Paul Holmes 22 Apr 2007 // 11:00PM GMT
Gordon Gekko is back. The fictional corporate raider, immortalized by Michael Douglas in the 1987 Oliver Stone movie Wall Street, came to stand for all that supposedly was wrong with corporate America in the 80s—and not entirely incidentally, inspired a whole generation of aspiring investment bankers in the U.S. and beyond. Today, the charges that were leveled 20 years ago at Gekko and his real-life counterparts are being leveled at his spiritual progeny, who are leading private equity firms and have in recent years become a prodigious force in the global financial markets.
Private equity fundraising reached new record levels in 2006, according to research by Private Equity Intelligence, which says that a total of 684 funds worldwide raised an aggregate $432 billion last year. And according to Thomson Financial, private equity net returns outperformed the S&P 500 by 19 percent to 9.7 percent for the 12 months to last September and have done so by 14 percent to 9.7 per cent over the past 20 years.
But the private equity business has become, to some extent, a victim of its own success. Until relatively recently, fund managers saw little reason to communicate with anyone except their shareholders, but as private equity deals have increased in size, they have attracted more attention—and more criticism.
In Germany, Bertelsmann—after decided not to offer its stock to the public last year—tapped private equity funding as a way of keeping its acquisition options only. In the U.K., a trio of private equity firms—KKR, CVC and Blackstone—announced in February that it was considering a $22 billion bid for supermarket chain J Sainsbury. A month later, KKR offered around $19 billion for pharmacy group Boots. And in the U.S., a group of private equity firms led by KKR and Texas Pacific Group paid $54 billion for TXU, the Texan utility.
“Until recently the firms have operated well below the radar screen of public interest,” Richard Lambert, director general of the Confederation of British Industry, told a conference later the same month. “Now they have reached a size where that approach has to change.”
Chris Higson, of the Private Equity Institute at the London Business School, agrees: “Private equity firms have a good story to tell, in turning around under-performing firms. But until now there’s been no pressure to tell it.”
But now, communications expert say, the pressure is there and the industry needs to respond, to seize the initiative while it still can.
“The structure and strategy of the sector has changed significantly over the last decade with increasingly large transactions and involvement in higher profile and often iconic and cherished ‘national’ brands,” says Steve McCool, director of Weber Shandwick Financial in London. “As with many industries, commentators and stakeholders can often focus on a small number of investments which have either been a huge success—inciting comments about egregious earnings—or failure, leading to job losses, asset sales, industrial plant closures. Both of these situations need to be managed more effectively by private equity owners, and stakeholder communication is critical.”
Some observers, including Lord Bell, the chairman of U.K.’s Chime, parent company to the Bell Pottinger family of public relations firms, suggest that any response may already have come too late. According to Bell, the private equity sector has already “lost the argument” in some European markets.
Politicians in France and Germany have been vocal in their criticisms of hedge funds and private equity groups. Nicholas Sarkozy, the most conservative candidate in this year’s presidential elections in France, urged the introduction of a European tax on “speculative” capital movements. In Germany, where the former leader of the Social Democratic Party two years ago characterized private equity firms as “locusts,” private equity firms attending the Super Return Conference in Frankfurt were welcomed by protesters brandishing placards proclaiming a “Conference of the Locusts” and “Private Equity Equals Asset Stripping.”
In the U.K., Labour politicians and financial experts have warned about the lack of transparency and increased debt. Member of Parliament Michael Meacher recently warned that “Private equity firms… often extract huge personal gains at the expense of enormous job losses and cripple a firm with large debt.” Even Michael Hughes, chief investment officer at Baring Asset Management in London, has warned that: “High levels of debt at a time when interest rates are rising could lead to a financially destabilizing environment.”
There’s even pressure on private equity in the U.S., where Senator Charles Grassley, the ranking Republican on the Senate Finance Committee, has suggested doubling the taxes on the profits of private equity firms. Currently, the firms’ share of the profits—known as the “carry” and typically around 20 percent—are taxed at the capital gains rate of 15 percent; Grassley would like to see it taxed at the regular income tax rate, about 35 percent.
The U.S. Department of Justice has launched an investigation into possible collusion and anti-competitive behavior among U.S. firms, and in the U.K., the Financial Services Authority concluded an investigation of the entire sector with a warning that some big buyout deals would fail and “excessive leverage” was a risk for some companies. In Asia, meanwhile, South Korean prosecutors are investigating a large U.S. firm and its investment in one of the country’s largest banks, while Japanese authorities are cracking down on private equity deals in the wake of the flotation of Shinsei Bank.
Critics level four main complaints: that private equity destroys jobs and runs business for the short-term, neglecting investment and mistreating employees; that it lacks transparency, in part to conceal the massive sums in pays its senior executives; that it tends to fund its purchases with large amount of debt, which is then loaded onto the acquired companies; and that it benefits unfairly from tax breaks on interest payments.
Still, private equity also has some high-profile supporters in the body politic. British Prime Minister, Tony Blair, for example, recently gave a speech in which he praised the sector’s contribution to the U.K. economy: “Britain is one of the number one places in the world for private equity, and I think the private-equity market is a market that brings a lot of benefits to our economy.”
