The Paradox of Private Equity
Even the critics of the private equity industry find that the gross performance of funds is higher than that of public companies. This is puzzling because almost all academic evidence shows that M&A destroys value in public companies and Private Equity is all about M&A. How can a strategy that is shown to destroy value in public companies, be at the very heart of value creation in private companies? (whoever ultimately receives the value created)
Since 2007 when Mike & I first wrote together, we have made the argument that PE has developed practices and processes that manage the consequences of information asymmetry and illiquidity. Others have found ways to express the idea more clearly than we did, but in essence the argument is that PE firms are able to buy assets in imperfect markets created by information asymmetry. They do this by having rigorous processes that other corporates do not employ to unearth and assess potential acquisitions. PE Firms are better at buying businesses because it is their core competence. The fact that they spend more time and money on the process is not an accident. In our world. the most relevant Nobel prize to understand Private Equity is George Akerlof’s Nobel prize winning "Market for Lemons". Akerlof pointed out that if bad second hand cars ("Lemons" in the States) are indistinguishable from good ones, nobody will trade in good ones at a fair price and the market mechanism fails to operate.
PE processes help to solve the market failure caused by information asymmetry by having close to open book access to targets in due diligence, and, because the market is failing, there are excess profits to be made over buying and selling shares in public companies.
The strategy is not without its costs. In addition to high transactions costs, the other key cost is illiquidity. You get better information and but give up the ability to trade in shares. You also have to buy control of the business if you ever want to realise any value created. Once you buy control, you quickly learn to use it. PE firms active management style emerged as a consequence of illiquidity.
If you tried to use the PE strategy only on public companies, you'd be in jail, because insider dealing is strictly illegal. That is why PE deals are overwhelmingly private transactions.
A second paradox is one for researchers. Researchers need data to test hypotheses to get published. Data was only generally freely available on public companies, so much research focusses on them. But as Mike would always say, the research on public company buyouts misses out the vast majority of PE deals. These are the deals that are not public, because of very information asymmetry problem we described above. That was why he started logging all the private deals 30 years ago and was able to do research on them at a company level, as opposed to PE fund level, that led to published papers with over 90k Google scholar citations
PE is a Lemon Squeezer...
“Private Equity Demystified” with Prof Mike Wright OUP 2020 was published on 4th November 2020
https://www.amazon.co.uk/Private-Equity-Demystified-Explanatory-Guide/dp/0198866992/