Critical Thinking Analysis - Essay Example

Critical analysis Are private equities merely another recent anomaly in the American stock market? This is the question posed by Clive Crook in his article “Cashing Out” published in The Atlantic in September of 2007. In general, private equities are defined as “equity securities of companies that have not ‘gone public’ … generally illiquid and thought of as a long-term investment” (Private Equity, 2007). Despite this seemingly restrictive definition, the industry has managed to return profits at much higher rates than firms operating in the public sphere while holding onto companies for sometimes only a span of a few years. This tremendous ‘cash cow’ means of doing business has managed to both fly under the scope of public radar until relatively recently as well as profit on weaknesses within the American corporate system, but Crook (2007) questions whether this means of doing business is sustainable into the future. Although the subject is broached later in the article, Crook does take the time necessary within his article to describe just what he means when he discusses private equity firms and how they are different from hedge funds or other such approaches. Under the private equity firm’s umbrella, struggling individual firms are bought out and placed under a hands-on, ruthless and strictly disciplinarian form of management. By taking over such undervalued public companies, the private equity is able to significantly restructure those elements that aren’t operating at the greatest possible efficiency or reduce management structures to their lowest common denominator as a means of ‘turning’ the company. Once a fix of some sort has been established, whether it is more appropriately considered temporary or permanent is irrelevant, then the firm turns around and sells the company to the highest bidder, often taking a large portion of the profit out of the deal and leaving behind a company with reduced assets and increased debt. This increased debt on the balance sheet, Crook argues, is one of the key characteristics of these business deals. “If the firm does well, the owners’ returns, now teetering on a smaller base of capital, are much higher than they would have been without the new leverage” (Crook, 2007). Likewise, if the business does badly, it can be destroyed in the private equity process. According to Crook, it’s only been within the past two years that the industry has garnered public notice as the result of poor decisions made by some of the industry leaders. Crook supports his ideas of the demise of private equity upon two key events that have occurred within the previous year. The first he recognizes is an ostentatious birthday party thrown by Stephen Schwarzman, one of the co-founders of Blackstone, upon the occasion of his 60th year. The other event was Blackstone’s initial public offering made in June following nearly 20 years of resisting such a move, thereby revealing to the public the value of the firm and its nature of business. According to Geoffrey Colvin writing for Fortune magazine in late 2006, the evidence presented by such displays is well supported by the facts. “Over the past ten years, the score is 11.4 percent a year [for private equities] vs. 6.6 percent [for other firms]; over the past 20 years, 14.2 percent vs. 9.8 percent. Those are significant differences, and some critics charge that huge fees and sweetheart deals with management are siphoning value from public shareholders.” With the increased attention on the industry, Crook indicates that there are only two possible directions for the industry to head in now. The first of these is to continue to build tremendous fortunes for the few who are lucky enough to fall into the right deals and willing to undercut the public shareholders out of their rightful due, proving in the process the fallacy of the American corporate system. The other direction is for the industry to burn itself up in the same types of public displays of wealth and opulence that initially created such a stir among businesspeople with the display put on by Schwartzman. The question becomes whether the significant financial gains that have been seen in firms such as Blackstone, which has increased its value from approximately $400,000 in 1985 to more than $90 billion in its most recent reports, is truly making money or is simply reorganizing financial information. To attempt an answer to the question, Crook examines the pros and cons of the private equity approach within the latter half of his article. For example, private equity does provide firms with better management and more creative financial engineering in a generally cooperative environment in which public firms willingly hand over the reigns to the private group. This perspective is well-recognized by others as well. “Look inside the companies owned by major private-equity firms, talk to the executives who run them, and you’ll find a distinctive way of managing that’s sharply different from what goes on in most publicly traded companies or most private companies under conventional ownership. Investigation shows why privately held firms – at least if they’re owned by one of the major buyout shops – have important advantages over competitors, and why they’re regrading the playing field in several industries” (Colvin & Charan, 2006). While Crook doesn’t go into much detail regarding the significant management differences that exist between the private enquity and the public or privately held independent firm, he does hint at several of the issues pointed out by Colvin and Charan (2006) such as the short-term focus of the private equity that typically holds a company for a period of less than 10 years. As other authors have pointed out, this short term aspect changes the mindset of the management to one of immediate results and pressure to perform. Another argument in favor of the private equity firm as a means of quickly turning around a sluggishly or poorly performing firm is the availability of appropriate funding to accomplish stated goals or objective, pursue new lines or develop better products. Crook points out that there is some argument to the claim that private equity managers, because of their more direct involvement within the firm and greater control of the decisions made, are more aware of the risks they are running and more capable or willing to take greater personal risks in investing in the company. Again, while Crook hints at these elements, others delve into deeper explanations of how this