Privateequity Updated 2012 Final

PRIVAte EQUItY DeMYStIFIeD: 2012 UpDAte
John Gilligan and Mike Wright FINANCINg CHANge INItIAtIVe
buSineSS with confidence
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Financing Change
An initiative from the ICAEW Corporate Finance Faculty
This report is part of the Private Equity Demystied series published under Financing Change, the thought leadership programme of the ICAEW Corporate Finance Faculty. The faculty is the worlds largest network of professionals involved in corporate nance and counts accountants, lawyers, bankers, other practitioners and people in business among its members. Financing Change aims to advance the economic and social contribution of corporate nance activity by promoting better understanding and practice. First published in 2008, Private Equity Demystied An Explanatory Guide appeared at a time when the private equity sector faced considerable public and political scrutiny. Its aim was to enable a better informed debate. As the major economies moved from growth to recession and the global banking community experienced unprecedented turmoil and distress, the private equity industry saw investee companies striving to cope with economic uncertainty and faced an environment where availability of debt was severely restricted. Private Equity Demystied An Explanatory Guide, 2nd edition was published in 2010 and examined the way in which the banking market had changed its approach to private equity investments and the dynamics of the restructuring industry. It also included discussion of regulatory proposals such as the European Commissions Alternative Investment Fund Managers Directive and industry efforts to become more transparent to wider stakeholders. This report, the 2012 Update, is an update of developments in the private equity sector including market trends, regulation and academic research. Private Equity Demystied An Explanatory Guide, 2nd edition should be referred to for: the analysis of private equity fund structures; the explanation of risks and rewards of banks and other participants in private equity transactions; and the detail behind evaluating, structuring and restructuring a private equity investment. Both reports are available to download from icaew.com/nancingchange and hard copies may be obtained by emailing nancingchange@icaew.com. As with previous reports in this series, the 2012 Update provides an objective explanation of private equity. Its value will be measured in better-informed debate, in private equitys effective engagement with wider stakeholders and in well thought out public policies. We welcome views and other comments on this work and related themes. For further information on the Financing Change programme please email nancingchange@icaew.com or telephone +44 (0)20 7920 8685. For information on the ICAEWs work in funding academic research please contact Gillian Knight, Research Manager on +44 (0)20 7920 8478.
Copyright John Gilligan and Mike Wright 2012 All rights reserved. If you want to reproduce or redistribute any of the material in this publication, you should first get the authors and ICAEWs permission in writing. The views expressed in this publication are those of the contributors. ICAEW does not necessarily share their views. ICAEW will not be liable for any reliance you place on information in this publication. You should seek independent advice. ISBN 978-0-85760-301-2
PRIVAte EQUItY DeMYStIFIeD: 2012 UpDAte

John Gilligan and Mike Wright
CONTENTS
List of gures and tables Acknowledgements About the authors Preface 1. OBJEcTIVE of THE 2012 UpDaTE 2. KEY coNcEpTS aND DEfINITIoNS 2.1 What is private equity? What is not private equity? 2.2 Who are the parties involved in private equity? 2.3 What do private equity fund managers do? 2.4 How are private equity fund managers rewarded? 2.5 How is a buy-out completed? 2.6 What is leverage and how is it used? Amplication 2.7 What are the risks of leverage to investors and other stakeholders? 2.8 Borrowings in a fund and shareholder/investor liquidity 2.9 Information, management inuence and ability to sell an investment 2.10 Alignment: economic theory, corporate governance and the principal-agent problem, equity not bonuses 2.11 Taxation in the UK 2.12 3As: amplication, alignment and attention to detail
Page 03 04 05 06 07 08 08 08 09 09 10 11 11 12 12 13 13 14 15 15 15 17 17 20 30 37
3. WHaT Do THE cRITIcS of pRIVaTE EQuITY SaY? 3.1 The general criticisms 3.2 Did private equity create or disseminate risk in the banking crisis?
4. WHaT aRE THE RolES of pRIVaTE EQuITY MaNaGERS? 4.1 Fund raising 4.2 Sourcing and making new investments 4.3 Active management of investments to improve performance 4.4 Exits
Private Equity Demystied: 2012 Update
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5. REGulaTIoN aND TRaNSpaRENcY 5.1 What are the Walker Guidelines? 5.2 What is the Alternative Investment Fund Managers (AIFM) Directive and what are its implications for private equity? 5.3 What are Transfer of Undertakings, Protection of Employment (TUPE) regulations and when are they applied? 6. REcENT DEVElopMENTS IN acaDEMIc RESEaRcH 6.1 Does corporate governance in public to private deals differ from other listed corporations before buy-out? 6.2 What is the investment performance of funds? 6.3 What is the impact of private equity on employees? 6.4 How does taxation impact on private equity-backed companies? 6.5 Do private equity deals involve the short-term ipping of assets? 6.6 What is the extent of asset sales? 6.7 Do the effects of private equity continue after exit? 6.8 What do secured creditors recover in failure? 6.9 Does higher leverage lead to increased likelihood of failure? 6.10 Where do buy-outs get the cash to pay down the debt? 6.11 To what extent do private equity deals involve strategies to grow the business? on investment and R&D? 6.13 To what extent is replacement of management important? 6.14 To what extent are managerial equity, leverage and private equity board involvement responsible for performance changes? 6.15 How are portfolio company management incentivised and rewarded?
43 43 44 45 47 47 47 48 49 50 50 50 50 51 51 52 52 52 52 53 54 54 54 54 57 58 77
6.12 Do private equity deals and buy-outs have adverse effects
7. WHaT aRE THE pRoSpEcTS foR THE pRIVaTE EQuITY INDuSTRY? 7.1 Where will future deals come from? 7.2 Where will private equity deals be exited? 7.3 How will value be generated in future?
8. SoME aREaS foR fuRTHER RESEaRcH AppENDIX: SuMMaRIES of STuDIES of BuY-ouTS aND pRIVaTE EQuITY REfERENcES
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LIST OF FIGURES AND TABLES
2. KEY coNcEpTS aND DEfINITIoNS Figure 2.1: Typical participants in a leveraged buy-out Figure 2.2: Relationship between debt and returns Figure 2.3: Debt and the risk of losing equity 4. WHaT aRE THE RolES of pRIVaTE EQuITY MaNaGERS? Figure 4.1: Sources of new investment 20082010 Figure 4.2: Funds raised by source 20082010 Figure 4.3: Dry powder by vintage 20082010 Figure 4.4: UK buy-out market by value Figure 4.5: UK buy-out market by number of transactions Figure 4.6: UK buy-out market by number of transactions: % MBO versus % MBI/IBO Figure 4.7: UK buy-out market by number of transactions: MBO versus MBI/IBO Figure 4.8: UK buy-out market by value: MBO versus MBI Figure 4.9: UK buy-out market by value: % MBO versus % MBI/IBO Figure 4.10: UK private equity-backed deals market: new deals versus secondary buy-outs by value Figure 4.11: UK market: secondary buy-outs as a percentage of total private equity-backed deals Figure 4.12: Buy-outs from insolvency as a percentage of all UK buy-outs Figure 4.13: UK buy-out market: number of transactions by size band Figure 4.14: UK buy-out market: % of transactions backed by private equity by value bands Figure 4.15: Debt lent to UK buy-outs Figure 4.16: Percentage of equity and debt in UK buy-outs Figure 4.17: Buy and build acquisitions by buy-outs Figure 4.18: Buy and build acquisitions as a % of total new investment Figure 4.19: Realised versus unrealised value by vintage of the fund 2010 Figure 4.20: Enterprise value, equity value and asset value Figure 4.21: Value per 1 invested in UK private equity rms distributed and undistributed value Figure 4.22: Total return per 1 invested by vintage of fund Figure 4.23: Upper, lower quartile and median returns Figure 4.24: Range of returns distribution per 1 invested by vintage year since inception to December 2010 Figure 4.25: Inter-quartile range by vintage to December 2010 Figure 4.26: UK exits by number Figure 4.27: Exits of buy-outs over 10m by year of investment Figure 4.28: Average time to exit for private equity-backed buy-outs by year of exit Figure 4.29: Exits by value Figure 4.30: UK private equity-backed buy-out/buy-in receivership/administration exits (%) by vintage year Figure 4.31: UK buy-out receiverships/administrations as a percentage of all UK company administrations 5. REGulaTIoN aND TRaNSpaRENcY Table 5.1: Private equity rms and portfolio company compliance with the Walker Guidelines 7. WHaT aRE THE pRoSpEcTS foR THE pRIVaTE EQuITY INDuSTRY? Figure 7.1: Building the future for private equity
10 11 12 17 18 19 20 21 21 22 22 23 24 25 26 27 27 28 29 31 31 32 33 35 35 36 36 37 38 38 39 39 41 41 43 56
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ACKNOWLEDGEMENTS
This report has beneted immeasurably from the support and positive criticism of a number of people, including anonymous reviewers and colleagues within both PKF and The Centre for Management Buy-out Research at Imperial College Business School. Our eternal thanks go to Katerina Joannou at ICAEW for her encouragement and forbearance. All errors and omissions are entirely our own responsibility. Giles Derry, Dunedin; Mark Hammond, Caird Capital; Jim Keeling, Corbett Keeling and Jon Moulton, Better Capital gave of their valuable time. Thanks also to Robert Hodgkinson and Debbie Homersham, ICAEW and Nick Toyas, NT&A.
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ABOUT THE AUTHORS
John Gilligan is a Corporate Finance Partner in PKF (UK) LLP. He has worked in the private equity and venture capital industry for over 20 years. He started his career in 1988 at 3i Group plc as a nancial analyst. He joined what is now Deloitte in 1993 and was a partner from 1998 to 2003. He is a Special Lecturer at Nottingham University Business School and has also taught at Craneld University Business School. He has a degree in economics from Southampton University and an MBA in nancial studies from Nottingham University. Professor Mike Wright is Professor of Entrepreneurship at Imperial College Business School and has been Director of The Centre for Management Buy-out Research since 1986. He has written over 25 books and more than 300 papers in academic and professional journals on management buy-outs, venture capital, habitual entrepreneurs, corporate governance and related topics. He served as an editor of Entrepreneurship Theory and Practice (199499) Journal of Management Studies (20032009) and Journal of Technology Transfer (2008-2011). He is currently an editor of the Strategic Entrepreneurship Journal. He holds a BA (CNAA), MA (Durham), PhD (Nottingham) and honorary doctorates from the Universities of Ghent and Derby. He is the winner of the Academy of Management Entrepreneurship Division Mentor Award 2009 and Chair of that Division in 20112012. He is a member of the British Private Equity and Venture Capital Association Research & Advisory Board. Contact details John Gilligan Partner PKF (UK) LLP Farringdon Place 20 Farringdon Road London EC1M 3AP, UK T: +44 (0)20 7065 0241 E: John.Gilligan@uk.pkf.com Mike Wright Centre for Management Buy-out Research Imperial College Business School Exhibition Road London SW7 2AZ, UK T: +44 (0)207589 5111 E: mike.wright@imperial.ac.uk and Department of Management, Innovation and Entrepreneurship University of Ghent Tweekerkenstraat 2 9000 Ghent, Belgium
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PREFACE
When we sat down to write the rst edition of Private Equity Demystied the world was a somewhat different place. In the UK the Treasury Select Committee was investigating private equity to establish whether or not companies were over borrowing. It was completely routine for journalists to interchange the phrases private equity and hedge fund, without any apparent appreciation of the differences between them, and very few people had any understanding of the fragile interconnectedness at the heart of the banking system. The concerns at that time were what would happen to private equity if the long run of economic stability and favourable lending came to an end? Could the growing private equity industry sustain a downturn, and if so, how would the investee companies and the wider group of employees and trading partners fare? No one anticipated the severity of the test that was to come, but a shock certainly happened. The credit crunch followed by a near global recession of unprecedented length started almost as soon as we put our pens down and went to press. From a purely research, rather than a human perspective, this is a very silvery cloud; it gives us the opportunity to see what happens after a huge discontinuity in the economic environment. It is against this background that, ve years after we originally started, we revisit the subject for the third time to see what, if anything, has changed and what has been learned. Perhaps the biggest surprise is how little of what we originally wrote needed revision.
John Gilligan Mike Wright April 2012
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1. OBJECTIVE OF THE 2012 UPDATE
Private Equity Demystied: 2012 Update addresses the key changes in the buy-out sector since Private Equity Demystied 2nd edition was published in 2010. The update is a survey of developments in the private equity sector, in academic research and European regulation and forms a stand-alone summary of the earlier, more comprehensive, work. Since 2010, the private equity and buy-out sector has continued to adapt to the postboom climate yet, despite changes, much of what was written in the second edition remains valid. The 2012 Update reects that fact and should therefore be read in conjunction with the second edition where more detailed analysis is required regarding: private equity fund structures; the differences between private equity and hedge funds; the mid-market and large buy-out market; evaluating and structuring a private equity investment; and the dynamics of a leveraged buy-out and a restructuring. Both publications may be downloaded from icaew.com/nancingchange.
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2. KEY CONCEPTS AND DEFINITIONS
2.1 What is private equity? What is not private equity? Private equity is risk capital (equity) provided outside the public markets (hence private, as opposed to public). Private equity is about buying stakes in businesses, transforming businesses and then realising the value created by selling or oating the business. These businesses range from early stage ventures, usually termed venture capital investments, through businesses requiring growth capital to the purchase of an established business in a management buy-out or buy-in. Although all these cases involve private equity, the term now generally refers to the buy-outs and buy-ins of established businesses and these are the focus of this study. Private equity investments are illiquid and traded only on acquisition or exit (although this is changing). Generally, but not always, private equity managers have very good information prior to making their investment through their due diligence processes and during any investment through contractual rights and close involvement with the investee company. Private equity is not about trading on public markets, or trading in currencies, bonds or any other publicly quoted security or derivative. These are the realm of other fund managers including hedge funds. Investors in public markets buy liquid assets (shares, bonds and options) and generally use a trading strategy to try and make exceptional returns. Insider dealing laws are designed to prevent anybody from making exceptional returns from private information not available to other participants in the public markets. These types of investors sell out of companies when they think that they are no longer likely to generate good returns. In summary, they have high liquidity and trade frequently on the basis of publicly available information. Although private equity funds have traditionally been seen to lie at the opposite end of the spectrum from hedge funds, there is some blurring of the distinction as some hedge funds have become involved in active management of investee companies and the acquisition of unquoted shares. 2.2 Who are the parties involved in private equity? The parties to a private equity transaction are: the private equity fund manager (who generally manages pooled money in the private equity fund on behalf of the investors in the fund, although there has been recent growth in managed accounts and direct investing); the private equity fund a pooled investment fund invested in by the investors in the fund, including the senior members of the private equity fund managers; the company, including both its shareholders and its management; and in the case of a leveraged buy-out, the bank proposing to lend money. Each of these parties has their own perceptions of risk and expectations of reward and will negotiate with the others.
08 Private Equity Demystied: 2012 Update
2.3 What do private equity fund managers do? Private equity fund managers have four principal roles: 1. Raise funds from investors. These funds are used to make investments, principally in businesses which are, or will become, private companies. 2. Source investment opportunities and make investments. 3. Actively manage investments. 4. Realising returns primarily through capital gains by selling or oating those investments, but also from income and dividend recapitalisations. Fund raising: funds are raised from investors internationally, such as pension funds, banks, insurance companies as well as high net worth individuals. These investors will generally invest via a limited partnership, as will the private equity fund managers themselves. The largest investors in private equity are pension funds. Sourcing investments: a private equity fund must source and complete successful transactions to generate prot and support the raising of further funds. A signicant amount of effort and resource is invested in prospecting for transactions and relationship management with individuals who may give access to deals. These include investment bankers, accountants and other advisers and senior gures in industry. Increasingly, investment teams are focusing on particular sectors of the economy. This contrasts with early buy-out experience where investors were usually nancial experts rather than sector specialists. Active management of investments: private equity fund managers have become hands-on managers of their investments. While they do not generally exercise day-to-day control, they are actively involved in setting and monitoring the implementation of strategy. This is the basis of the argument that private equity has become an alternative model of corporate governance. Realising capital gains: the industry generally now talks of a four to six-year exit horizon, meaning that the investment will be made with the explicit assumption that it will be sold or oated within that timeframe. This exit horizon is the source of the criticism that private equity is a short-term investment strategy. 2.4 How are private equity fund managers rewarded? Private equity fund managers are generally rewarded with an income and a share of other income and capital gains known as carried interest: Fee income: fund managers receive management fees that are expressed as a percentage of the funds raised. The larger the fund, the greater the fee income, although the percentage generally declines from around an occasional 3% in a few smaller funds to 11.5% in larger funds. This fee income pays for the operating costs of the fund managers business and any excess belongs to the partners of the fund management company. Therefore, there is an incentive to maximise the fund size (consistent with the investment opportunities for the fund) in order to increase the management fee income. Critics have argued that as fund size has grown, the funds costs have grown less rapidly and therefore the prot from fee income has become material. It is argued that this income, which is effectively guaranteed, has created a misalignment between the partners in private equity funds and their investors. In essence, a new principal-agent problem is said to have been created by the high levels of guaranteed income from fees. Private equity funds may also receive deal fees for various services that they provide to the portfolio company. These include transaction fees paid by the portfolio company for costs incurred by the private equity rm in making the investment and monitoring fees which portfolio companies pay to their private equity investors each year for advisory services.
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At the time of writing, there is debate about what is happening to fees. Some survey evidence suggests that fund management fees are being squeezed while transaction and monitoring fees have been rising. Anecdotally, other evidence indicates that limited partners (LPs) are requiring transaction and monitoring fees to be reduced or attributable to the fund rather than the management company. The pressures may differ according to market segment; in the mid-market, LPs may be more comfortable with management fees being maintained at current levels while management fees are under greater pressure with larger funds. Carried interest: the second source of reward for private equity fund managers is a share in the prots of the fund; this is generally known as carried interest. Once the investors have achieved a certain pre-agreed rate of return (called the hurdle rate), usually the fund managers will share 20% of any excess. The hurdle rate (historically around 8% per annum) is calculated on the amounts actually invested. As the market has matured there has been a constant renement of industry practice to attempt to ensure that the carried interest calculation tightly aligns the interests of investors and fund managers. However, in a long-term, illiquid investment business with low levels of transparency to new entrants, this process of realigning interests may take longer than in other industries. Management fees can be structured as an advance of carried interest. 2.5 How is a buy-out completed? A new company (Newco) is typically formed to make the acquisition of the company that is the subject of the buy-out. Funds are invested in Newco by the private equity fund, the management team and the bank. Newco then makes an offer to acquire the company that is the subject of the buy-out. If the offer is accepted by the shareholders of the buy-out company, after the transaction completes the target company becomes a wholly owned subsidiary of Newco and is therefore owned by Newco. Newco is in turn owned by the private equity fund and management (and any other shareholders of Newco).
Figure 2.1: Typical participants in a leveraged buy-out
Private equity fund

