Private Equity, Risk, and Government:

The Great Challenge

Josh LernerHarvard Business School

My argument

•The single greatest challenge that the PE industry faces is not…▫Market cycles.▫Overleveraged existing portfolio

companies.▫Access to debt.▫Limited partner nervousness.

•But rather overactive and ill-informed regulators.

My argument (2)

•Much of the proposed regulations appear profoundly ill-conceived.▫But it doesn’t seem to matter!

•The private equity must be more creative in responding!

Central issues

•In aftermath of economic crisis, many questions regarding regulation:▫How did regulators miss the antecedents to

the financial crisis?▫Does institutional approach to regulation

still make sense?▫Should regulators’ reach be expanded to all

institutions that pose systemic risk?

Widespread regulatory proposals•Broad array of regulatory changes

proposed in both U.S. and Europe, as well as various multilateral bodies:▫Precise shapes of legislation remain

uncertain. ▫But seems clear something will happen.

”[PE and hedge funds] are, in short, a major challenge to financial stability, and, unless regulated, they are likely to contribute to future crises.”

”The big private equity funds have proven to be a menace to healthy companies, to workers’ rights, and to the European Union’s Lisbon Agenda.”

”Leveraged buy-outs leave the company saddled with debt and interest payments, its workers are laid off, and its assets are sold. A once profitable and healthy company is milked for short-term profits, benefiting neither workers nor the real economy.”

Paul Nyrup Rasmussen, ”Taming the Private Equity Locusts,” Europe’s World, 2008.

Private equity is not exempt• EU Alternatives Investment Fund Managers

Directive:▫Long-running legislative process specifically

focused on private equity and hedge fund industry. http://ec.europa.eu/internal_market/investment/

alternative_investments_en.htm/• Dodd bill may or may not contains provisions

directly addressing private equity, but begins process that is ultimate likely to ensnare PE:

http://www.financialstability.gov/docs/regs/FinalReport_web.pdf

EU Proposals

Source: Oliver Wyman [2009].

U.S. Proposals

Source: Oliver Wyman [2009].

US Proposals

“Would everyone check to make sure they have a lawyer? I seem to have ended up with two.”

Thinking about the justification

•Extremely complex problems pose policy challenges.

•To what extent are proposed private equity regulations justified?

•Little evidence one way or another, except anecdotes.

Differing perspectives

•Private equity leads to better operations:▫Industries with more private equity backing

should do better.•Or private equity as asset strippers?

•Private equity has “deep pockets”:▫PE-backed firms can do better in downturns.

•Private equity is over-leveraged and cyclic?▫PE-backed firms will do worse in downturns.

The WEF 2010 project

• Look at all buyout and private equity investments around world.

• Look at evolution of industries at national level:▫ Revenues, employment,

profitability, etc.▫ 26 countries and 20

industries.• Use data from OECD,

CapitalIQ, etc.

The sample•8,596 country-industry-year observations

between 1991 and 2007. ▫PE industry = at least one PE investment in

industry last 5 years▫Low (High) PE = fraction of total imputed PE

investments last 5 years divided by total production smaller (larger) than the median (conditional on non-zero level of PE investment).

▫Quartiles of PE investment / production•Look at deviations from average growth

rates at the industry-year level

Two key questions

•How does more PE investment in past five years impact industry performance in a given nation?

•Is the pattern the same in times of industry shocks, particularly downturns?▫E.g., if more PE investment in Swedish

steel industry than Finnish, does industry performance differ… In general? In downturns?

The basic story

Basic regression results

•Lagged PE-investment is associated with▫Higher growth in production (0.9 percentage points)▫Higher growth in value added (1.1 pp)▫Higher growth in total wage compensation (0.7 pp)▫Higher growth in number of employees, but mostly

for moderate levels of PE investment▫No significant effect on capital formation /

investment

•Also true when look at continental Europe alone.

Looking at cyclicality

•If anything, PE investment seems to dampen industry shocks

•Particularly consistent for employment and labor costs:▫5% increase in total labor costs in a given

year PE industry will experience 5.576% increase

▫5% decrease in the wage bill PE industry will experience a 2.394% decline

Worrying about causation

•Does PE cause or chase growth?▫Do PE funds choosing faster-growing or

less volatile industries?•Results unchanged if we only consider the

impact of PE investments made several years before on industry performance.

•Also go through when look at pension policy changes that drove PE fundraising.

•Seems to be PE driving growth, not vice versa.

Key conclusions

• Industries where active PE funds in the past 5 years grow more rapidly:▫True if measured using total production,

value added, or employment. ▫Few significant differences between

industries with low and high PE activity.•Activity in “PE industries” no more volatile

in the face of industry cycles, and sometimes less so.

Bernstein, Lerner, Sorensen and Stromberg [2010].

But it doesn’t seem to matter!

•Pressures to “do something.”•Lack of patience of policymakers with

details.•Hard to sympathize with private equity

titans.•Regulatory creep:

▫What starts as a modest regulatory regime almost invariably expands.

© Charles Barsotti. All Rights Reserved

You have logic, I have Reggie.

Some thoughts about carry tax

•A philosophical conundrum best left to taw professors!?

•Uncertainty as to who will bear tax and consequences:▫LPs: Fewer capital commitments?▫GPs: Even fewer incentives to “do the right

thing”? Metrick-Yasuda results.

Carry tax (2)

•Other questions:▫How much revenue will this collect really?

Difficulty of distinguishing between entrepreneurial and private equity contributions.

▫Distinguishing between venture capital and private equity funds: mission impossible? The weakness of holding period as a criteria.

▫ The desirability of enterprise taxation provisions?

A modest proposal

•PE must become much better at making a case for intelligent regulation.▫Widespread consensus that regulation that

is piece-meal and institution-specific just opens doors to “gaming” and arbitrage.

▫Moreover, private equity is likely to suffer disproportionately due its visibility.

•Should be encouraging independent voices to get the word out about these issues.

An example from Europe

•Proposed limitations on leverage in private equity deals:▫Why should PE funds be limited but not…

Sovereign wealth funds? Family offices? Companies themselves?

▫Likely to lead to huge disruption and poorer investments.

Another modest proposal: “Green shoots”• Governments world-wide

eager for growth and employment:▫ Numerous subsidy

schemes geared toward venture capital and new ventures. Australia Canada China India New Zealand United Kingdom United States …

Many recent examples

Private equity is likely to be part of the solution•Tool kit is very relevant:

▫Experience screening potential investments.▫Skill at overseeing firms making operating

improvements.▫Abilities to help firms access additional

financing. Track record of growth equity sector. More general evidence presented today.

•But industry has not been engaged in a proactive manner.

One of few exceptions

Wrapping up

•Regulation is real and only likely to intensify.

•Many of the concerns about PE seem misplaced…▫But it doesn’t seem to matter!

•The industry must be much more pro-active and creative in its response to these challenges.

Josh LernerRock Center for Entrepreneurship

Harvard Business SchoolBoston, MA 02163 USA

617-495-6065josh@hbs.edu

www.people.hbs.edu/jlerner