The Truth About Private Equity

Until his private equity firm, Permira, bought the AA motoring group, Damon Buffini was a relatively anonymous figure. By all accounts he had made millions from previous deals, but neither he nor his industry had entered the public consciousness. That all changed when Permira, seeking to scale back costs at the AA, began a series of job cuts - and became the target of a campaign by the GMB union. Mr. Buffini's Sunday prayers at Holy Trinity church in Clapham, south London, were disrupted by a protest outside at which the GMB paraded a camel, evoking the biblical saying that it is easier to thread a camel through the eye of a needle than for a rich man to go to heaven. Private equity began to move from the ‘Companies & Markets’ section of the FT to the popular broadsheets and tabloids. If you didn’t read the articles, you probably saw the cartoons: the ‘fat cats’ of private equity, casting company traditions and honest workers aside in a ruthless, selfish pursuit of personal wealth.

What emerged was something of a media-led campaign against private equity. Much of this focused on an apparent tax loophole: capital gains tax paid by private equity partners was deemed too low, all the more so given their supposedly ‘obscene’ wealth. Mr. Buffini, a working class boy from Leicester, had reportedly accumulated over £100 million himself. The government joined in, dragging a number of senior executives – including Buffini - in front of a Commons select committee. Interestingly, this very public grilling brought little in the way of punchy criticisms, beyond a recommendation that capital gains tax be increased. This limited outcome seemed to meet with a satisfied ‘serves them right!’ tone in much of the media. Not only were these ‘fat cats’ making obscene money for doing very little (and laying honest workers off in the process), they had been paying ‘less tax than their cleaners’.

Reporters and much of the interested public moved quickly to compare private equity partners like Mr. Buffini with those employed – and then made redundant – in his and other private equity firms’ deals. It was presented in many quarters as a classic case of the rich exploiting the poor. As the issue thrust the industry in the spotlight, other issues and criticisms surfaced. Newspapers were full of images of similar pickets and protestors, chanting about private equity funds’ supposed malevolence. The phrases ‘locusts’ and ‘asset strippers’ were used liberally. The general thesis was very simple: private equity firms as predatory, unethical capitalists, who buy into businesses, then manage them without regard for anything except a return on their own investment. Surely company traditions, and honest, long serving staff shouldn’t be at the mercy of ‘faceless’ capitalists? The critical journalists were the crusaders, having uncovered and exposed these previously ‘faceless’ men. Much of the public were only too happy to join the apparently righteous crusade.

But undoubtedly private equity has been both misunderstood and misrepresented, as revealed by the extraordinary frequency of one particular question: ‘What, exactly, do these people do?’ This appears strange in a country where 20% of the private sector workforce is employed by companies that have been taken over by private equity. Meanwhile many of those not employed by private equity would very much like to be; a 2005 survey of senior managers in UK public companies conducted by the FT and the UK’s Finance Directors’ Forum found that three-quarters of those surveyed said they would definitely or probably consider a position in the industry. Indeed this has almost become a cliché: the accountant or management consultant who speaks confidently of his/her future with a buyout fund. There are many to choose from, with over 170 active UK private equity firms, which provide several billion pounds each year to unquoted companies. Yet despite private equity’s ubiquitous presence, and the popularity and high reputation of the industry among much of the white-collar workforce, the recent media coverage and public response displayed a vortex of misplaced emotion and misunderstanding.

So what is private equity? The short answer is a form of investment: private equity partners are investment managers who raise and manage capital, and seek to make a good return on their funds. Unlike traders in investment banks and hedge funds, who generally take hands-off, short-term positions in companies and other assets, private equity managers look to take large stakes in established companies and then involve themselves in their management. Venture capital is essentially the same model, but with a focus instead on providing capital and expertise to early-stage, growth companies, rather than the more mature acquisition targets of private equity. Industry deals vary in type. Many private equity deals are from corporate divestments - unloved or non-core businesses being sold off or snapped up - while other forms include public to private buyouts (buying the majority of a publicly listed company and taking it private) and secondary buyouts (purchasing assets or businesses off another private equity firm). Potential targets are always on the market – a large public corporation might wish to offload one of its less profitable divisions, for example, or poor management might have made shareholders restless, critical, and seeking a quick exit…. Contrary to popular imagination, ‘hostile takeovers’ by private equity funds are relatively rare – almost by definition, private equity partners pick up businesses or assets that are not in the most vigorous health at the point of acquisition. It is this that often persuades shareholders and/or the existing management of an acquisition target that the business would best be served by the capital and expertise of an interested fund. The same factor, of course, suggests to the fund itself that there is perhaps a bargain to be had, operational improvements to be made, and value to be added.

Once targets have been identified, private equity funds bid to buy into them using both equity – their own capital and that which has been provided by investors – and bank debt. As much of the latter is employed as possible – sometimes up to 90% of the deal price – and the interest and debt is then, essentially, added to the books of the target business or asset. The target must, of course, then produce sufficient cash flows over the interest payback period in order to repay the lending banks. While private equity is evidently not just about what is termed ‘financial engineering’, the use of high debt/equity ratios has been particularly controversial. A very public example is the recent storm over the American owners of Liverpool FC. The two American businessmen in question, Tom Hicks and George Gillett, purchased the club with a leveraged (high debt) buyout (or “LBO”) - the essential private equity deal mechanism. Private equity funds use leveraged buyouts – with as much debt as they can raise – because it allows them to purchase assets of much higher value, and to make a much more significant return on their own equity capital invested into the deal. At Liverpool, the purchasers employed as much debt as possible, in order to meet the asking price and to ensure a higher return on their own capital – and most of this debt was then thrust onto the clubs books. The buyers used the club’s high (and predictable) gate receipts as a form of guarantee to the lending banks. Such banks wouldn’t lend you and me hundreds of millions, but they can be persuaded when they can clearly see just how – and when – they will receive their money back.

