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Looking at Private Equity Through Pink Glasses

Private equity (PE) is a mixed blessing, having the potential to generate wealth at the same time being held as a source of policy concern heavily discussed around legal society. In this article we will try to understand the basics and the positive features of this investment model, while in the second part we will see the other side of the coin.

There are several ways for a company to raise fresh capital for investment. They can be owned by states, by other companies or individuals. They may choose to offer their shares to public through a stock market. Alternatively, they can be backed by PE.

The main idea behind PE is to invest 
in a company and to make it more valuable, over a number of years, before finally selling it to a buyer who appreciates that lasting value has been created. Start-up firms, private middle-market firms, firms in financial distress and public firms seeking buy-out financing seem to be the main beneficiaries of this kind of source of funds. In a typical PE buy-out, instead of a private company going public, a public company goes private.

PE market grew enormously in the period until 2008, to the point where it was said to rival the public markets as a source of financing. For instance, in the first half of 2006 UK-based PE fund managers raised £11.2 billion of capital, compared to just £10.4 billion raised via IPOs on the London Stock Exchange.[1] Although in the aftermath of the financial crisis, and the accompanying credit crunch, PE activity has reduced significantly, a strong recovery is observed in the European buy-out market. According to the Centre for Management Buy-out Research, after falling to just €20.2 billion in 2009, values of buy-outs rose in 2010 by 166 per cent to end the year at €53.8 billion in Europe. Another sign is that the funds raised by UK PE groups in 2013 so far were 50 per cent more than in 2012.[2]

Private equity and value creation

1. Public to private transaction involves tax savings. A private equity-backed company can carry more debt than a public company. Since debt is cheaper than equity because of the tax saving that is made on interest payments, purchasing a public company and leveraging it highly results in saving on behalf of its shareholders.

2. Since listed companies have so many owners, they can’t all be involved in the running of the business. So the task is given to ‘executives’ who wield significant power. This leads to the separation of ownership and control, thus, misalignment of interests. In political science and economics this is called ‘agency problem’.

Due to the alignment of the incentives of the directors and shareholders in private equity-backed companies, a significant value arises. The reduction of agency cost is reached by the share ownership by a small number of professional investors and the purchase of a minority stake (sweet equity) in the company by the management team acting as carrot and stick for them. This can also alleviate the pressure on CEOs to produce profits and give them enough time and flexibility to enact the changes needed to turn around subpar companies.

3.The fact that regulatory burdens are lower for private companies means that also transactions costs for PE funds are smaller and managers can spare time and effort for more productive activities.

[1] FSA, Private Equity: A Discussion of Risk and Regulatory Engagement, Discussion paper 06/6, November 2006, 3.


Image source: Flickr

Cem Veziroğlu

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