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Opinion CLOs
Focusing on leverage obscures the fundamental role private equity serves
by Randy Schwimmer
Randy Schwimmer
Vice chairman
Churchill Asset Management
Private equity should align the interests of owners, operators and investors
The notion of private equity as anything but constructive for shareholder value is of recent vintage. Despite how they are sometimes portrayed, PE firms don’t buy businesses to strip assets and fire employees. If that were true, investors would have given up on the industry long ago. Instead, of course, the number of privately held companies is growing, and the number of public companies is shrinking.
The real story of PE is the story of commerce itself. Before World War II, most “private equity” transactions were funded and financed by wealthy families. The lack of sophisticated lending infrastructures and regulatory frameworks for what we today call leveraged buyouts, left most corporate investments to the Vanderbilts, Rockefellers and Whitneys, who were expanding their family empires after veterans with entrepreneurial instincts began many small and medium-size companies in the post-war period.
The rise of leveraged buyouts
Another boost came after the conglomerate era in the 1960s and 1970s, when companies such as ITT owned everything from hotels to food businesses. Public markets discounted holding companies of unrelated industries. Private buyers looked to unlock their hidden value. As founders aged, many faced a succession problem. With few new generation members carrying on the family business, and not wanting to sell to competitors, they turned to private finance buyers, such as Jerome Kohlberg and Henry Kravis, who pioneered the leveraged buyout using borrowed funds.
Two key pieces of legislation helped launch what we know as the US PE boom of the 1980s. In 1978, restrictions of the Employee Retirement Income Security Act (ERISA) were relaxed to allow investments in private companies by corporate pension funds. Then the Economic Recovery Tax Act of 1981 lowered the top capital gains tax from 28% to 20%. These moves resulted in a dramatic surge of PE fundraising and deployment, including the buyout of RJR Nabisco made famous in the book Barbarians at the Gate.
After the S&L crisis and junk bond pullback, the PE industry tracked economic cycles. Activity and performance slowed during the 1990 recession and tech bust of 2001, grinding to a halt during the great financial crisis. Leverage became a primary driver of returns.
But too much debt hurts cash flows. Some firms carelessly over-leveraged in cyclical industries. Instead of earnings growth as the gold standard for multiple improvement, paying lower purchase prices coupled with debt paydowns became the norm. So PE developed a bit of a boom-or-bust reputation. Today’s higher rates and double-digit purchase price multiples for top companies make that strategy difficult.
Focusing on leverage strategies obscures the fundamental economic role PE serves. Families or entrepreneurs are hard-pressed to grow companies without outside capital. PE can fill that void by buying into ownership, allowing the seller upside as the business expands. Firms then work with management teams to improve profitability by streamlining operations, implementing systems and reporting upgrades, recruiting management talent, and pursuing strategic growth opportunities. With more capital, companies can invest meaningfully in enterprise resource planning systems, customer relationship management platforms and advanced technologies to professionalise a business.
Transparency for limited partners
General partners do all this to improve enterprise value on behalf of limited partners, sharing gains and losses based on how well portfolio companies and funds perform. But those LPs — insurance companies, pension funds, family offices — are anything but passive investors. They have full access to all performance data for the businesses, and are keenly focused on how transparent GPs are with that information. It is a major factor in whether LPs will invest in the next fund.
What’s the future of PE? With an estimated USD 70tn in generational wealth transfer from baby boomers alone, there’s no shortage of future demand for growth capital.
As an asset class, PE has an established history of delivering strong returns to investors, often better than public market benchmarks. It also diversifies investor portfolios by providing access to small high-growth private companies. Understanding the underlying dynamics behind these investments is essential to dispelling outdated narratives and evaluating PE on its merits — as a discipline that aligns the interests of owners, operators and investors in building businesses that create lasting value.