And Charlie McCreevy, the European Union’s internal market commissioner, has dismissed recent attacks on the sector and insists there is no reason to tighten the rules governing its activities. “Hedge funds and private equity are good for the market,” he says. “They have given greater liquidity, they have added shareholder value and they have helped the rationalization and innovation of companies.”
But McCreevy also chastised hedge fund and private equity firms for failing to make their case to the public.
“If you were to pick an example of any group that has done a notoriously bad job at public relations, it is these two. And I am not sure whether they will be able to recover the lost ground. All you ever read about them are the massive fortunes that individuals make. You just see loads and loads of bad publicity.”
And a recent study by Technical University Munich, European Business School and White & Case, sponsored by the Federal Finance Ministry, shows the positive impact of private equity on former privately-owned German Mittelstand companies, creating value and sustaining global success.
But “private equity as a sector has never explained itself,” says Ralf Hering, managing director of Hering Schuppener, Germany’s leading financial communications firm. “When they started to focus on Germany, only few specialists knew about their business model. It was easy for their enemies to put that ‘locust’ stamp on the sector.”
The same is true in the U.S.
“For a long time, private equity companies operated under the radar,” says Rich Tauberman, senior vice president at MWW Group. “Many were unprepared for their starring role and let other investment professionals, the media and government officials define what private equity does, the deals, and their impact before they did. This has resulted in misperceptions about private equity in general, their place and power in the financial marketplace along with negative view of particular firms and players.
“The bottom line is that private equity does not deserve its current image, but the firms themselves are somewhat responsible for not telling their story and their position effectively enough.”
Others are less forgiving of the industry’s neglect of its own reputation.
“I don’t think there is any doubt that the private equity industry deserves the reputation it has,” says Michael Geczi, executive vice president at Ashton Partners, a financial communications firm based in Chicago. “Negative perceptions develop where there are information vacuums. The industry’s reputation has been built up over years and years of private and complex dealings, a lack of transparency and a disregard for external perceptions. But until recently, I don’t think the issue of reputation mattered to the private equity players. It simply did not register that high in their list of priorities.”
That’s because the sector enjoyed a positive reputation with its most critical stakeholders: its investors.
“Those inside the ‘war room,’ including management teams, board of directors, investment bankers as well as shareholders, more times than not have a great appreciation and respect for private equity firms,” says Geczi. “Private equity firms are often viewed as the solution for companies looking for a way out of a financial dilemma. And they are seen by investors as value drivers.
“On the other hand, company employees, the general public, media and local government officials often perceive PE firms to be a threat to job security because of their immediacy in ‘fixing’ operating problems. Many times, employees are fearful that a private equity firm will announce major job cuts or office closures that directly will impact the lives of those employees and trigger loss of revenue for their communities. To many people, these firms represent the worst example of how the system works—or doesn’t work—because they are seen as creating wealth for a select few at the expense of others.”
There are reasons for the disparity between the industry’s reputation with financial stakeholders and the perceptions of others.
According to Geczi: “Historically, it has been hard to argue the case that the industry should care, because private equity professionals believed they could drive value through their own actions, and that they did not have to address softer issues, especially the matter of reputation management. That is changing now and we are seeing more and more companies realizing that they need to focus on both—as reputation also has a meaningful influence on valuation, as well as on other important matters such as completion risk. Perception drives action, especially in the area of increased regulations.”
Answering charges about the lack of transparency, for example, the sector’s supporters point out that publicly traded companies are highly regulated because of the strong possibility that the interests of managers and investors might diverge or even conflict. In the private equity arena, that possibility is eliminated because the interests of managers and investors are closely aligned. And as long as investors are making money, it does not matter how much the managers are receiving.
But there are deeper issues.
Private equity “needs to better explain its business model, financing structures, sustainability of investments, simply because part of the success model of private equity is to take over underperforming players and to restructure the investments,” says Hering. “Layoffs, closing of plants or disinvestments are usually going along with these restructurings. This has a massive impact on local communities or regions and on tax incomes of cities.
“Layoffs are also partly financed with money from mandatory unemployment insurance, part of the German social security system. Furthermore, workforce committees and trade unions have to agree to social plans in connection with lay-offs. This can easily lead to strikes. And all is publicly accompanied by massive media coverage.”
That means private equity firms will need to broaden their communications horizons.
“Private equity firms have historically been strong at communicating directly and confidentially with their investors,” says McCool. “However, the increasing number of public-to-private deals has meant that PE firms have a wider range of stakeholders than ever before: significantly government, unions and other employee groups. A strong and positive reputation across all stakeholders can deliver value in terms of price, approval and ultimately the long-term success of their investments.”
Individual companies are clearly making more of an effort. “On a company-by-company basis, private equity firms are becoming far more involved in proactively managing their reputations, both on an ongoing basis, as well as with each deal they do,” says Geczi. “Increasingly, they are spending time detailing their own differentiators and core competencies so that acquisitions are seen as being strategic and not simply financially driven. I think we have seen a larger number of companies focusing both on their own reputations as well as the reputations of their portfolio companies. They still don’t open up the way public companies do, but there have been meaningful changes.”
