The Role of PRivaTe equiTy in u.S. CaPiTal MaRkeTS
ing that private equity operations involving large companies generally create net new jobs,
which usually area sign o an expanding market and sales. Many actors help to explain this perormance, rom the operationalimprovements carried out by private equity investors to the eects 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.
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 hasound 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
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,
and the nancial leverage or arbitrageactivities by hedge unds. While the role that leverage plays diers 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 unolded 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 hedgeund 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 eect.Systemic crises involve cascading eects transmitted across nancial institutions, which ultimately produce
what economists call “correlated deaults.”
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/hedgund.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.