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Private Equity, Risk, and Government: The Great Challenge. Josh Lerner Harvard Business School. My argument. The single greatest challenge that the PE industry faces is not… Market cycles. Overleveraged existing portfolio companies. Access to debt. Limited partner nervousness.

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Presentation Transcript
my argument
My argument
  • The single greatest challenge that the PE industry faces is not…
    • Market cycles.
    • Overleveraged existing portfolio companies.
    • Access to debt.
    • Limited partner nervousness.
  • But rather overactive and ill-informed regulators.
my argument 2
My argument (2)
  • Much of the proposed regulations appear profoundly ill-conceived.
    • But it doesn’t seem to matter!
  • The private equity must be more creative in responding!
central issues
Central issues
  • In aftermath of economic crisis, many questions regarding regulation:
    • How did regulators miss the antecedents to the financial crisis?
    • Does institutional approach to regulation still make sense?
    • Should regulators’ reach be expanded to all institutions that pose systemic risk?
widespread regulatory proposals
Widespread regulatory proposals
  • Broad array of regulatory changes proposed in both U.S. and Europe, as well as various multilateral bodies:
    • Precise shapes of legislation remain uncertain.
    • But seems clear something will happen.

”[PE and hedge funds] are, in short, a major challenge

to financial stability, and, unless regulated, they are

likely to contribute to future crises.”

”The big private equity funds have proven to be a

menace to healthy companies, to workers’ rights, and

to the European Union’s Lisbon Agenda.”

”Leveraged buy-outs leave the company saddled with

debt and interest payments, its workers are laid off, and

its assets are sold. A once profitable and healthy

company is milked for short-term profits, benefiting

neither workers nor the real economy.”

Paul Nyrup Rasmussen, ”Taming the Private Equity Locusts,” Europe’s World, 2008.

private equity is not exempt
Private equity is not exempt
  • EU Alternatives Investment Fund Managers Directive:
    • Long-running legislative process specifically focused on private equity and hedge fund industry.
  • Dodd bill may or may not contains provisions directly addressing private equity, but begins process that is ultimate likely to ensnare PE:
eu proposals
EU Proposals

Source: Oliver Wyman [2009].

u s proposals

US Proposals

U.S. Proposals

Source: Oliver Wyman [2009].

thinking about the justification
Thinking about the justification
  • Extremely complex problems pose policy challenges.
  • To what extent are proposed private equity regulations justified?
  • Little evidence one way or another, except anecdotes.
differing perspectives
Differing perspectives
  • Private equity leads to better operations:
    • Industries with more private equity backing should do better.
  • Or private equity as asset strippers?
  • Private equity has “deep pockets”:
    • PE-backed firms can do better in downturns.
  • Private equity is over-leveraged and cyclic?
    • PE-backed firms will do worse in downturns.
the wef 2010 project
The WEF 2010 project
  • Look at all buyout and private equity investments around world.
  • Look at evolution of industries at national level:
    • Revenues, employment, profitability, etc.
    • 26 countries and 20 industries.
  • Use data from OECD, CapitalIQ, etc.
the sample
The sample
  • 8,596 country-industry-year observations between 1991 and 2007.
    • PE industry = at least one PE investment in industry last 5 years
    • Low (High) PE = fraction of total imputed PE investments last 5 years divided by total production smaller (larger) than the median (conditional on non-zero level of PE investment).
    • Quartiles of PE investment / production
  • Look at deviations from average growth rates at the industry-year level
two key questions
Two key questions
  • How does more PE investment in past five years impact industry performance in a given nation?
  • Is the pattern the same in times of industry shocks, particularly downturns?
    • E.g., if more PE investment in Swedish steel industry than Finnish, does industry performance differ…
      • In general?
      • In downturns?
basic regression results
Basic regression results
  • Lagged PE-investment is associated with
    • Higher growth in production (0.9 percentage points)
    • Higher growth in value added (1.1 pp)
    • Higher growth in total wage compensation (0.7 pp)
    • Higher growth in number of employees, but mostly for moderate levels of PE investment
    • No significant effect on capital formation / investment
  • Also true when look at continental Europe alone.
looking at cyclicality
Looking at cyclicality
  • If anything, PE investment seems to dampen industry shocks
  • Particularly consistent for employment and labor costs:
    • 5% increase in total labor costs in a given year  PE industry will experience 5.576% increase
    • 5% decrease in the wage bill 

PE industry will experience a 2.394% decline

worrying about causation
Worrying about causation
  • Does PE cause or chase growth?
    • Do PE funds choosing faster-growing or less volatile industries?
    • Results unchanged if we only consider the impact of PE investments made several years before on industry performance.
    • Also go through when look at pension policy changes that drove PE fundraising.
    • Seems to be PE driving growth, not vice versa.
key conclusions
Key conclusions
  • Industries where active PE funds in the past 5 years grow more rapidly:
    • True if measured using total production, value added, or employment.
    • Few significant differences between industries with low and high PE activity.
  • Activity in “PE industries” no more volatile in the face of industry cycles, and sometimes less so.
        • Bernstein, Lerner, Sorensen and Stromberg [2010].
but it doesn t seem to matter
But it doesn’t seem to matter!
  • Pressures to “do something.”
  • Lack of patience of policymakers with details.
  • Hard to sympathize with private equity titans.
  • Regulatory creep:
    • What starts as a modest regulatory regime almost invariably expands.

You have logic, I have Reggie.

© Charles Barsotti. All Rights Reserved

some thoughts about carry tax
Some thoughts about carry tax
  • A philosophical conundrum best left to taw professors!?
  • Uncertainty as to who will bear tax and consequences:
    • LPs: Fewer capital commitments?
    • GPs: Even fewer incentives to “do the right thing”?
      • Metrick-Yasuda results.
carry tax 2
Carry tax (2)
  • Other questions:
    • How much revenue will this collect really?
      • Difficulty of distinguishing between entrepreneurial and private equity contributions.
    • Distinguishing between venture capital and private equity funds: mission impossible?
      • The weakness of holding period as a criteria.
    • The desirability of enterprise taxation provisions?
a modest proposal
A modest proposal
  • PE must become much better at making a case for intelligent regulation.
    • Widespread consensus that regulation that is piece-meal and institution-specific just opens doors to “gaming” and arbitrage.
    • Moreover, private equity is likely to suffer disproportionately due its visibility.
  • Should be encouraging independent voices to get the word out about these issues.
an example from europe
An example from Europe
  • Proposed limitations on leverage in private equity deals:
    • Why should PE funds be limited but not…
      • Sovereign wealth funds?
      • Family offices?
      • Companies themselves?
    • Likely to lead to huge disruption and poorer investments.
another modest proposal green shoots
Another modest proposal: “Green shoots”
  • Governments world-wide eager for growth and employment:
    • Numerous subsidy schemes geared toward venture capital and new ventures.
      • Australia
      • Canada
      • China
      • India
      • New Zealand
      • United Kingdom
      • United States
private equity is likely to be part of the solution
Private equity is likely to be part of the solution
  • Tool kit is very relevant:
    • Experience screening potential investments.
    • Skill at overseeing firms making operating improvements.
    • Abilities to help firms access additional financing.
      • Track record of growth equity sector.
      • More general evidence presented today.
  • But industry has not been engaged in a proactive manner.
wrapping up
Wrapping up
  • Regulation is real and only likely to intensify.
  • Many of the concerns about PE seem misplaced…
    • But it doesn’t seem to matter!
  • The industry must be much more pro-active and creative in its response to these challenges.

Josh Lerner

Rock Center for Entrepreneurship

Harvard Business School

Boston, MA 02163 USA