Private Equity Issues - Essay Example

Running Head: PRIVATE EQUITY PRIVATE EQUITY Of PRIVATE EQUITY INTRODUCTION The term private equity describes investments for which there is no public market. Typically one invests either directly in the equity or convertible debt of private companies or in a private partnership, which in turn purchases such instruments. There are two principal sub-markets: venture investments in new or early stage companies and buyouts, which invest in corporate finance transactions (Bray,1997). Though these are distinct markets, some firms are active in both, shifting emphasis with market conditions. FEATURES OF PRIVATE EQUITY The two principal economic appeals derive from the facts that the private market is informational inefficient and that successful investments can produce astronomically high returns (high enough to more than make up for a much larger number of failures). On average, private equity has produced very high returns with low correlations to public stocks and bonds and real estate. In other words, private equity offers the prospect of both high returns and increased portfolio diversification. In some cases, private equity may also provide collateral benefits, e.g., a vehicle to make economically targeted investments or to create or preserve union jobs. Finally, there is also the undeniable appeal of seeking innovative investments (Gompers, 2003). At least four things need to be kept in mind about private equity returns. 1. Until the investments go public or are liquidated, investments are carried either at cost or at prices set by later rounds of financing. Except in this latter case, private equity is even harder to accurately value than real estate (Bray,1997). 2. Ultimate returns have varied (and are likely to continue to vary) widely by "vintage year," i.e., the year of initial investment, because of wide fluctuations in the business cycle. For example, the median 1986 private equity fund returned only 8.4% per year through 1997, whereas the median 1990 private equity fund returned more than 17% per year through 1997. 3. The performance differences between good and bad managers are much more significant than in public markets (Gompers, 2003). Further, the distribution of returns is not "normal," i.e., outstanding managers have extremely high returns, while poor managers often have abysmal returns. (In statistical terms, the mean return is much higher than the median.) For example, for venture funds formed in 1988, an upper quartile manager returned almost 18% more per year than a lower quartile one from 1988 through 1997 (21.6% vs. 3.9%). 4. Reputation is very important: The best deals and the largest investment flows tend to go to firms with the best track records. Consequently (and quite unlike public equity markets), success tends to persist. The result, however, is that it is often difficult, if not impossible, for new investors to get into the best partnerships or deals. Here, the services of an established fund-of-funds manager can be of real value (Gompers, 2003). AIM OF THE PAPER Private equity (PE) buy-out deals have profound influence on domestic economies. Since the beginning of this year, they have accounted for more than one third of all deals that have been done on the New York stock Exchange1, and have raised $240 billion of cash for their acquisition plans2. The purpose of this report is to discuss the consequences of this type of buy-out on public markets, jobs, and tax revenues. Nevertheless, The effects of high leverage, which is used by PE firms to finance this class of acquisition, are beyond the scope of this report. DISCUSSION Private Equity investment used to be defined as "an equity investment in a company which is not quoted on a stock exchange". However, currently this definition has many limitations because it does not include investments that are structured as convertible debt and investments in public companies that are taken private3. For the purposes of this paper, Private Equity Buy-Out deal is a subset of private equity investment in which private firm rises capital using both debt and equity to acquire companies quoted on stock change and take them private4. In 1989, Michael Jensen wrote an article titled "The Eclipse of Public Corporation". He argued that the era of public held corporation has ended. This article was written when private companies had acquired a number of U.S firms such as RJR Nabisco and Trans Word Airlines in leveraged buyouts1. His article drew attention to the weakness of public held companies that could be solved by going private. There are many disadvantages of publicly held corporations. Executives have been accused of misusing shareholders' money. To supervise managers' and boards' behaviours, owners have implemented lots of regulations and auditing, leading to huge expense. In a study that examined a sample of 245 United States' companies that went private, researchers found that the audit fee became less that it had been when the companies were in the public market1. Not only do managers cause problems, some investors also cause troubles to public corporations. They often obligate managers to meet