While private equity funds have existed for years, they have come under increasing scrutiny and examination after the financial collapse of 2008. Much like the mortgage securitization movement, private equity funds grew at considerable rates in 2006 and 2007 prior to the financial crisis, with activity of both investment vehicles falling off sharply thereafter. Private equity funding was down 61% from the prior year in 2008 and down 88% from a previous high in 2006. What has caused this shift in funding, who stands to lose the most, and what impact does this have on the financial markets going forward?
What Do Private Equity Funds Do?
Private equity funds seek to meet the funding needs of companies that are either unable to or not willing to go public. These funds pool investment dollars to provide funding for capital investment and growth for privately held companies. They typically have a lifespan of 10 years, often with annual extensions available thereafter. Initial funding is accomplished by seeking investors to pledge large sums of money at the inception of the fund, which will then be drawn on over the life of the fund. The fund is typically structured in a way that creates a limited partnership between investors and fund managers, with oversight and decision making reserved for the fund managers. With the potential of high returns, as much as 30% or more for highly successful funds, private equity funds are an attractive option to expand the portfolios of ambitious investors.
The fund managers earn revenue through management fees, performance bonuses, and capital gains. Management fees are typically 1% to 2% of the total committed capital, regardless of fund performance. If the fund performs well, managers can earn performance incentives up to 20% or more of profits, providing the hurdle rate is achieved. The hurdle rate is a predetermined measure of performance that investors are expecting, such as an annual return of 8%-12%. If this is met, a performance bonus is earned based on profits of the portfolio companies, with the remaining profits being paid out to investors in the fund.
While investment styles can vary from fund to fund, they generally have the same characteristics. The fund seeks out investments to fund the growth and expansion of portfolio companies, that is, a collection of different companies, often from various industries. This approach is done to diversify the fund and mitigate the risk involved; the more companies in a funds portfolio, the greater the diversification, and the lower the overall risk of default or loss. The fund is financed from either capital investments from individuals and companies, or through leverage. Leverage in private equity funding is typically obtained from commercial and investment banks, and to a lesser extent, hedge funds, by taking on liability. Due to this leverage, some private equity funding is considered a leverage buy-out, or LBO. It is this side of the business that has come under great scrutiny during the past few years, given the condition it has left funds, companies, and investment banks in.
The objectives of these funds are fairly straightforward. As stated, private equity funds are formed to provide funding to private companies, while offering attractive returns to investors. This funding is intended to help firms grow and prosper, which is then returned in part to investors and fund managers. These relationships are not intended to be a permanent source of funding, with most relationships ended after a 10 year period.
In short, the objective once a fund is formed is to make money, cash out their position, and repeat with another portfolio of companies.
Common exit strategies include a sell off or spin off of the fund’s equity position in the company, or an initial public offering of the company, with the goal of a positive return for the fund. Profits realized upon exit, along with fees and bonuses collected during the life of the fund is how managers ultimately measure the success of a fund.
Who Invests in Private Equity Funds?
The investors in private equity funds typically consist of two classes: wealthy individuals, and institutional investors, such as insurance companies, pension plans, public universities, and endowments. With the typical capital commitment being $1MM or more, the average investor is priced out of these investment instruments, and the often lucrative returns associated with the funds.
Returns are expected to be high, and are demanded by investors to offset the risks that they are taking. Liquidity of investment dollars is very low. Large amounts of capital are committed over a long period of time. Sometimes the commitments are not fully funded i.e. invested in companies, presenting opportunity cost risk to investors. In addition, investors take a passive role, as decisions and daily fund transactions are left to the managers of the fund. As most investments go, there is no guarantee of return, or even that the fund will be successful. Investors in these funds stand to lose everything they invest, and potentially more if they are highly leveraged.
What are Some Ethical Considerations of Private Equity Funds?
