Private Equity Demystified
We first met John Gilligan a few years ago and already regarded the book that he co-authored with Professor Mike Wright - Private Equity Demystified - as the definitive guide to what the private equity industry is all about, such that it's compulsory reading for anyone that joins our team! Updated in 2020, we asked John for his thoughts and insights on how the private equity world has changed over the last couple of decades and what might be in store for the future. Here are his thoughts:
In 2007 Prof Mike Wright of Imperial College and I were asked by Chris Ward who was then Chair of the ICAEW Corporate Finance Faculty to write a short briefing note on Private Equity. It was for the chair of The Parliamentary Treasury Select Committee, who were investigating the Private Equity industry. I would write the practitioner’s view and Mike would summarise the available academic evidence.
As we wrote it, it turned into a booklet and the first version of “Private Equity Demystified: An Explanatory Guide” was born. It was 73 pages long. We published it in 2008 in the midst of the global financial crisis and then did updates for the ICAEW every couple of years thereafter. By 2014 it had evolved into a book.
In 2016 I decided that I’d had enough of doing Corporate Finance and I left professional practice to do other things. I ultimately landed at Oxford University as the Director of a programme called The Oxford Said Finance Lab and as a trustee and Non Exec of The Big Issue’s social impact investment business. Mike had continued to be a prolific researcher and had become chair of The Society for the Advancement of Management Studies. At a dinner celebrating the 30th anniversary of Mike founding CMBOR, the Centre for Management Buyout Research, we sat and watched the BREXIT referendum votes being counted. Amidst the gloom we agreed that I would write a chapter for Mike’s forthcoming academic book, “The Routledge Companion to Management Buyouts” and we would also do a comprehensive re-write of PED, as we now called it, to reflect all the changes since the GFC.
It took us much longer than we thought. In summer of 2019 Mike told me he was ill and so his update might take a bit longer than usual. He didn’t say what was wrong and I quipped “I hope it isn’t serious or painful!” He replied, “not painful, but it is serious”. He died in November 2019, weeks after the 4th Edition was sent to the publishers.
What had changed in Private Equity over the decade or more that we talked and wrote together?
Firstly, the level of interest exploded. When we started there were very few books about Private Equity. Those that did exist either targeted managers who wanted to lead a management buyout, or fund managers who wanted to know a bit more before investing in a fund. Today there are shelves of books about the subject, some more informed than others.
Secondly the idea of the management buyout virtually died. The idea that a management team would lead the effort to try to buy a business that they ran has become broadly obsolete in developed markets. Today Private Equity firms buy companies as principals, usually in a competitive auction and then cut the management into the deal.
This standardisation of the process is now a defining feature of Private Equity. It always struck me that professional investors are entirely process driven. Try doing a deal on the back of a napkin and you’ll need a lot of napkins for all the due diligence that inevitably comes your way. There is a rigour to the way funds operate and the life of any analyst or associate reflects this process.
PE outsources almost everything, although this is changing in some of the largest managers. Outsourcing attracts a myriad of consultants and we now see these people migrating across the divide to become the next generation of private equity executives. Gone are the days when everyone you met in a deal team was either an accountant, leveraged finance banker or, like me, ex-3i. Today the investment bankers and consultants are flooding in.
The treatment of acquisition debt, the leverage of a leveraged buyout, has changed beyond recognition. The taxation of interest is a complicated and very poorly understood area. You routinely see commentators and even academics calling for the elimination of the deductibility of interest. They do this without apparently any recognition of the fact that large swathes of interest are not tax deductible and haven’t been for years.
The market for debt has also transformed. In 2007 banks led the European market. Today private debt funds dominate, and banks are being driven out of large areas of the market. The route into private equity through the leveraged finance arms of the big clearing banks is evaporating.
Deal sizes grew rapidly in the boom up to 2008, and today a PE fund is a viable buyer for most corporate assets in the world. Private markets have in many areas displaced public markets. Maybe the future is big, quoted funds owning portfolios of smaller, unquoted companies. If it is, there are big questions about liquidity mismatches to be thought through.
PE funds themselves are changing. There used to be 10-year commitments to a private fund by institutional investors. Today there is financial engineering within funds and a growing secondary market for those wishing to buy and sell their investments. This creates risk, but we aren’t sure whether it is material or inconsequential. Experience suggests that risk creeps in where regulation allows it to, so regulators need to be vigilant.
Across the world governments are looking at how to give private individuals access to PE fund investments. This again has some risks that need careful thought if you are not to see a raft of disaffected individuals who didn’t read the small print.
Arguments rage about returns (they are high, but the managers take a big share of the gain), corporate governance, regulation and the complex ways that fund managers arbitrage global tax and regulatory zones. All these are too wide to summarise here - we tackled them in the book. What I would say is that the evidence is that PE Funds come in all shapes and sizes, so if you want to look for any behaviour, good or bad, you can probably find examples.
Mike and I took over ten years to pull all the research together and to try to explain what’s going on and why it looks like it does as clearly as we could. We came to see Private Equity as an information industry. They use rigorous methods and processes to collect and analyse information that is not readily accessible to all potential owners. The exaggerated financial incentives created by both leverage in the investee companies and carried interest in the funds, attracts and motivates action to be taken swiftly. In our view of Private Equity, information acquisition lies at the heart of the industry, both structured data and informal relationships. This enables funds to make returns not available from stock picking in liquid markets.
The last version was published in February 2020 and is 438 pages long. It is for others to decide if the extra 365 pages since the first edition add or detract from the attempt to demystify.
“Private Equity Demystified: An Explanatory Guide” John Gilligan & Mike Wright was published by Oxford University Press in November 2020.
All author royalties in 2020 are being gifted to The Big Issue Trust to support their work with Big Issue vendors in the wake of COVID-19.