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Private Equity: A New Role for Finance?

India's experience with private equity is illustrative of the rush of this form of finance to the developing world. The acquisition of shares through the foreign institutional investor route today paves the way for the sale of those shares to foreign players interested in acquiring companies as and when the demand arises and/or FDI norms are relaxed. This trend of transfer of ownership from Indian to foreign hands would now be aggravated by the private equity boom. Private equity firms can seek out appropriate investment targets and persuade domestic firms to part with a significant share of equity using valuations that would be substantial by domestic wealth standards.

Private Equity/Hedge Funds

Private Equity: A New Role for Finance?

Economic and Political WeeklyMarch 31, 20071137leveraged buy-outs of the 1980s that gave private equity itsfame,making it largely an activity which involved the takeoverofrelatively large companies financed substantially with debt.Growth of Private EquityThe transformation of the 1980s was related to two develop-ments in the world of increasingly deregulated finance. The firstwas the desire of banks and pension funds to find new avenuesfor investment of their burgeoning resources. The assets ofautonomous pension funds in the US, for example, rose from$ 786 billion in 1980, to $ 1.8 trillion in 1985, $2.7 trillion in1990, $ 4.8 trillion in 1995, $ 7.4 trillion in 2000 and $ 8 trillionin 2004 [OECD 2001 and 2003]. With investible resources ofthat magnitude accumulating at that rate, it was not surprisingthat these entities were keen on entering new areas that wouldensure adequate returns to meet their commitments. Public pensionfunds like the California Public Employees’ Retirement System,the largest public pension fund in the US, have taken the lead.According to Politi and Guerrera (2006), quoting estimates byRussell Investment Group, an investor services company, publicpension funds have nearly doubled their exposure to private equityover the past decade and on average invest some 8 per cent oftheir funds in that asset class. On the other hand, corporate pensionfunds invest less than 7 per cent and their exposure has decreasedslightly since 1995. A similar though different situation characterisedthe banks. In their case, developments such as the oil priceincreases of the 1970s, which led to large deposits of petrodollarsurpluses, resulted in an increase in their lendable resources andhadthem also looking for new avenues for investment and lending.The second development of significance, influenced by thefirst, was the relaxation of rules relating to investments that couldbe undertaken by institutional investors like banks and pensionfunds. In 1971, the Competition and Credit Control policy in theUK gave banks greater investment flexibility. Similarly, in theUS, a clarification of the “prudent man” rule (incorporated inthe Employee Retirement Income Security Act of 1974)3 issuedby the US Labour Department in 1978 relaxed many of thelimitations placed on institutional pension funds allowing themto invest in private equity and other alternative assets. Since thenthere have been a series of structural and legal changes in Europeand the US, involving inter alia pension fund and insurancecompany regulation, that have had the same impact. These havebeen accompanied by changes in taxation laws that have encour-aged leveraged investments and made investments that promisecapital gains more attractive. Most recently in the US, the Gramm-Leach Bliley Act, which became law on November 12, 1999,is seen as having opened new opportunities for lenders interestedin mezzanine financing or other equity participation to supportleveraged buyouts and other leveraged transactions, and forbanking organisations interested in venture capital and otherequity-based financing. The law expanded the permitted secu-rities and merchant banking activities of those bank holdingcompanies that are well-capitalised and well-managed. Amongthese new activities is investment in portfolio companies, thecreation of their own qualifying private equity funds or investingin other qualifying private equity funds.The expansion of funds available for and seeking alternativeinvestments resulted in increased demand for an asset class likeprivate equity, and for agents who could intermediate the investmentof such capital. Simultaneously, interest in and concern aboutprivate equity increased with the proliferation of private equityfirms and funds in which investments were made not just by highnet worth individuals but also by institutions such as banks andpension funds. Banks and pension funds account for an over-whelming share of total capital raised by private equity firms.In Europe for example, of the total of Euro 161.3 billion raisedbetween 1998 and 2002, banks, pension funds and insurancecompanies