The Uneasy Crown

The buy-out business is booming, but capitalism's new kings are attracting growing criticism.
Economist StaffFebruary 8, 2007

Herod was not the monarch this newspaper had in mind when in 2004 it proclaimed the leaders of the private-equity industry the “new kings of capitalism”. It was Louis XIV perhaps — the sort of ruler whose kingdom grew rapidly in size, power and reputation, just as private-equity firms have done.

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). Ever bigger companies are being gobbled up. On February 7th Blackstone Group won a bidding war for Equity Office Properties, setting a new high of $39 billion, including debt, for a private-equity acquisition.

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.

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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.

Making Their Case
The kings of capitalism have started to respond. In December several top American private-equity firms formed the Private Equity Council to fight their corner in Washington, DC. Similar groups already play that role across the Atlantic.

In Davos Carlyle’s Mr Rubenstein conceded that the industry “does an awful job” in presenting itself to the public. Rather than talk about the jobs created for blue-collar workers, too often people in private equity “brag about how much money we make”. As a first step, the private-equity bosses agreed to sponsor a two-year research project. Mr Rubenstein expects it to show that “most of the money we make goes to public pension funds. We create a lot of jobs and pay a lot of taxes.”

The main defence offered by private-equity firms is that they are good for the companies they own and for the economy as a whole. Henry Kravis of KKR claimed last year that private-equity investing “leads not only to value creation, but also to economic and social benefits, for example, increases in employment, innovation, and research and development”.

The past three years have been extremely good for private equity with returns for all but the smallest funds comfortably beating the S&P 500 index (see chart 2). Long-term performance also looks strong, at least at first glance. From 1980 to 2001, the average fund generated higher gross returns than investing in the S&P 500, according to a study by Steve Kaplan of the University of Chicago and Antoinette Schoar of the Massachusetts Institute of Technology.

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Given the obsession of investors with yield, no wonder so much money has poured into private equity. There are now some 2,700 private-equity firms, managing assets of $500 billion. They are led by a number of giants (see chart 3). Only two years ago the largest fund was worth $6 billion, but some reports say Blackstone’s fund is now worth some $20 billion.

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However, the headline numbers come with caveats. First, they do not include the typically huge fees paid to the general partners who manage the funds. Mr Kaplan and Ms Schoar found that, on average, the returns to investors after subtracting these fees were slightly lower than they would have received by investing in the S&P 500 in 1980-2001.

Secondly, they found huge differences in performance between funds. In 1980-2001, the top quartile of private-equity funds produced an annual rate of return of 23%, well ahead of the S&P; the bottom quartile earned investors only 4%. Not only was there a large gap between the best and the rest, but their respective performances were also remarkably consistent. The study showed that the winners in private equity tend to keep on winning and the bad firms stay bad — if they remain in business. Anecdotal evidence suggests that this pattern has endured, with the notable change that big firms are now outperforming the rest and in turn attracting a disproportionate slice of new money.

What makes a top performer? Mr Kaplan lists some characteristics: the expertise to analyse deals and add value; the ability to attract the best executives and other talent to companies; and a strong network to search for deals, sometimes avoiding auctions.

Some suspect that success is all about higher levels of debt. Private-equity firms borrow heavily to buy companies — the equivalent of a gambler borrowing money to double his bet. Given that higher leverage equals higher risk, where is the benefit? As Fidelity’s Mr Gordon puts it, ultimately investors in private equity are backing the same companies that they held as listed groups. “Performance over time will be driven by the same factors: earnings growth, cost management and so on,” he adds. “The difference is leverage. Strip out the leverage and the correlation with quoted equities is tight.”

There is a lot to this. In the early days leverage was responsible for most of the superior returns. Moreover, the easy credit of the past three years has helped. (An arguably worrying development has been the rise in “leveraged recaps with equity dividends”, whereby a recently acquired company borrows heavily in order to pay a large dividend to its new owner.)

On the other hand, since the mid-1990s private-equity firms have taken every opportunity to stress that they do not depend on financial engineering — a technique that they say is now widely imitated by public companies and thus no longer a source of advantage. Instead, they prefer to draw attention to other ways in which they improve the firms they own.

