Select Committee on Treasury Written Evidence


Memorandum submitted by Kenneth Robinson Wade

EXECUTIVE SUMMARY

  Lack of transparency is a meaningless accusation unless qualified in terms of the subject, the observer, and the comparator. Companies owned by private equity (PE) funds are no different to any other privately owned company of comparable size in respect of the public transparency of their activities and performance, and there is no reason why any distinction should be made. The legal and financial relationship between a PE manager (general partner) and the investors (limited partners) in a PE fund is arguably a matter for the parties concerned. How will the public interest be served by singling out PE for the forced disclosure of commercially sensitive information, and to what extent is a perceived lack of transparency due to a lack of understanding?

  The rise of PE has been driven by investment performance. Historically this was due to benign economic and business conditions enabling PE houses to exploit their deal-making skills. More recently, the stewardship of investee companies combined with the efficient use of capital has emerged as the key source of superior investment performance. However, there is a possibility that uncompensated risk has been transferred to the banking sector. Although deal-making opportunities have been reduced, the economic environment remains favourable for PE. On the whole, PE ownership provides worthwhile benefits to the investee business, although there are issues arising from the short-term nature of PE. Eventually, an alternative to the buy, improve, sell PE model may emerge.

1.  INTRODUCTION

  This memorandum addresses firstly the issue of transparency in PE and then discusses some of the economic issues, in particular the reasons for current rise of PE and the advantages and disadvantages of the PE model of corporate ownership. It may be helpful to look briefly at the structure of PE funds and how this affects the issues addressed.

2.  STRUCTURE OF PE FUNDS

  A PE fund is a partnership between (usually institutional) investors (limited partners) and the fund manager/PE house (general partner). A PE house typically will manage a number of funds, each of which will be a closed end fund with a ten-year life. During the fund-raising phase, limited partners commit specified amounts to a fund, which are drawn down by the managers as suitable investments are identified and bought. The aim is to buy, improve, and sell each investment within typically three to five years, (but in any case before the end of the nominal (10 year) life time of that fund), and return the realised cash to the limited partners after deducting whatever is due to the general partner.

3.  INVESTMENT PERFORMANCE

  The performance of any investment is usually specified in terms of the internal rate of return (IRR). The IRR is a function of the amount of cash returned and the timing of the payments. Although it is normal to estimate the IRR for a PE investment on a running basis (by estimating the probable current value of that investment at that point in time), the actual achieved IRR for each investment will only be known once that investment is realised. The achieved IRR for the fund as a whole will only be known once the fund has closed out and all the investments realised. In some cases, not all the investments in a fund will be sold within the nominal lifetime. It is common for estimated valuations to err on the low side, and in consequence the IRR during the early years of a fund can be considerably lower than the eventual achieved IRR. Achieved IRRs vary considerably between investments within a fund's portfolio, between funds managed by the same PE house, and between PE houses.[108]

4.  TRANSPARENCY

  4.1  PE is often accused of lack of transparency—an accusation that in reality is too general to be meaningful. The accusation could apply to the PE house, the PE fund, the companies owned by the fund, or any combination of these. For the accusation to be meaningful it is also necessary to specify the observer and the comparator: lack of transparency for whom compared to what? Taking the company first, there is no difference between a PE owned company and any other privately owned company of equivalent size. The various reporting requirements of all companies are set out in the appropriate legislation. Clearly, listed companies are subject to additional reporting requirements since their securities are traded on public markets, but there are many large private companies and on the face of it there is no reason why companies in PE ownership should be treated any differently to these from the point of view of publicly available information.

  4.2  The partners in the PE fund that owns the company are in the same position as shareholders in any private company. They are concerned with the performance of each company they own, and with that of the fund as a whole. As mentioned above, the investment performance of the PE model is intrinsically opaque compared to investments in quoted securities (which can be valued on a minute by minute basis if need be). However, this is offset by the closer involvement of the limited partners in the businesses in which they are invested through the fund concerned. They will receive far more information about each business, including strategy, and management information such as key performance indicators and monthly accounts. Much of this information is commercially sensitive and therefore confidential (as it would be for any business). The limited partners are presumably satisfied with the information they receive (if they weren't they wouldn't invest in future funds). It is hard to see how the public interest would be served by public disclosure of information that is normally confidential to the partners in the fund.

