Private Equity
Before the global credit crunch hit the markets in mid-2007, newspapers and news channels on television were full of stories about another fascinating multi-billion private equity (PE) deal. More and more companies were willing to go private.
After the bursting of dotcom bubble in March 2000, private equity became the fad in the global financial system. For the past several years, PE funds have created ripples across the global with their multi-billion dollars buyouts.
Private equity is no longer a ‘niche’ business. In the initial years, private equity business remained small and fragmented. But over time, it developed its own distinct characteristics and dynamics. In the last two decades, private equity firms have moved from periphery to the centre of global finance capital.
Some of the well-known companies and brands (such as Burger King, Jimmy Choo, Toys "R" Us, Dunkin' Donuts, Polaroid, The Automobile Association, Coles and Debenhams) are now owned by private equity firms. Private equity firms have increasingly become the employer of choice for politicians, senior government officials and celebrities.
The dramatic rise of PE firms has also widened the schism between its supporters and critics. The supporters of private equity firms would crown them as the “new kings of capitalism” while critics would label them as “locusts” or “barbarians.”
What is Private Equity?
Private equity is a broad term used to define any type of equity investment in an asset or a company that is not listed on a public stock exchange. Therefore, the purchase of shares in a company is privately negotiated. The shares of a company could be acquired through the sale of existing shares by shareholders or private placement of new shares.
Private equity covers a wide range of investment opportunities, including early stage investment (angel investors), take off (venture capital), mid-growth investment (mezzanine finance), later stage (private equity), distressed debt financing and others. Private equity encompasses a wide spectrum of investment vehicles from angel to leveraged buyouts. Because of heavy dependence on leveraged buyout to raise money, a private equity fund and a buyout fund have almost become interchangeable in the US and Europe.
Private equity funds are the pools of capital invested by private equity firms. Predominantly Limited Partnership is the legal structure used by private equity funds. The partnership consists of a General Partner (the management firm which has unlimited liability) and Limited Partners (the investors, who have limited liability and are not involved with the day-to-day operations). The General Partner receives a management fee and a percentage of the profits while the Limited Partners receive income, capital gains and tax benefits. The Fund raises money from a variety of outside investors such as pension funds, investment banks, university endowments, financial institutions and wealthy individuals. Since private equity funds are generally less regulated than other funds (such as mutual funds and pension funds) and therefore considered very risky, they are only offered to big institutional investors and wealthy individuals. In the US, for instance, most private equity funds require potential individual investors to have $1 million of net worth (exclusive of primary residence), $200,000 of individual income, or $300,000 of joint income (with spouse) for two years and an expectation that such income level will continue. However, the involvement of pension funds, university endowments (for instance, $34 billion Harvard University’s endowment) and sovereign wealth funds in PE businesses means that a significant amount of money flowing into such businesses globally is “public” in nature and therefore can generate a very different power dynamic and outcome.
Does Private Equity Matter?
The answer is an affirmative ‘Yes.’ Private equity is a cross-cutting horizontal issue given its strong linkages with global financial system, labor rights, public interest, taxation, corporate governance and public services.
If private equity firms are to be ranked in terms of their annual revenues, several PE firms would rank in the top 25 global corporations. The biggest five private equity deals involved more money than the annual budgets of Russia and India. Some executives of PE firms earn billions of dollars in fees and profits often at the cost of workers and the companies they buy and sell.
With many big private equity firms joining hands and owning a large number of businesses across the world, a new type of corporate conglomerate has emerged which is reshaping the way business is being conducted. Unlike traditional owners, private equity firms have no long-term stakes in their portfolio companies. The so-called ‘invisible’ PE owners are least interested in improving the output, productive capacity and launching of new products and services. The PE owners also desist investing in new machinery, training, research and development as cash is diverted into debt repayment, fees and dividends. Nor do they recognize labor rights and honor collective bargaining agreements built up through decades of union struggle. For PE firms, every investment is essentially a portfolio of financial assets which could be moved from one company to another.
PE has become an integral component of the world’s financial system and therefore should be viewed in the wider context of financialization of the economy. In many countries, PE buyouts are not legally considered as a change in ownership affecting industrial relations. In such situations, the PE owners portray themselves as ‘shareholder’ rather than an ‘employer.’ This poses new challenges to labor unions, NGOs and community groups while dealing with these new forms of corporate ownership and power.
2006 was a record year for private equity firms both in terms of fundraising and investments. According to the Thomson Financial, a data firm, PE firms carried out more than $664 billion of corporate buyouts in 2006.