accounted for 58 per cent of the commitment (Table1).A more general survey of US funds in 2005, conducted by DowJones Private Equity Analyst, arrived at a lower but similarlysubstantial figure: 45 per cent [Tracy 2006].Issues of ConcernThe sources of concern are many. Private equity firms or fundsare most often limited partnerships, with the firm as the generalpartner that manages the fund being paid an annual fee (calculatedas a percentage of the money invested in and managed by thefund) as well as a share of the profits, if any, garnered by thefund. The investors themselves are limited partners with a rightonly to a share of the profits.Since the shares are not traded, the exit from an investmentby a private equity investor normally takes one of four forms:(i) direct sale to investors seeking a shareholding in a firmacquired by the fund; (ii) post-purchase listing of the companypermitting sale of equity through the stock market;(iii)“recapitalisation” by increasing the debt outstanding andusing the money to make dividend payments that the fund dis-tributes to its limited partners; or (iv) sale to another private equityfirm, referred to as a secondary buy-out. Realising profits throughthese means often requires waiting for as long as 10 years ormore, during which period expectations of an increase in the valueof the original investment may or may not be realised. Theconsequent relative illiquidity of the investment implies thatprivate equity investors expect to take in their returns over themedium or long term, unlike many investors in publicly tradedequity. Given the risks involved and the long periods for whichcapital is locked up, private equity investors normally expect theirinvestments to significantly outperform investments in bond andequity markets. This can create a problem inasmuch as the originalinvestment is based on a purely financial calculation, while therealisation of returns implicit in that calculation requires coun-terpart investors looking for returns from acquiring an asset thatallows engaging in a profitable non-financial activity. That is,the expectations of conventional investors in different kinds ofeconomic activities must match, with a lag, that of pure financialinvestors represented by private equity firms.Table 1: Sources of European Private Equity 1998-2002Total 1998-2002 (Euro billion)161.3Shares(in per cent)Corporate investors8Private individuals6Government agencies6Banks24Pension funds22Insurance companies12Funds of funds9Academic institutions1Capital markets1Realised capital gains5Others6Source:European Private Equity and Venture Capital Association athttp://www.evca.com/html/investors/inv_why_01.asp.
Economic and Political WeeklyMarch 31, 20071138Advt PAges
Economic and Political WeeklyMarch 31, 20071139Since private equity returns derive from an appreciation in thevalueof the acquired asset or company, private equity investmentsareoften followed by efforts at restructuring to resuscitate loss-making companies or substantially improving the performanceof profit-making ones. These efforts are aimed at adding valueto the investment before private equity investors exit with a profit.Less appreciated forms of intervention by private equity firmsare those in which bought-out firms are stripped of assets or arebroken up so that the pieces can be sold to the highest bidderfor an aggregate sale price that exceeds the purchase price. Therevival or improvement of the performance of a poorly perform-ing company must be a prerequisite for ensuring the appreciationof an asset, excepting in cases where: (i) the company concernedwas bought cheap and could therefore be sold for a profit, whichwould be more an aberration than the rule; (ii) the market forthe company’s products takes a turn for the better, which wasnot foreseen by the original owner but expected bythe privateequity firm; or (iii) the company develops a new product ortechnology which can be commercialised for a large profit, asdoes happen in the case of some venture capital investments.While these may be the principles on the basis of which theprivate equity business is rationalised, in the final analysis thebusiness rests on the fact that “valuations” are speculative. Privateequity firms would like to keep their buy-out prices cheap, butloaded with funds find the need to push up valuations to acquireassets. While informed by the profit potential of the target, thesevaluations do often imply a high degree of risk. But the veryfact that such initial valuations are made, by firms led by indi-viduals with a track record, creates an environment for futuresale at a price that incorporates a profit. And the longer investorsin private equity funds are willing to wait for returns, the longerwould fund managers have to wait out the market in search ofa profitable sale. Further, in certain circumstances, valuationsin the private equity market could influence stock market pricesas well, with high valuations in the