THE rulers of
the capitalist roost change remarkably often. Consider just
the past two decades. In the 1980s Michael Milken and the
small crowd of deal-making junk-bond financiers who followed
in his wake seemed to be the kings of capitalism. In the
early 1990s, the crown passed to the traders of Treasury
bonds, who helped to terrify even President Bill Clinton
into fiscal prudence. By the end of the decade, investment
bankers appeared to occupy the throne, as they brought hot
initial public offerings of shares to stockmarkets and their
analysts, such as Morgan Stanley's “internet queen” Mary
Meeker, touted them to eager buyers.
And today? The
candidates are unusually publicity shy. Hedge funds—private
pools of capital that can invest, long or short, in whatever
they please—regard themselves as capitalism's top dogs, and
yet they already seem past their prime. There is talk of a
hedge-fund bubble, as billions of dollars pour into these
funds even while their performance slumps. Besides, it is
not clear that, in the scheme of things, hedge funds really
matter much: they provide useful liquidity to the financial
markets but, essentially, they are mere speculators who
profit from correctly anticipating market movements rather
than by shaping the fundamentals of the business world.
That, increasingly, is the role played by a different sort
of secretive pool of capital: private equity.
Private-equity
firms are those which purchase other firms or take big
stakes in them (and often take public firms private by
purchasing most of their publicly traded shares) in order to
reshape their businesses, and then sell these holdings for a
profit. Private equity comes in two main forms: venture
capital, which aims to help young firms grow; and buy-out
capital, which is used to improve established firms.
Private-equity firms now wield much of the transformational
power at the heart of the capitalist system. Although they
rarely seek the limelight, the sheer clout of leading
private-equity firms such as Blackstone, the Carlyle Group
and Kohlberg Kravis Roberts (KKR)
has attracted attention, and sometimes controversy.
Many a
household name—from Burger King to Jimmy Choo shoes—is owned
by a private-equity firm. Many big mergers or takeovers now
involve private-equity firms. Even if they are not acting as
buyer or seller, their potential interest is, at a minimum,
putting a floor under the deal price. Five firms are jointly
planning the biggest private-equity deal yet in Europe: a
$14 billion purchase of Auna, a Spanish telecoms group. Last
week's merger of Sears and Kmart, two big American
retailers, was led by Kmart's private-equity owner, Edward
Lampert's ESL Investments (one of a growing band of hedge
funds that are also doing private-equity deals). Here is one
crude measure of the rise of the industry: in the Wall
Street Journal, New York Times and Financial
Times, the use of the term “private equity” this year is
up by around 60% compared with just two years ago, and by
over 3,000% in the past ten years.
Yet if private
equity is now king, is that something to celebrate? Are
private-equity firms using their power wisely? Do they
really create economic value for anyone but the people who
run them? And is it really desirable, in this age of
transparency, for such secretive firms to have so much
power?
As is explained
in our
survey of private equity published in this issue, it is
frequently a force for good—in many ways a superior model of
capitalism to that based on firms traded in public
stockmarkets (though neither model can thrive without the
other). In private equity's infancy in the 1980s, firms such
as KKR and Forstmann Little, though derided as “corporate
raiders”, pioneered efficiency-enhancing innovations that
are now standard business practice: a focus on cash flow;
the better use of debt; and equity-based pay as a way of
offering incentives to managers to act more in the interests
of shareholders. Today, private-equity firms often seem to
provide better corporate governance than is generally found
at many public firms, whose shareholders usually own too
small a stake to keep management in line. (Ironically, the
recent wave of new corporate-governance regulations has made
more people in public companies yearn to go private.)
Despite their early reputation as asset-strippers,
private-equity firms increasingly help companies to maximise
their long-term value by protecting them from stockmarket
pressure.
In the 1980s
and 1990s, private-equity firms helped to break up America's
many badly run conglomerates, taking neglected non-core
businesses off their hands, polishing them and finding more
suitable owners. They hope to repeat this trick in other
places where inefficient conglomerates are rife, starting
with continental Europe—especially Germany. The efficiency
gains for Europe's economies could be huge. Private-equity
firms are also pioneering restructuring in Japan, starting
with its wretched banking system. Private-equity firms have
high hopes of spreading cutting-edge business practice to
nascent economic superpowers such as China and India as
well—though it remains to be seen if they can pull this off.
Yet not
everything about private equity is wonderful. Greater
transparency is needed. This is not because many of these
firms are part of a scary political/military/industrial
complex, as some critics (along with the re-makers of “The
Manchurian Candidate”) fear, but simply because growing
amounts of pension-fund money are being invested in them,
and the beneficiaries of these funds have a right to know
how their savings are being used. The challenge for
private-equity firms is to meet this legitimate demand
without giving away commercially useful information, or
succumbing to the short-term financial pressures they have
sought to escape.
Another risk is
that too much money will flow into private equity, creating
a bubble—just as may now be happening in hedge funds. As
private equity grows, and its leading firms become even
bigger, there is also a danger (perhaps it is already
becoming a reality) that they will lose their edge. If that
happens, it will be time for capitalism to crown a new king.
Leadership Focus