Private equity is a broad term denoting any investment in assets or companies that are not listed on public stock exchanges. Private equity funds are pools of capital managed and invested by private equity firms.
In the last two decades, private equity has become an important component of global finance capital, developing its own distinct characteristics and practices. Until the onset of financial crisis, newspapers and TV news channels were full of stories about multi-billion private equity buyout deals. Supporters crowned private equity funds the “new kings of capitalism,”1 while critics labeled them “locusts.”2
Private equity has a significant and distinctive influence on taxation policy, corporate governance, labor rights and public services, deeply affecting society, human rights and environment alike. Were they to be assessed in terms of annual revenues, several private equity firms would rank among the world’s top 25 corporations. The biggest five private equity deals have involved more money than the annual public budgets of Russia and India.3 Some executives of private equity firms earn billions of dollars in fees and profits, often at the expense of the companies they buy and sell.
Private equity firms do not take long-term stakes in the companies in which they invest and show little interest in improving the productive capacity of companies or in launching new products and services. For private equity firms, every investment is simply one element in a portfolio of financial assets that move in and out of companies as the market demands (rather than as the long-term health of the companies requires).
Private equity firms tend to buy companies not to own and run them with a long-term perspective (as foreign direct investors such as Siemens or Vodafone might do by investing in a manufacturing plant or telecommunications network), but in order to sell them on at a profit as soon as they can.
The involvement of pension funds, university endowments and sovereign wealth funds in private equity businesses means that in fact a significant amount of money flowing into private equity funds globally is “public” in nature, not private. Some development finance institutions such as the World Bank’s International Finance Corporation (IFC), the Asian Development Bank and Germany’s Investment and Development Company have also invested in private equity funds. Yet these outside investors do not participate in the funds’ investment decisions.
The five largest private equity firms are The Blackstone Group, The Carlyle Group, Bain Capital, TPG Capital (formerly Texas Pacific Group) and Kohlberg Kravis Roberts & Co. (KKR). Together, these companies manage assets worth hundreds of billions of dollars. Their influence over the “real economy” can be gauged from the fact that these five firms alone control companies that employ more than two million workers.
In 2006, their most recent peak year, PE firms carried out more than $664 billion worth of buyouts, according to data firm Thomson Financial.
The Buyout Business
Once private equity firms buy out companies, they invariably downsize the workforce, slash workers’ benefits and abrogate collective agreements between workers and management. Even the proponents of private equity admit that buyout deals lead to significant job losses, particularly in the initial years. Unlike publicly listed companies, private equity firms are not legally bound to disclose information about their operations or those of the companies in which they invest or buy. As a result, they (and the companies they own) are shielded from the glare of public attention and from public accountability.
Private equity firms have made extensive use of “leveraged” or borrowed finance to buy out companies – they borrow money to acquire a company’s shares in hopes that the interest they will pay on the resulting debt will be lower than the returns they will make from their investment. In many cases, the levels of borrowing are unsustainable.
Private equity investments can also threaten hospitals, water supplies and other public services when they buy firms involved in these services because they place short-term financial objectives over the public interest. The way that the private equity business model exploits regulatory loopholes, tax arbitrage and offshore entities and transactions can further endanger the public good. Furthermore, when several big private equity firms join hands to buy a target company, the significant flow of price sensitive information creates considerable potential for market abuse.
The Boom and Bust Cycle
Pre-crisis, the period from 2000 to mid-2007 witnessed low interest rates, a worldwide glut of capital, buoyant credit markets, rising corporate profits and a massive growth in structured credit products such as collateralized debt obligations. The resulting easy liquidity in the global financial markets nourished a boom in the private equity business. Wealthy investors were encouraged by low interest rates to look for more remunerative investment options. Big institutional investors, such as pension funds, found it preferable to invest in a big private equity fund rather than holding direct stakes in several companies. Big investment banks, too, entered the private equity business to serve their own commercial interests. Attracted by the advisory fees they would get for arranging deals, particularly leveraged buyouts, they eagerly lent money to private equity funds.
In 2006, global investment banks such as Goldman Sachs and JP Morgan Chase picked up $12.8 billion in fees from private equity firms, and in the first half of 2007 alone, another $8.4 billion. Some investment banks (such as Goldman Sachs) launched new private equity funds to benefit from the boom, while others (such as Citigroup) simply continued to use their own capital to underwrite buyout deals.
Post-crisis, the turbulence in the credit markets and the resultant credit squeeze has negatively affected the global private equity industry, which has largely relied on leveraged finance to acquire companies. The lifeblood of private equity – cheap debt – quickly vanished. The crisis has made it more difficult and more expensive for private equity firms to borrow money for their buyouts. Besides, it has also negatively affected the portfolio companies of private equity firms.
In many ways, the financial crisis crunch has broken the popular myth that the boom in private equity is the result of an efficient business model based on superior management skills and “patient capital” that does not expect immediate returns. A report by UK-based Centre for the Study of Financial Innovation noted that buyout firms do not always run companies better and called for greater transparency around private equity performance.4
To a large extent, the private equity business was all about debt assembled in a DIY (Do-It-Yourself) fashion by financiers. Governments, central banks and public monetary authorities chipped in with a supply of easy money, lax credit controls and tax concessions.
But the eruption of global crisis does not necessarily imply the end of the private equity business. It could well bounce back from the slump just as it did previously in the late 1980s and early 1990s. The fact that private equity firms have more financial muscle than they used to, and closer linkages with other global financial actors, such as hedge funds, sovereign wealth funds and banks, increases the chances of a comeback.
1 (2004) “The New Kings of Capitalism,” The Economist, 25 November
2 In April 2005, during the national election campaign in Germany, Franz Muntefering, then Chair of the Social Democratic Party (SPD), described private equity firms as “locusts.” He subsequently published a “locust list” of companies that he circulated within the SPD.
3 Service Employees International Union (2007) Behind the Buyouts: Inside the World of Private Equity, April, p. 10, http://www.behindthebuyouts.org/buyout- industry
4 Morris, P. (2010), Private Equity, Public Loss?, Center for the Study of Financial Innovation, 2010
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