How to Think about Private Equity
Wednesday, January 18, 2012
Interest in the private equity business has exploded with the intense scrutiny of Mitt Romney’s experience as a private equity investor. Some of the discussion has been confused and confusing. In what follows, I briefly describe how private equity works and what the results have been. When all is said and done, the evidence from empirical research is that private equity funds have delivered strong returns to their investors, improved the operating performance of their companies, and had surprisingly small net effects on employment.
Where does the money come from? Private equity firms like Bain Capital start off by raising capital commitments. The capital comes primarily from large institutional investors like pension funds, foundations, and endowments. Large investors in private equity include Calpers (the California Public Employees Retirement System), New York State Teachers' Retirement System, and even the National Public Radio (NPR) Foundation. When private equity fund returns are strong, a lot of workers, teachers, and pensioners benefit.
Where does the money go? Private equity funds take this capital and use it to buy companies. When doing so, they often use debt financing, hence the common name of leveraged buyouts. This is particularly true in the case of more mature companies. These days, the leverage is usually on the order of 60 or 70 percent of the purchase price—less than the leverage in most home purchases. Some private equity firms specialize in growth equity, where they use appreciably less leverage and invest in growing companies that are less mature. The vast majority of private equity fund investments—both leveraged buyouts and growth equity—are privately owned companies that are not publicly traded.
There is no evidence that the average company is gutted or declines precipitously.
What do the private equity firms do? The private equity funds and their managers then work hard to increase the value of their companies and investments. Usually, this involves looking for ways to increase the growth of the business as well as ways to cut costs. If the companies increase in value, the private equity fund and its investors will make money (when the companies are sold). If the values decrease, the private equity fund and its investors lose money.
Private equity firms typically apply three types of engineering to help increase the value of their investments—financial, governance, and operational engineering. Financial engineering involves providing very strong incentives to the CEO and top executives of the company. The private equity firms also typically require the CEO and executives to invest their own money in the company. With equity and options, the executives usually own 10 percent to 20 percent of the company. This means that if the company does well and the investment makes money, the executives do very well. One the other hand, if the investment fails, the executives suffers real losses. The upsides and the downsides tend to be greater than for executives at comparable public companies.
Governance engineering involves playing a strong role in corporate governance. Private equity investors control the boards of their portfolio companies. As they do so, they closely monitor and regularly advise the company and its executives.
More recently, most top private equity firms have added operational engineering. Operational engineering means bringing consulting and executive resources systematically and consistently to portfolio companies. These resources might include advice on and help with pricing, sales management, manufacturing, and procurement. At Bain Capital, Mitt Romney pioneered the use of consulting resources (from Bain Consulting) in private equity investments. More than 20 years later, that strategy has been widely adopted.
Private equity investors cannot systematically and purposely loot their companies. Banks do not purposely make bad loans.
How are private equity fund managers paid? Private equity funds receive an annual management fee on the money invested. For large funds, this is usually 1.5 percent per year. In addition, private equity funds (like hedge funds) typically receive 20 percent of the profit of their investments. Unlike hedge funds, private equity funds only receive their 20 percent share of the profits if their investors earn at least an 8 percent annual return.
What have the results been? There are three types of results that are of interest—returns to investors, the operating performance of the companies themselves, and employment at the companies.
Returns to investors. The returns to investors have been very good. In a recent paper, Bob Harris, Tim Jenkinson, and I look at returns to private equity funds (net of fees).1 We carefully compare the returns on the private equity investments to those an investor would have earned in the public stock market. We find that the average private equity fund has beaten the public stock markets by a substantial margin over the last 20 years. On average, every dollar invested in a private equity fund delivered at least 20 percent more than a dollar invested in the S&P 500. The funds outperformed public equities in both good and bad markets. This benefited the pension funds, endowments, and other LPs who invested in private equity funds over this period. In our sample alone, the outperformance works out to more than $120 billion in additional value to investors.
Company performance. The empirical evidence on the impact of financial, governance, and operational engineering is almost entirely positive. Large sample studies in the United States (as well as the United Kingdom and even France) consistently show that portfolio companies become more productive on average. The studies find that companies increase their profit margins and cash flows by more than their industry competitors. In other words, the evidence indicates these companies are operating better on average. There is no evidence that the average company is gutted or declines precipitously. (The results are positive, but less so, for the larger public-to-private transactions.)2
At Bain Capital, Mitt Romney pioneered the use of consulting resources in private equity investments. More than 20 years later, that strategy has been widely adopted.
Employment. Some, including presidential candidates Newt Gingrich and Rick Perry, criticize private equity for gutting companies and destroying jobs. The private equity industry and Mitt Romney argue that private equity creates jobs. The best empirical evidence—co-authored by one of my colleagues, Steve Davis—says the answer is that private equity both creates and eliminates jobs.3 After a buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3 percent. Many of those job losses are undoubtedly painful.
