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private equity
This page considers private equity funding.
It covers -
It
is supplemented by a detailed note that explores the shape
of private equity funds,
discusses the origins of their capital, profiles fund
managers such as Apax and KKR, and highlights landmarks
in the history of the private equity sector.
introduction
Definitions
of private equity (PE) are contentious and reports often
conflate statistics regarding 'acquisition funds', hedge
funds, realty funds, venture capital and even angel funding.
That conflation reflects genuine disagreement, advocacy
(larger figures can for example be more persuasive in
lobbying regulators or impressing journalists) and blurring
of some boundaries (with some financial institutions now
operating hedge, PE and other funds).
It also reflects the rebadging of the leveraged buyout
(LBO) industry since the late 1980s, with entities such
as Kohlberg Kravis Roberts (KKR) now promoted as private
equity fund managers rather than creators of 'junk bonds'.
For the purposes of this page and the associated more
detailed note, a private
equity fund is taken to involve a pool of capital that
is typically -
- handled
by a specialist equity fund manager (sometimes an offshoot
of a traditional investment bank)
- provided
by a small number of participants, including pension
funds, banks, endowments and wealthy individuals
- used
for the acquisition of an existing enterprise (a corporation
or discrete business unit within an enterprise) or other
asset (for example a highway, a pipeline or a chain
of broadcasting towers).
The
expectation is that participants in the fund, and the
fund managers, will be rewarded through disposal of the
assets within one to seven years. That disposal may involve
floating the asset on a stock exchange, selling the asset
to an enterprise or selling it to another private equity
fund.
A fund - or consortium of funds - might thus buy all shares
in a corporation that hitherto had a large number of shareholders
and was traded on a stock
exchange. Dividends from that acquisition would allow
the fund to recoup some or even all of the capital used
in the takeover. The fund would then unload the acquisition
for a substantial. The internal rate of return on capital
is often greater than 100%, making participation attractive
to entities with the necessary resources. Those entities
include banks, insurers, pension funds, wealthy individuals,
endowed universities, museums and hospitals.
Although there is substantial churn of assets - industry
journals and associations have recurrently awarded 'deal
of the year' or 'manager of the year' labels for acquisition
and disposal of an entity within 12 or 18 months - most
participants in funds are committed to remain with that
fund for a longer period, often for ten years.
Most private equity funds are concerned with acquisition
and disposal of existing assets, in contrast to venture
capital funding of new enterprises and innovation.
Their activity also contrasts with the often frenetic
trading of hedge funds,
which exploit shorter term arbitrage of currency, financial
derivatives and other assets.
Unsurprisingly, they have been assailed as an embodiment
of 'short-termism' (concerned only with devouring and
disgorging their targets within a few years, with little
heed to ongoing development), ruthless asset strippers
that flip debt-ridden carcases to naive 'mum & dad'
investors, or simply as "locusts" from another
jurisdiction.
Defenders have responded that PE activity benefits both
those who sell assets and those who participate in funds,
encourages best use of resources, provides an incentive
for managers, unfreezes stagnant capital or simply reflects
the restlessness of capital (and the ingenuity of its
custodians) in global markets.
leverage
Acquisition often involves the assumption of substantial
debt by the fund or the acquired entity. That debt may
be in the form of bonds, preference shares or loans from
a financial institution such as a bank.
It is best known for management buyouts (MBOs), in which
an organisation's senior executives gain the support of
a financial services specialist to buy some/all of that
enterprise. Ownership of that enterprise is then shared
by the managers and their financiers, with the expectation
that the enterprise's performance will be sufficiently
improved to allow repayment of debt and/or a financially
advantageous exit for those participants in the acquisition.
Debt in such a leveraged buy out (LBO) is usually significantly
higher than equity, with risk accordingly being reflected
in loan payments that have a higher rate of interest than
standard and characterisation of bonds as 'below investment-grade'
(aka junk bonds),
similarly offering higher yields to offset the possibility
that lenders may not recoup their capital.
