March 05, 2007	Monday	Safar 15, 1428

A NEW debate is raging in London’s financial circles. Is what the private equity firms doing to raise funds and make profits good for the economy in the longer term or are they going to take the economy and many more things down along with them when the bubble would finally burst.

Prime Minister Tony Blair is all for leaving the private equity alone as according to him these firms bring benefits to the British economy and should not be stereotyped as asset-strippers. Last week when he was asked for his comment on the debate at his monthly media briefing he weighed in with his full support for the private equity firms.

What is private equity? It is a broad term that refers to any type of equity investment in an asset in which the equity is not freely tradable on a public stock market. Passive institutional investors may invest in private equity funds, which are in turn used by private equity firms for investment in target companies. In other words this is capital accumulated by fund managers from private sources looking for ways to escape the demands of public accountability on the stock markets and which also do not feel comfortable with corporate governance rules.

Categories of private equity investment include leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically control management of the companies in which they invest, and often bring in new management teams that focus on making the company more valuable.According to the Financial Services Authority, in the first six months of 2006 private equity firms raised £11.2 billion in capital on the London Stock Exchange. Ordinary firms raised £10.4 billion.

Private equity funds are the pools of capital invested by private equity firms. Although other structures exist, private equity funds are generally organised as limited partnerships which are controlled by the private equity firm that acts as the general partner. The limited partnership is often called the "Fund", and the general partners are sometimes designated as the "Management Company" (although at times, that is a separate company affiliated with the general partner).

The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment.

All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often extends up to 10 years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10 per cent of the total commitments.

General partners are typically compensated with a management fee, defined as a percentage of the fund's total equity capital. In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund.

Typically, the general partner will receive an annual management fee of 2—4 per cent of committed capital and carried interest of 20 per cent of profits above some target rate of return (called "hurdle rate"). Gross private equity returns may be in excess of 20 per cent per year, which in the case of leveraged buyout firms is primarily due to leverage, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not freely tradeable like mutual fund interests.

The shrinking of the London Stock market by about £50 billion despite rising of the average share prices is attributed mainly to the massive takeovers of public companies by private equity companies over the last one year. At the moment more than 2.5 million people in Britain work for some 700 private equity companies which have acquired saving and borrowing power of more than £1 trillion.

That these companies are making huge profits is not in doubt. But how they are making it is what is bothering the old fashioned financiers because it is being done by no more than old-fashioned financial engineering - that is, leveraging up returns by incurring lots of debt. Indeed, as one media analyst said, if pension funds and insurance firms had borrowed money themselves and invested in a basket of companies in which private equity groups invested, they would have made higher returns than even the best-performing private equity firms.

Borrowing to live beyond one’s means is very easy as long as it is not time for repayment. The private equity after taking over a not –so-profitable company turns it around by stripping it naked and then pumping into it borrowed money while at the same time reducing staff and hiking the price of the produce.

For example a consortium bought the car rental company Hertz in 2005, packaged up the car fleet in blocks of tradable assets that could be bought and sold by banks, and sold the weakened company back to the stock market another private equity firm bought media outfits such as PanamSat in the US or EirCom in Ireland “not to develop a free media that holds truth to power but, as Columbia University's Eli Noam argues, to weaken that capacity while remaining unaccountable owners themselves.”

One of the high-end departmental stores of Britain, Debenhams was bought, its stores sold off to be leased back by the enfeebled company, which was then sold back to the stock market. And other public companies, including ICI, Amec and EMI, are also said to be on the hit list of the private equity firms.

Some trade unions feeling the pinch have denounced the private equities as "casino capitalists" and some others are said to have mounted a clever and effective campaign against one private equity firm, Permira, over the closure of a clothing factory in south Wales.

While the prime minister seems to think private equity business as one of Britain’s success stories some of his Labour colleagues have termed these firms as job shedding tax-dodgers.

But those who defend the private equities say that it is not simply the high rates of return on investment which they bring in but according them there is evidence that takeovers by private equity firms, in the medium- term, generate jobs, rather than destroy them.

A study by Nottingham University's Centre for Management Buy-Out Research which looked at private equity deals over a five-year period, 1999-2004 is said to have found that there was an initial fall in employment by an average of 2.3 per cent in the first year after a buy-out. Thereafter, there was a significant increase in employment - up by an average of 26 per cent after five years.