Another View: Taking a Page From Private Equity
The New York Times, December 9, 2008
As icons of Corporate America struggle to stay afloat, they would do well to revisit the rules of private-equity investing — that’s the view of Jonathan F. Foster, founder and managing director of the private equity firm Current Capital. Mr. Foster was previously co-head of diversified industrials and services investment banking at Wachovia Securities and spent more than 10 years at Lazard, where he established a financial sponsors group that works with private equity firms.
The private equity model is, in simple terms, one where equity capital is invested along with substantial leverage, and management’s interests are aligned with those of all shareholders, to create long-term value. This asset class has evolved tremendously and grown geometrically since the first significant leveraged buyout, the acquisition of Houdaille Industries by Kohlberg Kravis Roberts in 1979.
Today, there are literally hundreds of private equity funds and various publicly traded private-equity vehicles. Many large pools of investment capital have at least some allocation to private equity.
In fact, the Pension Benefit Guaranty Corporation, the federal agency that insures pensions in the United States, has changed its asset allocation to include private equity.
Some critics say that private equity has “lost its way,” claiming, among other things, that so-called megafunds act more like asset managers than hands-on investors, and that private equity firms being publicly traded is, at a minimum, a contradiction in terms. Critics also argue that private equity being invested in PIPEs — private investments in public equity — is inappropriate: Why pay the private equity firm’s fees when you can just buy the public securities in the marketplace?
Nonetheless, numerous studies have shown that private equity capital has proven to be an effective way to build value. In today’s stunningly disrupted equity markets, the basic rules of successful private equity investing have been broken, with disastrous results for investors and other stakeholders across the globe. What are the basic tenets of private equity?
- Back proven executives.
- Align management’s interests with those of all shareholders.
- Invest for the long-term, not the next few quarters.
- Reduce costs as appropriate.
- Put in place a capital structure that facilitates growth.
Three industries exemplify the causes and symbols of the current financial extremes: housing (which saw too much building driven by too much easy credit), automotive (too little attention to costs and too little anticipation of consumer preferences) and banking (too aggressive with risk-taking).
Senior executives in the housing sector were driving for continued, explosive quarterly growth, not long-term earnings. While no one should be blamed for trying to increase cash flow faster, quality or reliability of earnings is important, too. It is hard to believe that, as huge, cookie-cutter developments continued to move from the suburbs to the “exurbs” and across the country, housing starts set new records month after month, and “subprime” became not only a generally recognized term but a lending practice with virtually no credit analysis, most major builders continued to be, well, major builders — until the lending stopped. Private Equity Rule No. 3 was violated.
How sad it has been to see the chief executive officers of the largest automotive companies go to Washington to literally beg for financial help. The automotive industry accounts, in some way, for perhaps 3 million jobs. So, whatever your politics, it seems fair to at least give these executives a hearing. However, it has quickly become clear that these companies have violated Private Equity Rules No. 2 and 4.
Remarkably, three of the most visible corporate leaders in this country initially went to Congress without a carefully developed business plan. Yes, we have a health care cost problem in America. However, the automotive companies have simply postponed this pain for so long, that, on top of its inability to anticipate customer tastes, Detroit may be too far gone to rescue.
Finally, it was unfortunate that each of these stewards of formerly iconic brands came to our nation’s capital as heads of desperate companies, yet each in his own private jet. The difference in cost in round-trip private jet flights and commercial flights between Detroit and Washington is immaterial to the Big Three. Nonetheless, it is a terrible symbol and shows a clear disconnect between the interests of the management team and the other stakeholders. It was appalling that, in response to a question, not one C.E.O. agreed to give up his private jet if the bailout, which apparently is needed to protect the major automotive companies and millions of jobs, is provided. Of course, the public-relations disaster that ensued resulted in these executives driving from Detroit to Washington last week for further hearings.
While the banking industry is strewn with formerly powerful institutions that either no longer exist or are shadows of their former selves, such as Bear Stearns, Lehman Brothers and Washington Mutual, one of the most startling falls from grace is that of Citigroup. The third-largest bank in the United States by deposits, this financial services beacon operates in some 100 countries. Its market value has fallen from about $300 billion to about $40 billion; today’s market value is, astonishingly, less than the capital it has raised in the last year. In other words, the market effectively attributes no current value to Citigroup’s brand, people and other assets.
At the same time, Citigroup’s board of directors has violated Private Equity Rules No. 1, 2 and 5. The company’s current chief executive is a well-respected former investment banker. However, in 2006, Citigroup’s last full year under its prior chief executive, the bank derived less than 40 percent of its revenues from investment banking and alternative investments. Moreover, when Citigroup acquired the hedge fund founded and run by the bank’s current chief, he was apparently not required to reinvest any of his proceeds in Citigroup stock. It is typical to have senior executives who realize liquidity in a private-equity-sponsored transaction reinvest a meaningful portion of their proceeds in the acquisition company.
Finally, much has been written about Citigroup’s accelerated risk-taking. Its capital structure was less structured for growth than it was for remarkably aggressive trading.
Private equity has played a major role in resuscitating many moribund companies and accelerating growth in many others. Today, in the midst of the most challenging economic conditions since the Great Depression, we would be wise to carefully consider the simple yet effective maxims of the original, successful private equity approach.