And so ends the famous "Greed is Good" speech featured in the clip above by Michael Douglas's fictional character "Gordon Gekko" in the 1987 film Wall Street. (As an aside, if you're an 80s junkie like me, I highly recommend the Stuck in the '80s blog for a trip down memory lane.)
Ah, to revisit the 80s: Extracting cash, exploiting tax loopholes to gain outrageous profits, stripping assets for short-term gain, and pruning staff counts. It seems that the charges leveled against private equity firms nowadays are similar to those made against leveraged buy-out (LBO) firms in the 80s. A slight difference is that LBO outfits today have decided to use the euphemism "private equity" to substitute for the older term "LBO," but critics of private equity say that nothing much has changed. Once again legislators are devising bills aimed at limiting the perceived excesses of this industry, and unions are upset at the massive profits these firms rake in--presumably at the expense of labor from their point of view. However, private equity has a formidable ally in Treasury Secretary Henry Paulson and presumably the White House as well. You can bet your bottom dollar on a veto for legislation aimed at circumscribing private equity's playing field.The most recent issue of the Economist has a pair of articles dealing with private equity. While it notes the challenge made by left-leaning politicians and organized labor, the Economist unsurprisingly argues that the real challenge to private equity may be rising interest rates worldwide. As easy money becomes less so, leveraging up to strike private equity deals may become more challenging:
For the past few years the wild men of private equity have rampaged through the public markets. They have ventured into the drowsy glades of badly managed companies and they have stormed the citadels of multinationals. The wind has been at their backs for so long that it has been hard to imagine how anything could stop them.
This week witnessed the biggest private-equity offer in history, a buy-out of BCE, a Canadian telecoms operator, that would be worth a total of $48.5 billion. Virgin Media, a British cable company, faces a $22 billion bid. The value of takeover deals—plenty of them involving private-equity firms—soared to $2.7 trillion in the first half of the year, almost half as much again as in the last six months of 2006. Optimists will take all that as further evidence of private equity's bright hopes. But it is also possible that the weather is turning and the debt that powers private equity's siege engines is starting—just starting, mind you—to become harder to scrape together. It may not happen this month, perhaps not even this year, but sooner or later the private-equity boom will come to an end.
This possibility will delight private equity's many critics. Private equity is routinely charged with all sorts of iniquity. It strips companies of assets and flips them for a fast buck. It loads them up with dangerous amounts of debt, to suck out capital for its investors. It pays scant attention to employees and suppliers. Its greedy partners avoid the tax that others have to pay. If the markets turn, the volume of condemnation will only increase. Imagine the derision when funds stop making money even as their partners take home large salaries on the basis of past achievements; when private-equity-owned companies default on debts, leaving insurers and pension funds saddled with the losses; when workers are put on to the street because of desperate cost-cutting or bankruptcies.
The power of this debt-market transformation looks as if it is about to be tested. Rising long-term interest rates have pushed up the cost of borrowing. Sensing a shift in the economics of the industry, creditors around the world have started questioning the easy money offered to private-equity firms, which feed off risky types of debt. Last week US Foodservice, an American wholesaler being bought by private-equity groups, cancelled a $3.6 billion bond-and-loan deal when lenders balked at the lack of protection they were being offered. In Australia, private-equity firms pulled out at the last minute from the country's biggest takeover, complaining of the high cost of debt. This week the sale of a British retailer fell into confusion, after two private-equity bidders withdrew. The prospect of dwindling returns makes buy-out firms reluctant to club together to buy the big companies they covet; banks, meanwhile, are growing wary of offering their own capital as “bridge” finance. Shares in Blackstone, a private-equity chieftain that listed on the stockmarket last month, have fallen below their offer price—though it is still worth a tidy $32 billion.
