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Private equity, public good

Thursday, 26th July 2007

In today's Wall Street Journal, my CNE colleague, Wilfried Prewo, puts the private equity issue in its proper place:

Private Equity has raised our wealth in four major ways.

First, private equity funds are not charities...Their job is to make money for their investors. Their short time frame puts them under pressure to raise a company's valuation, or net worth, fast.

...While their take-no-prisoners attitude in restructuring has not endeared private equity funds to labor unions and politicians, layoffs are usually outweighed by later employment growth. The public view has been distorted since the short term pain of restructuring receives much press, while the ensuing recovery and long-term job gains get short shrift.

...In a 2006 survey, the consultancy A.T. Kearney found that private equity firms contribute to sustained net job gains and revenue growth in Europe. This is good news for society. The profits earned by the funds when they exit are a reflection of the value they have added. The gain to the overall economy comes in the form of more competitive companies with solid prospects for growth and jobs.

Second, private equity offers an alternative new form of corporate finance. Financial innovation has allowed private equity funds to earn a high return where conventional finance could not. They have, on more than one occasion, taken over companies that were on the brink of disaster and that nobody else wanted to touch. When DaimlerChrysler sold off its flailing U.S. unit earlier this year for example, the only interested buyers were a combination of industrial and private equity funds.

...Third, private equity recharges entrepreneurship. "Family-owned" also means that the family are the prime source for managerial talent. But there is no guarantee that a great founder's entrepreneurial genes are passed on to subsequent generations; they may have the desire to be boss but not the DNA of a leader. In many private equity takeovers, fresh entrepreneurial spirit has been injected by putting second-tier, non-family managers in charge and giving them an equity stake in the venture as an incentive to perform.

Finally, private equity transactions have created a wider and more competitive market for buying and selling closely held companies. Before private equity firms came in, a company that was for sale usually attracted only few potential buyers, typically competitors from the same industry or large companies seeking to expand.

...At the end of 1999, the previous German government of Chancellor Gerhard Schröder announced a corporate tax reform that abolished the capital gains tax on the sale of corporate subsidiaries as of 2001. The unintended consequence was to help restructure German corporations and dismantle many corporate cross-holdings. What once was called Deutschland AG, or Germany, Inc., is now history. German industry owes much of its regained competitiveness to this and other supply side moves.

Private equity has a similar supply side effect. What the capital gains tax reform was for restructuring corporate Germany, private equity may do for closely held companies. As a capitalist tool of our time, it is proof that capitalism does not just enrich investors but improves social welfare as well.