Economic Effect of Private Equity Industry

Introduction

Private equity is a term that is used in economics to describe a class of assets that do not directly trade on the stock exchange. This term has quite often been used synonymously with buyout investments. Private equity involves investment in an already operating company through the purchase of the entire stake of ownership or part of it. The company that is purchased might be listed privately on the stock exchange. The buyout is characterized by a small equity investment of between 5% to 20 % while the rest comprises of a debt that can be counted in terms of loans or bonds. Purchase of a company can be done with the intention of improving the performance of the company in various ways then reselling it to another company or organizing an IPO to cash it out. In its history, operations of private equity have tended to focus on small companies that are under performing. After purchasing such companies the management of a private equity company can make significant contributions to the underperformance through major decisions by the board meetings. This would often include cost cutting measures and improvement in market mix of products. This is aimed at improving and placing the company in a better position to compete with the rest and make progress in terms of profits and sustained growth. The value of the shareholders in such a company is therefore increased as a result of the actions of the management of the private equity who can even go into personal investment. (Maxwell, 2007).

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Types of Private equity

Leveraged Buyouts

This refers to the process of acquiring a company with a considerable portion of borrowed funds. Such acquisitions have their history in the years after the Second World War. In the 1980s leveraged Buyout firms attracted the attention of many. Firms that are involved in such transactions have been characterized by maturity and generation of cash flows that are necessary for the buyouts. In this type of private equity, the firms involved enjoy tax advantages that come with debt financing, they are free from scrutiny as a result of being a public company and present an opportunity for the managers to become owners of larger proportion of the company’s stake. The amount of debt used to sustain a leverage buyout depends on a number of factors including the financial position of the firm being acquired, market environment and the access to credit services. In the history of leverage buyouts the debt normally varies from around 60% to 90%.

Venture capital

This refers to a sort of investment made to the young upcoming companies. This decision is made with the intention of helping the immature company in the launching process, initial developments and even expansion process. This is because of the fact that some upcoming companies lack the capacity to take off during the early development stages. This type of private equity has been found in places where new technology or new products are yet to be put on test. Venture capitals are quite often divided into the current stage of company development. Such investments arise because in the modern times, entrepreneurs are ever coming up with new technology, products and ideas that require substantial amounts of capital to launch. Mature companies would take advantage of such opportunities and pour investments into such small upcoming businesses. Venture capital suits companies that require large capitals to start up. It is important to mention that such large capital requirements cannot be met by the cheaper alternative means like the use of debts. (Lerner, 2000).

Growth capital

Growth capital refers to expansion investment pumped into the relatively mature companies that cannot meet the financial requirements for expansion activities.

As indicated by Maxwell, (2007), firms that have already taken off might be in need of finances to carry out restructuring operations or get into new markets. This can come at a time when the company does not intend to loose control over the entire business. This would then prompt a growth capital investment. The intention to reduce the amount of debt on the balance sheet can also be consideration for growth capital transactions.

Companies have their growth lifecycles which they go through in the course of their business operations. Some stages of the lifecycles require enormous financial resources to be completed. Growth capital is required at these particular stages and it is provided by other mature companies. Growth capital has thrived in markets where there are not adequate debt resources to finance leverage buyouts for the underperforming and weak companies. It is also common where there is a lot of competition amongst the immature companies over financial resources from mature companies in form of capital ventures.

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Since the 1980s private equity has gained momentum in most economies. This is because in some situations it has acted as a saver to some companies which otherwise were at the threat of collapse due to mismanagement and other operational problems. With globalization and technology explosion, private equity has been instrumental in the process of launching new technology aspects in the society using the immature firms in the market. Developments in the capital markets have been known to drive development in the private equity companies. (Maxwell, 2007).

Performance of private equity and hedge funds compared

In the past few years the performance of private equity has been higher than that of hedge firms. It has been estimated that in the year 2007 a total of $686 billion was invested in private equity. This figure is higher than the estimates of hedge firms. Hedge funds have been experiencing losses as compared to private equity firms. Their worst losses in the year 2008 with the assets under hedge funds management falling by 30% to $1,500bn1. (IFSL, 2009)

The impact of the financial crisis on private equity sector

The last decade witnessed growth in private equity investments with $10bilion around 1991 and $180 billion towards the end of 2000.However with the financial crisis things are likely to change. As small unstable companies collapse, private equity will utilize the opportunity to buy them out using the money that has been collected. According to OECD (2008), the higher debts of private equity has been fundamental in their survival and sustained activities even in the harsh economic times that have been brought about by the global economic crisis.

It is important to note that the financial crisis has had an impact on major sectors of economy. Private equity sector has not been spared either in the crisis. Since leverage buyouts have been known to depend on debt to finance the transactions, there comes a situation where it would be difficult to finance the debts due to the global financial crisis. Since such companies depend so much on borrowing, it would become expensive for them to buy underperforming companies with credit which has also proved to be had to come by as a result of the crisis. It can be argued that leverage buyouts would be expensive to private equity companies because of the slowing economy due to the financial crisis. The private equity firms would find it had to repay their loans with such slowing economies due to the slowed cash flows resulting from the slowing economy.

The global financial crisis presents a phenomenon whereby an estimated 50 to 200 private –equity firms are at high risk of breaching the contract they had with banks. This is likely to lead to massive job losses especially in the United States. Furthermore the crisis would lead to the undervaluing of investments. A good example has been demonstrated by Permira, Blackstone Group LP and KKR & Co. LP that have been on record for marking down their investments including German broadcaster ProSiebenSat.1 Media AG and Dutch chipmaker NXP BV in the recent past.