former encouraging higherprice earnings ratios in the latter. This could help the sale of assetsthrough the stock market.Valuations may also be sticky upwards in the relatively goodtimes, or when there is liquid capital looking for investmentavenues, because of a fact noted earlier: the distinction betweenpurely financial capital and capital aiming to derive returns fromproduction of goods or services in the long run has blurred.Increasingly, investments in production are driven by the pos-sibility that the creation of a successful company could offer theoption of selling out at a high price, delivering wealth that canbe invested in financial assets. Since wealth is measured by theprevailing market value of the asset, the process can feed itself,leading to unsustainable valuations at which someone has to carrya loss. The bourgeoning of finance results in the “dematerialisation”of wealth, permitting wealth accumulation at a pace much fasterthan the growth of production, so long as the game of risingvaluations can be sustained.What needs to be noted is that this process breeds in anenvironment of inequality and feeds on it. Global and nationalinequalities concentrate incomes among a few, whether they bethe millionaires in the developed and developing world whoaccumulate savings looking for avenues of investment or sectionsof the middle class that accumulate financial capital throughinvestments in mutual and pension funds, which need to beinvested to meet future commitments. Neoliberal reformsreducingstate provisions for social security only aggravate this process,since they requires the middle class to save for contingenciesor old age. The financial component of neoliberal reform permitspension funds and insurance companies to invest this capital ina wider range of assets, resulting in the expansion of an assetclasslike private equity. The financial system adjusts by courting risk.Since interest in alternative asset classes like private equityis driven by the amount of capital in circulation looking forfinancial investment opportunities, while the return on privateequity is dependent on the demand from investors outside theprivate equity business for profitable long-term assets, there isa fundamental asymmetry that underlies the business. There couldbe a period when poor performance in stock markets or low longterm yields on bonds, or a combination of the two, results inintensified interest in private equity. To cash in on this interest,private equity firms can trade their reputation to mobilise fundsto invest while they search for buy-out opportunities. When theinflow into private equity is large, some or all firms would haveto make investments in whose case the probability of subsequentsale at a profit is lower.This, however, would not deter private equity firms as inter-mediaries from mobilising large volumes of capital, since a largepart of their returns derive from a one time management feedefined as a percentage of the volume of the fund, and aretherefore linked to the amount of capital they mobilise. In fact,the evidence seems to be that when funds are aplenty, privateequity firms agree to reduce the management fee defined inpercentage terms. But with bigger funds, fees only increase. Toquote an insider analysis of the problem: “When prospectiveinvestors in Bear Stearns Merchant Banking’s third buyout fundbaulked at some details of the fund’s planned fee structure, thefirm’s response at first glance looked quite generous. Bear Stearnsdutifully lowered the fund’s management fee to 1.75 per centfrom 2 per cent. All other things being constant, the move wouldhave resulted in about $ 4 million of savings a year for limitedpartners – a clear win. But other variables changed. Bear Stearnsdecided to raise the overall size of its fund to at least $ 2.5 billionfrom $1.5 billion, meaning it will collect more fees in absoluteterms, despite its willingness to give ground on a percentagebasis” [Kreuzer 2006].Recent GrowthBut this has not deterred investors, at least in the big funds.Figures from Venture Economics suggest that between 1980 and2000, the amount of commitments of capital to funds managedby private equity firms increased from $ 2.3 billion to about $177billion, cumulatively totalling $ 737 billion (Table 2). However,estimates of the industry’s size vary, reflecting the secrecy thatshrouds it. According to estimates made by Thomson Financial,2006 was a record year for private equity in both fund raisingand investments. 684 PE funds raised a record $432 billionworldwide in 2006, led by buy-out and real estate funds with$213 billion and $63 billion respectively. The total value ofannounced private equity buyout deals hit a record $700 billionin 2006, more than double the record set in 2005 and 20 timesbigger than in 1996 [Metrics 2.0 2007.] According to one study,private equity assets under management are now nearing $400billion in the US and just under $200 billion in Europe. Privateequity expansion is also reportedly strong with aggregate dealvalue growing at 51 per cent annually from 2001 to 2005 in NorthAmerica.4The largest private equity firms, such as Blackstone,
