Can the private-equity bonanza last?

Jan 27th 2005
From The Economist Global Agenda

Though investors are still queueing to throw money at private-equity funds and the best funds are making tasty returns, in some ways the business is getting ever tougher

WHILE investors in shares fret about a further rise in the price of oil and holders of bonds worry that the bull market in fixed-income securities may be at an end, the world of private equity (buy-outs of existing firms as well as venture capital for budding ones) is all smiles. After a bumper 2004, in which more venture-backed companies floated their shares in America than in the previous two years combined, investors are queuing up to pledge new money. Indeed, such is the demand for private equity that investment banks are reported to be preparing to launch some big new funds.

More companies than ever before are also inviting private-equity firms to help them restructure or raise money, especially in Europe. Among those to have put up part or all of their businesses for auction to private equity recently are Travelex, the world’s biggest provider of foreign exchange to tourists; Wind, a subsidiary of Enel, Italy’s biggest utility company; and Bezeq Israel Telecom, the Jewish state’s main telephone company.

Deals are getting bigger too. Last year, the number of transactions worth more than $1 billion jumped to 79 from 42 in 2003, according to Dealogic, which tracks such things. If it goes ahead, BC Partners’ and Cinven’s joint offer for Amadeus, which handles reservations online for airlines and travel firms, at around $5.6 billion, would be the biggest so far this year.

After a lean period following the bursting of the internet bubble a few years ago, private-equity firms are also cashing in a bigger proportion of their investments. No fewer than 62% of the venture-backed companies that went public last year received their first dollop of finance between 1997 and 2000 during the internet boom, says America’s National Venture Capital Association. Trade buyers are also stepping up. Newbridge Capital recently pocketed around $1.5 billion when it sold a 48.6% stake in Korea First Bank to Britain’s Standard Chartered Bank.

Private equity is now big business. In Britain, one-fifth of the workforce outside the public sector is employed by firms that are, or have been, invested in by a private-equity firm, according to the British Venture Capital Association. Worldwide, there are now more than 2,700 such firms, reckons Goldman Sachs. And their fire-power and influence are likely to grow. More than half of existing private-equity investors expect to put in more money this year, according to a recent survey by Coller Capital.

Even in Germany, where compared to the size of its economy the number of deals involving private equity has been tiny, the idea is finally catching on. Last year, the value of deals by private-equity firms rose to a record of €22 billion ($27 billion)—three times the amount in 2001. Indeed, such deals accounted for around 40% of all mergers and acquisitions in Germany during the year, a huge proportion for the world’s third-largest economy.

Celanese, a German chemicals firm bought by Blackstone Group, a private-equity house, was returned to public investors last week in a flotation worth $800m. Indeed, many of the country’s biggest companies—among them DaimlerChrysler, Deutsche Telekom and Siemens—have sold businesses to private-equity firms. Politicians approve of the trend because they realise it makes companies more efficient while often creating jobs.

Yet private-equity firms are already in danger of becoming victims of their own success. This is partly because managers of companies have become more adept at use of debt instruments and leverage, boosting cashflow and motivating their workforces—all of which were comparatively novel business methods when the pioneers of private-equity began applying them to floundering firms in the 1970s and 1980s. Thus there are now fewer candidates for such treatment. And as the number of private-equity houses has grown, there has been ever more competition for those promising targets that come up for grabs. Indeed, it is not uncommon for private-equity firms to sell their shareholdings to a rival if a traditional exit—a trade sale or a flotation of the shares on a stock exchange—proves tricky to arrange.

The gulf in performance between the best and the worst private-equity houses is also widening. The top firms have delivered far better returns on average to investors than stockmarkets have done (producing annual gains of 23% between 1980 and 2001, according to a study by Steve Kaplan of the University of Chicago and Antoinette Schoar of the Massachusetts Institute of Technology). But those at the bottom of the pile have done much worse (after deducting hefty fees) than the typical investment fund that tracks a stockmarket index.

In future, the gap could widen still further as competition intensifies. A handful of big international firms producing consistently high returns is likely to emerge at the top. At the other end of the scale, small firms specialising in a part of the market—such as biotechnology—could thrive. In the middle, however, many firms will find it tough. Some of the larger of these—such as Kohlberg Kravis Roberts and Apax Partners—say they will continue to concentrate on private equity. Others, like Blackstone and Carlyle Group, are pondering setting up hedge funds or offering other kinds of investment.

The industry is at a watershed for other reasons too. In Japan, private-equity groups face demands to pay more tax. Accustomed to operating behind closed doors, the industry also faces pressure to open up its books. In America, private-equity groups that invest on behalf of public authorities’ pension funds have already been forced to divulge information about their returns. Now, thanks to the introduction of a freedom-of-information law, the same thing is happening in Britain.

Private-equity houses could soon face an uncomfortable choice: either to reveal all or, like Sequoia Capital, a big American firm, to turn away public pension funds. Most private-equity firms realise that, in today’s climate of open corporate governance, they must become more accountable. But many still insist that private equity should remain private or risk losing its edge.

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