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Role of Private Equity in US Capital Markets - Sonecon Oct-2008

Role of Private Equity in US Capital Markets - Sonecon Oct-2008

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Published by AsiaBuyouts
The Role of Private Equity in U.S. Capital Markets by Sonecon (Dr. Robert Shapiro and Dr. Nam Pham) dated October 2008.

For an article discussing this document and/or more private equity info, please visit: http://www.asiabuyouts.com.

Source: http://www.privateequitycouncil.org/wordpress/wp-content/uploads/pec-study-role-of-pe-in-capital-markets-10-16-08-final.pdf
The Role of Private Equity in U.S. Capital Markets by Sonecon (Dr. Robert Shapiro and Dr. Nam Pham) dated October 2008.

For an article discussing this document and/or more private equity info, please visit: http://www.asiabuyouts.com.

Source: http://www.privateequitycouncil.org/wordpress/wp-content/uploads/pec-study-role-of-pe-in-capital-markets-10-16-08-final.pdf

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Published by: AsiaBuyouts on Feb 05, 2010
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The Role of PRivaTe equiTy in u.S. CaPiTal MaRkeTS
 
T R  Prt et  u.S. Cpt Mrts
Rbrt J. Spr d nm D. Pm
octbr 2008
SONECON
 
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The Role of PRivaTe equiTy in u.S. CaPiTal MaRkeTS
T R  Prt et  u.S. Cpt Mrts 
Rbrt J. Spr d nm D. Pm
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inTRoDuCTion
Private equity transactions and operations in the United States have grown dramatically over the last genera-tion. The number and value o U.S. private buyout-related deals rose rom 12 transactions in 1970, involv-ing less than $13 million in direct capital raised and invested, to 2,474 deals in 2007 or which buyout rmsdirectly raised and invested approximately $70 billion (net o leverage or borrowing).
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Including leverage, thevalue o U.S. buyout deals averaged about $100 billion per-year rom 2000 to 2005.
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However, these sharpincreases in private-equity buyouts, virtually all o them leveraged and some very highly so, have raisedconcerns about the economy’s vulnerability to a systemic nancial market event i a large rm, or a series orms purchased in a highly-leveraged buyout or a major private equity rm should suddenly ail. These con-cerns have been heightened by the systemic crisis and enormous costs triggered by the large-scale ailureso mortgage-backed securities and their derivatives, including the collapse o Bear Stearns, Lehman Broth-ers, AIG, Fannie Mae, Freddie Mac and Countrywide Financial Corp., and the severe nancial stresses andextraordinary government interventions on behal o other major nancial institutions. This report examinesthe basis or these concerns. Based on the data and analysis, we conclude that the organization o privateequity buyout unds and the nature and dimensions o their investments are undamentally dierent rom theconditions which have produced our current systemic instability, and that the private equity sector does notseem to present a systemic risk or U.S. capital markets or the economy.Private equity unds play a distinctive role in U.S. nancial markets and the economy by organizing and chan-neling capital and skilled managers to acquire and operate rms based on their analysis o the returns thoserms could generate i new management brings about signicant changes in those rms’ operations. Privateequity investors may buy struggling rms; they may purchase solid but unwanted divisions o conglomerates,and they may acquire strong companies with signicant growth potential. Regardless, their role contrastsclearly with other nancial institutions and investors — including hedge unds, mutual unds, pension plansand other asset management companies, insurance companies, banks, and universities and other endowedinstitutions — who purchase securities traded on secondary markets. These types o portolio investors seekto orecast the uture value and returns o the companies or indexes in which they might invest, based ontheir current or announced operations. Private equity unds provide investment opportunities that otherwisewould be unavailable to most institutions, as well as high net-worth individuals, to participate directly in theturn-around operations o non-public companies. As we will see, numerous studies have ound that the investors in private equity unds, on average, earn above-market returns, because the earnings o the acquired companies, on average, increase more than those ocomparable, publicly-held corporations. These ndings are consistent with other studies showing that privatelyacquired companies which subsequently go public generally outperorm the market,
4
as well as with data show-
1 This report was supported by the Private Equity Council. The analysis and conclusions are solely the authors’.2 VentureXpert Thomson Financial. Over these years, venture capital transactions by private equity investors and unds increasedrom 160 deals totaling approximately $103 million in direct capital invested to 5,303 investments with $40.2 billion invested.3 VentureXpert, Thomson Financial and the Private Equity Council.4 Cao, Jerry and Lerner Josh. (2006). “The Perormance o Reverse Leveraged Buyouts,” NBER Working Paper, http://www.people.hbs.edu/jlerner/RLBOPerormance.pd.
 
