Legal Village

Private equity is not secret equity

Posted 2/02/2007 by Charles Martin

We read almost hysterical articles daily in the press demanding transparency in private equity. This journalist chant, whilst mesmerising, is pretty imprecise in exactly what it is seeking. 

Transparency is self-evidently a virtue, so arguing against it is may be a little like arguing in favour of greed, fraud or manipulation.  However, the intrinsic virtues of transparency really find their roots in the public markets, where a clear and legitimate right to know exists.  Private equity now represents a huge proportion of western economies (never mind the M&A market). Too often it does little to prevent itself being perceived as a black box worthy of suspicion, probably concealing greed in its shrouds of confidentiality. But what is the transparency that people want to see and what are the legitimate reasons for it? 

Transparency could operate at three levels: 

• the activities and performance of portfolio companies;

• the overall performance of private equity funds themselves; and

• perhaps most tantalisingly, at the level of the individual working in private equity (how much do they make?).

Portfolio companies. All stakeholders (not just shareholders and directors) might be said to have a legitimate interest in fuller disclosure about what is going on in a private equity-backed company.  Given that these companies are often larger than all but the very largest listed companies, why should information about them be restricted to shareholders and lenders? This is probably the most legitimate area for shining a light into the black box.

One idea might be to change Companies Act accounts requirements to force companies over a certain size to produce a full set of report and accounts that goes beyond the present existing Companies Act requirements and includes a full commentary from management on the business:  rather like the accounts that listed companies produce. Private equity-backed companies that have issued publicly-traded bonds generally have to do this anyway.

Introducing such a requirement might also reduce some of the concerns that exist around inequality of information in the secondary debt trading markets, where some buyers and sellers have information of businesses that is not available to counterparties. Assuming that the burdens of producing such a document more than annually would be unacceptable, the real benefits may be illusory: the information would often be stale. Perhaps, however, it would also go some way towards placating the demands of union leaders that regulators and governments challenge the private equity community.

Fund performance. Investors in private equity funds almost without exception get all the information that they want on portfolio performance, including access to underlying portfolio companies and management. In fact, investors in private equity funds almost certainly get more transparency in relation to their investment than investors in public markets.

Fund performance is always examined in detail when private equity sponsors go out to raise new funds, as they do with increasing frequency in these buoyant and active markets. Many investors also do very detailed additional due diligence of their own before they invest. Freedom of information laws - in the US, at least - mean that a certain amount of information about fund performance is publicly available in any event.

As regards the need to make this kind of information available to people who are not actual or prospective investors in a fund, this must be questioned.

Individuals. The earnings of both the private equity sponsor management companies and individuals are generally available to investors. The fact that these earnings are not available to the general public is unsurprising. What people earn is a confidential matter, with the only exception being the highest-paid individuals in public companies and public sector employees. No-one knows what top investment bankers, fund managers or lawyers for that matter really earn. Journalists may be irked by it, but that is hardly a good reason for changing things. 

A point that overlays all of this is that private equity is meant to be just that: private. As a business/governance model, this means that businesses have the flexibility to be re-structured, turned around, take risks, take on leverage and do other things that cannot traditionally be done in the glare of the public markets. No doubt if private equity were regulated to produce greater disclosure requirements, some new asset class would spring up to make sure that business would have some environment available to it that did not attract the glare of public exposure. It might be called secret equity rather than private equity. 

Working for businesses that have that flexibility (and that also have the potential to generate significant personal wealth) is highly attractive to many of the most talented management teams, who are increasingly preferring the model to working in public companies.

In the UK, private equity is regulated by the Financial Services Authority (FSA), with a remit to ensure appropriate standards of integrity and to monitor the impact of the industry on financial markets at large. The FSA has almost completely unfettered access to information about the industry as its regulator and often this goes beyond what strictly may be technically required.

For example, when the FSA investigated the industry recently (focusing principally on its concerns over the impact of leverage on financial markets), it received a huge amount of co-operation and information from the industry itself on a purely voluntary basis. No lack of transparency there.

All this is not to suggest that things are absolutely fine as they are, but maybe the arguments in favour of transparency are not quite as compelling as they may, at first, seem.