How does a fund seek to make money? The premise of private equity is that value can be added and created by purchasing – and then managing more efficiently – particular companies or assets.
Funds have variously employed a number of value creation strategies. The leveraged buyout pioneers in USA of the 1980s started with arbitrage plays: the identification of companies or assets that for some reason were undervalued, perhaps due to being private and out of the spotlight. Such businesses could be bought, restructured, and managed more effectively - then sold on for huge profits through a lucrative public flotation. Another component was the financial engineering already mentioned, involving the use of high debt ratios and sophisticated financing in order to provide large-scale funding for (and eventually to squeeze value out of) acquisition targets.
However, as private equity has evolved, the key driver of value creation has been the fund taking an active management role in the acquired business. Witness a 2006 report by management consultants McKinsey, which noted a correlation between time invested in a business on the part of the private equity partners and its success and growth. A similar correlation was found in cases where the fund had invested in strengthening the management team soon after the acquisition. Simply put, it is in a private equity fund’s interests that their investment portfolio performs strongly – and most find that active engagement, microscopic knowledge of businesses and relevant markets, and ‘100 day plans’ involving top management allow for substantial value creation in the medium to long-term. Such a focus on management and long-termism is likely to continue, given a tightening of debt financing following the global ‘credit crunch’. One of many elements of the management process is, in industry jargon, the ‘cutting of fat’ – a careful and often ruthless attitude to corporate waste and inefficiency. Corporate excesses like private jets were rife in 1980s America: such luxuries were the first to go once a new private equity owner tightened the strings of a sagging, inefficient business. Inevitably, staff can suffer from being either inept or surplus to requirements – hence the controversial cuts at the AA and others. Yet job losses are far from being an aim or an inevitable consequence of private equity deals. The drive for efficiency and profitability appears to result instead in a net creation of employment opportunities (according to a report by the World Economic Forum). The private equity ethos emerges from a presentation by industry leader Apax; with high interest payments to service, as a result of the takeover, ‘value is created by sweating the details, with no lazy production manager or surplus company car safe from attention.…’

If private equity, then, means tighter management, increased financial skills in a business, and the use of high leverage (debt), does it deserve the reflexive criticism of the press and public in recent months? Private equity firms are certainly concerned with their own profits. This must of course be recognised. But in seeking to improve businesses, by providing management with skills and funding, the industry is essentially beneficial to both those businesses and to the wider economy. Media scare stories, fuelled by some less-than-successful deals such as Permira’s ownership of the AA or Terra Firma’s takeover of EMI, have tended to obscure this basic fact. Private equity backed companies have actually been shown to grow faster than other types of business; growth made possible by the provision of both capital and experienced personal input from skilled private equity executives. This combination of powerful funding capabilities and strong management input favourably sets private equity apart from other forms of finance. Private equity, like venture capital, can help companies achieve their ambitions by providing them with a stable base for strategic decision making and financing. Lionel Assant, of American giant Blackstone, spoke eloquently at a 2007 conference in Oxford as he sought to dispel some of the myths surrounding his industry. Blackstone, according to Assant, has net created 40,000 jobs through their deals; similar positive statistics have emerged from some of the more careful media research. Assant answered other criticisms too. Private equity is not hostile, he stressed, explaining how his own firm has a covenant for non-hostile takeovers, while he hit back at criticism of the industry being about ‘quick flips’ – selling acquisitions on for quick profits – by explaining that holding periods are typically two years at least, and that funds often hold onto a stake even once a business has been divested.

A further key criticism of private equity has been of its apparent secretiveness – remember the ‘faceless’ men characterisations, of shadowy financiers rattling up huge personal gain with little regard for anything but their own fortunes. Private equity has perhaps been its own worst enemy here, incurring its mixed reputation partly through the lack of a single representative voice and the sometimes contradictory media comments from industry leaders. Yet the ‘opaque’ reputation does not seem to be justified; as Martin Halusa (CEO of Apax) has pointed out, there is a constant flow of information between the buyout funds and the limited partners such as institutions and endowments that invest in them. Private equity firms may nevertheless face increased pressure to put more performance data in the public domain – and this may serve to reassure those who feel they are not sufficiently accountable. Yet it should not be forgotten that at the other end of the scale, it is the enforced ‘short-termism’ of the obsession with quarterly earnings reports that has led to problems and inefficiency in many publicly quoted companies. Management's and shareholders’ (apparent) interests are not always identical – many senior executives report a frustration at not being able to act for the long-term. Private equity, by fuelling growth through private funding and management incentives, has always profited from the greater operational leeway that comes from being out of the public eye. If there are any positives of the recent media reporting, one is the drive to seek the right balance between accountability and sufficient operational freedom.

Pickets and protests, like those against Damon Buffini, suggested – wrongly – a selfish and iniquitous industry which ought to be reformed, taxed and reined in. Most issues in the debate were astoundingly misunderstood; during the interrogation of private equity partners at the Commons select committee, some of the latter appeared to think the tax relief on capital gains was specifically private equity-focused piece of legislation. Once the tax had been increased by the Labour government, to 18%, someone had to point out to Chancellor Alistair Darling – himself evidently no expert on private equity - that this would also drastically affect the UK’s entrepreneurs…. Similar misunderstandings have riddled both the media's perception of private equity and that of the public. Once private equity is better understood, its motives and methods do not perhaps seem so distasteful. As a force for efficiency – and indeed employment – in a capitalist system, perhaps the industry should for once be commended rather than barracked. Perhaps someone should tell the camel-parading union members outside Mr. Buffini’s church….

Ben Gilmour, 25, is an Investment Analyst at a private equity fund based in Mayfair.