Private equity off the leash

The rise and rise of PE is changing the corporate landscape and shifting the balance of power in the City. Investment banks are no longer top dogs, having ceded territory to an aggressive new breed. Matthew Lynn reports from the Square Mile

by Matthew Lynn
Last Updated: 09 Oct 2013

Where do top chief executives go when they get eased out of power? A few years ago the answer would have been simple. They might collect some non-executive directorships. They might chair a bank. And maybe pick up a peerage or a quango to run. Now, the chances are that they'll find themselves a comfortable berth in the private-equity industry - along with an occasional ex-prime minister or ex-president of the US.

Take Lord Browne, the suddenly-retired CEO of BP and for many years Britain's most admired businessman. Despite quitting unexpectedly last month following revelations about his private life, Browne will still be chairing the advisory committee at private equity outfit Apax Partners. And Lord Hollick, who used to run United Business Media and was best known as the proprietor of the Daily Express, is now a partner in Kohlberg Kravis Roberts.

Sir John Major has been an adviser to the Carlyle Group - as, of course, has the first president Bush. Jack Welch, who was probably the world's most celebrated businessman when he ran GE, is now a ‘special partner' at the New York private-equity firm Clayton, Dublier & Rice. Meanwhile, Lou Gerstner, the chairman and CEO credited with saving IBM in the 1990s, is now chairman of Carlyle.

That is just one measure of how, in the past few years, private equity has moved from the fringes of the financial universe to its very heart.

The impact of private equity on the economy has been widely discussed - and remains controversial. Yet at the same time, it has transformed the financial markets. PE funds have become among the most lucrative sources of fees for banks. They have made huge sums of money for their bankers and advisers - and for the fund managers who invest in them.

But they have also provided competition. Com­panies no longer have to go to a bank for an IPO - they can also go to a PE fund. By offering a ready and accessible means of finance, these funds have taken com­panies away from the public stock exchanges. Indeed, the biggest PE firms, such as KKR and Blackstone, are now the equal in prestige and power of the big investment banks - prompting rumours in the markets that even the likes of Goldman Sachs or Lehman Brothers could end up being owned by a PE fund.

It's a long time since these funds were regarded as outside the financial mainstream. They are now simply too powerful for anyone in the City to ignore. ‘This year, I was invited to the Stock Exchange Christmas party for the first time,' says Jon Moulton, founder of the Alchemy Partners PE fund. ‘I was invited to a breakfast at the Bank of England. That never used to happen. We used to be considered beyond the pale, but we've moved into the mainstream now.'

Says Kevin McNally of consultancy Arbor Square Associates, which has studied the impact of the PE funds on the financial markets: ‘The alternative assets industry - and that includes hedge funds as well as PE houses - has been one of the major sources of growth for the City over recent years. I wouldn't say it has sucked all the talent out of the traditional banks, but it has certainly provided an attractive alternative for talented financiers.'

Certainly, no-one in the financial markets can afford to ignore PE funds any more. They have too much muscle. The funds have been raising money on a colossal scale, and they haven't been nervous about spending it either.

PE firms have drawn in an estimated $210 billion in funds since the start of 2006, according to figures compiled by Bloomberg. Add in the leverage that PE firms always use, and that gives them the power to do deals worth $2 trillion. That kind of cash would allow them to buy the world's biggest company - currently Exxon Mobil, with a value of $445 billion - four times over.

Not surprisingly, as the money pours in, the funds have been shipping it out as well. The deals are getting bigger. In the first quarter of this year, the value of PE deals globally rose by 40% to $188 billion, led by the $43 billion agreement to buy the Dallas-based power producer TXU. In Britain, 2007 has already brought an ultimately unsuccessful attempt to take control of Sainsbury's, as well as a PE bid for Alliance Boots worth more than £10 billion. Those are unlikely to be the last PE bids of the year, and may not be the largest, either.

To the City, that translates into one thing: lots of hefty bills for advising on all those bids. ‘Private equity has become very important in terms of fees,' says Peter Linthwaite, CEO of the British Venture Capital Association (BVCA). ‘And the City has built up some real centres of excellence in serving the PE funds, which is another source of strength.'

The figures are startling. In 2005, PE funds generated £3.3 billion of fees for the City, or 7% of the turnover of Britain's financial services industry, according to figures compiled by BVCA. PE directly employs 5,500 people, of whom 3,500 are investment professionals. In total, 10,000 people are employed either within the funds or providing services to them. That adds up to a powerful chunk of the City's income - and one that's growing all the time.

Money is generated in other ways too. Investments in PE funds spice up the portfolios of many pension funds. Similarly, when a listed company is bought out by a PE fund, the premium will turn up on the balance sheet of a fund manager somewhere. Add in the complex financial re-engineering that the buy-out funds always impose on the companies they own - issuing and re-packaging bonds to leverage up the balance sheet - and the money really clocks up. ‘The wealth generated by PE is starting to be noticed by the City,' says Alchemy's Moulton. ‘It has become one of the biggest sources of fees in recent years.'