A Few Players Dominate the Global PE Business
Though there are more than 2700 PE firms globally, only a handful of large firms dominate the business. Blackstone Group, the Carlyle Group, Bain Capital, TPG Capital (formerly Texas Pacific Group) and Kohlberg Kravis Roberts & Co. (KKR) are the five largest PE firms. The funds raised by these five firms are huge and they together manage assets worth hundreds of billions of dollars. Their influence over the real economy can be gauged from the fact that these five PE firms control companies that employ more than 2 million workers. While the top 20 PE firms control companies that employ nearly 4 million workers.
The Blackstone Group, which started as a two-man team from a single room, now has close to 350,000 employees at its acquired companies worldwide. Whereas, more than 500,000 employees work at KKR-controlled firms. Since its establishment in 1976, KKR has completed more than 160 private equity transactions with a value of more than $400 billion. Of late, KKR is venturing into other businesses including hedge funds, real estate, infrastructure and debt financing.
There are numerous instances of buyout firms downsizing workforce, slashing welfare and not honoring existing collective agreements between the workers and management.
Unlike publicly listed companies, private equity firms and the companies they own are shielded from the glare of public attention and accountability. As a result, PE firms are not legally bound to disclose information about their own operations as well those of the companies they invest and buy. One of the negative consequences of making a company private is the complete elimination of shareholder activism to influence company’s disclosure and other practices. For almost two decades, campaign groups and institutional investors have used shareholder activism to seek out more information from the public-listed companies.
For corporate researchers, seeking information about the operations of private equity firms is a nightmare. Unlike public-listed companies which are leally bound to disclose certain business information and practices, PE firms are not legally bound to disclose information about their own operations as well those of the companies they invest and buy.
Besides, PE firms fund buyouts with unsustainable levels of debt through the leveraged buyout financing model which in turn poses systemic risks to the entire financial system. The current sub-prime mortgage crisis has revealed the inherent risks involved in LBO financing model extensively used by PE industry. Further, PE firms can also easily load risk to the target company given their legal structure of limited liability. This has negative implications for lending institutions and financial system as a whole.
In addition, there are serious concerns related to the impact of PE investments in public service sectors (such as hospitals and water supply) given the short-term management behavior of PE firms. Large regulatory gaps and loopholes, tax arbitrage and widespread use of offshore entities and transactions are other important policy issues which are central to the debates on PE business model.
Furthermore, with several big private equity firms joining hands to buy a target company, the significant flow of price sensitive information creates considerable potential for market abuse.
It is also important to emphasize that private equity has strong financial linkages with hedge funds and sovereign wealth funds (SWFs). Many of these linkages among them are structural so they also reinforce each other in myriad ways. For instance, several state-owned sovereign wealth funds are increasingly getting involved in the private equity business. The Temasek Holdings of Singapore is a shining example of this trend. Temasek Holdings is a sovereign wealth fund owned by the Government of Singapore but its investment strategy is private equity. It is the largest private equity investor in India.
The development finance institutions [such as International Finance Corporation (IFC), Asian Development Bank (ADB), European Bank for Reconstruction and Development (EBRD), FMO and German Investment and Development Company] are also committing substantial money to PE funds. The ADB, for instance, invested in 75 PE funds with a combined value of $900 million between 1983 and 2007.
The Asian financial crisis in 1997 provided the opportunities for PE funds to enter the region. In particular, PE funds bought distressed assets, particularly in the banking and financial sector, in Thailand and South Korea.
The first infrastructure fund in Asia was established by US-based Emerging Markets Partnership in 1994. In the aftermath of Asian financial crisis, infrastructure funds disappeared and did not return until 2003 when Australia-based Macquarie Bank initiated a infrastructure fund in collaboration with South Korea-based Shinhan Financial Group.
Of late, Asia has witnessed the mushrooming of home-grown PE funds which receive money from high-net-worth-individuals, sovereign wealth funds, local governments, banks, corporate and private investors in the region and outside.
In the aftermath of sub-prime crisis in the US in mid-2007 and the subsequent squeeze in the global credit markets, a slowdown in the pace of buyout deals by PE firms is imminent.
Private Equity Investments in India
Since 2004, India has emerged as one of the biggest centers of private equity investments among emerging markets. There are more than 100 PE firms already operating India and some the biggest firms including Blackstone, the Carlyle Group, Warburg Pincus, KKR, Temasek Holdings, 3i and Citigroup have already started their operations in India. Many big PE firms treat India as a “key hub” in their Asian investment strategies. Lately some big PE firms have also launched India focused funds which are mandated for investment in Indian companies only.
Although India liberalized its investment regime for private equity as early as 1989, it was only during the end of 1990s that PE investors showed keen interest in the Indian markets. Since the liberalized regime in the initial years was geared towards IT sector, much of PE investments were in the form of venture capital to help start-ups in this sector. However, PE investments underwent rapid transformation in India in the mid-2000s.