conflicting inquires that managers struggle to reconcile. Moreover, Mutual funds and institutional investors emphasize on short-term achievements since their performances are judged on quarters returns, which may affect long-term strategies and future growth. Beside all that, managers have to deal with the media, pressure groups and actives investors such as short sellers. These types of problem have added to distracting bureaucracy and regulations to make public company less dynamic2. Despite all these drawbacks, the argument that the public held corporation has outlived its usefulness in many sectors of the economy and is being eclipsed should be re-evaluated because it omits some important concerns that must be addressed to validate the argument. Firstly, bank's loans, which are the main driver of leverage buy-outs deal, are becoming harder to obtain, partially because interest rates have started to increase and partially because lenders have started to concern about the stability of PE firms. In July 2007, lender cancelled 3.6 billion bond and loan contract to finance the acquisition of U.S Food service, an American wholesaler due to the high risk of the deal. Also in Australia, private equity firms pulled out from the country biggest take over because of the high cost of debt2. Secondly, PE takeover tend to have short period of time before the targeted company either return to the public market or undergo secondary buy-out. On a study of a group of 1350 British companies that undergo leverage buy-out, the average longevity was just below 4 years to just over 5 years1. This needs of exit route was verified by the IPO of both Blackstone, which is one of the leading private equity firm, in New York stock market and Kravis Roberts, another leading tycoon2. Although, Michael Jensen's argument appears at first glance to be logically sound, it has many weaknesses. Therefore, the public held company would continue to Exist. Stock market would continue to be the key source for rising capital but part of its functions will be shard by PE market. One area of concern that should received more studies and analysis is the effects of PE takeovers on jobs and wage levels. Media and trade unions required that employment lay-off after the buy-out is restricted and regulated1. Also, on a report submitted to the Treasury Select Committee by The Tax Justice Network and UK Tax Research LLP in July 2007, they claim that PE firms pay little attention to staff and suppliers in the company they bought and they tend to reduce the staff in order to cut the cost in the short term3. However, there are some justifications of work force reduction that follow the buy-out of a company. The first non-U.S. private equity market to develop in any substantial way was that in the United Kingdom. The U.K. market has gone through an evolution, starting with investment funds with a diversified investment strategy covering everything from startups through expansion/growth financing and buyouts. Returns in the mid-1980s in the United Kingdom were generally unsatisfactory, and investment funds in the United Kingdom increasingly focused on growth capital and buyouts, where success had been greater (Bray,1997). The predictable result of this success at the larger end of the U.K. buyout market has been the attraction of significant additional capital, mainly from larger U.S. investors, and a rapid maturation of the large buyout market in the United Kingdom. As in the United States, larger funds are more easily accessed by institutions looking to deploy significant amounts of money into private equity. Large buyouts in the United Kingdom are now frequently sold in efficient auctions and trade for high prices, much as in the large buyout market in the United States. The United Kingdom continues to be the largest private equity market in Europe, representing a large percentage of the total investment deals done and an even larger percentage of total funds invested, since U.K. deals on average tend to be larger than deals in the rest of Europe. Exhibit 5 shows deals done in 1996 in Europe by number and value. "Other" is mostly Scandinavia and the Benelux (Bray,1997). Subsequent to the initial development of the U.K. market, the markets in the rest of Europe began to develop. Most private equity transactions in Continental Europe are either growth/expansion financings or buyouts. Technology investing is very limited, in contrast to the United States, where technology venture capital represents a material part of the total U.S. private equity market. Another significant difference between the U.S. and Continental European private equity markets is the presence in Europe of a large number of "captive" investors, which are dedicated to private equity investments but are subsidiaries or affiliates of larger financial institutions, typically banks or insurance companies. As directors of public companies are highly aware, the alternative to keeping excess cash is to return it to shareholders. One way to do this, favored in recent years, has been for the company to buy back stock. This tactic calls for some vigilance by directors. Despite the continuing announcements