Monday, July 16, 2007
The Financial Times has a brief article today on lending to private equity executives. Private banks lend to private equity executives who need required cash to invest in their own funds. In Europe, the market is estimated to be about €1 billion ($1.37 billion), and the U.S. market is thought to be even bigger. The need for this money arises from investor requirements that the prinicpals of a private equity fund put their own money into any fund they raise. This usually amounts to 1-5 per cent of the total. With the rise of the mega-private equity funds, these sums are substantial even for these people thereby providing the impetus for this market.
The borrowing raises issues of risk for the executives themselves. They are borrowing money to invest in transactions which themselves are levered. But it is also a meaningful way to align the interests of private equity fund advisers and the investors themselves. The private equity advisers stand to earn fortunes if they can return an appropriate amount to their investors, but can also lose substantially if they fail. The success of this model is apparent in private equity fund returns. The studies are mixed but most find that, when fees are included, private equity returns are greater than comparable levered investments in the S&P 500. The returns have also been found to have statistically significant alpha (See, e.g., Steven N. Kaplan and Antoinette Schoar, Private Equity Performance: Returns, Persistence and Capital Flows (November 2003). So, I am still surprised that this private equity model has not had wider adoption in the public company forum. It appears to be a promising way to greater align the interests of public shareholders and executive officers than other types of incentive-based compensation such as stock options or stock plans, reducing agency costs and producing mutually beneficial results.