Private equity found not to contribute to boom & bust after all

Private Equity 03 Mar 2010

By: Konstantin Danilov, CAIA, Editorial Board

There has been a lot of debate about the social and economic impact of private equity in recent years.  For example, the third paper in the World Economic Forum’s Globalization of Alternative Investments working paper series provides some interesting insights into the macroeconomic impact of private equity. The project – launched in 2007 to provide a “fact-based look” at the global impact of private equity – brought together a team of international scholars to conduct extensive research on the subject.

The paper sets out to answer the following question: does the presence of private equity investment affect the growth rate and cyclicality of the industry where the investment is made? The research focuses specifically on private equity’s impact on productivity, employment and capital formation growth in the industry. The findings are positive, which is good news as private equity continues to face heavy scrutiny from public officials and regulators.

Wait.  Greed is Good…

Contrary to the media-driven belief that private equity is a destructive tidal wave of greed and financial leverage, the research finds evidence that private equity investment actually provides a societal benefit. According to the report, industries where PE funds have been active in the past five years have higher growth rates than other sectors, whether measured by total production, value added or employment levels (click to enlarge).

To those who understand (and believe in) the private equity model, this should not come as a surprise. In theory, private equity increases the operational efficiencies of portfolio companies by employing the carrot and stick method of equity incentives and high leverage; this appears to be sufficient motivation for lackadaisical managers. In turn, companies that compete with PE-backed firms face competitive pressure – not to mention the threat of a takeover – which leads to overall industry growth. And despite initial layoffs as a result of cost-cutting efforts at PE-backed firms, the subsequent (improved) growth in production should lead to overall employment growth within the industry.

Virtuous Cycle

The more interesting finding is that PE-saturated industries are no more cyclical than other industries; in fact, they may be less volatile, especially in terms of employment. Cyclicality is inherent in private equity: The availability of cheap credit drives the number of deals and valuation levels – just look at what happened in 2007. Thus, we would reasonably expect that this cyclicality carries over into the PE-saturated industries: Higher leverage employed by PE-backed firms forces their competitors to over-leverage also to keep pace.

The apparently counter-intuitive finding – that industries with high levels of private equity investment are no more cyclical than other industries – can potentially be explained by a combination of factors:

  • Concentrated shareholder base: Unlike their counterparts, private equity backed firms can rely on a concentrated and focused shareholder base that can provide equity financing during economic downturns.
  • High debt levels: Higher leverage forces firms to respond more quickly and effectively to negative business shocks.
  • Favorable creditor structure: Funds lock-up LPs for 10 years, and portfolio companies are financed without recourse to the overall fund or other portfolio companies; hence, the funds have no short-term creditors that tend to simultaneously withdraw capital during times of stress.

Employment volatility in PE industries – or the less than average occurrence of it – can probably be explained by the aforementioned factors as well.

But what about LPs…?

The researchers focused extensively on controlling for reverse causality in their experiments – it does not appear that private equity funds can predict which industries are poised for growth. It is rather the investments that have the causal effect on the industry, not vice versa.

Overall, the report makes some interesting conclusions about the positive impact of private equity at the macroeconomic level. Many champions of the private equity cause have long proclaimed that the industry provides tangible economic benefits to society, and now it seems they have proof to back it up.

Despite the apparent benefits of private equity for industry growth, the overall aggregate returns for the average LP remain less than stellar. Investors in a handful of funds capture most of the gains, while the rest of the industry muddles along providing below-market returns for above-market risk. To paraphrase a well-known endowment manger, if you take into account the leverage and illiquidity of buyout funds and the returns the average investor gets for bearing that risk, buyout funds should not exist. The next WEF working paper should focus on how investors can capture the economic gains that accrue to private equity funds.

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