of stock buybacks, many public companies have accomplished only modest reductions in their share counts. Some companies do not fully implement their announced plans; others use a large portion of the acquired shares to fund executive compensation plans. Directors would be well advised to closely monitor the count of actual shares outstanding including shares for compensation plans. Share buybacks do not automatically increase shareholder value, of course. A buyback makes sense only if the directors conclude that the company's shares are currently underpriced by the market. The empirical results of share buybacks are quite mixed. Buybacks have generally increased the stock price of the acquiring company in certain periods (such as from 1999 to 2001) but not in others (2004 to 2005, for example). In recent years, share buybacks have tended to increase the company's share price in certain sectors (technology, health care, and utilities) but not in others (energy, materials, and telecommunications). The much more reliable way to increase shareholder value is to raise cash dividends. According to Citigroup research, stocks in the top quintile for dividend growth on average outperformed those in the bottom quintile by 12.6% from 1990 through 2006. Companies that raised dividends on average outperformed the market by more than 4% in the year they were raised, and companies that started paying cash dividends for the first time on average outperformed the market by more than 5% in that initial year. A recent change in tax law has made the argument for raising dividends even stronger. Cash dividends used to be taxed at ordinary income rates to shareholders, while company buybacks of stock were taxed at the lower capital gains rate. That changed with the passage of the 2003 Tax Act; now the tax rates on both qualified dividends and most capital gains are 15%. Yet the average portion of earnings paid out in dividends by S&P 500 companies has been cut in half - from approximately 60% in the early 1990s to approximately 30% today. The main argument by company management against higher cash dividends is their inflexibility: It is very difficult to lower an existing level of cash dividends. Ironically, this difficulty is a key attraction to shareholders: Company management becomes subject to the discipline of paying this higher level of cash dividends year after year. PE firms employ a number of characteristics to choose companies for acquisition. One of these characteristics is their Keys Performances indicators, of which labour productivity is one. Low labour productivity figure indicates a degree of over-manning in this company. A study on 5000 acquiesced company reveals that these company had lower total factor productivity, which measures the productivity of assets and labour, before the takeover than their non-buy-out equivalents. For that reason, it is predictable that some labour shedding occurs4. Additionally, the Centre for Management Buy-out Research in Nottingham University Business School conducted an analysis of 1350 leverage buy-out deal that were done in United Kingdom between 1999 and 2004. After the deals were disaggregated, they found that the employment growth is .51 of a percentage higher for Private Equity's buy-out after the change in ownership than in companies that have not experienced a buy-out. The study also indicates that although the employment level in PE takeovers decreases at first, it continues to climb on average4. One of the major's complaints about PE buy-out deals is that they are paying less tax than their competitors. According to a research submitted to the Treasury Select Committee by the Tax Justice Network in United Kingdom and Tax Research organization, PE firms benefit from two unnecessary tax regimes allowing them to have competitive advantage over companies that are quoted on the United Kingdom's stock market. First, they commonly pay less tax on their capital gains, and second they receive unwarranted tax relief on interest paid (carried interest). Nonetheless, PE executives claim that there are a number of justifications for these tax breaks. All companies whether public or private are benefiting from tax break on interest payment since it is capital gain from high-risk business and since it encourages entrepreneurship1. Also, they claim if carried interest were subjected to income tax rates, other countries will become more appealing for Private Equity business. However, the last claim is unsupported because of three reasons. First, the economic contribution in terms of tax paid to governments is already minimal. Second, the public companies, which are targeted by PE firms, are located in these countries. Support services, which are needed to maintain PE firms, are also located in these countries. Indeed, these tax breaks are economically unjustifiable because they provide unfair competitive advantage to PE firms over Public Corporations thus create economic distortions. Also, they cause tremendous lose of tax revenue and increase social inequality. However, in my opinion, before any legal actions or regulation are being requested, it is important to ensure long-term