private equity, asset-stripping, British Venture Capital, Simon Nixon

Rise of private equity a case for celebration, not condemnation

07.03.2007

by Simon Nixon

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I’m not surprised by the ferocious global backlash against private equity. It’s hard to muster much love for an industry that tends to bring traumatic change to the employees of every firm it touches, while rewarding its own practitioners lavishly. What’s more, it’s bought the current firestorm upon itself through its refusal to engage with the public. It failed to recognise until too late that, as it became bigger and more powerful, it had become a legitimate target for public scrutiny. The industry is happy to take people’s pension money, and contemplate bids for firms that employ thousands. But most buyout groups have drawn a line at providing adequate public information about their own businesses. The only time they would break their traditional secrecy would be to brag about what they made on their latest deals. No wonder they’re now labelled “amoral asset-strippers”.

Why private equity criticisms are often wrong

That said, much of what has been said about the industry over the past couple of weeks is mendacious and often plain wrong. Indeed, for the most part, this backlash is not about private equity at all. The industry has just become the latest whipping boy for opponents of globalisation. All big firms, public and private, have had to go through painful restructurings. But far from being asset-strippers, private equity-backed firms increased their numbers of employees by 9% in the year to June 2006, according to the British Venture Capital Association. And all firms, public and private, have taken advantage of cheap debt to increase their borrowings. So too, for that matter, have British consumers. As for the idea that private equity’s “obscene” salaries are fuelling social tensions, doesn’t the same apply to footballers? And would Britain’s social problems really disappear if private equity promised to be less successful?

In fact, the most damaging criticism has come not from rabble-rousing trade unionists and second-rate Labour MPs, but from within the City. A number of bigwigs have taken the opportunity to put the boot in, including the chief investment officer of Fidelity, one of the world’s biggest traditional fund managers, and Paul Myners, former chairman of Marks & Spencer, who spent his early career at Gartmore. City critics claim that private equity is little more than a confidence trick that delivers pretty average returns, relies on massive leverage and lucky market timing to do so, and that it milks its assets for its own benefit at the expense of its investors.

This is nonsense. Supposedly sophisticated investors poured $430bn into private equity last year, and half plan to increase their allocation this year. That’s more than the funds raised in the whole of the 1990s. Are they daft? No. They did so because in the year to June 2006, private equity returned nearly 26% on average, according to Cambridge Associates. Sure, these returns were partly due to leverage and market timing. All firms use leverage to juice up returns. Private equity-backed firms do so more than most because their shareholders accept the risk of their doing so. It would be remarkable if market timing wasn’t a factor in returns. After all, private-equity people are primarily investors: their job is to spot value.

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Private equity brings performance improvements

But leverage and market timing are not the only drivers of returns. Almost 40% of the returns on private-equity investments sold in 2005 were down to improvements in the performance of the business, according to a study by Ernst & Young. The truth is that private-equity groups are not just good investors; they are good owners of businesses too – particularly for firms that need to change management or strategy. Public-market shareholders have traditionally been bad at driving change. It’s hard to take on an entrenched management when you are a minority investor relying only on public information. Few investors have the time, skill or incentive to do so. It’s easier to sell an underperforming share instead. But private equity can bring to bear the advantages of 100% ownership: rapid decision-making, clear incentives, short lines of communication, and a wealth of expertise. All the big buyout groups now employ top business leaders as advisors. Apax Partners, for example, recently recruited departing BP boss John Browne.

That’s not to deny that private equity faces challenges. Perhaps some of the mega-funds recently raised will encourage excessive risk-taking. And it’s hard to justify some of the fees private equity charges investors. But investors are going in with their eyes open. They know that private equity has unleashed a remarkable renaissance in the UK and US, restructuring companies and returning them to the public markets stronger and healthier, where they have consistently outperformed. They also know there are still many firms, particularly in Europe, yet to benefit from the private-equity revolution. That may be unsettling to those with a stake in the current failed corporate system: mediocre managers, traditional fund managers, and trade unions. But for employees, investors and everybody else who has an interest in healthy companies, the rise of private equity should be a cause for celebration.

Simon Nixon is executive editor of Breakingviews.com