August 02, 2007

Private Equity = Public Gain

Controversies over the rising power of private equity firms continue to rage.

Time Magazine labels their leaders, “Private-Equity Pigs.” To hear critics describe private equity, they are the new robber barons, ready to plunder our great corporations and leave them in a shambles.

Nothing could be further from the truth. The dynamic leadership of private equity firms and the executives they hire to run client firms is providing great benefits to the corporate world, the American economy, and society as a whole.

Five years ago private equity firms had trouble coming up with more than $1 billion for a single deal. Today, they can top $50 billion, and there seems to be no limit to the size of deals that can be put together. Why? It´s simple: investors are attracted by the returns of these deals and willing to tie up their money for three to five years.

Let´s take a closer look at the myths about private equity:

Myth #1: The growing power of private equity firms is a threat to public corporations.

Unlike the raiders of the 1980s – remember Mike Milken, Irwin Jacobs, and Carl Icahn? – private equity is doing its deals on a friendly basis. They show up when no public buyers are interested. That´s what happened when Daimler put up Chrysler for sale, no automobile companies showed up, so PE leader Cerberus stepped up to Chrysler´s challenges.

Myth #2: Under private-equity, acquired firms get torn apart and value destroyed.

PE does the vitally needed restructuring that the previous public owners did not have the will or ability to undertake. Ten years of changes are compressed into three years or less. PE firms can achieve those high returns by creating value that public managers apparently did not see, and monetizing their gains in the public market.

That´s what happened in 2001when Blum Capital Partners purchased by CB Richard Ellis, the nation´s leading commercial real estate firm. The firm was drastically restructured, and brought public three years later. In three years its market capitalization grew from $1.3 billion to $9.1 billion, a 600% increase.

Myth #3: CEOs flee public companies to avoid scrutiny from demanding investors.

Wrong! Private equity investors are far more demanding than public investors and much more engaged in the business. Leading PE firms generate returns that far exceed the public market.

Just look at what Eddie Lampert has done with the venerable Sears Roebuck, whose public market valuation declined steadily for thirty years as its retail sales slumped. Lampert consolidated Sears into his bankrupt Kmart operation, monetized the value of its real estate portfolio, and brought it back to the public market. Just four years later, its stock has risen ten times.

Myth #4: The greed of private equity owners is harming the economy.

Like any capitalist who starts his own business, private equity firms invest their own money, putting it all at risk. When they gain, they deserve every penny. That´s the essence of capitalism. If their wealth makes us angry, then we should take it out on poor old Warren Buffett, the greatest capitalist of all, who made $40 billion through his investments in select companies and is giving it all away to philanthropy, to be managed by the Gates Foundation.

Rather than harming the economy, PE firms are giving it new vitality by taking moribund corporations – or pieces of them – restructuring them to uncover real value, and making them healthy, competitive, and viable once again. This benefits the entire economy by reducing the “drag” from poorly managed firms and replacing them with revitalized competitors.

This sounds so easy. Why don´t publicly held companies do the same thing? Is Wall Street restraining them from facing problems? Not exactly. Wall Street generally cheers when public firms face the music and restructure, as the stock tends to go up. The answers lie deeper. Here are the reasons why firms under the PE model are doing so well:

  1. Take on high leverage and spread the risk. PE firms take on much greater amount of debt. In recent years the low cost of debt and high liquidity have made this model very attractive. Why don´t publicly held companies do the same? No doubt they could handle more debt, but the PE firms can spread their debt across many companies, thereby mitigating the risk. If a public company cannot meet its debt obligations, it is bankrupt, a la Delphi or Delta Airlines. If a PE-held company goes down, the PE holder can cover its losses from its broadly-based balance sheet of multiple holdings.
  2. Compress the time frame of making changes. PE firms don´t waste any time making changes. They aren´t concerned with internal objections, reluctant boards, and unfavorable publicity. They determine what needs to be done, and move swiftly with surgical precision to implement changes. Can´t public companies do the same? Of course they can, but often they fall into the trap of worrying about quarterly earnings, internal morale, power struggles on their boards, and external criticism, and vital time is lost. Worse yet, they rationalize the real problems and make “quick fixes” but never get the business healthy.
  3. Leadership. Aren´t private equity managers just a bunch of financial manipulators, not leaders?

Au contraire. Private equity has attracted some of the most talented leaders in business, both to run the PE firms themselves and to run the companies they acquire. Their leadership is characterized by extreme intensity and clear focus on the business and its results. PE leaders have the courage to make the changes immediately, and restore the business to on-going health. They are clear in their purpose and decisive in their actions. Sounds like leadership to me. . .

So what´s the risk with private equity? First, if short-term interest rates rise sharply, the high levels of leverage could become infeasible. Second, with more PE money chasing fewer deals, there is always the risk of overpaying for a major deal. Or not having access to the public market to monetize their gains. This is a real risk in the case of Cerberus´ acquisition of Chrysler.

Finally, private equity has had the benefit of paying capital gains taxes on profits rather than ordinary income tax, as publicly held corporations do. These loopholes in our tax system accruing to the benefit of private equity owners are simply wrong: all firms, public and private alike, ought to play by the same tax rules. Congress is right in attempting to correct this inequity.

There are reasonable questions about whether the private equity model works for well-run, long payout businesses like high tech, biotech and pharmaceuticals, and aerospace. Personally, I am very skeptical. Thus far, the PE firms have steered clear of these industries. We´ll see where they go in the future.

What does all this mean for publicly held companies and their boards? There is a great deal they can learn from private equity if they don´t buy into the myths or bury their heads in the sand. First of all, they should take an objective look at their business as if it had just been acquired by PE. What would a PE firm do differently? Where would they find value? What would they jettison? If they can make these changes without damaging the long-term value of their company, then they should act immediately.

In the regard, private equity is serving as a positive impetus to publicly-held companies to get their act together.

Bill´s bottom line: The private-equity movement is good for the U.S. economy and good for business. It will be around for a long time.