Financial Intermediaries Exist Purely Because Of Information Asymmetries And Agency Conflicts

Private equity is usually medium to long-term finance provided in return for an equity stake in potential high growth unquoted companies. These equity investments include securities that are not listed on a public exchange and are not easily accessible to most individuals [1]. There are usually available only to high net worth individual's, corporation's, institutional clients etc. These investments range from initial capital in start-up enterprises to leveraged buyouts of fully grown-up corporations. Mostly Private Equity funds are structured as closed-end funds with a finite life span of 10 or 12 years, which may be extended with the consent of the majority of the shareholders (Gompers and Lerner, 1999). Although they are illiquid and possibly more risky than publicly traded investments, when employed consistently as fraction of a larger balanced portfolio, they can offer higher returns than traditional public equity investments.

According to "Lerner et al. (2004) and Gompers and Lerner (2002)" Private Equity funds are typically structured as limited liability partnerships in which a specialized Private Equity firm serves as the general partner (GP) and institutional investors or high-net-worth individuals provide the majority of capital as limited partners (LP). The GP undertakes investments of various types (e.g. venture capital, bridge financing, expansion capital, leveraged buyouts), with the obligation to liquidate all investments and return the proceeds to the investors by the end of the fund's life.

Summary of private equity characteristics:

High risk asset class - As private equity market is not transparent, as there is little publicly available information. So investing in private equity is riskier than investing in other publicly traded firms. The risks and illiquidity of investments are compensated for by a higher expected return. [2]

Long-term time horizon - An engagement in private equity is usually long term investment with usual life span of 10-12 years.

Illiquid asset class - It is generally structured as a fixed limited partnership and often there are sale restrictions. Hence it is generally regarded as illiquid.

"Today most private equity investments are also financed by debt. The use of debt in addition to equity is known as "gearing" or "leverage" and is common in the financing of most companies. Private equity companies are highly geared as compared to other publicly traded or private companies"[3]. Private equity firms are very much aware of the advantages and risks of using debt and have been used it as an integral part of their competitive advantage as buyers and owners of a business. Debt is often repaid from the cash flows of the portfolio company, thus enhancing the value of the equity. Mature companies with stable cash flows are able to support a higher degree of borrowing, allowing repayments to the equity investors as compared to newer companies. Levels and types of debt tend to reflect the prevailing interest rate climate and the opportunities for acquisitions and internal investment available to the company [4].

[1] BVCA's "Guide to private equity" by Keith Arundale

[2] Matthias Huss, October 2005 "Performance Characteristics of Private Equity"

[3] Matt Krantz, USA Today " Private Equity Firms Spin Off Cash"

[4] House of Commons, Treasury Committee - Private equity -Tenth Report of Session (2006-07),Volume I

Private equity firms help out companies to secure capital for expansion and consolidation. With high levels of private equity debt, firms taken over by private equity groups are prone to interest rate hedging to levels that may, in some unfortunate instances, become an unsustainable drain on the resources of those firms. But when the debt levels in the capital injected grow to levels that may not be sustainable over the longer term, high interest rates can cause debt levels to topple a company. An expected turnaround can be crippled by a slowdown in the economy. So firms should watch the debt levels and any turn in the interest rate cycle [7].

For eg. the current turmoil in the US mortgage market has sparked a sharp contraction of credit markets, which may lead to meltdown in a number of private equity funds. Some private equity funds that have made high-debt buyouts could crash too, and a number of pending buyout deals may not go through. For eg at the end of July 2007, financing for the Alliance Boots and Chrysler buyouts, two of the biggest private equity-backed deals in the markets, ran into serious difficulties, intensifying fears about a looming credit crunch [5].

In recent months, all that has changed. Investors who previously snapped up private equity loans are now being refused low interest rates and easy credit conditions [4]. The success of private equity firms depends a lot on the availability of low cost debt. But in a situation like this it becomes more difficult and more expensive for PE funds to borrow money to buy companies. If the economy slows down, acquired companies' cash flow will too, making it harder for PE funds to pay back borrowed money. Volatile share markets will also make it more difficult for PE funds to re-sell companies, especially as the potential buyers may themselves face tighter credit conditions. [5],

Globally private equity backed companies have shown to grow faster than other types of companies. This has been made possible by the provision of a combination of capital and experienced personal input from private equity executives, which sets it apart from other forms of finance. Private equity helps firms to achieve their ambitions and also provide a stable base for strategic decision making.

Private equity firms add values through numerous stages such as active management, operations and financial strategy. The most effective private equity managers play an ongoing role as board members and strategic advisors to the business. In many cases, this includes actively stepping into a direct operating role for a period of time to take advantage of a particular opportunity or manage through a transition period. Strong operational and strategic talent within the fund manager's team can make the difference between success and failure. Financial expertise is required in every investment to effectively price, structure and complete the transactions, to ensure that portfolio companies are effectively financed as required from time to time and to facilitate exit transactions.

[4]