Forbes.com

When Private Equity Goes Public

Public shareholdering could erode private equity's activist investor mindset.

By Orit Gadiesh, Luca Caruso and Hugh MacArthur

First published on junio 15, 2007
min read


Blackstone's recent move to nearly double the size of its planned public offering to $7.8 billion, hard on the heels of a $3 billion investment by the Chinese government for just under 10% of Blackstone's management company, gives the private equity firm bragging rights to one of the largest U.S. public offerings of the year so far. In fact, a host of private equity firms have been considering creative ways to raise cash, both before and since Blackstone announced its plans for a mid-June IPO. But much depends on the approach. And the wrong course could erode private equity's real advantage—its active investor mindset. Private equity firms are tapping the public markets in two different ways. The first is offering a piece of the management company. The Chinese government and other investors who secure shares in Blackstone's IPO, for instance, will end up owning about 20% of Blackstone, entitling them to a share of the profits of the firm from management fees and carried interest, with no voting rights. The second approach is floating shares in a private equity fund itself, which the management company then invests. To get access to more capital, the fund can issue more shares, like a rights issue for a public company. These shares trade and value the fund and its investments like any other public company. A handful of firms, including London-based 3i Group and Onex in Toronto, have taken a hybrid approach, with relatively good returns. At this point, however, leading private equity firms appear to be looking at floating shares in either the management company or their funds. The implications of these two approaches are quite different. The money raised by selling a stake in the management company is not a source of "evergreen capital." Rather, it allows the firm to diversify its ownership without radical changes in the way it does business—at least, that's the expectation of how such public offerings will be treated by regulators. Thus, some proceeds from the Blackstone IPO will help fund expansion in China and elsewhere, but much of it will be used to cash out some holdings of the firm's partners. Selling shares in a fund, on the other hand, holds the potential for some big opportunities—but also contains bigger risks to private equity's model. The upside is that the firms don't need to waste time and precious human capital on fund-raising, a time-consuming process that takes some of the vital players in a private equity firm off the field every few years for months at a time. Another benefit is differentiation. Money, after all, is rapidly becoming a commodity, and leading private equity funds are looking for ways to stand out even further from the crowd. Top funds want to do deals of almost any size on their own so they can apply their particular approach to improving company performance without dilution by a consortium of investors. Access to public equity also means that funds can be more nimble pursuing deals in different parts of the world with different types of assets. In Japan, for instance, firms often need to structure deals with more debt products; in India, minority equity stakes are the key to entry; in China and Brazil, the current focus is on infrastructure investments. Pursuing those opportunities involves a range of risk and return that reaches beyond the typical Limited Partner agreements private equity firms strike with institutional investors. Finally, the leading funds have clearly developed their own brands. Taking a page from their own playbooks for growing the value of their portfolio companies, they see ways to use their brands to raise more capital, extend their range and pursue more opportunities. The danger is that this type of public shareholding will constrain the ability of funds to act like owners. As their public float increases, so do the risks that compliance with regulations and reporting requirements will slow down or stall private equity's fast attack. Even more serious is the risk of eroding private equity's activist investor mindset. After all, that's the real advantage that private equity players hold. They invest with a thesis for improving profits and performance in a given business in three to five years, instead of taking a quarterly view of performance improvement. They create a blueprint for change, detailing what, how, when and where to drive the big adjustments in a company's organization and performance. They also measure only what matters and measure it often, to understand whether a business is moving in the right direction and gaining speed. They hire, motivate and retain hungry managers, stimulating them to think like owners. And they make equity sweat: the average private equity firm finances about 70% of its assets with debt, vs. 40% a typical public company. Scarce cash forces managers to redeploy underperforming capital. When private equity succeeds, it presents an enormously compelling business model. Over the 35 years from 1969 to 2006, the top quartile U.S. private equity funds had annual rates of return ranging from an average of 39% to well over 200% through good times and bad. The moves by private equity firms to tap public sources of funds are in some ways the natural evolution of an industry that continues to grow. But the industry's leaders will need to move carefully to preserve what's unique and effective about private equity. Orit Gadiesh is chairman of Bain & Company. Luca Caruso is a partner in Stockholm and co-directs the firm's European Industrial Practice. Hugh MacArthur directs Bain's Global Private Equity Practice. Bain Book Lessons from Private Equity Any Company Can Use Learn more about how PE firms use six disciplines to attain their edge.

