In the first instalment of this article, I discussed the growth in importance of private equity, and how the funds are organized and rewarded. I now continue the analysis by looking at the performance of private-equity funds and how they can add value.
Tim Jenkinson is professor of finance at the Saïd Business School, University of Oxford
The evidence on performance suggests average returns have been unremarkable and, in some cases, downright disappointing. For instance, looking at the European market over the last 25 years shows that investors in early stage venture-capital funds, on average, barely received their original investments back. And note this just measures cash returns—there is no allowance for inflation, or the opportunity cost of not investing in the stock market or even leaving the cash in the bank to earn interest.
Things look a lot brighter when you look back at the returns earned by buyout funds. For instance, in Europe over the last 25 years’ the average returns have been around 10% per annum. And the average returns of the top-quartile funds have been nearly 30% per annum. These figures demonstrate an important point: that private-equity funds differ hugely in their performance.
So, if you are investing in private equity, manager selection is everything. But the funds run by successful managers are often hugely oversubscribed, and so it can be difficult for investors new to private equity to obtain access.
So, the best private- equity firms can produce excellent returns. But how do they add value?
Again, the story is different in venture capital (VC) and buyouts. In a typical early-stage company, the venture capitalist is working closely with the entrepreneur, providing not just finance, but also mentoring, access to networks, business discipline, support services and so on.
The venture capitalists typically sit on the boards of directors and, although not often in overall control, would have considerable influence over the company, its strategy and the entrepreneurs. And for this, the VCs often need industry-specific knowledge, in part to shape the strategy of the firm, but also because their networks can enable collaboration with potential suppliers or complementary firms which can be critical to success.
With buyouts, the game is really very different. Buyout funds are looking for existing companies where they can create value. In a typical buyout deal, the private-equity fund puts in about a third of the money and the remaining two thirds is debt finance. This is why they are often referred to as leveraged buyouts. At this stage, people often start seeing images of asset-stripping swashbuckling capitalists, such as Gordon Gecko in the film, Wall Street. Financiers who have no intention of running the business, want merely to buy companies using other peoples’ money, sell off some parts, shut down others, sack plenty of workers and end up with a lot of cash. This is not the way it typically works.
The successful buyout firms aim to grow a business, to provide clear strategic direction and prepare it to be sold to a new owner within a few years. They are buy-to-sell investors, not buy-to-own, and the only way to increase the value of the firm is to make it more efficient and competitive. And they are impatient— they want to achieve results quickly, not over decades. Only when they exit do the profit shares flow. So, they typically take full control of the company.
Unlike in stock market-quoted companies, where shareholders play only a limited role in the governance and decision making of the firm, private-equity owners are in control and define a clear strategy for the firm. They set tough, but realistic targets and keep management focused on them. They establish extremely sharp incentives for the management in the form of financial returns if they are successful, and they recruit the best talent to execute their vision.
It’s really a different form of corporate governance. Rather than being required to publish quarterly results, which are then gone over with a fine-tooth comb by analysts, ratings agencies and the media, and to generate nice steady profit and dividend growth for investors with no surprises, managers of private-equity firms can operate outside the public arena. They are owned by one, or sometimes a few, private-equity funds, who set very clear objectives, which might involve a radically different strategy. In the case of a public company, it could be difficult (or indeed, dangerous, in terms of alerting competitors) to explain such strategic shifts to all shareholders through public statements. So, radical and quick transformation is difficult.
Although private equity is challenging the dominance of the stock market-quoted company, I don’t want to give the impression that one form of governance is necessarily superior at all times for all companies. For some firms, life on the stock market may be fine. Strategic direction is well defined, the board of directors functions well, capital structure is efficient, incentives are aligned, and investors value the firm appropriately. It’s not clear in such a case what value private equity would add. But for companies that are underachieving, or have neglected or non-core parts of the business, or where the management is not delivering, or where governance is ineffective, private equity can provide rapid and fundamental change. The focus on value creation and the buy-to-sell approach can produce some spectacular returns for investors.
So, are those who work in private equity the new kings of capitalism? Some are certainly paid royally, although success is far from guaranteed. History is littered with unsuccessful one-fund wonders, or previously successful firms that have lost their way. It’s worth remembering that the riches do not just fall from heaven—the successful private-equity firms employ some of the best talent around. This new model and approach to governance and value creation is certainly shaking up the thinking of all companies, few of which can feel immune to the reach of private equity. It’s not quite a revolution, but certainly a challenge to the throne.
(Send your comments to businessatoxford @livemint.com)