If you grabbed a Burger King for lunch, did some shopping at Neiman Marcus, munched at Outback Steakhouse for dinner, enjoyed a Budweiser, checked into a Hilton hotel, took a ride on an elevator made by Thyssenkrupp, turned on your Dell laptop, and watched the Weather Channel before going to sleep, you never left the world of private equity. Private equity is one of the hottest and most controversial buzzwords in corporate governance. Private equity firms often take an underperforming publicly listed firm off the stock exchange, add some heavy dose of debt, throw in sweet “carrots” to incumbent managers, and trim all the “fat” (typically through layoffs). Private equity firms get paid by 

(1) the fees 

(2) the profits reaped when they take the private firms public again through a new initial public offering (IPO).

Private equity first emerged in the 1980s, with a stream of deals peaked by Kohlberg Kravis Robert’s (KKR) $25 billion takeover of RJR Nabisco in 1988—then the highest price paid for a public firm. While KKR disciplined deadwood managers who destroyed shareholder value, it received a ton of bad press, cemented in a best-selling book Barbarians at the Gate that portrayed KKR as a greedy and barbarous raider.

After the RJR Nabisco deal, the private equity industry stagnated during the 1990s. However, in the 2000s, private equity rose again. In 1991, just 57 private equity firms existed.

In 2007, close to 700 chased deals. Now it is a $3 trillion industry, with more than 3,500 firms and more than $1 trillion “dry powder” (unspent cash in search of deals).

Private equity deals now routinely represent 25% of all mergers and acquisitions (M&As) in the world (and 35% in the United States). In 2007, Cerberus, a private equity firm, purchased Chrysler from DaimlerChrysler (now Daimler) for $7.4 billion. In the same year, APA X Partners spent $7.75 billion to buy Thomson Learning—the publisher of this book (which changed its name to Cengage)—from Thomson Corporation (now Thomson-Reuters) listed in New York and Toronto. However, private equity suffered a tremendous setback during the Great Recession of 2008–2009. Many deals struck in the easy credit environment of 2006–2007 collapsed. In a record-breaking $43 billion deal in 2007, Texas Pacific Group (now TPG) and KKR jointly took over Dallas-based utility TXU (now Energy Future Holdings). However, by 2011, KKR valued its investment at only ten cents on the dollar. More recently, private equity scaled new heights, routinely bagging deals worth billions of dollars.

Although controversial, private equity is a response to the corporate governance deficiency of the public firm. Private equity excels in four ways:

● Private owners, unlike dispersed individual shareholders, care deeply about the return on investment. Private equity firms always send experts to sit on the board and are hands-on in managing.

● A high level of debt imposes strong financial discipline to minimize waste.

● Private equity turns managers from agents to principals with substantial equity (typically 5% equity for the CEO and 16% for the whole top management team). Private equity firms pay managers more generously, but also punish failure more heavily.

Managers’ compensation at firms under private ownership, according to Michael Jensen (see Strategy in Action 11.2), is 20 times more sensitive to performance than at firms listed publicly.

● Private equity makes the same managers, managing the same assets, perform much more effectively.

On average there is a 2% boost in productivity and efficiency.

Finally, privacy is fabulous. For managers, no more short-term burden to “meet the numbers” every quarter for Wall Street, no more burdensome paperwork from regulators (an especially crushing load thanks to SOX and Dodd-Frank laws), and better yet, no more disclosure in excruciating detail of their pay (an inevitable invitation to be labeled “fat cats”). Top managers under private ownership are indeed fatter cats. It is no surprise that more managers prefer a quieter but far more lucrative life. In 1997, more than 8,000 firms were listed on US stock exchanges. In 2017, thanks to private equity, only more than 4,400 bothered to be listed.

All of the above, according to critics, are exactly what is wrong with private equity. Other than “barbarians,” private equity has also been labeled “asset strippers” and “locusts.” As high executive compensation at public firms has already become a huge controversy, private equity has further increased the income inequality between the high financiers and top managers as the top 1% and the rest of the 99%.

Inherently global, private equity has rapidly proliferated, reaching emerging economies such as China, South Korea, and the United Arab Emirates, as well as developed economies in Europe. Some of the fuss reflects the shock in countries suddenly facing the full rigor of Anglo-American-style private equity. In Germany, some politicians labeled foreign private equity groups as “locusts who feast on German firms for profit before spitting them out.” In South Korea, Lone Star Funds of Dallas was initially hailed in 2003 as a brave outsider willing to save troubled Korean firms. However, in 2006, when Lone Star tried to cash out by selling its 51% equity of Korea Exchange Bank, unions took to the street to protest and prosecutors issued a warrant to arrest its co-founder for alleged financial manipulation. But over time, private equity has become an accepted part of the corporate governance landscape in many countries.

Despite the initial resistance, Germany has recently become the most popular European destination for private equity deals, reaching an all-time high of $32 billion in 2019. In the largest private equity deal in Germany (and one of the largest in Europe), Thyssenkrupp sold its elevator division to Advent International and Cinven for $19 billion in 2020.

Is private equity “Monsters, Inc.?” asked an Economist editorial in 2012. To be sure, private equity results in job cuts (about 1%–2% of the jobs). But the same would happen if targets were acquired by public firms. In other words, private equity buyers are no more barbaric than public firms. In terms of returns, private equity investors earn slightly more than S&P 500 before the fees are charged. However, after the fees are charged, private equity performs slightly below S&P. In other words, investors would do as well or better with their money in an S&P index fund. In summary, while private equity is under attack for destroying jobs, its real problem is that returns to investors are low. With too many private equity firms with “dry powder” chasing a limited number of worthy deals, the returns are unlikely to be too fabulous. Now that four of the leading players—Apollo Global Management, Blackstone, Carlyle Group, and KKR—have themselves become publicly listed, they may become less glamorous and more boring “middle age” corporations struggling to deliver better returns to their investors.

CASE DISCUSSION QUESTIONS

1. What are the pros and cons of private equity?

2. If you were a private equity specialist, what kind of target firms would you look for?

3. If you were CEO of a publicly traded firm and were approached by a private equity firm, how would you proceed?