investments, new ventures and small business are not harmed science the main intention from tax breaks was to reward and encourage these kind of business. In reality, that logic is not borne out. It's true that leverage beyond a certain point will lead to a lower credit rating for the company's debt. However, the increase in borrowing costs for lower credit ratings has been modest until the recent turmoil in the debt markets. For example, during the initial four months of 2007, the option-adjusted spreads between a credit rating of single A and BBB (the two lowest rungs of investment grade bonds) were only 32 to 34 basis points, and the option-adjusted spreads between single A and BB (the highest rung of noninvestment grade bonds) were only 112 to 120 basis points. More important, investors in public companies have become comfortable with firms that have higher leverage ratios. As shown by the exhibit "The Diminishing Impact of Credit Rating," based on data from Goldman Sachs, the impact of a lower credit rating on a company's market multiple has shrunk sharply over the past five years. Indeed, in 2006 there was almost no difference between the market multiple for companies with debt rated A- or higher (17.4) and the market multiple for companies with debt rated BBB (17.3). The sub regional focus, which seems to be broadly centred on those countries likely to achieve accession to the European Union within the next two or three years, is an important one. This is because for investment opportunities to become completed transactions stability and predictability of the domestic economy and its infrastructure is required and those elements are often lacking outside the accession countries. The situation within the accession countries is not perfect, however. (Bray,1997) Economic and infrastructure stability - as benchmarked by Western European standards - is a process that has gathered momentum among the accession countries in the last couple of years. In Poland, for example, some 200 new laws were passed last year to further bring it in line with European Union law. This proactive and time consuming process has been necessary because Central European countries tend to operate under the rule of law i.e. if something is not specifically allowed, you cannot do it. As opposed to Anglo-Saxon law, which takes the view that what's not illegal is possible and consequently financial and regulatory law can be a mixture of the reactive and retroactive. (Jorion, 2000) Central Europe is certainly a land of private equity opportunity but infrastructure issues will temper the resulting deal flow and as such it's difficult to imagine that the flood gates holding back private equity investors are about to open. For one thing the majority of European and American private equity investors are fully occupied by their expansion activities in continental or northern Europe and for another it's difficult to imagine that raising a fund to invest in the region would be easy (Bray,1997). The majority of limited partners have seen write downs on their investments in recent months and many will be unwilling to back Central Europe when the better understood economies of continental Europe offer plenty of opportunity. Given this backdrop new entrants are unlikely to get credible backing unless, at the very least, they have a considerable track record of investing elsewhere. If getting into this market is a problem, exiting investments can be equally tricky. This restricts the number of viable investment opportunities since, as a rule of thumb, the investment will be sold to an international, rather than domestic, trade buyer. IPOs are not really a reliable option given the instability and/or illiquidity of many of the region's stock markets. However, the Polish stock exchange may provide an exit for Poligrafia - see boxed item. Poland is unique in this sense. As George Swirski, director at Advent International, points out private pension funds in the country are creating domestic pools of money that have fund managers, and therefore shareholders, looking to maximise their returns. Given the five per cent limit on overseas stock holdings, as these cash pools grow they will act as a driver for the Warsaw stock exchange (Bray,1997). Some company executives make a further argument against taking on more debt. They point out that a company is much less diversified than a private equity fund, which owns many firms, and therefore high debt levels are riskier for the company. But this perspective is too parochial; the proper viewpoint is that of the company's shareholders. Since they can hold stocks in a diversified portfolio of public companies, shareholders can adjust their aggregate exposure to leverage to whatever level they wish. Other executives argue that during the past few years private equity has enjoyed a particularly favorable era of low long-term interest rates, which has now passed. But interest rates change rapidly and will again become favorable, so directors need to examine their capital structure on a regular basis. The appropriate degree of leverage for a public company is seldom obvious. To discover it, the company's directors should