Reality checks for private equity
Chris Higson, Professor of Accounting at London Business School, provides a reality check into what went wrong with private equity as well as his insights into what the future now holds.
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Between 2005 and 2007 it was boom time for private equity firms as they chased - and often achieved - higher and higher profits spurred on by generous rewards and incentives. Frenetic activity enabled them to reap huge rewards. But as the credit bubble began to deflate so did their fortunes.
Reality check #1: Both sides were right!
What was interesting about the furore around private equity that peaked about a year or 18 months ago before the credit crunch blew it out of the headlines, was how polarised the debate was. The critics of private equity spoke about asset stripping, savage cuts in headcount and the extraordinary profits that private equity firms were making.
In response, the private equity industry was indignant. It regarded itself as bringing operating efficiencies, strategic innovation, turning around underperforming firms and generally aiding the efficiency of the economy as a whole.
Which story was right? Well, I think they were both right which is why the debate was so confusing. There's no doubt that during the period of slack and easy credit private equity firms were awash with debt finance. This meant that they geared up the companies they bought to such a level that when the recession arrived these companies couldn't survive. But it's equally the case that there are many heroic stories told by insiders -- by the acquired companies -- about the transforming light that private equity was able to shine into some underperforming businesses. Both stories are correct.
Reality check #2: Private equity is a bit part player in and contributor to the credit crunch.
The asset bubble that we've seen in all asset classes and in all developed economies in recent years is much bigger than private equity. The private equity industry, even by 2007, was still a very small player in global markets.
Private equity had clear effects in certain sectors. For example, look at the brewing industry or the pub industry, where there are some inefficient companies sitting on a lot of very attractive real estate. The share prices of those companies rocketed in 2005, 2006 and 2007. This was clearly in anticipation of bids from private equity. But that was rather localised.
So, I don't think you can blame the world's problems solely on private equity though it clearly played a role in creating the situation.
Reality check #3: The future remains uncertain.
At the moment there's no doubt that the big private equity houses are suffering. Even a few weeks ago people were observing that private equity houses are sitting on billions of pounds of uninvested cash and are simply waiting for the next round of opportunities. And, let's be clear, in a deep recession there are a lot of undervalued firms and you would have thought that this would offer rich pickings to private equity.
Extraordinarily, some of the big houses have started to return cash to their investors. They're clearly under severe internal pressure. And the line up of the big private equity houses in two or three years remains unclear.
The problem is that many of the firms in which they are currently invested and haven't yet sold are both struggling and are hard to sell. So if you're a private equity house that's bought a manufacturing firm, the market for that firm's products may well have collapsed but you still own it.
Private equity firms have always relied on being able to briskly sell companies after two, three or four years. The opportunities to float or sell to another company have, for the moment, disappeared. This is a big problem for private equity firms.
Reality check #4: Private equity firms do better when credit is tight.
The best benchmark for the private equity industry is corporate acquirers. There's a lot of research going back decades that shows that corporate acquirers tend to overpay in the frenzy of boom markets. They tend to destroy value. The research we have done suggests that of corporate acquirers, only about 25 per cent make any money from acquisitions they make during the peak of merger waves.
The same applies to private equity. They have a similar logic. They tend to overpay. They have too much cash when credit is cheap and easy -- exactly the world of the last few years. The evidence isn't so extensive on private equity because we don't have so much history and there are not so many private equity firms around. But as far as we can tell private equity have always done better when credit is tight.
Reality check #5: Private equity should be seen as a way of working.
Private equity should not be regarded as an institutional form, but as a way of working, a modus operandi. It's an approach to buying firms and turning them around and selling them. And most of the tools in the private equity toolkit can be copied. It is not rocket science.
It will be interesting to see just how much of private equity's advantage it can sustain. Attracted by the potential returns, many other institutions with deep pockets -- pension funds, insurance companies, large companies, sovereign funds, family offices and so on -- have learned from private equity and will seek to copy and cherry pick what private equity does. It will be interesting to see what will be private equity's sustainable competitive advantage in a much more competitive environment.
Reality check #6: The future is different but more focused.
The private equity industry will look somewhat different when we emerge from the crisis. It will return to basics because the buyout end of the private equity industry is a relatively recent development. It grew out of the venture capital industry, which is much longer established.
We will always have and will always need venture capital firms who share some of the characteristics of the buyout firms. They are essential to the growth and prosperity of small start up technology businesses, in particular. I think we will see the focus return to that end of private equity.
Chris Higson (chigson@london.edu) is Associate Professor of Accounting at London Business School.