Does Private Equity Create Value?

Private equity will emerge much-changed

By Tony Jackson
Published: September 16 2007 16:17 Financial Times

Remember private equity? It was the future once – the model not just for amassing vast personal wealth but for running companies, period. At present, it is shrouded in the fog that covers most of the financial landscape. But when that clears, what place will private equity have in the scheme of things?

To answer the question, we must first deconstruct the model. How much of the industry’s returns in recent years came from running companies better, and how much from financial engineering or simple leverage?

Indeed, how much of the takings for private equity managers came from their share of the profits and how much from management fees?

The hard-line advocates of private equity will tell you that nearly all the returns came from better management.

That ignores one obvious fact. The huge expansion of private equity in recent years coincided with two powerful cycles: mergers and acquisitions on the one hand and credit on the other.

It is worth recalling that not all M&A cycles are credit-driven. The last big one, which culminated in 2000, was funded mainly by the issuance of equity. This was because credit then was substantially more expensive than equity, as measured by the earnings yield. As a direct result, private equity never made it to the party. In 1999-2000, according to Citigroup, only 5-7 per cent of global M&A by value was accounted for by private equity.

This time round, of course, credit was substantially cheaper than equity. So in the first half of this year, private equity’s share of M&A globally was 31 per cent.

In this latest cycle, leverage was the key – and given the way interest rates kept falling and asset prices rising, it was money for old rope. This is not to say that superior management skills did not exist. But they were a much smaller part of the equation.

Indeed, evidence suggests that in recent years, the same top quarter or so of private equity funds have produced the lion’s share of the returns. Mostly, those were the old established firms that really did know how to manage better.

The other three quarters, it is fair to speculate, were largely opportunistic creations of the credit boom.

Why were they allowed to exist? Largely because admission to the top funds, as with hedge funds, is by invitation only. So institutions that had no experience of alternative asset classes – but which were urged by their consultants to diversify into them – had to take what they could get.

As for fees, a damning report came out last week from a couple of academics at the Wharton School of the University of Pennsylvania, who examined 144 funds over 14 years.

The study concluded that the average firm made a little over $5 from its share of the fund’s profits for every $100 it managed. Management fees, though, contributed double that.

In other words, for less talented firms the whole trick was to find enough gullible institutions to give you money in the first place. The 2 per cent management fee would make your fortune, whatever happened to your investments.

So where now? The short answer is that the industry will shrink. But it may take some time to do so.

First, of course, there are still a number of big deals in the pipeline. Thereafter, even the more sanguine private equity managers I have spoken to argue that the industry has many further billions of equity still to deploy.

Maybe so. But pipeline deals, such as KKR’s for First Data and Alliance Boots, also involve hundreds of billions of debt which the issuing banks are desperately trying to offload.

Once that pig-in-the-python process is complete, they will be less willing to put up further debt to match the industry’s remaining equity. It might be objected that on paper, there is still a profitable gap between the cost of credit and the cost of equity. So on that basis, why should the banks not lend?

Because the cost of credit is only one part of the equation. The other bit is the level of supply. And that, I strongly suspect, has changed for the foreseeable future.

It is worth recalling that the Basel II rules will apply in Europe in just over three months. They will introduce a risk-adjusted element to capital adequacy.

In other words, banks issuing leveraged loans to private equity will have to put up more capital than for a loan to an AA corporate. At a time when their capital will probably
be squeezed by write-offs anyway, that is asking a lot.

There was a time when private equity did a humble but useful scavenging job – picking up family firms and the unloved divisions of big companies, then brushing them up for sale.

Once the fog lifts, that could well be its role again for quite a while.

And no more nonsense about visions of the future. Until the next time, anyway.

© Copyright The Financial Times Ltd 2007.