What do the fabled chief executives of top corporations do when they retire?
Many golf, sail, or write their memoirs ? but a growing number of them get involved in the lucrative world of private equity.
? Jack Welch, the former CEO of General Electric, evaluates buy-outs for the $6 billion private equity firm, Clayton, Dubilier & Rice.
? IBM’s former CEO, Lou Gerstner, is now chairman of the $35 billion Carlyle Group in Washington, which is also the business home of former U.S. President George H.W. Bush.
? Jacques Nasser, former CEO of Ford Motor Company, serves as chairman for Equity Partners, a $5 billion firm.
Similarly, the retired presidents or CEOs of Continental Airlines, Viacom, and the Target Corporation have all made the move to private equity.
In addition, the world of private equity and fast buy-outs is scooping up top management talent at mid-career.
Furthermore, many of the top MBA stars graduating from the nation’s best business schools are joining private equity firms.
Why is this happening?
One answer is that the offers are simply too good to refuse.
People like Jack Welch are obviously making enormous sums of money, but even the new MBA grads are making far more than they would anywhere else by choosing private equity firms.
In addition, top executives who have slaved to make their quarterly numbers for investors find themselves suddenly freed from this relentless treadmill by moving into the private equity sector.
There, the rules and pressures are far less stringent.
A big part of the appeal, as the Trends editors predicted, is that they don’t have to worry about the Sarbanes-Oxley Act in the same way.
By opting out of the publicly-held world, they can simply sidestep the SEC.
They don’t have to disclose how much money they make. Moreover, they can build for the long term, instead of worrying about Wall Street analysts breathing down their necks.
Sometimes, drastic measures are needed to turn around a failing corporation and, in the private equity sector, CEOs can take those steps without worrying about protests from shareholders, activist hedge funds, or the public.
For example, Bear Stearns Merchant Banking bought Lerner New York from The Limited, renamed it New York & Company, and remodeled or opened 260 new stores, doubling the number of venues.
In a public company, this would have been viewed as an outlandish expense.
But in private equity, it’s seen as a necessary strategy to turn around a poorly performing company.
And with private ownership, it’s possible to cut bureaucracy to the core and become much faster and more flexible at making decisions.
As Lou Gerstner told BusinessWeek1 in a recent cover story, “The private equity industry allows an organization, or a part of [one], that is operating at a subpar level to be spun off, refinanced, reenergized, [or] refocused.
It’s a very significant part of what is going on in the world today.”
There are many other theories for why this is happening, but most observers believe that this trend has emerged for a very basic reason:
Private equity is simply more profitable for those involved.
The private firms do not like to disclose the details of their finances, but we can get a sense of how much money is being made by looking at the general rules for how the game works.
First, private equity partners take 1.5 to 2 percent of the total amount of money in the fund each year, according to Forbes2 magazine.
If they manage $1 billion, for example, they might pay expenses of $10 million.
That leaves $5 million for the partners to divide. With only four to six partners in a typical private equity partnership, that’s a big payday.
The partners also collect 20 percent of profits.
So if they sell a company they own at a profit of $1 billion, the partners would split $200 million.
Making this even more attractive is the fact that, as a long-term capital gain, that money is taxed at 15 percent ? compared with 35 percent for CEO salaries.
Forbes’ list of the wealthiest Americans last year included 10 who were partners in private equity firms.
Even those CEOs who aren’t partners can do extremely well.
Their salaries are not typically high, but because the companies they run are privately owned, they can be paid in equity. This part-ownership of the company gives them a huge incentive to make a profit.
In this kind of arrangement, the CEO of J. Crew earns $200,000 in salary, which is considered low, but he owns 22 percent of the company.
J. Crew is expected to go public this year, at which point he could reap $300 million in new wealth.
Although there is risk involved in that situation, public companies simply have nothing to offer a CEO that can compare with the upside of taking a company public because, of course, they are already public.
The investment banks find the private equity business appealing because of the fees they earn.
