When it comes to Private Equity (PE), there can be numerous schools of thought. You have the group that would completely go gaga over PE. You have another that would simply want to wipe off this infatuation from the market. There is also one that would hold PE responsible for failed, inefficient and weak government policies. In India unfortunately, what we have (mostly) seen so far is the havoc that PE has caused. And I clearly see it as one key reason that has snowballed into the economic crisis that we face today.
It was back in 1946 when PE emerged in the American market in its true sense. The era between 1960s to 1980s saw the Vanderbilts, Whitneys, Rockefellers and Warburgs build fortunes in businesses ranging from real estate construction projects to airlines, banking to whatever moved on the streets of Silicon Valley. Running parallel and equally fast was Warren Buffet, who through Leverage Buy-Outs (LBOs) acquired one corporation after another. The US Congress then opposed every change in tax policy that could have made life more difficult for PE firms (the Carter Tax Plan of 1977 was the first of such acts that failed to be enacted). What followed up until 1990 was quite understandable (given the quick, sweet success PE had witnessed in its early years). Thousands of PE labels mushroomed across the globe.
But beneath this rolling of the Red Carpet was a weakly-constructed foundation. Cracks on the PE wall first became visible in the first half of the 1990s. Ills related to the massive rise in leveraged buyouts that were financed by junk bonds led to the-then collapse of the LBO industry. Amidst various companies that went into a tailspin was a big name – Drexel Burnham Lambert. This one company that was credited for the boom in PE back in the 1980s had several allegations made against it. The firm was charged with insider trading and had to file for Chapter 11 in 1990. Thus, one of the founding pillars of PE was turned to dust. Companies and markets across the globe experienced a similar avalanche.
The ‘true’ global effect of PE became more publicised and shamefully dramatic in the early 21st century. It began with the dot-com bubble bursting. This disaster has so far caused the maximum damage because it sent more than just tremors across the global financial market. It shook the very belief in Private Equity (and Venture Capitalism). In the quick years that followed this early 2000s disaster, more than half of PE firms that had invested their dimes and coffers in web start-ups were forced to throw in their towels. Of course, the market as a whole, and the investors were left at the mercy of no modern capitalistic gods. Many IT firms that had become bigger with the prime support of PE saw the cash and asset balance levels in their wells fall. Much below even the amount of capital initially invested! And the biggest reason for such an unwanted outcome was that those very PE firms that had promised to fuel their dreams ran out of fuel themselves. They backed out in the name of retreat and failed to live up to their investment commitments. By the end of the year 2000, globally, the count of PE firms fell by a horrific 50 per cent!
Obviously, India was not one to remain idle when it came to being mesmerised by this hypnotic trick and believing in the permanent magic of a volatile formula. It was one of those markets that felt the maximum impact of the dot-com bubble slap. The Indian IT industry came under huge pressures – returns vapourised for some time and much hope was lost. There are huge apprehensions still – that have spread to other verticals. Even today, every now and then, cases of insider trading and embezzlement are reported across various sectors. And we’re not even counting unrevealed scams yet. Private equity dealings in the first decade of the 21st century has left us in ruins. Worse, during this period, PE entered one sector after another and that resulted in excess supply being created. The bubble of a hope that PE generated ruined organisations far and wide – some temporarily and some forever – with excess pressure of expansion that has left them in a complete mess with visible supply-demand mismatch.
Take for instance the case of the much-hyped – and one that still finds fanatic believers – industry (in India) called Real Estate. Real estate was once considered an immovably strong and non-volatile sector. Then came PE intervention, and left the industry in a shambles. It’s one heck of a mess you cannot just ignore. Back in the 1997-2003 period, withdrawal of funds by PE led to a crash in Mumbai region’s real estate business. The same was repeated in the 2011-2012 period when prices of real estate properties fell by 20 per cent (and higher) in Delhi and Mumbai. The fundamentals of the entire sector have seen a paradigm shift after the SEZ Act of 2005. Most residential and commercial concrete jungles that were built post-2005 were aimed towards investors who wished to park their money in real estate properties. Ghost towns were being built all around the metros and bigger cities, and were sold at prices that were headed for the moon. [Forever it seemed.] What is the present scenario? When PE investors decided to stop funding such ‘(not-so-)concrete’ dreams by cutting off the supply of money, the expected came to pass. Empty malls, vacant residential properties, half-completed high rises and incompletely dug up construction sites with building material left untouched for months is a common sight. Not many souls move about in such ghost towns these days! How PE has totally tricked buyers and sellers in an entire industry is an incredible story to be told. But not one to gain inspiration from.
Holistically stated, the purely economical repercussions of PE’s entry and exit across sectors and markets have also led to several socio-economic crises. In a 2011 study by the University of Chicago, Harvard Business School and the US Census Bureau, it was proved that “companies tend to terminate more employees after a buyout compared to competitors in the same sector.” “After a PE buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3 per cent. Many of those job losses are undoubtedly painful,” writes Prof. Steven Kaplan, the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, in a 2012 article titled, ‘How to think about Private Equity’. But PE investments always offer higher returns given the risks. Right? Actually, no! In a 2005 study by Prof. Steven Kaplan of the University of Chicago Booth School of Business and Prof. Antoinette Schoar of MIT, covering the period ranging from 1980 to 2001, it was revealed that, “Investors actually made slightly less on PE deals than they could have by investing in an S&P 500 Index fund.”
All in all, PE funding not only degrades and makes a sector volatile but also injects malpractices into companies. Thought leaders have not been very vocal about it, but in the West, film-makers have tried to depict the same through their works. Today, PE funding worldwide is headed southwards. And that is good news. It implies greater stability for the global economy as a whole. A more sustainable future, if I may add. In the last one decade or so, PE ownership across companies has reduced by leaps.
Going back where I started, when it comes to PE funding, there are several schools of thought, but when it comes to India, the thought that PE can and will leave you in ruins appears most logical. The Indian government has to be very careful going forward about the manner in which it allows PE to enter any given sector – whether it be for the sake of developing Greenfield projects in the most undesirable of sectors or for the sake of lighting a bulb in the most underdeveloped of villages.
PE is a double-edged sword. Popular perception is that it makes you stronger – but only until you measure the blood you have lost. Period!
- 05 September 2013 |
- Dr. Arindam on Indian Economy