The Many Virtues of Private Equity

SIMPLICITY_______________________________
Because there are no public equity investors the private equity firm's
financial reporting requirements to all the relevant governmental entities
are reduced. This simplifies management's responsibilities and
results in transaction cost savings for the firm.
With private equity there are no requirements that management
keep Wall Street informed of the firm's expected earnings and then
provide an explanation of the actual earnings and why they differ
from the expected earnings. Decisions are not affected by short term
earnings and the anticipated stock market's reactions to the earnings;
thus the firm's decision making may be improved.
The firm's board of directors can be chosen for effectiveness
rather than appearances or public relations.
ALIGNMENT OF MANAGEMENT AND OWNERSHIP
With the average publicly held firm the interests of management and
the firm's ownership are not always perfectly aligned. An entire area
of study called agency theory has been created with the objectives of
studying and reducing the conflicts between a firm's management
and its owners. The classic papers on agency theory are Jensen and
Mecking (1976) and Jensen (1986).
We assume the common stock of the private equity firm discussed
in this book is to a significant extent owned by management.
Management has an incentive to act in a manner consistent with
maximizing the well-being of the equity owners.
DIVIDEND POLICY OF A PRIVATE EQUITY FIRM
The owners of a private equity firm tend to be paid for their services
as members of management, consultants, or members of the firm's
board of directors. They also hope for a value accretion to their
stock holdings.
If the owners are also employees of the firm, the incomes earned
for services will be taxed at ordinary income tax rates. But there is
only one level of tax since the corporation gets a tax deduction for
the amounts paid for service. This is the first tax advantage.
The gain from the value accretion of the stock will be taxed in
the future at a capital gains rate when the gain is realized for tax
purposes. Thus there are two tax advantages from value accretion
and the use of private equity; one is tax deferral and the second is
the lower capital gains tax rate compared to the tax rate on ordinary
income.
The private equity firm has little or no incentive to pay cash dividends
on the common stock. The investors would rather be paid as
employees or have their equity investment gains be converted into
capital gains and have these gains taxed at the lower capital gains
tax rate in the future.
CAPITAL STRUCTURE_____________________
The normal public corporation has managers and owners. While the
managers may also be stockholders, the total value of their stock investment
in the corporation tends to be much less than the present
value of their salaries and bonuses. The senior managers of public
corporations have a significant incentive to act in such a way as to
not jeopardize the stream of salaries that will be earned if the managers
are not dislodged from their jobs.
With a private equity firm the relative values of salaries and
ownership are changed. Now the owners have an incentive to substitute
debt for equity both to gain (or maintain) control and to add
value. The use of debt becomes a much more important tool for
adding value with a private equity firm than with a public firm.
VENTURE CAPITAL _______________________
This is not a book on venture capital though many of the conclusions
of this book apply equally to venture capital activities, since
venture capital is a form of private equity.
It is assumed in this book that the firm being taken private has
a track record and its value can be estimated based on objective
financial measures of the results of operations. Frequently, a venture
capitalist is evaluating the story told by an entrepreneur.
While there may be projected financial results, they frequently are
not backed up by actual results. The valuation of such a firm is
more an art than a science.
MBOs_______________________________
DeAngelo and DeAngelo (1987) review the early history of managerial
buyouts (MBOs). From 1973-1982 they identify 64 buyout
proposals made by managers of New York and American Stock Exchange
listed firms. They identify eight factors that are important in
the decision to effect a management buyout. These are:
1. Potential improvement in managerial incentives
2. Save costs of disseminating information to stockholders
3. Company secrets are better protected
4. Tax savings of interest tax shields and other tax savings
5. Avoidance of hostile takeovers
6. Difficulty to raise capital
7. Illiquid stock (leading to greater difficulty attracting managers)
8. Disagreements among stockholders (because of illiquid in
vestments)
Diamond (1985) put together a team of practitioners of the
LBO art to construct a book that explores the legal, tax, accounting,
operational, and financial considerations of an LBO transaction.
It is a handy reference book regarding the practical aspects of
the LBO deal.
THE J.P. MORGAN CHASE FUND ____________
In February 2001 J.P. Morgan Chase announced that its J.P. Morgan
Partners unit was raising $13 billion for a private equity fund
(see the Wall Street Journal of February 6, 2001). While $8 billion
was to be the bank's own funds, $5 billion was to be raised from
other investors. These investors were to include pension funds, university
endowments, and foundations. This fund raising effort followed
the creation within a few months of Thomas Lee's $6.1
billion buyout fund and KKR's raising of a $6 billion fund.
Private equity funds primarily invest in leveraged buyouts but
they are not precluded from investing in venture capital activities.
Their main investment destination is the LBO but private equity investment
can take many different forms.
J.P. Morgan Chase and its predecessors investing in private equity
had earned a 40 percent annual return on equity capital. To
evaluate this return we would need to know the amount of debt and
other senior securities used, as well as the status and age of deals
that have been undertaken, but are not yet completed (thus there is
not yet an objective measurable internal rate of return). Also, the 40
percent return was earned on a smaller amount of capital than was
now being raised. Investing a large sum of capital in firms of larger
size has its own set of challenges for a private equity operation. The
number of eligible targets is reduced. On the other hand the number
of firms competing for those larger targets is also reduced.
CONCLUSIONS__________________________
There are several reasons why value may be added by a firm converting
from being organized as a publicly owned firm to be a private
equity firm. First, there are operational reasons why a private
equity firm may have more value. Second, two financial decisions
(dividends and capital structure) are likely to be different with a private
equity firm than with a publicly owned firm. The set of financial
decisions with the private equity firm is likely to add value to
the investors owning the stock.
QUESTIONS AND PROBLEMS _______________
1. What are the advantages of private equity?
2. Of the eight factors listed by DeAngelo and DeAngelo, which
one do you consider most important?