Ne got iati
Negotiation
Shareholders Pension fund trustees
Neg otiat ion
on
Management
Newco
Target company
Banks
Customers Suppliers
Employees
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2.6 What is leverage and how is it used? Amplication Private equity rms use both the money that they manage to invest in equity and also raise further funds from banks to top up the price that they pay for any business. The use of bank debt is termed leverage (or gearing) because it amplies the returns on the equity invested, much as a lever (or a gear) amplies the effect of a physical force. Figure 2.2 shows that as the amount of equity decreases (and the debt correspondingly increases) the returns on equity are amplied. This happens because debt has a limit to its return (its interest rate) whereas equity owns the amount that is left over after everyone else has been paid. If you increase the amount that has a xed return, you amplify the returns on the balancing equity. Figure 2.2 also illustrates the amplication of gearing in an investment that doubles in value. When funded by 50% equity: 50% debt, returns increase from 200% to 300%. Increasing leverage further shows that as the equity percentage falls to 10%, the returns rise to 1100%. So, not only does leverage amplify returns on equity, it increases the amplication the greater the borrowings.
Figure 2.2: Relationship between debt and returns
1200 1100%
1000 % return on equity invested
800 600% 433% 400 350% 300% 267%
600
243%
225%
200
211%
200%
0 10 20 30 40 50 60 70 80 90 100 % of price funded by equity invested
2.7 What are the risks of leverage to investors and other stakeholders? It is a general rule of economics that where there are higher returns there are higher risks. The same rules naturally apply to private equity as any other investment type. In general terms the less equity invested in any given acquisition, and correspondingly the higher the amount of debt, the greater the risk of losing the equity. Furthermore, the less equity that a company has, the smaller the cushion against banking problems and insolvency or failure. Therefore, high leverage increases both the risk of losing the equity invested and increases the risk that a company becomes unable to repay its bank and therefore becomes insolvent. The increased risks of high leverage are borne by both the investors and any other stakeholders in the business. Conversely, any business that is under-leveraged will generate lower than market returns for its investors and provide lower than market risk to its wider stakeholders.
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Private equity therefore uses leverage to consciously increase risk in the anticipation of making exceptional prot. In the example below we plot the amount by which the value of the company must fall to wipe out the equity value against the gearing or leverage. Again, the leverage amplies the risks including that of losing the equity and amplies them more at higher levels of borrowing.
Figure 2.3: Debt and the risk of losing equity
Higher risk Probability of losing equity invested Lower risk 10 20 30 40 50 60 70 80 90 100
% of equity invested
2.8 Borrowings in a fund and shareholder/investor liquidity With a few exceptions, private equity puts all the gearing in each individual Newco investment, tailored to that investments characteristics. Hedge funds and many other quoted investment fund managers mostly put the gearing in the fund itself and hold a diversied portfolio of investments that may, or may not, be individually geared. We believe that this distinction is important in understanding the market risks created by hedge funds and private equity funds and for informing regulatory responses to the systemic failures seen in the past few years. In particular we have argued that the level of leverage needs to be understood by reference to the entire investment chain. We argue that the traditional private equity fund structure has operated to limit systemic risk by offering long-term, illiquid, unleveraged investment assets to investors with large diversied portfolios. We noted in the second edition the appearance of pressure to increase leverage within funds and to provide liquidity to investors. We argued that if the pressure led to geared private equity funds it would lead to increased systemic risk. We noted that the debt-free structure of a private equity fund was, in most European jurisdictions, a market-driven norm, not a regulatory requirement. The contribution, if any, of the private equity industry to the market failures seen in 2007/2008 arose through failures in the associated acquisition nance banking market, not within the private equity fund structures. On this analysis the private equity industry was a (wholly willing) victim of a failure of the banking system, not a cause of the failure. 2.9 Information, management inuence and ability to sell an investment Risk can be mitigated and managed by buying assets that are easy to sell and by having as much information as possible before and during an investment. If you can have both liquidity and good, timely information, you can achieve consistently superior returns
with lower risks than other market participants. That is one major reason why insider dealing in quoted shares is illegal. In reality you usually have to trade liquidity for information rights. Similarly, you can adopt either an active investment stance and seek to inuence the management of the company, or a passive one and simply sell out if you perceive management to be weak or taking the business in the wrong direction. If you have decided to trade liquidity for information you lose the option to trade out of investments that are not going in the direction you hoped. Private equity funds are illiquid and therefore are generally active investors. 2.10 Alignment: economic theory, corporate governance, the principal-agent problem, equity not bonuses Economic theory suggests that in a perfect market, risk and reward are always matched so that you cannot make exceptional returns without creating equal and opposite exceptional losses. So how do private equity rms justify their increase in risk taking? Economic theory also argues that there is a principal-agent problem in many companies whereby managers (who act as agents of shareholders) are not incentivised to maximise the value to the shareholders of a corporation (who are the absent principals who own the company). It is argued that this lack of accountability of senior managers has allowed them to pursue projects that are either excessively risky or, conversely, excessively conservative. This is one of the central problems facing what is known as corporate governance: how do shareholders make managers accountable for their decisions? Private equity seeks to capitalise on the market failure caused by this principal-agent problem. It does this by changing incentives to tightly align the economic interests of managers and shareholders to achieve efciencies. Furthermore, the alignment is structured in such a way that unless the efciencies increase the value in cash to all shareholders, no value accrues to the managers. Generally, therefore, private equitybacked companies do not pay material cash bonuses to senior managers. They are expected to get their returns if, and only if, the business is sold or oated. The return therefore comes as a capital gain not in a higher income. This idea of alignment is central to all the economic structures observed in the private equity market. Some argue that private equity is an alternative long-term form of corporate governance to traditional public companies. Others see private equity as a type of transitional shock therapy for under-performing companies. 2.11 Taxation in the UK There have been a number of misconceptions about the taxation of private equity. The rst thing to say is that all the participants are treated exactly the same as anyone else in their position; there are no special loop holes for private equity of any kind whatsoever. However, it is true that the industry legitimately seeks to minimise its tax liabilities (as does every industry). The critics point to: deductibility of interest on loans which reduces corporation tax in a company; capital gains which are currently taxed at a preferential rate to income; private equity limited partnerships which are not taxed (the partners themselves are); and private equity rms which are often structured with offshore structures.
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Some of these criticisms may have been true in the past but take no account of the changes in legislation since they were rst made. Interest deductibility, for example, has changed very materially over the past 20 years with the explicit objective of preventing the deduction of interest on loans not on commercial terms. Similarly, the capital gains tax regime has changed many times over the past two decades as policy has sought to incentivise investment and entrepreneurship without creating distortions in the overall tax system. The criticisms that limited partnerships are not taxed are based upon a simple misconception. Partnerships are intended to be invisible to the tax man. The central idea is that the partners pay the tax, not the partnership. A fuller explanation is in Private Equity Demystied 2nd edition.1 2.12 3As: amplication, alignment and attention to detail In summary, the key concepts behind private equity are amplication of returns by using debt and incentivising capital growth by encouraging alignment and attention to detail. These are coupled with a focus on the detailed structures put in place while an extensive use of professional advisers ensures that every level of a buy-out organisations legal structure and its investments are made in a tax efcient manner.
It was argued by one of the high-profile private equity investors, David Rubenstein of Carlyle Group, that the attack on private equity tax strategies by its critics was misjudged and misdirected. He argued that private equity investors were not cheating the revenue authorities; they were simply applying attention to the details of their tax affairs in a lawful and legitimate way. He went on to argue that if society wanted private equity to pay more tax, the rules should be changed to achieve that.
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3. WHAT DO THE CRITICS OF PRIVATE EQUITY SAY?
3.1 The general criticisms Any industry has its critics. Critics of course can be mistaken or ill-informed as well as being correct. Our objective in writing this series of publications has been to eliminate the criticisms that were based on errors and to attempt to summarise the academic evidence on the genuine areas of debate. Private equity has been criticised both for the way in which it nances and operates individual investments and operates its own business. At the level of the individual investment, the criticisms include: using excessive levels of debt to acquire corporations; using complex structures to reduce or eliminate tax; aggressively managing businesses to reap short-term prot at the expense of long-term performance; under-investment in new products and process; lack of consultation with workers prior to and after an acquisition. At the level of the fund, the criticisms include: a lack of public information on the funds and their investors; criticisms of the compensation of partners and staff of the funds; concerns on the minimum regulatory capital requirement of fund structures; and reiteration of concerns regarding the use of tax havens. Further concerns have been raised that are relevant to private equity transactions but are symptomatic of wider issues. For example, developments in the banking market materially changed the incentives and alignment of the parties concerned resulting in the banking market failures seen in the credit crunch. As the body of work in these areas has expanded rapidly in recent years, we are able to start drawing conclusions about most of these criticisms. We return to these below and in the Appendix tables. It is little compensation, but the nancial crisis created an almost perfect storm to test the private equity business model. 3.2 Did private equity create or disseminate risk in the banking crisis? As we have described and extensively illustrated, private equity relies on banking for funding to enable transactions to be completed and to amplify the returns of those transactions. Clearly, since 2008, there has been an unprecedented disturbance in the global banking market. We looked at the role of private equity in the banking crisis in the second edition where we argued that while private equity was a voracious consumer of cheap debt, the industry itself did not create or disseminate risk in the nancial markets.
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On the contrary, the structure of most private equity funds and their ring-fenced investments actively restricted the spread of risk from excessive borrowing by any of their individual investee companies. We concluded that contrary to pre-credit crunch speculation about the risks created by private equity, the investigation was probably looking in the wrong place. Individual companies may have borrowed too much but the banking markets were the predominant source of systemic risk, not the borrowers, including the private equity industry. It has been argued that the rewards of private equity were so high that this helped to fuel a bonus culture across the nancial industry that was a major contributory factor in the failure of the banking market. This argument could be understood in at least three different ways. Firstly, it could simply be arguing that mimicry, or a perceived need to retain key staff who could leave to go to private equity funds, caused the widespread misalignment of interests between people who worked in nancial services and the wider public. Secondly, it could be an economic argument suggesting that due to some unspecied market failure, private equity earned economic super-prots. Thirdly, it could be a general statement regarding equity, fairness and income distribution. The rst argument seems to us potentially to have some merit, but to be wholly inappropriately aimed at private equity. As we have described at length that the central ideas of private equity are alignment and amplication. Private equity has a great deal to teach others about how to align the incentives of senior people in organisations. We therefore consider this to be valid, but ill-judged when directed at private equity. The second argument may have greater merit when applied to private equity. It is of course the case that some of the losses of banks were matched by the prots of borrowers and other counter-parties. Private equity is not the only industry that is predicated on large levels of borrowing; so too is the property investment industry. The private equity industry probably was a beneciary of cheap debt due to market failure in the banking market, and continues to benet from low interest rates for those deals currently able to borrow. However, the converse may also be true; the tightening of credit has, as we will show, adversely affected those who borrowed the most and borrowed most aggressively. The third argument is a judgement about which we leave the reader to form their own opinion. In summary therefore, we reject the hypothesis put forward that private equity as an industry was a material contributor to the causes of nancial crisis, but are not able to reject the argument that the industry may have made exceptional prots during the boom that might otherwise not have been earned. This is of course what happens more often when you amplify returns by using debt.
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4. WHAT ARE THE ROLES OF PRIVATE EQUITY MANAGERS?
Private equity fund managers have four principal roles: 1. Raise funds from investors. These funds are used to make investments, principally in businesses which are, or will become, private companies. 2. Source investment opportunities and make investments. 3. Actively manage investments to improve performance. 4. Realise capital gains by selling or oating those investments. In this section we look at each of these activities separately to try and paint a picture of where we were, how we got there and of recent developments. 4.1 Fund raising 4.1.1 How much money is in the private equity market? Around 75% of all private equity is invested through closed-end funds managed by independent fund managers. In the long run, without new funds to invest, there will be no private equity industry. In the wake of the crash new commitments to private equity funds (and many other investment classes) fell sharply.
Figure 4.1: Sources of new investment 20082010
30,000 UK Overseas 25,000
20,000
15,000
10,000
5,000
0 2005 2006 2007 Year

Source: BVCA/PwC.
2008
2009
2010
17
Historically, the overwhelming majority of investment into funds managed by members of the British Private Equity and Venture Capital Association (BVCA) came from outside the UK. After the banking crisis this investment fell by over 95% and despite a recovery in 2010, was still 80% below its peak in 2007. 4.1.2 Who is investing in private equity? Substantially the largest investors in private equity in the UK have been pension funds which have accounted for around 35% of all monies invested in private equity funds. The majority of these commitments came to UK-based managers from overseas. These commitments fell by similar percentages as overall investment levels.
Figure 4.2: Funds raised by source 20082010
9,000 2010 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 2009 2008
ns
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Source: BVCA/PwC.
The picture post-crisis was one of signicant reductions in cash availability across the industry. Of course this analysis necessarily over-emphasises the large buy-out market, where fund sizes are substantially larger. According to the BVCA data, no large buy-out funds were raised in 2010. 4.1.3 Dry powder: what is left to invest from before the boom? In other data published by the BVCA we can obtain an estimate of the amount of dry powder that might be awaiting investment. The data show that the pre-2004 funds were substantially invested at the end of 2010.
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Ac
In
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Figure 4.3: Dry powder by vintage 20082010

25,000 2010 2009 2008
20,000
15,000 m 10,000 5,000 0
Source: BVCA/PwC.
At the end of 2010 there was some 3bn of vintage 2005 funds uninvested. Even allowing for some follow-on investments in existing portfolio companies, it seems highly likely that commitments were cancelled, undrawn. Unless investment volumes recover soon the magnitude of this excess capital commitment will increase. 4.1.4 What do the changes in volumes and maturities mean? For investors in private equity funds fees are generally charged based on committed capital during the investment phase (typically 46 years). If the capital is never invested, there is clearly a conversation to be had about the fees paid to the fund managers. Anecdotally, there have been signicant and concerted efforts by investors to reduce the level of fees and to avoid this type of misalignment persisting or arising in future. This has seen both pressure on fee levels and greater scrutiny of what is actually paid and when. For the fund managers there is extreme pressure to invest the capital, if it is possible to do so. Returning commitments materially undrawn is not the route to growing a fund management business. This appetite for risk comes at a time when banks are in a period of extraordinary risk aversion. Therefore, we expect to see more equity in deals with lower initial projected equity returns. To attempt to recover some of the value lost due to lower amplication of the winners, we expect to see continued aggressive negotiation during any sale or purchase process, especially during and immediately post-due diligence. Furthermore, the organisation structures needed to invest and manage the largest funds is predicated on utilising the commitments and raising further funds with fee levels to service the enlarged overheads. If new funds are not being raised, fee income will fall. This can only result in either lower xed rewards to staff working for private equity funds, or fewer people in the industry. Given the deal volumes discussed below, we expect both to be seen.
19 80 19 84 85 19 89 90 9 4 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10
Year
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Due to the long-term nature of the funds, if a fund manager has longevity, and therefore multiple funds of differing maturities generating fee income, they are less exposed than newer managers with one, or few, funds under management. The economics therefore make the managers with the most funds, the least likely to be distressed. However, private equity has been a highly personal business with a few so-called star investors being key to attracting investment. Inevitably the older the fund, the more likely it is that there is, or has been, a succession issue at the top. For vendors of businesses thinking of selling to private equity, knowing whose funds are at what maturity might be considered a reasonable question to ask any advisers appointed. 4.2 Sourcing and making new investments At the heart of the industry is new investment. 4.2.1 What has happened to new investment volumes? Data for the whole private equity market in 2011 are not available as we write. The buyout data set for 2011 is however.
Figure 4.4: UK buy-out market by value
60,000 Total value
50,000
40,000 m
30,000
20,000
10,000
Source: CMBOR/Ernst & Young/Equistone Partners Europe.
Figure 4.4 shows both the bubble leading up to the nancial crisis and the subsequent collapse in the overall volume of buy-outs in the UK. From a peak in the year to Q1 2008 of 50bn, the market contracted to a trough in Q3 2009 below 6bn; a fall of nearly 90%. By number, the collapse is equally clear, with volumes falling by around 45% from the peak (Figure 4.5).
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20 02 20 I 02 II 20 I 03 20 I 03 I 20 II 04 20 I 04 III 20 05 20 I 05 II 20 I 06 20 I 06 III 20 07 20 I 07 II 20 I 08 20 I 08 II 20 I 09 20 I 09 II 20 I 10 20 I 10 II 20 I 11 20 I 11 III

