German locusts and all that...

These comments were made against the political backdrop of the forthcoming state elections in the advent of the state elections, and were undoubtedly intended to stir support from working-class voters. Unsurprisingly, the remarks have caused a commotion in Germany, with anti-private equity sentiment coming to the surface, including calls to boycott private equity-backed companies from some quarters. Müntfering even went as far as to compile a list of ‘locusts’ – private equity firms that he believed were responsible for undermining the German economy. Amongst these were the well-known names of KKR, Blackstone, CVC, Permira, Apax Partners, BC Partners, Carlyle and Deutsche Bank and Goldman Sachs.

The German Private Equity and Venture Capital association (BVK), of course, was quick to point out that foreign investment in Germany was key to the economy, and that private equity investment, in particular, creates profitable companies, which in turn provide job opportunities. However, subsequent events at the Deutsche Börse, where the CEO and other board members resigned under pressure from foreign investors, has added weight to the case against international private equity houses as short-term investors focusing on profit-creation.

The UK private equity market, although the most developed and widely-accepted in Europe, is not without its critics. Recent figures estimate that in the UK one in five people are employed by private equity backed companies, yet there is a widespread lack of understanding of the role of a private equity house in the development of a business. Critics of the asset class point to the fact that private equity houses often generate annual returns of around 30% on their investments and, as the incident in Germany demonstrates, the ‘anonymity’ of some groups can sometimes engender suspicions of their means of achieving this.

One aspect of the industry that is worrying some critics in the current market is that as private equity firms continue to raise increasingly large amount of capital from LPs, banks become increasingly willing to provide funding to support buyout transactions, and companies that are the subject of a private equity buyout are burdened with large levels of debt. It has been estimated that in 2004, as much as EUR 35bn+ of capital was raised by European buyout funds and the total value of buyout activity in the market reached an unprecedented EUR 76bn. Furthermore, with lending levels reaching as high as 7x EBITDA, it can be surmised that 2004 saw as much as EUR 50bn of debt applied to buyouts.

Whereas in a stable economic climate, companies can easily shoulder large debt levels, but the danger is that, in the event of a sharp rise in interest rates or a dip in the economy, could render companies unable to repay loans. However, private equity backed firms that fail to meet debt repayments are few and far between, and one might surmise that lenders have become more cautious since the days of aggressive gearing that saw Isosceles (Gateway) spectacularly go under.

In light of the endemic threat of adverse press, private equity houses are keen to stress their worth and defend their practices. They have attracted much criticism in recent years for their supposedly opaque business practices, with some critics citing the non-disclosure of returns information as an example of this, however industry practitioners argue that complex restructuring of companies requires a certain degree of subtlety, which is best achieved without excessive public scrutiny. Furthermore, private equity houses, by their very nature, are skilled financial managers, and possess a far better business acumen than industrial managers.

Secondary transactions have incurred the wrath of industry critics of late, with some accusing large buyout houses of simply passing around companies in order to squeeze every last drop of profits from them. Whereas it is difficult to understand how the sale of a firm from one private equity manager to another similar-sized financial buyer, can be justified as a business model, provided there is sufficient room for development of the company, there is no need to be wary of the transaction. However, if a situation arises whereby one private equity house needs to divest a company to demonstrate returns and begin fundraising, and sells the business to another financial purchaser, it is difficult to se how the change of ownership can add value to the business. But this view is too cynical, since most secondary transactions occur when a company has grown to a size that is beyond the range that one private equity firm feels comfortable with managing, and is more suited to a larger player.

Recent surveys and economic impact studies have highlighted that private equity backed companies commonly out-perform listed companies over the long-term in terms of financial stability and profitability. However, in light of recent cases where private equity houses have bought and exited companies within a relatively short period of time, and have recorded exceptional returns on these investments, there is a need for some managers to state the case for private equity more coherently to quell public concern. Private equity houses, far removed from their ‘locust’ tag, often provide lifelines for failing companies and play a key role in developing a nation’s economy.

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