Private Equity, Public Gain

Let's lay to rest the myths about private equity, once and for all. There's no question PE is a boon to society

by Bill George

Recent turmoil in credit markets and hedge fund losses, along with the public offering of the Blackstone Group (BX), have reignited controversies over the growing power of private equity. Critics call private equity outfits such as Blackstone (BusinessWeek.com, 7/26/07) the new robber barons, ready to plunder great corporations and leave them in a shambles.

Nothing could be further from the truth. The dynamic leadership of private equity is providing great benefits to corporations, the economy, and society.

Let's take a closer look at some myths about private equity:

Myth No. 1: PE's growing power threatens public corporations.

Unlike the deals done by the raiders of the 1980s (such as Michael Milken, Irwin Jacobs, and Carl Icahn), private equity deals are friendly. Private equity shows up when public buyers aren't interested. For example, when Daimler (DCX) put Chrysler up for sale, automobile companies declined to bid, so Cerberus Capital Management stepped up to take on Chrysler's challenges.

Myth No. 2: Under private equity, acquired firms get torn apart and their value destroyed.

To the contrary, private equity does the kind of restructuring public companies wouldn't undertake. Managers of public companies are often reluctant to make these massive changes because they are trying to protect their short-term earnings and stock price, or are locked into a traditional view of their companies. PE firms achieve high returns by creating value that public managers didn't see, and monetize their gains by going public once again.

When Blum Capital Partners purchased real estate giant CB Richard Ellis Group, the firm was restructured and taken public after three years. In three years, CB Richard Ellis' (CBG) market value has grown 600%, from $1.3 billion to $9.1 billion.

Myth No. 3: CEOs are fleeing public companies to avoid the scrutiny of demanding investors.

If they are, they're in for a rude awakening. Private equity investors are far more demanding than public investors and more engaged in the business.

Look at venerable Sears Roebuck (SHLD), whose retail sales and market valuation slumped for 20 years. When ESL Investments' Eddie Lampert purchased Sears, he consolidated it into bankrupt Kmart, monetized its real estate, and took it public. Four years later, its stock has risen 10 times.

Myth No. 4: The greed of private equity owners is harming the economy.

PE owners have their personal money at risk. They give the economy new vitality by restructuring moribund corporations and making them healthy and competitive. These revitalized competitors reduce the economic drag from poorly managed firms.

What enables PE firms to perform so well?

1. They take on high leverage and spread risk. High liquidity and low cost of debt make the PE model very attractive. To mitigate the risk, PE firms spread their debt across many companies. Public companies that cannot meet debt obligations are bankrupt, à la Delphi (DPHIQ) and Delta Air Lines (DAL). If a PE-owned company gets in trouble, the PE firm covers the losses from its diversified balance sheet.

2. They compress the time frame for changes. PE firms don't waste time making changes. They move with surgical precision, compressing 10 years of changes into three. They are unconcerned with internal objections, reluctant boards, or unfavorable publicity. All too often, public company executives worry about quarterly earnings, morale, and external criticism, and wind up rationalizing problems with "quick fixes" rather than addressing fundamental issues.

3. Leadership: PE managers are leaders, not just financial engineers. PE attracts highly talented leaders to run its firms and to run acquired companies. Their leadership is extremely intense and focused on results.

So what's the risk of PE's growing power? First, turmoil in the financial markets and the resulting liquidity crunch have made it difficult for PE to fund the high levels of debt required to make its models work. Second, with more money chasing fewer deals, there is the risk of private equity overpaying for companies, and not being able to monetize gains by going public once again.

Third, PE benefits from paying capital-gains taxes rather than ordinary income tax. Tax loopholes benefiting PE are wrong: Public and private firms should play by the same rules.

Finally, it is questionable whether PE works for well-run, long-payout businesses such as high tech, pharmaceuticals, and aerospace. Thus far, PE firms have steered clear of these industries.

If the benefits of the PE model are so evident, shouldn't public companies do the same thing? Why not look at their business as if it were acquired by PE? Where would they find value? What would they jettison? If they can make these changes without damaging long-term value, publicly held firms should absolutely take similar actions.

The bottom line? Private equity is good for business and for the economy. It will be around for a long time.

George, professor of management practice at Harvard Business School, is the author of two best-selling books, True North and Authentic Leadership. The former chairman and chief executive of Medtronic, he serves on the boards of ExxonMobil, Goldman Sachs, and Novartis.