Going Private

Another private equity boom has passed,

but the underlying need for the industry has not
BY VA N E S S A S U M O

I n the mid-1980s, Meineke Discount Muffler had a problem. Automakers began

fitting their cars with stainless-steel mufflers with life spans of 12 years. Until
then, cars had been fitted with cold-rolled steel mufflers, which rusted after three
years. This innovation was worrying for the Charlotte, N.C.-based company
because a huge chunk of its business, about 65 percent in 1995, depended on
short-lived mufflers.
Meineke managers were determined to find new ways to Hundreds of deals involving private equity firms take
grow, but its parent company, an Australian multinational, place in the country every year. For more than 25 years, the
wasn’t too interested in investing in new plans. “They were private equity industry has been an important source of
very forthright about it,” says Kenneth Walker, Meineke’s funds for a number of groups: entrepreneurs starting a
president and chief executive. Meineke’s role in the parent business; families wishing to sell the business after the death
company’s portfolio was mainly to generate cash, which the or retirement of a founder; firms with strong growth
parent wanted to spend in other ways. prospects but in need of capital; companies in financial
Meineke executives longed to be independent, a wish distress; and publicly listed companies seeking to go private.
that was fulfilled in August 2003 when two private equity Private equity managers typically restructure the companies
firms, Carousel Capital, located just down the street from they buy and sell them later, keeping a part of the profits and
the Meineke headquarters, and The Halifax Group, giving the rest to investors.
which has offices in Washington, D.C.; Dallas, Texas; and Often, the deals take place with little publicity. Others
Raleigh, N.C., helped management buy Meineke from its are more high-profile, like the infamous takeover of RJR
parent company for $68.5 million. Meineke changed its Nabisco in 1988 by Kohlberg Kravis Roberts & Co., one of
name to Meineke Car Care Center and was transformed into the world’s largest private equity firms. That deal inspired a
an independent company with a more diverse service book and a movie, Barbarians at the Gate: The Fall of RJR
offering, significantly improved marketing, and increased Nabisco, a title that suggests the kind of reputation which
sales and profits. Carousel and Halifax assisted Meineke to private equity firms had then and have even today.
PHOTOGRAPHY: GETTY IMAGES

get to that point in more ways than just injecting capital. Private equity has burst into the limelight again in recent
Less than two years after buying Meineke, Carousel and years, primarily because of the large amounts of capital that
Halifax sold their investment and another private equity some groups have been able to raise, as well as the size of the
firm stepped in. deals that have been made. In the 1980s, a $200 million to

