Private equity’s business model sets it apart from institutions at center of financial crisis, PEC study finds
WASHINGTON, DC, October 16, 2008 — Because of their unique business model, the way they raise capital, the type of investments they make and their modest share of the financial system, private equity firms have fundamentally different characteristics than the financial institutions that created the cascading losses at the center of the current financial crisis, according to a new study released today by the Private Equity Council.
The study, authored by Dr. Robert J. Shapiro, former Under Secretary of Commerce in the Clinton Administration and Chairman of Sonecon, LLC, and Dr. Nam D. Pham, founder and president of NDP Group, LLC, is based on data provided by large private equity firms. The study is the second phase of a project undertaken by the PEC and Drs. Shapiro and Pham to assess the economic impact of private equity on the U.S. economy.
“The new Administration and Congress that take office next year will have to quickly put in place a fresh framework to minimize the possibility that the credit crisis now facing average Americans and U.S. businesses of all sizes will be repeated,” said PEC President Douglas Lowenstein. “We hope the Shapiro-Pham study will help provide useful context to public officials who are working to design a more modern and dynamic system that will ensure a stable and growing global economy.”
“When we began work last year, we approached this study by asking whether private equity poses a significant level of risk to the global financial system,” said Dr. Shapiro. “We found that, based on their organization and operations, modern private equity funds present little, if any, realistic prospect of triggering cascading losses and systemic problems in U.S. capital markets. The ownership structure and rules of private equity funds strongly mitigate against their triggering a systemic crisis,” he added.
Systemic risks begin to unfold when highly-leveraged investments threaten the solvency of a financial institution, forcing it to sell other assets as nervous investors bail out, the study reported. This “run on the bank” further depresses the value of both the original investment and comparable assets held by other institutions. As concern spreads, other highly-leveraged institutions are forced to sell other assets, depressing their prices as well. As other investors pull out of the growing circle of damaged institutions and their prices plummet, the institutions pull back from making new investment and loans, reducing liquidity across large parts of the market.
Private equity firms, Drs. Shapiro and Pham concluded, are insulated from these cascading losses for the following reasons:
• Efforts to turn around or strengthen undervalued companies represent a very unlikely source of systemic problems in capital markets. In the physical economy of factories and offices, the operations of private equity buyout funds facilitate the productive use of existing assets and resources, usually by identifying companies with untapped potential and reorganizing their operations in ways that increase their value, including making additional investments. The investment focus on potentially undervalued firms should largely preclude a systemic crisis arising from the collapse of overvalued assets.
• Private equity losses are unlikely to be of a cascading nature that could trigger a systemic event. Private equity transactions are financed with significantly less debt than the investment holdings of large financial institutions like banks and broker-dealers. For example, a recent study reported that the gross leverage ratio of private-equity acquired companies in 2001-2007 averaged slightly less than 3 to 1. On the other hand, recently failed financial institutions reported gross leverage ratios of 33 to 1. While the role that leverage plays differs across asset classes and institutions, the greater the leverage, all else being equal, the less cushion for losses and the greater the risk of a systemic event.
• The character of PE investments is fundamentally different from those of leveraged financial institutions because they involve the acquisition of individual commercial businesses rather than financial instruments. While portfolio companies can and do fail, a privately held commercial business that failed is very unlikely to be so interconnected financially as to cause ripple effects and it is unlikely to occur suddenly.
• Private equity funds occupy a place in the capital markets that is likely too small to trigger broad, cascading financial market problems. The total average annual value at risk in private equity is equivalent to just 2.6 percent to 4.3 percent of the average annual value of all corporate equities. Also, the loans or leverage for all private equity deals averaged about $83 billion per-year in this period, or the equivalent of less than 3 percent of the $2,902 billion in average annual borrowings for all purposes.
• Private equity funds are diversified and have built-in protections from systemic events. The investments of individual private equity funds, and the buyout sector as a whole, are highly diversified across industries and sectors. In addition, private equity investors usually cannot exit a fund without giving considerable notice, and the bulk of financing is provided by sources that are less subject to selling pressure from sudden losses.
• Bank exposure to Private Equity is relatively small. Leveraged financial institutions play a relatively modest role in private equity: From 2000 to 2007, banks provided 12.4 percent of private equity fund capital, and other financial intermediaries and insurance firms companies another 9.7 percent and 7.4 percent respectively.
The study is available in PDF format on the PEC web site at www.privateequitycouncil.org.
About the Private Equity Council
The Private Equity Council, based in Washington, DC, is an advocacy, communications and research organization and resource center established to develop, analyze and distribute information about the private equity industry and its contributions to the national and global economy. PEC members are: Apax Partners; Apollo Global Management LLC; Bain Capital Partners; the Blackstone Group; the Carlyle Group; Hellman and Friedman LLC; Kohlberg Kravis Roberts & Co.; Madison Dearborn Partners; Permira; Providence Equity Partners; Silver Lake, THL Partners; and TPG Capital (formerly Texas Pacific Group).
