January 10th, 2018
Private Equity in Developed Countries
Effects of Private Equity Firms on Economic Outcomes
Private equity firms comprise investment vehicles that offer opportunities for institutional and high net worth individuals to invest in unlisted securities of public and private entities (Ismail 86; Fenn, Liang and Prowse 2). In the US and Europe, private equity firms have become increasingly common as sources of financing to entities, on one end, and ways to offer investors a higher return than offered by the stock market, on the other. In the UK, for instance, Wright, Renneboog, Simons and Scholes trace the increased activity of the buyout market from its antecedent in the 1980s through five faces (3-4).
In the early1980s, Wright et al. document the antecedent of such buyouts to attempts to restructure to avoid failure and or revive failed corporations during the 1979-82 deep recession (3). Secondly, rise of such buyouts arose from the relaxation of prohibitions for lenders, for instance, allowing them to secure the loans via investing in stocks of the firms to which they advanced the loans (Wright et al. 3). Thirdly, the establishment of the Unlisted Securities Market in 1980, offered opportunities for exiting the investment in the case of small buyouts (Wright et al. 3). At this phase, the buyouts thus appeared positive for the economic outcomes since they were organized to rescue failing entities.
In the subsequent phases, the buyout market started to gain root. The second phase was in the mid-1980s to the early 1990s, mainly fuelled by corporate refocusing strategies (Wright et al. 3). In this time, buyouts mainly included the management of the firms being bought, hence their reference as “management buyouts” (MBOs). It was also during this period that there was a rise in “Management buy-ins” (MBIs), where the private equity firms that invested in the entity brought along their management to refocus the entity’s strategies, to achieve the required return for the investors (Wright et al. 3). Alternatively, a combination of MBO and MBIs arose where the acquirer grafted its team of management into the existing management team (Fraser-Sampson 46). Such a time also marked the establishment of specialist private equity funds and entry of US banks, which led to an impetus in the funding of MBIs and MBOs.
In the third phase, in the early 1990s, the impetus was to restructure the deals made in the 1980s, following a recession that led to the failure of some of the buyout firms (Wright et al. 3-4). Such a period, specifically the failure of entities that had been subject to leveraged buyouts, highlighted that the buyouts may not necessary be helpful to the economy. It was due to such failures, which were usually occasioned by massive asset sales following buyout that resulted into inability to service debts, that perspectives of the negative effect of buyouts arose. From such failures, it became apparent that some buyouts, rather than helping the recovery of the firm, left the firm with a highly-leveraged capital structure from which it would be difficult to recover (Cheffins and Armour 5). Due to the restructuring activities that involved the reduction of employees to enhance the profitability, hence the value to the investors, buyouts via private equity also were thought to exacerbate income inequalities in society, as recounted in a 2007 US House of Representative hearing on how private equity affects workers and firms (cited in Cheffins and Armour 5).
However, various studies (cited in Cummings, Siegel and Wright 4), have suggested that buyouts result into a superior financial performance for the entity, thus beneficial to the economy by preventing failures of such entities. Additionally, a research by Lerner, Sørensen and Strömberg suggests that firms that are acquired via private equity buyouts “pursue more influential innovations, as measured by patent citations, in the years following private equity investments” (4). A limitation of this study was, however, that entities might not reveal most of their inventions, especially those protected as trade secrets, which may influence the quality of use of declared patents as a measure of innovations undertaken. However, the perspective that private equity helps to build firms rather than strip such firms’ assets, has offered further support for a positive effect private equity-funded buyouts (Cheffins and Armour 6).
One review presenting such mixed effects of private equity on economic outcomes is by Tåg that evaluated the real effects of buyouts on the economic outcomes of various countries (3). In this study, private buyouts were associated with a weakly negative effect on employment in the US and the UK, with the a marginal decline in employment in firms during the period of leveraged buyout (9). However, such buyouts were associated with positive wage gains for employees who remained with the firm (9-10). Such an effect, of loss of jobs accompanied by increased wages, could result into a negative aspect of increasing wage inequality as noted in the House of Representatives hearings (as cited in Cheffins and Armour 5). Beyond UK and US, relative little evaluation was available but there was no effect in employment levels found in one study in Sweden, while in France, buyouts were associated with a significant (13%) increase in employment levels (Tåg 10). With respect to productivity, the review indicated that buyouts led to enhanced productivity especially where reorganizations involve closing of unproductive operations and opening of more productive operations (Tåg 10). With respect to the effect on long-run investments, the review found mixed evidence, where studies based on firms expenditures on research and development highlighted both negative and positive effects, while studies on patenting activity, e.g. the study by Lerner, Sørensen and Strömberg, indicate a largely positive effect of buyouts (12). Finally, evaluating whether buyouts enhance susceptibility of firms to bankruptcy due to a high leverage, the reviewed literature did not demonstrate any correlation between private equity-funding and susceptibility of an entity to bankruptcy (Tåg 13).
