Private equity has come under enormous criticism, especially from labor groups and their congressional allies, for eliminating jobs and gutting employee benefits.
But labor unions have to recognize that restructuring would have to take place eventually in these companies, whether through the public or private markets, for many of them to survive in the highly competitive global economy. Private equity groups merely accelerate the process and might, in fact, save jobs in the long run.
On the other hand, other, more competitive and rapidly growing companies, are adding jobs. Overall the U.S. unemployment rate has remained around 4.5% during the past 17 months, in the face of a growing work force and increasing global competition.
One question is whether activist shareholders and the Sarbanes-Oxley corporate reforms have contributed to the private equity boom. That question comes up, but we arent talking about that, said Clark McKinley, spokesman for the $245.3 billion California Public Employees Retirement System. CalPERS is both an activist investor, pressuring corporations for better corporate governance and results, and a big investor in funds taking companies private.
But the public equity markets even under the pressures of increasing shareholder activism and SOX regulation are soaring, with the Dow Jones industrial average and the Russell 1000, 2000 and 3000 indexes repeatedly topping their records and the S&P 500 coming close.
Such economic success typically brings less scrutiny of public and private equity managers. Success can induce complacency. Now is the time to ensure that conflicts of interest and other bad practices do not grow unnoticed in both the public and private markets, and for investors in the public markets to learn from the private equity successes.
Private equity companies command a different perception among investors. Private companies appear to have advantages in performance over public companies. Take short-termism the practice of corporate boards and executives, as well as active money managers, making decisions based on short-term expectations that jeopardize the creation of long-term value.
Private equity firms trumpet their ability to give the companies in their portfolios a long leash because they operate out of the public scrutiny. Private companies dont have the trading swings that public corporations face from skittish active investors scanning quarterly financial reports.
Private equity firms have conditioned their investors to have patience. CalPERS even instructs its participants on the J-curve effect, in which private equity returns will show low or negative returns in early years and a steep upswing in gains later. More public market investors should learn patience from private market investors.
But then there can be the L effect of private equity firms own short-termism that might temper pension fund enthusiasm. Private equity firms can leverage up companies to pay principals big special dividends, professional fees and management fees, profiting in the windfall but leaving huge burdens of debt the companies must pay before they reach the up part of the J curve. Some will not make it.
And there is a dark side to private investing, too. Private equity firms attribute their successes in part to confidentiality. But the lack of transparency makes it hard to independently determine valuation and risk, as well as uncover conflicts of interests and other unacceptable practices. Public pension funds often wont name the companies in their private equity portfolios. CalPERS wont even identify the private equity firms in which it has an ownership interest, except for its 5.5% share in Carlyle Group.
Private equity fosters a dependency on managers that pension funds dont need. The move toward hidden investing by public and other funds is dangerous. Unhealthy practices tend to grow in the darkness. All investors should remember that sunshine is a powerful disinfectant against the growth of such practices.