While there are several aspects of private equity funds, such as fee structures, fund objectives, and investor motives, to analyze from an ethical viewpoint, we focus on one aspect: the consequences of high leveraged buyout funding. The issue to be addressed is, what are the risks, ethical implications, and ethical questions when banks become involved in high leveraged buyouts? Who ends up paying the most when these highly leveraged funds fail? Are high risks being passed on to investors for the sake of fund revenue, or are large amounts of debt being pushed into funds for the sake of investment profits?
First, the parties involved include, but are not necessarily limited to the investors, the individuals represented by the investors in the case of investing firms, the management companies and their employees, investment banks and their employees and clients, and portfolio companies and their employees and clients. The funds have the potential of impacting a significant number of people from different groups.
The inherent risk, and potential ethical pitfalls arise from actions driven by the non-virtue of greed. The bank providing funding can see the lucrative nature of a deal, and may cross ethical lines to provide the amount of funding requested beyond what is prudent. Overlooking certain aspects of the fund during underwriting, creatively packaging the debt to improve the look of their balance sheet, or having self-interests in the portfolio companies are also issues that a bank may face. If these were to occur, the systemic risk to the credit market through interdependencies could be greatly increased. Consider this hypothetical:
Suppose JP Morgan Chase stretched its underwriting guidelines to provide significant funding to a private equity firm with a limited number of companies in its portfolio. Within this portfolio is a large cap firm that has deposit relationships and a guaranteed line of credit with JP Morgan that is very profitable to the bank. It is under this consideration that JP Morgan was willing to “bend the rules” during the underwriting process to indirectly benefit this high value client. Fast forward a few years and the economy has taken a turn for the worse. Some of the companies that are in the equity fund’s portfolio are performing poorly, and a few have gone under. As a result, the remaining companies, that also are struggling, are not able to service the debt obligation of the equity fund’s liability to JP Morgan. Soon the fund becomes insolvent and the large cap firm that was part of the portfolio loses key funding during an already difficult economic time. What might the results of this situation be?
Due to the overly leveraged position that JP Morgan created, they are now facing a very large loss that will impact their shareholders as the stock takes a hit. The large client that originally benefited from the additional funding of the private equity firm is now without a major source of funding, and is struggling to stay solvent. Meanwhile, JP Morgan has called its line with the client to help offset the losses it suffered from the failure of the equity fund. The problem is the client who owes on the equity line has no means to pay. JP Morgan is now facing another large loss as the client defaults on the line of credit, and goes under. Due to a failure to follow strict underwriting guidelines and overleveraging the fund while ignoring key interdependencies and obvious conflicts of interest, the bank has taken huge losses, a private equity fund is now insolvent, and a portfolio of companies is in financial trouble. These issues reach out into the market, demolishing consumer confidence and driving down stock prices. While this is a purely hypothetical example and perhaps slightly sensationalized, it illustrates the complexity of these deals and the far reaching impact that a lapse in moral judgment can cause.
The Good of Private Equity Funds
While that was one example of what might potentially happen, there are other considerations before writing off private equity funds altogether. These funds have the potential to offer positive benefits for those involved as well. The companies that become part of the portfolio receive funding for capital investments without going through the expense and time of a public offering, and are able to limit the ownership stakes in their companies to those with whom they choose to work. This infusion of cash helps a company grow, which can in turn creates a positive impact on: (1) the economy, (2) individuals working for and with the company, (3) increased tax revenue for the government, which can help society and people that have no direct relationship with the fund or the portfolio companies. In addition, the investors and fund managers benefit financially which may be good for the economy.
When working under moral and ethical considerations, private equity funds can benefit those involved and society as a whole. These funds serve an important role in the financing of new and growing companies, offering opportunities that may not otherwise exist. However, when financial decisions and actions are principally driven by greed, ethical issues take on little importance.
Greed and Christian Deontological Considerations
It is worth examining the idea of greed under an ethical/moral framework. To this end, we attempt to apply Christian moral philosophy to the idea of wealth and greed by examining what the tradition says on the subject.
