The Rise of Private Equity

The Rise of Private Equity

What’s driving the surge in the last decade?

By Raj Gupta and Michelle Lowry

The amount of money invested in private equity has increased dramatically over the past decade, With growth rates that outpace the growth in public markets, the obvious question is what makes private equity so attractive? 

There are three key factors underlying the growth in private equity. 

First, the ‘skin in the game’ factor.  Both managers and directors of private equity-owned firms frequently have a greater ownership stake in the companies.  These higher ownership stakes align managers’ interests with those of shareholders.  Individuals with more skin in the game are incentivized to work harder, to focus more on the key value-drivers of the business.

Second, the long-term focus factor.  Unlike their counterparts in public companies, managers of private-equity owned firms do not have to devote substantial time to quarterly reports.  This frees them up to focus more energy on the long-term growth potential of the business.

Third, the agility factor.  Managers of private-equity owned companies answer to fewer people.  The lack of multiple investors and analysts following the company gives them more latitude to more quickly make key strategic decisions, if and when market conditions demand such moves.

The substantial influx of capital into the private equity space has enabled an increasing number of firms to operate under this structure.  However, it should be noted that this structure is not without disadvantages.  Private equity funds offer limited liquidity, which means they are riskier than typical public market investments.  Also, these investments are generally limited to institutions and wealthy individuals, thus shutting many out from these investment opportunities.

These disadvantages notwithstanding, academic evidence suggests that investors are increasingly recognizing the benefits of private equity.  Mutual funds are investing in a growing number of private companies, for example with 40% of VC-backed IPOs in recent years having mutual fund investment prior to going public.  Moreover, the mutual funds on average earn positive abnormal returns in these investments.  More generally, private equity funds, venture capital funds, and hedge funds use their superior information to earn positive abnormal returns on their investments in a broad array of firms.

This evidence raises the question of whether there is something that public investors and public managers and board members can learn from their private counterparts. What mechanism can best shift the focus of more managers and board members away from quarterly numbers and towards long-term value maximization?

Raj L. Gupta, is director for Arconic Inc. and Dupont, and chairman of Aptiv PLC (formerly Delphi Automotive PLC), and Avantor. From 1999 to 2009, Gupta was Chairman and Chief Executive Officer of Rohm and Haas. He has also served on the boards of HP, IRI, The Vanguard Group and Tyco International, amongst other companies. Michelle Lowry is the TD Bank Professor of Finance and the Academic Director of the Gupta Governance Institute, at the LeBow College of Business at Drexel University.

 

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