Economic and Political WeeklyMarch 31, 20071140Advt PAges
All Private Equity Europe All Private Equity US EU MSCI US S&P EU MSCI US S&P +9 per cent +20 per cent +3 per cent +9 per cent 12121212
Economic and Political WeeklyMarch 31, 20071142Kaplan and Antoinette Schoar (2003) investigated theperformanceof private equity partnerships using a data set ofindi-vidual fund returns collected by Venture Economics. Over theirsample period, average fund returns net of fees approximatelyequalled the S&P 500. In fact, over 1980 to 2001, the averageprivate-equity buy-out fund generated slightly lower returns toinvestors (after subtracting fees to general partners) than theywould have obtained by investing in the S&P 500. What wasofsignificance was that there were huge differences in performancebetween individual funds. The top quartile of private-equity fundsproduced an annual rate of return of 23 per cent, well ahead ofthe S&P; the bottom quartile earned investors only 4 per cent.David Swensen (2000), chief investment officer of the YaleUniversity, argues based on an analysis of 542 buy-out dealsconcluded during 1987 to 1998 that the performance of muchprivate equity over the preceding two decades was poor, whenseen in light of the facts that (i) interest rates had fallen, therebyreducing the cost of debt; (ii) there were a relatively small numberof private-equity firms competing for investments; (iii) there weremany badly run and underperforming companies to improve; and(iv) price earnings ratios in public stock markets had registereda sharp rise.He found that annual returns of 48 per cent compared wellwith the 17 per cent return which could have been garnered frominvestment in the equity of firms included in the S&P index. Buthe also found that most of these gains came from heavy borrowingby buy-out firms seeking to multiply their investments. If thesame amount of debt had been used to multiply the investmentsin the S&P, he argues, the leveraged portfolio of public equitieswould have generated an 86 per cent return, outperforming thebuy-outs by nearly 40 percentage points a year. Not surprisingly,private equity firms speak less of the absolute returns they wouldoffer investors, and only promise to deliver better returns thanthose available in public equities which they may deliver giventhe recent poor performance of stock markets.These assessments have backed expectations that the prolif-eration in private equity could affect returns from the sectoradversely in the near future. Many reasons are quoted for this.To start with, private-equity firms profit more from “proprietary”deals in which they are the only bidders. The costs of acquisitionare then lower than they would be if there are competing bidders.However, firms are now increasingly resorting to auctions in salesto private-equity firms. Even in the 1980s, KKR set the recordfor the biggest buy-out in the course of a bidding war for RJR,only to reap poor returns from the deal. The same can befall dealssuch as the one Blackstone struck for Equity Office in competitionwith Vornado.Second, stock markets are not as buoyant as they were in the1990s. So the possibility of exploiting high price earnings ratiosto list equity and sell at high prices equity acquired cheap in aprivate deal is far less today. Third, corporations are becomingmore circumspect when making costly acquisitions, because ofshareholder pressure. Finding corporate buyers for expensivelyacquired firms, may prove more difficult.Finally, wielding the hatchet against workers or to break upcompanies when firms are being restructured is coming up againstopposition. Brendan Barber, the general secretary of the TradeUnion Congress (TUC) in the UK recently launched an attackon the private equity industry [Adams and Smith 2007]. Barbersaid that, while private equity had sometimes turned roundailingcompanies, operators sometimes gave the impression “ofbeing little more than amoral asset-strippers after a quick buck;casino capitalists enjoying huge personal windfalls from dealsat the same time as they gamble with other people’s futures.”In his view: “The problem is simple: private equity can steer clearof the responsibilities a public company has to live up to. Itsowners will disclose as little as possible about what they are doing,and why. In companies that are often leveraged to the hilt, it’semployees who end up shouldering much of the risk, withdownward pressure on pay, pensions and job security.”Barber has declared his intention to take the attack along twolines. The TUC will shortly produce a briefing paper on privateequity for more than 1,000 pension fund trustees controlling£300bn of assets, urging them to “look long and hard” beforesupporting investments in private equity. And he has