27th May, 2018

Private equity’s little secrets are not always that dirty

Private equity is a curious corner of the business world. Is it an industry, a trade or a profession? It is almost unknown, except by those who work within it and the advisers who service it. It has been an economically influential activity for only about 25 years, whereas the stock market has been around for more than 200 years. The entire sector is run by a few thousand people, many of whom have become very wealthy. Yet what is it that they do, exactly? And are they fundamentally a force for good?

The private equity sector deliberately encourages a conflation with venture capital, as that is much easier to defend against critics. The initials of the trade body for both, the BVCA, stand for British Venture Capital Association. In truth, venture capital is perhaps 5% of the whole; the overwhelming proportion of all the capital is deployed by private equity. Venture capital is much more difficult, less lucrative and shows worse financial results.

The trade association asserts that only 3,000 companies in Britain are backed by private equity, with about 385,000 employees. But this is a dramatic underestimate. For a start, it excludes businesses owned by overseas private equity houses, directly or indirectly. I would guess the numbers are at least 50% higher than the published figures, possibly more. In America, the industry owns roughly a third of all companies with revenues between $100m and $500m, and that is growing.

In many auctions of companies, private equity firms comprise the substantial majority of bidders. The industry keeps on growing. More capital flows to it from many sources — high-net-worth individuals and family offices, pension funds, insurance companies, endowments and sovereign wealth funds. Institutions keep increasing allocations to the asset class because they believe it outperforms other categories, such as public markets.

Private equity funds have kept almost too much powder dry and are desperate to do deals. Total funds available globally now exceed $1.8 trillion [£1.35 trillion], with $750bn raised in 2017 alone. Global assets under management — including committed capital, dry powder and asset appreciation — exceed $5 trillion.

But the returns private equity delivers are not as stellar as that. After fees, funds overall produce returns of perhaps 1.7 times the invested capital after an average seven-year hold. Moreover, I look at lots of private equity portfolios and see zombie investments that will surely be a write-off for investors.

The industry argues it delivers returns by innovation and investment. This is debatable. A good proportion of capital gains have almost certainly derived from leverage and financial engineering. It is no coincidence private equity focuses on earnings before interest, taxes, depreciation and amortisation (ebitda) as a profit measure — they exclude depreciation from their calculations because they often minimise capital expenditure to boost shorter-term cash flow. However, long-term companies must invest to remain competitive.

Private equity partnerships excel at buying and selling companies because that is what they do all the time. They are also adept at borrowing. Whether they can add value and grow companies organically is more questionable. I have met lots of private equity executives who claim a measure of expertise in an industry because they invested in a company in that sector for a few years. But the combination of arrogance and ignorance common among such Masters of the Universe means they frequently don’t really understand the technical, market, financial and personnel aspects of the industry. Yet they are ultimately in charge in the boardrooms of the companies they own.

On balance, there is a case to be made that private equity is the least bad sort of ownership. It is medium-term custodian, holding assets for up to 10 years — a stark contrast to most investors in public companies. It is much less prone to the nepotism, generational problems and emotional conflicts that can plague family firms. And management incentives in private equity are much more aligned with the shareholders than in the quoted arena.

Moreover, the partnership structure and reward systems in private equity generally provide stable leadership, which helps produce results over the long term. Given how many companies private equity owns, the industry must do more to explain how and why it works: society deserves to understand better the model’s merits and defects.