Private equity firms now control about 7% of U.S. corporate equity, or $800 billion, according to estimates of Thomson Venture Economics and quoted in the BusinessWeek cover story, “Going Private”, of February 27, 2020.

Private equity firms gather capital from the Super-Rich in order to take firms private and to concentrate on long-term goals, escaping over- and misguided- regulation by the SEC and the provisions of the Sarbanes-Oxley Act.

Since the Super-Rich own 47% of U.S. household financial assets and hold about one-third of this in equities (1997 estimates), $800 billion invested in private-equity ventures would amount to about 14% of their stock holdings — a substantial portion!

(See: “Rich and Poor“)

Private-equity ventures seem smart, compared to investments in ‘hedge funds’, which are often little more than flimflam deals, in which investors hand over cash, no-questions-asked, agreeing to pay 25% of profits, with no penalty for loss, to operators of essentially blind trusts, which, in recent years, have produced, on average, very mediocre results.

In contrast, partners of private-equity ventures typically receive 1.5% as an administration fee and 20% of the profits only when a venture is taken public or is sold.

The most attractive aspect of such arrangements is that, at least during the phase in which companies are privately-held, management does not need to focus on quarterly results or the burdensome reporting to government regulators, while the negative aspects of the buyback-options schemes that now dominate public equity markets are avoided.

A Reduction of 7% in the Overall Supply of Equities

Assuming that the estimated $800 billion of U.S. equities controlled by private-equity firms is reasonably accurate, this would amount to about 7% of the $11 trillion dollar U.S. equity market (Q3 2005).

According to estimates by Thomson Financial Buyouts magazine, $174 billion flowed into private-equity funds in 2005. This is more than twice the average level of flows into corporate buybacks between 2001 and 2004.

In other words, the private-equity movement has a significant impact on equity prices.

The going-private movement, combined with stock buyback-option schemes, results in the supply of public equities being constrained faster than in the 1990s. This puts upward pressure on an already over-valued equity market.

(See: “Stock Valuation“)

A Sophisticated Pump-and-Dump Arrangement

The important feature of the private-equity movement is that, unlike equity investors of the 19th century, these private-equity managers do not expect the big payoff to come from cash dividends, but rather from an eventual resale, often by taking a company public again.

In a flow of funds context for the whole market, here is what happens:

1. Accumulation Phase: Stocks are withdrawn from the public market by ‘going-private’.

2. Mark-up Phase: Over a period of years, free from uneconomical burdens of a public company and free to focus on long-term growth, a company is managed to improve profits, dividends, and long-term growth prospects. Meanwhile, executives of public companies, with agreement from open-end mutual fund managers, continue to keep stock prices high by stock buyback-options programs.

3. Distribution Phase: After sufficient time to achieve real improvement in results and to allow long-term capital gains rates to kick in (one-year), the private-equity managers resell the company into the public market, hopefully at price-earnings ratios at least as high as when the company when private.

Of course, there is nothing illegal, or even immoral, in this.

In fact, any plan that allows companies to be managed with long-term goals, even temporarily, is good for the economy.

However, the private-equity arrangement depends, in the final analysis, upon the assumption that average price-earnings ratios will not fall. This, in turn, depends upon the continued acceptance of the Common Stock Legend by unsophisticated investors in tax-deferred investment funds, as well as the public continuing to be oblivious to the true nature and costs of stock buyback-option schemes.

Off in the future, to weigh upon this arrangement, there will be the market impact of retiring Baby Boomers to consider.

In the meantime, equity privatization would seem to be extremely relevant to capital flows in the stock market.

This entry was posted on Friday, February 17th, 2006 at 11:13 am and is filed under Equities, Corporate Managers, Individual Investors, Demographics. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.

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