insist on a careful empirical analysis of various combinations of debt and equity to arrive at the lowest weighted after-tax cost of total capital, including debt and equity In public companies, by contrast, many capable candidates with industry expertise do not qualify as independent because they have substantial ties to competitors, service providers, large suppliers, or customers. Thus, the independence requirement reduces the size of the pool available to public companies of potential directors with skills needed to increase company value. Most distinctively, the expert directors recruited by private equity spend much more time on company business than do the directors of public companies. The boards of public companies usually meet six times a year with each meeting lasting a day and a half on average. Add to that the time public directors spend on review of materials, travel to meetings, and conference calls between meetings, and the total time spent on company business by public directors ranges from 132 to 183 hours a year, according to various surveys by search firms. Smaller public companies in one line of business, even those not facing threats of immediate takeover, should consider switching to the private equity model of a small board composed of retired industry executives paid primarily through stock options. These are the companies that have the most trouble recruiting and paying for directors, with their heightened concerns about personal liability and the increased board time devoted to compliance procedures. At the same time, because these companies are operating mainly in one line of business, expert directors willing to make a substantial time commitment can make significant contributions. In other words, these are the companies where the small expert boards have proved effective for private equity. CONCLUSION In conclusion, despite all the weaknesses of publicly held corporations, stock markets will continue to be the main sources to raise capital either to expand business of to release wealth but its role will be shared by Private equity market. Also, studies have shown that although the employment levels deep initially after the buy-outs, they continue to rise after that and that employment growth is higher for Private Equity's buy-out after the change in ownership than in companies that have not experienced a takeover. These findings are inconsistent with the popular nation that PE acquisitions have negative effects of the job market. Finally, tax allowances on PE buy-out have negative consequence on the domestic economy but they should be given to long-term investments, new ventures and small business. Private equity is here to stay, though, if the past is any indication, the current overheated venture market may cool off unpredictably. In buyouts, strategic corporate investors have been bidding up the prices of prospective acquisitions, making it more difficult for financial investors to find good deals (Bray,1997). Based on their announced policies, endowments, investment banks, family offices, large corporate plans and some public plans will continue to be major participants. They have the staff, resources and market clout to invest directly in individual deals, companies and partnerships. Smaller participants (and this includes all but the very largest Taft-Hartley plans) have fewer options. For them the safest approach is to go the fund-of-funds route. But for all its attractions, there are several reasons why private equity may not be suitable for many Taft-Hartley plans. We list five, in no particular order: 1. Even if the trustees are willing to invest in illiquid assets, many may feel more comfortable with real estate, which has more tangible assets and can be expected to throw off cash income. 2. The foreign component of many private partnerships poses a major policy issue, one that is probably insurmountable for plans that don't permit even publicly traded foreign securities. 3. Many trustees may object to the high fees involved. 4. Trustees may not wish to invest in an asset class when there is no assurance that one will have access to the best deals, especially when the downside risks are so high and the investment cycle is seven to 12 years. 5. Illiquid investments such as private equity take much more time to supervise and therefore may consume a disproportionate amount of trustees' time relative to their percentage of plan assets. (Gompers, 2003) REFERENCES "Report on Alternative Investing." Goldman, Sachs & Co. and Frank Russell Company, 1999. -----. "Managed Pricing and the Rule of Conservatism in Private Equity Portfolios." The Journal of Private Equity, vol 5, no. 2 (Spring 2002), pp. 18-30. -----. "Maximizing Expected Utility with Commodity Futures." The Journal of Portfolio Management, Summer 1999. -----. "Money Chasing Deals The Impact of Fund Inflows on the Valuation of Private Equity Investments." 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Wright, M., Burrows, A., and Scholes, L.,(July 2007). Private Equity and Buy-outs: Jobs, Leverage, Longevity and Sell-offs. Centre of management Buy-out Research, Nottingham University Business School, UK Read More