process works. “Pay is a whole different concept in PE-owned companies. Don’t come to play unless you’re prepared to put significant skin in the game. While public companies talk a lot about aligning executive pay with performance, they typically award stock options and restricted stock on top of already substantial pay packages, giving executives lots to gain but little to lose … By contrast, private-equity firms make the game much more serious. Not only is a far larger share of executive pay tied to the performance of an executive’s business, but top managers may also be required to put a major chunk of their own money into the deal” (Colvin & Charan, 2006). As part of this discussion, however, Crook indicates that the mere presence of the private equity firm within the American capital system itself indicates problems as firms should not need to be taken private in order to be better managed or intelligently financed. In discussing the sudden and astronomical success of the private equity business, Crook argues the number of private equity firms within the corporate system has been increasing alarmingly and the balance of public and private has become overweighted toward privatization. One of the reasons for this shift, according to Crook, is the Sarbanes-Oxley law, or Sarbox for short, which forces many public companies to provide much greater accountability regarding the numbers reported, with personal accountability taken on by the companies’ CEOs. This concept is supported by the idea that offshore companies and those in other countries have been growing as well, presumably as a result of a lack of such strong legislation. However, at the same time, Crook points out that those firms listing in the United States have also gained a significant increase in valuation, perhaps as it is recognized that the owners must be more careful in order to avoid the kind of legislative mess that spawned such fiascos as Enron and Tyco, engendering such legislation in the first place. The danger of this overbalance of private equity versus public firm, Crook indicates, lies within the nature of the stock market itself. Through his discussion, Crook illustrates how this market has seen possibly inflated ideals of possibilities as it emerged during a period in which the stock market has remained strong and continuously rising, making it simple for these firms to sell their re-organized companies for a tidy profit. “Rising stock prices have undoubtedly flattered private equity’s results. Yet this cannot last: Wall Street goes down as well as up. In addition, interest rates have been low of late. More than anything else, cheap credit has fueled the private equity boom” (Crook, 2007). When the stock market loses its strength, it is expected that these high profit reports will experience a significant decline. Crook’s argument seems poorly organized and sketchy regarding what he is trying to communicate. Rather than arguing in favor of private equity firms or for the increased protection of public firms, he seems to take a line down the middle, illustrating the benefits of the private equity firms and wishing these benefits to make the transition into the public sphere. Even as he does this, he acknowledges that many of these practices, such as the short-term approach to management and the influx of large sums of invested capital, are not possible within the public sphere either by law or nature of the business. A general map of the argument illustrates the success of the private equity firm, the description of what is meant by private equity firms, the beneficial management styles such firms have to offer and the dangers they face with a fluctuating Wall Street market. From here, he moves on to discuss the better financial position brought in by the private equity firm and the dangers of a corporate mix dominated by such firms rather than increased public firms. A glimpse into the laws that have been produced to hold public firms more accountable is seen to have both positive and negative aspects to public firms attempting to hold their own against the private equities while the conclusion nods off into a recognition that the case of private equity versus public firm is not an open and shut case. The organization and detail presented in this argument leave much to be desired. While attempts are made to distinguish what makes one form of business better than the other, these attempts do not go as far as they should and leave numerous questions in their wake. In summing up the advantages offered by private equity firms, Crook manages to complicate the issue by refusing to present a solid picture of either form of business. He hints at deeper reasons for advantages and disadvantages of each, but never fully explores them or illustrates why such exploration might be helpful. His glossed-over discussion regarding the danger of private equity firms within the greater marketplace is insufficient to raise concern regarding an over-balanced market on its own merit while his brief introduction to Sarbox is equally insufficient to indicate whether this has been as detrimental to public firms as he suggests. Finally, his conclusion is weak, offering little to no insight into the true nature of the dynamics involved. My recommendation regarding whether to include this article in the next edition of Advanced Critical Thinking for Business is not to run it. The argument does not provide the strong give and take exploration of the issues involved that would be required for a true understanding of the topic. Issues discussed remain only tentatively linked with one another, further weakening the author’s argument. While the article does provide information for further research or investigation, it does not provide the type of depth and detail that it should within the space of text it comprises. Perhaps because of its general nature, the claims made are not well-supported nor are they well-organized and juxtaposed against a solid ideal. No strong conclusions are offered with the strongest suggestion seeming to be an investigation into the possibilities of taking a combination approach to business. I recommend seeking another author for this subject that can formulate a clearer, stronger argument and take a stand on some aspect of private equity firms. Works Cited Colvin, Geoffrey & Charan, Ram. “Private Equity, Private Lives.” Fortune Magazine. November 27, 2006. October 4, 2007 Crook, Clive. “Cashing Out.” The Atlantic. September 2007. Private Equity. VC Experts. 2007. October 4, 2007 Read More