The big economics story in 2006 was PE. Not the phys-ed kind or even the price-earnings ratio that investors are familiar with. The PE that energized financial markets in 2006 and will likely dominate 2007 is private equity.
Private equity is an alternate source of capital for businesses. It substitutes a few private investors – sometimes just one – for all the stockholders that own a public company. Then, instead of being a publicly traded company, where shares are held, bought, and sold in markets such as the New York Stock Exchange and NASDAQ, the new company becomes private.
Shares are not offered for sale to the public, quarterly and annual financial reports are not published, and the company essentially disappears off the financial radar screen.
The companies continue to do business, and their customers may not even notice any difference. Shoppers at Toys “R” Us, for example, may not realize that the once publicly owned stores are now privately held by an investor group. There is no visible reason why they should either know or care.
For well over half a century, the traditional pattern of financing has been for firms to start up on their own, obtain private financing to pay for the next growth stage and later to go public to gain access to the big money that only the organized finance markets with their millions of investors could provide.
But now private equity is challenging that model. It has the financial strength to support big-money deals that can match stock market billions. Being a public company is no longer the capstone of a corporation’s financial history.
Financial markets are the jewel in the crown of the American economy. The stock market especially is the place where the American dream becomes real; the place where good business ideas can get access to the capital needed to transform them into thriving enterprises.
It is also the hall of justice for U.S. businesses, the place that rewards good business management and punishes those who couldn’t deliver. Like a giant scoreboard, the stock market sorts out winners and losers.
Of course, to get access to all that market capital, a company has to do two things: pay the price of admission and play by the rules.
The price of admission in most cases means paying investment firms a substantial portion of the capital received – and accepting the fact that sometimes they earn it and sometimes they don’t.
Playing by the rules involves satisfying two masters: the market itself and the regulatory authorities.
The market isn’t easily satisfied, but its needs are simple. As far as a company’s performance goes, rule one is that the market does not like unpleasant surprises and is even skeptical of pleasant ones. Rule two is that the market is not your friend; growth and profitability are your only friends. And rule three is there are no excuses.
Satisfying the regulatory authorities is more complicated. Left to their own devices, the private and federal regulatory authorities who run the exchanges are not generally difficult to deal with. They have capital requirements and don’t like late (or flawed) financial reports, scams or deceptions. Compliance is a manageable task.
When driven by Congress, though, the regulatory authorities are another matter. The most recent congressional effort, the Sarbanes-Oxley law, was intended to prevent corporate stink bombs like Enron and WorldCom, but unintentionally adds fuel to the private equity fire as companies run away from the onerous regulations.
Companies that are “taken private” no longer have to comply with Sarbanes-Oxley or exchange regulations. They also find satisfying a few, well-informed investors a lot easier than trying to communicate publicly with thousands of stockholders with diverse needs and goals.
No one knows how far the private equity movement will go. It seems to be gaining momentum still, so it is not likely to peter out in 2007.
What we do know, from economics, is what will slow it down: a liquidity crunch. Private equity investment has generally delivered higher returns to investors, but at the cost of liquidity. Unlike a portfolio of traded stocks, if you need cash, it isn’t easy to sell out your position in a private equity investment.
We also do not know if the private equity expansion will turn out to be a good thing for the U.S. economy. The odds are that it will not, for the strength of our economy has always been the openness of its financial markets. Private equity is the opposite of that.
And, looking beyond economics, it is ironic that as invasions of privacy become more common in our society, corporations find protection while individuals become more exposed. Somehow that can’t be good.
James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101” monthly for the Snohomish County Business Journal.
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