However, VC is not the biggest part of PE deals: according to the EVCA's Preliminary Figures for European Private Equity Performance and Activity for 2006, out of 90 billion € raised by private equity funds in 2006 only 16 billions go to venture capital and 71 billions to buy-outs, which represent 78% of the investment made by private equity funds...
Two remarks:
- A PE fund aiming at short-term profit will likely tend to reduce the wage bill and to sell some of the purchased company's assets in order to improve the cash flow generated, hence a higher IRR. Likewise, it will tend to limit long-term investments in order not to lower the cash flow generated.
- In case of a highly leveraged operation, the debt might be affordable by the company, but it will be used to pay for the company's shares acquired by the buyer and thus will not allow using debt for other, more productive investments. Furthermore, the burden of the debt will prevent the company to distribute equitably the fruits of productivity gains...
There is an interesting paper from the UK Financial Services Authority: Private equity: a discussion of risk and regulatory engagement. Excerpts:
Not all public authorities around the globe follow the open market approach favoured by the UK.
Really?
In venture capital investment there are concerns that excessive company (nonfinancial services) regulation (e.g. health and safety requirements, the minimum wage, flexible working etc), could cause undue burdens on companies. This could limit the scope for venture capital investing by limiting the profitability of potential target companies.
From the private equity funds point of view, health, safety and wages requirements... are "undue burdens"...
Banks face increasing competition in their bids to win the mandate to provide the debt finance for private equity transactions. Such finance provision (particularly in relation to the top tier of private equity transactions i.e. the larges deals) is now generally the subject of a competitive auction. The private equity fund manager frequently takes the most advantageous elements of individual banks' bids (i.e. the most debt finance offered on the cheapest and most flexible terms) and combines them into one highly leveraged package, asking the banks to accept those terms or lose the mandate. Winning a mandate can be highly lucrative in terms of both transaction fees and other fee-earning ancillary services the banks may be invited to provide, so there are strong incentives for banks to participate in these auctions. As private equity firms frequently re-use the same banks for consecutive deals, the banks are reluctant to impair their relationship with the private equity fund manager by rejecting a particular transaction, potentially losing the right to provide lucrative debt finance packages for future deals. Leverage levels are being competed upwards because of this process and increasingly appear to approach the limits of prudence. Snip) Some lenders may no longer be prioritising strict risk-return criteria based on the credit quality, transaction value and interest rate when deciding how much to lend. (snip) Purchasers of this debt may be either unaware of, or under-pricing, the inherent risk. On the assumption that a re-financing on more favourable terms will be possible, private equity owned companies are increasingly being initially financed with a capital structure that is unsustainable in the long term.
Some lenders may no longer be prioritising strict risk-return criteria based on the credit quality, transaction value and interest rate when deciding how much to lend. (snip) Purchasers of this debt may be either unaware of, or under-pricing, the inherent risk. On the assumption that a re-financing on more favourable terms will be possible, private equity owned companies are increasingly being initially financed with a capital structure that is unsustainable in the long term.
Ever heard of "limited rationality"? Read Nobel Prize Herbert Simon...
19% of the private sector workforce is employed by companies that have received private equity backing. As the situation of these companies becomes less stable due to their over-leveraged status, so these jobs start to look increasingly precarious. The impact of a private equity market downturn on the UK economy could therefore be felt not just through the transmission mechanism of capital markets but also more directly via the unemployment rate.
The situation will be further complicated by the general opacity surrounding the transfer of leveraged loans and their related risk. There is no general market-wide transparency surrounding loan risk transfer. Risk transfer mechanisms allow lenders of record to have a materially different level of net exposure than their lender of record position may suggest. Lenders are unlikely to be under any legal or contractual obligation to disclose their true position, even if they form part of a work out committee. Even the debtor company and its private equity backer may be unaware of the true extent of the net exposure of the lenders of record so the chance of a counterparty possessing all of the relevant facts is extremely slim. This opacity as to counterparties' true exposures can create significant difficulties. Risk transfer mechanisms may distort incentives in any credit event negotiation, leading parties to act in ways that are unpredictable to, and potentially to the detriment of, their fellow debt holders.
Many of those companies formerly owned by private equity fund managers that have been floated on the stock market recently have underperformed the market, bearing out fears that private equity will only sell off assets from which all of the growth potential has already been stripped.
Here is an interview of the European Commissioner Charlie Mc Creevy (EU Internal Market) on the subject. "Dieu se rit des hommes qui se plaignent des conséquences alors qu'ils en chérissent les causes" Jacques-Bénigne Bossuet
