Into the Light: the changing face of private equity

Into the Light: the changing face of private equity

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Private equity is regarded by many as the unacceptable face of capitalism. The common view of private equity is that it generates returns for the wealthy at the expense of jobs and incomes for ordinary people. It is widely – and too often correctly – criticised for a callous attitude to other stakeholders and an unhelpfully short-term view of business development.The description of private equity as “hard-nosed” and “only in it for the money” by Martin Brassell of Inngot at ACCA SME's Alternative Finance conference this week is typical: “Where private equity has been involved, you can see the treadmarks”, he said. Private equity has a serious image problem.

Until recently private equity firms haven't been too concerned about their image in the wider community. But it seems that this is changing. The theme of the European Venture Capital Association's (EVCA) Symposium in Vienna last week was how to deliver value not only to investors, but to society as a whole.

In an inspiring speech, Thomas Van Koch of EQT Partners issued a stirring call for fundamental redefinition of the role of private equity:

Private equity is there to provide good returns to investors. But that's not enough. It needs to develop partnerships with companies in order to deliver value for all stakeholders in society.

Other speakers, too, emphasised the role of private equity investment in delivering economic growth and jobs. From time to time there was a reminder that PE investment is primarily about delivering returns for investors. But this was largely drowned out by the calls for the value to society of private equity investments to be more widely recognised.

So what is driving the private equity industry's new-found interest in delivering economic benefits as well as investor returns? In a word, regulation. Regulations regarding capital, liquidity and transparency are being significantly tightened for the private equity industry, just as they are for banks and insurance companies. Firms are currently grappling with the recent Alternative Investment Fund Managers Directive (AIFMD), but as Investec warns in its Private Equity Insights report, “any assumption that the current raft of regulation is “it” for private equity is potentially dangerous”. When one panel at the EVCA conference was asked what their main concern was about investing in Europe, all the panellists responded “unhelpful regulation”. It's clearly a considerable worry.

Interference by policy-makers with private equity business models is also a concern. There is growing pressure to close down tax havens, and recommendations from international institutions such as the IMF and from highly-regarded economists that wealth, and the returns from wealth, should be more highly taxed. On the first day of the EVCA conference there was a discussion of tax planning and the use of tax havens, in which the participants concluded that helping clients avoid, or evade, tax perhaps wasn't all that great for the image of private equity. “Don't do things regarding taxation that if reported in a newspaper you would be embarrassed to admit”, said one panel member. Image, indeed. Substance? At this point, not so clear.

If the private equity industry's desire to improve its image is driven entirely by the desire to avoid unwanted regulation and interference, then we should expect policy-makers to resist. After all, regulators are only responding to the perceived risks that the private equity industry poses both for investors and for the economy as a whole. Systemic risk is not limited to banks and insurance companies. And there is little doubt that tax avoidance and evasion seriously affects government finances in many countries. If the private equity industry really wishes to be seen as delivering value to society, it does have to change its attitude to taxation.

But private equity's problem is not simply one of image. There is a gulf of understanding between the public sector – and indeed the public at large – and the rarefied world of private equity investment. Private equity is widely seen as having an unhealthy focus on delivering short-term returns at the expense of long-term sustainability for the businesses they own. It is true that some parts of the industry do prefer quick turnaround and resale of acquisitions: but long-term stable investment in companies – 10 years or more - is actually much more typical of the industry. The health and sustainability of the businesses they own is an issue for private equity firms too. Van Koch warned that private equity firms that failed to deliver sustainability “would fail”.

So if policy-makers, regulators and the public at large do not understand private equity, it is hardly surprising if policies and regulations are devised that do not suit it – such as accounting standards and regulations that force firms to compromise long-term returns for the sake of liquidity, when their liquidity needs could be adequately met by well-functioning collateral transformation and repo markets and their main challenge is delivering capital growth in a world of low returns. Private equity can be too private for its own good.

Opacity no longer works in the financial industry's favour, and private equity is no exception. If policy-makers, regulators and the public at large are to appreciate its role in generating growth and jobs, it will have to become far more transparent. Just as Mark Carney wishes to shine a light into shadow banking, so the private equity industry must come into the light.

Bringing private equity into the light is bound to expose problems, just as it has for banks and insurance companies. There are undoubtedly firms out there whose practices leave a lot to be desired. But a few bad firms tarnish the image of the whole industry, to the detriment of everyone. Transparency will force the industry to put its own house in order. Van Koch called for creation of an independent body to “police” the investment industry with a view to ensuring that firms act openly and honestly. Good firms should have no problem with this: after all, as Van Koch said, “we have nothing to hide”. Only those who have hitherto used the cloak of opacity to hide bad behaviour have anything to fear from transparency.

There are huge benefits to be gained from bringing private equity into the light, both for investors and for the economy as a whole. The opacity of private equity tends to blind it to new investment opportunities: some investors at the EVCA conference had never heard of Bitcoin, for example. In the course of a panel discussion on smart cities, Anne Glover, the new chair of EVCA, asked whether any of the investors in the room (about 200 people) invested in smart city infrastructure and technology development. Not a single hand went up. It seems all their investments are in traditional asset classes. No wonder they are experiencing poor returns and the economy is starved of capital investment.

Glover wondered how investors could support entrepreneurial development of smart city infrastructure and technology solutions. “Where are the entrepreneurs?” she asked. But in reply, Paula Hirst of Future Cities Catapult pointed out that many of the solutions already exist – they have been developed by public sector and third sector providers, whose funding needs are not being met because of misunderstanding and prejudice regarding private equity involvement. This is perhaps understandable given previous bad experiences with PFI schemes. But private equity's new interest in delivering value to society as a whole should enable new forms of collaboration which deliver both value for money to service providers and long-term stable returns to investors. Bridging the gulf of understanding between the public sector/third sector and private equity would enable much-needed capital to flow into key sectors such as city technology and infrastructure.

Encouragingly, the EVCA conference participants agreed that there needs to be a new partnership between the owners of capital and its beneficiaries. But in the final panel of the conference, Sir Brendan Barber reminded everyone what a true partnership should look like. Job creation is great, but the quality of jobs matters as much as the quantity: returns for investors should no longer come at the cost of depressed wages for workers. And opaque corporate structures that enable owners to make unilateral decisions affecting the jobs and livelihoods of thousands have to become a thing of the past. In the new partnership model, all stakeholders should have a voice. 

There has never been so much capital desperately looking for productive uses. But to unlock its potential, the owners and managers of capital must come out of their silos, look around and see the many new investment opportunities that the world has to offer. And other players must put aside past grievances and engage positively with the newly transparent and (we hope) ethical private equity industry.

Private equity's new-found interest in delivering economic growth and jobs must be far more than an image makeover. There need to be some fundamental changes in attitude and behaviour. The aim of investment should be to benefit all stakeholders in society, not just a lucky few, and bring prosperity to the whole economy.

Related reading:

Towards a new Golden Age



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