What you need to know about private equity

Private equity firms may be castigated as “smash and grab merchants”, but you can’t afford to ignore these emerging giants of the financial world.

Private equity businesses have been castigated as "smash and grab merchants" and "deal flippers." Germany's vice-chancellor, Franz Mntefering, famously excoriated them as "locusts that fall on companies, stripping them before moving on." They have been accused of misleading promises, dodging tax and threatening social stability.

Yet they are the emerging giants of the financial world, an alternative asset class that is increasingly attracting investor interest.

When the private equity group Blackstone recently went looking for money, it stopped accepting any after more than $15 billion flooded in. Just think about that. How would you like to have $15 billion to invest, pretty much any way you liked?

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

According to the consultancy Private Equity Intelligence, 550 funds raised $275 billion last year. Worldwide, investors have earmarked $1.3 trillion for future investment in private equity funds, whose financial firepower cash in hand, plus borrowing capacity is already equivalent to half the market value of all America's listed companies.

Private equity: what is it?

It's risk capital invested in businesses that aren't listed on stock exchanges, or won't be after they've been taken over and delisted. It's also a shorthand term for the firms operating in the field, which specialize in raising capital for new enterprises, financing management buyouts, and restructuring companies to realize the full value of their assets.

Initially based on partnerships of small numbers of fabulously wealthy private investors, the sector now encompasses larger entities, drawing most of its capital from institutional investors - pension funds, banks and insurance companies attracted to mouthwatering returns while also attracting a widening range of individual investors.

One well-known institutional example is the endowment (trust) fund of America's oldest university, Yale, which has achieved an annual return on its private equity investments averaging 31 per cent over the past third of a century, and nearly 40 per cent over the past decade, backing some spectacularly successful business start-ups such as Compaq, Oracle, Dell, Amazon and Yahoo.

Thomson Financial reports that buyout funds achieved average annual returns of 24 per cent in both 2004 and last year, or triple that of the benchmark index for US shares. The British Venture Capital Association claims its members have delivered long-term returns averaging nearly double those of the UK all-share index.

Private equity: how do they do it?

An excellent example is what a private equity consortium did when it bought the UK retailing chain Debenham's for nearly £2 billion, putting in £500 million of capital from its own investors and borrowing £1.4 million, then delisting the company from the London stock exchange:

- Property was sold off and leased back to realize £400 million.

- Borrowings were boosted dramatically from the £100 million when it was a public company, to £1.9 billion.

- Huge "special dividends," believed to be between £200-300 million, were paid to the new owners, reducing their personal capital risk exposure.

- The three most senior employed managers were incentivized by being given 10 per cent of the shares (fairly described as "potentially life-changing rewards").

- About £100 million of tax was saved by the shift to debt financing (as such interest costs are a fully deductible expense, reducing taxable income), and some financial engineering making use of offshore companies.

- Cash flow was boosted by a sharp cutback in capex.

- Creditors were made to wait longer for their money and customers' discounts were cut, reducing working capital costs.

- Stockturn was improved.

The result? On sale of the restructured company, the owners completed a process that earned them about £1 billion and the three top employee managers were personally worth £100 million.

Private equity: why it gets the top talent

Such breaktaking returns are not uncommon in the private equity business. And as the partnerships that manage such ventures typically take for themselves 20 per cent of profits above a hurdle return such as 8 per cent a year, it's not surprising that the sector is attracting some of the world's greatest business talent.

The Financial Times reported a few days ago that there is now a mass exodus of heavy hitters from publicly-listed financial institutions into private equity.

The prospect of becoming seriously rich is only one reason. You can become seriously rich managing publicly-listed companies, but you're exposed to constant public scrutiny that often includes unpleasant publicity and a barrage of criticism, especially from populist politicians. In the private equity sector, how rich you become is, well private.

You are freed from the responsibilities of public life, such as obligatory socializing and being expected to sit on industry boards; you have much more time to be creative in the business without having to motivate and manage thousands of employees; you can focus your energy on one or a few businesses; you don't have to worry about pleasing thousands of shareholders and short-term performance as shown by quarterly reports.

Jonathan Bloomer, former chief executive of the giant life insurer Prudential, and now an exec with the US buyout firm Cerberus, says: "In corporate life, different shareholders have different views about the things they want you to do; in private equity, you are dealing with one shareholder and have a very clear conversation."

Private equity: what techniques do they use?

The techniques used by private equity managers to create wealth for themselves and their investors include identification of start-up businesses with great potential, companies with talented managers who don't have the personal capital or skills to buy out the owners, and firms with great hidden value in their assets that can be bought cheaply.

Once they're owners in a business, private equity firms use aggressive gearing, stock options for key managers, ruthless pruning of non-core operations, mobilization of property assets and restructuring to save tax as I have shown in the case of Debenham's.

Those are techniques equally available to managers of listed companies. But private equity groups can use them far more effectively because they operate out of the public eye, not having to worry much about public or shareholder opinion; and they run very small, tightly focused management structures, which makes for greater efficiency.

They typically exit from ventures after a few years through a stock-market flotation; sale to another company, usually in the same business sector; to another private equity group that believes it can see further restructuring potential; or by reclaiming capital provided in the form of preference shares or loans.

One reason for the explosive growth of private equity in recent years has been the availability of huge amounts of loan capital at very low rates of interest for the relatively high risk levels involved. In a typical MBO (management buyout), major banks are willing to put up half the capital as "senior debt" at interest rates of (say) 3 per cent above their base lending rate.

This abundant cheap capital has encouraged private equity groups to become increasingly aggressive in gearing up their ventures. In Europe the average "debt load" (cost of servicing debt) to earnings ratio has risen from four to six times, and in some cases as high as eight times, over the past two years.

Industry figures such as Ronald Cohen and John Moulton have warned that in the current "permissive environment" some borrowers are taking on excessive debt and exceptional risk.

Which brings us to the other downsides and criticisms of private equity

- Are the profits really that good? Michael Moritz, a partner at the long-established US private equity firm Sequoia Capital, warns: "Investors need to be aware that most of the publicly-available data on private equity returns are usually wrong and often grossly misleading."

The FT's John Plender says: "Performance measurement data is suspect, transparency is poor and the media trumpet successful deals while the dogs go mainly unreported."

A study by investment bank Goldman Sachs of returns of US private equity funds over the long term showed average returns about the same as for listed shares and hedge funds, although the top tenth of funds did very well, delivering net returns to their investors averaging 22 per cent a year.

Yet another case of - you can only do well if you're clever or lucky enough to select a future winner.

By Martin Spring in On Target, a private newsletter on global strategy

You can read the second half of Martin's piece on private equity - including how you can invest - tomorrow.