Private equity schemes in particular markets have become
increasingly sophisticated over the past thirty years,
with investors often being able to participate in an LBO
through purchase of debt (acquisition of bonds or participation
in a bank loan) or through via a private equity fund operated
by a specialist manager. Some investors have been individuals
- particularly those with substantial income/assets -
but typically most support has come from pension funds,
insurance companies, banks and institutions with diverse
investment portfolios. (A discussion of their involvement
is here.)
Leveraged financing in Australia, the US, UK and other
jurisdictions over the past three decades has been hailed
as unlocking substantial returns for investors and more
broadly for driving improvement in the performance of
individual enterprises and markets.
It has, however, been criticised as a form of 'casino
capitalism', with abuse by junk bond vendors, manipulation
of the tax system, demise of debt-burdened enterprises,
destruction of communities as managers slashed operations
to satisfy the demands of their lenders and failure to
invest in innovation (or even maintenance) because of
that debt.
Critics have pointed to concurrent erosion of regulation
and ready access to junk finance as resulting in the dismemberment
of particular enterprises, the creation of unwieldy debt-fuelled
enterprises such as Primedia
and concentration of wealth in the hands of a few financiers
in ways that are reminiscent of the 1870s-1890s.
Others have questioned claims about the effectiveness
of some funds. That questioning has included scepticism
about rewards for some managers, which typically seek
to extract substantial fees at every stage (eg advising
on initial acquisition by a fund, sale of the assets to
a trust, underwriting subsequent float of the acquired
enterprise and even continuing management). One contact
mordantly commented that the fund manager - like a casino
operator - never loses, in contrast to the punter or some
of those who invest in a fund.
It has also featured scepticism about the affinity between
some managers and the acquisition, particularly the preparedness
to invest in longterm growth or merely to ride out bad
times. That is particularly the case in the media sector,
where some funds clearly paid too much for assets and
then managed them indifferently amid a concentration on
cutting costs to fund debt and to spritz up an enterprise
for early sale.
shape
Private equity transactions essentially take three forms
-
- those
in which a public company is taken private, through
an LBO, MBO or management buy in (MBI)
-
divestitures that result from selling off units of a
public or private company to a private equity fund
-
private market transactions involving companies whose
stocks are not publicly traded.
As with venture capital, discussed later in this guide,
those transactions centre on profitable exits for investors.
Possible exit strategies for private equity investors
include -
-
an initial public offering (IPO),
which allows investors to liquidate some or all of their
interest in the particular entity when it becomes a
public company
-
recapitalisation, which allows equity holders to realize
a return by taking a sizable dividend
-
outright or partial sale to another buyer, which in
some instances is another private equity fund.
The
landmarks here illustrate
acquisitions by private equity funds and subsequent listing
on exchanges, sale to corporations or disposal to other
PE funds.
the
industry
Contemporary private equity funds trace their origins
to investment banking at the turn of last century and
beyond, in which a handful of well-connected (or merely
aggressive) partnerships such as Morgan, Drexel and Peabody
acquired enterprises - often from individual owners or
families - and then recouped the cost of acquisition by
issuing shares or bonds.
That activity might be on a very large scale (for example
creation of US Steel and International Mercantile Marine
under the auspices of JP Morgan) and might involve substantial
international investment. Those responsible for such deals
often retained substantial control of the enterprises
through corporate directorships, made money through a
range of fees, enjoyed privileged access to information
and frequently retained equity on a preferential basis.
Financial deregulation in the US during the 1970s and
1980s, reversing restrictions imposed earlier in the century
(particularly after demonstration of egregious abuses
during inquiries under FDR), resulted in a wave of corporate
takeovers funded by junk bonds. Contrary to some of the
more hagiographic accounts, vendors and buyers of those
bonds often acted as a herd. Typically vendors contributed
around 10% of the acquisition price, with the remaining
percentage comprising bonds or bank debt. That leverage
- or merely poor assessment of risk as competitors chased
increasingly weaker opportunities - resulted in difficulties
after the 1987 crash. Of the 41 US$100m+ LBOs between
1980 and 1984, only one defaulted on its debt by 1992.