promisedto urge ministers to regulate an industry “that at the moment ispretty much allowed to operate with impunity”.Criticism of Private EquityMeanwhile, criticism is growing among investors as well aboutthe practices and performance of private equity firms. The viewthat private equity firms align the interests of investors, or limitedpartners, and the general partners who manage the funds, is underchallenge. This is because, as noted earlier, even as funds havegrown in size, the management fee defined as a per cent of thefund has reduced little. In the past, general partners were paidan annual management fee of 1.5 to 2 per cent, with a profit shareof 20 per cent. These percentages should have fallen to reflectthe growing scale of funds under management. In practice, therehas merely been a marginal reduction in management fees from2 per cent to 1.5 per cent. This means that fund managers earnhuge fees on the billions of dollars they have managed to raisein recent times, even if the investments do not garner promisedreturns. The study by David Swensen referred to above foundthat net of fees, limited partners received lower than marketreturns with substantial levels of risk while the general partnersreceived large fees. There is evidence that incentive structuresare such that general partners satisfied with high fees are notdelivering performance and returns to limited partners, in amarket that is flush with funds.A second criticism of private equity is their lack of transpar-ency. Paul Myners, former chairman of Marks and Spencer,whose review of institutional investment in 2002 had recom-mended that pension schemes should consider investing in a widerange of asset classes including private equity and hedge funds,declared: “We are seeing public companies go private and theygo from being transparent and accountable into a dark box”.[Packard and Smith 2007]. The performance of funds and theirunderlying businesses should remain as open as those of publiccompanies, he reportedly said.The secretiveness of private equity has become an issue alsobecause of evidence that oil-rich Gulf countries flush with surplusesare putting their money into private equity investments. Recently,reports linking Qatar’s government investment funds to a possiblebuy-out of J Sainsbury, as well as a strategic stake in EADS,triggered a controversy.Third, big private equity firms are now increasingly operatingin concert. When they jointly invest in a takeover target, effortsof investors to hedge by spreading their investments across anumber of private equity firms is partly defeated. Hedging ofthis kind is warranted by the sharp differentials in the performance
Economic and Political WeeklyMarch 31, 20071143of private equity firms. Further, “secondary buy-outs” where oneprivate equity firm buys out an investment from another privateequity investor creates suspicion that this may be a way of helpingeach other encash investments to pay off limited partners. Collusionof these kinds could result in a further misalignment of theinterests of limited and general partners.Finally, private equity firms are seen as being favoured bygovernment in the UK because of its practice of taxing profitsafter interest has been deducted. Since private equity firmsfinance their investments with a high proportion of debt, whichreduces taxable profit, buy-out firms are seen as being given anunfair advantage in pursuing their questionable practices.One result of all this is that private equity firms are finding theirbusiness getting harder to conduct in the US and Europe. Notsurprisingly, there are signs that the business is increasingly movingoverseas, especially to emerging market countries where marketsare booming because of foreign institutional investment inflows.According to Emerging Markets Private Equity Association,fundraising for emerging market private equity surged in 2005and 2006. Estimated at $ 3.4 billion and $ 5.8 billion in 2003and2004, the figure shot up to 22.1 billion in 2004 and $ 21.9 billionin the period to November 1 during 2006. Asia (excluding Japan,Australia and New Zealand) dominated the surge, with the figurerising from $ 2.2 and $ 2.8 billion in 2003 and 2004 to $ 15.4billionduring 2005 and $14.5 billion during the first 10 months of 2006.7Deal making in the region has also gained momentum. Dealogicestimates that the value of private equity deals in the Asia Pacific,excluding Japan, more than tripled to $26 billion in 2006 from$7 billion in 2005.8 Private equity buyouts have accounted for7 per cent of regional merger and acquisition volume this year,upfrom 3 per cent in 2005 but still below the global figure of 17percent. Though Australia accounted for $11.7 billion in activity,deals in the Indian subcontinent jumped to $3.1 billion in 2006from $764 million in 2005, with Kohlberg Kravis Roberts &Co’s$900 million purchase of Flextronics Software Systems, India’slargest deal. North Asia deals totalled $10.4 