There are several reasons behind the growing allure of PE investments in India. Firstly, the Indian authorities have recently opened up a number of sectors to foreign investments which gives greater market access to PE funds. For instance, foreign investment limits in telecom sector have been enhanced from 49 percent to 74 percent. In the retail sector, 51 per cent FDI has been allowed in single brand products. Besides, 100 per cent foreign investment has been allowed in a wide range of infrastructure sectors such as the development of new airports, laying of natural gas pipelines, petroleum infrastructure, mining, and development of townships.
Secondly, a substantial number of Indian companies are unlisted in the stock markets which become an easy prey for PE firms. Thirdly, due to increased competition from foreign companies, many Indian companies are ready to exit businesses which do not fit in their future strategy. This provides an excellent opportunity for PE firms to come in.
Fourthly, PE firms are facing tough competition and dwindling returns in their traditional markets (US and Europe) and therefore are looking for alternative investment markets.
Infrastructure, financial services and real estate are the dominant sectors which have received the bulk of private equity investments in India.
Private Equity and Extractive Industry
The high levels of secrecy maintained by PE industry makes it difficult for outside researchers to find out the exact involvement of PE industry in the extractive industry. Also it is difficult to assess whether the acquired company is violating labor, health, competition and environmental regulations. The complex investment processes and structures used by PE firms make the task further difficult for corporate researchers to present a credible assessment about their operations.
Much of financial information about PE funds and their buyout companies usually come from media reports or passive investors in PE funds such as pension funds and investment banks which regularly disclose financial information as part of statutory reporting requirements in their home countries.
Traditionally the private equity firms have shown little interest in the mining and other extractive sectors because these sectors being not perceived as appropriate for financial buyers.
However, the recent trends indicate that this sector offers a timely opportunity for private equity firms. The reasons why this sector is becoming attractive to private equity are obvious. The mining industry is currently enjoying a sustained boom. The M&A deals reached US$68 billion in 2006 from US$16 billion in 2004. Each day metal and mineral prices are hitting record highs. Internationally, metal prices have increased substantially since 2005, with nickel and lead hitting record highs in early 2007 and tin enjoying a 22-year high. The prices of copper and aluminum have also experienced record highs. Despite higher prices, there is no let up in the international demand for metals and minerals. The mining industry has seen net profits rising by 64 per cent and return on equity reaching 33 per cent in 2006.
Another major factor which attracts PE industry is the fact that the higher prices are creating predictable and secure cash flows for mining companies. To finance a deal with debt, private equity firms generally prefer businesses with regular cash flows. Some big international mining companies are sitting with large cash surplus in their balance sheets. The extractive industry also offers relatively low debt and cheap stock market valuations. Besides, this sector provides ample exit opportunities including initial public offerings (IPOs).
The year 2007 saw the first move by PE investors in the mining sector. In Australia, the proposed takeover of Consolidated Minerals was financed by private equity investor Viktor Vekselberg and coal giant AMCI. Another PE-backed buyout was recently carried out by HG Capital of Mondo Minerals of Finland.
Till date, however, no private equity fund has gained a key stake in any of the world's major mining companies. But various market and media reports indicate that buyout firms are interested in buying a number of big international mining conglomerates including BHP Billiton (BHP) [the world’s largest mining corporation] and Alcan. To some, this may sound astonishing because these mining conglomerates are typically perceived as the acquirer not the acquiree. However, with so much money in the hands of PE firms, such big-ticket acquisitions cannot be ruled out.
Some market reports also suggest that China's leading steel company, Baosteel, backed by the country's sovereign wealth fund (CIC), might make a counter bid for Rio
Tinto, another mining giant, in order to block attempts by BHP to takeover its closest rival. However, the Chinese authorities have denied such reports. Industry analysts have voiced strong opposition to the proposed merger between Rio Tinto and BHP Billiton on the grounds that such a merger would a near monopoly over global iron ore
supplies.
Besides, the PE industry may also targeting junior and mid-tier mining companies from Canada and Australia. The extractive industry analysts indicate that given the severe credit crunch, private equity investments may focus on less-risk-intensive and growing downstream stream of mining (such as recycling plants and refining operations and services businesses) in the coming years instead of core assets. However, the biggest competition to PE firms eyeing buyouts comes from the mining industry where big companies themselves are aggressively bidding for buyouts of their own industry players.
A recent paper by Stephanie Fried looks into "Alternative Investments and Secrecy Jurisdictions" (pdf) and looks into how hedge funds and private equity works.
