An excellent special report on the prospects for private equity firms in the Economist. In essence, the article says that these firms’ success is beginning to work against them, in the form of concerns about their concentration of economic power, and, due to their large aggregate scale, increasing difficulty of earning superior returns:
Last year the value of private-equity buy-outs, usually by taking private a company which is trading on a public stock market, surged to $440 billion in America and Europe (see chart 1)….Few firms seem beyond the industry’s grasp. J. Sainsbury, a British supermarket chain, is among the latest targets. The grapevine buzzes with talk of others, including Dell and even IBM. Such is the fuss that some boosters extrapolate the rise of private equity even to the death of the public-listed corporation, which they argue has become obsolete.
Yet when a group of tycoons gathered in London in January for the Private Equity Foundation, a new charity for children, a trade union picketing the launch said it was “like Herod becoming a patron” of Britain’s National Society for the Prevention of Cruelty to Children.
Sharp criticism has become a daily nuisance for the private-equity industry. Its leaders, such as Steve Schwarzman of the Blackstone Group, David Rubenstein of the Carlyle Group and Glenn Hutchins of Silver Lake Partners, were treated like royalty at the recent World Economic Forum in Davos. But having to debate “Is bigger better in private equity?” and then listen to Philip Jennings, general secretary of UNI Global Union, tell them they “should no longer consider themselves untouchable” took the edge off their acclaim.
They can be forgiven for a sense of déjà vu. Until recently, private equity seemed to have shed its bad-boy image of 20 years ago, summed up in “Barbarians at the Gate”, a bestselling book about the battle by Kohlberg Kravis Roberts (KKR) to buy RJR Nabisco. But from barbarians to Herod in two decades hardly seems like progress.
The 1980s boom in private-equity deals—then known as leveraged buy-outs (LBOs)—came to an abrupt and messy halt. The buy-out firms found they had over-paid for some acquisitions, credit markets dried up, some of the important providers of finance (such as Michael Milken, the “junk-bond king”) ended up in jail and regulators cracked down on their beloved hostile takeover bids.
Nobody expects to see a repeat of that reverse, even though some criticisms are eerily familiar. Unions complain that buy-out firms are asset-strippers: the London protest was against the axing of jobs by Birds Eye, a food company owned by Permira, the biggest European private-equity firm. But now fellow financiers are also on the attack. “Am I alone in struggling to make sense of private equity’s appeal?” wrote Michael Gordon, the chief investment officer of Fidelity International, in a recent letter to the Financial Times.
Regulators, too, are growing agitated. Last year Britain’s Financial Services Authority concluded after an inquiry that at least some of the industry’s activities will end in tears. America’s Department of Justice is investigating whether the increasingly common bidding consortia, in which several private-equity firms club together, are in breach of antitrust laws. Last month the Federal Trade Commission ordered Carlyle and Riverstone to cease day-to-day involvement in one of the two energy firms they own, so as to ensure competition. In Congress Barney Frank, the new Democratic chairman of the powerful House finance committee, is due to hold hearings on private equity.
Shareholders of targeted companies are also starting to smell a rat. They suspect that top managers, who usually remain in charge when their business passes into private hands, are selling too cheaply in order to get a bigger slice of the profits for themselves when the private-equity buyer eventually sells the firm on. Recent attempts to take ClearChannel and Cablevision private met fierce opposition from shareholders feeling short-changed…
More threatening than criticism are the problems of success. With so much interest in private equity, more money than ever is chasing deals. To increase the number of deals they can do, several of the bigger firms are said to have become interested again in hostile takeovers, at least for the funds they are now raising. Club deals may also pose difficulties, especially if things do not go according to plan and partners have a difference of opinion.
And there are the diseconomies of scale common to any business that has grown so far from its entrepreneurial roots. Not for nothing have the biggest private-equity firms been called the “new conglomerates”….
Can private-equity firms manage their empires? Harvard’s Mr Lerner worries about the spread of bureaucracy and in-fighting, including battles over how to share out the spoils when the performance of different parts of the firm varies sharply. He points to Carlyle as a good example of a firm tackling these difficulties with its centralised, team-building “One Carlyle” process. As the founders step down at several of the bigger private-equity firms, succession may add to the burden.
When the credit stops
The credit markets show no sign of losing their appetite for lending. On the contrary, private-equity firms report turning down offers of credit because they are too generous. Nonetheless, leverage is rising steadily, to worrying levels. One day the market will dry up, perhaps suddenly, and what will happen then?….
The industry also has to watch for a change in the behaviour of public companies, which are starting to respond to shareholder pressure to get a higher price from private-equity bidders….
Activist hedge funds are also putting pressure on likely targets to increase their borrowing. This, they think, will both increase the value of the firm in just the way it would under private-equity ownership, and remove one of the main incentives for private equity to buy.
Perhaps the greatest threat to the continued growth of private equity is regulation. The burden on public companies may be eased. Sarbanes-Oxley is likely to be given a makeover this year, with its notorious section 404 on internal controls watered down. On the other hand, politicians may increasingly try to regulate the private-equity industry.
One chief executive recently observed: “The moment a public pension fund loses 20% of its value due to some private-equity investment going wrong, private equity will get its own Sarbanes-Oxley.” The new kings of capitalism must try to prevent this from happening by showing that they really are a force for good.