First Principles September 2007

Cashing Out

Is private equity just another bubble, or a sign of sickness in America’s public stock markets?
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The private-equity business isn’t new, but the attention it’s lately been getting sure is. Carlyle, Blackstone, and some of the industry’s other leading firms have been around for more than 20 years. For most of this time, doing whatever it is they do, these companies conducted themselves with painstaking discretion and, so far as public opinion was concerned, operated invisibly. No longer. In the past year or two, the public has realized that private equity’s footprint on American business and finance is huge. People have also noticed—partly because the industry’s leaders have been foolish enough to show them—just how much money some of its executives are making.

Also see:

"Private Equity Deconstructed"
Atlantic senior editor Clive Crook weighs in on the private-equity business—why it's booming, where it's headed, and what it means for American capitalism.

For reasons I will come to in a moment, no one can be sure whether private equity is going to soar even higher or fall to earth. If it does the former, this means that something has gone wrong with America’s model of corporate capitalism. But if it does the latter, the history of its downfall will partly write itself: Two events in 2007 will irresistibly be seen as moments when the wings began smoldering.

The first was a birthday party. Stephen Schwarzman, co-founder of Blackstone, celebrated turning 60 in February with a Manhattan bash of arresting opulence. A giant portrait of the host, which ordinarily hangs (it was explained) in his living room, formed the centerpiece. The press reported the event in drooling detail. If Schwarzman’s purpose was to draw attention to his wealth, it worked. Politicians, financial regulators, and the Internal Revenue Service all surely took note. When people joked that it was the most expensive party in history, they weren’t thinking of the catering.

The other event was Blackstone’s initial public offering, in June. Schwarz­man had decided that this was a good time to cash out some of his gains. That was telling in itself, of course, since the firm had hitherto emphasized the drawbacks of a public listing. Whether or not the IPO signaled a peak in valuation—or at any rate a loss of future momentum—it required disclosure. Legal documents showed that in 2006, Schwarzman was paid $400 million, that he expected to receive nearly $700 million from the IPO, and that his remaining stake in the firm would be worth more than $7 billion.

How have Blackstone and the others created such wealth? Private equity is an elastic term, but the typical buyout transaction involves scooping up an undervalued public company, taking it into private ownership, fixing it, then a few years later selling it at a profit. Private-equity firms, unlike hedge funds, are hands-on owners of the assets they acquire. In many cases they bring superior expertise, and in all cases ruthless discipline. They usually bring one other thing as well: debt. The target firm is financially restructured, with less owners’ capital and more debt on its balance sheet. If the firm does well, the owners’ returns, now teetering on a smaller base of capital, are much higher than they would have been without the new leverage. If the firm does badly, the debt makes the hurt much worse, and sometimes terminal.

The business has boomed. There are thousands of private-equity firms worldwide. Blackstone, the biggest in terms of total assets under management, was just a four-person, one-room outfit with a balance sheet of $400,000 in 1985, according to the firm’s Web site. Today it manages, in all, nearly $90 billion in assets. The 50 companies in which it has a stake employ 400,000 people. The other big firms—Carlyle, TPG, Bain, KKR—also carry assets valued at tens of billions of dollars. From almost nothing in the mid-1990s, the global value of private-equity buyouts rose to $700 billion last year. That was more than twice as much as in 2005, and it accounted for about a fifth of all mergers and acquisitions worldwide. This year’s figures are on track to exceed that total.

Is it all a bubble? Many market professionals think so, but only harder economic times will reveal how much these gains represent real economic value, rather than financial illusion.

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.

Clive Crookis an Atlantic senior editor.
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