Samuelson: The Enigma of Private Equity

Pictured recently on the cover of Fortune, Steve Schwarzman is "the new king of Wall Street," says the magazine. Schwarzman heads the Blackstone Group, a big "private equity" firm. In capitalism's toolbox, private equity is the latest socket wrench. It's made many people rich. In 2006, Forbes put Schwarzman at 73 on its list of the 400 wealthiest Americans, with a fortune of $3.5 billion. The question is whether private equity is good for the country.

Modern capitalism is a study in contrasts. On the one hand, it's dominated by massive enterprises that tend to become high-cost bureaucracies. On the other hand, these giant firms are increasingly policed by activist shareholders—including private-equity firms—that focus single-mindedly on profits. To its champions, private equity forces companies to cut costs and improve efficiency; profits are deserved. To critics, profits flow mainly from loading companies up with debt; private equity is a sophisticated swindle that often cheats ordinary shareholders.

Let's start with the basics. Private equity refers to the practice of groups of investors—private-equity firms—buying up all the publicly traded stock of target companies. These companies are then said to "go private." Usually, this is done with much borrowed money, explaining why this same process in the 1980s was known as "leveraged buyouts" (the leverage referring to borrowing), or LBOs. By whatever name, the buyouts are booming again. In 2006, private-equity firms bought 654 U.S. companies for a record $375 billion, says Thomson Financial. That was a quarter of all U.S. mergers and acquisitions last year, and 18 times the level in 2003.

Nine of the 10 largest buyouts have occurred in the past year. The list includes many familiar corporate names: HCA, the hospital chain; Harrah's Entertainment, the casino firm, and Univision, the Spanish-language TV network. The pace may pick up, because money has poured into private-equity funds, managed by companies like Blackstone, Kohlberg Kravis Roberts & Co. and the Carlyle Group. Investors in private-equity funds include wealthy individuals, insurance companies, college endowments and pension funds. The present boom stems from ample cheap credit and the prospect of big payoffs. Over the past 20 years, buyout firms have averaged annual returns of 13.2 percent, says Thomson. By contrast, the stocks in the Standard & Poor's 500 Index have averaged only 9.7 percent.

But how are these superior returns achieved? Are companies permanently improved—a process that would ultimately lead to higher living standards? Or are gains short-term, reflecting the magic of debt? The Carlyle Group offers several hypothetical cases that highlight the differences. In each example, the company "taken private" has $10 million in annual profits and is bought for 10 times that, or $100 million. The private-equity firm puts up $30 million and borrows $70 million.

In case one, profits don't increase. Five years later, they're still $10 million annually. But the profits have been used to repay $30 million in debt. (Lower taxes help, because interest payments are tax-deductible.) After five years, the company is then resold for the same $100 million. But the private-equity firm has doubled its original investment of $30 million. Here's why. It uses $40 million to repay the remaining loan and is left with $60 million.

Next, suppose that profits increase to $15 million. The private-equity firm is an exacting owner. It eliminates the corporate jet, fires middle managers, shuts losing operations and invests in new products. The company is still sold for 10 times profits, but now that's $150 million. After repaying the $70 million loan, the private-equity firm has $80 million—almost triple its initial investment.

Private equity's social utility depends on whether better management overshadows the debt effect. Opinion is split. "On balance, private equity increases efficiency," says economist Steven Kaplan of the University of Chicago. "It certainly did in the 1980s." Then, LBOs helped break up unwieldy conglomerates. But today's skeptics are not just antibusiness types. In a report called "The Great Wealth Transfer," strategist Henry McVey of Morgan Stanley argues that private-equity firms mainly exploit corporate managers' aversion to debt. Companies that keep too much cash and have too little debt, he writes, become buyout targets. Ordinary shareholders lose, because buyout prices are too low.

Capitalism has always had two faces: an exercise in personal greed, and a collective effort in raising living standards. Private equity mirrors the confusion. The managers of private-equity firms—the world's Schwarzmans—take lavish fees for themselves (typically 20 percent of profits and 1.5 percent to 2 percent of assets under management). These limit the returns to other investors. Meanwhile, the buyout boom so dwarfs anything in the past that its collective benefits are unclear. A few adverse events (higher interest rates, a deep recession) could sabotage many deals. If today's buyout bonanza becomes tomorrow's subprime mortgage bust, Wall Street's newest royalty may be dethroned.