In Defense of Private Equity
Addressing the critiques
The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does. The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.
From the green revolution to the present, technological innovations and centralization of farming operations enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant. This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services.
As the example of agriculture illustrates, there are multiple ways to increase economic productivity. One is to build and finance companies with entirely new innovations, typically the domain of the entrepreneur and the venture capitalist. Another is to improve the way existing companies work, often by merging many smaller companies to form one large one, or restructuring management goals and employee incentives within a company. This is typically the domain of the “private equity” firm or a large acquisitive corporation. The two methods sometimes complement each other: when a VC-backed entrepreneur develops a new technology, corporations or PE-like firms often scale the product and quickly spread it throughout the economy.
How Private Equity Works
Today, a private equity or “PE” firm is a company that raises funds from institutions and wealthy individuals and then invests that money in buying and selling businesses. PE firms are usually “activist” investors, which means that rather than pursuing a passive buy-and-hold strategy, they are involved in managing (fixing…or screwing up) the internal operations of the businesses they acquire.
Imagine you’re an investor who wants to make the economy run more productively by improving as many businesses as you’re able to, starting with those with the most potential for improvement. You pore over a map of the economy that shows how different sectors have evolved, which business models have proven effective, where consumer demand is trending, and rafts of other economic data. You want to do more with less – but how? The leaders of private equity firms find themselves in exactly this position, and employ some of the following strategies:
1) Combining back offices of multiple firms to cut redundant costs. Sometimes PE firms will bundle several companies within an industry vertical to reduce supply chain costs. They may also combine an ailing company with a healthy company so that the former can develop better processes and become more productive.
2) Aligning incentives by increasing CEOs’ and operational officers’ stakes in their business. This technique rewards management for increasing company growth and performing a successful company exit.
3) Rescuing and restructuring businesses that are squandering their resources. PE firms commonly target older companies that lack financial discipline, particularly those with inefficient middle management, or where executives spend money on private jets and extravagant parties. These kinds of organizations benefit immensely from the tutelage of private equity firms experienced at leading and running capital-efficient businesses. By aligning rewards with performance (rather than nepotism or habit), PE firms can make portfolio companies much more productive.
4) Locating great sectors and geographies to invest in. PE firms may be able to spot undervalued industrial sectors or localities that others have missed. When these areas are capitalized to their potential, they can fully develop and thrive.
5) Using equity capital more efficiently. The capital markets are highly competitive, and securing loans (“leverage”) for deals requires finesse. Though the popular press often disparages “financial engineering”, reorganizing a company’s capital structure can free up money to deploy to other parts of the business or the economy. Of course, irresponsible leverage makes a firm more likely to fail. But the market accounts for this possibility – investors in private equity firms carefully monitor their investments. A PE fund with failed portfolio companies will have trouble raising as much money and freely determining how to allocate it next time around.
A good example of how PE can positively impact an industry is Carlyle’s buyout of Hertz Corporation in 2005. After the buyout, Hertz improved operational efficiency in a variety of ways – for instance locating car cleaning and refueling services in the same parking lots. Not only did these improvements raise Hertz’s value by $3B, they forced the entire car rental industry to respond with innovations of their own. During the same period, Avis-Budget and Dollar-Thrifty profit margins and labor productivity increased substantially. Another example of private equity techniques at work is the brewing industry. The average worker at a North American brewing company is 7x as productive as his counterpart in 1950. Private equity groups such as 3G Capital, which merges and restructures brewing operations (recently, Anheuser-Busch), have made the industry much more efficient.
Private Equity and Its Discontents
The classic critique of private equity is that its success derives from financial engineering tricks, such as increasing leverage and minimizing tax liabilities, rather than real operational improvements. Michael Moritz recently claimed, for instance, that PE is akin to
“making a small down payment on your neighbors’ house; paying for the balance by taking out a mortgage secured by their savings, jewelry, silverware and car; selling off the contents of their property; and then siphoning off some of the loan for yourself.” Similar invectives were leveled during the 2012 presidential campaign of Mitt Romney, who helped create Bain Capital. Like any industry, PE is occasionally corrupt – as when it partners with crony state and local governments to charge exorbitant rates on water utility bills, ambulances, and inmate phone calls. But the image of private equity purely as a parasitic form of business completely misses the point.
The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long-run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, the PE firm ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them. Furthermore, enabling companies to do more with less allows workers to specialize at other tasks, and frees up wealth with which investors and management can capitalize internal improvements or ventures in other regions of the economy. PE firms succeed to the extent that their portfolio companies succeed, and to the extent that their portfolio companies succeed, America prospers.
Another conventional critique made by Moritz is that PE destroys millions of jobs when cutting costs at portfolio companies. This is empirically false – the private equity industry as a whole is responsible for large job creation as well as destruction, with only modest net job losses. But the deeper fallacy with this argument is that full, constant employment is a kind of summum bonum in America’s economy. If we wanted to create full employment it would be easy: we could simply ban 20th century agricultural technology, immiserating millions of Americans and forcing them back into farm labor. It’s easy to intuit that this would be a bad idea, but it’s harder to imagine the economic progress that layoffs and labor migration imply. The truth is that creative destruction of antiquated jobs and invention of new forms of labor is what drives productivity growth, and PE firms are integral to this process.
Finally, some argue that PE only enriches a select few at the expense of ordinary Americans. In fact, the largest investors in PE are American pension funds, which have committed hundreds of billions of dollars to the American private equity industry. PE assets make up 9% of CALPERS portfolio, for instance, and have generated an annualized net return of 12.3% over the last ten years. When private equity firms succeed, every state government pension plan, university endowment, and large philanthropic endowment shares in their profits. It’s no stretch to say that the primary beneficiary of the private equity industry is the American public.
Private Equity and Venture Capital
Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as “private equity for fledglings”. Like their counterparts in PE, VC funds have long lifespans, allowing partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. Also, like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).
Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund “mutant” start-ups that offer completely novel technological innovations, private equity firms facilitate the process of ensuring that only the “fittest” companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can’t believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.
We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations. But leveraged buyout (LBO) techniques are now “commoditized,” and the industry is extremely saturated: PE backs 23% of America’s midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must “evolve” itself.
PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will limit waste, increase their margins, and become more valuable to their partners.
Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista pioneered these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make those assets more productive. Some may even reclaim 1980s or 1990s-level returns. At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity’s bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.
There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the “Wall Street” mentality of the American financial establishment. Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.
Conclusion
Critiques of PE reflect a naïve understanding of what creates economic prosperity. No industry is perfect, but private equity is an integral part of the economy, and should be celebrated for making our country wealthier overall. The confluence of the venture capital and private equity industries will only make each more productive, strengthening and fine-tuning the economy. Savvy, competitive investors able to build, buy and fix companies will continue to stimulate growth by allowing us to do more with less – the only way to create prosperity.