Private equity is attracting increasing political hostility because of job losses in companies subject to aggressive restructuring, tax losses through financial engineering, and ideological hatred.
Private equity is dominated by American and British groups, and is seen by many in Continental Europe as the epitome of ruthless capitalism that ignores local priorities such as job security and social benefits, and leaves behind fundamentally weaker, debt-burdened enterprises. Its profits are seen as excessive, and largely taken out of the country.
Some countries already have measures to discourage foreign takeovers, such as a special tax in Japan.
Britain is considering changing the basis on which the profits of private equity teams are taxed, effectively hiking their tax rate from 10 to 40 per cent, while in Germany the government plans to attack the tax deductibility of interest paid by the corporate sector on borrowed money.
Increased regulation is another threat. This is becoming a nightmare for business generally in many advanced economies, and would be a particular burden for private equity with its buccaneering culture.
Against this, I must point out that private equity has been a major force for destroying complacent, self-satisfied managements and raising corporate productivity. One reason is that the heavy burden of being forced to pay high interest charges on debt loads forces top managers to have an intense focus on financial efficiency.
There is also some evidence that suggests private equity creates more jobs than it cuts, which is not surprising if it brings greater efficiency and therefore stronger economic growth.
Invest in private equity: drawbacks of growing demand
Private equity’s explosive expansion means there is now a huge amount of capital looking for investment in a pool of assets where most of the best and potentially profitable assets have already been bought up, or already restructured and sold off.
Shareholders of listed companies, having seen how those who sold earlier were to discover they had sold ridiculously cheaply, are now unwilling to accept takeover bids unless they are generous.
Shortage of prospects is forcing private equity groups to “trade up” to ever-bigger targets, such as the current $33 billion bid by Kohlberg Kravis Roberts (they of Barbarians at the Gate notoriety) for the US private hospital group HCA. It is much harder work to get high returns from restructuring large enterprises than from smaller ones.
This is one reason why there is a move towards much higher gearing, as that’s one way of getting high returns… at higher risk.
Another reason for intensifying competition is that public-equity companies are no longer paralyzed by risk aversion and obsessed with balance-sheet strength, as they were after the stock-market collapse.
They are also out there, seeking to use their paper and their borrowing power to buy up enterprises that are sometimes prospective targets for private equity. Because of the synergies possible from integration with their existing operations, they can often afford to pay higher prices.
This could be a bad time to invest in private equity, not only because of that environment of greater competition/lower returns, but also because of the risks in the global economy.
Central banks’ tightening of interest rates poses a double threat to private equity – the higher cost of servicing existing and future debt, and the threat to corporate earnings from slowing economies.
One analyst suggests that it might only require one big private equity venture to go bust to trigger a panic among lenders to the sector, especially the junk bond investors. This would have far-reaching repercussions.
Invest in private equity: investment positives
Private equity managers are among the brightest investment people, and their rewards are geared to bring out the best in them. If you have to trust your capital to others to manage, as nearly all of us do, these surely must be worth serious consideration. They’re practising what has been described as “a very pure form of capital.” That must be good for participating capitalists.
There is much evidence that private equity returns are not correlated with returns from other major asset classes, such as listed shares. So inclusion in a balanced portfolio reduces overall risk.
It’s long been my view that when it seems pushing up interest rate threatens to precipitate recession, or even a crash in major asset markets such as property or shares that might trigger such a recession, the central banks will turn tail and open up the credit taps. With a reversion to easy money policies, private equity should be able to count on plentiful liquidity to finance its expansion.
Invest in private equity: get into this new asset class
If you are interested in investing in private equity, there are now many options available to you.
If you’re wealthy enough, you would be welcome as a “limited partner” in a “limited liability partnership,” of which many are on offer from private equity firms. However, you have to be really rich, and your money, although paid over in tranches over several years, is then locked in for several years.
More appropriate for nearly all individual investors are the many investment trusts (closed-end funds) listed on North American and European stock exchanges. In London the highest-rated ones are HgCapital Trust, which has given an average annual return in sterling of 17.5 per cent over the past ten years, and Electra, which delivered 13.2 per cent over the same period.
Banks, insurance companies and similar financial groups offer a wide variety of funds-of-funds. They offer lower risk through diversity, but of course also involve an extra layer of costs.
The London-based consultancy Private Equity Intelligence (www.prequin.com) is a professional source of information as it monitors the performance of more than 2,800 private equity funds worldwide. Funds can be compared against one another and appropriate benchmarks. Its single-user products are priced in the range $495-2,600 a year.
“More and more investors are entering (this) asset class from all around the world, while existing and new investors alike are increasing their target allocations,” says Mark O’Hare of Private Equity Intelligence.
Private equity groups are now mainstream players in the financial world managing the largest takeovers in history and set to become even more important – too big for individual investors to ignore.
However, if you fancy investing, you should be prepared to first research it carefully, then to spread your capital over a range of funds and strategies.
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Recommended further reading:
For more on private equity, read regular MoneyWeek contributer Simon Nixon on how private equity went mainstream. For another perspective on the rise of this asset class, find out why debt costs could burst private equity bubble. (Non-subscribers can sign up to a free 3-week trial here for access to all articles on our website.)