People's Democracy

Private Equity And The Dematerialisation Of Wealth

C P Chandrasekhar

THERE is growing concern in recent times about a most elusive set of intermediaries managing assets for financial investors: private equity firms. What are these entities? How do they behave? And what are the implications of their growing presence?

Portfolio diversification by financial investors in developed countries seeking new targets, higher returns and/or a hedge has over the last quarter of a century taken them into new and ostensibly “innovative” and “alternative” asset classes. One such is private equity, which as originally broadly defined involved investment in equity linked to an asset that is not listed and therefore not publicly traded in stock markets. More recently, private equity firms have invested even in listed companies, though the buy-out by the investor occurs through a negotiated process.

Private equity gained prominence in the 1980s because of two developments in the world of increasingly deregulated finance. The first was the desire of banks and pension funds in the developed countries to find new avenues for investment of their burgeoning resources. Public pension funds like the California Public Employees' Retirement System, the largest public pension fund in the US, have taken the lead. According to estimates by Russell Investment Group, an investor services company, public pension funds have nearly doubled their exposure to private equity over the past decade and on average invest some 8 per cent of their funds in that asset class. A similar though different situation characterised the banks. In their case, developments such as the recent oil price increases, which led to large deposits of petrodollar surpluses, resulted in an increase in their lendable resources and had them also looking for new avenues for investment and lending.

The second development of significance, influenced by the first, was the relaxation of rules relating to investments that could be undertaken by institutional investors like banks and pension funds. In 1971, the Competition and Credit Control policy in the UK gave banks greater investment flexibility. Similarly, in the US, a clarification of the "prudent man" rule (incorporated in the Employee Retirement Income Security Act of 1974) issued by the US Labour Department in 1978 relaxed many of the limitations placed on institutional pension funds allowing them to invest in private equity and other alternative assets. Since then there have been a series of structural and legal changes in Europe and the US, involving inter alia pension fund and insurance company regulation, which have had the same impact. These have been accompanied by changes in taxation laws that have encouraged leveraged investments and made investments that promise capital gains more attractive.

The expansion of funds available for and seeking alternative investments resulted in increased demand for an asset class like private equity, and for intermediaries who could intermediate investment of such capital. Figures from Venture Economics suggest that between 1980 and 2000, the amount of commitments of capital to funds managed by private equity firms increased from $2.3 billion to about $177 billion, cumulatively totaling $737 billion. However, estimates of the industry’s size vary, reflecting the secrecy that shrouds it. The largest private equity firms, such as Blackstone, the Texas Pacific Group, or Kohlberg Kravis Roberts & Co., each control companies with combined net revenues that exceed most US companies. And the large volumes of committed investor capital controlled by these funds and their substantial access to bank credit make them consider and execute deals that are huge and often unprecedented. One such recent deal is the Blackstone take over, after an intense battle with Vornado Realty Trust, of Equity Office Properties (the publicly traded owner of US office towers) at a price of $39 billion. This is reportedly the largest leveraged buyout ever. But matters are not expected to stop there with talk of a potential take over by private equity of Canadian telecom operator BCE for an estimated $49 billion.

While private equity has been growing rapidly, its activities in the developed countries is being curbed by the growing opposition to these firms and their activities. In particular they are being accused of yielding the hatchet against workers or breaking up companies when firms are being restructured. Brendan Barber, the general secretary of the Trade Union Congress in the UK recently launched an attack on the private equity industry, accusing some operators of being "amoral asset-strippers" and "casino capitalists". Barber said that, while private equity had sometimes turned round ailing companies, operators sometimes gave the impression "of being little more than amoral asset-strippers after a quick buck; casino capitalists enjoying huge personal windfalls from deals at the same time as they gamble with other people's futures."

In his view: "The problem is simple: private equity can steer clear of the responsibilities a public company has to live up to. Its owners will disclose as little as possible about what they are doing, and why. In companies that are often leveraged to the hilt, it's employees who end up shouldering much of the risk, with downward pressure on pay, pensions and job security."

Another major criticism of private equity is their lack of transparency. Paul Myners, former chairman of Marks and Spencer, whose review of institutional investment in 2002 had recommended that pension schemes should consider investing in a wide range of asset classes including private equity and hedge funds, declared: “We are seeing public companies go private and they go from being transparent and accountable into a dark box.”. The performance of funds and their underlying businesses should remain as open as those of public companies, he reportedly said.

Finally, private equity firms are seen as being favoured by governments in the developed countries because of its practice of taxing profits after interest has been deducted. Since private equity firms finance their investments with a high proportion of debt, which reduces taxable profit, buy-out firms are seen as being given an unfair advantage in pursuing their questionable practices.

One result of all this is that private equity firms are finding their business getting harder to conduct in the US and Europe. Not surprisingly, there are signs that the business is increasingly moving overseas, especially to emerging market countries where markets are booming because of foreign institutional investment inflows.

According to Emerging Markets Private Equity Association, fundraising for emerging market private equity surged in 2005 and 2006. Estimated at $3.4 billion and $5.8 billion in 2003 and 2004, the figure shot up to 22.1 billion in 2004 and $21.9 billion in the period to November 1 during 2006. Asia (excluding Japan, Australia and New Zealand) dominated the surge, with the figure rising from $2.2 and $2.8 billion in 2003 and 2004 to $15.4 billion during 2005 and $14.5 billion during the first ten months of 2006.