In contrast, over 30 of 86 large buyouts between 1985
and 1989 defaulted (with 18 going into bankruptcy) by
1992.
regulation
Private equity funds are lightly regulated, particularly
in contrast with entities such as mutual funds.
The lightness of touch reflects the nature of participation:
investors in private equity funds are institutional investors
and wealthy families/individuals, rather than 'unsophisticated'
retail investors. It also reflects the shape of investment:
PE funds typically acquire infrastructure or whole enterprise,
which are then run as private companies and thus attract
less scrutiny by corporate regulators, particularly when
investment is made across borders. In 2006 the UK Financial
Services Authority (FSA) released a discussion paper (PDF)
arguing that although the major funds and their lenders
require closer surveillance they do not pose a broad risk
to the overall financial system.
In practice the primary regulation facing private equity
funds concerns -
- competition
policy, eg a particular fund would be unlikely to gain
permission from the Australian Competition & Consumer
Commission to acquire all the nation's airlines or all
the major pathology chains
- terms
on which entities are acquired and subsequently floated,
in particular adequate disclosure during the IPO process
- the
same compliance with taxation regimes facing limited
partnerships or corporations.
Low regulation has reinforced the secrecy with which PE
funds and managers shroud their activity. Arguably it
has encouraged movement by institutional investors to
assign capital
to those funds. Managers appear to justify weak disclosure
to their institutional participants as necessitated by
their operation and consistent with practice across the
industry. Corporate governance is thus a concern and restrictive
covenants (ie contractual requirements binding managers
and investors) are particularly important.
Australia
Private equity funds have been increasingly active in
Australia, with acquisition of landmark enterprises such
as the Myer department store chain, Affinity Healthcare
group, specialist retailers Repco and Just Group, consumer
products group Pacific Brands and half of PBL's media
interests (broadcasting and publishing).
That activity reflects the nation's investment culture
(eg more receptive to PE funds than Germany and "speaking
American"), deregulation, economic and political
stability, perceptions that acquisitions are affordable
and expectations that assets can be unloaded fairly quickly.
Much of the dealmaking has involved overseas entities,
whether directly or through local offshoots. However,
domestic fund managers have emerged in emulation of their
peers and in recognition of the availability of local
capital as a result of changes to the Australian superannuation
(pension) regime. In 2006 the superannuation sector had
assets of over $600 billion, reinvesting some 14% per
year. One industry figure commented that "is a lot
of money to invest ... you can't forever be buying and
selling BHP shares to each other".
Some PE fund managers have accordingly directed their
attention offshore, with an often aggressive drive to
acquire overseas enterprises such as the London Stock
Exchange in addition to facilities such as tollways and
airports in Europe, North America and Asia.
The Australian private equity fund sector - as an importer
and exporter of capital - is discussed in more detail
here.
studies
There is a large technical literature on private equity
fund management and assessment, much of it directed at
practitioners or fund participants. Broader literature
on the shape of the industry, regulatory concerns and
impacts is however disappointingly thin.
Popular writing about particular funds such as KKR and
Carlyle tends to be unduly favourable or critical, with
an emphasis on anecdote and little effort to analyse marketing
statements by some managers.
Pointers to work on particular private equity funds, the
economics and regulation of LBOs, and fund managers as
a target for cultural criticism are provided elsewhere
on this site.
media sector
We have a particular interest in the acquisition, aggregation,
disassembly and sale of media groups
by private equity funds.
Some of those deals - notably KKR's Primedia
- have turned out to be dogs. Others have attracted attention
because of their size or because of competition policy
concerns. They include aggregation of parts of Kluwer
with BertelsmannSpringer
to form a dominant scientific publisher, the spin off
of Warner Music, takeover of MGM, spin off of the Packer
print and broadcast interests, US$13.7bn takeover of Univision
and US$9.7bn takeover of VNU.
Salient media industry deals are highlighted here.
A broader chronology of private equity sales and acquisitions
is provided elsewhere on
this site
Snapshots of major funds such as Apax, Cinven, Candover,
KKR, Texas Pacific, Blackstone and Providence Equity are
here.
next part (public
equity)
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Ketupa