Private Equity Public Policy Concerns

There are a number of practices of private equity buyout firms that are creating widespread concern among public policy-makers, securities markets, and other stakeholders.

1. Quick Flips.
Private equity typically owns companies for three to five years, seeks to improve operations and profitability, and then relists the companies as healthier and better suited for long-term growth. Increasingly in recent years private equity has sought to increase their funds’ investment returns by liquidating part or all of their investment more quickly. To accomplish this they engage in “quick flips,” relisting companies within a year or two of taking them private, with more leverage, but few if any operational improvements. They also cause their portfolio companies to borrow more money to pay the private equity firm a special dividend, sometimes within months of the original acquisition.

2. Conflicts of Interest.
The managers and directors of a public company owe a fiduciary duty to maximize returns to shareholders. But when private equity invites those same managers or directors to participate in a leveraged buyout, their interest shifts to help the private equity group get the lowest price possible for the company. More than one commentator has suggested that this inherent conflict should be regulated by prohibiting management participation in buyouts. In addition, the big private equity firms are now the largest customers and generators of fees to the global investment banks and commercial banks for their stock and bond underwriting, bank lending and investment banking advisory services. These multifaceted relationships with firms such as Goldman Sachs, Merrill Lynch, and JPMorgan Chase led Robert Kindler, vice chairman for investment banking at Morgan Stanley, to say at a recent panel at the Corporate Law Institute at Tulane University, “We are all totally conflicted — get used to it.”

3. Debt Risk.
Leverage is the key to the high returns private equity is able to generate (see box on Page 13). The easy credit markets of the last few years have helped fuel the surge in private equity, and the persistence of relatively low interest rates with steady economic growth has meant that there have been relatively few defaults among private equity-owned companies. In addition, the banks that are underwriting most of this debt are repackaging it and selling it to other lenders and investors, laying off the risk on others with limited additional due diligence by the new creditors. One result is a relaxing of underwriting standards by the original lenders, with debt that is “covenant-light” or even “covenant-free.” Observers and policymakers worry about the impact a sudden downturn in the economy or an increase in interest rates will have on portfolio companies and the ripple effect of a rash of defaults on the broader financial markets.

4. Private Equity Exuberance:
Private equity firms raised $215 billion in 2006— the most ever. The total exceeds the amounts raised during the last private equity bubble, in 2000. For 2007, buyout firms are hoping to raise even more—as much as $400 billion. With all this capital being raised, it increases the competition for deals, increasing the likelihood some firms will overpay for deals or do deals that make less economic sense. In addition, a significant downturn in the public equity markets would severely impair the ability of private equity to exit deals that were poorly conceived, highly leveraged, or overvalued.