Private Equity: Hero or Villain?

The battle for the Republican presidential nomination seems to have claimed another "financial markets" casualty, at least in public opinion. In the last few weeks, we have seen Mitt Romney, who made his fortune at Bain Consulting, attacked for being a heartless, job-destroying private equity investor. I prefer not to enter political debates, but some of the critiques of private equity are so misdirected and over the top that I have to believe that these critics have no sense of what private equity is, the companies that they target and what they do at these companies. 


What is private equity?
If asked to provide a prototype of a private equity investor, many critics present you with Gordon Gekko , endowed with all of the characteristics that they want to attribute to a villain: a greedy, immoral man who delights in inflicting pain on the less fortunate. I could tell you that most private equity investors that I know don't even come close to that stereotype, but that is unlikely to convince anyone. In my view, here are the three ingredients for an investor to qualify to be a private equity investor:

1. Equity: At the risk of stating the obvious, to be a private equity investor, you have to be an investor in equity, either in publicly traded companies (as stock) or in private business (as owners' equity). So any criticism of private equity that segues into mortgage backed securities, which are generally debt, or into overreach at investment banks prior to 2008 is mixing up its villains.
2. Activist: A second feature of that separates private equity investors from most other equity investors is that they are activist, rather than passive investors. Thus, you and I, as passive investors, may buy stock in a company, believing it to be under valued or sub optimally managed, and then sit back and hope that the price moves up. An activist investor would buy stock in the same company and put in motion actions aimed at changing the way the company is managed (shutting down bad businesses, take on more debt, pay more dividends) or in fixing the reasons for under valuation (spin off, split offs, divestitures).
3. Private: While activist equity investors have been around as long as markets have been around, there is a third aspect to private equity investing that sets it apart. Private equity investors preserve the option (though they don't always use it) of "taking private" some of their targeted publicly traded companies. In effect, they remove these companies from the public space, run them as private companies for a period of time (during which they make changes), and then either go public again or sell them to other public companies.

With this definition in place, you still see diversity within this group. Broadly speaking, private equity investors can be classified into three categories: lone wolves (like Carl Icahn, Nelson Peltz and Bill Ackman), institutional activists (mutual funds and pension funds that trace their lineage back to the Calpers fund in the 1980s and are activist on the side) and activist hedge funds (which is where I would put Romney's Bain fund, KKR and Blackstone).


What types of companies do private equity investors target?
If activist investors hope to generate their returns from changing the way companies are run, they should target poorly managed companies for their campaigns.

• Institutional and individual activists do seem to follow the script, targeting companies that are less profitable and have delivered lower returns than their peer group. 
•  Hedge fund actvists seem to focus their attention on a different group. A study of 888 campaigns mounted by activist hedge funds between 2001 and 2005 finds that the typical target companies are small to mid cap companies, have above average market liquidity, trade at low price to book value ratios, are profitable with solid cash flows and pay their CEOs more than other companies in their peer group. Another study of the motives of activist hedge funds uncovered that the primary motive is under valuation, as evidenced in the figure below.

In summary, the typical activist hedge fund behaves more like a passive value investor, looking for under valued companies, than like an activist investor, looking for poorly managed companies. Activists individuals are more likely to target poorly managed companies and push for change.

What do they do at (or to) these targeted companies?

The essence of activist investing is that incumbent maangement is challenged, but on what dimensions is the challenge mounted? And how successfully? A study of 1164 activist investing campaigns between 2000 and 2007 documents some interesting facts about activism:

• Two-thirds of activist investors quit before making formal demands of the target. The failure rate in activist investing is very high.
• Among those activist investors who persist, less than 20% request a board seat, about 10% threaten a proxy fight and only 7% carry through on that threat.
• Activists who push through and make demands of managers are most successful (success rate in percent next to each action) when they demand the taking private of a target (41%), the sale of a target (32%), restructuring of inefficient operations (35%) or additional disclosure (36%). They are least successful when they ask for higher dividends/buybacks (17%), removal of the CEO (19%) or executive compensation changes (15%).  Overall, activists succeed about 29% of the time in their demands of management.

A review paper of hedge fund activist investing finds that the median holding for an activist hedge fund is 6.3% and even at the 75^th percentile, the holding is about 15%. Put differently, most activist hedge funds try to change management practices with well below a majority holding in the company. The same paper also documents an average holding period of about 2 years for an activist investment, though the median is much lower (about 250 days).