Year
Figure 4.5: UK buy-out market by number of transactions

800 Total number 700 600 Number of transactions 500 400 300 200 100 0
Year
While the value of transactions has started to increase the volumes remain at the depressed levels of 2009/2010. 4.2.2 Auctions and the decline of the MBO Breaking the data down by buy-out (MBO) versus buy-in (MBI/IBO) reveals two underlying trends. Firstly, there is a long-term trend against management buy-outs led by incumbent management teams (Figure 4.6). This trend is even clearer when a longer data run is analysed. Figure 4.7 shows that the once dominant MBO has been in relative decline over the entire history of the UK private equity industry.
Figure 4.6: UK buy-out market by number of transactions: % MBO versus % MBI/IBO
100 90 80 70 60 % 50 40 30 20 10 0
81 83 85 95 01 03 79 05 87 99 07 89 91 93 19 19 19 19 97 20 20 09 20 19 20 19 19 19 19 19 19 20 20 11
Buy-in %
MBO %
Year
21
The trend away from MBOs accelerated in the wake of the crisis and has shown no signs of recovering. Secondly, there has been a recovery in the volume of investor led buy-ins since the lows of 2009. We examine the reasons behind this further below.
Figure 4.7: UK buy-out market by number of transactions: MBO versus MBI/IBO
800 700 600 Number of transactions 500 400 300 200 100 0
MBO number Buy-in number Total number
Year
Figure 4.8 separates out the more traditional MBO market, where managers lead a deal, from the buy-in market, where institutions are the leaders of the transaction, in terms of deal values.
Figure 4.8: UK buy-out market by value: MBO versus MBI
60,000 MBO value Buy-in value Total value
50,000
40,000
30,000
20,000
10,000
22
04 I 04 III 20 05 20 I 05 II 20 I 06 20 I 06 III 20 07 20 I 07 II 20 I 08 20 I 08 II 20 I 09 20 I 09 II 20 I 10 20 I 10 II 20 I 11 20 I 11 III 20

Year
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03
02
20
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While the long-run trend in the value of the MBO market is not as clear as it is in the volume data, there is evidence of a cyclical pattern. The MBO market never ew as high as the MBI market, but has nevertheless fallen by 8085% and has yet to recover in value terms (Figure 4.8). The 11bn Alliance Boots acquisition by KKR contributed about 25% of the peak of the buy-in market and therefore exaggerates the bubble. However, there was a collapse in investment in 2009. In contrast to the MBO market there is clear evidence that after the collapse, a recovery in new investments began in early 2010.
Figure 4.9: UK buy-out market by value: % MBO versus % MBI/IBO
100 90 80 70 60 % 50 40 30 20 10 0
81 83 85 95 01 03 79 05 87 99 07 89 91 93 19 19 19 19 97 20 20 09 20 19 20 19 19 19 19 19 19 20 20 11
MBO % Buy-in %
Year
The data analysing the relative importance of MBOs and MBI/IBOs by value above again shows the sustained emergence of the institutional purchaser of businesses (Figure 4.9). The reasons for this relate to the emergence of the practice of vendors auctioning companies. In the early days of the buy-out industry, management often expected to lead a transaction. They would appoint advisers who would raise funds to acquire a business from the vendors. In this process vendors had to attempt to manage a process that could lead to a trade sale or a management buy-out. The potential trade purchasers were understandably concerned about the impact on the business if the management team were the losing under-bidders. Similarly, the vendors had to manage the potential conicts of interest with their own management teams who were both running the business and trying to buy it. The solution was the creation of the auction process by corporate nanciers. In an auction a sales document is prepared and circulated to potential interested parties including both private equity and trade buyers. The level playing eld should eliminate conicts for management and capture more of the value for the vendor. It also encourages private equity houses to team up with external managers in an attempt to gain a sector advantage, giving a boost to the MBI/IBO numbers at the expense of the MBO numbers. This trend is virtually ubiquitous both in larger transactions and in disposals by private equity rms (secondary buy-outs). It largely explains why 90% by value of private equity lead deals are now MBI/IBOs rather than MBOs.
Private Equity Demystied: 2012 Update 23
If auctions generally increase the price paid for buy-outs by acquirers, there is a transfer of value from the purchasers to vendors. If prices are not higher as a result of the process, there is a leakage of value due to transaction costs. Other things being equal we would expect either of these to reduce returns when compared to past performance. In addition to paying an increased price, there is a further downside as purchasers, with poorer access to management in any auction process, take on more risk as they lose access to managements inside view. This again might be expected to reduce returns in private equity overall. This problem may be exacerbated in the case of inexperienced investors lacking the expertise to undertake adequate due diligence. If the pure MBO has declined, what are the sources of new investment opportunities? 4.2.3 New investments and secondary buy-outs In earlier editions we looked at the sources of buy-outs and analysed the relative importance of private and public companies versus, say, subsidiaries of larger organisations. In this section we focus on the recycling of transactions within the private equity industry via so-called secondary buy-outs. A secondary buy-out is a transaction where one private equity fund acquires a business owned by another. It contrasts with a primary transaction when a private equity fund acquires a business from anybody other than a private equity fund (a private company, a public to private, or a division of a company). The data show that while the dislocation of the banking crisis caused the overall market value to fall dramatically, secondary buy-outs had been increasing as a proportion of the market and account for an increased proportion of transactions in 2011 (Figure 4.10).
Figure 4.10: UK private equity-backed deals market: new deals versus secondary buy-outs by value
35,000 New deals 30,000 Secondary buy-outs
25,000
20,000 m 15,000 10,000 5,000
0 2002 2003 2004 2005 2006 Year

2007
2008
2009
2010
2011
The pattern of primary versus secondary investments is very similar, by value, with secondary transactions accounting for a signicant proportion of transactions. Despite a fall off in the dislocation that followed the banking crisis, we nd that the numbers of secondary deals have been rising and at the time of writing some 2530% of all buy-outs are now transactions between private equity houses (Figure 4.11).
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Figure 4.11: UK market: secondary buy-outs as a percentage of total private equitybacked deals
50 45 40 35 % of total 30 25 20 15 10 5 0 2002 2003 2004 2005 2006 Year
Value % Number %
2007
2008
2009
2010
2011
There is debate about whether or not the private equity model is a form of shock therapy for underperforming companies, or a long-term corporate governance structure that may or may not generate superior outcomes. If it is shock therapy, it has traditionally been seen as working only once. If it is an enduring system of governance there are gains to be made from secondary buy-outs. Yet the emergence of secondary buy-outs also introduces the possibility for shock therapy every few years that reinforces the private equity model and offers the opportunity for sustained gains. Secondary buy-outs raise signicant questions for investors in private equity. Firstly, it is possible that an investor with a portfolio of investments in various funds may be advancing cash to the acquiring fund to purchase a company within the portfolio of another of the investors funds. The investor may view themselves as funding the purchase of business that they already part own, and paying both transaction fees and carried interest for the privilege. Estimates suggest that total transaction costs to underlying investors are about 10% of their investment. The counter argument is that any publicly-owned asset also has owners and the largest investors in private equity are also investors in other public assets. Only private companies could be guaranteed to be outside the investment portfolio of any individual investor. There is of course no guarantee that investors in a given fund do not acquire public companies that a particular investor owns via another fund. The probability of the issue arising is determined by each investors asset allocation. The more that is allocated to a portfolio of private equity funds operating in a similar area of the market, the more likely it is to occur. In the nal analysis investors are backing fund managers who they believe can achieve higher returns due to their skill and connections and should accordingly give them the freedom to pursue the opportunities that they see as attractive. There are a number of under-researched questions that arise from this potential conict; how commonly does the situation actually arise? What is the signicance of transaction costs in value distribution? What is the performance of secondary versus primary transactions in the long run? Is there a cohort of private equity funds that are disproportionately active in primary transactions, and if so do they have better or worse returns? Conversely, are there funds that are disproportionately invested in secondary deals and how do they fare?
These are important partially or wholly unanswered research questions that address the central question regarding the sustainability of performance with a private equity system of corporate governance. 4.2.4 Buy-outs from insolvency As we described in the second edition of Private Equity Demystied, the origin of buy-outs lies in the Companies Act 1981 which changed UK law in a way that enabled companies to be acquired using borrowed funds. The idea at that time was to facilitate the rescue of companies and divisions of companies that had either failed or were failing and could be rescued. The industry has obviously moved a long way in 30 years, but nevertheless we might expect that some of the excesses of the pre-crisis banks and the subsequent recession might throw up opportunities to invest to rescue viable businesses. The evidence is clear that, in general, private equity is not usually a signicant buyer of companies that are in insolvency as primary buy-outs, although as this report goes to press there have been notable examples in the rst quarter of 2012. This might reect the fact that transactions happen without a formal insolvency occurring, or that portfolio companies acquire insolvent companies. With less than 10% of gross investment in these types of transaction in a typical year, they are exceptional transactions, not the norm (Figure 4.12).
Figure 4.12: Buy-outs from insolvency as a percentage of all UK buy-outs
25 Number % Value %
20
% of all UK buy-outs
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10
0 2002 2003 2004 2005 2006 Year

2007
2008
2009
2010
2011
4.2.5 Private equity and smaller transactions: developments in the UK In November 2009 The Provision of Growth Capital to Smaller and Medium Sized Enterprise widely known as the Rowlands Report, was published in the UK. It examined how private equity addressed the needs of smaller companies that might grow more rapidly if they received equity investment. The report is extensive and covers the issues more fully than we could or would wish to. It highlights a number of reasons why there may be a funding gap that is not addressed by private equity. The analysis splits the issues into demand side (company) and supply side (investor) factors. Distilling a comprehensive work to some simple statements, the issues include; xed transaction costs making returns lower than in larger deals; a lack of information to potential investors increasing perceived risk and therefore required return and; a lack of information to companies leading to a propensity to fail to be investment ready or to shy away from pursuing growth in order to maintain control. The establishment of the Business Growth Fund was designed to ll the growth capital gap.
We do not intend to rehearse the arguments of the Rowlands Report, but it is interesting to note that the number of smaller buy-outs has been in long-term decline over the whole of the past decade. Although Figure 4.13 relates to the UK, a similar trend is evident elsewhere. It is one of the striking features of this analysis that the credit crunch accelerates a pre-existing decline. An examination of the data set without any knowledge of the background, would probably conclude that whatever started the decline happened in the period around 20022003.
Figure 4.13: UK buy-out market: number of transactions by size band
600 Under 10m 10m100m Over 100m
500
400 Number
300
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100
0 2002 2003 2004 2005 2006 Year

2007
2008
2009
2010
2011
The proportion of transactions involving private equity has uctuated at between 20 30% of the smaller buy-out market (Figure 4.14). This of course may reect the fact that smaller transactions do not require external equity, or it may be that institutions are also being driven out of the small buy-out market for all the reasons identied by Rowland.
Figure 4.14: UK buy-out market: % of transactions backed by private equity by value bands
100 90 80 70 % of transactions 60 50 40 30 20 10 0 2002 2003 2004 2005 2006 Year
Under 10m 10m100m Over 100m
2007
2008
2009
2010
2011
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4.2.6 Transaction structures and the fall in amplication The single biggest factor impacting the private equity industry has been the reduction in the availability of debt to fund transactions.
Figure 4.15: Debt lent to UK buy-outs
20,000 18,000 16,000 14,000 12,000 m 10,000 8,000 6,000 4,000 2,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year
If one graph tells the story of the new investment market, it is Figure 4.15. It clearly illustrates the precipitate decline in lending to new transactions in the UK. It also alludes to the second nancial hangover facing the private equity industry as discussed below. 4.2.7 Debt maturity: another lump in the snake During the boom, debt was raised both in higher volumes than previously experienced and on terms that were less onerous than in previous years. We discussed cov-lite loans and payment in kind (PIK) loans in earlier editions: these are loans that weaken the ability of banks to foreclose and reduce the on-going cash requirements of the loan respectively. They effectively defer both the transfer of power to the banks in a distressed situation and simultaneously defer the ultimate cash repayment of the loan. These loans were typically 710 year loans made between 20052008 and were assumed to be renanced by sale of the business or by re-borrowing from banks monies that had previously been repaid. There is therefore a very large renancing requirement working its way through the system. With banks seeking to increase capital ratios and reduce risk it is likely that this lump in the snake will not be renanceable on the basis of the original investment assumptions. The possible outcomes include: Insolvency: this is unlikely if the underlying business is viable. Extend (and pretend?): it is of course entirely possible to renegotiate the terms of any debt package, indeed the assumption of many structures put in place was that this would happen during the life of the investment. Cynics have characterised this as extending the term of the loans and pretending that it has solved the problem. The truth of course varies depending on the prospects of the underlying business. As we explained in detail in the earlier editions of this work, excluding grants, there are only four sources of cash in a business: prots;
increased capital efciency; reduced taxation; or an external borrower of investor. Only if the underlying cash generation can service the funding structure will a restructuring work. The dynamics of a restructuring is discussed at length in the second edition. Transfer of ownership from the private equity house to the lending banks: This has occurred in a number of cases. It raises questions about the long-term suitability of banks as owners of trading businesses. At best it would appear to be a stop-gap solution. Banks trading out of loan positions by selling to investors prepared to hold this risky debt: The purchasers of this debt include specialist funds, including funds established by traditional private equity investors for the purpose. Furthermore, a few private equity funds have gained agreement to buy back debt in the companies in which they are invested. Effectively, this action de-risks the equity investment by buying the debt that was threatening to cause a default. Unless the terms of this debt change in the course of the transaction there is no change in the underlying liabilities of the company, and therefore no change in the risks for the company. This can be supercially addressed by injecting equity into the company to buy back its own debt at a discount to its face value. The value of this depends on the relative cost of the equity and the debt bought back. 4.2.8 Has the market responded to lower debt availability? With lower debt availability and limited life funds pressing to be invested, investors have increased the proportion of equity in new investments.
Figure 4.16: Percentage of equity and debt in UK buy-outs
80 70 60 50 40 30 20 10 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year
Equity Debt Other
The increased proportion of equity and reduced proportion of debt will reduce the amplication of returns in the future and therefore reduce the returns to the funds (Figure 4.16). There are essentially three ways to maintain returns with reduced debt and therefore reduced amplication at the purchase date.
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First and most certain to improve returns, is to pay less for each investment. However, with the private equity industry funded and resourced for a boom that has ended, competition for any deal is intense and it is difcult to see why a general improvement in pricing would emerge in that competitive environment. Second is to enhance the value of each investment to a greater extent. This means private equity rms being actively involved in greater efforts to assist portfolio companies. Third is to re-engineer the investments to increase debt and therefore amplify returns post-acquisition, if the banking market returns. However, given the rate of recovery of banks balance sheets this may be outside the timeframe of most investments. We therefore expect to see absolute returns diminish over the coming years. It is less clear whether the variance of returns will decline. This is important to both investors and private equity managers; in future a higher proportion of the return to any investment will probably come from operational improvements in the business and less from nancial engineering. 4.3 Active management of investments to improve performance The third role of a private equity investor is that of active ownership, what we characterise as attention to detail. In what is essentially an empirical update there is only a limited amount of hard data that can cast any light on the day-to-day activities of private equity fund managers. Since the rst edition of Private Equity Demystied in 2008, there has been an explosion in the number of books, studies and research groups looking at private equity. The evidence of the papers and case studies produced by these generally qualitative academic studies shows that private equity rms are very hands-on owners. They create active boards involving high levels of interaction with executives. On average, in contrast to some quoted companies, the boards of private equity-backed companies lead strategy through intense engagement with top management. The close involvement draws on previous experience and any industry specialisation of private equity rms. In some cases the behaviours are in many ways comparable to the way that the methodological consultancies behave towards clients. The private equity rms have evolved processes and procedures post-investment to attempt to ensure that the maximum value is extracted from the business. It is increasingly common to see one hundred day plans agreed pre-completion to formalise the detailed actions that are to be taken after the deal completes. Leaving aside potential manipulation of nancial reporting between deal entry and exit, the evidence available from academia generally supports the view that these active engagements do create increased protability. 4.3.1 Platform investments and buy and build strategies The data collated by The Centre for Management Buy-out Research (CMBOR) under the supervision of one of us is the longest and most complete data set on buy-outs in the world. As the industry has developed that data set has been expanded and modied to allow light to be shed on the various emerging issues. A data series that has been built over the last few years looks at an area that has to date escaped most attention: buy-outs as platform investments to follow a buy and build strategy. Buy and build is nothing new; many large corporations grew by acquisition. What is relatively new, however, is the emergence of private equity groups which specialise in acquisitive growth by actively consolidating narrow sectors of the economy. These rms are marketing their skill as acquirers as well as their skill as stock/management team pickers.
Figure 4.17: Buy and build acquisitions by buy-outs

