First Principles September 2007

Cashing Out

Is private equity just another bubble, or a sign of sickness in America’s public stock markets?

Nobody disputes that in many instances private equity has delivered better management. The talent for financial engineering that private equity brings to its acquisitions is also real, and can genuinely boost corporate value. Private- equity firms are not, for the most part, raiders or asset-strippers. Many of the acquisitions are friendly, not hostile. The target companies may get an infusion of capital to embark on new ventures or to enable unprofitable lines of business to be cut back. The idea that this is all smoke and mirrors is wrong.

Recently, though, as the industry has been scoring its most startling successes, a strong stock market has made it unusually easy for the firms to sell their restructured enterprises back into public ownership at a profit. Rising stock prices have undoubtedly flattered private equity’s results. Yet this cannot last: Wall Street goes down as well as up. In addition, interest rates have been low of late. More than anything else, cheap credit has fueled the private-equity boom. But in June, as Blackstone was preparing its initial public offering, the bond market shuddered, and long-term interest rates climbed to a five-year high.

A deeper and more important question about private equity is this: Supposing even some of the gains in value achieved by these leveraged buyouts are real—and that seems likely—then what is wrong with the public capital markets? Why does a firm need to be taken private to be better managed or more intelligently financed? You could see the success of private equity as an indictment of American capitalism. If Wall Street were working as it’s supposed to, you might argue, private equity would have found no space to overrun in the first place.

Private equity has a genuine advantage in financing risky undertakings. Arm’s-length creditors, such as banks and bond investors, typically will not supply capital to a firm about to undergo a big restructuring or to embark on a chancy new venture, unless they are well compensated for the extra risk. Because private-equity investors participate in the running of the company, they can see the risk more clearly and have a say in how best to control it. So, the theory goes, they are more willing to invest, and thus they improve the supply of capital to ventures that might otherwise be starved of funds. This comes at a cost—the value that private-equity managers extract for themselves—but it is worth it. The point is not that the public markets fail; it’s that they cannot do everything. In principle, a mix of public and private equity is fine.

But why has the mix changed so abruptly in the past few years? At the very least, the surge in private equity raises the possibility that the public markets are not as good as they used to be at channeling capital to its best and most productive uses. And that, in fact, is exactly what many finance experts are arguing.

High on their list of factors is the Sarbanes-Oxley law, passed in 2002 in the wake of Enron, Tyco, and other corporate scandals. It called for more- demanding audits of public-company financial accounts, and its Section 404, regarded as especially burdensome by many CEOs, legally requires company bosses to personally vouch for the numbers. “Sarbox” is only one aspect of a regime of corporate regulation that seems, by international standards, increasingly persnickety, complex, and hazard-prone. It does not help that the United States has overlapping sys­tems of public- company regulation. Different types of securities have different federal and state oversight agencies. State attorneys general (following the example of New York’s Eliot Spitzer) have been broadening their role as corporate policemen as well. Between 1995 and 2005, securities class-action lawsuits ran up settlements on the order of $25 billion.

Blackstone’s IPO notwithstanding, New York has been losing its share of the global IPO market, notably to London. In London, litigation that puts company directors at personal risk is less of a danger. Regulation is more streamlined, and is based more on the application of broad principles than on compliance with endlessly proliferating rules.

The issue is not open-and-shut. Some finance experts argue that the American approach is right. The drift of IPOs offshore may point one way, but other evidence shows that foreign companies listing in the United States gain a valuation premium, perhaps reflecting the extra investor confidence that tighter regulation brings. Maybe Sarbox, added to the rest, went too far. Or maybe the balance was wrong before and now is right. In either case, it is plausible to argue that an unintended consequence of “No more Enrons” was Stephen Schwarzman’s net worth.

Presented by

Clive Crookis an Atlantic senior editor.

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