Private equity isn’t fading away

Despite the credit crunch, private equity isn't fading away. In fact, the industry's assets may double by 2012, Diana Farrell writes in Businessweek.

Private equity funds are under attack, criticized as "vultures," "locusts," and worse, particularly in Europe, as their ability to scoop up huge companies—some bearing household names—continues to grow. Many observers worry that heavy borrowing by private equity funds may be increasing credit risk in financial markets, and some wonder whether the high fees they charge are justified.

These concerns are genuine and worth examining. But new research from McKinsey Global Institute also finds grounds for optimism. The best private equity funds do improve the performance of the companies they buy and, in doing so, are beginning to influence both corporate boardrooms and financial markets.

Private equity firms start by targeting companies that are undervalued in public markets or underperforming compared with their peers and potential. Although they are often accused of seeking short-term profits, private equity funds typically invest with a three-to-five-year horizon, allowing them to engage in long-term, root-and-branch corporate restructuring. By adding debt to an acquired company's balance sheet, they force managers to hit tough financial targets. And the extra leverage boosts returns.

Mixed Returns to Investors
This approach has breathed new life into private ownership. Private equity growth has soared in recent years, fueled by low interest rates that make a larger range of buyouts attractive. Strong inflows of capital from institutional investors such as pension funds and endowments, as well as from petrodollar investors, also have driven the surge in private equity. According to our research, the assets under management in global private funds reached $710 billion at the end of 2006, more than double the amount in 2000. US-based funds accounted for $423 billion of the total, and European funds for $183 billion.

Until the credit market turmoil of mid-2007, these trends enabled private equity firms to buy ever larger companies and play a growing role in financial markets. The industry accounted for one in three mergers and acquisitions in the US at the end of 2006, and one in five in Europe.

Despite this rapid growth, though, private equity's returns to investors are actually quite mixed. Just one in four funds significantly outperforms public equity markets—and half of the funds provide investors with negligible returns. But growing evidence shows that those funds in the top quartile also fundamentally improve the performance of the companies they acquire. In doing so, they have an impact on other companies in that sector, causing them to reconsider their own strategies and corporate governance.

Market Risks May Be Amplified
A growing number of companies, public and private, are starting to feel the ripple effects from the private equity boom. Shareholders are becoming more inclined to closely scrutinize the performance of company managers and demand improvements; executives and directors, in turn, feel pressure to boost performance. Managers at some companies say they would welcome a private equity buyout—as long as they retained their jobs.

As the pace of private equity buyouts quickened earlier in 2007, many public companies also reconsidered their attitudes toward debt and equity. In both the US and Europe, for instance, many companies chose to buy back equity shares, sometimes using cash flow but in other instances by raising debt levels.

To be sure, private equity also may be amplifying financial market risks. Leveraged buyout funds are behind the dramatic growth in high-yield debt—the preferred financing for today's corporate takeovers. Until recently, these funds also used their growing clout to extract looser lending covenants and financing terms from banks.

Still A Small Player in the Corporate World
These risks warrant monitoring. But while the volume of lending to private equity has indeed risen in recent years, McKinsey Global Institute's analysis shows that the industry is only a small part of the overall debt market—arguably still not large enough to pose systemic risk.

In 2006, private equity accounted for just 11% of overall corporate borrowing in the US and Europe. Even if defaults on private equity loans rose far beyond past rates, to 15% from historic highs of 10%, McKinsey estimates the implied losses would equal only 7% of the 2006 syndicated lending issuance in the US and 3% in Europe.

And for all the noise, private equity remains a relatively small player in the corporate world. Private equity-owned companies are worth just 5% of the value of companies listed on US stock markets and 3% of those in Europe.

The recent tightening of credit markets has complicated the financing of some buyout deals and may dampen the flow of investor money into private equity firms. Skeptics on both sides of the Atlantic have been quick to proclaim that the private equity boom is over. But don't expect private equity to suddenly fade to the background, as did the leveraged buyout boom of the 1980s. Even if growth slows in the short term, pension funds and other institutional investors will remain interested in private equity. McKinsey projects the industry's assets under management may double by 2012, to $1.4 trillion.

Of course, some poorly performing funds may fold along the way (which would be a healthy development for the industry). And the huge investment funds owned by Asian governments and oil-exporting countries will present an opportunity for private equity to tap new pools of capital—but also could pose a threat as they become direct competitors on some deals. Nonetheless, the evidence suggests that in the years to come, the private equity industry will mature, consolidate, and diversify its investment strategies, amplifying its influence on the broader corporate and financial landscape.

Diana Farrell is the director of the McKinsey Global Institute, McKinsey's economics research institute.

This article originally ran in Businessweek.

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