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The Role of PRivaTe equiTy in u.S. CaPiTal MaRkeTS
ing that private equity operations involving large companies generally create net new jobs,
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which usually area sign o an expanding market and sales. Many actors help to explain this perormance, rom the operationalimprovements carried out by private equity investors to the eects that leverage can play in increasing returnson investment. Whatever the causes, the dramatic growth o private equity largely refects the market’s rec-ognition o these results. This recognition has been especially acute among public and private pension plans,and universities, oundations and other endowed entities, which have become the largest investors in privateequity unds, accounting or more than 42 percent o the capital committed to those unds rom 2000 to 2007.
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 Moreover, these institutions contribute an even larger share o the capital raised in large private equity unds.Despite this rapid expansion o the private equity sector and its use o leverage nancing, our analysis hasound that these developments do not create new systemic risks or the capital markets and economy.To begin, data indicate that private equity rms and their transactions are much less highly-leveraged
•
than the leverage seen in numerous markets that either have experienced systemic problems or havebeen subject to severe stresses
without
creating such problems. In a sample o 63 o the 70 largest trans-actions carried out by eight large private equity rms rom 2002 to 2005, borrowed unds accounted or70 percent o the value o the assets purchased by the unds’ partnerships. While several purchases bythese rms in the last two years have been more highly leveraged, these levels are noticeably less thanthe leverage o Bear Stearns or Lehman Brothers’ holdings o subprime mortgage-backed securities andderivatives, the average leverage o the ve largest U.S. commercial bank holding companies in the late-1990s, the average leverage o the ve largest investment banks,
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and the nancial leverage or arbitrageactivities by hedge unds. While the role that leverage plays diers across asset classes and nancialinstitutions, as we will see, the greater the leverage, all else being equal, the greater the risk o a systemiccrisis arising rom cascading losses.In contrast to the systemic crisis that has recently unolded in the U.S. nancial system rom the ailures
•
o mortgage-backed securities and derivatives, or the interest rate-based securities and derivatives in-volved in the cascading problems triggered by the ailure o the Long-Term Capital Management hedgeund in 1999 and 2000, where the potential losses were virtually unlimited, the losses that could arise romthe ailures o rms held by private equity unds are limited to those rms’ direct liabilities and purchaseprices. An estimated 6 percent o private equity purchases result in bankruptcy or nancial restructuring,and those ailures result in investor losses. But as well will see, investors’ losses in such instances, oreven i a number o private equity held-rms ailed, pose little risk o a systemic eect.Systemic crises involve cascading eects transmitted across nancial institutions, which ultimately produce
•
what economists call “correlated deaults.”
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In a typical instance, a major event or development createslarge losses or a number o highly-leveraged investment banks, hedge unds or other nancial institutions,orcing them to liquidate assets in order to service their debts and restore their capital; and those largesales in turn drive down the price o those assets and spread the losses to other nancial institutions. Aprivate equity-held company that ailed is very unlikely to be so interconnected nancially as to cause such
5 Shapiro, Robert and Pham, Nam (2007, July). “American Jobs and the Impact o Private Equity Transaction.” World Growth, www.worldgrowth.org/assets/File/Shapiro-IPstudy.pd.6 VentureXpert, Thomson Financial.7 Report o the President’s Working Group on Financial Markets (1999). “Hedge Funds, Leverage and the Lessons o Long-termCapital Management,” http://treas.gov/press/releases/reports/hedgund.pd.8 Chan, Nicholas, Getmansky Mila, Haas Shane, and Lo Andrew. (2005, March). “Systemic Risk and Hedge Funds,” NationalBureau o Economic Research, Working Paper No. 11200.

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