India’s experience is illustrative of the rush of private equity to the developing world. Observers began to take note of private equity’s growing presence in India when in late 2002 Oak Hill Capital and Financial Technology Ventures resorted to a buyout deal by backing a management bid to acquire Conseco's stake in Delhi-based EXL Services. Subsequently in September 2003, ICICI Venture bought out the Tatas' controlling stake in Tata Infomedia. Three months later, CDC Capital Partners, the UK-based private equity investor, struck a Rs 75-crore deal to buy ICI India's industrial chemicals business in Gujarat. The private equity asset class had arrived in the country.

Since then there has been an increase in such activity with all the majors finding their way to the country. Growth has also been substantial. The total number of M&A deals struck in 2006 was estimated at 782 ($28.2 billion) compared with 467 ($18.3 million) in 2005. Of these, 302 involved private equity. Private equity investments also saw substantial growth in 2006. From $1.1 billion invested in 60 deals in 2004, private equity investments rose to $2 billion in 124 deals in 2005, and a remarkable $7.9 billion in 302 deals in 2006. This remarkable 287 percent increase in the total value of private equity during 2006, points to a growing value in each deal. There were more than 29 deals valued at over $50 million as against 10 such in 2005. The average private equity investment size increased from $16.40 million in 2005 to $26.02 million in 2006.

Some of the big deals included Kohlberg Kravis Roberts & Co's $900-million investment in Flextronics Software Systems; Providence Equity Partner's $400-million investment in Idea Cellular and Temasek Holdings Pte's $330-million investment in Tata Teleservices Ltd. Such deals are continuing in 2007 with Blackstone Group acquiring a 26 percent stake in Ushodaya Enterprises Limited , which publishes Telugu-language newspaper Eenadu and owns television channels under the same name.

Since private equity returns derive from an appreciation in the value of the acquired asset or company, private equity investments are often followed by efforts at restructuring to resuscitate loss-making companies or substantially improving the performance of profit-making ones. These efforts are aimed at adding value to the investment before private equity investors exit with a profit. Less appreciated forms of intervention by private equity firms are those in which bought-out firms are stripped of assets or are broken up so that the pieces can be sold to the highest bidder for an aggregate sale price that exceeds the purchase price. Such means of reviving or improving the performance of poorly performing companies must be a prerequisite for ensuring the appreciation of an asset, excepting in cases where: (i) the company concerned was bought cheap and could therefore be sold for a profit, which would be more an aberration than the rule; (ii) the market for the company’s products takes a turn for the better, which was not foreseen by the original owner but expected by the private equity firm; or (iii) the company develops a new product or technology which can be commercialised for a large profit, as does happen in the case of some venture capital investments.

While these may be the principles, on the basis of which the private equity business is rationalised, in the final analysis the business rests on the fact that “valuations” are speculative. Private equity firms would like to keep their buy-out prices cheap, but loaded with funds find the need to push up valuations to acquire assets. While informed by the profit potential of the target, these valuations do often imply a high degree of risk. But the very fact that such initial valuations are made, by firms led by individuals with a track record, creates an environment for future sale at a price that incorporate a profit. And the longer investors in private equity funds are willing to wait for returns, the longer would fund managers have to wait out the market in search of a profitable sale. Further, in certain circumstances, valuations in the private equity market could influence stock market prices as well, with high valuations in the former encouraging higher price earnings ratios in the latter. This could help sale of assets through the stock market.

Valuations may also be sticky upwards in the relatively good times or when there is liquid capital looking for avenues to invest because of a fact noted earlier: the distinction between purely financial capital and capital aiming to derive returns from production of goods or services in the long run has blurred. Increasingly, investments in production are driven by the possibility that the creation of a successful company could offer the option of selling out at a high price, delivering wealth that can be invested in financial assets. Since wealth is measured by the prevailing market value of the asset, the process can feed itself leading to unsustainable valuations at which someone has to carry a loss. The bourgeoning of finance results in the “dematerialisation” of wealth, permitting wealth accumulation at a pace much faster than the growth of production, so long as the game of rising valuations can be sustained.

What needs to be noted is that this process breeds in an environment of inequality and feeds on it. Global and national inequalities concentrate incomes among a few, whether they be the millionaires in the developed and developing world who accumulate savings looking for avenues of investment or sections of the middle class that accumulate financial capital through investments in mutual and pension funds, that need to be invested to meet future commitments. Neo-liberal reform by reducing state provisions for social security only aggravates this process, since it requires the middle class to save for contingencies or old age. The financial component of neo-liberal reform permits pension funds and insurance companies to invest this capital in a wider range of assets, resulting in the expansion of an asset class like private equity. The financial system adjusts by courting risk. By permitting and even encouraging private equity investments in India, the government is not merely increasing the risk of volatile flows of capital in search of high profits in and out of the country, but is paving the way for an acceleration of acquisition of assets currently held by domestic capital by foreign players.