If you’re reading this blog, I probably don’t need to define what private equity is for you. But just in case, private equity firms are those that raise capital in order to buy public firms and take them private. Moreover, we’re all familiar with the role that private equity plays in our capital markets. Most of us would likely agree that they play a beneficial role, and that the market for corporate control keeps managers in check. Severely underperforming managers need to be very afraid that their firm will be acquired and that they’ll end up without a job. And although many of the benefits that private equity provides are well known and agreed upon among many parties, in this post I’d like to focus on one function that seems to be overlooked and is increasingly on the rise – the role that private equity plays in the strategic reorientation of firms.

Private equity and LBO funds (I will use them interchangeably here) have a long and well-known history. You know you’re mainstream when you’ve been portrayed not just in popular books (e.g., Barbarians at the Gate) but also in Hollywood movies (e.g., Wall Street). The common view of private equity is of a fund that buys firms that have overextended themselves by diversifying themselves into disparate, unrelated businesses. In extreme cases, such diversification destroys shareholder value (widely known in academic circles as the diversification discount – where diversified firms trade at a discount to their individual parts). Private equity firms traditionally bought over-diversified firms to sell them off as parts, where chopping up the individual businesses fetch more than it costs to purchase the whole firm. This is the type of activity that characterized the late 1970’s and early 1980’s activity that brought an end to conglomerates.

Another private equity story we’re familiar with is the one in which the private equity firm buys a target with excess cash and/or little debt. Private equity firms in this case will often buy the firm, take on a large amount of debt and use that debt to focus the firm (while at the same time, using that debt to pay themselves a dividend). The theory here is that debt imposes discipline on the firm because it leaves little room for managerial error and/or malfeasance. This works in much the same way that college debt, in that it incentivizes students to become productive after graduation (after all, the debt has to be paid back somehow and how can it be paid off when someone is goofing off traveling around the country in a car and/or working at a bar at a ski slope in Aspen). 

Private equity firms also exploit arbitrage opportunities that exist in capital markets. Often, they will buy firms in old, mature industries that have solid cash flows but limited growth potential. I call this the non-sexy industry acquisition. That is, they buy firms in industries that are not that sexy but in which the businesses are not yet dead. It could be that these firms are attractive targets because public equity markets apply too great a discount rate to firms in non-sexy, mature industries. After all, investors love growth.

There are several other explanations that we’ve heard driving private equity purchases as well. For example, the argument has been made that in strong, efficient capital markets (like the US), firms need not rely on banks for capital. Capital is abundant and available from institutions, individuals, banks, etc. Therefore, the benefit that firms formerly received from being public don’t necessarily exist anymore (e.g., the ability to raise capital due to some status or reputation effect). In addition, pundits point out that with the advent of Sarbanes-Oxley legislation, being public has become so costly that it does not necessarily pay to be public anymore. Specifically, by taking firms private, all associated compliance costs (e.g., especially 404 compliance) goes straight to the bottom line. Not only that, but many of the requirements associated with being a public firm goes away – so we can fire many of our lawyers, accountants, public relations folks, etc. Therefore, private equity activity in recent years has been geared toward taking advantage of these additional costs to being "public" by taking firms for which it is too costly to be public private.

All these are explanations that we’ve all heard, and that probably make some sense. I, however, believe that there is another explanation for the increase in private equity activity. In particular, if we agree that equity markets are increasingly short-term focused given the nature of the changes to shareholders that has occurred in the last half century (see my previous post on executive compensation), some private equity activity has been undertaken in order to give their targets the opportunity to engage in a long-term focused strategic reorientation that the equity markets will not perceive as beneficial. If investors are not particularly good at valuing long-term investments made by firms (as recent research in behavioral economics suggests), then there must be some way for firms to make those difficult, and sometimes painful, long-term decisions without incurring the penalties that the market is likely to impose (from which the firm may not recover). Therefore, private equity firms may be good at identifying firms that are undervalued by investors who do not see the value of its strategic makeover. This is one factor that could be behind the findings of Lerner and Cao. That is, they find that firms that are re-floated in the public markets after being taken private generally outperform the market. In essence, firms that are taken private are stronger after they are re-floated.

This latter explanation supports a view of private equity funds as more than simply a group of financial wonks that identify minor, technical arbitrage opportunities in equity markets and pounce on them like their arb trader/hedge fund counterparts. Moreover, they fill more than just a role as sales folks and valuation experts like their I-Banking brethren. Rather, private equity funds can be viewed as a collection of pricing experts and strategic generalists with the financial skills to not only identify arbitrage opportunities and accurately value firms, but also the management skills to help its targets pursue, realize and capitalize on their value-added strategy. This is a very valuable function.

So to the list of benefits that private equity firms provide to healthy, functioning capital markets I’d like to add their role in taking firms private to allow them to strategically re-orient themselves away from the microscopic, short-termist scrutiny of the public equity markets. This explanation is not often recognized, but no less important than the rest.

This entry was posted on Wednesday, April 4th, 2007 at 6:26 pm and is filed under Corporate Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.