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Home / Finance & markets / Private equity / Private Equity: Capitalism’s New Kings or Locusts?

Private Equity: Capitalism’s New Kings or Locusts?

Private Equity: Capitalism’s New Kings[1] or Locusts[2] ?

In the previous paper we saw that private equity (PE) is one of the central players of financial sector, aiming for value generation after acquiring the control of a company. In this paper we will explore the concerns arising from this investment model. So let’s put our pink glasses on the table and see the other side of the coin.

Risks arising from PE

1. Lack of transparency: Does “private means private” to the point of secretiveness?[3] It is argued that the PE industry is complex and opaque due to the fact that there is relatively no regulation as to mandatory disclosures. However, as size of the investment stakes required is very high, only sophisticated investors can invest in them. These are persons or institutions who can protect themselves in terms of acquiring and understanding information and monitoring the fund. Still, retail investors may be indirectly exposed to PE risks by investing their money to pension funds which invest in ‘funds of funds’.

In addition to this, other stakeholders in portfolio companies, such as employees, suppliers and customers still need to be informed about the company’s policies and performance.

2. High Leverage: A typical PE buy-out (LBO) involve higher levels of debt:equity ratio than that of public markets. For instance, ratios of 70:30 (debt:equity) were seen prior to the crisis. The level of leverage may increase the risk of default and insolvency, but this does not seem to cause any externality leading to a systemic risk. This stems from heterogeneity of  PE’s assets, since they invest in diversified sectors. Also neither PE funds nor portfolio companies are cross-collateralised, meaning that their failure should not effect each other’s stability.

Still, it should be born in mind that the debt burden of the acquired company is transferred from the acquirer to the target company, meaning that creditors and employees will carry this pressure and risk.

 3. Market abuse: The significant flow of price sensitive information in relation to private equity transactions creates considerable potential for market abuse. This flow is increasing as the complexity of the transactions grows and more parties become involved. The involvement of participants in both public and private markets and the development of related products traded in different markets, e.g. CDS (Credit Default Swaps) on leveraged loans, increases the potential for abuse.[4]

4. Conflicts of interests: The manager of a fund has responsibilities towards i) the fund, ii) the investors in separate funds it manages and iii) the firms owned by the funds. And mostly these interests are not aligned.

In the next paper we will discuss how the PE industry is regulated.

 

[1] The Economist, 27 November 2004.

[2] Franz Münterfering (a leading German politician) in a speech in November 2004 .

[3] J Payne, “Private Equity and its Regulation in Europe”, 2011 EBOR 559.

[4] FSA, “Private equity: a discussion of risk and regulatory engagement”, November 2006.

Image source: Flickr

Cem Veziroğlu

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