Gilles MOUGENOT – January 2020
There was a saying in ancient Rome: “It is not far from the Capitoline Hill (where consuls took their oaths) to the Tarpeian Rock (from which criminals were thrown to their death) Is this not a most appropriate expression to apply to the situation of Private Equity?
It is generally used to mean that after honours, the downfall can come quickly. Private Equity (PE), which is regularly the subject of fundamental criticism that can largely be attributed to anti-capitalism, is today exposed to threats that come from the system itself, even as falling interest rates (which have become negative) are pushing investors to increase their exposure to this asset class. Last March, the daily Les Echos ran the headline “Global Private Equity ready to depose the stock market”.
Like all other financial instruments, PE has to face the challenges that stem from: (i) recession and (ii) falling multiples, to which must be added (iii) a wall of LBO debt which, it was already predicted after the sub-prime crisis of 2007, would devastate the funds’ portfolio. This, however, did not happen.
Nonetheless, as allocations to the unlisted sector progressed, we heard sour remarks from investment professionals in the stock markets. For example, at the Berkshire Hathaway general meeting on May 4th 2019 Warren Buffett ironically pointed out that introducing leverage when making an acquisition naturally allows for a better return on investment if all goes well, thus implying that the slightest protection of lenders due to their “exuberance”, makes them run a risk in case of an economic downturn.
The other criticism of the “Oracle of Omaha” was based on the observation that the funds only called the money when they needed it and that the internal rate of return (IRR) was calculated on the amounts drawn and not those committed by the investor, thus introducing a bias against an investment in shares paid in cash. This remark was taken up by Alpha Value, the leading independent European provider of credit and equity analysis. But their criticism went further by adding the famous lack of transparency of PE and by ending their analysis with, and I quote:
“Under what pretext does an investor, however foolish, agree to invest his good money (or the money of third parties entrusted to him subject to fiduciary obligations) in what is nothing more than a Ponzi scheme of macro-economic dimensions, this leaves us looking for a valid explanation”.
More seriously and more surprisingly, last July, a number of American politicians including Massachusetts Senator Elizabeth Warren (who has just caught up with Joe Biden in the polls for the Democratic nomination race) launched a bill called The stop Wall Street Looting Act of 2019, which does not target Wall Street as one might think, but PE exclusively.
Senator Brown of Ohio, another associate of Elizabeth Warren’s, says “with the help of our rigged tax code, private equity firms have been acting like bandits at the expense of workers and communities”.
The main provisions of the act are as follows:
1. The liability of fund management companies (GPs) in the case of difficulty in paying the debts of the target company purchased, and employee pension plans;
2. In order to discourage “irresponsible leveraging”, the non-deductibility of loan interest and carried interest and profit-sharing for fund managers;
3. A ban on distributing dividends from the company purchased to investors for a period of two years from the closing of the transaction;
4. The obligation of the funds to disclose fees and returns, in the interests of transparency;
Voices from across the Atlantic have pointed out that this legislation would be difficult to enact as it ignores the limitation of shareholder liability that is one of the founding elements of corporate law.
Still others pointed out that these limitations could have negative consequences for the economy by restricting asset stripping operations and added that even if it were considered that the industry should be “tamed”, it should not be “killed” (Noah Smith in Bloomberg).
The pre-election period in the United States is always an opportunity for over-kill. One particularly remembers the presidential campaign of Mitt Romney who, as founder of Bain Capital, was scolded by journalists about his ability to create wealth on the “backs of the workers” by closing and/or relocating factories.
In spite of numerous studies detailing the merits of long-term PE, the same litany regularly reappears like the flu epidemic.
In conclusion, PE must continue its efforts to promote its merits and simultaneously improve its practices by introducing even more moral and social values of the ESG (Environmental Social Governance) type. Beyond our modest participation in saving our planet and making it better, we are condemned to irreproachability.