180 160 140 120 Number 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year
Acquisition number
The number of bolt on acquisitions to existing buy-out investments remained remarkably robust when compared to the precipitate drop in new buy-outs completed (Figure 4.17). This continued support for existing investments has resulted in some 30% of all businesses acquired using private equity being acquired by existing portfolio companies (Figure 4.18). Generally, these are materially smaller than the platform investment, with only around 510% of gross investment going to fund these acquisitions. This new data set points to the importance of private equity as an agent to structurally change industries; this volume of acquisitive activity represents a signicant proportion of all mergers and acquistions activity in the UK.
Figure 4.18: Buy and build acquisitions as a % of total new investment
45 40 35 30 25 % 20 15 10 5 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year
Percentage by number Percentage by value
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4.3.2 Portfolio performance We have discussed the so-called J curve effect at length in the past; the idea that the cash ows of an investor are necessarily cash out followed by realising prots some time later. Failures also tend to occur before successes; the idea is captured by the colloquial phrase lemons ripen faster than plums. These two factors make assessing recent investment performance problematic. In the long run only the cash invested and the cash returned to investors matters, but private equity is a long-term investment horizon and at any date before a fund is nally fully distributed the total return to an investor consists of cash received plus the value investments in the portfolio (plus or minus any future new investment returns yet to be made) ie: Total investment return = Realised value + Unrealised value While the timing of receipts will materially affect the actual rate of return on the investment, as a good rst proxy the value per 1 invested provides a good pointer towards investment performance. The BVCA has responded to the demands for more openness by publishing (with PwC) data on portfolio performance since 2007 which includes both rates of return and value per 1 invested data. This work provides an excellent lens through which to examine both the characteristics of the investment class and the most recent performance data. When we look at the relative proportions of value realised and still invested it is abundantly clear that in aggregate the vast majority of the value of investments made since 2005 is, at the date of the last analysis (end 2010), unrealised (Figure 4.19).
Figure 4.19: Realised versus unrealised value by vintage of the fund 2010
100 90 80 70 % of total value 60 50 40 30 20 10 0 Realised value (cash) Unrealised value
19 8
Source: BVCA/PwC 2010.
Given the preponderance of investment in the last decade, it is true to say that the jury is still out on whether or not returns have been maintained as the industry grew.
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019 84 85 19 89 90 -9 4 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10
Year fund was raised
The total return to the aggregate sample across the three years analysed gives some indication of the way the last three years have impacted portfolios. In summary, portfolio value per 1 is higher in 2010 than in either of the previous two years for which we have data in all vintages. The industry sample was showing aggregate losses/breakeven for the funds raised in 20062009 but each of these vintages (which are of course still investing) are now showing improved, positive returns, albeit so far well below the long-run results of earlier vintages. 4.3.3 A brief digression on valuation As competition for new funds has grown, so has the importance of valuations and we briey summarise the differences between equity value and enterprise value (Figure 4.20). For a detailed description please see the second edition. When talking about structuring any transaction it is of utmost importance to understand what is meant by the terms price and value. There are two widely used, but different, measures of the value of a business: Equity value or market capitalisation is the value of 100% of the shares of the business. It measures the equity value after all other claims on the business, including debt, have been deducted. P/E ratios (price earnings ratios) measure the ratio of equity value: posttax prots (note that as published, most P/E ratios are based on prot before tax less notional tax at the mainstream corporation tax rate, not the companys actual tax rate, if it is different). Enterprise value is the debt-free/cash-free value of the operating business. Enterprise value is measured by reference to prot before interest and tax (EBIT) or prot before interest tax, depreciation and amortisation (EBITDA) and reects the value of the business regardless of how it is nanced. Accounting value is the net book value of the assets and liabilities of the business. These are generally stated at the lower of cost or net resale value. If a company is acquired for more than its net asset value, the excess is the accounting goodwill paid.
Figure 4.20: Enterprise value, equity value and asset value
Equity value
Goodwill
Enterprise value
Value of outstanding debt
Net book value of assets
The importance of valuations has increased for the industry as competition for new funds has grown. There is an incentive to inate reported valuations in order to attract investors in new funds and there has been research and debate about whether this occurs and how to increase transparency and consistency between managers and investors to avoid it happening.
The International Private Equity and Venture Capital Board (IPEV) issued a set of international valuation guidelines in 2005 in an attempt to address the problems of inconsistent valuation methodology. These are periodically updated, the last occasion being in 2009. These rules suggest that there are ve main valuation methods (plus a sixth, that we call other). These are: cost of last investment; multiples; generally EBIT or EBITDA; net assets; discounted cash ows of the underlying business; discounted cash ows of the investment; and other industry valuation benchmarks. Typically, investments are initially valued at cost and then move to a different valuation method as the investment matures. If the business is protable (by which we mean it has at the date of the latest accounts, a positive EBITDA) it may be valued using a multiple. Conversely asset rich investments eg, real estate, may be valued on a net assets basis. Irrespective of the method adopted, the change in investment value in the early years after making an investment often reects a change in method, not a change in the real underlying economics of the investment case. If a portfolio was all valued at cost in the rst year of investment and then on EBITDA multiples, the change in portfolio value would be: (Change in EBITDA multiple x change in EBITDA) + (Investments previously valued at cost now valued using EBITDA) (Cost of investments no longer valued at cost) In practice, changes in valuation method post-buy-out may lead to apparent changes in value even without changes in multiples or prots. This is an area where care is needed in researching rm level returns. Generally studies have compared exit receipts to pre-exit valuations and found that the exits are generally at higher values than the pre-exit valuations. From this it is concluded that valuations are conservative. In fact this shows that valuations are conservative immediately prior to exit, it has less to say on the question that exercises limited partners (LPs): are interim valuations currently inated to attract investment in new funds? 4.3.4 Latest valuation and performance data As most funds are 10 year funds, any fund raised prior to around 2004/2005 will now have stopped investing in new companies, although it might be making follow-on investments in existing portfolio companies. If we compare the valuation per 1 invested in each of the three surveys conducted by the BVCA, we obtain an indication of the rate at which distributions and valuations have moved over the period 20082010. It should be noted that this is work that is evolving and the samples, while materially the same, are not identical. The data suggests that for BVCA members who took part in the survey there were limited distributions over the period and the valuations of unrealised investments improved (Figures 4.21 and 4.22). This is perhaps not surprising given that the period covered began in 2008 in the aftermath of the liquidity crisis.
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Figure 4.21: Value per 1 invested in UK private equity rms distributed and undistributed value
250 2009 Distributed 2009 Undistributed 200 Value per 1 invested 2008 Distributed 2008 Undistributed 2010 Distributed 2010 Undistributed
150
100
50
Source: BVCA/PwC 2010/2009/2008.
Figure 4.22: Total return per 1 invested by vintage of fund

250 2010 2009 2008
200 Value per 1 invested
150
100
50
19
19
85
19
80
19
19
90
19
Year
Source: BVCA/PwC 2010/2009/2008.
The distribution of returns around the mean and the performance relative to other investments is of primary importance to any potential investor. Funds often refer to being in the upper quartile of investment returns, yet by denition not all funds can be in this category (Figure 4.23).
02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10
95
96
00
97
98
-8
-8
-9
19
19
20
99
20
20
01
19 80 19 84 85 19 89 90 -9 4 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10
Year 0
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Figure 4.23: Upper, lower quartile and median returns

350 25th Median 75th
300
Value per 1 invested
250 200 150
100 50
Source: BVCA/PwC.
The data indicate generally falling absolute returns. This could reect falling absolute performance or conservative valuations in unrealised investments in the later vintages. The data only show funds raised prior to 2006 and therefore should only include funds that are substantially invested. An analysis of the committed but uninvested funds, so-called dry powder, by vintage, shows that only 2005 and 2006 in this period have substantial uninvested commitments. This analysis shows the outstanding undrawn commitments at the end of 2010. As we discuss below, some investors have sought to reduce their commitments to funds that have not performed as anticipated. When pure cash distributions are analysed, the data shows that the later funds on average have made zero distributions, and the inter-quartile range, a measure of the dispersion of the returns around the average is small; in essence the jury is still very much out (Figures 4.24 and 4.25).
Figure 4.24: Range of returns distribution per 1 invested by vintage year since inception to December 2010
300 25th Median 75th
250 Distribution per 1 invested
200
150
100
19 8
Source BVCA/PwC.
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0 19 84 85 8 9 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06
Year
19 80 19 84 85 8 9 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06
Vintage of funds 50 0
Figure 4.25: Inter-quartile range by vintage to December 2010

250 Inter quartile range: distributed Inter quartile range: total return 200
Range per 1
150
100
50
Source: Authors analysis of BVCA/PwC.
We have presented above a re-analysis of the BVCA/PWC data covering three year-ends from 20082010. We have illustrated that returns are slow to be nalised and that the trends are difcult to unpick due to the uncertainty surrounding the valuation of unrealised investments. The long-term trend to the end of 2010 was for falling absolute returns but with signicant variations around the median. The problem for investors in new funds is that the long-term nature of the commitment makes it very difcult to objectively discern which managers have an enduring track record. The data are simply too thin. 4.4 Exits 4.4.1 A brief digression on the short-term/long-term debate Realising investment value is the ultimate goal of any investment. In private equity this is in sharper relief than in many other asset classes because the investment is generally realised in a single transaction. This distinction sometimes gets lost in the discussions about short-termism and long-term investment. All investors in equities seek to buy and sell periodically. Portfolio managers of quoted stocks and derivatives are often marketing their superior ability to pick winners and to trade in a wide variety of publicly quoted stocks and shares to potential investors. Private equity managers are not marketing any trading ability; they market stock picking and active management skills. It turns out from the academic research in this area that while private equity-backed companies are sold more frequently than companies that are quoted, the term that the private equity investors hold their investment is generally longer than the comparable term of investment managers holding shares in quoted companies. This is the essence of the short-term/long-term debate; critics concentrate on the frequency of change of control, while advocates compare and contrast the term of the investment and the long-term nature of carried interest as a reward. In a sense both critics and advocates are right, but the real question is not how long or short a hold period is. The real economic question is how efciently the people and assets of the business are deployed.
19 80 19 84 85 8 9 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06
Year
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Figure 4.26: UK exits by number

180 160 140 120 Number 100 80 60 40 20 0 Creditor exit Flotation Secondary buy-out Trade sale
As the industry has grown, the number of exits has increased (Figure 4.26). Including all buy-outs, the data suggest that 50% of transactions are exited within 1011 years. As discussed above, the smaller buy-outs are not generally private equity-backed, therefore the more relevant data is deals with a value over 10m, where the comparable statistic is that 50% of transactions are exited in around ve to six years (Figure 4.27). What we might call the half-life of a private equity investment.
Figure 4.27: Exits of buy-outs over 10m by year of investment
100 90 80 70 % exited/not exited 60 50 40 30 20 10 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Vintage year of investment
Figure 4.28 shows the long-term trend in average hold period has been increasing consistently.
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19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11
Calendar year
Exited over 10m No exit over 10m
Figure 4.28: Average time to exit for private equity-backed buy-outs by year of exit
90 80 70 60 Months 50 40 30 20 10 0
The value of exits has also fallen sharply since the peak of the boom years, with some recovery in 2010 (Figure 4.29).
Figure 4.29: Exits by value
16,000 14,000 12,000 10,000 Value 000 8,000 6,000 4,000 2,000 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Calendar year
4.4.2 What is the secondary market? In the rst two editions of Private Equity Demystied we noted the emerging market in secondary investments. By this we do not mean the buying of one investment by another private equity fund in a secondary buy-out, as discussed above. Rather, we are referring to the purchase of whole portfolios from a private equity fund manager.
19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11
Exit year
Flotation Secondary buy-out Trade sale
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This can happen in a number of different scenarios. Originally when captive private equity funds spun out of their parents (see Private Equity Demystied 2nd edition for a detailed discussion) there was the question of who would own the existing investments made by the team that were leaving. On the one hand they made the investments and managed them day-to-day, on the other they were owned by the parent company. To buy the fund would require a fund that was several orders of magnitude bigger than the fund needed to set up a new-business-only fund. To ll this gap a few secondary funds were created specically to acquire orphaned private equity portfolios.2 As private equity funds become distressed and it becomes apparent that there will be no follow-on fund, the ultimate investors may be able to invoke clauses in the investment agreement to terminate the management contract. Effectively they give notice to end the contract and seek a new manager to manage the investments made. This can be achieved by transferring the contract to another manager, or alternatively simply selling the underlying assets as a portfolio and winding-down private equity business. In the post-boom fall out, the secondary market was widely predicted to grow. Although it has taken some time to emerge, this is now happening as banks sell off portfolios for regulatory reasons and to deleverage. 4.4.3 Funds of funds We illustrated earlier (Figure 4.2) that funds of funds have been one of the larger investors in private equity funds. These investment vehicles are feeder funds that give access to large private equity funds by aggregating smaller investors and also allow investors to hold a more diversied group of private equity funds than they could have held as a primary investor. They may also have some preferential rights due to the longstanding relationships with certain funds that a new direct investor could not access. As volumes of new deals have fallen and the overhang of committed but undrawn capital has stopped new funds being raised, funds of funds have been consolidating and withering away. This seems to be a natural process in the maturing of the market. 4.4.4 What is the failure rate in private equity investments? Critics of private equity argued that the high leverage typically associated with these deals would lead to short-term performance horizons, reductions in employment and increased insolvency risk particularly in an economic downturn. Defenders of private equity counter that favourable credit conditions, notably low interest rates, were a major driver of the amount of leverage in private equity deals and that, in the early stages of the buy-out, optimal leverage may be high. A focus by private equity rms on investing in stable sectors with strong cash ow may mean that portfolio companies are better placed to withstand economic downturns. Close monitoring and timely intervention by private equity investors to deal with problems may also mean that the performance of portfolio companies is maintained. Failure can mean company failure ie, receivership and liquidation, or investment failure, where the value of the investment is nil but the company continues to exist. There is no aggregate industry data on the number of failed investments. We are therefore only able to present comprehensive data on receiverships/administration. There was an increase in failures in the recession that followed the 2007 boom but the number of buy-outs entering insolvency peaked in the rst quarter of 2009 at a level below expectations and continued to decline through 2010. It also appears that deals done in the periods of greater activity or boom years have a higher failure rate (Figure 4.30).
Perhaps the best known of these early funds was Coller Capital.
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Figure 4.30: UK private equity-backed buy-out/buy-in receivership/administration exits (%) by vintage year*
25
20
% of number
15
10
0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Year of investment/vintage
*Year 2011 figures are for first nine months only. Source: CMBOR/Ernst & Young/Equistone Partners Europe.
Importantly, the number of private equity-backed buy-outs entering the formal insolvency process rose less than those of non-private equity-backed rms (Figure 4.31). A key issue is whether buy-outs are more or less likely to fail than enterprises that have not gone through a buy-out. Academic evidence from the population of rms in the UK found that private equity-backed deals completed post-2003 through to the end of 2010 were not signicantly more likely to fail than other rms.
Figure 4.31: UK buy-out receiverships/administrations as a percentage of all UK company administrations
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
06 98 01 02 08 09 07 03 99 00 04 95 96 97 05 10 20 20 19 20 20 20 19 20 20 19 19 19 20 20 20 20 20 11 *
%
All buy-outs as % of UK administrations Private equity-backed buy-outs as % of all UK administrations

