Fiction: Private equity only benefits the wealthy.
Fact: Private equity investment provides financial security for millions of Americans from all walks of life. The biggest investors in private equity include public and private pension funds, endowments and foundations, which account for 64% of all investment in private equity in 2012.
Public and private pension funds invest with private equity for good reason. They have received returns that far exceed those available from the stock market. As of December 2012, private equity returned more than 14% annually over a ten-year period, whereas the S&P 500 Index returned 7.1%. One study shows that $1 invested in private equity provides 20 percent more return than $1 invested in the stock market. Recent calculations estimate the total net profits distributed to investors worldwide by private equity funds equal more than $1.4 trillion.
Fiction: Private equity firms weaken companies by stripping them of assets and saddling them with debt.
Fact: Private equity firms build companies; they do not tear them down. In the last 30 years, private equity has been adding assets and value to portfolio companies. A 2008 study by the Boston Consulting Group found that since the 1980s, operational improvement as a source of value increased two-fold to more than one-third of value creation. A 2012 study finds that operational improvements are the primary source of value created by private equity. Furthermore, so-called asset stripping is unwise. A shell of a company will be steeply discounted – not a business in which partners would be comfortable investing.
Private equity is a long-term investment that takes years before the full benefits are realized. This long-term focus aligns the interests of the private equity firm with the company it buys and ensures that the company has lasting success.
Fiction: Private equity buyouts always result in layoffs.
Fact: U.S.-based companies with private equity investment employ approximately 7.5 million workers. A recent academic study using data from the U.S. Census Bureau shows that the relative difference in employment at private equity-backed companies and comparable companies is minimal. While companies receiving investment may experience an initial drop in employment, employment growth occurs in new locations where these companies expand their operations. The study concludes that “the overall impact of private equity transactions on firm-level employment growth is quite modest.”
Fiction: Private equity firms do more harm than good for the companies in which they invest.
Fact: Private equity firms often invest in undervalued companies and work with them to increase growth and value. Private equity provides capital, resources, expertise, and long-term vision. Private equity ownership also helps to align the interest of the company and its investors. Companies listed on public exchanges often have multiple owners, making it difficult for management to set a clear plan for the long term. By taking the company private, management can set long-term operational goals, without the concern of meeting market expectations quarter by quarter.
Some private equity firms invest in struggling companies and work to put them on the right track. During the last five years, private equity invested almost $30 billion in more than 1,987 U.S.-based companies that had filed for bankruptcy to help turn the businesses around. These companies employed over 250,000 people.
Fiction: Private equity firms are “quick flip” artists that buy companies and sell them to make a fast buck.
Fact: A typical private equity investment lasts five years or more—the amount of time needed to grow a company so it is worth more to future buyers. The foundation of private equity is to strengthen companies and private equity general partners must put substantial time and effort to accomplish this goal. According to a study conducted for the World Economic Forum, of all the companies acquired by private equity firms between 1980 and 2007, 69 percent were still owned by private equity by November 2007. A related study for the European Union Parliament found that only 16 percent of all private equity exits take place in less than two years.
Furthermore, management compensation at private equity-owned companies is tied to long-term performance. Unlike many other compensation structures that reward short-term accomplishments that may be harmful in the long-run, private equity firms introduce a structure that ensures that companies succeed over a span of years.
Fiction: Private equity’s size creates big risks for the financial system.
Fact: Private equity’s place in capital markets is too small to trigger a cascading market problem. Private equity firms and private equity funds are also not meaningfully interconnected with other financial system participants, with very limited counterparty exposure in the form of swaps, derivatives, borrowings or otherwise. Private equity firms do not invest in mortgage backed securities or complex derivatives—just companies. The assets of private equity funds are highly diversified across nearly every industry and sector. In addition, while there are operational relationships between them, there are no meaningful financial interconnections (such as cross-collateralization) between a private equity firm, the funds that it manages and the companies in which those funds invest (“portfolio companies”). Therefore, the material financial distress or failure of a private equity firm, a private equity fund or a portfolio company would not cause the material financial distress or failure of an affiliated firm, fund or portfolio company. For these and other reasons, private equity firms and private equity funds, as a class and individually, do not present systemic risk concerns.
Fiction: Private equity firms benefit from an unfair tax loophole called carried interest.
Fact: The current tax treatment of carried interest is not a “loophole,” but rather a long established policy that is designed to encourage growth. For more than fifty years, the tax code has recognized that carried interest and enterprise value are long-term capital gains. Carried interest is an equity stake in an operating business owned for years. If the operating business is not sold for a profit that ensures hurdle rate of return (typically 8 percent) for outside investors then a private equity general partner receives no carried interest. Moreover, recipients of carried interest obtained on the successful sale of a business remain subject to clawbacks that require them to pay back their carried interest in the event that subsequent investments in a fund are sold at a loss. That is hardly the same as ordinary income.
Fiction: Private equity firms load companies with debt and then take the money out of the company to make a profit. Companies can fail and private equity managers still make a lot of money.
Fact: In order for private equity investment in a company to be profitable, the company needs to succeed. Private equity managers work hard to make their invested companies successful. Success is defined as increasing the value of the company by driving growth or implementing better ways of operating the company. Part of this success is also the company’s ability to service and, over time, retire its debt.
Sometimes private equity firms fund the purchase of companies using debt. The amount of debt a company borrows is a function of the profitability of the company and the willingness of banks to lend. Historically, there have been periods when banks will lend higher amounts and, other times, lower amounts. Industry data show that the debt to equity ratio of private equity investing has declined from roughly 9 to 1 in the late 1980s to less than 1.5 to 1 today. On some occasions, private equity firms may request a recapitalized dividend on their investment if the company has performed well. Issuance of this debt is ultimately decided by the bank, which reviews the performance of the company and its ability to repay the loan. Some firms may have difficulty servicing their debt if their industry or the larger economy suffers a sharp and unforeseen downturn, such as during the recessions of 2001 and 2008. Private equity managers work equally hard to make these companies successful, because if these companies fail, the private equity firm may not be able to raise its next fund.
Fact: Private equity firms must provide superior returns to their investors in order to survive. Private equity firms rely on their ability to attract capital from outside investors, mainly, pension funds, foundations and endowments. With a growing number of private equity firms and limited available capital, fundraising by private equity firms has become very competitive. To attract this capital, a firm needs to generate superior returns. To generate superior returns, the firm needs to invest in companies that grow and prosper. A private equity firm with a track record of multiple bankruptcies will not produce the returns that are required to compete for limited capital from these sophisticated investors. Academic studies, such as this 2011 report, show that U.S. buyouts have produced superior returns for their investors over the past decades. Private equity could not continuously attract capital if it did not generate consistently good returns, by working with companies it invests in to become bigger and better.