12 R e g i o n F o c u s • Wi n t e r 2 0 0 8
 public markets, hence the name
“private equity.” But instead of invest-
ing directly in private companies,
investors or the “limited partners” —
typically big groups like public and
corporate pension funds, financial
institutions, college endowments, and
sovereign wealth funds or very wealthy
individuals — place their money in the
hands of a team of professionals,
or the “general partners.” The general
partners then select and manage a
portfolio of companies on their behalf.
Private equity investing took off in
the early 1980s thanks in part to the
widespread adoption of this limited
partnership arrangement. The other
big boost came in 1978 from a ruling
that putting money in seemingly risky
private equity funds did not violate
the Employee Retirement Income
Security Act’s (ERISA) “prudent man”
$300 million fund would have been painful for private equity firms in requirement for investing private
considered large. But today, that’s just terms of their ability to finance deals pension funds, as long as these invest-
a fraction of the $21.7 billion fund and the returns that they can expect, ments were part of a larger pool. As a
that Blackstone, another large private has prompted questions on whether result, venture capital partnerships —
equity firm, raised in 2007. this is the end of private equity. the predominant private equity
The large influx of money from That seems doubtful as past waves activity at that time — raised $50
various investors, favorable credit have shown. The private equity market million in the first six months of 1979
conditions, and the willingness to tends to be cyclical. Moreover, most from pension plans governed by
form “club deals” allowed private academic studies suggest that private ERISA, up from less than $5 million a
equity firms to splurge on buyouts of equity firms do enhance the perform- year between 1976 and 1978.
some big-name companies. Chrysler, ance of the companies they purchase. During the life of the partnership,
Hilton Hotels, and Hertz are just a few The new owners, refining techniques usually about 10 to 12 years, the
names. In the United States, the num- developed over many deals, introduce investors’ money is tied up and they
ber of private equity-backed mergers strategies to make their companies have little control over how it is
and acquisitions (M&As) with values more efficient. If so, then why is this managed. It might seem that investors
topping $1 billion jumped from eight industry so controversial? Part of the would be better off without an inter-
in 2002 to 102 in 2007, according to problem is the veil of secrecy that sur- mediary. However, this would involve
Thomson Financial. rounds it. “This is still in many identifying and monitoring each of
But private equity is not just about respect[s] a very mysterious business,” their investments. Effective private
the deals and the firms that make the said Harvard Business School’s Josh equity investing requires considerable
splashy headlines. About nine out of Lerner at a private equity conference skill in choosing and structuring
10 private equity-backed M&A deals organized last fall by the think tank investments as well as in providing
worldwide were less than $1 billion in American Enterprise Institute (AEI). business advice to acquired compa-
the last three years, and seven out of “There is a lot which is not really nies, expertise that firms presumably
10 were under $250 million. understood about it, and a lot of have gained through participating in a
Critics are skeptical whether what seems to be understood is large number of deals. Thus, working
private equity firms leave companies absolutely wrong.” through a private equity firm can be
better off in the long run. They cite better than investing directly provided
the quick flips, the sometimes ruth- What is Private Equity? the limited and general partners’ inter-
less, cost-cutting way private equity The private equity market is one ests and incentives are well-aligned.
firms go about getting results, and the way through which companies can The compensation structure
seemingly nonchalant way they spend obtain funds. Investors provide capital provides this control — as well as a
money. The current turmoil in the in exchange for ownership shares lucrative way to reward general
credit markets, which will likely be in companies that are not traded in partners for good performance. When

Wi n t e r 2 0 0 8 • R e g i o n F o c u s 13
 Heady Growth
a private equity firm sells a The value of private equity deals surged to about a third sell later at a higher price.
portfolio company, the firm of all merger and acquisition deals in 2007. However, Companies typically go
returns the investors’ capital analysts say that private equity activity slowed in the last through a process of what
and whatever remains is split few months of that year. Harvard’s Lerner calls “inten-
between the general and limit- 35 sive therapy.” This process can
ed partners. Investors typically 30 be painful as private equity
take 80 percent of the profit, 25 firms work to weed out ineffi-
and the private equity firm gets ciencies. But the hope is that

PERCENT
20
20 percent or what the industry 15 companies will emerge health-
calls the firm’s “carried inter- 10 ier, more profitable, and more
est.” The bigger the profit, the 5 valuable. How do they do this?
larger the firm’s share of the 0 A report by consulting firm

