Private Equity Redux


By Jack & Suzy Welch What's your opinion about all the hoopla surrounding private equity lately? — Dev Patel, Chicago

We think it looks a lot like a movie we've seen before, from its exciting action scenes, to its scary parts, to its larger-than-life heroes and their headline-grabbing foes. It even seems like this movie is going to have the same ending: a contentious climax and then a swift resolution that leaves a few people disappointed but most people feeling like they got their money's worth. In other words, we think the controversy surrounding private equity today is pretty darn similar to the clamor that accompanied what was called the LBO movement in the late 1980s. And that resemblance can only tell us one thing—that capitalism is working, with its cycles and ever-increasing competitiveness.

So to answer your question, we think the hoopla is just hoopla, and when the industry eventually cools off, most people will see the latest run of private equity for what it was, a galvanizing mechanism that directly made several thousand companies more productive and indirectly made the American economy more competitive than ever.

Now, that conclusion might not sound surprising given our typical pro-business stance and the fact that one of us (Jack) spent the 80s involved in dozens of leveraged buyouts. But our view on private equity today also grows out of more current participation: Over the past six years, Jack has worked with the private equity firm Clayton, Dubilier & Rice. That experience has confirmed for us why private equity deserves not disdain but appreciation. Because private equity almost always creates thriving businesses. It makes a company's vision clear and goals measurable. It tightly aligns goals with compensation systems. It creates an exciting ownership mentality, unleashing renewed passion from employees. And it does all those things fast.

We're often asked: "Can't regular companies do all the same things?" Some do, of course, but too many do not for myriad reasons, including entrenched management, inertia, fear of change, bond rating concerns, and neglect. Left to their own devices, too many companies also fail to install the kind of governance you find in private equity firms, where owners and managers with skin in the game take the place of directors who fly in every other month to maintain the status quo. In private equity, board meetings center not on questions like, "Has anything happened to embarrass us lately?" but on comments such as, "Forget the quarter. Make the investment." Put it all together, and no wonder private equity makes companies so competitive.

YES, THAT COMPETITIVENESS has, in turn, made some high-profile entrepreneurs very rich, like Steve Schwarzman, whose Blackstone (BX) IPO made billionaires out of, well, founders. But private equity has also been responsible for widespread wealth creation. The pension funds of teachers unions and all types of employees in the public and private sectors are major beneficiaries. Indeed, private equity has done more to enhance the security of retirement funds than most other kinds of investment. The winners: not only several thousand bankers but millions of ordinary workers.

And yet, the debate over private equity continues to intensify. Witness the recent call for an increase in the industry's tax rates. Incidentally, that's a repeat scene, too. In the late 80s, Congress imposed a levy on corporate pension fund withdrawals that were being used to fund LBOs.

Regardless of whether tax legislation occurs now or not, the private equity cycle will play out. Look, private equity thrives when businesses, underperforming for whatever reason, can be bought at attractive prices with low-cost money. Inevitably, though, those deals dry up. That's what happened last time. With EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples climbing from 5 to 6 to 7 to 8 to 9 and credit getting more expensive and restrictive by the day, private equity continued buying less promising companies at a premium. The poster child for this dangerous dynamic was Federated Department Stores. It declared bankruptcy in 1990.

Today, a property available at a single-digit EBITDA would be rare and wondrous, which is why, perhaps, so many are beginning to suggest that the private equity heat wave is starting to cool. That's not a bad thing. It's natural. Credit will undoubtedly tighten, activity will slow, and there will probably be our own era's version of a Federated or two. But the $13 trillion U.S. economy, more competitive and resilient than ever—thanks in part to private equity itself—can handle what comes. And when this movie reaches its conclusion, you can be sure most people will be looking forward to a sequel.

Jack and Suzy Welch look forward to answering your questions about business, company, or career challenges. Please e-mail them at thewelchway@BusinessWeek.com For their podcast discussion of this column, go to www.businessweek.com/search/podcasting.htm


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