Margin of Trust by Lawrence A. Cunningham

Author:Lawrence A. Cunningham
Language: eng
Format: epub
Tags: BUS041000, Business & Economics/Management, BUS104000, Business & Economics/Corporate Governance
Publisher: Columbia University Press
Published: 2020-01-14T00:00:00+00:00

Private Equity

Berkshire’s preferences can be contrasted with that of PE, once known as leveraged buyout (LBO) firms. The PE or LBO business model and philosophy are at the other end of the spectrum from that of Berkshire Hathaway in nearly every way.

Having arranged for the purchase and sale of thousands of U.S. companies, the PE industry has structured mountains of debt, generated enormous fees from merger advisory work, and reaped additional gains from innumerable consulting services.

The PE business model involves creating a series of separate funds that buy, run, and sell a discrete number of individual companies, relying on massive borrowing. A typical fund deal is financed with at least 70 percent debt.2

Moreover, virtually all equity—all but 1 or 2 percent—is staked not by the firm but by outside investors solicited in private placements facilitated by intermediaries, including pension plans, university endowments, rich families, sovereign wealth funds, banks, and insurance companies.3

In form, funds are dubbed partnerships, with the PE firm as the general partner and each such equity investor a limited partner. The attitude, however, is hierarchical, with the general partner calling all shots in a setting rife with conflicts of interest.4

The PE firm, as general partner, is far less an investor than a multiline intermediary. In a typical arrangement, the PE firm collects 2 percent of investors’ equity called a “management fee” plus 20 percent of the return on investment above a hurdle rate (typically 8 percent) dubbed “carried interest.”

In addition, the PE firm levies extensive fees for a wide variety of activities it might engineer, such as board service on acquired companies, strategic consulting, executive search, merger guidance, and financing advice.

PE’s time horizon for deals is far more short term than long term, and it is never indefinite. Rather, purchases and subsequent steps are all conducted with a focus on exiting by maximizing profits and minimizing duration. Purchases are not made without an exit strategy—ideally, a premium-priced public offering or a sale to a strategic buyer or another financial buyer.

As with most other activities that PE firms conduct on behalf of the funds and companies they buy, the firm charges fees to make such arrangements. When buying and selling, PE firms favor formal valuation models, such as earnings multiples, rather than traditional business analysis of the kind Berkshire and other long-term investors apply.5

Operational change is usually part of every takeover plan. Although PE operators may look for incumbent managers to remain in place, weak management is often blamed for a target’s struggles and the takeover includes reshuffling or replacements. In every case, intervention is deep, as the PE firm provides close direction to managers to execute the plan and conducts careful monitoring.

Cost reductions are often part of the plan, meaning the PE firm directs not only management changes but also plant closings, layoffs, research and development cuts, product terminations, pension reductions, and other business surgery with clear-cut short-term gains. The long-term prudence of such steps is not the focus.

Financial engineering is at the heart of many PE deals, all involving substantial and costly intermediation.

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