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A look at the share markets reveals a situation of volatility with the global financial crisis. Once companies have been purchased, it would become difficult to resell the companies due to the volatile markets. Besides, the potential buyers in the market are likely to face stringent credit conditions from financial institutions. This would complicate the process of acquiring firms through leverage buyouts. (Cendrowski, 2008)

The global financial crisis has created more complex phenomenon of tax risks on private equity firms. This is because of the fact that private equity firms have penetrated into new market territories that are characterized by different structures. This has called for new tax schemes that are not favorable to the transactions of private equity companies. A complicated tax scheme for the private equity firms has its consequences reflected in the overall cost of buyouts and venture capitals. Tax issues have also reduced on the number of acquisitions by the private equity firms due to the ever increasing risk that has been catapulted by the global economic crisis.

In countries like the United States tax policies are evolving with issues such as anti –avoidance measures and increased audit activities have further complicated the process of acquiring companies through leverage buyouts. ECB, (2008),

The global economic crisis has brought about stiff competition between companies. Most companies and struggling for top performance with the resources they have in the economic crisis. The need for venture capitalization has declined as a result of the financial crisis. Companies have had to undergo restructuring and change of tactics to survive in the financial crisis for in stance Dana after fling for bankruptcy in the year 2006, the company tried to do away with labor contracts. However this could result in further disputes with trade unions. (Cendrowski, 2008)

Global financial crisis would lead to asset change in the private equity industry. This can be viewed in the light of financial assets being lost and the firms remaining only with infrastructure, markets that are emergent and distressed financial institutions like banks. This can be attributed mainly to the problem of borrowing that has resulted in exhaustion of the capacities of banks in their lending strategies. Distressed banks would be as a result of slow rate of cash flow as the economy drags due to the financial crisis. The rate of debt recovery by the banks would also account for the stress in the near future.

The global financial crisis would also foresee a decline in the discounts that are at the present times being allowed on senior loans. This is because banks are beginning to feel the pinch with the decline in cash flows. This means that a reduction in credit is inevitable for them to survive in the crisis. ECB, (2008),

Market difficulties continue to be a major threat to private equity firms as the global financial crisis deepens. With such implications, there is hope that the future of private equity industry is dependent on the refuge that would be provided by flexibility in financing structures to be more accommodative to the demands of the private equity sector. (Cendrowski, 2008)

It cannot go without mentioning that the harsh economic climate has affected the share prices of private equity companies. It has been noted that their share prices have been on the deceline.This has affected the performance of the private equity firms in the capital markets. Though the decline has been noticed, investors do still have confidence in the shares on private equity. The IPOs floated by the private equity sector were losing because of the high prices and high debt levels in the firms. ECB, (2008),

Opportunities in the private equity sector would be provided if financial institutions begin lending on one another and on businesses. The assets of private equity companies would also of importance if good deals are sought.The problems of the global financial crisis deepen in private equity industry because of lack of a regulatory mechanism. For this industry to achieve the desired ends amidst the financial crisis there is need to strike at limits on the number of buyouts and debts the firms get into. This cannot be well undertaken by the government structures. Experts have called for self regulation in the industry to ensure that standards are followed to ensure that the industry does not collapse as a result of the financial crisis and other market factors. (Lerner, 2000)

So as to survive in the prevailing economic climate, private equity firms have to come up with strategies that would favor them in future and help them to fulfill their long term objectives. Instead of engaging in the buyouts of individual firms, a combination of companies to form multinational groups would work in the best interest of private equity firms and they stand to benefit a lot from the strategy. (Cendrowski, 2008)

In the capital markets, private equity plays a very important role. This concerns the performance and share value of other companies that are listed on the stock market. The private equity sector has a lot of influence on the share values. With declining buyouts, the performance of shares in the capital markets is affected and this translates into the init value of shares in public sector companies and other sectors. The activities of private equity companies affect cash flows. This in turn affects investment in the capital market and even affects the unit prices of shares of different companies. ECB, (2008

The global economy has been so much affected by the financial crisis. This can be viewed in the way the crisis had resulted in a decline in capital flows between countries because of investor withdrawal from economies due to the unfavorable economic climate. This has further been complicated by the situation whereby local and foreign investors are withdrawing from the asset class because of the financial crisis. In such cases domestic and foreign economies have been negatively affected by the financial crisis with companies performing poorly in the capital markets and declining share values in the market. OECD (2008)

Conclusion

The future of private equity is based on proper strategies being put in place to adjust to the effects of the financial crisis. The risk of leveraged buyouts has to be reduced substantially if the buyouts are o yield tremendous results in the harsh economic environment that has been prevailing since the onset of the financial crisis. The private equity sector still has a great potential because of the condition of the emerging and immature companies.

Bibliography

Cendrowski, Harry (2008). Private Equity: Governance and Operations Assessment. Hoboken, NJ

ECB, (2008), “Financial stability report”.

IFSL Research, 2009, Private Equity and Hedge funds. London.

Lerner, Joshua (2000). Venture Capital and Private Equity: A Casebook. New York.

Maxwell, Ray (2007). Private Equity Funds: A Practical Guide for Investors. New York.

OECD (2008), OECD Economic Outlook No 83, Paris.

Strömqvist, m., (2008), “hedge funds and international capital flows”, doctoral thesis, Department of finance, stockholm school of economics.

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