Private Equity, Risk, and Government: The Great Challenge

1. Private Equity, Risk, and Government: The Great Challenge Josh Lerner Harvard Business School

4. 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.

5. 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!

6. 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?

7. 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.

9. ”[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.

10. 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

11. EU Proposals Source: Oliver Wyman [2009].

12. US Proposals U.S. Proposals Source: Oliver Wyman [2009].

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

14. 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.

15. 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.

16. 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.

17. 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

18. 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?

19. The basic story

20. 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.

21. 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

22. 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.

23. 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].

24. 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.

25. You have logic, I have Reggie. © Charles Barsotti. All Rights Reserved

26. 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.

27. 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?

28. 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.

29. 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.

30. 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 • …

31. Many recent examples

32. 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.

33. One of few exceptions

34. 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.

35. Josh Lerner Rock Center for Entrepreneurship Harvard Business School Boston, MA 02163 USA 617-495-6065 josh@hbs.edu www.people.hbs.edu/jlerner