At the same time, however, employment in new operations tends to increase relative to other companies in the same industry by more than 2 percent. Davis et al. conclude that “the overall impact of private equity transactions on firm-level employment growth is quite modest.”
The job picture, however, varies a lot by industry. Net job losses are concentrated in buyouts of retailers. This is not surprising given that Wal-mart, Target, Sam’s Club, and Amazon, among others, have put a great deal of pressure on retailers over the last two decades. In the analyses, in fact, Wal-mart and Target are competitors to private equity-funded companies. Given that competition, it is possible that employment would have declined in the private equity-funded retailers even if they had never received private equity.
If retail buyouts are excluded, the overall net employment change appears to be neutral or even positive. In other words, there does not seem to be a large net employment effect when compared to companies in the same industry. Interestingly, in France, private equity leads to employment increases.
When private equity fund returns are strong, a lot of workers, teachers, and pensioners benefit.
The overall pattern of the empirical evidence suggests that private equity firms make companies more productive. They make cuts or grow more slowly when that makes sense and they invest and grow more quickly when that makes sense.
So if the overall pattern is so positive—for investors, companies, and even employment—why is private equity so controversial? One complaint, uttered by Newt Gingrich, Rick Perry, and others, is that private equity investors are vulture capitalists who “loot” their companies. According to this view, private equity firms pay themselves dividends by having the company borrow additional money. These transactions are known as dividend recaps. If the company subsequently goes into bankruptcy, the private equity firm still gets to keep the dividend.
While it is true that the private equity firms get to keep the dividends, it is ridiculous to say that private equity investors actively loot their companies. As Steve Rattner (former Obama administration “car czar” and former private equity investor) pointed out recently, private equity firms can take cash out of a company only when banks are willing to lend more money. That happens only when the company has done well and is expected to do well in the future. In most dividend recaps, therefore, the private equity investors and the banks are positive about the company—the banks expect to be repaid, and the private equity investors expect their equity to be worth even more. When those companies go bankrupt instead, something unexpected (and negative) has usually happened.
In other words, private equity investors cannot systematically and purposely loot their companies. Banks do not purposely make bad loans. That just does not happen.
Private equity funds only receive their 20 percent share of the profits if their investors earn at least an 8 percent annual return.
Second, a bankruptcy of a private equity-funded company is usually assumed to be a complete failure. That, too, is usually not true. While a bankruptcy often leads to some additional job losses, it does not mean the company goes out of business. And in some cases, when the company emerges from bankruptcy, it becomes quite healthy. In the early 1990s, Bloomingdale’s, Macy’s, and Seven-Eleven, among others, all went bankrupt. You would not know that today.
Similarly, Dade Behring went into bankruptcy in 2002. This occurred after Bain Capital had cashed out $216 million. Bankruptcy was not the end of the story. The company recovered relatively quickly, exited bankruptcy, generated operating income of roughly $300 million in 2007, and was acquired by Siemens for over $6 billion. This is one of the companies Bain Capital supposedly “looted.” Bain Capital would have been much better off holding onto its investment.
Finally, when private equity investments do end well (not badly), there is a different kind of controversy—the private equity firms make large profits and the partners receive large payouts that attract a lot of attention. It is important to recognize that the large payouts are a product of the 20 percent profit share the private equity funds receive. The private equity funds earn those large amounts only when they perform well and return money to their investors—the pension funds and endowments. In years when they do not return money to their investors, private equity funds earn far less. So, while the sums are sometimes large, they are closely tied to performance.
Steve Kaplan is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. He has consulted for investors in private equity funds and for private equity funds. He also has invested personally in both private and public equities. He has no involvement with any presidential candidate.
Editor’s note: Kaplan’s next piece for THE AMERICAN will be an analysis of Bain Capital.
FURTHER READING: Scott Shane writes “Scrap the Accredited Investor Rule” and “Small Businesses and Big Unintended Consequences.” Edward Tenner discusses “The Dismal New Science of Stagnationism.” Kevin A. Hassett and Steven J. Davis contend that “Private Equity is a Force for Good.” Jonah Goldberg reflects on “Romney's Authenticity Problem.” AEI President Arthur C. Brooks says “The Value of Free Enterprise has Nothing to do With Money or Wealth.”
1. See “Private Equity Performance: What Do We Know?” Robert Harris, Tim Jenkinson and Steven Kaplan, University of Chicago, September 2011.
2. See, “Leveraged Buyouts and Private Equity,” Steven Kaplan and Per Strömberg, Journal of Economic Perspectives, Winter 2009, 121-146. Also, see “Private Equity, Leveraged Buyouts and Governance,” Douglas Cumming, Donald Siegel and Mike Wright, Journal of Corporate Finance, 2007, 439-460.
3. See, “Private equity and employment,” Steve Davis, J. Haltiwanger, R. Jarmin, J. Lerner and J. Miranda, working paper, University of Chicago and Harvard Business School, September 2011.
Image by Rob Green / Bergman Group