*Year 2011 figures are for first nine months only. Source: CMBOR/Ernst & Young/Equistone Partners Europe.
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Formal insolvency was avoided in many cases, especially among larger deals, where private equity buy-outs breached their debt covenants or were unable to service their debt commitments. Low interest rates have helped private equity buy-outs in servicing their debt servicing commitments. Timely restructuring through debt for equity swaps with banks and equity cures, enabled these enterprises to continue, if the underlying trading business was sound. As the crisis deepened, lenders increasingly began to work constructively with private equity rms and buy-out clients to address the causes of covenant breaches in ways that preserved value. Lenders have become more responsive to proactive approaches from private equity rms with potential solutions to distress problems. While a debtequity swap helps avoid the formal bankruptcy process, it can have a negative impact on growth strategies and future development. As banks may be ill-equipped to provide added strategic value, private equity rms with a track record of deal doing and retaining a board seat can adopt a positive proactive approach to working with the banks, so that over time the business can recover value.
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5. REGULATION AND TRANSPARENCY
Throughout the years that we have been writing about the industry we have consistently been motivated by a desire to lift the perceived veil on the private equity industrys motivations, objectives and processes. The industry itself has responded to the pressures to be more open voluntarily. Regulators have introduced new laws designed to ensure that funds are marketed and regulated appropriately. Much of this new regulatory environment is as yet unnished and we therefore offer a commentary only on two key initiatives: in the UK, the Walker Guidelines on transparency and disclosure and, at European level, the Alternative Investment Fund Managers (AIFM) Directive. 5.1 What are the Walker Guidelines? The Walker Guidelines were published in 2007, following a request of the BVCA, with the intention to bring greater transparency to the private equity industrys largest investments and investors. The guidelines are a voluntary code of practice. The industrys implementation of the guidelines is monitored by the Guidelines Monitoring Group consisting of a chairman, two independent representatives from industry and/or the trade unions and two representatives from the private equity industry. From end 2010, adjustments to the criteria were introduced so that they apply to portfolio investee companies with an enterprise value of 350m at acquisition (previously 500m) or 210m in the case of companies that were quoted prior to acquisition (previously 300m), have 50% or more of their business in the UK are covered by the guidelines and employ over 1,000 people in the UK. Any private equity rm that has invested in a business covered by the guidelines is then required to make disclosures about itself. This represents a relatively small proportion, by number, of the total population of companies that have been invested in by the private equity industry but account for a signicant proportion of the total amount invested by private equity rms (Table 5.1).
Table 5.1: Private equity rms and portfolio company compliance with the Walker Guidelines
2008 Portfolio companies required to conform Portfolio companies voluntarily conforming Total number of portfolio companies covered by the code Total number of private equity rms covered by the code
Source: Guidelines Monitoring Group.
2009 45 15 60 34
2010 43 12 55 35
2011 78 9 87 43
27 27 54 32
Excluding pure venture capital rms, we estimate that around 2025% of private equity rms active in the UK are required to be in compliance with the Walker Guidelines. The guidelines broadly require that companies provide the same kind of information to the public that would be provided if the companies were publicly traded.
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The guidelines reect the argument that current communication practices have generally been seen to be satisfactory by both limited partners and general partners. The new element has been the requirement to communicate more broadly with any and all interested parties. The information required is included in an annual review published on the private equity funds website. It is not required to (and generally does not) contain accounting or investment performance data. It seeks to identify who the individuals are within the private equity fund and what investments they hold. Limited information on intended investment duration and limited partner type (but not identity) is also given. Case studies are suggested as a means to illustrate their activities. Further data provision to the BVCA for its annual report also requires high-level nancial data including the amount of capital raised, number and value of investments made and fees paid to advisers. Data that analyses the source of investment performance in exited investments is also sought to enable the annual review to be completed. The third report of the Guidelines Monitoring Group published in 2010 noted that there was a higher standard of compliance than in previous years and that reporting was in line with, and in some cases better than, FTSE350 companies. The Guidelines Monitoring Group issued a guide providing practical assistance to companies to help improve levels of transparency and disclosure, and which included examples of portfolio company reporting reviewed by the Group over the last two years. 5.2 What is the Alternative Investment Fund Managers (AIFM) Directive and what are its implications for private equity? The AIFM Directive was passed by the European Parliament in November 2010. The directive does not come into force until 2013. It will be implemented by means of a series of European regulations, as well as transposition into national law, and there may be changes during this process. The directive applies to alternative investment fund managers (AIFM) who are based in the EU, market funds or invest in the EU. The directive applies to private equity fund managers except where the total funds under management fall below a threshold of = C500m (without leverage) or = C100m (with leverage). In practice this is most private equity funds. Funds falling under the directive are restricted as to whom they may market their funds. The intention is to protect unsophisticated investors from complex and risky funds. The UK resisted the imposition of trans-EU regulation and the marketing aspects of the directive are now being phased in over 10 years. Initial proposals designed to stop asset stripping would have prevented leveraged buyouts where the loan was secured on the assets of the target company. Essentially this would have taken us back to where we were prior to the Companies Act 1981. The measures would effectively have removed the business model used in leveraged buyouts. The measures included in the directive have been signicantly diluted from these original proposals. The directive contains provisions to limit the levels of leverage that can be used by AIFM within funds. Leverage at the portfolio or holding company level used by private equity rms is not included in the denition of leverage used throughout the directive. As private equity transactions leverage deals at the portfolio company level, this leverage is generally secured on the assets of that company and does not carry a systemic risk. There are requirements for AIFM to have minimum capital related to the size of the underlying funds. Some consider that these requirements are misguided where the funds are inherently illiquid, as in most private equity funds.
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The directive requires AIFM to introduce a remuneration policy consistent with, and which promotes, sound and effective risk management. An alternative investment fund manager must prepare an annual report for each EU alternative investment fund (AIF) it manages or non-EU AIF it markets in the EU. The report must be provided to the relevant EU competent authorities, as well as to investors on request. An alternative investment fund manager must notify its voting rights to its relevant regulator when it acquires voting rights of 10/20/30/50/75% of a non-listed company. When an alternative investment fund manager acquires voting rights of greater than 50% in a non-listed company, additional disclosures must be made to its regulator, the company and its shareholders. The private equity rm needs to disclose to regulators the chain of decision making regarding the voting rights of investors in the company; and practices to be put in place to communicate to employees. In changes to the original draft, there is no longer a need to disclose detailed information on the private equity rms strategic plans for the company. Companies with less than 250 employees are excluded from these disclosure requirements. AIFM are required to maintain an external depositary to safeguard the assets of the fund. Private equity received a specic derogation providing that national regulators may authorise non-investment bank entities to act as the depositary for private equity and venture capital funds, thus reecting the circumstances of the industry. Overall the directive represents a signicant increase in regulatory disclosures and regulatory burden, but does not materially impede any private equity fund manager from continuing their business. At the time of writing, the directive has yet to be nalised. 5.3 What are Transfer of Undertakings, Protection of Employment (TUPE) regulations and when are they applied? We include this section because the TUPE regulations continue to be a source of heated and ill-informed debate. TUPE was established in 1981 and revised in 2006 to incorporate the European Union Directive on Acquired Employment Rights. Employees have a legal contractual relationship with the company that employs them. This is embodied in their employment contract and is supplemented by protections guaranteed by employment law. When shares are sold and the ownership of the company transfers to new owners, this has no impact on the contractual relationship between the employee and the company being sold: the legal relationship remains unchanged and is legally identical before and after a sale. If a purchaser subsequently wishes to change any employment conditions they must do so in exactly the same way as if no sale had occurred. If the assets or the business undertaking are sold rather than shares, the employees will have a new contractual relationship with the acquiring company. They will cease to be employed by their former employer and become employees of the company that bought the assets or undertaking. TUPE is designed to protect employees from employers who seek to use the change of legal employer to vary the employment terms or to use the sale to dismiss workers. TUPE gives employees an automatic right to be employed on the same terms by the new employer. These rights include the right to be represented by a trade union where the employees transferred remain distinct from the employees of the acquiring company. This is almost always the case in a private equity transaction because Newco has no business prior to the transaction, and therefore no employees other than those acquired as part of the transaction.
The regulations require that representatives of the affected employees be consulted about the transfer by the employers. They have a right to know: that the transfer is to take place, when and why; the implications for the employees legally, socially and economically; and whether the new employer intends taking any action that will have a legal, social or economic impact on the employees. TUPE also places obligations on the selling employer to inform the acquirer about various employment matters. The regulations apply to all companies and public bodies without exception.
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6. RECENT DEVELOPMENTS IN ACADEMIC RESEARCH
Key ndings from the studies of buy-outs and private equity are summarised below and the studies are listed in the Appendix. Since we rst wrote on this subject, the volume of academic research has grown at an increasingly rapid rate all around the world. This growing body of research has not only sought to look at unanswered questions but also, more recently, retrospectively reappraised some of the earlier academic work. In particular, some of the data sources have come under scrutiny. It has been argued that the conclusions of some of the widely cited empirical studies on performance have been undermined by possible data biases. In particular, data provided to researchers by the private equity industry and commercial databases have been argued to show the industry in a more favourable light by omitting the worst performers or being incomplete. This point needs to be appreciated to understand the context within which some early empirical studies should be viewed. Overall the eld of study has continued to grow as the industry has opened up. This is to be welcomed. 6.1 Does corporate governance in public to private deals differ from other listed corporations before buy-out? The UK Corporate Governance Code recommends that the roles of CEO and chairman should be held separately and that to avoid concentration of power in one or two individuals, there should be a powerful presence of non-executive directors. Studies have shown that before they go private, public to private companies (P2Ps) tend to separate the functions of CEO and chair of the board less often than those rms remaining public, though this is to some extent a size effect. However, they do not have fewer non-executive directors (Appendix Table 1). Companies going private have a higher concentration of shares in fewer hands, including management, than rms remaining public. UK P2Ps have higher duality of CEO and board chair than traditional acquisitions of corporations. P2Ps have lower valuations than traditional acquisitions of listed corporations by other corporations and it has been suggested that outside bidders may have been deterred from bidding because of the potential difculties involved in dealing with signicant board ownership. However, Australian P2P evidence indicates that insider ownership is not signicantly higher in P2Ps than for traditional acquisitions of listed corporations. 6.2 What is the investment performance of funds? Private equity funds provide extensive information to their investors but up to now they have provided very little information to external parties which has made it difcult to assess the performance of funds independently. The available data are contradictory (Appendix Table 2). Evidence sponsored by the private equity industry trade associations indicates that private equity funds out-perform alternative forms of investment such as quoted shares, although the variation between the top performing funds and the others is very wide. Academic evidence attempts to adjust for risk and fees, as well as whether investments are realised or not. US evidence shows leveraged buy-out (LBO) fund returns (gross of fees) exceed those of the S&P 500 but that net of fees they are slightly less than the S&P 500. After correcting for sample bias and overstated accounting values
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for non-exited investments, separate evidence shows that average fund performance changes from slight over performance to under performance of 3% pa with respect to S&P 500. There is also quite strong evidence that some buy-out fund managers generate more from fees than from carried interest. Buy-out fund managers earn lower revenue per managed dollar than managers of venture capital funds. The timing of fund raising seems to be important: private equity returns on funds appear to be higher for those funds raised in the 1980s than those raised in the 1990s. Funds raised in boom times seem less likely to raise follow-on funds and thus appear to perform less well. These studies also nd that the top performing funds had enduring out-performance. Most recently it has been speculated by the authors of these studies that this long-standing relationship is breaking down and that out-performance in many funds will no longer endure. In particular, recent academic work suggests that, historically, most successful funds have become too large, too fast. There are indications, however, of diseconomies of scale among private equity rm investors as investments held at times of a high number of simultaneous investments underperform substantially, with diseconomies being highest for independent rms, less hierarchical rms, and those with managers of similar professional backgrounds. 6.3 What is the impact of private equity on employees? Employment: Evidence on the effects of buy-outs on employment is mixed (Appendix Table 3 Panel A). Some US studies from the 1980s report small increases in total rm employment following LBOs. Others report that buy-outs do not expand their employment in line with industry averages but that non-production workers experience the largest fall over a three-year period, while production employment was unchanged. Recent US plant level data shows that employment grows more slowly in private equity cases pre-buy-out and declines more rapidly post-buy-out but in the fourth to fth year employment mirrors that in non-buy-out control group rms. Existing buy-out plants create similar amounts of jobs to control group forms while greeneld buy-out plants create more jobs. Early rm-level UK evidence relating to the 1980s suggested that job losses occurred most substantially at the time of the change in ownership and then began to rise. UK evidence from buy-outs completed over the period 19992004 shows that employment growth is 0.51 of a percentage point higher for management buy-outs (MBOs) after the change in ownership and 0.81 of a percentage point lower for management buy-ins (MBIs). Recent more detailed data also indicates that employment in MBOs dips initially after the buy-out but then increases, on average. In contrast, for MBIs and for initial public offerings (IPOs) of listed corporations, the employment level remains below the pre-buy-out level. The majority of both MBOs and MBIs show an increase in employment. Further evidence suggests private equity-backed buy-outs have no signicant impact on employment while traditional acquisitions have negative employment consequences. The impacts of buy-outs on employment growth rates are similar to those for traditional acquisitions. A private equity deal would be unlikely to occur if the pre-buy-out rm was performing optimally because there would be few performance gains to be obtained from restructuring. As on average MBO/MBI plants have lower productivity before the buy-out than their non-buy-out counterparts, it is not surprising that some job losses occur. However, reducing staff at the time of buy-out helps set the rm on a more viable footing, reducing the likelihood that the rm will subsequently fail with even higher likely loss of employment. Where there is little alternative except closure, a private equity deal may have its attractions. Recent new US evidence suggests that private equity accelerates both job destruction and job creation resulting in productivity gains.
Wages: US studies from the 1980s indicate a decline in the relative compensation of non-production workers (Appendix Table 3 Panel B). Evidence from the late 1990s and 2000s in the UK shows that the average growth in wage levels in MBOs and MBIs is marginally lower than in rms which have not undergone a buy-out. Buy-outs have more negative wage effects than traditional acquisitions. MBIs typically are underperforming problem cases prior to the change in ownership that require more restructuring and which generally have a higher failure rate than MBOs. Pre-buy-out remuneration may not have been sustainable if rms had been underperforming. The impact of private equity-backed deals may be different from that of non-private equity-backed deals but preliminary evidence indicates that this difference disappears once the problem that certain types of rm are selected as buy-outs is taken into account. Data are not available concerning whether buy-outs had a higher or lower wages trend than non-buy-outs and hence whether the position is worse, better or the same after buy-out. It is also problematical to integrate the weekly/monthly wage aspects of remuneration and any benets from the introduction of employee share ownership schemes at the point of the buy-out; the latter may substitute for standard wage payments which may not necessarily be the same in non-buy-outs. Thus, these ndings are likely to bias against nding positive wage effects due to buy-outs if they are more likely to use such schemes than non-buy-outs. HR management: Buy-outs in the UK and the Netherlands result, on average, in an improvement in human resource management practices (Appendix Table 3 Panel C). Buy-outs in general result in the adoption of new reward systems and expanded employee involvement but the effects depend on the type of buy-out. Insider buy-outs and growth-oriented buy-outs had more commitment-oriented employment policies. Preliminary evidence also suggests that buy-outs backed by private equity rms report fewer increases in high commitment management practices than those that are not private equity-backed. Employees in UK MBO rms tend to have more discretion over their work practices than comparable workers at non-MBO rms, with skilled employees, in particular, having low levels of supervision at MBO rms. Recent pan-European evidence from managers nds that private equity investment results in negligible changes to union recognition, membership density and attitudes to trade union membership. Managers in rms recognising unions after private equity buy-outs do not report reductions in the terms and conditions subject to joint regulation. Under private equity ownership more rms report the presence of consultative committees; managers regard these as more inuential on their decisions, and indicate increased consultation over rm performance and future plans. Comparing industrial relations changes in different social models in Europe, the recent evidence suggests private equity rms adapt to national systems and traditional national industrial relations differences persist after buy-out. 6.4 How does taxation impact on private equity-backed companies? Using debt rather than equity to fund a business may reduce the corporation tax bill of any company because some interest is deducted from prots before tax is calculated, whereas dividends are not. Since 2005 the rules in the UK (and elsewhere) have been tightened so that if debt is provided by a shareholder on a non-arms-length basis then the interest is not allowed to be deducted against corporation tax. In leveraged buy-outs (LBOs), a great deal of effort is applied to creating a structure that is tax efcient. This is generally the case for almost any company, but comes into sharp relief when a company changes the way that it is funded, as in a buy-out. It has been argued that the returns earned by LBOs can be explained by the effect of interest payments on corporation tax and there is extensive academic research investigating this hypothesis.
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Early studies in the US showed some support for the argument, but since these studies were completed there have been many changes in the taxation of LBOs in many countries, including the UK (Appendix Table 4). The most recent studies around the world have found no evidence to suggest that taxation is an adequate explanation for the performance gains seen in successful buy-outs. 6.5 Do private equity deals involve the short-term ipping of assets? The academic evidence (Appendix Table 5) suggests that there is a wide variation in the length of time any investment is held. There is no evidence that the industry systematically seeks to ip investments in a short time period. Evidence from the 1980s in both the US and UK shows that some buy-outs are exited in a relatively short period of time, while others remain with the buy-out structure for periods in excess of ve years. On average larger deals exit signicantly sooner than small deals. There have been some recent very short periods to exit of private equity deals but this is neither new nor surprising. Some deals fail quickly while others may receive unsolicited bids by trade buyers within a short time after buy-out. Over the past two decades, the average time to exit has been increasing, the most common timing of exit for those deals that have exited since 2000 is in the range of four to ve years. 6.6 What is the extent of asset sales? US evidence from the 1980s suggests that larger buy-outs involving P2Ps engage in substantial divestment of assets (Appendix Table 6) to an extent signicantly greater than for buy-outs of divisions. The extent of asset sales among UK buy-outs completed in the 1980s was much less than in the US. It should be noted that buy-outs divesting assets may also have been making acquisitions. Partial sales made up just over a third of the total value realised in the UK in 2001, but have since become less frequent. 6.7 Do the effects of private equity continue after exit? An important unresolved issue is whether the claimed benets of private equity deals are sustained once the buy-out structure ends (Appendix Table 7). US evidence is that while leverage and management equity fall when buy-outs return to market (reverse buy-outs), they remain high relative to comparable listed corporations that have not undergone a buy-out. Pre-IPO, the accounting performance of buy-outs is signicantly higher than the median for the respective sectors. Following the IPO, accounting and share price performance are above the rms sector and stock market benchmarks for three to ve years, but decline during this period. This change is positively related to changes in insider ownership but not to leverage. Those private equity-backed MBOs in the UK that do IPO tend to do so earlier than their non-private equity-backed counterparts. There is some evidence that they are more underpriced than MBOs without private equity backing, but not that they perform better than their non-private equity-backed counterparts in the long run. Private to public MBOs backed by more active private equity rms in the UK tend to exit earlier and these MBOs performed better than those backed by less active private equity rms. However, as we have noted above, IPOs of private equity-backed buy-outs are now rare. 6.8 What do secured creditors recover in failure? US buy-outs that defaulted on their loans in the 1980s generally had positive operating margins at the time of default and, from pre-buy-out to distress resolution, experienced a marginally positive change in market- or industry-adjusted value (Appendix Table 8). In UK buy-outs that defaulted, secured creditors recovered on average 62% of their investment. In comparison with evidence from a more general population of small rms, MBOs experience fewer going-concern realisations in receivership (30%), make a lower average repayment to secured creditors, and make fewer 100% repayments to these creditors.
These results appear to contrast with expectations that the covenants accompanying high leverage in buy-outs will signal distress sooner than in rms funded more by equity. However, that these MBOs entered formal insolvency procedures despite the presence of specialised lender monitoring suggests that these are cases that will have been the ones considered most difcult to reorganise. UK evidence on failed buy-outs shows that coordination problems among multiple lenders do not create inefciencies resulting in signicantly lower secured creditor recovery rates. However, when there are multiple secured lenders, the senior secured lender gains at the expense of other secured creditors as the lender rst registering the charge over assets obtains priority. Recovery rates for junior creditors are lower for private equity-backed buy-outs. 6.9 Does higher leverage lead to increased likelihood of failure? As a general point, deals can sustain high capital leverage if they have high and stable interest cover which enables them to service the debt. Studies of larger US buy-outs and UK research provide strong evidence that higher amounts of debt are associated with an increased probability of failure or the need for a restructuring to take place (Appendix Table 8). Higher turnover per employee and the reduction of employment on buy-out is negatively associated with failure; this suggests the importance of measures taken to restructure an underperforming company early in the buy-out life-cycle. P2Ps that subsequently enter receivership have higher initial default probability and distance to default than P2Ps that exited through IPO, trade sale, secondary buy-out or no exit. Recent evidence comprising the population of private rms in the UK nds that after taking into account a large range of nancial and non-nancial factors, companies with higher leverage, whether buy-outs or not, are signicantly more likely to fail. Controlling for other factors including leverage, buy-outs have a higher failure rate than non-buyouts with MBIs having a higher failure rate than MBOs which in turn have a higher failure rate than private equity-backed buy-outs. However, MBOs and private equity-backed deals completed post-2003 and the introduction of the Enterprise Act 2002, which changed the corporate bankruptcy regime in the UK, are not riskier than the population of non-buy-out private rms if these other factors are controlled for. 6.10 Where do buy-outs get the cash to pay down the debt? Research on buy-outs during the 1980s covering the US, UK, France and the Netherlands indicated substantial average improvements in protability and cash ow measures over the interval between one year prior to the transaction and two or three years subsequent to it (Appendix Table 9). These buy-outs generated signicantly higher increases in return on assets than comparable rms that did not experience an MBO over a period from two to ve years after buy-out. More recent US and UK evidence from P2Ps, nds signicant increases in liquidity but not protability. Recent UK evidence from other vendor sources provides mixed evidence regarding post-buy-out return on assets but shows that divisional buy-outs in particular show signicant improvements in efciency. Intensity of private equity rm involvement is associated with higher levels of protability. US plant-level data shows that MBO plants had higher total factor productivity (TFP) than representative establishments in the same industry before they changed owners (Appendix Table 10). MBO plants experienced signicant improvements in TFP after the MBO which could not be attributed to reductions in R&D, wages, capital investment, or layoffs of shop oor/blue-collar personnel. More recent US evidence shows that private equity-backed rms increase productivity post-transaction by more than control group rms and that this increase is in large part due to more effective management and private equity being more likely to close underperforming establishments.
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In contrast, UK data shows that MBO establishments were less productive than comparable non-buy-out plants before the transfer of ownership but experienced a substantial increase in productivity after buy-out. These improvements appear to be due to measures undertaken by new owners or managers to reduce the labour intensity of production, through the outsourcing of intermediate goods and materials. 6.11 To what extent do private equity deals involve strategies to grow the business? Buy-outs are associated with refocusing the strategic activities of the rm, especially for deals involving listed corporations (Appendix Table 11). Divestment activity by buy-outs appears to be greater than for comparable non-buy-outs. However, US, UK and Dutch evidence from the 1980s shows that buy-outs are followed by signicant increases in new product development and other aspects of corporate activity such as engaging in entrepreneurial ventures, technological alliances, increased R&D and patent citations. Private equity rms also contribute to the development of management control systems that facilitate strategic change in different types of buy-outs. Private equity funders contribute to keeping added-value strategies on track, assisting in new ventures and broadening market focus, and in having the knowledge to be able to assess and invest in product development. More recent evidence shows that higher levels of private equity rm experience and intensity of involvement are associated with higher levels of growth, especially in divisional buy-outs. 6.12 Do private equity deals and buy-outs have adverse effects on investment and R&D? US evidence from the 1980s strongly supports the view that capital investment falls immediately following the LBO as a result of the increased leverage (Appendix Table 11). The evidence on UK MBOs from the 1980s indicates that asset sales are offset by new capital investment, particularly in plant and equipment. The effect of buy-outs on R&D is less clear, although on balance US evidence suggests there is a reduction. However, as many LBOs are in low R&D industries, the overall effect may be insubstantial. There is evidence from buy-outs that do have R&D needs that this expenditure is used more effectively and that private equity buy-outs result in increased patent citations and more focused patent portfolios. 6.13 To what extent is replacement of management important? Larger deals out-performance is often associated with signicant replacement of CEOs and CFOs either at the time of the deal or afterwards and the leveraging of external support. Recent US evidence indicates that half of CEOs in private equity-backed buy-out are replaced within two years. Unlike public companies, boards in private equity-backed buy-out are likely to replace entrenched CEOs and are more likely to replace CEOs if pre-buy-out return on assets is low (Appendix Table 11). 6.14 To what extent are managerial equity, leverage and private equity board involvement responsible for performance changes? Early studies show that management team shareholding size had by far the larger impact on relative performance compared to leverage in both US and UK MBOs (Appendix Table 12). More recent studies suggest a weaker or negative relationship. Private equity rms create active boards involving high levels of private equity rm interaction with executives during the initial, typically 100-day, value creation plan. Private equity rm board representation and involvement partly depends on style but is higher when there is CEO turnover and in deals that take longer to exit. Private equity boards lead strategy through intense engagement with top management, whereas quoted company boards accompany the strategy of top management. Active monitoring and involvement by private equity rms is also an important contributor to improved performance. In particular, previous experience and industry specialisation, but not buy-out stage
specialisation, of private equity rms adds signicantly to increases in operating protability of private-equity backed buy-outs over the rst three buy-out years. More experienced private equity rms help build better businesses as their deep experience in making buy-out deals helps them take the right decisions during the deal and after the acquisition. A clear strategic focus on specic target industries enables these private equity rms to build up and leverage expertise. Early and honest communication of what the buy-out means for the company and its employees, including targets, risks and rewards, is important in creating the motivation necessary to meet ambitious business plans. A strong and trust-based relationship between company management and private equity investors is the basis for value added involvement in strategic and operational decisions. 6.15 How are portfolio company management incentivised and rewarded? Managers (and sometimes a wider employee group) in buy-outs are expected to invest personally in the shares in the company (Appendix Table 12). Most of the rewards from buy-outs are derived from capital gains on the sale or otation of the business, not from salary and bonuses. If a buy-out fails, the investment of the managers and employees will usually be lost. The incentive structures of the employee equity holders are therefore very similar to those of the private equity fund managers. This contrasts with the use of option schemes in some quoted companies. In an option scheme managers have signicant incentives to grow value but no cost (except opportunity cost) in reducing shareholder value: it is a carrot-based system. In a buy-out there are both sticks and carrots.
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7. WHAT ARE THE PROSPECTS FOR THE PRIVATE EQUITY INDUSTRY?
Private equity markets have faced a number of waves of boom and bust, yet have continuously adapted to changing conditions. The following important challenges will inuence the future direction of the private equity and buy-out sector. 7.1 Where will future deals come from? Secondary buy-outs have grown in importance in recent years and seem set to continue to do so as nding primary buy-out deals has become more difcult. Such deals are likely to prove attractive where incoming private equity rms have differentiated skills to be able to take the business to the next level of development. Data on buy-outs of subsidiaries and parent-to-parent sales suggest that divestment activity by UK corporations has passed its peak. However, as corporations continue to make acquisitions, opportunities for divestment buy-outs are likely to remain, especially where post-acquisition integration issues are not adequately addressed. The scope for restructuring of larger corporations seems to be greater in Continental Europe and private equity rms are increasingly likely to look for attractive deals in this environment. While there is a vast swathe of family-owned rms, many of which have an ageing founder, little active succession planning is undertaken worldwide. A central issue concerns the views of founders regarding their future involvement with the business, which may have important implications for the negotiation of the deal, especially the price at which they are willing to sell. Owners of private businesses in the UK, for example, seem in general to be more willing to sell than their counterparts in Continental Europe. 7.2 Where will private equity deals be exited? Just as it has become more difcult to originate buy-outs so it has become more difcult to nd exit routes. Reduced leverage and general macro-economic conditions are likely to mean that buy-outs will be held in private equity rms portfolios for longer than has historically been the case. To avoid the negative impact on expected internal rates of return (IRR) that would otherwise result, management and private equity rms efforts will need to focus on value enhancing strategies over a longer time period. Retaining and continuing to develop portfolio rms with growth potential may be especially attractive as build-up deals, with the larger company that results opening up greater exit opportunities. These kinds of deals emphasise a need for private equities to have skills to identify and integrate target acquisitions. 7.3 How will value be generated in future? As debt availability seems unlikely to regain the levels seen in previous boom conditions it makes it more difcult to generate returns on private equity buy-outs from the effects of leverage, though in any case this has been less important since the rst wave of the 1980s. Increased emphasis is likely on the roles of management and private equity executives to create value through gains in operating efciencies and the exploitation of entrepreneurial opportunities. There is some evidence of more active involvement
54
by private equity rm boards than is the case in listed corporations. However, it is debatable how widespread such expertise is across the private equity sector. The ability to contribute to the development and subsequent overseeing of portfolio companies strategy by way of insightful active board participation will be an even more important differentiator of successful private equity funds in the future. Many private equity rms are likely to need to recruit more executives who have the specialist industry, operational and technical skills to create value in their portfolio companies. There will also be a need to pay careful attention to the selection of portfolio management with business skills who can identify and deliver development strategies. In the light of these challenges, four future development options for private equity and buy-outs can be categorised in terms of combinations of lower versus higher deal activity and lower versus higher returns (Figure 7.1). If macro-economic activity continues to stabilise, Quadrant 1 involving low activity and low returns seems unlikely if institutional investors interest returns to the market, private equity rms are able to raise new funds, and condence returns regarding valuations and exit markets. But if structural problems in the economy are not resolved, signicant market resurgence would likely be delayed. Lack of limited partner interest and lack of deals at attractive prices would cause many private equity rms to exit. If potential deals are only available at high entry prices, and access to debt nance remains limited in an economy that is not growing, it may be extremely difcult to generate signicant superreturns even in a general macro-economic context of low interest rates where lower actual returns may be appropriate. Increased activity coupled with low returns, as in Quadrant 2, may arise if the economy improves but private equity rms fail to develop their value adding skills. Coming under pressure to invest the funds they have raised, they might target poor deals, leading to poor outcomes. A return to higher levels of deal activity and higher returns would seem to require several developments to come together as shown in Quadrant 3. Besides developing private equity rm and investment managers skills, there would need to be a resurgence of debt funding, the identication of new deal types and means found to add value to secondary and tertiary deals. More sophisticated private equity rms are expected to drive out underperforming peers, leading to a shake-out in the industry. Quadrant 4 envisages a more modest level of deal activity but the generation of higher returns as continuing private equity rms develop differentiated value adding skills and focus on build-up and secondary buy-outs in an environment of restricted primary deal availability. At the time of writing it is unclear which option seems most likely to unfold. However, whichever scenarios emerge, they are likely to emphasise the opportunities to examine the inuence of varying economic contexts on relationships between private equity investors and their portfolio companies.
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Figure 7.1: Building the future for private equity

