The Business of Making Money

Back in the late 1980s, the Financial Times carried a spoof story about a planned buy-out of General Motors. Nowadays the sale of such a giant would not be regarded as a joke. Every day yet another company seems to succumb to the clutches of private equity. And this week saw what could be the biggest deal ever: a $48.5 billion offer by a consortium of investors for BCE, a Canadian telecoms group. It was swiftly followed by a potential $22 billion bid for Virgin Media, a British cable-television company, and the $26 billion purchase of Hilton Hotels.

Even after those deals, the private-equity titans have plenty of firepower left. According to Private Equity Intelligence, a research group, the industry raised $240 billion in the first half of this year, leaving it well placed to surpass last year's record of $459 billion. That compares with less than $10 billion raised in 1991. In the process, private equity's share of mergers and acquisitions has grown massively (see chart).

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.

Public tedium

Life is no longer much fun in a publicly quoted company. Executives have to suffer the slings and arrows of intrusive media coverage, the oppressive tedium of “box-ticking” corporate-governance codes, the threats of activist investors and short sellers, and the scrutiny of single-minded political campaigners.

And what do companies get in return? Traditionally they have had three main reasons to list their shares on a stockmarket. The first is to raise capital, either to expand the business or to allow the founders to realise their wealth. The second is to help retain staff, who can be offered share options as an incentive to stay and work hard. The third involves prestige; customers, suppliers and potential employees may be reassured (and attracted) by the apparent seal of approval given by a public listing. However, all three reasons seem to be less compelling than they used to be.

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.

Mr Motivator

In the 1990s it seemed as though everybody in America had a neighbour or a relation who was about to become a millionaire through their stock options. Companies were handing them out like free newspapers on Piccadilly. Company boards were happy to offer options since accounting rules allowed them to pretend they had no cost. Employees were happy to take them in the belief that an ever-rising stockmarket would allow them to buy the condominiums of their dreams. Companies without a listing seemed likely to fall behind in the race for talent.

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