2007
2005
2003
2001
1989

1999
1997
1987

1995
1985
1983

1993
1981

1991
pie, which is a powerful incen- McKinsey & Company finds
tive to invest well. Limited that in the best-performing
SOURCE: Thomson Financial United States World
partners also pay management deals, partners devoted more
fees equal to about 2 percent of than half their time to a port-
the amount of capital they commit to The issue of succession applies to folio company during the first 100
a fund. But these fees are not based on middle-market family firms and days and met with top executives
performance and are intended to cover closely held private companies as well, almost every day. Carousel Capital
basic expenses. which are typically bigger, well- likewise thinks this is a key factor in
Reputation is also a valuable incen- established companies with stable determining the success of an invest-
tive. Private equity managers are eager cash flows. The company may be sold ment. “We’re a big believer that
to establish a good record because that to the heirs of the founding family or a investing relatively close to home is a
determines their ability to raise more new management team in partnership good practice, because it promotes so
funds from investors and lenders in with a private equity firm that much interaction between the
the future. Partnerships have a finite organizes the funds for the sale. investors and the management team,”
lifetime, and if a private equity firm Middle-market firms may also be says Brian Bailey, one of Carousel’s
earned a low return on its last fund, looking for capital to finance an managing partners.
investors would seek other places to expansion or acquisition. Depending Carousel prefers to invest in the
put their money. on their size, these firms do have Southeast so that the partners can
From the portfolio companies’ access to debt markets, but that may easily get to their companies and
perspective, private equity can be a not be sufficient to meet their financ- spend more time with management
good alternative, especially if they are ing needs. And because they may have when needed. Meineke’s Walker
unable to raise capital from other no desire to go public, private equity talked with his primary contacts at
sources such as banks or the public can be a good option. both firms about once a month, if not
market. For instance, firms with high- But perhaps the most familiar once a week. Although few private
growth prospects that are young private equity transactions today are equity firms are located just a few
and untested might benefit from buyouts of public companies. Many blocks from one of their portfolio
venture capital, which is a type of people have probably heard of a lever- companies, he could sometimes meet
private equity investment. America’s aged buyout, which is a common way up with a Carousel partner for lunch
venture capitalists have financed well- of taking over a big public company and talk business. “It was an informal
known companies like Google, Apple using a substantial amount of debt. way to stay connected with one of the
Computer, and Intel. Public companies go private so they partners,” says Walker.
Smaller family firms may have can have a freer hand in making adjust- Private equity firms are demanding
opportunities to grow but are ments that will benefit the company, bosses. “If you talk to managers who
resource-constrained. The founder without having to constantly worry work with private equity partners on
may have to put in more of his own about short-run fluctuations in their their board … ‘anxious vigilance’ can
money, but he can only do that stock prices, the costs of compliance sometimes describe their world,” said
for so long. “Their family and friends imposed on public companies by the economist Karen Wruck of Ohio State
network is only so big and so they need Sarbanes-Oxley Act, and various pres- University at the AEI conference.
to go to an outsider,” says Fred Russell, sure groups. Of course, CEOs will still General partners “vigorously exercise
managing director and CEO of have a boss: the private equity firm. their governance rights,” said Wruck.
Virginia Capital Partners, a small Running the business becomes a much
private equity firm in Richmond. Also, Inside a Deal more intense process, where private
as the founder of the firm ages, he may Private equity firms buy shares in equity partners ask tough questions
want to retire and sell the business. private companies that they hope to and make managers understand how