Blackstone's recent move to nearly double the size of its planned public offering to $7.8 billion, hard on the heels of a $3 billion investment by the Chinese government for just under 10% of Blackstone's management company, gives the private equity firm bragging rights to one of the largest U.S. public offerings of the year so far.

In fact, a host of private equity firms have been considering creative ways to raise cash, both before and since Blackstone announced its plans for a mid-June IPO.

But much depends on the approach. And the wrong course could erode private equity's real advantage—its active investor mindset.

Private equity firms are tapping the public markets in two different ways. The first is offering a piece of the management company. The Chinese government and other investors who secure shares in Blackstone's IPO, for instance, will end up owning about 20% of Blackstone, entitling them to a share of the profits of the firm from management fees and carried interest, with no voting rights.

The second approach is floating shares in a private equity fund itself, which the management company then invests. To get access to more capital, the fund can issue more shares, like a rights issue for a public company. These shares trade and value the fund and its investments like any other public company.

A handful of firms, including London-based 3i Group and Onex in Toronto, have taken a hybrid approach, with relatively good returns. At this point, however, leading private equity firms appear to be looking at floating shares in either the management company or their funds.

The implications of these two approaches are quite different. The money raised by selling a stake in the management company is not a source of "evergreen capital." Rather, it allows the firm to diversify its ownership without radical changes in the way it does business—at least, that's the expectation of how such public offerings will be treated by regulators. Thus, some proceeds from the Blackstone IPO will help fund expansion in China and elsewhere, but much of it will be used to cash out some holdings of the firm's partners.

Selling shares in a fund, on the other hand, holds the potential for some big opportunities—but also contains bigger risks to private equity's model. The upside is that the firms don't need to waste time and precious human capital on fund-raising, a time-consuming process that takes some of the vital players in a private equity firm off the field every few years for months at a time.

Another benefit is differentiation. Money, after all, is rapidly becoming a commodity, and leading private equity funds are looking for ways to stand out even further from the crowd. Top funds want to do deals of almost any size on their own so they can apply their particular approach to improving company performance without dilution by a consortium of investors.

Access to public equity also means that funds can be more nimble pursuing deals in different parts of the world with different types of assets. In Japan, for instance, firms often need to structure deals with more debt products; in India, minority equity stakes are the key to entry; in China and Brazil, the current focus is on infrastructure investments. Pursuing those opportunities involves a range of risk and return that reaches beyond the typical Limited Partner agreements private equity firms strike with institutional investors.

Finally, the leading funds have clearly developed their own brands. Taking a page from their own playbooks for growing the value of their portfolio companies, they see ways to use their brands to raise more capital, extend their range and pursue more opportunities.

The danger is that this type of public shareholding will constrain the ability of funds to act like owners. As their public float increases, so do the risks that compliance with regulations and reporting requirements will slow down or stall private equity's fast attack.

Even more serious is the risk of eroding private equity's activist investor mindset. After all, that's the real advantage that private equity players hold. They invest with a thesis for improving profits and performance in a given business in three to five years, instead of taking a quarterly view of performance improvement. They create a blueprint for change, detailing what, how, when and where to drive the big adjustments in a company's organization and performance.

They also measure only what matters and measure it often, to understand whether a business is moving in the right direction and gaining speed. They hire, motivate and retain hungry managers, stimulating them to think like owners. And they make equity sweat: the average private equity firm finances about 70% of its assets with debt, vs. 40% a typical public company. Scarce cash forces managers to redeploy underperforming capital.

When private equity succeeds, it presents an enormously compelling business model. Over the 35 years from 1969 to 2006, the top quartile U.S. private equity funds had annual rates of return ranging from an average of 39% to well over 200% through good times and bad.

The moves by private equity firms to tap public sources of funds are in some ways the natural evolution of an industry that continues to grow. But the industry's leaders will need to move carefully to preserve what's unique and effective about private equity.

Orit Gadiesh is chairman of Bain & Company. Luca Caruso is a partner in Stockholm and co-directs the firm's European Industrial Practice. Hugh MacArthur directs Bain's Global Private Equity Practice.