The question to ask is whether being wealthy is right. Is it moral to make money? The answer is yes, if the condition of the heart is right.
Christian ethics proposes that God wants to bless His followers, and that He will always provide for them. Deuteronomy 7:13 says “…He will bless the fruit of your womb, the crops of your land – your grain, new wine and olive oil – the calves of your herds…” We do not need to worry about money as God will provide for us according to Matthew, chapter 6, verses 25-33. The passage details how God has provided more than enough food for the birds, and how beautiful the flowers of the fields are dressed, even though these things will not last. With this mindset, we should not be greedy, as greed is in direct opposition to the trust we are to have.
An important factor to consider is that we are not the ultimate owners of our wealth. Anything God provides us, whether it is food to eat, clothes to wear, or millions of dollars from a successful private equity fund, is not ours but His. Psalm 24:1-2 says the following: “The earth is the Lord’s, and everything in it, the world, and all who live in it; for He founded it on the seas and established it on the waters.” God created it all, and He owns it all. When one fully grasps this idea and submits to it, one quickly sees how insignificant they and “their” wealth are in comparison to God; they see the foolishness in the greed of possessions and the accumulation of wealth.
According to Christian ethics, it is not enough to simply sit back and let God bless you. He calls us to action, and commands us to be good stewards of that which He has provided. Luke 12:48 states “…From everyone who has been given much, much will be demanded; and from the one who has been entrusted with much, much more will be asked”. This idea of good stewardship and action on our part is clearly set forth in the Parable of the Talents, recorded in the book of Matthew, Chapter 25, verses 14-30.
In this parable, there are three servants, each of whom their master entrusted a portion of his wealth. Two of the servants, having received the most, invested the money wisely and earned a handsome return on it. The third servant, given the least, feared that the small amount might be lost, so he hid it in the ground. When the master returned, he called the servants to see what they had done with the wealth that was entrusted to them. He was pleased with the two who had trusted and wisely invested the funds, but called the third servant wicked and lazy, as he did not even earn interest on the funds due to his fear and inaction. Through this parable, we can see the ethos of using what we have been entrusted with wisely to the benefit of those around us. This idea is in stark contrast to the idea of personal wealth accumulation and greed. Greed, or hoarding, is not ethical, and those who do so out of personal gain or fear rather than using what they have been given for good will be judged accordingly.
Christian ethics clearly proposes humans are not the ultimate possessors of wealth but must instead be good stewards. To do otherwise is ethically wrong, whether in the context of talents, time, or financial success in investments. So what about being greedy? While the previous ideas should be enough to convince someone not to be filled with greed according to Christian ethics, clearly many struggle to uphold this principle. Matthew 6:24 states: “No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other. You cannot serve both God and money”
Further warning of greed is found in the book of Proverbs:
“The greedy bring ruin to their households, but the one who hates bribes will live” – Proverbs 15:27
Thus, being wealthy, having success financially, is not unethical in itself. Our ethical evaluation is determined by how one gets wealth, uses wealth, and approaches wealth. 1 Timothy 6:10 says “For the love of money [not money itself] is the root of all kinds of evil. Some people, eager for money, have wandered from the faith and pierced themselves with many griefs”. These words were written two millennia ago, but they still are applicable to evaluating the ethics of how wealth is generated by private equity funds.
BY: THOMAS ADEN
Thomas More Griffin | “Effect of the recession on private equity and leveraged buy-outs (LBOS): Burned, but the phoenix is rising from the ashes” | March 2010 | Web, accessed 11-20-12
Wikipedia | “Private Equity Fund” | November 2012 | Web, accessed 11-20-12
Bible Gateway | Zondervan Corporation, LLC, ©1995-2010 | Web, accessed 11-20-12
Daniel Sweet | “Parable of the Talents: True Meaning Explained” | God’s Word First | Web, accessed 11-20-12
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