Following through and looking at companies that have been targeted and sometimes controlled by activist investors, we can classify the changes that they make into four groups as potential value enhancement measures:

1. Asset deployment and aperating performance: There is mixed evidence on this count, depending upon the type of activist investor group looked at and the time period. Divestitures of assets do pick up after activism, albeit not dramatically, for targeted firms. There is evidence that firms targeted by individual activists do see an improvement in return on capital and other profitability measures, relative to their peer groups, whereas firms targeted by hedge fund activists don’t see a similar jump in profitability measures.
2. Capital Structure: On financial leverage, there is a moderate increase of about 10% in debt ratios at firms that are targeted by activist hedge funds but the increase is not dramatics or statistically significant. There are dramatic increases in financial leverage at a small subset of firms that are targets of activism, but the conventional wisdom that activist investors go overboard in their use of debt is not borne out in the overall sample. One study does note a troubling phenomenon, at least for bond holders in targeted firms, with bond prices dropping about 3-5% in the years after firms are targeted by activists, with a higher likelihood of bond rating downgrades.
3. Dividend policy: The firms that are targeted by activists generally increase their dividends and return more cash to stockholders, with the cash returned as a percentage of earnings increasing by about 10% to 20%.
4. Corporate governance: The biggest effect is on corporate governance. The likelihood of CEO turnover jumps at firms that have been targeted by activists, increasing 5.5% over the year prior to the activism. In addition, CEO compensation decreases in the targeted firms in the years after the activism, with pay tied more closely to performance.

Do private equity investors make high returns?

The overall evidence on whether activist investors make money is mixed and varies depending upon which group of activist investors are studied and how returns are measured.

• Activist mutual funds seem to have had the lowest payoff to their activism, with little change accruing to the corporate governance, performance or stock prices of targeted firms. Markets seem to recognize this, with studies that have examined proxy fights finding that there is little or no stock price reaction to proxy proposals by activist institutional investors.  Activist hedge funds, on the other hand, seem to earn substantial excess returns, ranging from 7-8% on an annualized basis at the low end to 20% or more at the high end. Individual activists seem to fall somewhere in the middle, earning higher returns than institutions but lower returns than hedge funds.
• While the average excess returns earned by hedge funds and individual activists is positive, there is substantial volatility  in these returns and the magnitude of the excess return is sensitive to the benchmark used and the risk adjustment process. Put in less abstract terms, activist investors frequently suffer setbacks in their campaigns and the payoff is neither guaranteed nor predictable.
• Targeting the right firms, acquiring stock in these companies, demanding board representation and conducting proxy contests are all expensive and the returns made across the targered firms have to exceed the costs of activism. While none of the studies that we have reference hitherto factored these costs, one study that did concluded that the cost of an activist campaign at an average firm was $10.71 million and that the net return to activist investing, if these costs are considered, shrink towards zero. 
• The average returns across activist investors obscures a key component, which is that the distribution is skewed with the most positive returns being delivered by the activist investors in the top quartile; the median activist investor may very well just break even, especially after accounting for the cost of activism.

Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially:

Is private equity good or bad for the markets? How about for the economy? And for society?
For some of you, this entire post may be missing the point of the criticism, which is that private equity investors are job killers, not job creators. To me, that criticism is misplaced, because you cannot measure the success of a business by the jobs it creates or saves, but by the value it creates for its stockholders, by making money, and for its customers, by providing a needed product or service to customers. In the process, if it is successful, it will hire people and create jobs.
In fact, today's New York Times carries a story about one of the companies targeted by Bain in its Romney days, where 150 people lost their jobs, and it specifies that the company primary products was photo albums. Thus, while it is easy to blame Bain for the layoffs, the real reasons lay in a shifting market, where digital photography and computerized albums were replacing conventional photographs. The story's bigger point is that the people in the town have moved on, found other businesses to work for and are frankly surprised by the attention.
Since the critics are using fictional characters to beat up private equity investing, I will use one of my favorite fictional characters, from a great movie, "Other People's Money", to counter:


If private equity investors are primarily interested in slimming down companies and creating value for stockholders, do they create value for society? I believe that they do, and for two reasons. First, they are the battering rams that we use as passive investors to initiate and create change at public companies, and especially at companies that need to change. Second, even when private equity investors target companies, force them to divest assets, slim down and pay out the cash to stockholders, the cash does not disappear into thin air. The stockholders who receive the cash use it to pay for products and services (which creates jobs) and to invest in other companies with better growth prospects (which in turn hire more people).
In fact, my response to those who have a problem with private equity would be to ask the following question: Which aspect of private equity investing do you want to ban? Assuming that it is not equity investing collectively, it has to be either the activism or the "taking private" components. And what would that accomplish? Banning these practices would leave incumbent managers ensconced at publicly traded companies, unchallenged and unwilling to make changes, and the only jobs saved will be theirs.

Bottom line: If you don't like Mitt Romney, don't vote for him. Find a good reason, though! The fact that he worked at a private equity firm, and was good at his job, should not be that reason. In fact, since the US government looks more and more like a badly managed enterprise in need a major restructuring, a "good private equity investor" in charge may be just what the doctor ordered.