Private Equity: Part of the Crisis or Part of the Solution?Published: January 12, 2011 in Knowledge@Wharton
Panelists at the recent Wharton Private Equity and Venture Capital Conference considered whether private equity (PE) was a key contributor to the financial crisis -- or a scapegoat -- and also looked at what role it might play in a recovery. Some argued that if the reputation of PE was damaged, it was largely as a result of miscommunication with the public rather than any serious flaw in the model. Others felt PE insiders needed to reassess their practices in order to be an effective part of an economic recovery.
In the wake of the global economic collapse, the past and future of PE investments were the topic of a conference panel titled, "Alternative Investments: Strategies for the Future." Moderator Mark O'Hare, founder and managing director of Prequin Ltd., with offices in London and New York, began by asking panelists whether they believe that PE was at the root of the economic crisis or will be part of a solution to problem.
"To some extent, private equity is a scapegoat," said Chris Ip managing director of private equity at the University of Pennsylvania's Office of Investments. "When they look back maybe some of the deals were excessive in terms of leverage, but the banks were the ones that signed off on it and the rating agencies have some fault as well. No doubt private equity got ahead of itself, but to blame private equity for where we are today is a little bit unfair."
Ip said PE can help revive the economy. "But it's not that simple," he continued. "There are a lot of other constituents and stakeholders that need to step up. Bankers need to step up. Lenders need to step up. And regulation needs to balance between helping and curtailing recovery. In the right circumstances private equity can be a solution or at least part of the catalyst to change."
Garrett Moran, senior managing director and chief operating officer of corporate private equity at The Blackstone Group, said the PE model allows companies with well-aligned management, boards and investors to make decisions to acquire firms quickly and with a "crystal clear agenda. That's why public company managers clamor to come to private equity." Managers backed by PE can add value to companies through strong execution and focus. Problems in the leveraged buyout industry stem from a misalignment in governance throughout the industry, he said. The main problem is a systemic separation between loan originators who were in the business to collect fees and banks that would hold the debt longer term. "That was a moral hazard in the buyout business, but it was a problem 100-fold in sub-prime lending," according to Moran.
David Ingles, a partner at the New York City law firm Skadden Arps Slate Meagher's financial institutions group, said that in the past two years PE has been increasing its position in the financial sector dramatically. "We think private equity is part of the solution." He said his group is working to bring badly needed new investment to the financial industry, but finds firms are fearful that regulators will introduce structural changes that will alter deals two or three years from now.
A Communication or Over-leverage Problem?
O'Hare asked if PE has done a good job of communicating its value to the economy, given the criticism it has faced as a result of the crisis.
Moran noted the industry has formed a lobbying organization, the Private Equity Council, to spread more information about the asset class and improve its image. He said it is difficult for "the average newspaper reader" to understand the structure and role of PE in the economy. The industry organization has struggled with whether to focus on getting its message across to a broad audience, or to concentrate its message on "influencers." So far, he said, the industry has targeted politicians in Washington, D.C. and regulators. He noted that some labor organizations have blamed private equity for the economic problems their members are experiencing.
"We need to get out there and tell our story," he said. "I would say we get a C-minus so far."
Sebastien Burdel, a principal with Coller Capital Investment, which has offices in London and New York, said private equity has to "look in the mirror and admit we did over-lever and as a result overpaid. The benefit fell to the seller, not the buyer. That said, I would agree we are bound to be part of the solution," he continued. "Forget about leverage; what private equity is all about is taking an asset out of the public, short-term focus and allowing you to be more opportunistic."
He predicted that private equity-backed companies will grow at a faster pace in 2010 than the Standard & Poor's index, "because management can be focused on taking the right actions at the right time."
O'Hare said there seems to be two opinions emerging on the future of private equity. The first is that the model is broken. He pointed to a Boston Consulting Group study that estimated up to 40% of private equity firms would close down in the next several years. On the other hand, private equity returns over the past 12 months are relatively good. "Most investors, even if they can't invest right now because of constraints, are by and large pretty satisfied. Even if they can't commit new investments they are sticking with the program."
Burdel's firm conducts the Coller Capital's Global Private Equity Barometer of investor attitudes toward private equity. In December, the survey found that about 70% of private equity limited partners planned to keep their investment the same. Twenty percent planned to increase their allocation and 10% expected to decrease their exposure to the category. Burdel added that investors are ratcheting down their expectations for private equity returns to where they were about five years ago. "If you ask me that's healthy," Burdel noted. "I'd say limited partners are cautiously optimistic about the asset class. They will be more selective about the reputation and allocation to management but that is healthy and sets up the industry for a darn good future."
Moran said his firm is raising a fund now and small limited partner investors are re-upping. He said that over the past 100 years, private equity outperformed stock markets and top performing firms consistently outperformed the median. "The other thing that's documented," he continued, "is that the best returns are always in the years right after a recession. Deal volume is not necessarily the highest, but the best returns are then."