That's not to say their bull run is over yet. Following Blackstone's lead, big buy-out firms continue to tap the public markets for fresh capital. There may well be a few more record-breaking takeovers. But if these squalls continue, it is not just private-equity investors who will shiver. Banks have raked in profit from the buy-out industry's appetite for loans and deal-making advice. Stockmarkets have climbed on takeover fever; more than a third of all deals in America so far this year were done by private-equity firms (in 2000, the last such takeover boom, it was a meagre 4%). High share prices make targets more expensive, and private equity is still raising record amounts of money, meaning more competition—and higher prices—for acquisitions, lowering potential returns. Private equity has scaled amazing heights; but its headiest days are probably over.
The second Economist article suggests that private equity may eventually become the dominant capital raising model and that ultimately, economic efficiency gains enabled by private equity firms will be the arbiter of the usefulness of these firms:
Private equity has become a byword for money-making skills. “Why are we here attending conferences when we should be setting up private-equity firms?” quipped Niall Ferguson, a historian, at a conference held at the London Business School on July 2nd. But the industry's wealth has also made it plenty of enemies, with trade unions and left-wing politicians calling for curbs on its activities and higher taxes on its earnings.
The intellectual argument in favour of private equity has not changed much in 20 years. In 1989 Michael Jensen, of the Harvard Business School, wrote a paper* suggesting the public company had outlived its usefulness. Economic developments, in particular the recession of the early 1990s, made that forecast seem premature. But its underlying arguments have more force today...
Historically companies have got their equity capital from four sources: pension funds, insurance companies, mutual funds and retail investors. The first three groups faced legal or regulatory impediments to buying unquoted shares, while the public naturally valued the liquidity a stockmarket listing could bring.
In the absence of a public quote, companies often had only one financial alternative: the banks. In some areas of the world this worked quite well. Banks were reliable partners to Germany's Mittelstand of unquoted companies and to Japan's industrial empires. But in the Anglo-Saxon economies companies often felt nervous about being in hock to the banks. A change in lending policy, due to new management or an economic downturn, could lead to the sudden withdrawal of credit.
Nowadays companies have many more options when it comes to raising money. Banks are much less important as a source of lending; they have been “disintermediated” by capital markets. Banks might arrange loans, but they quickly offload them to outside investors such as hedge funds. Bond markets are much more liquid than they used to be, and thanks to high-yield products even companies with a poor credit-rating can tap them.
Then, of course, there is private equity. It can provide finance at an early stage (venture capital) or as an attractive alternative for companies that have a public quote (the leveraged buy-out). Whereas pension funds will be reluctant to hold a direct stake in an unquoted company, they are willing to pay hefty fees to private-equity firms to invest money on their behalf.
So companies have no difficulty in finding capital outside the public market these days. Just as importantly, in recent years they have had little need to raise capital at all. Corporate profits have risen to a 50-year high as a proportion of America's GDP. Companies have used the cashflow from those profits to buy back shares and pay down debt...
In the end, the argument comes down to a simple one: if private-equity firms are organising the assets of companies more efficiently, then the founders of the industry deserve their billions (though not, perhaps, all of their tax breaks). But it is hard to measure the efficiency of private-equity firms directly. The best that can be done is to look at their returns. Here, the evidence is murky. One much-cited study** found that average returns, net of fees, were roughly equal to that produced by the S&P 500 index between 1980 and 2001. That implies that private-equity firms do improve the businesses they own, since gross returns outperform the market. But investors do not seem to benefit. “Overall, returns have not been that special, especially if you adjust for risk,” says Richard Lambert, director-general of the Confederation of British Industry, Britain's main business lobby-group.
The calculations can be complicated by the tortuous accounting used to calculate the private-equity industry's returns. A recent study† suggests that the residual values of companies that remain in private-equity portfolios may have been overstated. Allowing for this cuts the average net return to three percentage points below that of the S&P 500 index.
Do see my previous post as well on how private equity deals have soared in recent times, enabled by low borrowing costs that the Economist thinks may be endangered. The value of deals nowadays is going through the roof, making the heyday of "Gordon Gekko" pale by comparison.