14 R e g i o n F o c u s • Wi n t e r 2 0 0 8
their decisions affect the value of the because it makes them less dependent
Private Equity’s Impact on Jobs
company. It’s not so much that private on the capital markets. There are other ways to measure the private
equity firms always know how to This may, however, lead to a equity industry’s contributions apart from
run a specific business. Their knack is temptation to invest in wasteful financial returns. A 2007 Journal of Corporate
in finding the right people and projects if they no longer need to Finance paper surveys U.S., U.K., and other
organizing the company in such a way convince providers of capital each country studies on the real effects of buyouts.
that they let managers use their time of the soundness of their invest- The summary finding is that buyouts
expertise but hold them closely ment plans. Borrowing, therefore, “enhance performance and have a salient
accountable for the results. Private can impose discipline on company effect on work practices” of their portfolio
equity firms can get very good at managers. Since interest is paid out companies. For instance, plant productivity
employing the same principles over of a company’s cash flows, paying increased substantially after a buyout.
and over again — applied many times off debt is in effect a substitute for However, much media attention has focused
to different deals and companies. paying dividends. Debt can improve on employment numbers. Critics, in particu-
Changing the capital structure of a the company’s performance because lar, have often accused private equity firms of
company through a leveraged buyout managers must make sure that there enriching themselves while slashing jobs in
is another way to align the incentives is enough cash to meet interest pay- the process.
of management and shareholders, but ments and because they are dissuaded That private equity destroys jobs is not
private equity firms often get much from squandering company funds. completely untrue. “It’s not that it’s an inaccu-
flak for using a lot of leverage. A leveraged buyout also puts equity rate claim, but when you fill out the whole
Borrowing to finance a buyout allows in the hands of a smaller group picture, the story is much more mixed,” says
private equity firms to purchase com- of investors, which mitigates the University of Chicago Graduate School of
panies with only a small amount of problem of monitoring managers Business economist Steven Davis, who
equity capital, and shareholders to when there are many dispersed share- co-authored a large-scale study of the
receive very high returns. Say, for holders. Moreover, buyouts usually employment impact of buyouts on U.S. estab-
example, a private equity firm buys dictate that managers invest their own lishments. “I don’t think the story fits with
a company for $100 million, using money in a substantial stake in the the narrative that the critics have put forth,
$30 million of its own equity capital company, so they’re given a bigger nor does it really fit the sometimes glowing
and $70 million in borrowed funds. chance to participate in the success (or testimonials from the private equity commu-
If the private equity firm later sells the failure) of the company. CEOs of nity itself,” says Davis in an interview.
it for $130 million, then, after repaying portfolio companies tend to own a The study, published in the January 2008
the debt, the investors actually larger share of the company than their World Economic Forum report, follows target
double their money even though the counterparts at public corporations, businesses before and after the buyout trans-
company’s value rose by only 30 and this can be a powerful incentive. action, and then compares them with other
percent. The gains flow mostly to Leveraging is an important part of establishments with no ties to private equity.
equity holders because debt holders the private equity firms’ tool box, but When broken down in terms of job creation
receive only a fixed rate of return. it is no longer a strategy that is only and destruction, target establishments are
Critics say, however, that piling on available to private equity firms. So, cutting jobs at a faster rate than comparable
debt makes a company more vulnera- even as firms apply financial and businesses, but target businesses create
ble to going bust and therefore poses a governance techniques, they also focus jobs at a similar pace. This suggests that
risk to the economy. specifically on improving their portfo- private equity firms start out with some
But leveraging can be a powerful lio companies’ operations, by building “housecleaning” of businesses which seem to
tool in changing the way managers industry expertise and bringing in be already in distress even before the buyout,
behave. Economist Michael Jensen operations specialists and consulting as the study finds.
of the Harvard Business School noted groups to help them identify points for But companies also expand their
almost two decades ago that a central improvement. Some of these measures businesses, and thus employment, when they
weakness of a public company is the include reducing costs, for which open new manufacturing plants, retail
inherent conflict between owners and private equity firms are sometimes locations, and other facilities. Thus, to
managers of a firm over the control heavily criticized. But even as they cut complete the picture, the authors look at jobs
and use of corporate resources. and tighten, buyout shops today also create by private equity-backed companies at
In particular, managers of public look for opportunities to expand the these newly opened establishments. Private
companies may be hesitant to reach of their companies’ products in equity emerges the winner: They find that
distribute the extra cash that is left this country or abroad. target firms create jobs at a much faster rate
over (after all profitable investments While it is possible for public than firms with no ties to private equity.
have been funded) to shareholders companies to employ these same Overall, it appears that job losses are partly
in the form of dividends. Managers techniques without having to go offset by job gains from this expansion.
want to hold on to this extra cash private, it may be difficult to do in — VANESSA SUMO