Lower Lower Quadrant 1 Lack of investor interest Lack of deal availability Lack of skills to add value Private equity rm exits Returns Higher Quadrant 4 Lack of primary deal availability Development of value adding skills and active board involvement Build-up deals Exits of under-performing private equity rms Activity Quadrant 2 Lack of investor sophistication Pressure to do deals Lack of skills to add value Little private equity rm exit Higher Quadrant 3 New deal, funding, private equity rm and exit types Ability to create value from secondaries, tertiaries... Development of value adding skills Continued investor interest Debt availability
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8. SOME AREAS FOR FURTHER RESEARCH
Although a continuing stream of studies of private equity continue to be published, there remain a number of areas for further research, including the following: In the light of the AIFM Directive, what are the implications of the regulation of cross-border private equity investment for the ability to restructure under-performing businesses? To what extent and under what conditions does the limited private equity fund model compare favourably to quoted private equity funds? In the context of recession, to what extent are private equity rms and their investee companies able to generate growth? What are the implications of differences in disclosure by private equity rms for fund raising? What has been the impact of private equity-backed buy-outs on employment and employee relations during recession compared to non-private equity-backed rms? How has the role of managerial equity stakes changed in driving performance in different types and sizes of private equity-backed buy-outs?
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APPENDIX: SUMMARIES OF STUDIES OF BUY-OUTS AND PRIVATE EQUITY
Light shading indicates new material added since the second edition.
Table 1: Pre-buy-out governance in P2Ps
Authors Maupin (1987) Country US Nature of transactions P2P MBOs Findings Ownership concentration, price/book value ratio, cash ow to net worth, cash ow to assets, private equity ratio, dividend yield and book value of assets to original costs distinguish P2Ps from comparable non-P2Ps. Prior takeover attempt, cash ow to sales and net assets to receivables predict likelihood of buy-out. Takeover threat strongly associated with going private. Firms going private have higher CEO ownership, higher institutional block-holder ownership, more duality of CEO and board chair but no difference in outside directors or takeover threats compared to rms remaining listed. Firms going private have higher liquidity, lower growth rates, lower leverage pre-buy-out, and lower R&D. FCF is not signicantly different. Takeover threat less likely to be associated with going private. Firms going private under-performed but had more cash assets than industry peers, and had higher relative costs of compliance with Sarbanes-Oxley. Firms going private have higher CEO ownership, higher institutional block-holder ownership, more duality of CEO and board chair but no difference in outside directors or takeover threats compared to rms subject to traditional takeovers. Irrevocable commitments for P2Ps depend on extent of takeover speculation, value of the bid and level of board shareholding, the premium offered to other shareholders and how active the private equitybidder provider was in this market, especially in MBOs less so in MBIs. Decrease in board size from pre to post-P2P, especially for LBOs funded by experienced private equity rms.
Singh (1990) Eddey, Lee and Taylor (1996) Weir, Laing and Wright (2005a)
US Australia UK
P2P MBOs, LBOs MBOs MBO, MBIs listed corporations
Evans, Poa and Rath (2005)
Australia
MBOs, acquisitions of listed corporations Management and nonmanagement led P2Ps MBO, MBI, acquisitions of listed corporations P2Ps
Boulton, Lehn, Segal (2007)
US
Weir and Wright (2006)
UK
Wright, Weir and Burrows (2007)
UK
Cornelli and Karakas (2008)
UK
All P2Ps
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Table 2: Financial returns to private equity and leveraged and management buy-outs
Authors Kaplan (1989) Ljungqvist and Richardson (2003) Country US US Nature of transactions LBOs VC and LBO funds Findings Investors in post-buy-out capital earn a median market-adjusted return of 37%. Mature funds started 19811993 generate IRRs in excess of S&P 500 returns net of fees; returns robust to assumptions about timing of investment and portfolio company risk; buy-out funds generally outperform venture funds, these differences partially reect differences in leverage used in investments; sample from one LP with disproportionate share of (larger) buy-out funds. LBO funds have a value-weighted IRR of 4.6% and VC funds have a value weighted IRR of 19.3%, commensurate with factor risks borne by investors; considerable variation in fund returns. Private returns to investors in relation to law quality, fund characteristics and corporate governance mechanisms. LBO fund returns gross of fees earn returns in excess of S&P 500 but net of fees slightly less than S&P 500; unlike mutual funds is persistence in returns among top performing funds; higher returns for funds raised in 1980s; acknowledge that average returns potentially biased as do not control for differences in market risk and possible sample selection bias towards larger and rst-time funds; funds raised in boom times less likely to raise follow-on funds and thus appear to perform less well. Risk adjusted performance of US buy-outs signicantly greater than S&P index. In contrast to VC funds, the performance of buy-out funds is largely driven by the experience of the fund managers regardless of market timing. Data from 797 mature private funds over 24 years shows high market beta for venture capital funds and low beta for buy-out funds, and evidence that private equity risk-adjusted returns are surprisingly low. Higher returns larger and more experienced funds mainly caused by higher risk exposures, not abnormal performance. General partners in successful mid-sized funds can expect carried interest to generate 515m on top of their salaries while general partners in large, successful funds can expect 50150m. Early and later stage funds have higher returns than buy-out funds in funds raised 199198; considerable variation in returns by type of institution; presence of unsophisticated performance-insensitive LPs allows poorly performing GPs to raise new funds.
Jones and Rhodes-Kropf (2003)
US
VC and LBO funds
Cumming and Walz (2004)
US, UK, Continental Europe, (39 countries) US
MBO/MBI, LBO, and VC
Kaplan and Schoar (2005)
VC and buyout funds
Groh and Gottschalg (2006) Knigge, Nowak and Schmidt (2006) Driessen, Lin and Phalippou (2007)
US and non-US Multi-country
MBOs VC and buyout funds VC and buyout funds
US
Froud, Johal, Leaver and Williams (2007); Froud and Williams (2007) Lerner, Schoar and Wongsunwai (2007)
UK
Mid and largesize funds
US
VC and LBO funds
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Table 2: Financial returns to private equity and leveraged and management buy-outs (continued)
Authors Ljungqvist, Richardson and Wolfenzon (2007) Country US Nature of transactions LBO funds Findings Established funds accelerate investments and earn higher returns when opportunities improve, competition eases and credit conditions loosen; rst-time funds less sensitive to market conditions but invest in riskier deals; following periods of good performance funds become more conservative. Private returns to investors enhanced by contextdependent corporate governance mechanisms. Buy-out fund managers earn lower revenue per managed dollar than managers of VC funds; buy-out managers have substantially higher present values for revenue per partner and revenue per professional than VC managers; buy-out fund managers generate more from fees than from carried interest. Buy-out managers build on prior experience by raising larger funds, which leads to signicantly higher revenue per partner despite funds having lower revenue per dollar; buy-out managers build on prior experience by raising larger funds, which leads to signicantly higher revenue per partner despite funds having lower revenue per dollar. Highly signicant impact of total fund inows on fund returns. Private equity funds returns driven by GPs skills as well as stand-alone investment risk. After adjusting for sample bias and overstated accounting values for non-exited investments, average fund performance changes from slight overperformance to under performance of 3% p.a. with respect to S&P 500; gross of fees, funds outperform by 3% p.a.; venture funds underperform more than buy-out funds; previous past performance most important in explaining fund performance; funds raised 19802003. Median investment IRR 21% [PME* 1.3], gross of fees; 1/10 investments goes bankrupt but 1/4 has an IRR above 50%; 1/8 investments held for less than two years, but have highest returns; scale of private equity rm investors is inuential: investments held at times of a high number of simultaneous investments underperform substantially, with diseconomies of scale highest for independent rms, less hierarchical rms, and those with managers of similar professional backgrounds. * Public market equivalent (PME) = the present value of the dividends over the present value of the investments. Maula, Nikoskelainen and Wright (2011) UK MBOs Industry growth drives exited buy-out returns and is particularly high in MBOs, divisional buy-outs and top-quartile deals.
Nikoskelainen and Wright (2007) Metrick and Yasuda (2007)
UK US
MBOs VC and LBO funds
Diller and Kaserer (2009) Phalippou and Gottschalg (2009)
Europe
VC and MBO funds LBO funds
US and non US
Lopez di Silanes, Phalippou and Gottschalg (2011)
Worldwide
Private equity investments
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Table 3: Employment, wage and HRM effects

Authors Panel A: Employment effects Wright and Coyne (1985) UK Firm MBOs 44% of rms shed employees on buy-out; 18% of pre-buy-out jobs lost subsequent re-employment but below pre-MBO levels. Small increase in employment postbuy-out but falls after adjusting for industry effects. 8.5% fall in non-production workers over three-year period; production employment unchanged. Median number of employees fell between LBO and IPO but those LBOs without asset divestment reported median employment growth in line with top 15% of control sample; divisional LBOs more likely to increase employment than full LBOs. Small increase in employment postbuy-out but falls after adjusting for industry effects. 25% of rms shed employment on buy-out. Small increase in employment postbuy-out. 38% reduced employment. Country Unit of analysis Nature of transactions Findings
Kaplan (1989)
US
Firm
LBOs
Lichtenberg and Siegel (1990) Muscarella and Vetsuypens (1990)
US
Plant
LBOs, NBOs
US
Firm
Reverse LBOs
Smith (1990)
US
Firm
LBOs
Wright et al (1990a) Opler (1992) Robbie, Wright and Thompson (1992); Robbie and Wright (1995) Wright, Thompson and Robbie (1992) Robbie, Wright and Ennew (1993)
UK US UK
Firm Firm Firm
MBOs LBOs MBIs
UK
Firm
MBOs, MBIs
Average 6.3% fall in employment on MBO but subsequent 1.9% improvement by time of study. Over three-fths did not affect redundancies on buy-outs, a sixth made more than 20% redundant and that the median level of employment fell from 75 to 58. Employment growth is 0.51 of a percentage point higher for MBOs after the change in ownership and 0.81 of a percentage point lower for MBIs. After controlling for endogeneity in selection of buy-outs, difference between employment effects of private equity versus non-private equity-backed buy-outs not signicant. Employment in buy-outs falls relative to control group for rst four years but rises in fth; initial rationalisation creates basis for more viable job creation.
UK
Firm
MBOs in receivership
Amess and Wright (2007)
UK
Firm
MBOs and MBIs
Amess and Wright (2010)
UK
Firm
MBOs, MBIs, private equity and nonprivate equitybacked Private equitybacked and non-private equity-backed companies
Cressy, Munari and Malipiero (2007)
UK
Firm
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Table 3: Employment, wage and HRM effects (continued)