billion, led byGoldman Sachs’ $2.6 billion investment in Industrial & Commer-cial Bank of China, this year’s biggest regional deal. Investmentbanks have raked in $304 million in net revenue from privateequityinvestors thus far in 2006, compared with $239 million last year.It must be noted that these figures differ substantially fromthose provided by Thomson Financial. Thomson’s figures pointtoinvestment of $7.6 billion in private equity deals in 2006 anddoesnot point to a surge in 2006 (Table 4). However, Thomson doessuggest that foreign investments accounted for 63 per cent oftheAsian private equity market in 2006, with $4.39 billion out ofthetotal.9Indian ExperienceIndia’s experience is illustrative of the rush of private equityto the developing world. Observers began to take note of privateequity’s growing presence in India when in late 2002 Oak HillCapital and Financial Technology Ventures resorted to a buyoutdeal by backing a management bid to acquire Conseco’s stakein Delhi-based EXL Services. Subsequently in September 2003,ICICI Venture bought out the Tatas’ controlling stake in TataInfomedia. Three months later, CDC Capital Partners, the UK-based private equity investor, struck a Rs 75 crore deal to buyICI India’s industrial chemicals business in Gujarat [Sengupta2004]. The private equity asset class had arrived in the country.Since then, there has been an increase in such activity withall the majors finding their way to the country. Growth has alsobeen substantial. The total number of M&A deals struck in 2006was estimated at 782 ($ 28.2 billion) compared with 467 ($ 18.3million) in 2005.10 Of these, 302 involved private equity. Privateequity investments also saw substantial growth in 2006. From$ 1.1 billion invested in 60 deals in 2004, private equity invest-ments rose to $ 2 billion in 124 deals in 2005, and a remarkable$ 7.9 billion in 302 deals in 2006. This remarkable 287 per centincrease in the total value of private equity during 2006, pointsto a growing value in each deal. There were more than 29 dealsvalued at over $ 50 million as against 10 such in 2005. The averageprivate equity investment size increased from $ 16.40 millionin 2005 to $ 26.02 million in 2006.Some of the big deals included Kohlberg Kravis Roberts &Co’s $ 900 million investment in Flextronics Software Systems;Providence Equity Partner’s $ 400 million investment in IdeaCellular and Temasek Holdings Pte’s $ 330 million investmentin Tata Teleservices. Such deals are continuing in 2007 withBlackstone Group acquiring a 26 per cent stake in UshodayaEnterprises, which publishes the Telugu language newspaperEenadu and owns television channels under the same name.This ability to acquire equity through the private market suggeststhat foreign acquisitions could increase sharply in Asia, sinceitisknown that there is a substantial proportion of companies in thesecountries that are either unlisted or in which free-floating (asopposed promoter-held) shares are a small proportion. Despitethis,there has already been some evidence of increased acquisitionthrough the stock market. In India, for example, as per the originalSeptember 1992 policy permitting foreign institutionalinvestment,registered FIIs could individually invest in a maximum of 5 percent of a company’s issued capital and all FIIs together up toa maximum of 24 per cent. The 5 per cent individual-FII limitwas raised to 10 per cent in June 1998. However, as of March2001,FIIs as a group were allowed to invest in excess of 24 per centand up to 40 per cent of the paid up capital of a company withthe approval of the general body of the shareholders grantedthrough a special resolution. This aggregate FII limit was raisedto the sectoral cap for foreign investment as of September 2001[Ministry of Finance, Government of India 2005]. These changesobviously substantially expanded the role that FIIs could playeven in a market that was still relatively shallow in terms of thenumber of shares that were available for active trading.This is because the process of liberalisation keeps alive ex-pectations that the caps on foreign direct investment in differentsectors would be relaxed over time, providing the basis for foreigncontrol. Thus, acquisition of shares through the FII route todaypaves the way for the sale of those shares to foreign playersinterested in acquiring companies as and when the demand arisesTable 3: Emerging Markets Private Equity Fundraising($ millions)AsiaCEE/LatinAfrica/Total(ex-Jap/ANZ)RussiaAmericaWest AsiaEM2003220040641735033732004280017777145455836200515446271112722706221352006145282759813380721907Source:‘Emerging Markets Private Equity: The Current Landscape and theRoad Ahead’, EM PE Quarterly Review, Vol II, Issue 4, Q4 2006,available at www.empea.net/docs/newsletters/EMPE_QuarterlyReview_Vol2_Issue4.pdf, accessed February 27, 2007.
Economic and Political WeeklyMarch 31, 20071144Advt PAges

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