Private equity firms, which in recent decades have become an important avenue for financial transactions in the US and UK markets, are being hard hit by the sub-prime crisis as they are unable to source their funding from investors. The resulting credit crunch and financial turmoil may also pose a threat to developing-country financial markets where they have become significant investors, particularly in Asia. The danger, according to a warning issued by the Reserve Bank of India, is that these equity funds could pull out from these markets in the face of the credit crisis in the US mortgage market, thereby causing greater financial volatility. But what is the creature called private equity? Andrew Cornford explains its character, history and role in financial markets.
LONG ignored outside the financial sector, private equity is now attracting widespread attention. This has been fanned by recent news items concerning some particularly large takeovers by private equity firms and the enormous income and capital gains which can accrue to their managers and principal shareholders, and which enable lifestyles recalling the earlier gilded age of the late 19th-century United States. Political interest has focused primarily on the loss of jobs in enterprise restructuring following takeovers by private equity firms, and on low rates of taxation of the remuneration of private equity managers and investors. Broader issues are also coming under scrutiny. The International Organisation of Securities Commissions (IOSCO), a body which fosters cooperation between different countries' securities markets and regulators, has established a task force to examine the implications of the increased role of private equity firms in global mergers and acquisitions (M&A), where their share of activity is now estimated to be as much as 20%. The ambitions of private equity firms are increasingly directed at new targets. These include sectors like banking and pharmaceuticals where the value of firms is large and performance is not necessarily crying out for restructuring. Moreover, as part of the globalisation of finance, private equity firms are raising their profile in Asia, a development likely to stimulate the growth of an indigenous private equity sector.
Character and history
Private equity is usually understood to cover the provision of medium- and long-term financing to firms not quoted on public stock markets as well as the financing of the equity tranches in buyouts of public companies. Financing in private equity operations is in the form of both equity and debt. The equity is typically provided by private equity funds which raise their capital from funds of funds, pension and investment funds, endowments and rich individuals. The initial debt is provided by banks but typically, a substantial share of this debt is subsequently distributed to other financial institutions. As a financing vehicle, private equity is most important in the United States and the United Kingdom. In both countries, private equity shares common historical origins with venture capital financing. In the United States, what is now called private equity financing developed features in the 1980s distinguishing it from venture capital. This followed some propitious legislative initiatives such as lower taxes on capital gains, relaxation of the Employee Retirement Income Security Act (ERISA) rules which had previously prevented investment of savings under this heading in high-risk ventures, and reduction in the reporting requirements for firms conducting private equity management. In the United Kingdom, for the first 30 years after 1945, the most important source of venture capital was the Industrial and Commercial Finance Corporation (ICFC) - later renamed 3i - established by the government in response to the finding of the 1931 Macmillan Committee (of which...