The private equity genie is out of the bottle. The scale and influence of private equity firms is now global and they pose a real alternative, or a threat, to the public markets. Between 26 February and 14 May this year, private equity-driven buy-out deals worth over $184 billion were announced, according to figures from capital markets research firm Dealogic. That doesn't mean that all deals will be consummated, but the messages that these numbers give out are loud and clear.
The first is that private equity companies, led by industry big hitters such as Blackstone, Carlyle, Kohlberg Kravis Roberts (KKR) and Texas Pacific Group (TPG) among others, are able to mobilise ever more funding for corporate activity. This comprises equity raised through their investment funds and debt, funded largely in the first instance by banks.
Second, deals are becoming larger. The biggest one announced so far this year is the $45 billion buy-out of US energy provider TXU by a group of investors led by KKR, TPG and Goldman Sachs Capital Partners. The number of transactions in the year to mid-May was significantly less than either of the previous years, according to statistics produced by Mergermarket, even though $647 billion worth of deals valued at $5 million or more were concluded, 40% more than in the previous 12 months and over double the value of the year before that.
Third, private equity has gone global in a big way. Whereas private equity investment had been led by US firms in their own backyard, there was next a significant move to buy businesses in the UK, then continental Europe and now Asia Pacific, with particular focus on India and Japan.
In a survey published last year entitled Venture Capital Goes Global, consultant Deloitte & Touche showed that out of 222 US venture capital firms, 20% were planning to increase their investments in China and 18% in India. It concluded that venture capital was turning global along with the rest of the business world, helped by the internet. Many of the major firms were quickly out of the blocks in broadening their geographical focus.
As long ago as 2002, Carlyle invested in Asahi Security, a Japanese security services provider, and currently has offices in Beijing, Hong Kong, Mumbai, Shanghai, Sydney, Seoul and Tokyo. TPG has a similar footprint, with the addition of Moscow. Blackstone has rather less global reach, but is still present in Hong Kong and Mumbai. Smaller UK firm 3i also has 14 offices round the world and invests its funds globally. There are many smaller local firms operating alone or in partnership with overseas companies, teaming up to buy and develop businesses, and recycling invested wealth.
It would be wrong to suggest that such expansion is without challenges. In common with other types of emerging market investment, the rewards can be great, but operating conditions may be difficult in new markets. Among the problems that the Deloitte study listed were a lack of deals that fit private equity firms' investment criteria, a lack of experienced investors, issues surrounding adequate protection for intellectual property of investee companies and lack of developed, liquid stock markets, leading to potential difficulties in exiting investee companies.
But despite these reservations, there is no doubt that private equity is a booming global industry. There are several reasons for this: first and foremost is the availability of cheap money. "The 'wall' of money created by the 2006, and prior, rounds of fundraisings means that there is a lot of private equity money chasing deals," says Dougal Bennett, director of Dunedin, the British Venture Capital Association's Private Equity House of the Year. "Banks too want a slice of the action, and are happier than ever to lend greater amounts of money."
Debt has been cheap for a number of years and banks have found themselves with plenty to lend, largely as a result of the general upswing in the world economic cycle. But if banks are seeking to fund transactions, it is noteworthy that bank lending is often refinanced in fairly short order by means of debt securities once the initial, often highly leveraged, private equity transaction has been completed. These, in turn, are sold to institutional and other wholesale investors.
The quest for yield among pension funds and insurance companies is another key driver. Tasked with gaining adequate investment returns in a period when yields on 'safe' asset classes such as government bonds and cash have been low, pension funds in particular have diversified into 'alternatives', such as private equity and hedge funds to spice up their results.
The make-up of Blackstone's $18 billion Blackstone Capital Partners (BCP) V fund tells this story graphically, with pension funds accounting for the lion's share. It also illustrates the point that private equity is an asset class for grown-up investors, institutions and high net-worth investors or their agents, who engage with private equity among other investments on the basis that they understand the risks, rewards and terms of their investments. They can operate without the safety nets put in place for the protection of the wider public of retail investors.