Blackstone Group, the largest private equity firm of all, paid out $358 million in such fees last year.
The banks earn additional fees for consulting services, brokering deals, underwriting, and the hefty loans private equity firms take out to support the companies they buy.
Then if all goes well ? or even if it doesn’t ? the banks are paid yet more fees for taking the company public. Such IPOs raised $35 billion last year. And, all in all, investment banks earned almost $12 billion in fees in 2005.
The buy-out business is even more profitable for the private equity firms themselves, bringing in about 20 percent a year return on investment, compared with an average of 5 percent for S&P 500 companies.
This trend is changing the career cycle for many people.
Instead of fading into the sunset after being the head of a public company, senior executives are moving into the hot and exciting world of private equity and writing an unprecedented new chapter in their careers.
They might conduct a successful buy-out, bring the company up to par, and then take it public again, completing the entire cycle. Then, they go back and do it again.
This invigorating work is attracting more people who are climbing the ladder at public companies, too.
They see private equity as a way to accelerate their drive toward independence and toward becoming the CEO of their own company.
At the entry level, graduating students are seeing that they can simply make more money and see more action in the buy-out game.
Harvard MBAs earned an average of $174,000 in starting salary in private equity, compared with $135,000 for other types of jobs. Stanford graduates earned $232,000 in private equity compared with $140,000 in other sectors.
And, a few new MBAs are paid starting salaries as high as $300,000 at some firms.
This makes private equity the hottest business there is right now, with some $800 billion of capital in play ? which is more than the entire housing market.
And, while only a handful of firms controlled more than $1 billion in private equity 15 years ago, today there are 260 firms of that size.
The three top private equity firms own businesses with nearly a million employees.
And companies owned by Blackstone, Carlyle Group, and Texas Pacific Group have $122 billion in sales.
Buyouts magazine counts $174 billion of new investment pouring into private equity last year alone.
Forbes estimated the number at only $106 billion, but either way, it’s more than double the previous year.
Worldwide, there are an estimated 2,700 funds, holding half a trillion dollars.
Counting the loans these firms have taken out, this represents $2.5 trillion in investment. Of these 2,700 firms, the six largest control half of all that money.
With all this money ? and banks eager to lend them more ? private equity firms are targeting larger and larger acquisitions, such as Neiman Marcus, Metro-Goldwyn-Mayer, Toys ‘R’ Us, Burger King, and Hertz.
According to the New York Times,3 the buy-out specialists are taking real estate investment trusts private at an accelerating rate as well.
Since 2004, a dozen of these huge, formerly public companies, which handle diverse real estate holdings, have been snapped up by private equity firms.
Blackstone recently bought CarrAmerica Realty for $5.6 billion. And, another 10 deals may well be in the offing in the near future.
Now Blackstone is raising $13 billion in new capital to extend its holdings.
Just last year, Blackstone’s previous REIT fund increased its value by 70 percent for investors. A number of the best funds boasted 50 percent returns or better.
While this trend is producing a great deal of excitement for insiders and those trying to get inside, it’s also drawing criticism from some quarters, including academia.
Some see the rush toward privatization of the American business landscape as a drain on talent and resources.
At the University of Pennsylvania’s Wharton School, some scholars worry that there aren’t enough of the checks and balances that stockholders and regulators bring to public companies.
Private companies don’t have to be transparent, so investors don’t always know what, precisely, they’re investing in. Scholars from both the University of Chicago and MIT complained that the numbers that private equity funds report aren’t accurate.
While the firms claim to beat the S&P 500 by at least five points each year, two professors recently charged that, in fact, they have been lagging behind S&P results since the 1980s.
In addition, some critics, recalling the buy-out craze of the 1980s that ended badly, worry that in turning around the companies they buy, private equity firms saddle the companies with too much debt to make them profitable when they return to the public sector.
For example, when a group of private investors bought Warner Music Group for $2.6 billion in 2004, they took $1.4 billion in dividends for themselves ? and saddled the company with $700 million in new debt.
