The role that private equity firms play in our economy through business growth and job creation is fundamental. However, the general public — and many astute business owners — mistakenly think of private equity firms as if they were Gordon Gekko, character from the movie, “Wall Street,” taking over businesses, eliminating jobs and trying to make money by shutting down companies and selling assets.
“I’ve often been astounded by the disconnect between the actual performance of private equity-backed businesses and the general public’s perception of what private equity is all about,” says Scott McRill, CPA, director in transaction advisory services at SS&G’s Cleveland, Ohio, office.
As a result, the private equity industry has recognized the need to be more open and vocal about what they are, what they do and the positives they bring to the economy, he says.
Smart Business spoke with McRill about the misperception of private equity’s role and how companies can benefit from this type of capital.
How has the private equity market evolved into what it is today?
In the 1970s, many business owners who started companies with family money in the post-WWII era had limited choices if they wanted to grow their business. They could take the company public through the public equity markets, infuse more family money or sell the business outright to a larger company. Private equity capital became a viable alternative, giving business owners another option. If you compare the job growth of companies owned by private equity to the overall economy over the past 10 to 15 years, it’s pretty astronomical. From 1995 to 2009, private capital-owned companies produced job growth at a rate of 81.5 percent compared to only 11.7 percent for all other businesses. Similarly, in the same period, private capital-backed companies produced sales growth of 132.8 percent compared to 28 percent for all other businesses, a surprising statistic to many.
How have lending policies driven more businesses toward private capital investment?
The lending environment always goes in cycles, and the involvement of private equity as a rule hasn’t gone away. However, the ratio of how much funding comes directly from private equity firms in the form of equity versus from banks and lenders in the form of debt has changed.
In the mid-2000s, there was a lot of economic growth and private equity investment, but the amount of money private equity firms were required to put into deals was less as a percentage of the total capital required to get a deal done than it is today. For example, 80 or even 90 percent might have come from lenders in the form of debt and the remaining 10 or 20 percent in the form of equity capital.
After the credit markets froze in 2008, private equity continued to invest in businesses but became more cautious and were required to put more of their own money into deals. In 2009 and 2010, it was not uncommon to see 50 to 75 percent of the capital coming from private equity firms, and lenders only providing 25 to 50 percent.
The lending environment has loosened some in the past couple of years, but it’s still relatively difficult, which can be partly attributed to the uncertainty regarding tax laws, interest rates, etc. Deals in the past 12 months might have a leverage model that is, for example, one-third equity, two-thirds debt.
Where does the negative perception of private equity come from?
There are always risks from private equity, and news stories are often negative about a private equity-backed business shutting plants down or a company that went bankrupt. Of course that happens, but the raw statistics show in many more cases private equity helps grow businesses, make them more profitable and create more jobs over the long term.
Other negative connotations can be attributed to the misperception that private equity is a secretive ‘club,’ which is highlighted by the nature of the word ‘private.’ Private equity firms receive a management fee for their expertise, but make the majority of their money by growing companies, producing more profits within those companies, and typically selling that company to another investor and sometimes taking the company public. Many have assumed bad things are going on behind the scenes at private equity firms, but private equity firms normally want the company to expand and become more profitable.
How are private equity firms responding to the negative bias, along with pressure for more disclosure?
The private equity industry has realized that the negative perception has to be dealt with, and industry professionals are trying to open up a widespread dialog about the industry and the positive things it has done for the economy. At the same time, they recognize there is going to have to be more, rather than less, disclosure and transparency about the industry. By the nature of the ‘private’ equity investments, the specific details of individual deals are private and confidential and probably won’t ever be disclosed widely by the industry. However, the inner workings of private equity firms — how they operate, the management fees they charge and, most importantly, the story about the economic growth engine they provide for small businesses — could become more widely available, especially with the political pressure for disclosure.
Many very entrepreneurial and talented business owners or operators are really good at what they do. They are really good at making widgets, selling certain services and serving their customers. But, the private equity world is foreign to many of them; it’s not something that they’ve ever really needed to tap into, so all they’ve heard is the negative soundbites. A faction of very talented business owners still need to be better educated about the good things the private equity industry does to expand companies and create more jobs.
Scott McRill, CPA, is a director in Transaction Advisory Services at SS&G’s Cleveland, Ohio, office. Reach him at (440) 248-8787 or [email protected].
