In times of change and crisis, a mark of stability becomes a basis for reassurance and trust. In this context, private equity has performed solidly throughout the past few years, though it suffers from a poor public image. The good news? Effective governance may be able to improve it.
By Prof. Jose-Miguel Gaspar, ESSEC Business School, Vincent Gombault, Managing Director Funds of Funds and Private Debt, Axa Private Equity, Jean-Louis Grevet, Founding and Managing Partner, Perceva Capital
As an asset class, private equity in Europe has performed well, creating value and delivering good returns. Why should that be? One notable reason is better governance characteristics due to the factor that private equity investors are highly engaged directors. And yet the private equity industry faces image problems, not least because its effects may produce extremes that opinion has difficulty in comprehending: at times buyouts result in lost jobs, while some deals produce massive rewards.
A good track record
Private equity has been an extremely successful asset class. Professor Gaspar defines private equity as an investment model that concentrates firm ownership in the hands of active, professional investors. As a result of the industry’s success, there are now about 30,000 funds around the world, managing $3 trillion. Research on private equity yields several important insights.
Why is private equity so successful?
- Superior performance: Private equity produces higher margins, higher productivity and higher capital efficiency than other investment classes.
- Highly pro-cyclical activity: The amount of private equity activity fluctuates with economic cycles. During boom times, cash is plentiful and there is more activity.
- Returns are counter-cyclical: While activity is high during boom times, the abundance of cash drives up prices and drives down returns. The best performing funds are those started in bad times.
- The industry exhibits persistence in performance: Unlike other asset classes like mutual funds which do not repeatedly do well over and over again, a good private equity fund will repeatedly perform well.
- Better governance characteristics: One of the reasons private equity performs better is its governance. Companies owned by private equity firms have smaller boards, with more outsiders, which meet more often.
- Growth strategies: In the 1980s, private equity investors bought under-performing companies, fired management and loaded companies with debt. But today in Europe, leveraged buyouts are a growth story.
From niche asset to more mainstream, more stable investment
According to Vincent Gombault, private equity was initially an “alternative” investment, which is no longer true. Even after the recent financial crises, most funds are able to raise capital, and the total amount raised is significant. Mr. Gombault’s observations on the industry include that there is greater stability. Today there is less volatility. Funds are using less debt (about 50%), and few deals (< 1%) end up in bankruptcy. With low interest rates, investors shouldn’t expect 20 – 25% IRRs, but 10 – 15% is realistic. A further observation is that there are longer horizons: private equity investors are keeping their investments long term, such as five years. Because of this long-term focus, the 20% carry aligns interests.
In France the mid-market requires focus, expertise and experience
Because of France’s unique environment and laws, knowledge and expertise of the French market is essential. With this focus, Perceva views each investment as different, requiring different strategies and actions. This might include shoring up a balance sheet, reassuring creditors, working with local authorities or developing new products to drive growth. Each investment is handled differently based on the specific situation.
The private equity industry struggles with image
As an industry, private equity has a bad image. Mr. Gombault suggested this is because successful deals can result in very large returns, which are reported by the press in a negative light. Prof. Gaspar sees such returns are a natural result of taking risk. In looking at specific areas affecting the industry’s image, he concludes:
- Jobs: Net job creation is negative, as private equity investments often shed jobs. However, these investments also create jobs, and those jobs tend to be higher level and better paying.
- Innovation: Companies owned by private equity investors have no innovation advantage.
- Leverage: The use of leverage is only responsible for about one third of the industry’s returns; improving firm performance and selling assets at favorable times are also responsible for about one third.
- Incentives: The intent of the standard model of 2% fees and 20% carry is to aligned incentives. However, research shows that 60% of the present value of a general partner’s compensation comes in the 2% fees.
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