The Big Deal: Private Equity Comes of Age

Large private equity transactions have been making a splash in the business world for the last several years. Recently, major buyouts of firms such as Chrysler, Alltel and TXU have helped the trend rise to national prominence. What is private equity? And what is behind its growing presence in the world of corporate finance? Finance Professor Robert Parrino brings Exchange up to speed.

What is the nature of a private equity buyout?
 
Parrino: The private equity investor is looking for a mature business with cash flows that are sufficiently stable to service a relatively high level of debt but that can be improved. They’re looking for undervalued assets they can manage to their full potential and on which the equity returns can be enhanced through the use of leverage. The private equity transactions that make the headlines tend to be those that involve wellknown brands or that are especially large. For instance, after being acquired by a private equity firm, Chrysler is now the third-largest private company in America.
 
What are the pros and cons of being taken private?
 
Parrino: One important advantage of going private is having the ability to focus on the long term, without worrying about shortterm fluctuations in the company’s stock price. If the company has no public debt, it does not have to disclose information about its performance and strategies in filings to the Securities and Exchange Commission. In other words, it does not have to release information that might help competitors.
 
Another important benefit is that a private company has more flexibility in reacting to changing business conditions or in taking advantage of investment or merger opportunities. There is no need to inform and obtain public stockholder approval for major corporate transactions. This benefit is especially true in the typical private equity transaction where the buyer acquires absolute control.
 
The private firm also has more flexibility in the way it can structure incentive compensation for managers. Aligning the incentives of managers with those of stockholders is crucial to achieving the types of objectives that private equity firms have.
 
Of course, since a private firm is not required to provide information to the SEC, its compliance costs are lower because it is not subject to Sarbanes-Oxley rules.
 
But there are disadvantages. It can be more difficult to raise capital if you don’t have access to the public markets. Your managers can’t observe a daily stock price, so there isn’t this very useful measure of how well the firm is performing and what it is worth. This makes it difficult for investors to value their investments and
also affects the liquidity of those investments. It can be difficult to sell an ownership stake in a private firm without giving up some value to compensate the buyer for the lack of liquidity. Also, if you want to provide managers stock options to get them to focus directly on creating shareholder value, it’s not as easy in a private company because you don’t have a stock price to benchmark performance.
 
Why has there been such an increase in private equity buyouts?
 
Parrino: There are a number of factors. An important contributor has been the substantial increase in the availability of equity capital. In recent years, institutional investors searching for higher returns have allocated increasing fractions of their portfolios to alternative assets, such as real estate, hedge funds and private equity. This has made it possible for private equity funds to raise large amounts of equity capital.
 
To give you some perspective, right now private equity firms have outstanding commitments totaling about $250 billion from their limited partners (institutional investors). This is enough money to acquire businesses with a total value of about $750 billion at typical debt levels. The result of this increase in equity capital is that more people are actively pursuing private equity transactions and considering opportunities that would not have been of interest in earlier years.
 
The availability of low-cost financing through the first part of 2007 also contributed greatly to the increase. Not only was the stated cost of debt low, but the terms in the debt agreements were very favorable to the borrowers. For example, some loans provided the borrower with the option of deferring interest payments if
cash flows from the business were not sufficient to make them. This low-cost debt enabled investors to pay higher prices while maintaining acceptably high expected returns for their investors.
 
Also, more sellers have become aware of the option of selling to private equity investors, and more executives have begun to recognize the attractiveness of managing a private business. These changes have led to increased availability of businesses for sale to private equity investors and of managers to manage them.
 
What are some of the consequences of this trend?
 
Parrino: Overall, I think it is very beneficial to the economy. To the extent these leveraged buyouts result in businesses operating more efficiently, they are improving the overall efficiency of the economy. Certainly
the private equity investors benefit, as do the limited partners and the institutional investors that put money into successful private equity firms. But the employees at these businesses also benefit in the long run. While there can be job losses initially when a business is restructured, if the business emerges stronger, then that is ultimately going to create more jobs and more value for everyone.
 
How do the transactions come about?
 
Parrino: It depends on the firm. For example, one of the things the prominent private equity firm Blackstone takes pride in is having developed relationships with executives at a large number of publicly traded firms.
Working these relationships, they are constantly trying to identify businesses within these public firms that can be managed more efficiently. They are also constantly looking for opportunities in which they can put different businesses together in a way that enables them to create more value. 
 
Other transactions might not come from such a well-structured process. A firm could get into financial distress and could be broken up and sold off, and a private equity firm might bid on a piece.
 
You might have a situation where one private equity firm has held an investment for a few years and they now feel it’s time to start wrapping up their partnership and so they might sell to another private equity
firm. Those are called sponsor-to-sponsor transactions. We have seen quite a few of those transactions over the last five years. Private equity transactions can come about in just about any way you can imagine.
 
What has surprised you about the private equity trend?
 
Parrino: The sheer size of some of the transactions is a surprise. There are a lot of large transactions taking place now that I wouldn’t have expected four years ago. Nine of the ten largest buyouts of all time have taken place since the beginning of 2005. I think that’s a function of the fact that the private equity markets are becoming more mature and more complete. They are better able to handle very large transactions. For example, the TXU buyout (now called Energy Futures Holding Corp.) is on the order of $45 billion. This transaction required several billion dollars of equity.
 
TXU is also an interesting case because it wasn’t a perfect candidate for a leveraged buyout in the traditional sense. TXU is a utility, and utilities tend to be regulated and often do not have a lot of growth opportunities. TXU also appeared to be reasonably well managed. Of course, the buyers of TXU believe there are opportunities to create additional value—apparently through use of greater leverage and even better management.
 
What are some of the implications of the recent volatility in the debt markets?
 
Parrino: Some of the transactions that have taken place in the last few years were possible only because of the availability of lowcost debt with few restrictions. We’re already seeing a substantial drop-off in the number of private equity transactions and in the repricing of previously announced transactions in response to the turmoil in the debt markets.
 
I don’t think debt-market conditions will return to what they were during the last couple of years anytime soon, but I also don’t think the private equity markets will be adversely affected over the long run. The private equity markets have been developing pretty consistently for a very long time now, and I believe this development reflects a fundamental change in the capital markets.