Global Strategy 3rd Edition by Mike Peng

Exercise 4

Emerging Markets: The Private Equity Challenge
Private equity is one of the hottest and most controversial buzzwords in corporate governance. Private equity firms often take an underperforming publicly listed company off the stock exchange, add some heavy dose of debt, throw in sweet "carrots" to incumbent managers, and trim all the "fat" (typically through layoffs). Private equity firms get paid by (1) the fees and (2) the profits reaped when they take the private firms public again through a new IPO.
Private equity first emerged in the 1980s, with a stream of deals peaked by Kohlberg Kravis Robert's (KKR) $25 billion takeover of RJR Nabisco in 1988-then the highest price paid for a public firm. While KKR disciplined dead-wood managers who destroyed shareholder value, it received a ton of bad press, cemented in a best-selling book Barbarians at the Gate that portrayed KKR as a greedy and barbarous raider.
After the RJR Nabisco deal, the private equity industry stagnated during the 1990s. However, in the 2000s, private equity scaled new heights. In 1991, just 57 private equity firms existed. In 2007, close to 700 chased deals. Private equity deals now routinely represent 25% of all mergers and acquisitions (M As) in the world (and 35% in the United States). Since 2005, Europe has had more actions (measured by deal values) than the United States. In 2007, Cerberus, a private equity firm, purchased Chrysler from DaimlerChrysler for $7.4 billion. APAX Partners spent $7.75 billion to buy Thomson Learning-the publisher of this book -from The Thomson Corporation listed in New York and Toronto. However, private equity suffered a tremendous setback since 2008. Many deals struck in the easy credit environment of 2006-2007 collapsed, resulting in severe losses. In a record-breaking $43 billion deal in 2007, Texas Pacific Group (now known as TPG Capital) and KKR jointly took over Dallas-based utility TXU, which is now called Energy Future Holdings. However, by 2011, KKR valued its investment at only ten cents on the dollar.
Private equity has always been controversial. Proponents argue that private equity is a response to the corporate governance deficiency of the public firm. Private equity excels in four ways:
• Private owners, unlike dispersed individual shareholders, care deeply about the return on investment. Private equity firms always send experts to sit on the board and are hands-on in managing.
• A high level of debt imposes strong financial discipline to minimize waste.
• Private equity turns managers from agents to principals with substantial equity (typically 5% equity for the CEO and 16% for the whole top management team). Private equity firms pay managers more generously, but also punish failure more heavily. Managers' compensation at firms under private ownership, according to leading expert Michael Jensen, is 20 times more sensitive to performance than at firms listed publicly. On average, private equity makes the same managers, managing the same assets, perform much more effectively. On average there is a 2% boost in productivity and efficiency.
• Finally, privacy is fabulous. For managers, no more shortterm burden to "meet the numbers" for Wall Street, no more burdensome paperwork from regulators (an especially crushing load thanks to SOX), and better yet, no more disclosure in excruciating detail of their pay (an inevitable invitation to be labeled "fat cats"). Top managers under private ownership are indeed fatter cats. It is not surprising that more managers prefer a quieter but far more lucrative life. In 1997, over 7,000 firms were listed on US stock exchanges. In 2012, thanks to private equity only over 4,000 bothered to be listed.
All of the above, according to critics, are exactly what is wrong with private equity. Other than "barbarians," private equity has also been labeled "asset strippers" and "locusts." As high executive compensation at public firms has already become a huge controversy, private equity has further increased the income inequality between the high financiers and top managers as one group and the rest of us as another group. Private equity has rapidly proliferated around the world. Some of the fuss reflects the shock in countries suddenly facing the full rigor of Anglo-American private equity. In Germany, some politicians labeled foreign private equity groups as "locusts who feast on German firms for profit before spitting them out." In South Korea, Lone Star Funds of Dallas was initially hailed in 2003 as a brave outsider willing to save troubled Korean firms. However, in 2006, when Lone Star tried to cash out by selling its 51% equity of Korea Exchange Bank, unions took to the street to protest and prosecutors issued a warrant to arrest its co-founder for alleged financial manipulation.
To be sure, private equity results in job cuts (about 1%-2% of the jobs at the firms that were taken over were lost). But the same would happen if targets were acquired by public firms. In other words, private equity buyers are no more barbaric than public firms. In terms of financial returns, private equity investors earn slightly more than the Standard and Poor's (S P) 500 before the fees are charged. However, after the fees are charged, private equity performs slightly below S P. In other words, outside investors would do as well or better with their money in an S P index fund. In summary, while private equity is under attack for destroying jobs, its real problem is that returns to investors are low.
Private equity is inherently global. As the homeland of private equity is now engulfed in economic recession and widespread resentment (think of Occupy Wall Street), the outlook is grim. Is private equity "Monsters, Inc.?" asked an Economist editorial. Thus, private equity firms have increasingly targeted emerging economies, especially China, for future growth. The following quote is from a speech in 2010 given by David Rubenstein, co-founder and managing director of one of the largest private equity firms, Carlyle Group:
When I'm in Washington, DC, people are barraging me, saying that I'm not paying enough taxes, I'm not worried enough about labor concerns. I've got labor unions protesting me. I've got everybody telling me that I didn't do something right. In China, people want my autograph. In China, private equity professionals are like rock stars. Because China has taken the view that private equity is a value-adding technique and a value-added resource, they encourage it… Honestly , I tell people … the center of capitalism is Beijing, and the center ofnon-capitalism is Washington, DC. Now obviously, that's an exaggeration to make a point, but there's no doubt that in China, what private equity people do is very much welcomed and not criticized.
Sources: Based on (1) Bloomberg Businessweek ,2011, The people vs. private equity, November 28: 90-93; (2) Bloomberg Businessweek , 2012, You're so Bain, January 16: 6-8; (3) G. Bruton, I. Filatotchev, S. Chahine, M. Wright, 2010, Governance, ownership structure, and performance of IPO firms: The impact of different types of private equity investors and institutional environments, Strategic Management Journal , 31: 491-509; (4) D. Cumming U. Walz, 2010, Private equity returns and disclosure around the world, Journal of International Business Studies , 41: 727-754; (5) Economist ,2012, Bain or blessing? January 28: 73-74; (6) Economist , 2012, Monsters, Inc.? January 28: 10-11; (7) M. Jensen, 1989, Eclipse of the public corporation, Harvard Business Review , September: 61-74; (8) S. Kaplan P. Stromberg, 2009, Leveraged buyouts and private equity, Journal of Economic Perspectives , 23: 121-146; (9) L. Phalippou, 2009, Beware of venturing into private equity, Journal of Economic Perspectives , 23: 147-166; (10) Wharton Private Equity Review, 2010, The Storm Clouds Begin to Clear (p. 19), Wharton School.
If you were a private equity specialist, what kind of target firms would you look for?