Like it or not, the City is now dependent to some degree on the wealth flowing out of the sector. But PE is also a competitor for talent. Until relatively recently, if you wanted to make a lot of money in the financial markets, you went to work in an investment bank. The big bucks were to be made in mergers & acquisitions and trading. Now that has changed: you go to work for a hedge fund or a PE fund.

Hedge funds have already provided one shock to traditional investment banks: for the past five years, every smart young analyst, fund manager or trader has wanted to be in a hedge fund instead. Now the PE funds are doing the same. It's where the money is. Sir Ronald Cohen, founder of Apax, for example, has made a fortune estimated at £250 million. Damon Buffini, who runs Permira, is thought to be worth £100 million. Henry Kravis, one of the eponymous founders of Kohlberg Kravis Roberts, has a fortune of $2.5 billion or so. Even by City standards, that is serious money.

‘I was at a bulge-bracket investment bank for most of my career,' says Simon Hirst, who had been chief executive of Durlacher and then executive vice chairman of Panmure Gordon before joining the PE firm Tri-Artisan Partners earlier this year as joint managing partner of its London office. ‘Private equity just seems a more exciting place to work right now. The deals are getting bigger and bigger. There is the "carried interest", so you are not just an adviser: you get a chance to participate in the business as well. And from a work perspective, it is much more hands-on,' adds Hirst. City financiers are used to being awarded big bonuses, but PE firms offer them the chance to take stakes in their target businesses as well. Typically, executives will receive an interest in the fund, which they can cash in so long as it does well. It gives them the opportunity to build up capital. There's another advantage too: so long as they keep the stake for a few years, they are liable for just 10% capital gains tax when it pays out. That's a lot better than the 40% income tax they would pay on a bonus.

The consequence has been that the PE funds have become in many ways more attractive places to work than investment banks - and the bankers who are left behind are as jealous of them as they are of all the people who have left to work in their own hedge funds.

Competition might be a good thing - it keeps everyone on their toes. But it has also changed the rules of the game for what was always the City's traditional business: raising capital for companies. A consequence of the boom in PE has been that there are fewer quoted companies left for the rest of the City to invest in. Every time a company is taken over by one of the funds, mainstream fund managers have fewer shares to choose from.

For at least some of them, that makes life harder. Paul Myners, former chairman of the fund manager Gartmore, launched an attack on the industry earlier this year for its secretiveness and its lack of accountability (although, as chairman of the Guardian Media Group, that didn't stop him selling a unit to Apax).

Much of that is sour gapes. After all, there isn't much to stop traditional fund managers doing exactly what the private equity funds do - re-engineering the company's balance sheet, using debt to slash its tax bill, and sharpening up its management. There isn't much of a secret about the formula.

But it means there's more competition to provide capital for companies ‘It is a two-way process,' says BVCA's Linthwaite. ‘You get companies leaving the public market, and then you get companies owned by PE firms coming back through IPOs. I think the great strength of London is that you have a very strong public market, but you also have a strong private market as well. So companies have a choice: they can be publicly or privately owned, depending on what looks right at the time.'

True enough. A decade ago, if you were an entrepreneur who'd built a business and wanted to cash in some of the wealth you'd created, you had no choice. Unless there was a big company that wanted to buy you out, you'd go to an investment bank and arrange an IPO.

That would cost you a lot of money in fees, and you could probably only sell a small slice of your shares: too much and potential shareholders would suspect you weren't committed. Similarly, if a giant multinational wanted to spin off a division, it could stage an IPO or a trade sale.

Now you just go to a PE fund. It has provided an alternative way for companies to raise money. In the medium term, of course, that's going to make life a lot tougher for the investment banks.

Most significantly, perhaps, the biggest funds have accumulated enough wealth and power to rival big investment banks. In terms of status, there isn't much to choose between KKR and Goldman Sachs, or between Blackstone and Merrill Lynch. There has been a steady stream of speculation about one of the funds taking control of one of the big investment banks.

And why not? After all, the banks have PE units of their own (although, with the possible exception of Goldman Sachs, they tend not to be as good at it as the standalone funds). The work that they traditionally did - raising finance for companies, restructuring their balance sheets, issuing bonds - is now just as likely to be done by a PE house. And indeed, since many of the PE funds are now floating themselves - led by Blackstone - they may find it easier to buy a bank rather than stage an IPO.

Until recently, there would have been no question about which were the biggest beasts of the financial jungle - the investment banks. But between them, the hedge funds and the PE funds have usurped that role. Goldman Kravis, or Blackstone Lehman? The names might sound ridiculous now, but don't bet against them becoming familiar a few years from now.

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