Private Equity Defense
Private Equity Defense
Private Equity Council’s Testimony to the Senate
The Private Equity Council is a trade association that represents twelve of the biggest private equity groups. Today, Mark Tresnowski will speak on behalf of the Council before a Senate Subcommittee on Securities, Insurance, and Investment. It’s important to dispel the erroneous stereotypes of private equity and to distinguish the industry from seemingly-similar but very different private investment areas such as hedge funds, venture capital and others.
Explaining Private Equity
Mr. Tresnowski begins with a brief explanation of private equity, dispelling some typical misconceptions of the industry. Tresnowski points out that PE firms and senior managers put their own capital at risk, too. This is significant because a typical argument for stringently regulating private equity firms is that they may recklessly invest the fund in risky ventures, hoping for the big carry and paying no penalty for a bad deal. Because buyout firms and managers often have “skin in the game” they do not act as carelessly as is often suggested. He concludes, “the PE model ensures that the interests of the shareholders (GPs and LPs) and the interests of management are fully aligned.”
Jobs Creation Vs. Loss
Mr. Tresnowski also touched on a sensitive aspect, job loss vs. creation when public companies are taken private. He highlights a The World Economic Forum report which found: “before they were acquired, private equity-owned companies on average were losing jobs at existing facilities faster than their competitors. But by the fourth year of private equity ownership, employment levels at those companies had increased to above the industry average. It also reported that in the first two years of private equity ownership, private equity portfolio companies increased the rate of job growth at new U.S. facilities to six percent above the industry average.”
In a rough economy, private equity firms are vulnerable to attacks from employee unions and media criticism if they reduce jobs at a firm. This is often a necessary sacrifice for ultimately bettering the company, as a private equity management team looks to improve the company by cutting unnecessary jobs or expenses. An Ernst and Young study came to a similar conclusion “that at eight out of ten private equity portfolio company’s employment is sustained or increased over time.” So there is data that negates the claim that private equity firms always cut jobs, moreover, often buyout groups actually increase jobs.
When Will Returns Return?
The value of portfolio companies also grows. According to the Ernst & Young survey, the businesses acquired by PE firms saw an increase in value of 83% during the years they were taken private. This value has transferred into impressive returns to private equity investors, a large portion of these LPs are institutional investors such as pension funds, endowments and foundations. The government has signaled a push toward protecting institutional investors–especially pension funds, which have taken huge hits lately–from greater losses. However, increasing regulation too much overlooks the huge returns institutional investors have enjoyed during a better economy.
Also, while returns to investors are poor now, private equity is a long-term investment strategy. Tresnowski is optimistic about the future of these currently struggling firms, ” Many investments now marked down as a result of the recession are likely to recover and be profitable for LPs, though perhaps not as profitable as was the case in more robust economic cycles.” Although some people are sure to lose their jobs in portfolio companies and entire companies may fall by the wayside, Tresnowski emphasizes that private equity firms do not represent a systemic risk to financial stability.
Private Equity Not a Systemic Risk
The Council then offers a series of reasons why private equity does not pose a systemic risk. Chief among the Obama Administration’s concerns is the use of leverage. The Private Equity Council rejects this charge, claiming that private equity firms use little debt and typically rely on a 3:1 debt-to-equity ratio, compared to Lehman Brothers’ 32:1 ratio. (I’m not sure it helps a case to compare yourself to a collapsed company saying “we’re not as leveraged…”). The Council rightly points out that PE firms typically have a long-term commitment of at least 5 years and as much as 12 years with a portfolio company–a strong reason for differentiating private equity from hedge funds or venture capital.
The other threat to systemic collapse is cross-collateralized assets where a lender or shareholders can force the firm to sell off unrelated assets to pay off a debt. Private equity firms are not cross-collateralized so there is no possibility of one private equity portfolio company’s bad performance impacting another directly. Furthermore, private equity firms try to diversify their investments across various business sectors to limit exposure to a single floundering industry.
The Private Equity Council’s closing statement quotes economist Dr. Robert Shapiro’s advice: “In good and bad times, the core business of private equity funds is to identify firms with long-term potential for higher productivity, sales and profits; secure the capital to purchase these firms; and inject additional capital, improve their strategies and reorganize their operations, to achieve higher returns. Public policy should support these activities, especially during the current crisis, and refrain from imposing additional burdens that could hamper these activities or redirect them to other economies.”
The following is the full testimony and includes notes on where to find all the supporting data:
Tresnowski Testimony
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