Authors Panel A: Employment effects Work Foundation (2007) UK Firm MBIs, MBOs Based on same data as Wright et al (2007) and Amess and Wright (2007a), MBOs increased employment. MBIs tended to cut it. Remaining workers often experienced signicantly less job security. Employment cuts may have been planned pre-buy-out. On average, employment initially falls but then grows above pre-buy-out level in MBOs; in MBIs, employment falls after buy-out; majority of MBOs and MBIs experience growth in employment. Private equity-backed LBOs have no signicant effect on employment. Both non-private equity-backed LBOs and acquisitions have negative employment consequences. Country Unit of analysis Nature of transactions Findings
Wright et al (2007)
UK
Firm
MBOs, MBIs
Amess, Girma and Wright (2008)
UK
Firms
LBOs, MBOs, MBIs, acquisitions, private equity and nonprivate equitybacked Matched private equitybacked and non-private equity-backed rms and establishments MBOs, MBIs
Davis et al (2008)
US
Firm and establishment
Employment grows more slowly in private equity cases than in control pre-buy-out and declines more rapidly post-buy-out but in fourth to fth year employment mirrors control group; buy-outs create similar amounts of jobs to control and more Greeneld jobs. More reputable private equity rms associated with increases in employment in both post buy-out and post exit phases. Private equity-backed deals experienced job losses in years immediately after going private but employment increased subsequently, non-private equity-backed buy-outs increased employment after the rst year post-deal. Employment falls in the year immediately after the completion of the IBO compared with non-acquired rms; no parallel or subsequent increase in productivity or protability. Decline in relative compensation of non-production workers. Average wages in both MBOs and MBIs are lower than their non-buy-out industry counterparts. Wages grow post-buy-out compared to pre-buy-out year; the majority of MBOs and MBIs showed growth in wages.
Jelic (2011)
UK
Firms
Weir, Jones and Wright (2008)
UK
Firms
P2Ps
Goergen, OSullivan and Wood (2011)
UK
Firms
IBOs/MBIs of listed companies
Panel B: Wages Lichtenberg and Siegel (1990) Amess and Wright (2010) Wright et al (2007) US UK Plant Firm MBOs, LBOs MBOs, MBIs
UK
Firm
MBOs, MBIs
62
Authors Panel B: Wages Amess, Girma and Wright (2008)
Country UK
Unit of analysis Firms
Nature of transactions LBOs, MBOs, MBIs, acquisitions, private equity and nonprivate equitybacked MBOs
Findings Employees gain higher wages after acquisitions but lower after LBO.
Panel C: HRM effects Wright et al (1984) UK Firm 65% of rms recognised unions before buy-out, falling to 60% afterwards; 40% of rms recognised one union; 8% of rms involved wider employee share ownership after buy-out. Employee share ownership had greater effect on cooperation than on performance but did improve employee cost consciousness. 58% of rms recognised unions before buy-out, 51% afterwards; 52% of rms recognised one union; 14.3% of rms involved wider employees in shareholding; 6% had share option scheme pre-buy-out, 10.4% afterwards. Shareholding and participation in decision making associated with feelings of ownership; perceptions of employee ownership signicantly associated with higher levels of commitment and satisfaction. Buy-outs resulted in increased employment, adoption of new reward systems and expanded employee involvement; insider buy-outs and growth oriented buy-outs had more commitment-oriented employment policies. MBOs lead to increases in training and employee empowerment. These effects were stronger in the UK than in the Netherlands. Employees in MBO rms have more discretion over their work practices. Based on data in Wright et al (2007) and Amess and Wright (2007a), in the case of MBIs, signicant cuts in wages generally took place. Insider buy-outs show greater increase in high commitment practices; buy-outs backed by private equity rms report fewer increases in high commitment management practices.
Bradley and Nejad (1989)
UK
Firm
NFC MEBO
Wright et al (1990a)
UK
Firm
MBOs
Pendleton, Wilson and Wright (1998)
UK
Firm and Employees
Privatised MEBOs
Bacon, Wright, Demina (2004)
UK
Firm
MBOs, MBIs
Bruining, Boselie, Wright, and Bacon (2005) Amess, Brown, and Thompson (2007) Work Foundation (2007)
UK and Holland
Firm
MBOs
UK UK
Firm Firm
MBOs MBOs, MBIs
Bacon, Wright, Demina, Bruining and Boselie (2008)
UK, Holland
Firm
MBOs, MBIs, private equity and nonprivate equitybacked
63
Table 3: Employment, wage and HRM effects (continued)

Authors Panel C: HRM effects Bacon, Wright, Scholes and Meuleman (2009) PanEuropean Firm All private equity-backed buy-outs above = C5m transaction value Negligible changes to union recognition, membership density and attitudes to trade union membership; absence of reductions in terms and conditions subject to joint regulation; more rms report consultative committees, which are more inuential on their decisions, and increased consultation over rm performance and future plans; private equity rms adapt their approaches to different social models and traditional national industrial relations differences persist. In private equity-backed buy-out negotiations, aloof top management can have negative effect on employee commitment and trust, exacerbating uncertainty and rendering HR-change initiatives powerless; binding effect of informal management practices undermined by nancial pressures that dominated senior management decision-making; divisional HR managers focused on divisional responsibilities in context of increasingly politicised relationships between division and centre; important for top management to engage with the organisation and introduce realistic people management initiatives; HR acting as a business partner with line management led to tension between corporate and divisional HR levels, limiting ability of local HR to engage with proactive corporate people management initiatives. Impact of private equity on high performance work practices (HPWP) affected more by length of investment relationship than by countries where private equity is going to or is coming from; buy-outs backed by Anglo-Saxon private equity rms as likely to introduce new HPWP as those backed by nonAnglo-Saxon private equity rms. Employment reductions in each case, though to varying extent; few changes in work organisation developments in employee voice and representation. National systems of labour regulation affect the extent to which worker representatives receive information after, though not during, the acquisition. Country Unit of analysis Nature of transactions Findings
Boselie and Koene (2010)
Netherlands
Firm
Single rm private equity-backed buy-out negotiation
Bacon, Wright, Meuleman and Scholes (2011)
Europe
Firm
All private equity-backed buy-outs above = C5m transaction value
Gospel, Pendleton, Vitols and Wilke (2011)
UK, Germany, Spain
Firm
Case of LBOs, hedge fund and SWF investments
64
Table 4: Effects on debt-holders, taxation

Authors Effects on debt holders Marais Schipper and Smith (1989) Asquith and Wizman (1990) US US LBOs LBOs No evidence of wealth transfer from pre-buy-out bondholders. Small average loss of 2.8% of market value to pre-buy-out bondholders. Bonds with protective covenants had a positive effect, those without experience negative reaction. Bondholders with covenants offering low protection against corporate restructuring lose some percentage of their investment. Bondholders with covenants offering low protection against corporate restructuring lose some percentage of their investment. Tax savings account for small fraction of value gains in LBOs; signicant correlation between estimated tax savings and buy-out bid premium. Total amount of taxes collected by government does not decrease as a result of LBOs. Tax savings account for small fraction of value gains in LBOs; signicant correlation between estimated tax savings and buy-out bid premium. Few control sample rms had lower tax rates than buy-outs. LBOs would have paid signicantly more tax depending on tax structure; signicant proportion of premia paid on LBO appears to be caused by reduction in taxes due to additional tax shields from debt; after Tax Reform Act 1986 less than 50% of premium paid on LBO can be attributed to reduction in taxes. No signicant relationship between pre-P2P tax to sales ratio and shareholder wealth gains (premia) on announcement of P2P but bidders willing to pay higher premia for rms with lower debt-toequity ratios which proxies for the tax advantage of additional interest deductibility and for the ease of nancing the takeover operation. Tax paid is signicantly below the industry average in each year post going private but is not statistically different in the year prior to going private but lower tax may be a function of lower protability reported post-P2P rather than from the tax shield element of going private. Country Nature of transactions Findings
Cook et al (1992)
US
LBOs
Warga and Welch (1993) Taxation effects Schipper and Smith (1988) Jensen, Kaplan and Stiglin (1989) Kaplan (1989)
US
LBOs
US
LBOs
US US
LBOs LBOs
Muscarella and Vetsuypens (1990) Newbould, Chateld, Anderson (1992)
US US
Reverse LBOs LBOs
Renneboog, Simons and Wright (2007)
UK
P2Ps
Weir, Jones and Wright (2008)
UK
P2Ps
65
Table 5: Longevity
Authors Kaplan (1991) Country US Nature of transactions LBOs Findings Heterogeneous longevity. LBOs remain private for median 6.8 years. 56% still privately owned after year 7. LBOs funded by leading private equity rms no more likely to stay private than other buy-outs; no difference in longevity of divisional or full LBOs. State of development of asset and stock markets, legal infrastructures affecting the nature of private equity rms structures and the differing roles and objectives of management and private equity rms inuence timing and nature of exits from buy-outs. Heterogeneity of longevity inuence by managerial objectives, fund characteristics and market characteristics; larger buy-outs and divisional buyouts signicantly more likely to exit more quickly. Heterogeneous longevity. Greatest exit rate in years 35; 71% still privately owned after year 7. MBIs greater rate of exit than MBOs in short term consistent with higher failure rate of MBIs. Exit rate inuenced by year of deal [economic conditions]. To achieve timely exit, private equity rms are more likely to engage in closer (hands-on) monitoring and to use exit-related equity-ratchets on managements equity stakes. Average longevity of private equity investment ve years; average length of private equity investment compares favourably with that of blockholders in public rms. 58% of deals exited more than ve years after initial transaction; exits within two years account for 12% and have been decreasing. Duration of investment shorter than in US and UK; exit primarily by trade sale; IRR positively related to initial undervaluation, target rm risk, private equity rm experience; fund size, lock-up clauses, puttable securities and exit ratchets. Average time to exit 46 months; smaller private equity-backed deals take longer to exit; private equity-backed MBOs exit sooner, have higher exit rates but fewer liquidations; syndicated private equity-backed MBOs exit sooner; backing by more reputable private equity rms increases likelihood of IPO exit.
Wright et al (1993)
UK, France, Sweden, Holland
MBOs
Wright et al (1994)
UK
MBOs
Wright et al (1995)
UK
MBOs, MBIs
Gottschalg (2007)
Worldwide
Private equity-backed buy-outs Private equity-backed buy-outs Early and late stage private equity
Strmberg (2008)
Worldwide
Caselli, GarciaAppendini and Ippolito (2009)
Italy
Jelic (2011)
UK
Private equitybacked and non-private equity-backed MBOs and MBIs
66
Table 6: Asset sales and disposals

Authors Bhagat et al (1990) Muscarella and Vetsuypens (1990) Kaplan (1991) Liebeskind et al (1992) Country US US Nature of transactions LBOs Reverse LBOs Findings 43% of assets in hostile LBOs sold within three years. 43% of reverse LBOs divested or reorganised facilities; 25% made acquisitions; divestment activity greater among full LBOs. 34% of assets sold within six years of buy-out. LBOs show signicantly greater reduction in number of plants than control sample of matched public corporations and divested signicantly more businesses in terms of mean employees, revenues and plants but not in terms of median revenue and plants; LBO managers downsized more lines of businesses than in the control group. 18% sold surplus land and buildings; 21% sold surplus equipment. 5/32 rms were complete bust-ups, all involving buy-out (private equity) specialists; 14/32 rms refocused by divesting unrelated lines; 21/32 rms engaged in business focus by divesting related lines and 9/32 in market focus. The average abnormal returns to publicly listed bonds of LBOs around asset sales depends on whether rm experiences nancial distress; distressed rms experience negative and signicant wealth effects, no distressed rms experience positive and signicant returns; evidence is consistent with returns being determined by whether divestment price exceeds, equals or is below expected price for the anticipated divestment. Partial sales of subsidiaries or divisions of buy-outs accounted for 1/3 of total realised in the UK in 2001 but accounted for 1/4 in 2005; number of partial sales generally ranges between 70 and 100 per annum; = C9bn was raised through partial sales in UK in 2005; in Continental Europe partial sales accounted for less than 1/20 of total exit value in 2005. Private equity deals generate greater seller returns relative to sales to strategic buyers and gains to rms that sell assets to private equity are related to type of exit transaction and the subsequent increase in the assets enterprise value, which exceeds that of benchmark rms; sellers earn a signicantly greater gain for assets that exit by IPOs or a sale to a strategic buyer rather than by a secondary buy-out.
US US
LBOs LBOs
Wright, Thompson and Robbie (1992) Seth and Easterwood (1993)
UK US
MBOs Large LBOs
Easterwood (1998)
US
LBOs
Wright et al (2007)
UK and Europe
MBOs, MBIs
Hege, Lovo, Slovin and Sushka (2010)
US
Divestments to private equity and corporate acquirors
67
Table 7: Post-exit effects

Authors Holthausen and Larcker (1996) Country US Nature of transactions Reverse LBOs Findings Leverage and management equity falls in reverse buy-outs but remain high relative to comparable listed corporations that have not undergone a buyout. Pre-IPO accounting performance signicantly higher than the median for the buy-outs sector. Following IPO, accounting performance remains signicantly above the rms sector for four years but declines during this period. Change is positively related to changes in insider ownership but not to leverage. Agency cost problems did not reappear immediately following a reverse buy-out but took several years to re-emerge. Reverse MBOs, MBIs Private equity-backed MBOs more under-priced than MBOs without venture capital backing but perform better than their non-VC-backed counterparts in the long run. Reverse MBOs backed by more reputable VCs exit earlier and perform better than those backed by less prestigious VCs. For a sample of 526 RLBOs between 1981 and 2003, three and ve-year stock performance appears to be as good as or better than other IPOs and the stock market as a whole, depending on the specication. There is evidence of a deterioration of returns over the time. For a sample of 128 LBO-backed IPOs and 1,121 non-LBO backed IPOs during 1990-2006 LBObacked IPOs outperform non-LBO backed IPOs and a stock market index; percentage of equity retained by buy-out group post offering drives out-performance. Improvements in employment, leverage, sales efciency and sales up to ve years post-IPO, especially for more reputable private equity rms; no signicant change in employment and efciency following non-oat exit.
Bruton et al (2002)
US
Jelic, Saadouni and Wright (2005)
UK
Cao and Lemer (2007, 2009)
US
Reverse LBOs
Von Drathen and Faleiro (2008)
UK
LBO-backed and non-LBO backed IPOs
Jelic and Wright (2011)
UK
MBOs, MBIs
68
Table 8: Distress, failure and recovery

Authors Bruner and Eades (1992) Kaplan and Stein (1993) Wright et al (1996b) Country US Nature of transactions LBOs Findings Given REVCOs debt and preference dividend obligations and its context, low probability could have survived the rst three years. Overpayment major cause of distress. Failed buy-outs more likely than non-failed buy-outs to be more highly leveraged, have lower liquidity ratios, be smaller and have lower labour productivity. Net effect of high leverage and distress creates value after adjusting for market returns. Secured creditors recover on average 62% of loans in failed buy-outs. Multiple secured creditors does not lead to inefciency in the distress process but lead secured creditors obtained signicantly higher recovery rates than other secured lenders. No signicant relationship between bankruptcy and deal size; divisional buy-outs signicantly less likely to end in distress; private equity-backed deals somewhat more likely to go bankrupt; no major difference in probability of bankruptcy across time periods; buyouts of distressed rms signicantly more likely to fail. Buy-outs sponsored by high reputation private equity rms are less likely to experience nancial distress or bankruptcy ex-post. Buy-outs have a higher failure rate (entering administration) than non-buy-outs with MBIs having a higher failure rate than MBOs which in turn have a higher failure rate than private equity-backed buy-outs/buy-ins. Private equity investors select companies which are less nancially constrained than comparable companies and nancial constraints tighten after buy-out, especially for stand-alone transactions and in times of cheap debt; private equity-backed companies do not suffer from higher mortality rates, unless backed by inexperienced private equity funds. 50% of defaults involve private equity-backed rms; private equity-backed rms not more likely to default than other rms with similar leverage characteristics; recovery rates for junior creditors lower for private equity-backed rms; private equity-backed rms in distress more likely to survive as an independent reorganised company. P2Ps signicantly higher default probability than nonacquired rms that remain public; high bankruptcy risk at going private increases chance of subsequent bankruptcy; post-P2P bankruptcy likelihood less when P2P is an MBO and with independent board pre-P2P.
US UK
LBOs MBOs, MBIs
Andrade and Kaplan (1998) Citron, Wright, Rippington and Ball (2003) Citron and Wright (2008)
US UK
LBOs MBOs, MBIs
UK
MBOs, MBIs
Strmberg (2008)
Worldwide
Private equity-backed buy-outs
Demiroglu and James (2009) Wilson and Wright (2011)
US
P2P LBOs
UK
MBOs, MBIs, private equity-backed buy-outs, nonbuy-outs LBOs, nonLBOs
Borell and Tykvova (2012)
Europe
Hotchkiss, Smith and Stromberg (2011)
Private equitybacked and non-private equity-backed rms obtaining leveraged loan nancing UK P2P LBOs
Sudarsanam, Wright and Huang (2011)
69
Table 9: Operating performance changes post-buy-out

