Private equity, plcs and the fund management fallacy
Behind the current furore about private equity and leveraged buy-outs, there are some interesting questions about the best alignment of shareholder and management interests, active engagement in companies by their investors, what fund managers are really best placed to do and whether the private equity bubble may burst at some point in the future.
Private equity does saddle companies with high debts and there is often painful restructuring, closures and redundancies in companies in the first years after private equity takes over. But the current campaign against private equity has not given credit where it is due to buy-outs which are shown by independent studies in the majority of cases to result within 3-5 years in higher growth for the companies acquired and considerably higher levels of employment. Short term pain is awful for those involved, but if it positions the company better for future growth and higher employment, then private equity is doing its job.
With the massive rise in the size of pension funds and the linked growth in hedge funds who need investment opportunities that can return superior levels of growth, private equity can perform a highly useful function. Similarly, in spotting underperforming companies, taking them private and turning them around in a range of ways to add value, they make the economy more efficient and create wealth.
Why has private equity done so well and is now in the position that it can buy some of the world’s largest public companies? Well cheap money, lots of investment income looking for a home and high and stable levels of corporate earnings are a major reason.
A further reason is that a lot of talent has flown from public companies because of the huge increase in regulation and compliance following Enron, Worldcom, Sarbanes Oxley etc. The reporting requirements of a public company are now extremely onerous and so private equity has become more attractive to some of the worlds best management talent who like the idea of being able to focus on a company’s medium term growth without having to report quarterly to the markets. Sir David Walker’s working group set up by the private equity trade body the BVCA (and privately encouraged by the Treasury), will encourage greater transparency but will not change this fundamentally.
A more fundamental reason though is that with private equity, the investors have real experience in running and managing companies and they engage directly with companies to improve their performance. It is almost the owner-manager model writ large. There is a far clearer alignment of interest between the management and a relatively small and focused group of owners than there is with a plc which has a large number of disparate shareholders.
The plc model is by no means dead and Marks and Spencer shows dramatically how a public company can turn itself around without submitting to private equity. (Would it have done so without the threat, though?). But in general, the contrast is marked with a plc where ownership and management are more separate.
Some of the public debate around this issue, often encouraged by the Government, encourages investors in public companies to get more involved with the public companies in which they invest. The implication is that if institutional investors get more engaged and active, that will massively improve corporate performance.
Generally, this approach completely misses the point that most institutional fund managers have little or no experience in managing major companies. Their career path has usually been within the City where they become expert in analysing the performance of different investments. In general, they are better at moving money around to find growth, not sticking with a company and helping to turn it around.
They do not, and many do not claim to, have the expertise to actively engage and assist with the management of public companies.
Making better use of the tax-deductability of debt finance is, of course, another reason for the current success of private equity - and this will remain the case even after Ed Balls has finished the Government’s review into this area. But the same rules apply to public companies who do not choose to load their balance sheets with the same high levels of debt as private equity owned companies do. They could if they chose to, but it would reduce their credit ratings and increase their debt interest payments. (Mind you, if they did that, it would reduce their tax bill… )
The problem – and it could be a massive problem – with private equity will be in a slowdown or a recession. The high levels of debt of many private equity owned companies mean there is little margin for error if the markets turn sour.
In a downturn, is it possible that a great many private equity owned companies will get into trouble and will be bought by public companies at bargain prices? That would be the revenge of the plc and would show that there is plenty of life left in the old plc model after all.