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How Private Equity works
Private equity is an integral part of the everyday lives of millions of Americans. When you buy coffee in the morning at Dunkin’ Donuts, you’re interacting with private equity; when you see a movie produced by MGM Studios and buy a pizza at Domino’s afterwards, you’re interacting with private equity. When you fly to a vacation resort on Continental Airlines and stay at a Hilton hotel, you’re touching private equity.
As private equity has become more prominent, as private equity funds and the size of the transactions they finance have grown larger and as the names of the companies they acquire have become more familiar, reasonable questions are being asked: What is private equity all about? How does it work? What does it mean for the American economy, for American workers and for American competitiveness?
Stonger Companies, Superior Returns
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.
Through 2007, private equity funds worldwide had returned more than $1.12 trillion in profits to limited partner investors, a third of which are public and private pension funds, university endowments and foundations, according to research firm Private Equity Intelligence.
Unique Ownership Structure
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, in some cases because they are undervalued or underperforming. The PE firm invests time, energy, talent and capital to improve the company’s performance and prospects.
After several years, usually between four and five, the PE firm sells the company, hopefully at a premium to the purchase price. Generally, 80 percent of the profits go to the limited partner investors.
Without the pressures from outside public shareholders looking for short-term gains, private equity owners and the managers of their portfolio companies can focus in a laser-like way on what is required to improve long-term performance. This structure also 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.
Recent PE Activity
For the past twenty years, private equity activity has ebbed and flowed depending underlying economic and capital market conditions.
Three major factors have converged to stimulate the record growth in private equity activity.
First, the shares of many public companies have been relatively inexpensive compared to the value of their assets and revenue.
Second, capital available to private equity firms has increased dramatically as major investors such as pension funds, mindful of the superior returns available, allocate more of their portfolios to private equity.
Third, until the current credit crunch began in mid-2007, the global market for the debt that is borrowed to help finance the acquisitions had been growing, permitting more borrowing at better rates.
The constriction of the global credit markets in the past year has dramatically reduced the number of private equity transactions, but industry leaders continue to believe that the private equity business model is not only sound, but powerful and resilient.
PE Makes a Major Contribution to the Economy
Private equity is an important and positive part of the American economy and, more importantly, plays a critical role in driving its growth. Private equity, directly or indirectly, makes a major contribution to the quality of life of tens of millions of Americans.
Consider:
Research in both the United States and Europe suggests that PE investments over time often slow or halt existing job losses and can drive job growth.
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 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.
A November 2005 study by the Munich Technical University’s Center for Entrepreneurial and Financial Studies for the European Private Equity and Venture Capital Association (EVCA) found that between 2000 and 2004, European businesses acquired in private equity transactions recorded a net increase of 420,000 jobs.
During the 25 years from 1980 to 2005, the top-quartile private equity firms generated annualized returns to investors of 39 percent (net of all fees and expenses). By contrast, the S&P 500 returned 12.3 percent a year during the same period. This suggests that $1,000 continuously invested in the top-quartile PE firms during this 25-year period would have created $3.8 million in value. The same amount invested in the public markets would have increased to $18,200.
Pension Funds, Endowments, Foundations Benefit
Who benefits from these returns?
The big winners are public and private pension funds, endowments and foundations. Together, these institutions account for 70 percent of all capital invested with the top 100 PE firms since 2005.
In fact, 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 nearly $140 billion invested in private equity, delivering strong investment returns to their 10.5 million beneficiaries.
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.
Fundamental Business Improvements
Some suggest that private equity delivers its substantial returns mainly as a result of financial engineering and does little to create real-world value. In its early years, private equity firms could simply change a firm’s capital structure and make considerable profits. But that is no longer the case. Winning private equity strategies must differentiate themselves on the basis of fundamental business improvements that often are more difficult to achieve by current managers working under the constraints of public ownership.
In fact, 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, reflecting a long-term historical shift away from leverage, whose contribution to portfolio companies’ value creation has dropped by half since the 1980s.
Because the managers of publicly-owned companies are forced to keep a close eye on quarterly earnings to maintain their company’s stock price, they sometimes are hesitant to make the often substantial investments in new processes, personnel or equipment required to drive strong, long-term growth.
Private equity firms, on the other hand, can take a longer-term view. Ultimately, the mangers of private equity firms understand that they must improve the underlying value of the companies they own over time to generate the returns their investors demand and to attract the capital they will want to raise for future funds.
By better aligning the interests of owners and managers and by instituting a nimbler operating style that fosters greater innovation and long-term investment, private equity owners are leaders in spurring improved productivity and competitiveness.
And their impact goes beyond the firms they own and operate. Increasingly, public companies are adopting the techniques of private equity to increase shareholder value and build more competitive companies, suggesting that the private equity industry’s impact on the future strength of the American economy is deeper than most imagine.