Wi n t e r 2 0 0 8 • R e g i o n F o c u s 15
 practice, particularly with respect to back-end resources, which include the paid to the general partners — beat
governance. In portfolio companies, accounting, legal, and financial man- the returns on investing in the S&P
CEOs effectively have a boss. In a agement departments. He was proven 500 (the analysis includes venture cap-
public corporation, by contrast, CEOs correct. “It was private equity that ital and buyout funds). Other studies
typically don’t have one. Jensen, who allowed us to do that,” says Walker. “It come to similar findings.
also spoke at the AEI conference, just allowed us to be a more efficient However, Kaplan and Schoar’s
said that the board of directors of a company.” study finds that the same returns to
public corporation generally see However, others are more doubtful private equity funds — net of fees —
themselves as employees of the CEO. about the merits of private equity. The were roughly equal to the returns on
This situation changes only in the quick flip is one tactic that doesn’t the S&P 500. So, while their findings
event of a crisis, but by that time, come across favorably, with many suggest that private equity firms cre-
too much inefficiency has already set asking whether overleveraged compa- ate value at the company level,
in. (Public-to-private transactions nies have been sold too rapidly in the investors don’t seem to do better than
account for about a quarter of all public market. For instance, the if they just put their money in a mar-
buyouts worldwide in terms of dollar private equity groups that bought car ket index fund. It would then seem
value, according to a recent World rental company Hertz in 2005 bizarre that investors pour so much
Economic Forum report. Most buy- announced an IPO in just less than a money in this asset class given the
outs are acquisitions of private firms year, which prompted BusinessWeek poor returns.
and corporate divisions.) to call that move “rent-a-company.” There may be other reasons why
In the end, whether the hard work A 2006 NBER paper by Lerner and investors put their money in private
has paid off partly depends on the Jerry Cao of Boston College finds equity funds. Investors might value
private equity firms’ ability to “exit” an some evidence that leveraged buyouts the option of participating in a
investment well; that is, to find the which went public after less than a year future fund if participating in the first
right buyer. An exit route can be performed much more poorly than one gives them access to the next.
arranged through an initial public companies held longer. Such a strategy Investors know that in this business, a
offering (IPO) of the company, would then seem futile since buyout firm can get better at what they do
accomplished by selling shares in groups typically retain large ownership over time. Certain investors like big
the public market or by selling the stakes after the IPO and failure is too investment banks may also value
business to another company or costly for their reputation. investing in private equity funds for
private equity firm. But Lerner and Cao also find, the relationship that comes along with
In Meineke’s case, the partners had overall, leveraged buyouts that later it, because they value the possibility
a five-year plan that they achieved offered shares to the public through that private equity firms will call upon
in less than two years, and everybody an IPO “consistently outperform their consultation or underwriting
around the table agreed that it other IPOs and the stock market services. Or, it could be that investors
was time to move on. “Companies do as a whole.” Moreover, they find no have a hard time comparing funds’
get to a certain point in their life evidence that the returns of these returns to that of the market index.
cycle where they would perhaps “reverse” leveraged buyouts deterio- But the best-performing funds
benefit from another owner,” says rated over time. This suggests that within this larger group do better than
Bailey. Carousel and Halifax were private equity firms make their the market index even after fees. There
bought out by Allied Capital, a portfolio companies more valuable, seems to be persistence in fund
private equity firm based in even long after an IPO. performance as well; that is, a good
Washington, D.C., together with Another way to measure perform- private equity firm can consistently
Meineke’s management. Carousel and ance is by comparing the returns of generate good returns. This persist-
Halifax say they earned more a private equity fund to one that ence is stronger than in other fund
than their typical annualized target invests in a stock market index such types such as hedge funds and
return of 25 percent. “They were the as the S&P 500. In other words, which mutual funds.
right partners at the right time,” would do a better job of generating
Walker says. higher returns — a private or a public Feast, Famine, and the Future
company? A well-cited 2005 Journal As credit markets became more
Measuring Performance of Finance study by University cautious over the past several months,
If you ask Walker, he’ll say that private of Chicago Graduate School of many predicted a substantial slow-
equity firms do create value. His big Business economist Steven Kaplan down and even the demise of what
idea was that the company could grow and Antoinette Schoar, an economist they perceived was an overheated
quickly and profitably by buying other at the Massachusetts Institute of private equity market. But the boom-
franchise automotive brands while Technology, finds that the returns to and-bust nature of the industry is
taking advantage of the company’s private equity funds — gross of fees nothing new. “This is a story we have

