156
A S T H E R O L E O F
P R I V A T E E Q U I T Y H A S
G R O W N , S O H A V E
T H E R I S K S I T P O S E S
THE PRIVATE EQUITY MODEL
S
ome economists believe
that “private equity” is
misnamed, since it is a
model based on debt, not equity
(the value of assets owned outright
by an individual or company).
Private equity involves “leveraging”
a balance sheet by loading debt onto
the business. This is similar to the
controversial practice of “leveraged
buy-outs” (LBO), in which a
company is acquired using a high
percentage of borrowed funds,
loading it with a high level of debt.
Such levels of debt pose
inherent risk, as US politician Jack
Reed highlighted. Pressure on
managers increases—good profits
are necessary in order to minimize
interest charges on the company’s
debt. The theory is that this forces
managers to perform better, but
critics claim that a company run on
the private-equity model is likely to
maximize short-term profit at the
cost of long-term business growth.Less pressure, more focus
To its supporters, the main strength
of the private-equity model is in
what it removes. First, it removes
the regular profit pressure from
shareholders that is faced by bosses
of a publicly traded company. ForAt first, private equity came
only from large investors
wanting long-term gains.But in the 1980s, smaller
investors used leveraging
and debt to buy companies.This type of private equity
requires high short-term
profit (to service debts).Long-term opportunities
are likely to be overlooked
in favor of short-term profit.As the role of private
equity has grown, so
have the risks it poses.IN CONTEXT
FOCUS
Profit and riskKEY DATES
1959 Fairchild Semiconductors,
the first venture-capital-funded
start-up, is created.1978 US investment group
KKR pays $380 million to take
manufacturer Houdaille
Industries Inc. private; this is
probably the first private-
equity transaction.1988 KKR buys conglomorate
RJR Nabisco for $25 billion in
the biggest private-equity
purchase the world has
yet seen.2006–07 A peak year for
private equity—in the US
alone, private equity
companies buy 654
companies for a total of
around $375 billion.