Private equity investors are fantastic fathers, kindly philanthropists - and "A boon to the British economy" (Tony Blair)

PRIVATE EQUITY AS A 'SUPERIOR MODEL OF CAPITALISM'?

SOME THINGS TO THINK ABOUT.

Currently, there is a great uproar about private equity - some say it is simply a latter-day extension of the leveraged buyout boom of the 1980's, with private equity companies characterised as the 'Gluttons at the Gate'. Trades Unions are up in arms, vilifying the greed, asset-stripping habits and heartless nature of private equity capitalists. Many others question whether the private equity boom will provide good long-term investment results or whether we are seeing the inflation of yet another financial bubble, with the destruction of viable companies as a damaging by-product.
Conversely, there are many defenders of private equity. They claim that private equity investors generate superior returns for their shareholders; that private equity is clean and simple, not cluttered by all the governance bureaucracy of the publicly quoted sector. Others assert that the close attentions of investors spurs sluggish managers into upping their acts, that private equity ownership is positively beneficial to companies and actually causes them to perform better and create employment.

What is Private Equity Investment? What is all the fuss about?

In the current shouting match about private equity, there are prominent proponents and opponents. Tony Blair and Gordon Brown, together with many journalists and prominent figures in the private equity business have fulsomely praised the wonders of private equity as a boon to the UK economy, creator of jobs and exemplar of the UK's pre-eminent position in world financial markets.
Detractors include the European and UK trades unions, some continental European politicians, one of whom described private equity investors as 'locusts'. Journalists are divided - as would be expected - those from the more right wing end of the spectrum like the 'Economist' seem to view the growth of private equity as signalling the arrival of a new golden age of capitalism, whilst those with a more social democrat leaning view it with grave misgivings.
But what are they describing? Nearly all the proponents and detractors are much clearer about their opinions than about the animal on which they are opining.
Here is a little clarification. Private equity investment can be divided into at least three categories, each of which is quite different from the other.

Category One is Venture Capital,

which is investing in new businesses, start-ups and often advanced technology ventures. Many of the businesses in the Cambridge University science park come into this category. The world leader by a long way in venture capital investment is the United States - the true venture capital investment industry in the UK is miniscule by comparison.
Most UK investors are purely financial in their skills and therefore tend not to develop a deep understanding of the companies and technologies in which they invest. This, allied to a strong risk-aversion, makes the environment for high tech and other start-ups quite different to the US, where there is a far greater diversity of investment types and skills. Venture capital investment is risky, but it represents the true creation of the seed-corn for the future. It is economically beneficial and crucial to Gordon Brown's vision of a high tech Britain - would that we had more of it.

Category Two is 'traditional' private equity investment.

Investors in this category take funds from private individuals, and tend also to invest some of their own capital. They build portfolios of smaller companies in which they invest and will typically expect to live with their investments for 5 to 10 years, take a close interest in the business and work with management to improve and grow it. They can be differentiated from venture capitalists in the fact that they buy established businesses in which they see the prospects of significant growth rather than brand new start-ups. This type of private equity investors generally aim to make their returns from the growth potential of the businesses in which they invest. Crispin Tweddle's long-established Piper Trust comes into this category.

Category Three is represented by the recent wave of large private equity funds.

These funds attract very large amounts of capital from private investors and some pension funds, promise very high returns and seek to achieve them through 'leveraging' their investments. This category of investment has seen explosive growth in the last few years, at the expense of equity investment through stock markets. Typically these investors will seek to buy companies at a discount to their assumed market value. They then borrow heavily, (the UK provides tax relief on these borrowings), load companies with debt and extract as much cash and 'surplus' assets as possible. Managers are placed in the companies and heavily incentivised to push as hard as possible for quick performance. The investors take out very high fees, typically in the region of 2% of the funds under management. Returns are made on the amount of cash and assets taken out of the companies and on the resale value compared with the purchase value. Investors will typically try to arrange an exit from their investments in 3 to 5 years.

It is this form of private equity that is attracting most of the controversy. What can be said is that the Primary Purposes of this type of private equity companies are to maximise returns for private investors, investment managers and company top executives. If there are beneficial effects for employees, customers and society in general, they are incidental to these central purposes.
Most of the evidence about the effects of this recent form of private equity investment is circumstantial - some refers to the decline in customer service, some to sweeping reductions in workforces, and to weakened competitive stamina. Proponents claim superb job creation and wealth creation for the economy. The current lack of serious research and very woolly understanding of what is meant by private equity doesn't appear to inhibit many commentators, opponents and proponents alike, from shooting off their mouths quite freely!
Despite the secrecy of private equity investors and the timidity of regulatory bodies some serious research is beginning to emerge on the dynamics and effects of this latest financial innovation. See for example the work of Prof. Karel Williams, Julie Froud et al, referred to at the end of this piece.