  4.3  The intrinsic lack of transparency in respect of the performance of any unquoted investment is compounded when several investments are conglomerated into a portfolio (as is the case with a PE fund). When a PE house manages a number of funds with different maturities, perhaps ranging from one to ten years, the problem is compounded further. However, whilst the performance of a PE house as a whole is difficult for outsiders to ascertain, institutional investors seem happy enough to subscribe to new funds (although some investors have referred to lack of transparency in respect of the historic performance of maturing funds and the fee structure of PE managers).[109] Since PE houses may well regard this information as both commercially sensitive and open to misinterpretation, they may understandably be reluctant to make it more widely available. It has to be questioned whether the problem for the wider audience is more to do with lack of understanding rather than lack of transparency.

5.  THE ECONOMIC CONTEXT—GROWTH OF PE

  Research into investor attitudes shows that investment performance coupled with lower volatility is the key factor driving the growth in institutional investment in PE. Limited partners demand a premium over public equity to compensate for lack of liquidity and transparency that are inherent features of unquoted investments. So far, PE has been able to deliver superior performance and it is worth examining the reasons for this in more detail.

5.1  Sources of Excess Returns

  During the 1990s, a combination of benign economic factors (low interest rates, a favourable business cycle, rising stock markets) made PE almost a one-way bet. Studies[110] into portfolio management in PE show an emphasis on deal making during that period, with less concern about managing the businesses subsequently. Later studies[111] show a considerable increase in the importance of portfolio management in the face of more difficult conditions during the early 2000s. The growing attraction of PE as an asset class has led to increased competition between PE houses in finding and buying companies, and it can be assumed that the majority of investments are now fully valued at the time of purchase. That implies that there are limited ways in which a PE house can add value to an investee business compared to the same business under other ownership. The two key areas are in the efficient use of capital, and in better management of the business.

5.2  Capital Structure

  In general, PE owned companies are more highly geared than equivalent privately owned or listed companies. It may well be the case that many privately owned and listed companies have less than optimum levels of gearing, and this factor alone will improve the return on equity when such a company is bought by a PE fund. PE owned companies are seldom required to pay dividends to shareholders, and given the short (3 to 5 year) holding period for typical PE investments, maximising cash-flow to pay for increased borrowing makes sense when the key participants are rewarded when the business is sold.

5.3  Transfer of Risk to Banking Sector

  An efficient level of gearing for a company with good cash generation and low and stable interest rates can look quite different if rates rise and/or the business turns down. Regardless of whether increased leverage represents a systemic threat, it does represent a transfer of risk to the banking sector, and it may be questioned whether this risk is adequately compensated. Arguably the banks are in a position to decide this for themselves, but if PE shareholders can consistently outperform public markets then it suggests that the excess returns will be at the expense of the other providers of capital to businesses, which are the banks and other creditors. These other providers are effectively taking on additional risks whilst the equity holders are receiving the additional return. Since the banks and other creditors are free to choose whether and on what terms to lend, the market should be able to cope provided the situation is recognised.

5.4  Portfolio Management

  The rewards to PE managers are exactly aligned with the interests of their limited partners. Since today the majority of PE purchases are de-facto auctions, there is little scope for buying assets at a discount. It may also be assumed that more efficient use of capital is a common feature of PE. Ultimately, the PE house has to add value by managing the acquired business at least as well, and hopefully rather better than before. This often involves disposing of non-key assets, the sale and leaseback of properties, and very tight managerial controls. Whilst this can lead to accusations of "asset stripping", in reality the PE manager has much more incentive than the CEO of a public company to make the business successful, since the reward to PE is entirely conditional upon a profitable realisation within a fairly short time.

