Thursday, January 04, 2007

KKR on private equity

I was interested in the views of George Roberts (of Kohlberg Kravis and Roberts) on the rationale for the boom in private equity – equity not publicly-traded in a share market.

‘Managements want to take a long-term view, but they know they get clobbered in the short-term. A lot of companies want to start new projects but they can’t because they are afraid of the hit to quarterly earnings, even though it may be right in 3 to 5 years. When we say our average hold [before selling the company or taking it private] is 7 years they sit up’.

It’s a version of the ‘short-termism’ arguments often directed at private equity investors and bolsters arguments that private equity boosts the efficiency of capitalism by forcing investors under the cold discipline of unrelenting debt to rid companies of underperforming assets, ruthless cost-cutting, outsourcing of jobs and so on. It also means, of course, that we don’t need to be as concerned about possible excesses of such firms.

Indeed one argument for establishing corporations with many shareholders is that, by sharing risks it is possible to access the vast amounts of capital necessary to fund capital-intensive industries. Some of the earliest joint-stock companies were US railways which needed huge funding to be feasible and old-fashioned family-style businesses would not work. But this type of argument is increasingly irrelevant when firms such as KKR can mobilize investment war chests of over $100 billion US. Last year KKR bought 12 companies for a shade under $7 billion. Moreover, they can afford to lose $1 billion on a particular deal given their spread of interests.

Another argument for the rise of private equity that one can make is that equity premia mean that debt is cheap, at least for firms that don’t experience disastrous ‘long-tail’ events. I’ve put this argument before. It suggests that equity premia arise because debt holders ignore the prospect of severe ‘long-tail’ adverse circumstances. In this case it is important to be concerned about the rise of private equity since it all can ‘end-in-tears’ (particularly for the shareholders of banks and the stakeholders in pension schemes who fund such purchases) as the RBA and other groups warn.

Both views here may have some truth to them. Some deals will work out delivering great efficiency while others won’t, instead delivering much financial pain. In any even capital markets must be now modeling by supposing there is a mix of both public and private equity claims.

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