|
The $45bn (£23bn) buyout
of TXU Corporation, the US energy group, by Kohlberg Kravis
Roberts and Texas Pacific Group raises a number of questions.
The most obvious, given the nature of markets, is whether
this exuberance signals an imminent downturn for private
equity.
The answer is: not yet. The boom
has been driven by increasing amounts of new money seeking
superior performance. According to Thomson Financial, private
equity net returns outperformed the S&P 500 19 per
cent to 9.7 per cent for the 12 months to last September
and 14 per cent to 9.7 per cent for the past 20 years.
The flow of new money into private equity will continue
as investors are attracted by two decades of out-performance.
Will private equity continue to
outperform public markets? Is this good for the economy?
In both cases the answer is yes, because public markets
are failing to allocate capital efficiently. This is not
a bubble but a cyclical trend that is likely to end only
as public companies become more efficient. At first glance,
public markets appear to be less costly for investors because
of private equity's notoriously high "friction
costs" - the various fees, operating costs and inefficiencies
that reduce return on investment.
These costs start with a 2 per cent fee on committed capital
(about 4 per cent on average invested capital) and 20 per
cent of the profits (or 5 per cent if returns are 25 per
cent). Acquisition fees, disposal fees, fees charged to the
companies and legal fees probably add 2 per cent, bringing
total friction costs to about 11 per cent a year. But in
profitable markets the greater leverage of private equity
funds in an environment of plentiful, low-cost debt acts
as a kind of steroid to returns that can offset half this
amount, resulting in net friction costs of 5 per cent a year.
Investors in public companies pay just 1 per cent to 2 per
cent in brokerage, mutual fund or money management fees.
But the total friction costs are often significantly higher
than 5 per cent because of other, less visible, costs such
as increasingly responsive boards, greater compliance costs,
litigation costs and the loss of management talent to private
companies.
Public boards are constructed to reflect society and encourage
independence, with the result that fewer board members have
business experience. Private board members, in contrast,
are usually chosen for their ability to increase revenues,
margins and profits. Public company chief executives must
also respond to all those who want a say in the management
of their companies, from shareholder advocates to regulators.
This means less focus on profitability, market share and
long-term strategy. Public companies, for excellent reasons,
must also comply with securities laws, Securities and Exchange
Commission mandates and Sarbanes-Oxley, which require expensive
accountants, financiers, lawyers and systems engineers.
The plaintiff bar targets public companies because they
are more susceptible to public relations pressures that can
affect their stock price. So they are often willing to settle.
Private companies are more likely to fight frivolous suits.
Private equity has begun to attract the best operating managers
from many industries. These managers can participate directly
in creating value, potentially earning multiples of what
they were getting at public companies. They can focus their
talents and energies on building a business rather than dealing
with bureaucracies.
What about the impact of private equity on the economy?
The focus of private equity firms is on the internal rate
of return, which forces capital to high return investments.
Private equity firms try to reduce excess capital - capital
tied up in inventory, payables, receivables and other forms
of working capital. When a portfolio company is sold, the
capital is reallocated to opportunities with higher returns.
The result is rapid reduction of capital in mature industries
and increased investment in growing industries. Public companies
must heed the demands of a wide range of stakeholders, employees,
management, division managers, lenders, unions and politicians
- most of whom have a stake in the current allocation of
capital.
Taking companies private spurs
innovation. This may seem paradoxical, given private equity's
reputation for "flipping",
or sale for short-term profit. It is true that private equity
firms have a near obsession with trimming costs and tidying
up balance sheets of portfolio companies so that they can
eventually be sold. But that can take five years or so, which
provides breathing room to consider promising innovations.
Public companies, on the other hand, face relentless pressure
to meet quarterly earnings estimates.
The halcyon days for private equity will eventually end.
The constraints on the public model will ease. The returns
in private equity and those in the public markets will begin
to converge. Increased regulation of private equity or a
radical turn in the credit cycle could also affect the current
dynamic. Until then, private equity firms will continue to
offer a classic capitalist response to a public market that
is failing to allocate capital efficiently.
The writer is president of Continental Investors. He is
a former chairman and chief executive of Morgan Stanley.
Copyright The
Financial Times Limited 2007
|
