First published in the Sunday Times on 10th January 2016.
There have been few revolutions in the ownership structure of companies. An early radical invention was limited liability, combined with the idea that subscribers of capital would be owners, separate from management. Thus the first English joint stock company was the Company of Merchant Adventurers to New Lands, chartered in 1553 with 250 shareholders. And the first business whose shares were publicly traded on an exchange was the Dutch East India Company. But the most important innovation of the past 50 years has been the introduction of venture capital — and, subsequently, private equity.
Venture capital was really the creation of one man in particular, Georges Doriot. He was born in Paris but became a US army officer, having worked as a Harvard Business School professor. In 1946 he was appointed to run American Research and Development Corporation, which financed more than 100 start-ups in postwar America — including its biggest success, Digital Equipment Corporation (DEC). Doriot put $70,000 into DEC, a holding valued at $125m 10 years later. This huge winner fuelled the entire industry of early-stage funding for technology companies, which has led to the rise of countless world beaters, from Microsoft to Apple, Google and Facebook.
Private equity came later, with the formation of KKR in 1976, and Forstmann Little and Thomas H Lee Partners around the same time. They devised the model of general and limited partners, and the idea of recruiting institutional investors for a series of funds to back leveraged buyouts. The target companies were typically orphan assets being sold by conglomerates, mature subsidiaries with strong cashflows that could support high levels of debt.
The industry has changed beyond all recognition in the past 40 years. Titans such as KKR, Blackstone and Apollo have gone public. Many of the early pioneers have retired. Some firms have disappeared. However, many new ones have been created, and private equity has become a powerful force on the M&A landscape.
Because it is now so mainstream, and so large, it will continue to come under more scrutiny. It is a mature industry and can hardly be called “alternative” any longer. For example, private equity owns about a third of all US companies with revenues of between $100m (£68m) and $500m. Its impact on the UK and US economies, in particular, is considerable. So a wider understanding of its advantages and drawbacks is important.
Returns continued to recover last year because exits were strong. Even though the market for floats was subdued, trade buyers were active, and secondary buyouts were prominent too. Meanwhile, fund-raising continued apace. For the fifth year running, distributions exceeded capital calls for investors — and mixed returns from other asset classes encouraged more institutions to participate. Thus sovereign wealth funds, pension funds, foundations and high-net-worth investors added to the $1.2 trillion of dry powder available to the 6,000 private equity firms around the world.
But this very abundance of capital contributes to the challenge facing every private equity house — how do they find value? They receive juicy fees to deploy cash, not to sit on their hands and say that everything is too expensive.
Meanwhile, the availability and cost of debt has fallen significantly, boosting the resources that can be utilised by private equity buyers. As a result, purchase prices for private businesses are higher than I can ever remember. Competition during auctions for attractive companies is intense: advisers say they sometimes receive 20 or more serious bids for a deal. Almost the only way to clinch a transaction is to pay a very rich multiple. BDO’s latest Private Company Price Index is almost 11 times earnings before interest and tax, which feels pretty heady to me, unless it applies to truly outstanding companies. And by their very nature, such situations are rare.
Moreover, there are disagreements about the performance of private equity relative to public company investing. According to a recent article in Fortune magazine, after fees private equity did not beat the S&P index from 2006 to 2010. And, of course, private equity is highly illiquid and requires its investors to commit to a fund for up to 10 years. Critics might say the performance of a fund only really becomes clear in the seventh year of its life.
The game remains the same as it ever was — to make capital gains through three basic mechanisms: growing the profits of a business; selling that business for a higher earnings multiple than the purchase multiple; and generating cash to repay debt during the period of ownership.
If private equity managers secure that perfect trifecta, they produce handsome profits for their investors and themselves. It sounds simple enough, but in reality it is a hard trick to pull off.
Increasingly, the only way to achieve such success is to add value through operational improvements. The era when financial engineering alone could deliver bumper profits is largely over. This all means that private equity teams are going to have to work ever harder to keep their backers happy.