Private Equity Must Prove Its Mettle, Says CBI Chief

by Amanda Banks, for LawAndTax-News.com, London

24 April 2008

The private equity industry must prove that its core business model works now the economic conditions have changed so much compared to a year ago, the Director-General of the CBI announced on Wednesday.

Then, PE firms were able to take advantage of highly leveraged debt and rising asset prices to do deals and deliver returns, but the credit crunch and global economic slowdown has brought those days to an end, temporarily at least.

Now firms need to show that their core business model, based on the close alignment of interests between owner and manager and freedom from plc pressures, works without the easy access to credit and rising prices of assets, according to the CBI boss.

Richard Lambert, speaking at the British Venture Capital Association 25th Anniversary Summit, pointed out that the PE model is the 'very opposite' of some banks and financial institutions which have got into severe difficulties during the credit crunch.

Some investment banks, the CBI director-general said, had overlooked basic risk management in their desire to make money, and had allowed some staff to take decisions which private equity firms, with their own equity at risk, would not have countenanced.

Mr Lambert explained that:

"The spectacular returns generated by some private equity houses over the past half dozen years have been derived from three sources. High leverage. Rising asset prices. And a business model that cuts out the agency problem inherent in listed companies, by aligning exactly the interests of owners and managers."

"It’s never been entirely clear which of these three elements was the most important. Now in today’s changed financial climate, the first two of these three drivers for high returns – high leverage and rising asset prices - are going to be much less powerful."

"Producing above average returns in the next few years is going to be more challenging and will have to rely much more heavily on private equity’s business model," he added.

The BVCA is currently pulling together data to identify how portfolio companies create value and this, Mr Lambert observed, will be "very important in demonstrating the contribution made by management activity as opposed to financial engineering to private equity performance".

He suggested that: "It should be much more telling than generalised data about job creation or business investment in demonstrating the value of this form of corporate ownership to the economy."

Mr Lambert continued:

"The PE business model is also the very opposite of that which has landed some financial service companies in such severe difficulties in the last six months. At the heart of many of Wall Street’s problems has been a serious misalignment between the interests of managers and shareholders."

"It’s clear that a number of investment banks had overlooked basic risk controls in their drive to increase profits."

"This pattern of behaviour has been exacerbated by a remuneration structure which has encouraged some employees to take spectacular short-term risks, confident that if things work out well they will reap huge rewards, and if they don’t, they won’t be around to pay the price," he stated, further observing that:

"If it had been their own equity at risk, things might have played out differently. And that, of course, is the way that private equity works."

A year ago, the CBI director-general suggested, PE was treated as a social pariah, turned into a convenient 'whipping boy' by trade unions, and caught up in a political and media storm.

Since then, the industry has woken up to the need to engage with the wider world and has begun to do so, while the credit crunch has stopped PE from doing its mega-deals, and given the media and politicians something new to focus on.

"The big lesson learnt by the industry over the past 12 months has been about the necessity of communicating with a wider public than that of its immediate stakeholders. This is going to remain just as high a priority in the years to come," Lambert went on to add, further stating that:

"The challenge is to show that private equity ownership is absolutely compatible with a sense of corporate responsibility, in precisely the way that also applies to listed companies."

"One test of this approach may well materialise at one point or another during the next couple of years. Economic growth is slowing, and credit is scarce. It seems highly likely that corporate failures will follow, and that private equity backed firms will be included among them."

"The way the PE houses behave if and when they face such problems will be a closely watched litmus test of where they want to be positioned within the business community."

Mr Lambert concluded:

"Private equity houses have a very valuable asset which is badly lacking in the rest of the financial community today. That is, they have lots of capital to invest."

"It would be fun, and also a little ironic, if the same firms that were being castigated as rascals a year ago were to be feted as public heroes for helping to refocus the financial system in the months to come."

"Maybe that’s asking a bit too much. Private equity investors are never really going to become part of the business establishment – they tend to be strong and driven individuals, with their own goals to fulfil."

"But they have become an important and permanent feature of the business community. And the next year or two is likely to bring significant opportunities for people with capital to invest, an eye for an opportunity, an ability to move quickly, and a rich streak of entrepreneurial flair."

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