5.5  Incentives

  The PE model is arguably unique in the extent to which it motivates the key drivers of the businesses in which it invests. The outstanding rewards available attract talented (often relatively young) people and encourage them to work exceptionally hard in small, close-knit teams. It is not simply about monetary reward: PE represents an exciting and stimulating environment quite unlike either the typical entrepreneur owned and managed business or the typical listed company.

6.  THE ECONOMIC CONTEXT—OTHER ISSUES

6.1  Favourable Economic Factors

  Despite recent rate rises, the combination of historically low rates of interest, high economic growth, a track record of relatively good returns, and a sympathetic tax regime provides a favourable climate for PE. Levels of investment are likely to continue to rise, and the weight of money will lead to more and bigger deals. With PE funds now able to acquire, or at least contemplate acquiring, FTSE companies, there is a greater incentive for these companies to review their management and financial structures. As long as the PE model can generate a return premium compared to public markets, PE is likely to continue to grow. However, PE as an asset class still represents a small proportion of total investment by UK institutions. There is also a question of whether the UK PE industry can profitably invest the available funds.

6.2  Advantages of PE Ownership

  From the point of view of the company, PE ownership is likely to result in higher quality and better incentivised senior managers, with skilled, committed support from the PE house team. Managers will be encouraged to identify every opportunity for profit growth (albeit relatively short term) and any necessary investment will be made available. At the same time, managers will be expected to stick to agreed plans, which will include tight controls of costs and working capital. The CEO of a PE owned company will report to a small team of experienced, professional and highly focussed executives within the PE house. Typically, the chairman will be part of that team, which may also provide a non-executive for the company board. PE houses also identify "friendly" appropriately experienced people to chair investee businesses, especially when industry-specific knowledge may be lacking within the PE house team. PE houses often tend to specialise in the business sectors they address, and will have strategies for acquiring and developing potential target companies.

  Provided the business is operating as planned, there will be minimal interference from the PE house team. However, if there are any problems the management can expect swift and often quite drastic action. The PE house is much more likely than the board of a public company to replace a CEO who is perceived as failing.

6.3  Disadvantages of PE Ownership

  The principal drawback to PE ownership is the short-term (three to five year) view that is inherent with closed-end funds. The PE fund has to exit, come what may. Whilst this imposes a sense of urgency and discipline, which may be all too often lacking in listed companies, it also tends to discourage long-term investment. PE houses tend anyway to avoid business sectors that may demand a longer view, in favour of cash-generative relatively unexciting sectors. PE is not venture capital. Relatively frequent changes in ownership are likely to be unsettling for employees, and perhaps also for customers and suppliers. Where a company has a succession of PE owners, that problem is likely to be exacerbated, since each owner will be seeking to accelerate short-term profit growth. Growth in PE will almost invariably result in more companies being subjected to successive changes since sale to another PE fund will be an increasingly common exit.

6.4  Looking Ahead

  A business model based on the buy, improve, sell formula may have a limited life. The threat of a takeover by PE funds can stimulate potential listed target companies to improve performance and capital structure. The scope for improving further the short-term performance of companies that have been in PE ownership must be limited. It can be expected that the performance premium available to investors in PE will be eroded over time, partly due to ever increasing competition between buyers and partly due to diminishing returns from short-term profit growth. This raises the question of whether the arguably superior corporate governance typical of PE can apply to a buy, improve, and hold model in which the investors obtain their return primarily as an income stream with long-term growth instead of a capital gain.

July 2007









108   BVCA private equity and venture capital performance measurement survey 2005 PricewaterhouseCoopers. Back

109   Insight into investor attitudes to PE KPMG Manchester Business School Private equity research programme, February 2003. Back

110   Insight into portfolio management KPMG Manchester Business School Private equity research programme, February 2002. Back

111   Insight into portfolio management 2003 KPMG Manchester Business School Private equity research programme, July 2003 Available from KPMG, 8 Salisbury Square, EC4Y 8BB 020 7311 1614. Back


 
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