O'Hare picked up on the theme of asset allocation and asked whether investors are sticking to rigid models that set hard percentages for private equity investments. "It seems to me the more sophisticated institutions are taking a more pragmatic view and there are no set buckets of assets," he added.
Ip said that for long-term investors, like university endowments, private equity will continue to be part of the asset mix. "In the short-term, private equity is not the flavor of the month," he said, "but it's a long-term game and we intend to be in the asset class a long time."
O'Hare asked Ip whether limited partners feel their interests are in alignment with private equity managers. Ip said limited partners do pay attention to alignment issues, particularly how much of the fund's revenue base is derived from capital accumulation and how much comes from fees. "When it comes to alignment I would put it at a C plus -- there is certainly room for [more] alignment," according to Ip.
Burdel said limited partners will pay for performance regardless of whether the deal is structured in the American-style with "carried interest," or profit sharing, going to the general partners earlier than in Europe, where typically all committed capital plus a hurdle return rate needs to be returned to the limited partners before any carried interest is paid. "All these terms are negotiable," he pointed out. "There's a pendulum that's swinging depending on demand between general partners and limited partners. It will keep swinging back and forth as long as there are business negotiations."
Three or four years ago, the industry talk was about getting access to funds and investors didn't care much about the terms. Now, in the wake of the financial crisis, the pendulum has swung in the other direction and limited partners are focusing on terms "because they can," Burdel added.
The Value of Operations
O'Hare then asked the panelists how much of the industry is based on leverage, or as private equity professionals insist, their superior ability to manage portfolio companies. "Is that the reality or is lip service when you talk about operations?" he asked.
Moran replied: "I think leverage is great but it is only for adults and should be closely supervised." He said Blackstone will continue to raise large funds but they will be closer in size to those that the firm managed before the boom years. [Blackstone announced a successful $280 million initial public offering on May 27. The Blackstone/GSO senior floating rate term fund's "primary investment objective is to seek high current income with a secondary objective of preservation of capital, ..." according to the company.] As for operations, he said that in the last six or seven years Blackstone has developed its own internal infrastructure to improve operations at the companies it acquires. In addition, the firm has increased its global footprint providing expert staff in parts of the world that provide new access to investors and potential acquisitions.
Moran used the example of the Nielsen Company, which was acquired by a group of large private equity firms, including Blackstone, in 2006. The private equity owners installed a CEO from General Electric. Moran said customers liked Nielsen's services so much they were "addicted" to some of them, but that delivery was sometimes "helter-skelter." The new owners consolidated operations, such as human resources and purchasing, but went beyond those quick fixes to drive a lean initiative throughout Nielsen's organization, eliminating excess layers, processes and people. "They had a great product but had become lazy," he said. "There are a lot of companies out there like that."
O'Hare said financial services appear to be the biggest opportunity for private equity in the economy at the moment and asked Ingles about obstacles to expansion in the sector. Ingles said private equity firms are expressing interest in the financial sector because there are many failed banks and bank deals in need of finance and restructuring. Pricing, he noted, is at a cyclical low in the financial services sector.
"Private equity firms that are able to get in and make good decisions, notwithstanding the limitations of the bank regulatory structure, and put some strong management in, can make a lot of money," according to Ingles.
He cautioned that private equity firms must be mindful of regulations governing the ownership stake of banks. Investors are limited to a maximum of 25% ownership of voting equity in financial institutions. If they go over that amount, they are considered to be a bank holding company and are prohibited from owning anything other than banks. "Private equity is much more diversified than that so to cross that line would be disaster," Ingles said. "Private equity firms have to be careful to remain in a neutral position."
O'Hare then asked the panelists what other industries might provide opportunities for private equity in the future. Ip said energy and natural gas investment might be interesting, but he said he is not a fan of [investing in] clean technology. He said his office prefers to put capital into areas where others have done well and are expanding markets. "It really is about a good management team and sometimes it depends on the cycle. In the right opportunity, private equity can work in most industries," he said.
Moran said that while most conventional funds have extended into more esoteric areas such as energy and finance over time, clean technology remains more "venturish." His firm has done lending to support a business launch in energy although it has not backed any clean tech. However, he said partners are looking into the power and forestry industries.
Burdel said firms can weigh liquid against illiquid investments in hedging risk. "It's a great opportunity for private equity managers to compete against each other with the same risk portfolio," he said.
Moran finished up the panel noting a trend at his firm of seeking out opportunities by blending investments in sectors that might not appear to be linked. For example, he said, Blackstone now operates a real estate investment fund that was once part of its corporate business. Now the firm is looking at companies with real estate assets in addition to their core business, such as nursing homes and hospitals. The company shied away from movie theaters when the real estate partners warned that repurposing those assets would be impossible.
He also noted that the corporate investment team worked with the firm's credit arm in structuring its acquisition of The Weather Channel. They provided the credit and Moran's team came up with the equity. "We do a lot with real estate and credit," Moran said. "It gives us the ability to do other things and gives us an internal fraternity of people that makes it more fun to work there. Looking at combined private equity and real estate investing is better than either standing on its own."