Skip to main content
Home Working together to build your tomorrow

"Schadenfreude" describes the feeling of smug satisfaction someone might gain upon hearing about the bad luck of someone else. It is not a good character trait.

Nevertheless, I found myself like Peter Seller's "Dr. Strangelove" having to yank my hand back down after reading that the private equity industry was in trouble these days. My initial burst of satisfaction was tempered by what the troubles of these grossly overpaid people could mean for the rest of us.

"Private equity" describes the practice of raising money to buy companies and then selling them for a profit after what is typically an exercise of "financial engineering." Firms raise money from investors and borrow even more to create leverage.

Using their war chest, they buy companies that are privately owned, or they initiate takeovers of existing public companies. A common approach is to break up the target company and sell it in pieces where the parts are greater than the whole. Another approach is to restructure the management and product line of the target company to make the latter more profitable before selling it to another firm -- or even taking it public yet again.

For an entertaining short cut to how this system works, check out the movie "Other People's Money" with Danny DeVito.

Private equity firms routinely make a lot of money even when they're unsuccessful, because, at the very least, they charge investors 2 percent per year of assets under management as their fee. When they complete a successful transaction they take 20 percent of the profit.

This investment type is attractive to large college endowment funds and government pension funds, however, because the good and bad years for private equity tend to be the opposite of good and bad years for the stock market. Private equity offers a "buffer" that can work effectively to smooth overall portfolio results beyond just balancing stocks against bonds.

Money flooded into private equity firms during the past decade while they were doing well, and now investors with false expectations are surprised to find that their investments are stagnating if not declining in value.

The problem stems from private equity firms having invested in companies for which they overpaid. Now, there are no buyers offering more than the original purchase price, so the current owners are stuck. The "greater fool theory" has experienced a short circuit.

Investors, conditioned to expect the returns of the past decade, have been taken by surprise. In many cases, they have yet to learn that the funds have undoubtedly lost money in recent years while the stock market has gained an average of 20 percent per year for the past three years.

Private equity enjoys the luxury of delaying bad news, because the value of their unsold investments is by an annual appraisal.

The light at the end of the tunnel for this subset of the financial services industry is the extent to which managers shift gears and become shareholder activists. Considering the lack of success with traditional approaches, this seems to be a promising new direction for private equity.

The archetype for this process was Michael Price, the founder of the Mutual Shares fund more than 40 years ago. He sold his fund to Franklin Templeton and retired in 2001, but back in his prime, his purchase of major blocks of stock in public companies struck fear into the hearts of corporate managers. He was the activist shareholder personified.

Today's equivalent would be someone like Daniel Loeb, whose private equity company, Third Point, owns 5 percent of Yahoo (YHOO) and who is clamoring for changes at the company.

Where private equity can deploy the resources to kick butt and command the attention of the power elite in corporate America, it serves a useful purpose for the rest of us.

Get weekly articles delivered to your inbox!

* indicates required
Is this content useful?