One is corporate governance. Unlike the owners of public companies, who tend to be too remote and thinly spread to spend time and money closely monitoring a business, private-equity firms have big stakes. Because their people’s careers are on the line, they have a powerful incentive to keep a close eye on things. There is also a strong incentive to maximise long-term value — which is what stockmarket investors are valuing in an initial public offering (IPO). Asset stripping is rarely the best long-term strategy. Even when they sell — at least in an IPO — private-equity firms often retain a significant shareholding for years after.

This claim has some academic support. In a recent study, “The Performance of Reverse Leveraged Buyouts”, Jerry Cao of Boston College and Josh Lerner of Harvard Business School, examined the post-IPO performance of nearly 500 companies floated by private-equity firms in 1980-2002. They found the shares of the firms sold outperformed both the overall stockmarket and shares issued in other IPOs that were not backed by private equity. Highly leveraged firms performed no worse than those with less debt. Bigger IPOs backed by private equity did even better than smaller ones.

But Messrs Cao and Lerner sounded a note of caution. Those firms that were owned by private equity for less than a year performed relatively poorly, suggesting that “buying and flipping” back to the market — increasingly common nowadays — is a less useful role for private equity than building improvements into the business over a few years.

Old Hands
Experience also counts for more. Private-equity firms used to be run only by financiers, but they are now adding partners (albeit not as fast as some would like) who have run big companies. These include superstars such as Jack Welch, formerly of General Electric (GE), and Lou Gerstner, once head of IBM. A huge service industry has grown up to help, providing lots of work for consultants and headhunters. Bidding consortia allow generalist firms to team up with specialists to gain expertise. Silver Lake, for instance, is much sought-after by clubs bidding for technology companies; Providence Equity Partners plays a similar role in media deals.

Firms in private-equity portfolios are free of the most onerous regulations to which public companies are subjected, such as aspects of America’s Sarbanes-Oxley act, which was rushed into law after the collapse of Enron. They are subject to less scrutiny in the press, especially when it comes to short-term dips in profits. And they can pay executives whatever they wish without facing an uproar. Compared with public companies, private-equity firms tend to be more generous in rewarding good performance, but they punish failure more heavily. Given that many of the most talented executives are risk-takers who want to get rich, it is no surprise that many are switching to private equity.

The “drain of management talent at all levels to private equity is one of the main reasons I am open to taking the firm private,” the boss of a company with a market capitalisation of $16 billion recently told The Economist. That is the most striking difference between private equity today and in the 1980s, says Chicago’s Mr Kaplan. “In the 1980s company bosses were implacably opposed to LBOs. Now they see an opportunity to be able to do a better job and be better paid when they succeed.”

Many bosses have become evangelists for private equity. Cristóbal Conde, the boss of SunGard, is quick to enthuse about how much more helpful his financial software company’s new private-equity owners were than he expected, encouraging him to concentrate on long-term growth.

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”. They are sprawling empires, with extremely diverse firms to manage. For example, Blackstone’s portfolio includes stakes in Michael’s, an arts and crafts retailer; Emcure Pharmaceuticals; Deutsche Telekom; Orangina, a drinks firm; FGIC, a bond insurer, and Houghton Mifflin, a publisher. It also owns part of SunGard in partnership with KKR. KKR’s assets include HCA, a health-care firm; NXP, once the semiconductor business of Philips; Primedia, a publisher; Sealy, a mattress-maker; and Toys “R” Us.

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?

Chicago’s Mr Kaplan is surprisingly optimistic. The repayment terms on loans to private equity are far more generous than in the 1980s, when repayment of the principal started immediately. Now there is often no requirement to start repaying the principal until after seven or more years. As a result, private-equity firms are likely to have a lot of time to put things right if one of their firms gets into trouble.

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. “Shareholders are increasingly asking why they are selling at a price less than what it will be worth in the future.” says Colin Blaydon, of the Tuck Centre for Private Equity and Entrepreneurship. GE recently imposed limits on the number of private-equity firms that could club together to bid for its plastics division to try to ensure a competitive auction rather than a carve-up.

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.