[T]he problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them.
--Joseph Schumpeter, Capitalism, Socialism, and Democracy
Private-equity partnerships, especially in the form of leveraged buyouts (LBOs), have grown in size and number at an unprecedented rate during the past few years. In 1990, the business attracted less than $10 billion from investors. In 2006, however, more than 680 private-equity funds raised $432 billion, and the value of deals reached more than $700 billion (see figure 1). (1) Driving this growth has been the impressive record of a number of large buyout groups in consistently generating superior returns for investors by overhauling the ownership structures of private and public companies. According to Thomson Financial, over the past three years, the S&P 500 averaged 9.9 percent returns, whereas buyout firms averaged 15.6 percent returns (McCafferty 2007). Higher expected returns and greater diversification are enticing institutional investors such as pension funds and endowments to allocate increasing amounts of capital to this alternative class of investments and away from public equities.
[FIGURE 1 OMITTED]
Yet, according to the views expressed in the financial press, by politicians, and even by a few financially astute investors, private equity provides little if any net value to the economy. Indeed, in liberal pundit Michael Kinsley's opinion, it is "a capitalist swindle" (2006)--a few are getting rich at the expense of the many. (2) This complaint is familiar; it is, indeed, what many regard as the problem with capitalism, the economic system that relies on private property and markets to allocate resources (Muller 2002). (3) Private equity is a vital element of the capitalist system. The private-equity revolution of recent years represents an evolutionary change in capitalism that works by aligning the interests of two sets of critical parties: corporate managers and investors, and investment managers and investors. This feat of organizational innovation helps to check the resource waste and corporate malfeasance that often hold back, if not sink, public companies.
That many people are skeptical of capitalism or even completely against it goes a long way toward explaining the bias against private equity. Behind both views is a familiar mix of ignorance, populist resentment, and self-interest, which creates fertile ground for government intervention. In this article, I seek to provide a better understanding of what private-equity firms do and to correct popular misunderstandings about them.
What Private-Equity Firms Do
As an extension of capitalism, private equity works to create value by moving capital, labor, and technology to more valued uses--in particular, from organizations with weak ownership incentives to ones with strong incentives. It does so by transforming the ownership and organizational structure of public and private companies. LBOs swap equity for debt, concentrating ownership in fewer hands, which results in much stronger incentives to manage a firm's resources productively. Unlike shareholders in a public company, the key owners in an LBO--a private-equity group and the managers--bear fully the consequences of their decisions. With concentrated ownership comes much greater accountability, better stewardship of a company's resources, and sharper incentives to create value. (4) Buyout partners are today's financial and operational entrepreneurs as they put their own capital at risk and drive an innovative organizational process that creates tremendous value.
This ownership-centered model is the hallmark of active investors because it involves taking significant stakes in public companies to monitor management and often to influence corporate strategy. Active investing dates back to the turn of the twentieth century, when J. P. Morgan's "men" sat on the boards of the companies in which Morgan's bank invested. Today, active investors include hedge-fund activists, such as JANA Partners, ESL Investment, Carl Icahn, and Atticus Capital; lower-profile financial investors, such as Warren Buffett and Wilbur Ross; and LBO partnerships. The investment strategy of Buffett's Berkshire Hathaway is often to acquire a significant stake and a board seat in a company. According to Berkshire's Owner's Manual, "most of our directors have a major portion of their net worth invested in the company" (1999, 1). (5) Eating their own cooking makes private-equity and other active serial investors highly motivated to create value while maintaining the integrity of the investment process.
One of the significant benefits of the public-company structure is that it offers an ownership base of well-diversified public stockholders, which tends to provide low-cost equity capital and a capacity to bear the risks of a cyclical economy. A highly diversified shareholder base implies, however, that few if any of these owners will have information on a company's prospects, such as that gained from sitting on a company's board, that is as good as the information that management has, nor will they have much incentive to gain this information or to monitor the management because their stake is so small. With private equity, in contrast, the informational asymmetry between investors and management disappears. (6) Alignment of interests fosters stronger incentives to perform and removes a big source of corporate governance problems.
Private-equity limited partnerships (LPs), which raise funds and make investments on behalf of limited partners, take various forms, including buyouts, venture capital, mezzanine capital, and distressed capital. Buyout funds, which focus on taking public companies private, and venture capital, which provides entrepreneurs with startup capital, are the two largest and best-known forms. In general, all of these forms of equity capital tend to have common attributes, including:
* Investors: Wealthy individuals, endowments, public and private pension funds, and insurance companies are the primary investors, or limited partners, in private-equity funds. These sophisticated investors have the wherewithal to meet the high minimum commitments that private-equity funds require.
* Fund life: A finite, contractually fixed life of five to ten years is set up, after which investors expect to recover their capital plus a substantial return. Each partnership fund is legally separate and managed independently of a private-equity group's other funds.
* Management fees: Private-equity general partners, who make, monitor, and actively manage their investments, generally charge an annual management fee of 1.5 to 2.5 percent of committed capital to cover operating expenses.
* Profit sharing: General partners' key incentive for creating value is a 20 percent carried interest, or profit, taken generally after the limited partners' capital has been returned. (7)
* Capital at risk: General partners usually invest a significant portion of their net worth along with the limited partners' money. These sums tend to reach 1 to 2 percent of a fund's total capital. Limited partners look for this coinvestment as a sign of a private-equity firm's commitment.
* Light regulation: A greatly underappreciated factor in private equity's success is
that it has taken root in large part because government interference is minimal relative to the regulation of investment in public companies. For example, in the United States, private-equity ownership is exempt from registration with the Securities and Exchange Commission (SEC) because going-private transactions do not involve a public offering. (8) Creating a much more levered capital structure is a critical part of what drives the organizational transformation of LBOs and explains their growth across the economy and increasingly throughout the world. A buyout group, generally with a public company's management group, will take a company private by replacing ("buying out") public equity with debt and concentrating equity in the hands of the buyout group and the firm's management. Where before the buyout a public company may have had a capital structure of 60 percent equity and 40 percent debt, after the buyout debt is pushed up to about 70 percent and equity down to 30 percent, with the management owning perhaps 10 percent of the equity and the buyout group holding the rest. The change in the capital and ownership structure has fundamental implications for the organization's governance and performance.
Powerful incentives to make value-enhancing changes over a five- to ten-year period are created when owners and managers have their own capital at risk, must return capital to limited partners, and are legally obligated to pay off debt. Unlike a public company, a private equity group will have multiple levers to create and harvest value, such as initial public offerings (IPOs), mergers, recapitalizations, distributions, and roll-ups. Moreover, through their normal operations of structuring and overseeing their portfolio companies, private-equity groups guard against a number of potential corporate governance problems. (9) Concentrating ownership mitigates the biggest source of governance problems that occur when managements' interests are not aligned with shareholders'.
Private equity's flexible ownership model has proved widely applicable in nearly every industry and in a growing number of countries. More than one in five mergers worldwide is a private-equity transaction, and the number rises to more than one in four in the United States and the United Kingdom (see figure 2). (10) With their own capital at risk and a need to return funds to limited partners, private-equity partners are smart buyers--they tend not to overpay. Acquisition bids from privately held companies tend to push prices up 22 percent, whereas public-company bids drive up the price of a target...