16 R e g i o n F o c u s • Wi n t e r 2 0 0 8
seen many times before,” said Lerner. current cycle turns. The difference, arrangement. Private equity firms are
Money from investors flows into however, is that the companies’ capital motivated to make deals work because
private equity when returns are structures are actually much safer their reputations are on the line. Their
perceived to be higher relative to other today, said Kaplan, who also spoke partnerships with investors have a
types of investment. Together with at the AEI conference. Even with fixed lifetime, so if they want to
favorable credit conditions, which are the firms’ aggressive use of debt, raise another fund, they must show
important to private equity because companies’ debt levels are lower and investors that their past funds have
the deals typically involve leveraging, there is more of a cushion to make performed well. Thus, replacing the
private equity firms can raise large repayments. Thus, in the event of a funding provided by a partnership
funds for their acquisitions. But more recession, portfolio companies will with permanent capital from issuing
capital available means more competi- probably not experience the large public stocks removes this important
tion, which bids up the prices of number of defaults that was seen in motivator.
companies they buy. Moreover, when the early 1990s. As this relatively young industry
the industry as a whole is doing well, But even those who believe in the grows in size and influence, it is
money also flows to inexperienced merits of private equity worry that perhaps inevitable that there are
groups who enter the market in the some of the firms’ practices may be increasing pressures for more regula-
hopes of replicating the success of the weakening the very attributes that tion and transparency. Some are also
industry’s best performers. Hence, as have made them effective at what they calling for private equity partners to
the supply of capital goes up, returns do. For instance, because the amount pay taxes on the carried interest based
go down and investors pull out. Poor of capital committed by investors has on the income tax rate, rather than the
performers leave the market, competi- increased tremendously in recent lower tax rate on capital gains.
tion eases, returns go up, and the cycle years, the management fees collected But those who think that private
starts all over again. by the firm as a percentage of this equity will fall under the heavy weight
The buyout boom of the late 1980s, capital has likewise soared. Lerner of criticism and its perceived excesses
culminating in Kohlberg Kravis cited a study that shows partners’ pay might be disappointed. The industry
Robert & Co.’s takeover of RJR from “carried interest,” the perform- has been remarkably successful and it
Nabisco, is in many ways comparable ance motivator, is actually a relatively generally has a good story to tell.
to the heady growth in buyouts in the small slice of their overall compensa- Its influence extends even beyond the
last few years. Both episodes were tion and that much of the income firms that it operates. “If you have a
marked by large amounts of capital, comes from fees. He thinks that this is competitor who has private equity as a
record-breaking deals, intense public a concern because it might lead to pres- significant owner and they are making
scrutiny, and the use of debt securities sure for firms “to just do the safe thing, huge improvements, you had better
that fueled aggressive deal-making rather than doing the right thing.” make similar improvements or you will
(the junk bonds of the 1980s and the There are also worries about not be competitive,” said Wruck. The
collateralized loan obligations of private equity firms themselves going message is clear: Companies that are
recent years). public — as Blackstone famously did not backed by private equity firms will
As in the earlier buyout wave, deal in 2007 — because it could undermine be forced to shape up. Otherwise, they
volumes and returns on private equity the incentive structure that has been may soon find themselves competing
investment will likely drop as the built into the limited partnership against one that is. RF

READINGS
American Enterprise Institute. “The History, Impact, and Future Kaplan, Steven N., and Antoinette Schoar. “Private Equity
of Private Equity: Ownership, Governance, and Firm Performance: Returns, Persistence and Capital Flows.” Journal of
Performance.” Conference presentations. November 27-28, 2007. Finance, August 2005, vol. 60, no. 4, pp. 1791-1823.
Cao, Jerry, and Josh Lerner. “The Performance of Reverse Ljungqvist, Alexander, Matthew Richardson, and Daniel
Leveraged Buyouts.” NBER Working Paper No. 12626, Wolfenzon. “The Investment Behavior of Buyout Funds: Theory
October 2006. and Evidence.” European Corporate Governance Institute Finance
Working Paper No. 174/2007, June 2007.
Cumming, Douglas, Donald S. Siegel, and Mike Wright.
“Equity, Leveraged Buyouts, and Corporate Governance.” Journal Phalippou, Ludovic, and Oliver Gottschalg. “Performance of
of Corporate Finance, September 2007, vol. 13, no. 4, pp. 439-460. Private Equity Funds” (April 2007). American Finance Association
2008 New Orleans Meetings.
Fenn, George W., Nellie Liang, and Stephen Prowse. “The
Economics of the Private Equity Market.” Federal Reserve Board World Economic Forum. “Globalization of Alternative
Staff Studies, December 1995, no. 168. Investments Working Papers Volume 1: The Global Economic
Impact of Private Equity 2008.”
Jensen, Michael C. “Eclipse of the Public Corporation.”
Harvard Business Review, September-October 1989.

Wi n t e r 2 0 0 8 • R e g i o n F o c u s 17