Some see this as just an easy way for partners to get instant cash bonuses. Standard & Poor’s estimated that partners had taken out some $18 billion in this way just last year.
Others view the trend as a bubble, with the enormous sums of new money pushing the prices of companies beyond reasonable levels.
Any change in interest rates, they worry, could cause the bubble to burst and the whole house of cards to collapse.
Still other critics worry that pension plans, which have put up some 40 percent of the money now in the buy-out funds, will suffer if the bubble bursts.
The buy-out fever of the 1980s, which was begun by Blackstone, saw one deal every day being closed by 1988, totaling $99 billion in that year alone.
It peaked with what is still the biggest deal ever, the takeover of RJR Nabisco by Kohlberg Kravis Roberts; that deal would be valued at $49 billion in 2005 dollars.
The next six largest deals of all time all took place last year. And, almost three-dozen companies, with a combined value of $54 billion, were bought up in 2005.
With these facts in mind, where is the private equity trend headed?
We offer the four following forecasts:
First, in the short term, expect the private equity sector to continue being a magnet for executives and MBA graduates; and expect it to remain an area fraught with controversy.
With so many diverse players in the field, performance will be uneven.
You’ll see a few great companies at one end of the curve, a few scoundrels at the other, and an increasing number of mediocre firms in the middle.
This is already being typified by a number of contentious lawsuits in which it appears that corporate pillagers may have “played fast and loose” with investors’ money, while looting a corporation of its assets.
Second, the result of this will be a period of shakeout later in the decade.
This will be typified by high-profile cases, such as the various lawsuits surrounding the purchase of KB Toys by Bain Capital.
Bain put in $18 million, and borrowed another $237 million, to complete the purchase.
It then took on $66 million in additional debt for KB Toys, and took $121 million of its cash to pay itself, Bain Capital, $85 million, even while paying another $36 million to its executives.
In the process, the weakened toy company lost $109 million in two years and filed for bankruptcy in 2004.
It shut 1,200 stores, laid off half its employees, and paid off some $218 million in debt at just eight cents on the dollar.
Big Lots, which originally sold KB Toys to Bain, lost $45 million it was owed and is now suing for fraud.
Another private equity firm, Prentice Capital, bailed KB Toys out for $20 million, and now is being sued by the creditors who received eight cents on the dollar.
Third, when this legal and financial free-for-all becomes the norm, expect lawmakers to respond by trying to regulate the private equity business.
A law similar to Sarbanes-Oxley will be proposed for private companies and a fierce battle over it will ensue.
The objective will be to protect creditors and employees.
High-profile cases, like Michael Dell’s recent acquisition of Monsanto’s Equal sweetener, won’t make things any easier.
Through a series of loans against the company, Dell’s equity business, Pegasus Capital, realized a 76 percent profit on its investment, even while Equal’s net worth went into negative territory to the tune of $130 million.
Fourth, within a decade, expect the private equity fad to become as discredited as dot-com IPOs and junk bonds ? until the cycle begins again.
This financial vehicle of choice will fall out of favor again and “go into hiding” until the conditions are once again right for this kind of solution.
Value-destroying legislation will be avoided, because reputable private equity firms will exert influence that will more than offset the negative publicity generated by the unethical firms.
And, when the best funds return their acquired companies to the public sector in successful IPOs, those companies will be stronger and leaner than before.
In that role, people will ultimately see that private equity benefited all players by optimizing the process of creative destruction. References
1. BusinessWeek, February 27, 2006, “Going Private,” by Emily Thornton, with Nanette Byrnes, David Henry, and Manjeet Kripalani. ⓒ Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
2. Forbes, March 13, 2006, “Private Inequity,” by Neil Weinberg and Nathan Vardi. ⓒ Copyright 2006 by Forbes, Inc. All rights reserved.
3. The New York Times, March 15, 2006, “A Trend for Public REITs,” by Terry Pristin. ⓒ Copyright 2006 by The New York Times Company. All rights reserved.