There are two other important drivers. The first is the eagerness of businesses and their managers to take the private equity route rather than, for example, listing on a public market if they are privately held. They have to welcome the chance of being taken private if they are already listed. A key weapon in the private equity armoury is the incentivisation of either incumbent or new management. Bringing private equity investors on board may place managers under more stringent controls and performance targets, but hit your numbers and you can get rich pretty quickly.
The final driver is the returns available to the private equity company general partners themselves, the typical so-called '2 and 20' remuneration structure. This pays a fee of 2% per annum on the amount of funds committed to an investment - over a 10-year period, a $1 billion fund would earn $200 million in management fees. In addition to the 2% charge, the private equity company also receives an additional 20% of any profits earned.
The 20%, or 'carried interest' fee, is realised when a private equity investment is repaid, probably when the investee company is resold or listed. So if a $1 billion fund repays $3 billion to investors, the private equity partners who enjoy a share in the carried interest would share 20% of the spoils - a cool $400 million between them.
Professor Tim Jenkinson of Oxford University's Said Business School says: "These annual fees and additional charges can yield very large sums of money, especially when one considers that the funds are extremely lean organisations with few employees and even fewer partners who enjoy a share of the profits." The attraction of harnessing other people's money to make a fortune for oneself is the raw capitalistic tinder to which private equity managers have set light, and which is fuelling the worldwide private equity boom.
Moreover, they can do so often under favourable tax regimes, such as those in the US and UK, and away from the public gaze to a large extent. One of the key criticisms of private equity as a market and as a modern business model is that apart from its reports to its fund investors, public disclosure by private equity firms is minimal. There has also been criticism of the vast amounts of money that partners make compared with the general level of incomes in the societies in which they operate in the US, western Europe and elsewhere.
In January Sally Dewar, capital markets sector leader at UK regulator, the Financial Services Authority (FSA) drew attention to this in a speech to the British Bankers' Association. "We have observed," she said, "significant growth in the amount of capital flowing into private equity funds in the past few years. In the first half of 2006 alone, £11.2 billion of capital was raised by UK-based private equity fund managers - more capital than was raised in the same period via initial public offers on the London Stock Exchange. When private market fund-raising outstrips public market fund-raising, it is difficult to ignore."
Add to this the public-to-private transactions, such as the $45 billion TXU buy-out mentioned above, and it is easy to see that private equity has become a significant force in the major economies. The FSA's queries about their influence and opacity were raised also by a UK government Treasury Select Committee, which summoned five of the leading buy-out specialists to appear for questioning in June. In the US, Washington politicians and union lobbying groups are also concerned over various issues relating to private equity's growth, influence and wealth.
"Private equity firms are not generally very keen to reveal financial information to people," says Jenkinson, who as a prominent academic in the private equity field was also called by the Treasury Select Committee. "One of the big ticket questions from a public policy perspective is what is the contribution of private equity to efficiency and productivity and economic growth, and that is one area where private equity as an industry has not done enough to provide information and even more qualitative stories about what it does. As it becomes more and more economically significant, I think that that position is no longer tenable."
Setting aside the public disclosure issues, the scale and profligacy of bank lending in support of private equity has also raised eyebrows. Jenkinson agrees with the FSA and others - including top fund manager Anthony Bolton and Carlyle founder and prominent private equity leader William Conway - that banks have loosened their lending criteria while increasing their lending to imprudent levels. A significant incident is now inevitable, predicts the FSA.
Right now, investment banks, some private equity houses, accountants and advisory firms are beefing up their corporate recovery departments. In addition, the market among distressed debt specialists, hedge funds included, prepared to buy or trade assets of distressed companies is now deeper than ever before. There seems to be a tacit acceptance that accidents will happen, but that if you can price an impaired asset, at whatever level, then you can sell it and start to rebuild, buy or sell businesses again. That at least is a cause for longer-term optimism that private equity firms and the banks that support them will be able to find a way out if boom does turn to bust.
