Thursday, May 1, 2008

Private Equity, friend or foe?

Hectic week, easy post.

In order to understand the old, heavy-set, gentlemen (except on Fox, where, they've determined through scientific study, that when talking about money, people prefer to see women) that debate financial and market news, one should understand the world of private equity. And it's not too difficult to grasp but is so vital to our economy that I thought I would give everyone some insight into this very private world. You've probably heard buzz words in the news, or on the radio, maybe some terms like, "leveraged buyout," "Blackstone," "IPO," etc. First I'll explain the vocabulary, then move to economic factors that influence success of private equity firms, and conclude with advantages and disadvantages.

Private Equity is an investment in a privately held business. I know, no surprise, but many don't really understand what the alternatives are. Let me take a step back. Anyone can buy a share of stock. For example, if I fancy Microsoft, I can purchase one share of their company at any time and there is plenty of information available to help me analyze Microsoft. That's because Microsoft is "publicly" traded. What does that mean? It means the general public can buy shares and participate in the growth, or demise, of a company. In order to do this, Microsoft must follow very strict reporting and accounting guidelines so that the general public can make an educated decision since most people are not financial experts. O.K., good. How is private equity different again?

Who are they and what do they do?

Private Equity is an investment into privately held companies, so they don't have to comply with the excessive reporting standards of the SEC, and because of that, the general public can't participate. So who can? The SEC has determined that, because of the lack of transparency, only financially sophisticated and wealthy individuals/organizations can participate (in other words, you better know what you're doing). And they have a checklist to establish who may or may not be potential investors. Some privately held companies include AMC Theatres, Countrywide, Chrysler, IKEA, and Earnst and Young, to name a few. Rather than ownership being split up among millions of shareholders, private companies may only have four or five larger shareholders.

Some of the largest private equity firms are Blackstone, KKR, Caryle, Apollo, and Bain and Company. You'll hear about all of them in the news on a weekly basis. Now, here is where it gets a little tricky. These firms don't use their own money to invest in these private companies, rather, they mostly use debt and other people's money. And they will invest in multiple companies, here's how. Take Blackstone for example. Blackstone will say, "We think there are some pretty good deals out there, let's go raise some money to invest in these attractive deals." Blackstone decides they need approximately $10 billion to invest. Then they say, "We'll put in $1 billion and let's see if we can go find the other $9 billion from pension plans, college endowments, and large foundations." Once they come up with $10 billion in commitments they're ready to find deals.

Here's an example of how a transaction might work: Blackstone finds company A and offers $300 million (for example, $150 million could come from Blackstone's investors, and the other $150 million they might borrow from the bank) to purchase 51% of the company. This is called a Leveraged Buyout ("leverage," because that's what it's called when you use debt, and "buyout" because they are taking a majority). Once they take control, Blackstone works to improve the operations of the business with the intent to either sell it to someone else (for more than they paid), or take the company public (IPO, for Initial Public Offering) where they list on an exchange and offer shares to the public and comply with all the reporting guidelines.

What determines if they are successful?

  • Buying cheap. Isn't that how it works for everyone. Essentially, you want to make sure you bought the company at a very attractive price.
  • Access to Debt. Since they use debt to purchase these companies, the restriction of debt causes serious problems. That's why the credit crisis is affecting the large Private Equity firms. They can't get lending to purchase these companies.
  • An exit market. They have to be able to get rid of the company. A down market can really affect their two most promising exits; an IPO (again, offering shares to the public), or the sale to another firm. IPO's are hard because public investors do not want to invest in the new kid on the block when everyone is worried about the economy. A sale to another firm is hard because the prospective buyer may not be able to get lending from the bank to make the purchase in a tight market like our current one.
Are Private Equity firms good or bad?

There are two sides to the story. When private equity firms take over, they usually discontinue unprofitable or non-core business lines. This means job loss, which is never good. Conversely, some posit that private equity firms create better businesses in the long term. The argument here is that private companies don't have to be worried about quarterly earnings (as publicly traded companies do) so they can focus on building strong organizations rather than gaming accounting rules.

Anyway, hopefully this allows you to understand just a little more on the nightly news, or NPR.


Jenga said...

I like your post. Now please explain what you do in your job re: Private Equity.

Jessica said...

sorry, that was me.

Jenga said...

When these private equity firms come asking for money to invest in whatever, I decide who to give money to and how much.