Over the course of the past eighteen months, there has been high pitched criticism of private equity organisations around the world. In Germany, politicians have assailed private equity firms as “locusts”. Oregon regulators last year refused to sell Portland General Electric to a buyout firm concluding that it was not in the public interest to do so. And Britain's Financial Services Authority recently announced that that it will increase its scrutiny of private equity firms and the banks that deal with them because it fears the collapse of a large buy out is now “inevitable”.
The myriad of sins attributed to private equity include conflicts of interest, reduction of the efficiency of capital markets, the opaqueness of groups' operations, abuse of inside information and anticompetitive behaviour in transactions involving multiple buyout firms. And that's on a good day.
REMEMBER THE 80s?
The Washington pros who have accepted the assignment to spearhead the Private Equity Council should take heart that political pressure on the asset class is not a new phenomenon. In some respects, the criticisms of today mirror the wave of controversy that surrounded the pioneering leveraged buyout funds 20 years ago in the US. But in some cases, the intensity of the anger seems to have been augmented by anti-Americanism and fears of globalisation.
Almost 20 years ago the US Congress felt compelled to ‘do something about’ the wave of debtfinanced buyouts and takeovers that were turning corporate America on its head. Punitive legislation seemed almost inevitable in the wake of the legendary RJR Nabisco buyout. Politicians were already roused by a frenzy of buyout activity and fears of an explosion of leverage, massive layoffs, community dislocations, and by accounts of excessive multimillion- dollar fees.
These are days that perhaps we should all remember. Congress back in the late ‘80s was determined to do something – almost anything – about the leveraged deal mania but found answers in shorter supply than indignation. The creative lobbyists for the Business Roundtable came up with an argument guaranteed to not only get Congress mad, but also give them ammunition to do something once and for all about LBOs. The argument was that the US Government – at a time of huge deficits, tax hikes and programme cutbacks – was providing gigantic subsidies to buyout artists through a quirk in the tax code. The answer: get rid of the tax deduction that acquirers enjoyed on the interest they paid on their borrowed funds.
This was serious. Takeover activity ground to a halt. Any sensible private equity firm assumed a low profile for fear of throwing fuel on the fire. But some of the most important firms became active on another front – government relations. Henry Kravis, Joe Rice, George Roberts, and Martin Dubilier – the most fiercely entrepreneurial and anti-political bunch you could ever imagine – began a coordinated push to reposition the battle that pitted Main Street against Wall Street. It was perhaps the first unified effort undertaken by the private equity industry.
The leaders of the industry's top firms recognised the importance of telling a more positive story and providing corrective context. The repositioning involved making the case that buyouts were the driving force for constructive change in the US economy at a time when the nation's competitiveness was in jeopardy. Remember, it was a time when Japan's star was still in its ascendancy.
Studies were commissioned. And academics like Michael Jensen of Harvard Business School made a real impact by writing about the positive reality of buyouts. Partners at private equity firms testified before Congress and used data to document that in stark contrast to public perceptions buyouts revitalised undervalued, poorly managed companies into global competitors. Not only was shareholder value boosted, they argued, but portfolio companies increased productivity and operating profits without cuts to R&D, capital spending and employment.
The essential difference between public and private equity is not a matter of privacy, but a matter of active versus passive ownership
Importantly, the industry also successfully challenged the view that buyouts hurt US tax collections, arguing that the capital gains realised by their firms generated tax revenues well in excess of the tax revenue associated with an LBO company in any given year. KKR estimated that their buyouts at that time generated $2 billion more in taxes for the US government.
The point is that the political debate was successfully recast away from the extreme position of Byron Dorgan, a member of the Ways and Means Committee, who famously characterised junk bonds as the “evil engine driving destructive hostile takeovers and lining the pockets of dealmakers” to a debate over the value of buyouts to the economy.
The campaign demonstrated that by changing the tax code Congress risked doing more harm than good. As one lawmaker observed about the proposed interest deduction cutback: “If you thought the problem was bad, wait till you see the solution.”
It's not every day that politicians recognise the error of their ways. The evidence that the buyout firms assembled was sufficiently compelling to persuade lawmakers that buyouts were facilitating the much needed corporate restructuring that would improve US competitiveness.
How does this relate to the mission of the Private Equity Council today? And what should its priorities be?
The sheer scale of global private equity today carries with it, if not the actual seeds of excess, at least the perception of excess. High profile transactions that focus exclusively on investment size and the amounts of money made by private equity groups have sparked storms of political criticism. To the average person, private equity is dark and mysterious – even more so to political leaders. At least three countries have launched inquiries into private equity in the last few months, wanting to better understand how the newly high-profile industry is affecting their economies. Clearly the ingredients are in place for a volatile politicallydriven public relations struggle – one that is unfolding in multiple jurisdictions around the world.
The first priority should be to reframe the debate as the buyout pioneers successfully did. Surprisingly, much of what is written about private equity today even in the most sophisticated business media reflects a fundamental misunderstanding about how private equity firms really work, how they are structured and how they operate to enhance the longterm value of the businesses they own. Unflattering characterisations associating private equity firms with locusts, crocodiles and buccaneers need to be replaced by a more fact-based discussion. There is an urgent need for more factual evidence to demonstrate the benefits of private equity similar to the studies from the 1980s.
It is fair to acknowledge, however, two important limitations of those studies. First, the bulk of the research into buyouts focused on transactions in the US and, to a lesser extent, in Great Britain. Second, while the private equity industry has grown and evolved since the 1980s, little research has examined the industry's evolution: almost all the published studies have focused on the industry's initial years.
The paucity of studies on the private equity industry in recent decades, as well as the lack of evidence about the role of leveraged buyouts outside of the Anglo- American nations more generally, underlines the need for a more concerted effort to create a factual context for policymakers, business leaders, financial institutions, the media, and labour organisations around the world.
The Private Equity Council should be more globally inclusive in terms of its membership with the potential of embracing capital providers, pension plans, employee groups and corporate executives
A separate but related priority for the Private Equity Council is an immediate need to broaden its ranks beyond the mega funds to include a cross section of stakeholders. There are a number of constituencies who are deeply affected by the asset class. Steve Schwarzman, chairman of the Blackstone Group and a founding member of the Private Equity Council, has noted that 48 percent of the firm's investment capital comes from state and government pension funds. He also notes that Blackstone-owned companies have created 25,000 new jobs in the last five years. Certainly this suggests that the organisation should be more globally inclusive in terms of its membership with the potential of embracing capital providers, pension plans, employee groups and others, such as corporate executives who recognise private equity's role in facilitating corporate restructuring.
Finally, the Private Equity Council should focus on the broad challenge of repositioning private equity itself. There needs to be more emphasis on “equity” and less on “private”. The essential difference between public and private equity is not a matter of privacy, but a matter of active versus passive ownership. Perhaps the name of the lobbying group itself should be changed to reinforce the structural advantages of the asset class as an engine of constructive corporate change.
Private equity can be an engine of change for conglomerates that are seeking to reorganise and streamline through divestitures of noncore assets. Private equity can be a powerful engine for changing the way people behave and businesses perform, transforming mediocre operations into top tier performers. And finally, private equity has proven to be both a powerful and flexible engine of value creation in a variety of economic and capital markets climates, particularly for those whose investment models are predicated on generating returns from controllable levers, such as operating performance improvements and profitable growth initiatives at portfolio companies.
These are the themes that need broader public understanding and acceptance on a global basis. The stakes are high. Making the case for the value of private equity – not only as a source of superior investment returns, which it is – but also as a catalyst for constructive corporate change and operational excellence, is a message that we cannot afford to let self-destruct in ten seconds.