Authors Operating performance Kaplan (1989) US LBOs Prots and cash ows increase post buy-out; operating income/assets up to 36% higher for LBOs compared to industry median. Operating income/sales increases by more than all of control sample rms; improvements in operating performance compared to control sample mainly due to cost reductions rather than revenue or asset turnover improvements. Revenue growth post-buy-out, working capital management and operating income better than industry comparators, especially for divisional LBOs. Operating cash ow per employee and per dollar of operating assets improves post buy-out; working capital improves post buy-out; changes not due to lay-offs or capex, marketing, etc. expenditures; cash ow to employees 71% higher than industry median. Buy-outs display signicantly higher than industry average cash ow and return on investment. Operating cash ow/sales ratio increased by 16.5% on average three years post-buy-out. 68% showed improvements in protability; 17% showed a fall; 43% reduced debt days and 31% increased creditor days. Median shock effect of buy-out [correcting for forecast performance] of 30% improvement in operating income/sales ratio between pre-LBO year and second post-LBO year. Consumers may face higher prices in supermarkets subject to LBO. Protability higher for MBOs than comparable nonMBOs for up to ve years. Accounting performance changes depend on vendor source of deal. Operating protability of private-equity backed buy-outs greater than for comparable non-buy-outs by 4.5% over rst three buy-out years. Post-LBO growth in sales, assets, productivity and jobs higher in industries that have insufcient internal capital. LBOs exhibit signicantly higher operating returns of 2-3% relative to matched control group, due to increase in gross margins, productivity gains and improved working capital utilisation. Higher growth in divisional buy-outs. Country Nature of transactions Findings
Muscarella and Vetsuypens (1990)
US
Reverse LBOs
Singh (1990)
US
Reverse LBOs
Smith (1990)
US
LBOs
Bruining (1992) Opler (1992) Wright, Thompson, Robbie (1992) Smart and Waldfogel (1994)
Holland US UK
MBOs LBOs MBOs, MBIs
US
LBOs
Chevalier (1995) Wright, Wilson, Robbie (1996) Desbrieres and Schatt (2002) Cressy, Munari, Malipero (2007) Boucly, Thesmar, and Sraer (2009) Gaspar (2009)
US UK
LBOs Matched MBOs and non-MBOs MBOs, MBIs MBOs, MBIs
France UK
France
LBOs
France
LBOs
Meuleman, Amess, Wright and Scholes (2009)
UK
Divisional, family and secondary buy-outs
70
Authors Operating performance Weir, Wright and Jones (2008)
Country UK
Nature of transactions P2Ps
Findings Performance deteriorates relative to the pre-buy-out situation but rms do not perform worse than rms that remain public and there some evidence that performance improves; private equity-backed deals have a negative effect on protability relative to pre-buy-out; private equity-backed deals performed better than the industry average; non-private equitybacked buy-outs expenses lower after going private and prot per employee higher, z-scores improved. Returns to pre- or post-buy-out capital signicantly positive except for rms ending in distressed restructuring. Returns to post-buy-out capital greater when deal nanced with a greater proportion of bank nancing, or when there is more than one private equity sponsor. Signicant improvements in output for private equity-backed buy-outs exiting by IPO; performance of secondary MBOs declines during rst buy-out but performance in second buy-out stabilises until year 3. Private equity-backed buy-outs show stronger economic performance before and during recession than comparable private and listed companies; with up to 4.8% higher ROA.
Guo, Hotchkiss and Song (2011)
US
P2Ps
Jelic and Wright (2011)
UK
MBOs, MBIs, private equitybacked MBOs, MBIs, private equitybacked, nonprivate equity companies
Wilson, Wright, Siegel and Scholes (2011)
UK
Table 10: Productivity changes in buy-outs and private equity

Authors Lichtenberg and Siegel (1990) Country US Unit of analysis Plant Nature of transactions Divisional and full-rm LBOs and MBOs of public and private companies Findings Plants involved in LBOs and MBOs are 2% more productive than comparable plants before the buy-out; LBOs and especially MBO plants experience a substantial increase in productivity after a buy-out to 8.3% above; employment and wages of non-production workers at plants (but not production workers) declines after an LBO or MBO; no decline in R&D investment. MBOs enhance productivity; marginal value added productivity of labour is signicantly higher than in comparable non-buy-outs. MBOs have higher technical efciency two years pre-MBO and lower technical efciency three or more years before than comparable non-buy-outs; MBOs have higher technical efciency in each of four years after buy-out but not beyond four years than comparable non-buy-outs.
Amess (2002)
UK
Firm
MBOs
Amess (2003)
UK
Firm
MBOs
71
Table 10: Productivity changes in buy-outs and private equity (continued)

Authors Harris, Siegel, and Wright (2005) Country UK Unit of analysis Plant Nature of transactions Divisional and full-rm LBOs and MBOs of public and private companies Matched private equitybacked and non-private equity-backed rms and establishments Findings Plants involved in MBOs are less productive than comparable plants before the buy-out; they experience a substantial increase in productivity after a buy-out; plants involved in an MBO experience a substantial reduction in employment. Private equity-backed rms increase productivity in two years posttransaction on average by 2% more than controls; 72% of increase due to more effective management; private equity rms more likely to close underperforming establishments; as measured by labour productivity; private equity-backed rms outperformed control rms before buy-out. Private equity-backed buy-outs show stronger economic performance before and during recession than comparable private and listed companies with up 11% productivity differential.
Davis et al (2009)
US
Firm/ establishment
Wilson, Wright, Siegel and Scholes (2011)
UK
Firm
MBOs, MBIs, private equitybacked, nonprivate equity companies
Table 11: Strategy, investment, R&D and control system changes in buy-outs
Authors Wright (1986) Bull (1989) Country UK US Unit of analysis Firm Firm Nature of transactions MBOs MBOs, LBOs Findings Divisional MBOs reduce dependence on trading activity with former parent. Evidence of both cost reduction but greater managerial alertness to opportunities for wealth creation more important. Capex falls immediately following LBO. Major changes in marketing and NPD; cost control given greater importance. LBOs typically in low R&D industries. R&D fall both pre and post buy-out not statistically signicant; R&D fall may be accounted for by divestment of more R&D-intensive divisions. Capex declines compared to pre-LBO. Capex and R&D fall immediately following LBO. Divisional buy-outs reduce trading dependence on former parent by introducing new products previously prevented from doing.
Kaplan (1989) Malone (1989) Lichtenberg and Siegel (1990)
US US US
Firm Firm Plant
LBOs Smaller LBOs LBOs, MBOs
Muscarella and Vetsuypens (1990) Smith (1990) Wright et al (1990b)
US US UK
Firm Firm Firm
Reverse LBOs LBOs MBOs, MBIs
72
Authors Green (1992)
Country UK
Unit of analysis Firm
Nature of transactions MBOs
Findings Buy-out ownership allowed managers to perform tasks more effectively through greater independence to take decisions. Managers had sought to take entrepreneurial actions prior to buy-out but had been prevented from doing so because of the constraints imposed by parents control. Buy-outs result in better match between accounting control systems and context, with increased reliance on management control systems inuenced by pressure to meet targets. MBOs enhance new product development; 44% acquired new equipment and plant that would not otherwise have occurred. LBOs result in a reduction in R&D expenditure but LBOs typically in low R&D industries; R&D intensive buyouts outperform non-buy-out industry peers and other buy-outs without R&D expenditure. Buy-outs focus strategic activities towards more related businesses. LBOs may lead to a reduced resource base for organisational learning and technology development.
Jones (1992)
UK
Firm
MBOs
Wright, Thompson and Robbie (1992)
UK
Firm
Divisional, and full-rm MBOs of private companies LBOs and MBOs
Long and Ravenscraft (1993)
US
Division
Seth and Easterwood (1993) Lei and Hitt (1995)
US
Firm
LBOs
Phan and Hill (1995) Robbie and Wright (1995)
US UK
Firm Firm
LBOs MBIs
Buy-outs focus strategic activities and reduce diversication. Ability of management to effect strategic changes adversely affected by asymmetric information, need to attend to operational problems and market timing. Large LBOs reduce lines of business and diversication. MBOs result in more effective use of R&D expenditure and new product development. MBOs result in more entrepreneurial activities such as new product and market development. MBOs result in introduction of more strategic control systems that allow for entrepreneurial growth.
Wiersema and Liebeskind (1995) Zahra (1995)
US US
Firm Firm
Larger LBOs MBOs
Bruining and Wright (2002) Bruining, Bonnet and Wright (2004)
Holland
Firm
Divisional MBOs MBOs
Holland
Firm
73
Table 11: Strategy, investment, R&D and control system changes in buy-outs (continued)
Authors Brown, Fee and Thomas (2007) Country US Unit of analysis Firm Nature of transactions Suppliers to LBOs and leveraged recapitalisations Findings Suppliers to LBO rms experience signicantly negative abnormal returns at announcements of downstream LBOs but not the case for leveraged recapitalisations. Suppliers who have made substantial relationship-specic investments more negatively affected. Suggests increased leveraged without accompanying change in organisational form does not lead to improved bargaining power. Pure restructuring deals less frequent than growth oriented deals; combination of growth-oriented (acquisitions, new marketing and markets, new products, JVs, etc.) and restructuring-oriented (divestments, layoffs, cost-cutting, closure of non-core units, etc.) changes common; 43% had complete/partial replacement of management. Signicant replacement of CEOs and CFOs either at the time of the deal or afterwards and leveraging of external support important especially related to investee out-performance. High CEO and board turnover during post-P2P restructuring.
Gottschalg (2007)
International
Firms
Private equitybacked LBOs
Acharya, Hahn and Kehoe (2009)
UK
Firms
Private equitybacked LBOs
Cornelli and Karakas (2008)
UK
Firms
Private equitybacked P2Ps (LBOs and MBOs) Private equitybacked buyouts
Lerner, Strmberg and Srensen (2008)
Worldwide
Firm
Buy-outs increase patent citations after private equity investment but quantity of patenting unchanged, maintain comparable levels of cutting-edge research, patent portfolios become more focused after private equity investment. Private equity management practices better than in other rms in terms of operational management, people based management practices and evaluation practices. An increase in patenting post buy-out.
Bloom, van Reenen and Sadun (2009)
Asia, Europe, US
Firms
Private equity owned and other rms
Ughetto (2010)
Europe
Firm
Private equity-backed buy-outs Private equity and non-private equity-backed buy-outs
Bruining, Wervaal and Wright (2011)
Holland
Firms
Majority private equity-backed buy-outs signicantly increase entrepreneurial management practices but increased debt negatively affects entrepreneurial management; entrepreneurial management positively affects exploration and exploitation, but the latter does not impact rm performance.
74
Authors Cumming and Zambelli (2011)
Country Italy
Unit of analysis Firms
Nature of transactions Private equitybacked buy-outs
Findings Following legislative changes private equity investors become more involved in the management and governance of the target rm by increasing ownership stake, the use of convertible debt, adopting more control rights especially right to CEO and the right to take majority board position. CEO turnover rate of 51% within two years of LBO; boards replace CEOs in companies with high agency costs, low pre-LBO ROA and entrenched CEOs.
Gong and Wu (2011)
US
Firm
LBO
Table 12: Drivers of post-buy-out changes

Authors Malone (1989) Country US Nature of transactions Smaller private equity-backed LBOs MBOs, MBIs returning to market LBO and leveraged recapitalisation LBOs of listed corporations Smaller MBIs Findings Management equity stake important driver of postbuy-out changes. Management team equity stake by far larger impact on relative performance of returns to equity investors from buy-out to exit than leverage, equity ratchets, etc. Gains in LBO greater than in leveraged recapitalisation attributed to more important role of equity ownership and active investors in LBOs. Managerial equity stakes had a much stronger effect on performance than debt levels for periods of three and ve years following the buy-out. Private equity rms less closely involved; debt commitment and covenants important trigger for corrective action. Active monitoring by a buy-out specialist substitutes for tighter debt terms in monitoring and motivating managers of LBOs. Buy-out specialists that control a majority of the post-LBO equity use less debt in transactions. Buy-out specialists that closely monitor managers through stronger representation on the board also use less debt. Industry specialisation, but not buy-out stage specialisation, of private equity rm adds signicantly to increase in operating protability of private-equity backed buy-outs over rst three buy-out years. High levels of private equity rm interaction with executives during the initial 100-day value creation plan, creating an active board.
Thompson, Wright, Robbie (1992)
UK
Denis (1994)
US
Phan and Hill (1995)
US
Robbie and Wright (1995) Cotter and Peck (2001)
UK
US
LBOs
Cressy, Munari, Malipero (2007)
UK
MBOs, MBIs
Acharya, Hahn and Kehoe (2008)
UK
Private equitybacked LBOs divisional, family and secondary buy-outs
75
Table 12: Drivers of post-buy-out changes (continued)

Authors Cornelli and Karakas (2008) Country UK Nature of transactions Private equitybacked P2Ps (LBOs and MBOs) Findings Board representation and active involvement by private equity rms changes according to private equity rm style and anticipated challenges of the investment; board size falls less and private equity rm representation higher when is CEO turnover and for deals that take longer to exit. Value creation focus of private equity boards versus governance compliance and risk management focus of PLC boards. Private equity boards lead strategy through intense engagement with top management, PLC boards accompany strategy of top management. Almost complete alignment in objectives between executive and non-executive directors only in private equity boards. Private equity board members receive information primarily cash-focused and intensive induction during due diligence; PLC board members collect more diverse information and undergo a more structured (formal) induction. Buy-outs sponsored by high reputation private equities pay narrower loan spreads, have fewer and less restrictive nancial loan covenants, use less traditional bank debt, borrow more and at a lower cost from institutional loan markets, and have higher leverage; no direct effect of private equity rm reputation on buy-out valuations. Private equity-owned companies use much stronger incentives for top executives and have substantially higher debt levels. Little evidence that private equityowned rms outperform public rms in protability or operational efciency; compensation and debt differences between private equity-owned companies and public companies disappear over a very short period (one to two years) after the private equityowned rm goes public. Private equity rms experience signicant driver of higher growth in divisional buy-outs; private equity experience important inuence on growth but not protability or efciency; intensity of private equity involvement associated with higher protability and growth; amount of management investment insignicant or negative relationship with protability or productivity change.
Acharya, Kehoe and Reyner (2009)
UK
Board members of large private equity portfolio rms and PLCs
Demiroglu and James (2009)
US
P2P LBOs
Leslie and Oyer (2009)
US
P2Ps that IPOd
Meuleman, Amess, Wright and Scholes (2009)
UK
Divisional, family and secondary buy-outs
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REfERENcES
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Privateequity Updated 2012 Final

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PRIVAte EQUItY DeMYStIFIeD: 2012 UpDAte

John Gilligan and Mike Wright FINANCINg CHANge INItIAtIVe

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PRIVAte EQUItY DeMYStIFIeD: 2012 UpDAte

Private Equity Demystied: 2012 Update

6.12  Do private equity deals and buy-outs have adverse effects

Private Equity Demystied: 2012 Update

LIST OF FIGURES AND TABLES

Private Equity Demystied: 2012 Update

ABOUT THE AUTHORS

Private Equity Demystied: 2012 Update

John Gilligan Mike Wright April 2012

Private Equity Demystied: 2012 Update

1. OBJECTIVE OF THE 2012 UPDATE

Private Equity Demystied: 2012 Update

2. KEY CONCEPTS AND DEFINITIONS

Private Equity Demystied: 2012 Update

Private equity fund

Shareholders Pension fund trustees

Neg otiat ion

Private Equity Demystied: 2012 Update

1000 % return on equity invested

800 600% 433% 400 350% 300% 267%

0 10 20 30 40 50 60 70 80 90 100 % of price funded by equity invested

Private Equity Demystied: 2012 Update

Private Equity Demystied: 2012 Update

Private Equity Demystied: 2012 Update

3. WHAT DO THE CRITICS OF PRIVATE EQUITY SAY?

Private Equity Demystied: 2012 Update

Private Equity Demystied: 2012 Update

4. WHAT ARE THE ROLES OF PRIVATE EQUITY MANAGERS?

0 2005 2006 2007 Year

Private Equity Demystied: 2012 Update

Private Equity Demystied: 2012 Update

Figure 4.3: Dry powder by vintage 20082010

15,000 m 10,000 5,000 0

Private Equity Demystied: 2012 Update

Source: CMBOR/Ernst & Young/Equistone Partners Europe.

20 02 20 I 02 II 20 I 03 20 I 03 I 20 II 04 20 I 04 III 20 05 20 I 05 II 20 I 06 20 I 06 III 20 07 20 I 07 II 20 I 08 20 I 08 II 20 I 09 20 I 09 II 20 I 10 20 I 10 II 20 I 11 20 I 11 III

Private Equity Demystied: 2012 Update

Figure 4.5: UK buy-out market by number of transactions

Private Equity Demystied: 2012 Update

MBO number Buy-in number Total number

Source: CMBOR/Ernst & Young/Equistone Partners Europe.

04 I 04 III 20 05 20 I 05 II 20 I 06 20 I 06 III 20 07 20 I 07 II 20 I 08 20 I 08 II 20 I 09 20 I 09 II 20 I 10 20 I 10 II 20 I 11 20 I 11 III 20

Private Equity Demystied: 2012 Update

20,000 m 15,000 10,000 5,000

0 2002 2003 2004 2005 2006 Year

Private Equity Demystied: 2012 Update

0 2002 2003 2004 2005 2006 Year

0 2002 2003 2004 2005 2006 Year

Under 10m 10m100m Over 100m

Private Equity Demystied: 2012 Update

Equity Debt Other

Private Equity Demystied: 2012 Update

Figure 4.17: Buy and build acquisitions by buy-outs

Percentage by number Percentage by value

Private Equity Demystied: 2012 Update

Source: BVCA/PwC 2010.

Private Equity Demystied: 2012 Update

Value of outstanding debt

Net book value of assets

Private Equity Demystied: 2012 Update

Source: BVCA/PwC 2010/2009/2008.

6.12 Do private equity deals and buy-outs have adverse effects