The Uneasy Crown

The buy-out business is booming, but capitalism's new kings are attracting growing criticism.

More threatening than criticism are the problems of success. With so much interest in private equity, more money than ever is chasing deals. To increase the number of deals they can do, several of the bigger firms are said to have become interested again in hostile takeovers, at least for the funds they are now raising. Club deals may also pose difficulties, especially if things do not go according to plan and partners have a difference of opinion.

And there are the diseconomies of scale common to any business that has grown so far from its entrepreneurial roots. Not for nothing have the biggest private-equity firms been called the “new conglomerates”. They are sprawling empires, with extremely diverse firms to manage. For example, Blackstone’s portfolio includes stakes in Michael’s, an arts and crafts retailer; Emcure Pharmaceuticals; Deutsche Telekom; Orangina, a drinks firm; FGIC, a bond insurer, and Houghton Mifflin, a publisher. It also owns part of SunGard in partnership with KKR. KKR’s assets include HCA, a health-care firm; NXP, once the semiconductor business of Philips; Primedia, a publisher; Sealy, a mattress-maker; and Toys “R” Us.

Can private-equity firms manage their empires? Harvard’s Mr Lerner worries about the spread of bureaucracy and in-fighting, including battles over how to share out the spoils when the performance of different parts of the firm varies sharply. He points to Carlyle as a good example of a firm tackling these difficulties with its centralised, team-building “One Carlyle” process. As the founders step down at several of the bigger private-equity firms, succession may add to the burden.

When the Credit Stops

The credit markets show no sign of losing their appetite for lending. On the contrary, private-equity firms report turning down offers of credit because they are too generous. Nonetheless, leverage is rising steadily, to worrying levels. One day the market will dry up, perhaps suddenly, and what will happen then?

Chicago’s Mr Kaplan is surprisingly optimistic. The repayment terms on loans to private equity are far more generous than in the 1980s, when repayment of the principal started immediately. Now there is often no requirement to start repaying the principal until after seven or more years. As a result, private-equity firms are likely to have a lot of time to put things right if one of their firms gets into trouble.

The industry also has to watch for a change in the behaviour of public companies, which are starting to respond to shareholder pressure to get a higher price from private-equity bidders. “Shareholders are increasingly asking why they are selling at a price less than what it will be worth in the future.” says Colin Blaydon, of the Tuck Centre for Private Equity and Entrepreneurship. GE recently imposed limits on the number of private-equity firms that could club together to bid for its plastics division to try to ensure a competitive auction rather than a carve-up.

Activist hedge funds are also putting pressure on likely targets to increase their borrowing. This, they think, will both increase the value of the firm in just the way it would under private-equity ownership, and remove one of the main incentives for private equity to buy.

Perhaps the greatest threat to the continued growth of private equity is regulation. The burden on public companies may be eased. Sarbanes-Oxley is likely to be given a makeover this year, with its notorious section 404 on internal controls watered down. On the other hand, politicians may increasingly try to regulate the private-equity industry.

One chief executive recently observed: “The moment a public pension fund loses 20% of its value due to some private-equity investment going wrong, private equity will get its own Sarbanes-Oxley.” The new kings of capitalism must try to prevent this from happening by showing that they really are a force for good.

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