Testing the model
Jul 9th 2009
From The Economist print edition
Private equity faces a more hostile world
Illustration by S. Kambayashi
THE private-equity industry faces a critical test. It prospered in an era when asset markets were generally rising, debt was plentiful and cheap, and recessions were rare and relatively mild.
Now private-equity firms have to manage their portfolios through a recession. They cannot buy companies, strip out costs and “flip” them back to the market or to a trade buyer; there are too few purchasers around. They cannot use as much debt to finance their deals because banks and institutional investors are less willing to finance them. The regulatory climate has also changed. European politicians have seized the chance provided by the financial crisis to propose new rules for the industry, despite the lack of evidence that it had much to do with the credit crunch.
All these changes should provide an answer to a long-running debate about the industry. Is it, as its supporters claim, a superior business model in which the interests of managers and investors are better aligned? Or is it, as its detractors claim, a simple financing ruse designed to allow rich people to take advantage of various tax breaks while simultaneously stripping assets and sacking workers?
Investors may also get answers to some big questions. Is private equity simply a geared bet on equities, offering higher returns but also higher risks? Does an investment in private equity genuinely diversify a portfolio or simply make it less liquid? And does the skill of private-equity managers lie in company selection or in the management expertise they bring to the companies they fund?
There is a potential historical parallel. In the 1960s investors were lured by the appeal of the conglomerate. Smart executives would assemble a portfolio of companies, save costs by sharing group services and use their expertise to allocate capital from head office. But with the admittedly large exception of GE, the dream died. The key driver of conglomerate growth turned out to be a financing trick, in which highly rated shares were used to acquire lowly rated ones, thereby enhancing earnings per share.
Private equity has benefited from the tax deductibility of interest, which gives debt finance an advantage over companies that use equity for the bulk of their capital. Detractors worry that too great an expansion of the private-equity model would weaken the corporate tax base and, by making companies more fragile, cause recessions to be either more frequent or more intense when they occur.
A new academic study of buy-out failure rates from Leeds University and Nottingham University comforts that: “For any given amount of leverage, if a company is private-equity-backed or not, it is no higher risk than others.” But that is an odd statement. First, the leverage is the whole point. The objection to private-equity firms is that they load companies with more debt than other businesses; the issue is whether the typical private-equity-backed company goes bust more often than other firms in its sector. Second, what about the argument that private equity is a superior business model? If that were true, the companies the industry funds should go bust less often.
The business-model argument runs as follows. Allow the managers to take charge of a company, motivate them properly with share options and it is amazing how they find the scope to eliminate costs and improve the business. Of course, it is the cutting of costs that the detractors worry about. A study by Josh Lerner for the World Economic Forum in 2008 found that firms run by private-equity groups shed more jobs than their peers in the two years after a buy-out, although the differences disappear after that. The corollary is that productivity improves at companies that have undergone a buy-out.
The problem for the industry now may be that every company is trying to cut costs in a recession. Highly leveraged companies will find the pressure most intense. Many of the businesses that the sector financed in the heady days of 2006 and early 2007 are struggling. And companies that emerge best from recessions tend to be those with the balance-sheet strength to invest and grab market share.
This suggests that the industry may be due a period of contraction, rather like the one the hedge-fund industry has suffered over the past 18 months. Those firms without any management skills will be weeded out. Investors will demand lower fees from those that remain. And every private-equity-backed company that fails will be cited as evidence for the prosecution by hostile politicians.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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