The fourth phase of Buyouts in the UK occurred in 1994 after the end of the recession. These were characterised by high-value deals, peaking in 2000, but collapsing thereafter with the burst of the dot.com bubble (Wright et al. 4). However, in 2004, a resurgent private-equity market, characterised by multiple high-value buyouts, emerged. By 2005, as much as 50 per cent of the acquisitions by value, in the UK were private-equity funded compared to less than 20 per cent in the mid-1980s (Wright et al. 2). Such activity has also been noted in other European countries, especially in France, the Netherlands, Spain and Italy (Wright et al. 2). In the US, similar phases of developments were evident as documented by Fenn, Liang and Prowse (9-15). Currently, Metrick and Yasuda note that about $1 trillion of capital worldwide is under the management of private equity funds (2303). This indicates the magnitude of the role that private equity funds play in financing entities, hence the subsequent evaluation of the business models.
Private equity business models typically constitute three layers of stakeholders: (a) the investors (limited partners) who provide capital for, (b) the private equity firms (general partners), who identify (c) the potential targets (entrepreneurs) in which to inject their funds (Ismail 86; Kaplan and Strömberg 4-5; Metric and Yasuda 2304). Typically, a private equity firm is a limited-partnership arrangement whose structure has been documented in various literature (e.g. Ismail 86; Fenn, Liang and Prowse 29-41; Metrick and Yasuda 2304-2305; Fraser-Sampson 11-16; Kaplan and Strömberg 4-12).
The limited partners mainly constitute institutional investors and high net worth individuals. Institutional investors constitute entities such as corporate pension funds, public pension funds, endowments and foundations, bank holding companies, insurance companies and investment banks. The private equity firms are usually established and managed by investment professionals (e.g. individuals with investment-banking backgrounds), who serve the purpose of identifying, buying and managing the turn-around or value addition activities of the investee firms. Typically, the LPs will not be involved in making such decisions, but in case of LPs such as public pension funds, who are subject to public scrutiny, nominated individuals sit on the private equity board to ensure that their interests are served by the investments that GPs engage in. The activities of private equity firms are broadly organized into four stages – fund initiation and setup, investing, portfolio management and Exit. These stages and their determinants are reviewed briefly subsequently.
Fund initiation and setup. The fund initiation and setup stage can be viewed to constitute two aspects – the setting of the structure of the fund and the raising of the capital from LPs (Ismail 88). The setting up of a fund follows identification of a specific investment opportunity by the private equity firms, that facilitates the establishment of the fund strategy (Kaplan and Strömberg 4; Ismail 86). The fund strategy involves aspects such as consideration of the barriers to entry in the identified opportunity so as to devise ways through which the entity can convince LPs that it will overcome such barriers, thus enhance their subscription to the set fund, during the fundraising step (Fraser-Sampson 61-64). The funds created are typically “closed-end” investment vehicles, where the LPs will commit to provide a specified sum of money that will be used for investments identified by the GPs and cover the management fees attributable to such GPs (Kaplan and Strömberg 4). Such GPs will also, customarily, provide a certain proportion of the total capital, typically 1 per cent (Kaplan and Strömberg 4). Usually funds are set for a fixed life, mainly ten years with a possibility of a three-year extension. Where the investment life is 10 years, the GPs will usually have five years to commit the capital invested in identified investees, and the subsequent five years to return the capital provided to the “original” owners – LPs (Kaplan and Strömberg 5).
Although the LPs only have limited control of the investments to which their capital is committed, various provisions could provide them with a way to safeguard their investment. For instance, agreements between the LPs and GPs could include provisions for the limit for investing in a single entity (ensure diversification of risk), types of securities into which the provided funds can be put, and the level of debt at a specific fund level (Kaplan and Strömberg 5). Additionally, for institutional investors such as public pension funds, elected members may serve as members to the equity fund’s trustee boards and investment committees to guard against imprudent investments that subject them to public backlash (Fenn, Liang and Prowse 47). When successful, the private equity firms will usually create a new fund every three to five years, the subscription to which will be determined by the interpretation of the previous successes by the LPs (Metrick and Yasuda 2304). Where such success is interpreted as skill rather than luck, the LPs will be attracted to the newly created fund, shifting the demand curve for the established fund outwards (Metrick and Yasuda 2304; Kaplan and Schoar 22). At equilibrium, such a shift will need the GPs to be paid before LPs receive their cost-of-capital, which in turn will incentivise the GPs to change the terms to increase their rate of earning management fees, increase the size of the next fund or do both, the effects of which is an increase in their earnings (Metrick and Yasuda 2304).
