Private Equity is Good

Private equity firms have been so often criticized for all the evils of the world; that they buy up good companies and then sell them off at a profit. That private equity "does not create anything" unlike venture capital firms. The list goes on. The truth however is very much the reverse and the thinking stems partly from ignorance and partly from socialist or left-wing views of many observers. In this article I cover a the broader definition of private equity, i.e. any type of fund managed by a professional investor with limited partners excluding venture capital. (could be buyouts, growth capital, turnarounds etc)

Private equity involves investing in businesses with upside potential, i.e. with potential to increase capilizable values vie improved product or service quality, greater productivity etc. Private Equity firms spend time and review hundreds and even thousands of projects each year to see which companies deserve financing. Projects are analyzed based on how attractive an investment opportunity it is and therefore Adam Smith's "Invisible Hand" is at work here. Private Equity firms support the forces of the free market system and work to benefit every nation's economy.

So how do private equity firms add value to companies if they truly are not just passive investors who speculate on big businesses and then force them to pay off their debts? Here are some of the things that private equity firms do:

a) Improve management - Private Equity (PE) firms know how businesses should be run and when they acquire companies they choose what is best for them and it is not in their interest to have a CEO that does not do the job. Normally PE firms bring in new management which then acts to turnaround the business and if needed by cutting staff and reducing unnecessary expenses. (Often owners and managers are hesitant to do so)

b) Give access to their business network. Companies owned by private equity are able to tap into a network of contacts that they did not have before. For example this could be valuable for a medium sized media business which can get a valuable license which it could not get access to without this help.

c) Invest in growth. No matter what is said about buyout firms, many firms invest in growth if it makes economic sense. If the company has a plan and the return from investment is high enough, PE firms do invest into businesses.

d) Improve corporate governance and transparency. Especially in emerging markets, PE firms are the driving force in corporate governance and transparency. Some bigger investment institutions like the EBRD even promote stronger business ethics and higher environmental standards.

So these are some of the things that PE firms actually do but the beneficial effects that their actions have on the economy are far greater.

PE firms often get rid of non-core assets and businesses which are often losing money for the company. Remember OPM --"Other Peoples Money", the film? The business was in fact dying, new technologies have emerged and there was nothing left to do then simply sell the assets in order to use the capital both in terms of money and human resources in order to employ it somewhere else more productive. Why should management of public companies maximize their own welfare and the welfare of the workers instead of maximizing value to the shareholders?

If your own pension fund invested in a private equity firm that bought out Boots (the London Stock Exchange Listed Company), I think you would like the management of the Boots to maximize shareholder value? Right? Instead many of those public company managers are afraid to do this. They are all too often interested in empire building and too many other things.

Private equity companies firstly make the businesses healthier, more competitive on the market which is becoming more and more global. Either a private equity firm buys Boots and makes it a great company, or some strategic player will do so and do the same. (And here too often many governments interfere causing an economic effect called government failure, where the tax payer pays for inefficiencies caused by government intervention)

At the same time, by firing staff which were not needed anyway (the consumer actually pays for these unneeded staff) PE firms force people that are capable of doing so to retrain, learn a profession that the economy needs. This is important, since this process is controlled by the market. Fired staff will train for professions where they will be paid higher, i.e. where the economy needs skilled staff. A better skilled labor force will improve productivity and grow the economy.

Don't forget, the money invested by the limited partners (PE fund investors) is usually pension fund money. PE firms are very often making money for the pensioners.

Also, doing a deal in private equity is immensely hard. There are very many firms out there and it is very competitive. They compete in valuation, terms, but also in how they can help a company like Boots improve its business, making it more valuable in a couple of years.

Private equity is a market economic phenomenon and it is not a phenomenon of market failure, there is nothing in the business that suggests this. The new investing model benefits the economy making it more efficient, in the end benefiting the consumer, both in terms of wages and prices for goods and services. A win-win situation for both: the economy and the consumer.