These are isolated pieces of news from the last few months, but they point to one direction — the rise of private equity players as `movers and shakers' in international capital markets and corporate board-rooms.

The existence of private equity firms is not a new phenomenon. Ever since the body corporate came into existence, there have been holding companies that only provided capital, such as Tata Sons and Birla Corp in India, Mitsubishi in Japan, and the chaebols of South Korea. The wealthy families of the US, like the Rockefellers and the Whitneys, also had private-equity-like holding companies.

A new animal

The first of today's big private-equity firms, Warburg Pincus, was formed only in the late 1960s, and had to raise money from investors, one deal at a time. It is now part of the mammoth UBS group.

This was a hybrid of the family-held holding companies, on the one hand, and mutual funds, on the other, as, like the family-held holding companies, it was purely a provider of capital and ran the business.

Like a mutual fund, it represented an eclectic group of shareholders/venture capitalists and was run by a professional manager who had an interest in returns, often short-term, and did not necessarily take pride in running the business that it took over.

If circumstances favour the business, then the private equity partner tries to turn it around. If not, it can cannibalise it and get on with life without any negative fallout.

The numbers

Though it is difficult to tell, Pensions & Investments magazine estimate that worldwide around $350 billion is invested in private equity. More than $200 billion is expected to flow into the sector this year. The amount raised by European equity houses is expected to rise from 25.5 billion euro in 2004 to 46 billion euro this year.

In India, the Blackstone group, the Carlyle group, General Atlantic Partners, and Britain's Actis Partners have invested large sums of money. Local firms such as ICICI Venture Funds Management Ltd. and Kotak are also stepping up investments.

In 2004, these firms poured an estimated $1.3 billion into private equity deals in India, according to Asian Venture Capital Journal. So far this year there have been 32 deals worth $420 million. And the year has already seen $1.2 billion in divestment, or exits, as they are known in the private equity business.

The pros

In a purely capitalist society, capital flows to where it is most efficiently used. Private equity firms look for opportunities to invest capital most efficiently and sometimes make all the difference between survival and failure for a nascent or struggling firm.

If a company is not doing well because its management is lazy or incompetent, then a private equity group can take over the company, infuse fresh capital, and help to turn it around. A few examples of private equity firms delivering value are:

In Japan, Advantage Partners, which acquired a loss-making powdered milk company, changed the sales structure and invested in system improvements, resulting in the company turning in a profit after a year of control.

This investment was subsequently sold for at more than double the initial price.

Doughty Hansen of the UK sold the Priory Healthcare group, which it took over for £116 million in 2002, to ABN Amro for £588 million in July 2005. It transformed the group from a small, boutique mental health spa and food company to an aggressive healthcare giant that runs expensive schools for young people with special needs.

Doughty Hansen also acquired the RHM Group in August 2000 for £310 million which is now valued at an estimated £900 million.

Well-known firms recently "nurtured" by private equity include Burger King, Polaroid, Universal Studios Florida, Houghton Mifflin, Bhs, Ducati Motor and the Savoy Group.

Then, of course, there is the wealth they create for investors. Private equity funds posted returns averaging 23.5 per cent last year, according to Cambridge Associates research. They enjoyed two record years of buy-out exits returning $113 billion to investors in the first three quarters of 2004, compared with $57 billion in 2003, according to Private Equity Intelligence.

These firms were able to do this by leveraging the extremely low level of international interest rates. So, to increase their returns, private equity firms have been increasing the amount of debt in their investments. The amount of capital invested (vis-à-vis debt) has fallen from a historical average of 35 per cent to close to 20 per cent now.

The cons

The Bank of International Settlements (BIS) recently warned central banks of an impending risk to global financial stability. It spoke of a possible asset bubble bursting, created out of the low-interest regimes that encouraged a `debt-culture'.

Already, there are mixed signals from Europe. If some large companies go belly up, it could lead to a `domino effect' on the highly-geared private equity firms, and see a lot of wealth getting eroded. But that is only one of the concerns surrounding this industry, albeit a major one.

As more and more players enter the fray, existing players have become wary that the gravy train may not last due to increased competition on sources of funds and take-over targets. Some, like Carlyle and Blackstone, have started to diversify into other areas of financial investments such as advice and property funds.

That apart, there is the political and human fallout when a private equity firm decides to shut the business, strip the assets and invest the cash elsewhere. The MG Rover factory in Longbridge, which was taken over by Phoenix Venture Holdings from BMW and shut down by it, is a case in the point.

Then there is the story hidden behind the huge profits that have come out of the exits by private equity firms. According to Standard & Poor's, secondaries (sale by one private equity firm to another) were 61 per cent of US and 88 per cent of European mid-market buy-outs this year, compared to 22 per cent and 18 per cent respectively in 2002.

That would mean that the capital is circulating among private equity firms and a different kind of bubble might be created — a rude shock could await investors in private equity firms when they actually go to the market, to float the target company again.

Even if these firms do reach the market with a good initial valuation, there could be further problems. There are cases where the private equity firm has taken over a company and then re-sold it to the market within a short time with a mark-up after only some minor cosmetic changes.

This may elicit a backlash from fund managers, who were shareholders earlier and who might feel short-changed.

Consequently, they may not support the stock price, and current holders will have to pay for the reduced valuation.

The association of people with strong political connections with some firms and the cloak of secrecy that surrounds their source of funds has also given rise to a lot of conspiracy theories relating to this industry. Hollywood has been an unintended beneficiary of this.

Some of these firms have interests in strategic industries like energy, oil and defence weaponry, and may precipitate dangerous outcomes through their politically connected representatives.

Moreover, when they privatise a public limited company, they do not need to publish data any more about it, so the target's activities also get hidden behind a veil of secrecy.

What needs to be done

Whereas private equity firms have succeeded in finding value and, in many cases, in generating value through specialised and close supervision, they can also de-stabilise financial markets through their actions. Therefore, there is the need for urgent regulation in three areas:

The level of gearing expected (including, if necessary, mandatory credit ratings for these firms) to prevent them from creating an asset bubble;

Publishing of data on activities of these firms and those they take-over, to prevent them from using the latter to do things that fall within the grey areas of the law;

Minimum lock-in period for these equity firms to prevent them from asset-stripping the companies they promise to turn around.

(The author is a Domain Consultant with the Financial Securities Group in Infosys Technologies Ltd, Bangalore. He can be contacted at Raghuvir_mukherji@infosys.com. The views expressed are personal.)

© Copyright 2000 - 2009 The Hindu Business Line