A Non-financial commentary.

Here is a strictly non-financial review of some factors that crucially affect corporate performance, which may help you to form a view of the pluses and minuses of private equity capitalism.

What makes businesses successful?

For the sake of making the contrast clear, it can be said that there are two fundamentally different 'Models' of what makes companies successful.

Model One - some key assumptions.

The primary purposes of companies are to serve the interests of their customers, generate surpluses to reward employees and shareholders, re-invest for the future and make a contribution to the well-being of the society around them.
Profit and financial returns are an outcome of successfully fulfilling their customer-serving primary purposes, not the purposes themselves.
Companies are essentially purposeful human institutions.
Leaders' most important duty is to work through people to achieve long-term sustainability of their companies.
They will have a dedicated focus on the performance and well-being of their staff and are acutely aware of what they have to do to compete to satisfy, retain and gain customers. Strategy is built from the bottom up, based on a detailed knowledge of the business and organisation, not from the top down.
The best results are achieved by investing continuously and smoothly, adapting constantly, encouraging experimentation and innovation involving many people, pre-empting unpredictable, violent upheaval and involving people closely and continuously in managing change.
Good companies build strong cultures and effective competitive strategies, grow their own managers but remain open to the outside world.

Model Two - key assumptions.

Left to their own devices, managers are likely to become complacent, under-exploit assets and under-perform. Businesses therefore perform best if placed under pressure by investors. Periodic restructurings ensure that complacency is not allowed to take root. It is frequently the case that breaking companies up and re-distributing their assets to other managers (creative destruction) will unlock value.
The primary purpose of a company is to generate returns for its owners.
Managers are the agents of the owners.
The job of managers is to work investors' assets hard to extract the maximum value for them.
Top managers are most closely bonded with the suppliers of capital.
Rewards and sanctions should ensure that investors' and managers' interests are closely aligned
The value of companies is the sum total of their assets. These include money, physical assets like plant and buildings, and the value of market shares, brands and intellectual property.
Assets cannot be valued efficiently unless they are tradable.
Things that cannot be measured and valued in financial terms are likely to be ephemeral and of secondary importance.

'Large' private equity is clearly Model Two.

The declared aim of these private equity funds is to provide its investors and managers with returns outstripping other forms of investment including the public equity markets. The Economist recently described them as espousing a "Superior model of capitalism".

Is one or the other Model 'Superior'?

In one corner is the 'Shareholder Value' model. Proponents maintain that the primary purpose of enterprises is to satisfy the needs of their financial owners.
There is formidable support for this from mainstream economists, the bulk of the financial press, including the Economist, and the full might of the investment banks and financial markets. Tony Blair and Gordon Brown recently described private equity as a boon to the British economy. Proponents aver that superior performance is achieved by continuous pressure for financial results through lean investment and stringent cost cutting. They support the idea of economic regeneration through 'creative destruction'.
The shareholder value model is predominantly Anglo-American and has only made limited inroads into Japan, India and continental European economies.

In the other corner is the 'Living Company' model; proponents of which claim that superior performance cannot be achieved by aiming directly for financial results but only through creating vibrant and innovative organisations providing customers with superior value over their competitors.
Supporting this philosophy are many researchers who have sought to look inside sustainably high performing organisations, and authors like Arie de Geus and Charles Handy.
Japan and continental European countries such as Sweden, Norway, Finland, Holland and Germany tend to espouse these philosophies.

Interesting questions.

Which perform better, Model One or Model Two companies? (Think about long-term versus short-term. Think of Tesco, Shell, John Lewis and many large family companies as Model One, and most of the FTSE 100 and large private equity owned companies as Model Two).
What effects are the different types of private equity investors likely to have on top management behaviour, corporate cultures and employees' and customers' interests?
Does private equity provide superior returns over conventional investment? (Think total costs of investment).
Are there differences between the current private equity model and the methods of Hanson, Goldsmith and the leveraged buyout practitioners of the 1980's and 'Barbarians at the Gate'? What happened to them and their investments?
The Economist has observed that private equity owned companies are no worse in their behaviour than publicly quoted ones. So they behave that badly??!
Has private equity activity created more jobs than:
- the public sector?
- social enterprise companies and charities?
- family companies and partnerships?
- smaller private businesses?
- publicly quoted companies?
What is the research used to justify job creation/destruction claims?
What has been the long-term (10 years) performance of companies that have been subject to private equity ownership?
Do Tony Blair and Gordon Brown have a clear idea of what they are talking about when they say that 'private equity' is a boon to the UK economy? And why do they only mention the financial services industry in the most effusively glowing terms?