It is disturbing to hear the current rhetoric around private equity. References to “vulture capital” and “destroyers of jobs” are clearly political and completely unfair. While some private equity or PE firms may have made questionable calls or taken unpleasant actions in past dealings, for the most part they play an important, constructive role in our economy. We need voices to emerge in support of private equity.
Most Americans are unaware of what PE firms do. They are overly impacted by dramatic accounts in films like “Barbarians at the Gate” that demonize the work of these firms and distort their actions. For many, Hollywood’s depiction of PE is the primary source of information about the industry and so it’s no wonder there is fear and criticism of the role these firms play. But most of the work these companies do bears little resemblance to their depictions in the movies or even their descriptions in the press.
PE firms are partnerships, LLCs, or corporations that pool private investment from individuals, pension funds, endowments, etc., and then use that cash to invest in or wholly buy companies. This practice is widespread in and outside the U.S. Investors in these companies are sophisticated and are willing to take higher risk to seek a return in excess of typical market returns. Therefore the strategies employed by PE firms are bolder, riskier, and more creative than average.
Investments by PE firms take many forms. Some examples are: purchase of public companies; purchase of pieces or divisions of companies that no longer fit their strategy; purchase of distressed businesses; purchase of a variety of related businesses that are merged into a stronger, more cohesive entity; private investment in a public entity (PIPE), etc. Sometimes PE firms make hostile advances on companies but usually their actions are friendly and welcomed by boards, management, and shareholders. In each case the PE firm is taking an unwanted or unloved company or piece of business, paying a premium (usually) to shareholders, and then working over the next three to five years to improve the business. If the business had been well performing under its previous ownership it likely would not have been sold. So in each case the PE firm is taking a risk on an underperforming asset with the intent to improve the business.
Sometimes to improve the business, or take multiple steps forward, the PE firms need to take a step back. Sometimes this means that in order to save the business some parts need to be rationalized or shut down, and sometimes jobs need to be eliminated to improve cash flow so the business can once again invest and grow. In these cases, without the actions taken by the PE firm, the company would likely go bankrupt or dissolve thereby causing an even greater number of lost jobs than those lost in the turnaround steps taken to save the company. These actions to save a company are the ones most misunderstood. In some people’s minds any lost jobs are bad. But sometimes the company made bad decisions and hired too many people for the firm to run profitably and these poor decisions must be undone. And sometimes the business models have not been modified to keep up with competition and so their costs are too high to be successful. Whatever the case, cut backs and restructuring are healthy tactics to return firms to profitability and growth. And after all, the objective of business is to make money. Customers demand to pay the lowest cost possible for goods and services. Therefore companies need to be as efficient and lean as possible to compete effectively and accomplish this.
Yes, PE firms can make a lot of money. Their traditional model of two percent annual fees on the total fund and retention of twenty percent of the profits can net a lot of gain for the successful firm and their members. But usually the two percent goes to cover the cost of operating the firm, and the twenty percent is great when an investment makes money but twenty percent of zero is zero. Also it takes many years for a successful investment to payout as profit is only realized when the company is sold. If a company is not improved and cannot be sold for more money than the purchase price, there may be no profit. The PE firm easily can lose money on a deal and be forced to absorb a huge loss for their effort. Profit or loss is exaggerated through the use of leverage. These investments are high risk, high return propositions and PE firms need to be rewarded for the level of risk they take on. Only smart, successful PE firms make money and survive themselves. Those that are unsuccessful go away and little is heard about them.
Critics of PE firms need to consider what would happen without their work. How many companies or businesses would go bankrupt without PE intervention? How many jobs would be lost? How many industries would become uncompetitive? How would American industry fare in a global competitive environment without their actions? PE firms perform a critical role in a free market economy. Yes, their managers and investors are well compensated when successful but they make nothing when they aren’t. Isn’t this precisely the pay-for-performance model advocated by governance critics today?
So let’s understand the economic role PE firms play. Let’s stop the criticism and rally in support. Let’s hope for success of these firms so that their pension and endowment fund investors achieve a return that supports their members’ work