Their influence on the global economy is increasing, three million of us are working for them in the UK alone, and they have hundreds of billions of pounds to spend in their battle for control of companies that are not already in their clutches.
Welcome to the discreet - some say secretive - world of the private equity firm. The term private equity will fly over most of our heads. But every day we enter the realm of these captains of industry. Bought a new skirt at New Look or Debenhams? Both are owned by private equity firms. A holiday from Saga? A private equity firm owns that company too. Bought some car insurance from AA? Same again. Jon Moulton is the boss at Alchemy in London, one of these private equity firms. "We are the people who run the new conglomerates," he tells BBC Radio Four's In Business. Twenty thousand people work at companies that are in Alchemy's portfolio, and Mr Moulton has real power, both over those companies' destiny and over their bosses. "I can change a chief executive in five minutes," he says. Creating value Private equity firms invest in companies in the early stages of their life and older companies that may be in trouble or are undervalued by other investors. Increasingly, they are buying companies that are listed on the stock market, such as New Look and Debenhams. Woolworths has just rejected an attempt by private equity firm Apax to buy it. The aim for firms such as Blackstone, Alchemy and Apax is simply to sell the companies in their portfolio at a higher price than they bought. The rewards - if the deals work out - can be staggering. The top brass in the industry can pocket tens of millions of pounds. But Richard Sachar, chief executive of Almeida Capital--a company that monitors and advises this industry--warns against seeing private equity firms as just there to fill the pockets of a small group of individuals. The pension funds that invest in private equity firms win too, he says. "Before everyone starts wondering if this industry is just set up to feed the wealth of a limited number of individuals; it does that as a result, ideally, of vast sums of money going to pension funds to benefit pension fund holders," Sachar explains. Deserting the stock market But just how accountable are private equity firms? In contrast to publicly listed companies, private equity firms and the companies they own are shielded from the glare of attention.
Why? Because they are not listed on the stock market and do not have to disclose the quantity or depth of information that those companies must. It is the attention given to their short-term misfortunes that will make public companies give up on the stock market to go private, industry experts say. "Markets... tend to way over-react to very short-term news," Steve Schwarzman, one of the world's biggest dealmakers, tells Radio Four's In Business. Mr Schwarzman is the head of the giant private equity firm Blackstone Group. He thinks stock markets can be an unattractive place for a company to have its home. Internal controls But then, how much better are a company's fortunes in the hands of a private equity firm? "We are better able to sort things out quickly, effectively," says Mr Moulton. "We can break companies up without having to worry about all the public company paraphernalia of doing so." The heads of private equity firms are in full control of the managers and chief executives who run the companies in their conglomerates, and they only have to answer to a small group of investors, typically big pension funds which look after our retirement money. Not everybody is comfortable with private equity firms' ability to hide from the limelight. Some Members of Parliament (MPs) have raised their voices about the accountability of private equity firms. But Mr Schwarzman refutes notions of secrecy. "The idea that this is one or two people in the dead of the night just couldn't be more wrong," he says. The investors in his firm are themselves highly regulated and there is good internal controls, he says. Giant warchest With the rise of influence of the global economy, these arguments may yet intensify. Private equity firms across the world are on track to raise up to $200bn of new investment this year, compared with $130bn last year, according to Almeida Capital. Borrowing on that amount will give private equity firms a $600bn warchest with which to go on a buying spree and bring more of us into their world. | ||
Private equity
Private equity is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others.
[edit]Private equity securities
Private equity refers to securities in companies that are not listed on a public stock exchange; while technically the opposite of public equity they are broadly equivalent to stocks, though return on investment often takes much longer. As they are not listed on an exchange, any investor wishing to sell securities in private companies must find a buyer in the absence of a traditional marketplace such as a stock exchange. In addition, there are many transfer restrictions on private securities. This long term investment area currently has over $710 billion in assets.[citation needed]
The sale of private securities is used by companies to generate capital. Investors generally receive their return through one of three ways: an initial public offering, a sale or merger, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.
[edit]Private equity funds
Although other structures exist, private equity funds are generally organized as limited partnerships which are controlled by the private equity firm that acts as the general partner. The fund obtains commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10% of the total commitments.
General partners are typically compensated with a management fee, defined as a percentage of the fund's total equity capital. In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will receive an annual management fee of 2% of committed capital and carried interest of 20% of profits above some target rate of return (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year, which in the case of leveraged buyout firms is primarily due to leverage, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not freely tradeable like mutual fund interests.
Considerations relative to other forms of investment include:
- Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus further investment for the first few years of the fund called a 'drawdown'.
- Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.
- If the private equity firm can't find good investment opportunities, they may end up returning some of your capital back to you. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.
- Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.
For the abovementioned reasons, private equity investment is for those who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.
Most private equity funds are offered only to institutional investors and individiuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth (exclusive of primary residence), $200,000 of individual income, or $300,000 of joint income (with spouse) for one documented year and an expectation that such income level will continue.
[edit]Size of industry
Nearly $180bn of private equity was invested globally in 2004, up over a half on the previous year as market confidence and trading conditions improved. Funds raised globally increased 40% in 2004 to $112bn. Prior to this, investments and funds raised increased markedly during the 1990s to reach record levels in 2000. The subsequent falls in 2001 and 2002 were due to the slowdown in the global economy and declines in equity markets, particularly in the technology sector. The decline in fund raising between 2000 and 2003 was also due to a large overhang created by the end of 2000 between funds raised and funds invested.
The regional breakdown of private equity activity shows that in 2004, 66% of global private equity investments (up from 58% in 1998) and 62% of funds raised (down from 72%) were managed in North America. Between 1998 and 2004, Europe increased its share of investments (from 24% to 26%) and funds raised (from 18% to 31%). Asia-Pacific region’s share of investments and of funds raised during this period was virtually unchanged at around 6% while share of the rest of the world fell. The country breakdown for private equity activity shows that private equity firms in the US managed 64% of global investments and 59% of funds raised in 2004. The UK was the second largest private equity centre with 13% of investments and 11% of funds raised.
Prominent private equity firms include: Kohlberg Kravis Roberts & Co., American Capital Strategies, Blackstone Group, Texas Pacific Group, Bain Capital, Carlyle Group, Madison Dearborn, Clayton, Dubilier & Rice, TA Associates, Harvest Partners, and Warburg Pincus.
Europe-based firms include: Apax Partners, AlpInvest Partners N.V., BC Partners, Bridgepoint Capital, Candover, Cinven, CVC Capital Partners, Permira, Terra Firma Capital Partners and 3i, Salus Alpha Group AG.