Risk & Compliance

Under The Microscope

Regulators put buy-out firms under scrutiny, but market forces may well be a tougher challenge for this booming investment sector.
Economist StaffNovember 14, 2006

First it was hedge funds, now private-equity firms. From the executive suites of Europe’s biggest companies to the bureaucratic cubicles of Washington, DC, there are growing calls for stricter oversight of buy-out firms, which lately have marched from one big takeover to another. The most recent (though failed) bold stroke—a €40 billion ($51 billion) offer for Vivendi of France by Kohlberg Kravis Roberts—has galvanised critics, who claim good corporate citizens are under siege.

Now the regulators are weighing in. On November 6th Britain’s Financial Services Authority (FSA) issued the first in-depth review of private equity by a top supervisory body. Its preliminary conclusions are that the biggest buy-out firms and their lenders deserve closer surveillance in several areas, but pose no broad risk to the financial system. The European Central Bank has also voiced concern over the growing exposure of banks to debt-hungry buy-out vehicles; but it, too, sees no cause for panic.

In America, the world’s largest private-equity market, the Department of Justice is said to be expanding its investigation of “club” deals, in which big firms have teamed up to launch large bids. The worry is that they may be anti-competitive. Suddenly private-equity lawyers are popping up everywhere.

As a growing number of pension funds and insurance firms take leading stakes in private-equity firms, the future of the sector may rest more with market forces than with regulators. Here, too, things look a bit murkier. For one thing the days of cheap money cannot last forever—though they have proved more enduring than many had thought possible. And the growth in the number of funds chasing a finite number of assets also creates problems. It makes targets more expensive, requiring more debt to make a purchase. Once acquired, companies are held for shorter periods than in the past, leaving less time to knock them into shape.

So far it is hard to detect a slowdown. The number of buy-out deals surged to 2,677 in 2005 (with a value of about $326.5 billion), up from about 1,200 deals (worth about $108 billion) in 2002, according to Thomson Financial, a data provider. The pace has picked up this year, with more than $542 billion in deals done.

Institutional investors have been lured in by strong performance. The average annual return on private equity has topped 13% over the past two decades, Thomson says, with stronger returns in the past few years. Data compiled by the British Venture Capital Association show that pension funds alone accounted for 31% of money raised by private-equity funds in Britain last year.

This, in turn, has prompted some of the calls for tighter regulation. The FSA paper identifies seven areas of potential risk coming from private equity, but labels only two of them—potential conflicts of interest and market abuse (use of price-sensitive information)—as highly significant. In response it has increased its scrutiny of credit markets and established an in-house team to monitor the sector. The FSA will focus on supervising the 14 largest firms among about 250 it monitors. This is broadly the strategy that it uses to keep tabs on the hedge-fund industry.

A lesser risk, in the regulator’s view, stems from the levels of debt used to finance private-equity deals. This, it says, is being monitored through lending banks, which have increased their loans to private-equity firms over the past year.

A high-profile example from America highlights one potential risk of so much debt. After a consortium of private-equity firms made a $33 billion offer this year for HCA, a big hospital operator, Standard & Poor’s moved its corporate credit to B , down three notches. David Peknay, of the ratings agency, says HCA will pay $1.5 billion more interest a year as a result. “This debt load handcuffs their capabilities.”

Yet private-equity firms and their advisers bristle at suggestions that they are borrowing recklessly. “Buy-out firms put huge efforts into risk reduction,” claims Patrick Dunne of 3i , one such firm based in London. Others say there is a bit more caution about debt in general. “The appetite for the most crazy deals is down,” says Jonathan Guise of Blenheim Advisors, a debt-financing consultancy for private-equity firms. “Leverage has reached its peak. The banks are starting to realise they don’t want to push it too much further.” Data from S&P confirm that the amount of equity put into leveraged deals has stabilised, though it remains high.

Today the risk in private-equity deals is spread more broadly than in the past. Just two years ago the lending market consisted largely of banks that operated in a relatively standard fashion. Now a range of non-bank institutional investors—from asset managers to hedge funds—hold most of the debt. “I’d estimate that in the next six to 12 months in Europe, only 30% of syndicated debt will be held by banks,” says Mr Guise. The existence of a secondary market spreads risk further. “If every investment made by Blackstone [a big buy-out firm] were suddenly to go south tomorrow—and that’s not going to happen—I don’t think there would be any systemic risk,” reckons Andrew Metrick, a finance professor at the Wharton School.

Yet he and others agree that the market cycle is at or near its top, particularly in America and Britain. Prospects look better in continental Europe (worries about Vivendi notwithstanding). “There are so many big lazy companies that can benefit from private equity,” notes Senia Rapisarda of London Business School.

Given the less exuberant mood in private equity today, it is perhaps not surprising that some firms are seeking permanent capital through public markets, either by
floating funds or parts of the firms themselves. This could be a sign of managers seeking a graceful way to get their own money out. A little more transparency would indeed be welcome. But private equity has done far too well operating in the shadows to let in any more than a pinprick of light.