Although trends in fundraising for equity funds indicate an increasing preference for larger but fewer funds in countries such as the UK (Wright et al. 4), the effectiveness of fundraising is contingent to the investment approach of the LPs. For instance in a study by de Zwart, Frieser and van Dijk, the willingness of the institutional investors to make new commitments to funds is shown to be influenced by aspects of existing private equity portfolio such as uncalled capital from existing commitments, received distributions and current allocation to private equity compared to levels deemed optimal (89-95). Following such considerations, Wright et al. note of intentions by UK institutional investors to reduce their investment in private equity in future, but note that the institutional investors in continental Europe intend to increase such investments (4). Apart from such institutional considerations, commitment to funds are significantly influenced by previous performance (Kaplan and Schoar 22), a factor that could serve as an incentive for fund managers to enhance their management of existing funds.
Investing. Following the setup stage, the next stage involves establishing an investment strategy, conducting due diligence on identified investment targets and structuring the investment transaction (Ismail 88). The investment strategy could for instance focus on specific types of firms such as technological firms that attract venture capitalist. Since the probability of failure, i.e. inability to return invested capital, for venture capitalist is 0.5 (Fraser-Sampson 153), most venture capitalist will seek to invest most of their capital in a small proportion of firms, whose chances of success are high, such that success in such entities will offset losses incurred in failures, and present substantial return to the investors. On their part, buyout deals will seek to achieve success in most of the investments in the portfolio, since every investee constitutes a significant amount of the invested capital. Such buyouts will thus involve evaluation of aspects such as the investee earnings compared to comparable firms in the industry or stock exchange, earnings growth potential and timing of investment return, i.e. short-term or long-term (Fraser-Sampson 68-75).
A study by Ljungvist and Richardson exemplifies determinants of investing decision under a competitive market. One of such determinants was noted to be supply of investment capital from the LPs. Using statistics from an institutional investor who participates in various private equity funds, the authors noted that the average fund took “11.7 quarters to invest 80% or more of its commitments” (11). The determinants of such investment rate were noted to be influenced by the availability of opportunities for investment and the competition among private equity funds for such opportunities. For instance, the authors demonstrated that more rapid investment occurred during periods of technological and other shocks, since such periods presented varying opportunities for investment (12). Similarly, where funds faced minimal competition for deal flows, their rate of investment increased (12). Subsequently, the study demonstrated a sequence of events that determine investment decision; increase in investment opportunities and subsequent increased demand for capital results in increased supply due to calls made by fund managers seeking to realize such investment. Increased supply of capital resulted into increased competition for deal flow thus resulting into fund managers cutting their investment spending.
Portfolio management. Following investment in identified investment, the next process is portfolio management, which involves implementing the strategy to enhance value for the entity and the governance and monitoring processes (Ismail 88). In this respect, funds engage in strategy that for instance involves divestment from unproductive operations and investment in more promising operations (Tåg 10). Aspects such as the period within which the investment is required to provide the required returns and existing market conditions determine such divestment and investment activities. For instance, for short-term targeted investments, engaging in investment plans would be rare since such investment could take long periods to offer the required return (Fraser-Sampson 68-75). On the other hand, for long-term targeted investments, and where market conditions prevent realization of profitable exit, investments to build the value of investee for future exit is usually pursued (Fraser-Sampson 68-75). The type of transaction conducted determines the monitoring and governance of such investments. For instance, in Buyouts, the introduction of external management with the buyout transaction (MBIs) would ensure the pursuit of the strategies envisaged by the fund (Wright et al. 3). In other setups, monitoring and governance would be ensured by the private fund assuming a lead role in the selection of members to sit on the boards of directors of the investee firm
Exit. Exit from the investment made could take place via three main channels; trade sale to a strategic buyer, secondary leveraged buyout and listing on the public markets through an IPO. Kaplan and Strömberg note that the most common of exit strategies is to a strategic buyer, followed by the secondary leveraged buyout and then by the IPO (11). The choice of exit strategies could be influenced by aspects such as lock-up provisions against complete disposal of securities in the stock market by existing stock holders in the firm (Fraser-Sampson 139), and country regulations that may exclude sale to some of the potential buyers (Fraser-Sampson 75). The next section evaluates the private equity markets in emerging economies and differences that could exist with developed economies.
Go to part four here.