● Private equity and venture capital are the same thing. Absolutely not. Private equity (PE) generally backs established businesses using debt and equity, normally carrying out leveraged buy-outs of entire companies. By contrast, venture capital provides development funding to early-stage companies, mostly in the high-technology or biotechnology sectors. The private equity industry is probably 50 times the size of the venture capital industry – partly because, until recently, it has shown better returns. This confusion is compounded thanks to entities such as the British Venture Capital Association, which in reality is dominated by private equity interests – but politically it pays to play the venture capital card.
● Private equity takes control of and runs companies. The people who run a business backed with private equity are usually the same executives who ran it before. PE managers may turn up to board meetings once a month but they are invariably non-executives who would not be able to take command if the entire team running the operation walked out. Well-run PE houses partner with entrepreneurs to create value – that is the only way the system works.
● Private equity executives are motivated exclusively by making capital gains. The managers of big PE funds make so much money from fees that the carry on any ultimate gains is merely a bonus. Obviously, if the fund fails to achieve successful exits, the manager’s ability to raise a follow-on fund is doubtful – but with seven years of 2 per cent on $10bn just for turning up, who really cares? Right now the industry has dozens of senior players at the top of giant funds whose hunger to carry on delivering must be open to question.
● The industry has taken all its writedowns of bad investments. From 2005 to 2008, almost half the private equity ever deployed was invested. A fair proportion of that is lost. There are hundreds of zombie companies where the equity is worthless, yet the banks have not assumed control – so far. PE houses remain involved in the hope that value can be recovered, perhaps in some sort of restructuring. But in almost all cases the conclusion must be inevitable – the entire deal was a total wipeout, and the private equity owners are in denial.
● The industry has emerged unscathed from the financial crisis. During the next few years, the PE business is likely to shrink materially. Many funds have wrecked their records, thanks to the devastating losses emerging from deals done before the recession. Plenty will never raise another fund – but will not admit this. Meanwhile, many limited partners who back PE firms have discovered just how illiquid and long-term holdings in the asset class are. Debt to back leveraged buy-outs is very scarce and expensive – so the entire financial model is under threat. And exits via an initial public offering appear to be impossible. The private equity sector must get back to providing growth capital for industry – and forget about secondary buy-outs, refinancings and all the other wizardry that has contributed to its difficulties.
● Private equity is private. The scale and influence of PE is now so great that it has been unable to remain secretive. Regulators in Europe and the US are looking at forcing greater disclosure. Any such legislation is likely to be overkill. It would be better for the industry to volunteer more information about its structure and investments, and to educate policymakers about its merits.
● Private equity is easy. Finding and executing great private investments is hard. Decent businesses are rare, competition is fierce – and all the obvious financial engineering has been done. Only operators who are both talented and lucky will keep producing attractive returns.
lukej@riskcapitalpartners.co.uk
The writer runs Risk Capital Partners, a private equity firm, and is chairman of the Royal Society of Arts