Some thoughts on private equity

• by Evan Davis | Notes on Real Life |

It’s very much in the news, but is it as bad as people say?

For those that do not feel they know what private equity is all about, let me offer a few arguments on both sides. Read original article

First an explanation. Private equity is quite simple. Investors borrow money (from banks); they usually add a little of their own and use the cash to buy companies. Often the companies they buy were publicly-owned - in the sense that a large number of relatively anonymous shareholders buy and sell shares in them on the stock market - and once bought, they become privately-owned, in that their shares are no longer traded.

Three features tend to follow:

• First, private equity investors usually put the debts they have incurred buying a company, into the company they have bought. Thus they are increasing the debt portion of finance in the economy

• Second, they have a very big incentive to run the company well, because they stand to gain all the profits from so-doing. So they tend to be ruthless in the pursuit of efficiency and value.

• And third, after a few years, they tend to sell the companies they buy.

In fact, private equity does for companies what some builders I know do with houses: they get a hefty mortgage to buy one, do it up as fast as possible and then re-sell it at a profit.

Now most of the current discussion about arguments have revolved around tax.

These investors pay very little tax on the profits of their sale, because it comes in the form of capital gain, and capital gains are lightly taxed if made after two years.

I’m not sure I understand why capital gains should be treated more generously than other forms of income. But I’m assured by experienced entrepreneurs that offering a low capital gains tax rate is – in practice – an effective way of promoting a risk-taking start-up culture.

However, private equity is not about start-ups. Indeed, most of the people who used to be involved in financing start-ups now seem to have switched their efforts to private equity deals on existing companies.

Some entrepreneurs think a capital gains tax distinction should be made between start-ups and private equity investments, so that the lower rate is given to the one but not the other. But personally, I would need to better understand the reason for having any kind of capital gains tax concession at all, before choosing between subtle distinctions between “good” capital gains and “bad” ones.

So let me turn to the substance of the arguments about private equity.

It totally changes the way we run companies. Out goes the Anglo-Saxon version of stock-market capitalism. No more do executives get paid a salary for running companies on behalf of disparate shareholders who keep the profits which are generated. In comes a system whereby the managers are the shareholders, and they keep the profits.

The day-to-day risks of running a company – the profits that can go up or down - is transferred from the shareholders to the private equity funds who are closely involved in managing the companies they buy.

Because the managers themselves can’t buy whole companies outright, debt plays a much bigger part in financing corporate activity.

In fact, private equity arguably takes us a step towards the German model of corporate governance. Which is ironic, as in the 1990s, when Germany was still top nation in Europe, writers like Will Hutton told us that our capitalism with anonymous shareholders selling their shares when the going got tough in a company, worked very badly. We needed banks to be more involved in companies, with shareholders taking a long-term, involved, view of what companies do.

In practice, the Will Hutton critique of the stock market seems to have some resonance with lots of executives who really do think private equity work in releasing them from the tyranny of half-yearly profits statements, and makes it easier to take a strategic view of what they’re doing.

You might even say private equity is like the business equivalent of releasing politicians from the slavery of opinion polls. We want our leaders to listen to us, and anticipate our reactions to things. But we do not want them to be guided only by the latest poll ratings to the detriment of a sensible long-term view of things.

So there are potential advantages to private equity, in delivering focused, long-term management.

But there is also a less-benign explanation for the growth of private equity.

It could be to do with the fact we have given companies limited liability and have very forgiving insolvency laws.

It’s all down to the crucial difference between debt and equity.

Suppose investors borrow £9 million to buy a company worth £10 million, and they put up £1 million of their own. Their investment is heavily geared. If they can create a 5% increase in the value of the company, they add £0.5 million to it. But because they keep the whole increase in value for themselves, their initial £1 million investment has not risen by 5%, but 50%. A fantastic return (particularly if it's taxed at 10%).

Fine. The principle of leverage through debt has been used by mortgage borrowers to make money out of home ownership for decades.

But in corporate life, there is a drawback to the arrangement. We have made the returns to the highly-geared investor asymmetric. The upside potential is enormous, but the downside risk is limited by insolvency law. If the company goes bust, they lose their million, but they cannot lose more than that.

Often, they have paid themselves generous management fees out of the company anyway, that covers a portion of their equity investment.

Now, it’s one thing to take risks. But deliberately loading debt on to companies in order to make risks more asymmetric is of less obvious social value than managing companies for long term value.

Of course, the people who should police this are the banks, as they stand to lose their loans if the company goes bust. But they too earn fees on the transaction, so they want the business.

And crucially, in many cases, the debt that they and the private equity buyers pile on to company books stands ahead of the other creditors in the queue, should anything go wrong.

So for example, I might lend a company some money because it is a customer of mine. I lend them a few tens of thousands pounds, which seemed a pretty safe to do that. Then, I find some idiot bank has lent some private equity buyers £100 million to gear the company up to the hilt. Much of the value for the bank and the investors derives from the fact that my previously safe loan now looks like an unsafe one.

This is a bit of a problem. And although there are some measures to prevent it from being over-exploited, they are apparently not very effective.

So, the worry about private equity is that at the more extreme end, it has just turned into a piece of elegant financial engineering that has succeeded in exploiting gaps in contracts and legal arrangements.