A Closer Look at Private Equity
October 19, 2006
The role of private equity in global capital markets has expanded at an extraordinary rate. Morgan Stanley estimates that there are now some 2,700 private equity funds that either have raised, or are in the process of raising, a total of $500 billion. With this abundance of available equity capital, the willingness of private equity firms to participate in “club” deals, and the leverage that can be put on top of the equity, private equity buyers now appear able and willing to pay higher prices for assets than ever before. And thanks in part to this new purchasing power, private equity transactions now reportedly account for a quarter of all global M&A activity (in terms of total transaction value) as well as a third of the high yield and IPO markets.
The stock of capital now devoted to private equity reflects the demonstrated ability of at least the most reputable buyout firms to produce consistently high rates of returns for their limited partners. Although a talent for identifying undervalued assets may be part of the story, the ability to produce such returns on a consistent basis implies an ability to add value and to improve the performance of the operating companies they invest in and control.
In a recent roundtable discussion hosted by Morgan Stanley and the Journal of Applied Corporate Finance, a small group of academics and practitioners addressed two main questions: How does private equity add value? And, are there lessons for public companies in the success of private companies?
According to the panelists, the answer to the first question has changed somewhat over time. The consensus was that most of the value added by the LBO firms of the 1980s was created during the initial structuring of the deals, a process described by the University of Chicago's Steve Kaplan as “financial and governance engineering” that includes not only aggressive use of leverage and powerful equity incentives for operating managements, but active oversight by a small, intensely interested board of directors.
In the past ten years, however, these standard LBO features have been complemented by increased attention to “operational engineering,” to the point where today's buyout firms feel obligated, like classic venture capitalists, to acquire and tout their own operating expertise.
In response to the second of the two questions, former Harvard professor and corporate governance authority Michael Jensen argues that much of the approach and benefits of private equity-particularly the adjustments of financial policies and stronger managerial incentives-can be replicated by public companies. And although some of these benefits have already been realized, much more remains to be done. Perhaps the biggest challenge, however, is finding a way to transfer to public companies the board-level expertise, incentives, and degree of engagement that characterize companies run by private equity investors.To learn more on recent trends in the private equity markets, the featured topic of the current issue of the Journal of Applied Corporate Finance, click here.