But while private equity is now globalising the flow of funds from investors to private enterprise on a huge scale and making tidy profits in the process, it seems highly unlikely that private equity will eclipse stock markets altogether - nobody is saying that the private markets will take over the public ones as a source of capital. The reasons are clear: markets make a healthy living for those that play in them, from private and institutional investors to hedge funds, brokers, traders and analysts. Their liquidity is their strength, and private equity feeds off this liquidity.
The final position of any private equity investor is that it must realise its investments, and there are only a limited number of exit routes. Trade sale is one, as is secondary buy-out or sale to another private equity investor. Flotation is another, but very large option, subject to market conditions, investor interest and precision timing. In this respect, private equity and the public markets are not so much rivals as complementary platforms, where investors and investment opportunities intersect.
This brings us to a further question about the current state of the global private equity phenomenon and that is: where are we in the cycle? A number of major private equity players are reported to be considering the IPO route: Blackstone has made its intention clear; KKR's Henry Kravis is believed to be considering a flotation for the firm as a route to unlocking value for its partners - as are TPG, Carlyle and Apollo, if there is substance to the wide press coverage on the subject. It is true that many of these firms' founders may be reaching an age where their thoughts turn to succession and to realising the fruits of their labours, but these individuals are nothing if not masters of timing and of the capital markets.
It remains to be seen if these are the golden days of private equity's influence in the repositioning of massive amounts of the world's investment capital. Or perhaps we will witness a generational change, with private equity firms moving on to bigger and greater things, fuelling the growth of emerging market economies, using locally raised funds and money from the North American and western European countries where they first plied their trade so successfully.
In February 2002, US-based private equity group Carlyle backed a management buy-out of Japanese firm Asahi Security. The company provides security services such as cash management and electronic security services, and was the proprietary provider of such services to Daiei Group, a major retail chain. Asahi's business consists of long-term accounts with major corporations, giving it predictable cashflow. "One of the things that drew us to Asahi is that the security services sector in Japan is ripe for consolidation," said Carlyle Japan's Haruyasu Asakura at the time. In January 2005, Carlyle sold the business to Toyota Industries. In a statement Carlyle said: "In the three years that Carlyle owned the company, Asahi Security built or expanded several business centres, increased the number of employees from 2,000 to 2,600 and doubled the number of customers, focusing mainly on business clients. Sales were forecast to grow 31% to Yen21.5 billion by the year ending February 2005."
THE BLACKSTONE GROUP
They don't come much larger than Blackstone, or more successful. Established in 1985 by partners and ex-Lehman Brothers investment bankers Peter Petersen and Stephen Schwarzman with two assistants and $400,000 of their own capital, today the Blackstone Group is probably the world's leading private equity firm. In fact, it is more than that because in addition to private equity, it has operations that include real estate investment, corporate debt advice and structuring, hedge funds, distressed debt, corporate advice, restructuring advisory services and various Asian investment funds.
In private equity to date, it has raised more than $32 billion through its six funds, investing in over 100 businesses, including Cadbury Schweppes, Deutsche Telekom and Center Parcs. The firm says that the total enterprise value of all of its transactions at the end of 2006 was more than $191 billion. Its five investment funds, Blackstone Capital Partners (BCP) I, II, III, IV & V, trace the rise and rise of the global private equity sector. The first, raised in 1987, was a mere $810 million. Since then, each fund has been progressively larger with BCP V raising over $18 billion in 2006.
The founding partners have achieved immense wealth, reportedly more than $3 billion each, and their names have become the stuff of Wall Street legend. Their net worth may be about to get a boost if Blackstone achieves its much discussed $40 billion flotation. Much discussed because one of the US' largest and most powerful unions, the 10 million member AFL-CIO, is trying to stop it going ahead on grounds that its structure will benefit its partners, but evade investor protection regulations. The IPO has also achieved wide coverage because on 20 May Blackstone announced that the Chinese government has agreed to buy a $3 billion non-voting minority stake in the business.
The big question is whether this is really about Blackstone's partners cashing in their chips while the going is good. Many investors and rival private equity firms will be watching the Blackstone float to see which way the wind is blowing.