent) on the list of current and planned investments in alternative asset classes.
Add in corporate and some union pension plans and it becomes clear that private equity has gone to work on behalf of tens of millions of Americans. Of course, the private equity industry’s executives also benefit from the returns generated by these investments. However, the perception that private equity is mainly about a handful of New York financiers doing very well at everyone else’s expense is demonstrably misleading.
Q: Do private equity firms only acquire publicly-traded companies?
A: Private equity transactions take many forms. Private equity may involve the acquisition of a private company with the intent of providing its founders the capital necessary to take its performance to the next level. It may involve the acquisition of a division of a large company, with the purpose of offering the newly-independent business the management focus and resources needed to achieve a new mission. Or it may involve a “public to private” transaction in an effort to undertake improvements that would be difficult to achieve given the short-term earnings focus of the public markets.
Most recently, public-to-private transactions have gained the most attention. These transactions offer a way of increasing the value of businesses by temporarily transferring ownership from millions of public shareholders to a much smaller number of private owners.
Without the pressures from outside shareholders looking for short-term gains, owners and managers can focus in a laser-like way on what is required to improve the medium to long-term performance of the company. This structure makes it far easier to align the interests of owners with those of managers, who also have a direct stake in the success of the company.
Q: What’s the difference between private equity funds and hedge funds?
A: Private equity seeks to create value over the long-term; hedge funds typically have a much shorter time horizon. Private equity funds typically buy and own whole companies and help them realize earnings growth over time. Private equity investors succeed only when the companies they own succeed. PE funds typically own companies in their portfolios for about five years, though they sometimes exit the investment sooner.
Hedge funds are pools of capital that usually invest in stocks, bonds, or commodities. Typically, they do not purchase a controlling interest in a company (although some are now doing so). Rather, they try to capitalize on short-term gains, using complicated trading strategies involving options and other derivative financial instruments. In some cases, hedge funds bet against the shares of companies they don’t own, hoping to profit from a falling price. The typical holding period for a hedge fund investment is weeks or months, not years.
Q: What’s the difference between venture capital funds and buyout/growth funds?
A: Venture capital firms are very close relatives of private equity investment partnerships. In one sense, their business models are the same, but their focus varies. Venture funds invest capital in start-up and young companies with little or no track record. Buyout/growth funds focus on another segment of the business cycle: They invest capital in more mature businesses that are underperforming or that have the potential to “outperform” with sufficient capital and/or operational improvements.
They seek to own and operate these businesses, typically for about five years, creating value by improving operations, governance, capital structure and the strategic direction of the companies in which they invest. More recently, the distinction between venture capital and buyout funds has been blurring. VC funds have been investing more heavily in companies at later stages of development, while private equity firms have been investing in companies that more closely resemble start-ups. In the end, both venture and private equity firms earn their money in the same way – by acquiring companies and increasing their value.
Q. Why would you want to take a public company private?
A. Over the last few decades, many experts, including leading CEOs and academics, have complained that the public markets create tremendous pressure on companies to generate steadily upward quarter-to-quarter growth. But it is well documented that decisions made to satisfy investors in the short term may not be in the best long-term interests of the business.
For example, faced with a major R&D investment that could depress earnings and the company’s stock price, management might opt not to make the investment to keep the stock price higher.
Similarly, a public company CEO might not pursue a strategic acquisition that made long-term sense if the short-term effect would be to dilute the earnings that large institutional investors use quarter-to-quarter to guide their stock buying and selling. In contrast, private equity firms focus on long-term performance.
Q. How does private equity change the short-term mindset and enhance growth?
A. As a backdrop, it is important to understand one overarching truth about private equity: The entire investment hinges on improving the business and increasing its value. If the private equity firm fails to do that, it loses its own money, its investors lose their money, and its ability to raise future funds is undermined.
The essence of private equity is the alignment of the interests and incentives of management with that of the owners. In a public company, the owners – shareholders – are largely separate from the management of a company. Private equity eliminates this disconnect. The owners often include the management (PE firms usually requirement management to invest their own money into the company so they have a vested interest in its success).
This provides a sharper focus on how capital is allocated across the business – without the constant pressure of delivering quarterly results to public shareholders. Everyone has a single objective: Grow the company’s value. Thus, they can make business decisions solely focused on that goal, rather than satisfying external constituencies, such as analysts, traders, stock brokers, and the media.
Q. What other steps do PE firms take to improve company performance?
A. To succeed today, a PE firm needs to bring much more to the table than financial creativity.
According to a 2007 study by Ernst & Young, 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. Cost reductions accounted for only 23 percent of pre-tax earnings growth in U.S. companies. In other words, PE investors add to the company’s strength by implementing significant operational improvements to the business.
Another study done for the European Parliament supports this view. The study found that PE-acquired companies outperformed comparable publicly- traded companies in terms of sales (14 percent), earnings before taxes, interest and capital expense (5 percent), and profitability (five percent) growth.
The PE firm must add new capabilities to the company it buys (by adding new products), increase competitiveness (by reducing waste and improving operations) and grow revenues (by entering new markets or finding new customers) to make any money for itself or its investors. And it needs to develop, implement and successfully execute a compelling business strategy.
