Private equity: Greed is good?

Date: 02 Mar 2017

Bumblebee Design

Blackstone's purchase of Conrad Hilton's resort and hotel empire for $26 billion is one of the largest private equity deals in history.

Since 2013, private equity funds have raised $500 billion annually worldwide and uninvested dry powder cash reserves today stand at a record $1.3 trillion, according to a report from the consulting firm Bain & Company. This gold rush of cash seems to have benefited everyone in the industry apart from one segment, current buyers. However, flush with success, there are not many incentives for private equity companies to change their current model.

There is though intense competition in the sector which is putting pressure on PE companies to diversify their investment strategies. Richard Clarke-Jervoise, partner at family office Stonehage Fleming, says: “One area which requires more attention is investment in some US real-asset strategies where taxes can present a significant additional administrative burden as well as a meaningful drag on returns.”

Despite the eighties-style environment and self-congratulation, private equity acquisitions increasingly have drawbacks for both the investor and the company being invested in. The basic formula, buying a company, increasing its value and selling it years later for a higher price, can drive hard against a company’s own objectives, expands Gareth Lewis, CEO and co-founder of Delio Wealth. He says: “The driven focus on productivity can put immense pressures on organisations, leading to a reduction in the workforce, replacement of senior management and selling of assets. Another obvious drawback of PE acquisitions is a loss or dilution of your ownership stake. Although private equity can generate accelerated returns, owners usually have to lose a much larger share of business. “There is a trade-off to be made,” he adds.

Toys out of the pram

An important drawback that comes with reduced control typical of PE acquisitions is that business owners often don’t follow the rules set out by their new PE partner which brings potential for conflicting views on how success going forward is achieved. Iain Baillie, co-CEO of investment platform Asset Match, goes even further, saying: “Many institutional private equity investors demand control, control and more control. And if it fails to work, they will take control.”

The private equity industry also lacks transparency. For new entrants, a poor understanding of private equity methodology can lead to confused investors. Baillie says their recent research revealed that twenty-seven percent of investors in private companies don’t know what their holdings are actually worth, while eleven percent of shareholders have been holding their shares for longer than originally intended. Opacity around fees and disclosure can lead to more discontent.

Clarke-Jervoise says that one of the main challenges for private clients is that there is little publicly available information for prospective investors. “Large firms such as Blackstone and KKR have dedicated investor relations teams for families and private clients. This is not the case for smaller, mid-market firms which makes it difficult for families and private clients to review these deals properly.”

However, Andrew Craig, partner at Maven Capital Partners, pushes back on this idea and says as the industry has become more main stream, high standards of corporate governance are now in place and regular reports are given to investors.

Private equity goes niche and impact

Increased transparency is not the only way the PE industry wants to lure investors. According to Gareth Lewis, private equity funds are moving into new territory with impact investing, particularly among the private client population. “Specific funds are also becoming more niche in areas such as distressed oil and gas, fintech, or even space exploration. Beyond this, strategies seem to come in and out of vogue although private debt is continuing to be a popular place to allocate capital.”

Private equity remains an attractive industry for UHNW individuals and institutions alike, providing solid returns. But in order to continue to sustain their business model, more transparency is needed. This will help investors and company directors believe, as Dick Whittington did, that all private equity streets are paved with gold.