Private Equity Investment: Pros and Cons - Essay Example

?Topic: Outline the Arguments for and Against Private Equity Investment Private Equity Private equity is a kind of investment whereby investors make direct investments into private companies or completely buyouts of publicly listed companies resulting in their delisting from the stock exchange. Companies can receive private equity from retailers and institutional investors and the funds serve a number of purposes such as acquiring new technologies, increasing working capital, strengthening the balance sheet and making acquisitions in terms of assets and other companies (Gilligan and Wright, 2008, p. 120). In most cases, private equity is driven by the opportunity to earn high returns from a company. Private equity funds mainly come from the private market but private equity firms can invest the funds in both the public and private companies. It is important to note that when the investment is made in a public company, the company becomes private because private investors take control of the company they have invested their money. The market for private equity has evolved significantly in the past one or two decades. This is driven by the fact that a majority of investors have identified good opportunities that reward very high returns in the private equity market. Research studies reckon that the number of expensive buyouts has been increasing every year with investors increasing the size of their investments in the private equity market. The growth of the private equity market has led to a number of concerns regarding its sustainability in the long run. However, one debate that has continued to dominate the financial market is whether private equity is a desirable investment or not. This paper sets to discuss the pros and cons associated with private equity in terms of improving company performance and benefiting the economy. Pros (1) Improving Company Performance The performance of a company is determined by a number of factors including professionalism and the use of technology. This therefore implies that a successful organization should have the best employees in terms of professionalism and also posses the most modern technologies. It is difficult for an organization to acquire the two in a situation where money is a constraint and this is where private equity comes to play an important role. Private equity ensures that investors acquire a company and place it among their portfolio. This is followed by the investors injecting funds into the operations of the company which brings along with it the concept of professionalism. Whenever an organization has been acquired by private investors, they tend to bring new practices and this includes new people and business experience. This is motivated by the fact that private investors are driven by the desire to record very high returns from their investment into an acquired company. They would therefore spend a lot of capital in acquiring competent managers that will record high returns. When a company sales a portion of its shareholding to private investors, there results in the injection of funds which eventually improves cash reserves (Gopalakrishnan, Scillitoe, & Santoro, M., 2008, p. 1356). The company is therefore in a good position to use the invested funds to accelerate its development projects. A case in point is the takeover of Sicomed by Zentiva. Sicomed is located in Romania whereas Zentiva is located in Czech Republic. There are a number of advantages resulting from the private acquisition of Sicomed by Zentiva. The main advantage of the private equity is that there was restructuring of and the redevelopment of the technological infrastructure of Sicomed. There was also the restructuring and redesigning of the company’s working environment starting from the management level down to the subordinate level. This can be viewed as a complete overhaul of the organizational structure of Sicomed. Sicomed used the private equity funds in acquiring new lines of production that replaced the old ones and this enabled the company to fulfill modern manufacturing conditions related to the production of medicine (Graafland, J., 2009, p. 10). A new organizational culture was also introduced in the company as a result of the restructuring and redesigning of the company. All these changes led to an improvement in the performance of Sicomed in the sense that it regained its competitiveness in the market for the production of medicine. (2) Benefiting the Economy A 2011 report by Price WaterCoopers records that private equity has positive impacts on the economy in various ways. The report noted that private equity contributes to the revitalization and restructuring of existing industrial companies. This is in form of financial assistance and growth potential of the firms. These positive impacts have led to the equity industry becoming a strong pillar of the global economy. Europe is among the continents that have enjoyed the massive positive impacts of private equity. The continent has recorded significant increases in the rates of employment in sectors that have been funded by private equity. This can be summarized below: The increase of employment in Europe by sector of activity The number of employees in companies funded by private equity & venture capital investment % of increases Biotechnology +46,9% Medical services and pharmaceuticals +46.3% Electronics and telecommunications +38% Industry +25.2% Production of goods for consumption 3.9% The average employment +30.5% Source: Processing by PWC Report on the Economic and Social Impact of the private equity funds According to the principles of economics, organizations that gain market share in a free market economy have the advantage of having a positive impact on the economy. This is attributed to the concept of ‘invisible hand’ that was developed by Adam Smith in his book The Wealth of Nations. According to Adam Smith, an individual pursuing personal interests has the impact of frequently promoting the interests of the society even when he or she never had such intentions. Private equity operates in numerous markets including the market for goods and services; the market for employment; the market for talent; the financial market; and the market for mergers and acquisitions (GMB/TSC, 2007, p. 38). Each of the identified markets is free to some extent. The general advantage is that there is an improvement in customer satisfaction in the sense that whenever they are offered poor value for their There is also the creation of additional employment opportunities because private equity provides funds for company expansions hence creating more opportunities for employment. An increase in the number of employment opportunities in a free market enables employees to seek alternative employment whenever they are dissatisfied with their existing jobs. Cons (1) Improving Company Performance Research studies indicate that private equity has the effect of creating unwarranted redundancies. This is in the case whereby there is a reduction in the number of employees in their efforts to improve short term organizational performance. However, this has the effect of undermining long term performance. Private equity often results in acquired companies cutting costs in areas such as business development, research or marketing. This only improves profits in the short term but undermines future success. Private equity firms also have the negative effect of asset stripping. They are accused of acquiring good businesses, selling their valuable assets to pay debts and eventually leaving the remaining businesses with a dark future. A case in point is the demise of MG Rover in the UK. The company was associated with a group of local business persons who made a profit of about $60 million during their ownership in the company but left the company with debts amounting to $1.4 billion. (2) Benefiting the Economy The private equity is associated with massive employee lay off as a result of restructuring following changes in management. In most cases, the process of restructuring involves altering of production lines and the funds invested in reducing the number of employees. Most of the private equity funds are used in acquiring new technologies which eventually results in layoffs. This is despite the fact the expansion of companies through private equity may create additional job opportunities. This can be explained using the acquisition of Sicomed by Zentiva. The acquisition resulted in almost 50 percent of the employees losing their jobs. The management of Sicomed explained that there was an urgent need to restructure in order to improve performance. The company provided a training program for its sacked workers in an effort to educate them on how they could start and run their own businesses. The other criticism on private equity is that it results in the payment of very little taxes. This is because private equity only increases debt finance in the economy while reducing the amount of equity financing. Companies use private equity as a means of debt financing where debtors have the opportunities to own part of the company (Ghoshal, 2005, p. 80). Debt financing is tax deductible whereas equity finance is not. This means that an increase in the number of private equity increases the amount of tax deductions hence reducing the overall amount of taxes. The third disadvantage of private equity is that they undermine pension funds in terms of their solvency. Large and well established companies are always the target of private equity firms and this has led to large pension liabilities. Private equity firms compound the problem when they sell properties or acquire debts because it increases the risk of pensioners. References Ghoshal, S., 2005, ‘Bad Management Theories are Destroying Good Management Practices’, Academy of Management Learning and Education 4(1), 75–91. Gilligan, J. and M. Wright, 2008, Private Equity DeMystified: An Exploratory Guide, Corporate Finance Faculty, ICAEW: London. GMB/TSC, 2007, Report and Evidence Submitted to the Treasury Select Committee on Private Equity as Part of the GMB Union Submission, GMB: London. Gopalakrishnan, S., Scillitoe, J. and Santoro, M., 2008, ‘Tapping Deep Pockets: The Role of Resources and Social Capital on Financial Capital Acquisition by Biotechnology Firms in Biotechpharma Alliances’, Journal of Management Studies 45(8), 1354–1376. Graafland, J., 2009, ‘Do Markets Crowd Out Virtues? An Aristotelian Framework’, Journal of Business Ethics 91(1), 1–19. PWC Report on the Economic and Social Impact of the PE funds in 2005 available online on www.evca.eu Read More