Tauberman agrees. “Private equity firms have quickly learned that they need to become more public, more transparent and better engage with the media,” he says. “The major players have devoted greater attention to telling their story and discussing transactions, investment strategy and management approach to help dispel the mystery and misperceptions that have marked the debate. They have also worked more closely with the companies within their investment portfolios to speak with other important audiences such as employees, customers, vendors and communities.”
But there is still a way to go.
“We do see more firms taking the broad and critical issue of reputation management into account in their investment and corporate strategy,” says McCool. “However, engagement with the media is often sporadic, defensive and tinged with suspicion. The media understand the limitations on deal confidentiality—they couldn’t get to talk to investment bankers if they didn’t—but firms do need to approach the media on a more open basis.”
Damon Buffini, managing partner at Permira, Europe’s largest private equity firm, has abandoned his own traditionally low profile to make the case that the industry needs to speak up for itself. Permira has promised to reveal the names of investors, provide more information about the companies it owns and meet with unions to discuss their concerns.
Peter Linthwaite, chief executive of the British Private Equity & Venture Capital Association, acknowledges that larger deals mean there is “a wider base of people with a legitimate interest” in the operation of private equity firms. “There will be more people than just the investors and employees who will want to know about how these companies are run.”
And a past chairman of the Association recently told The Financial Times: “There are some people in this industry who don’t care about the future of the industry. It doesn’t matter to them. But it is no longer acceptable for them not to disclose who controls these firms.”
As a result of increased pressure, firms in the U.S. have formed the Private Equity Council, a trade association that will be active in lobbying in Washington, D.C., and the large U.S. and U.K. firms working in Germany are in the process of creating a trade group that will lobby to overcome political resistance. And the U.K.’s Private Equity & Venture Capital Association has formed a working group—chaired by former Morgan Stanley chairman Sir David Walker—to come up with industry code of conduct dealing with disclosure issues.
Perhaps most telling, however, was the fact that KKR and Texas Pacific met before their takeover of TXU with environmental activists and pledged to cut the number of new coal-fired plants the company is constructing, invest heavily in clean technologies and promise to put environmental stewardship at the center of the company’s culture.
Those concessions led The Economist to observe, “Capitalism’s legendary ‘Barbarians at the Gate’ have become a bunch of tree-huggers.”
But not all of the industry’s critics are impressed.
“A flurry of public relations initiatives and reviews shows that the sector is growing worried,” said Brendan Barber, general-secretary of the Trades Union Congress, in an article before a meeting of unions from around the world designed to launch an international campaign for the regulation of private equity and hedge fund investment.
“The private equity industry says that there is nothing particularly different or special about what it does,” says Barber. “It is just an inevitable—if rather effective and efficient—part of a market economy…. Of course, the traditional role of venture capital in providing investment for start-ups is vital. Some companies have gone private genuinely to escape stock market short-termism. But neither of these is feeding the current controversy.
“Instead, the recent growth in private equity acquisitions looks more and more like a way of getting round the social contract at the heart of our market economies. Investors pay a lot less tax, keep things secret and, through high gearing, have introduced great potential instability. Creative destruction may be an inevitable part of a market economy, but private equity often seems to lead to straightforward destruction with nothing creative about it, apart from some of the accountancy.”
One example cited by many critics is the AA, a traffic service company in the U.K., where 3,400 jobs were cut within months of a takeover by CVC and Premira. Another is Debenhams, where private equity owners increased the retailer’s debt from $200 million to $3.8 billion while tripling their investment in two years and paying themselves dividends of $2.5 billion.
“The key question for policymakers is what will happen when conditions change. At the very least the growth of debt-financed investment will make any landing considerably harder. At worst a speculative bubble will burst and, while employees will pay the heaviest price, they will not be the only victims. Lenders will see that they have ended up bearing the risk without sharing in the massive returns. Pension fund losses could affect millions.”
Such criticisms suggest that the sector still has a lot to do to win the public relations war.
“Private equity firms that have not yet come out of the shadows need to understand that public perceptions are increasingly integral to their success and the success of their investments,” says Tauberman. “The new focus on private equity will continue and firms need to be savvy about using communications to promote their business and investment strategy. If private equity is not defining itself, others have shown that they can and will fill the void and that is not good.”
And it won’t be sufficient to focus attention on the political realm while ignoring broader public concerns.
“It’s not enough to lobby in Berlin or to communicate with the business press,” says Hering. “Private equity as a sector should educate politicians and media on local, regional and national level. And individual players should explain their plans in any deal situations to local communities, trade unions, workforce committees and local media.”
The bottom line: “Private equity firms, both individually and as an industry, need to manage their reputations by sending more information and messaging out to their key audiences,” says Geczi.
“They need to do this now, while they still have the ability to control the activities. It is too late when you already are being scrutinized. Voluntary transparency will allow the private equity firms to control the extent to which they communicate and how the communication is distributed. Waiting to see what regulations government officials impose upon the industry will likely result in a loss of control over the disclosure practices.”