The best private equity firms today deliver deep expertise in the sector in which the investment is being made; a performance culture that rewards entrepreneurialism and results; managerial and functional capabilities (IT, for example); and an ownership structure that allows even the toughest decisions to be made quickly.
Q. What happens when PE-owned companies return to the public equity markets through IPOs?
A. Private equity investment makes companies stronger when they enter public equity markets. According to a 2006 study, the share price of companies owned by PE firms for a year or more that went public between 1981 and 2003 outperformed the stock market as a whole over a three-to-five year period. The PE-backed IPOs were on average much larger in size, more profitable, and were backed by more reputable underwriters.
Q. How do private equity transactions affect employment at the acquired companies?
A. Over time, private equity investments often slow or halt existing job losses and under some conditions can drive significant job growth, according to two recently published studies.
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 concluded that private equity portfolio companies, prior to PE acquisition, were, on average, losing jobs at existing facilities at a rate one to three percent faster than their competitors. After a 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.
Another study, conducted for the Private Equity Council by Dr. Robert Shapiro and Dr. Nam Pham, concluded 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, 26,214 net new jobs were created – an increase of 8.4 percent over their combined employment of 310,420 at the time of acquisition. Seventy-six percent of the sample recorded job gains, while less than 24 percent reduced employment.
Among a subset of 26 firms providing data on U.S. employment, domestic jobs by private equity-backed firms increased 13.3 percent (or 13,861 net new jobs), compared to 5.5 percent for all U.S. businesses and 2.7 percent for large U.S. businesses. For manufacturing companies, employment increased 1.4 percent, while employment in the overall US manufacturing sector dropped by 7.7 percent during the same period.
Finally, 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.
Q. You said PE firms add debt to the balance sheets of companies they own. Don’t higher levels of debt create real risk that the company will go bankrupt?
A. Higher levels of debt can create more risk. But debt at sound levels often helps focus management on the right goals: increasing revenue to meet all their obligations. Spending on wasteful practices such as corporate jets, lavish corporate headquarters, and other outlays that have little to do with improving the bottom line are difficult to justify.
Rather, every action is predicated on the question: Will it grow the business and overall value? In a sense, the mindset in a PE firm is more like the homeowner with a mortgage who makes sure they can meet their monthly mortgage payments before spending on non-essential, luxury items.
Q. Why is debt involved if the ownership structure is referred to as private equity?
A. Virtually every company, public or private, has a capital structure made up of equity (stock) and debt (bank loans, bonds, etc.). When a PE firm acquires a company, they arrange financing that is made up of equity they invest from their funds and loans from a variety of sources, mostly banks.
Q. Have debt levels in PE transactions been increasing or decreasing?
A. Debt levels associated with private equity transactions generally have been decreasing over time. According to Standard & Poors data cited in M&A Quarterly 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 71.65 percent for the period from 1992 through 2000 and to 63.75 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.)
Q: What makes private equity an attractive investment?
A: Private equity has delivered superior returns to investors over the past two decades. Research by Professor Steven Kaplan of the University of Chicago, has shown that over the last 20 years the top buyout funds (typically those raised by PEC members) usually generate returns more than triple the overall returns of the US stock market.
Another study found that during the past 25 years, top-quartile PE funds generated annual returns of nearly 39 percent, compared to 12.1 percent for the S&P 500 and 12.3 percent for the NASDAQ. By 2008, the total net profits distributed to investors worldwide by private equity funds raised through 2007 were $1.12 trillion.
Q: Is there any evidence that PE firms improve businesses while in private ownership?
A: According to a study by Ernst & Young, businesses owned by private equity in the US significantly outperformed their public company equivalents with regard to average annual growth in enterprise value by as much as three to one. Moreover, employment levels were the same, or higher, at exit versus entry 80 percent of the time.
Harvard Business School Professor Josh Lerner and research associate Jerry X. Caso found that between 1980 and 2002, the stock price of the firms PE companies brought back to the public equity 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. Clearly, the PE firms were creating significant value.
Q. Are PE-owned companies more or less inclined to promote research and development?
A. Another study led by Professor Lerner of 5,000 U.S. transactions over a 25-year period, commissioned by the World Economic Forum found that U.S. companies owned by private equity firms are significantly more likely to pursue economically important innovations than companies that are not owned by private equity investors.
Q: Beyond benefits to the corporate sector and large institutions, does private equity benefit the broader economy and society?
A: Superior returns from private equity investments strengthen pension funds that provide benefits for millions of workers. By 2008, the total net profits distributed to investors worldwide by private equity funds raised through 2007 were $1.12 trillion, according to the research firm Private Equity Intelligence.
Many public pension funds report that private equity investments are their top or among their top two performing asset classes. For example, private equity investments have generated returns of nearly 26 percent for the California State Teachers Retirement System (CalSTRS) in the last five years, making PE the fund’s highest performing asset class
A corollary benefit from these exceptional returns is that dozens of states were able to avoid budget cuts or tax increases that would have been required to meet their legally mandated pension obligations to retirees who have devoted their careers to public service.
More broadly, the previously cited research shows that private equity investment over time can contribute to long-term employment growth and enhance the economic viability of businesses to the benefit of all stakeholders.
July 2008