The lure of private equity

Until recently, the buzzword in the world of finance was 'hedge funds'. Now it is 'private equity'.

Private equity funds typically position themselves somewhere in between venture capital and IPOs. That is, they invest in companies that have started up but have not gone public. Another big activity of such funds, which is making waves, is taking public companies private. These funds buy out existing investors, including retail shareholders, delist the company, restructure it beyond recognition- and sell it onward or often take it public all over again.

Private equity funds attract hostility, especially from workers, because they focus relentlessly on slashing costs. They are denounced as "asset strippers". The truth, however, is that private equity firms cannot afford to neglect investment or innovation because then they cannot hope to add value to the firm.

If private equity firms do not add value to the business they acquire, they cannot generate returns for their investors. Institutional investors who park their funds at private equity funds are willing to wait five to seen years for returns. At the end of the period, however, they will want their money back- with returns. If a private equity fund fails to deliver, the private equity firm cannot raise fresh money to stay in business- the reputational effects of failure are enormous.

Private equity is not new. It gained prominence in the eighties through "leverage buyouts (LBOs)" of companies- that is, purchases made through huge amounts of borrowing. One man who made the borrowing possible was Michael Milken, the investment banker at the now defunct firms of Drexel, Burnam Lambert. Milken created the "junk bond" market- debt instruments with high yields that was used in LBOs. Milken ultimately ended up in the can. He was portrayed as a scamster who profiteered from insider trading. This view has, however, been hotly contested. Many see the jailing of Milken as act of revenge on the part of a corporate establishment that did not take kindly to being challenged by upstarts.

Private equity emerged chastened from its earlier experience. Private equity firms still make use of large amounts of debt but not as much as in the past. When debt is too high in relation to a private equity firm's equity capital, that tends to create incentives for excessive risk-taking. Today private equity firms come into a deal with more of equity than before.

On the face of it, it seems odd that anybody would want to put money in private equity funds. The fees are much higher than in the mutual fund or even hedge fund business. A private equity firm will charge a minimum of 3-4% on funds managed plus 20% on profits. There are also acquisition fees, disposal fees etc. An investor can get a piece of a company by paying less than 1% in brokerage. Mutual funds charge just a little more. If private equity attracts money despite high fees, it is because the returns they generate net of fees are still high.

On the average, private equity firms do not outperform the S&P net of fees. But, the top performers do. What is more, unlike among mutual funds, the top performers continue to do well year after year- there is 'persistence' in performance.

Public firms being taken private and doing better is an astonishing phenomenon. And we all thought that being a listed public company was what brought out the best in management- the fabled 'discipline of the capital market' !

Some would rather glibly ascribe the superior performance under private equity to excessive regulation of public firms- Sarbannes Oxley, for instance. This is not true. There are good reasons why private equity firms do better. I touch upon these in my latest column in ET.

For a review of private equity, see the Economist (February 10, 2007).