Podcast Summary

Podcast: LSE: Public Lectures and Events
Episode: Private Equity: Leveraged Expertise or Leveraged Bets?
Date: September 27, 2010
Host: LSE Film and Audio Team
Speaker: Ulf Axelson (Abraaj Reader in Private Equity, LSE)

Overview of Episode Theme

This episode marks the launch of LSE’s new programme in private equity, made possible through a donation from Abraaj Capital. The main lecture, delivered by Ulf Axelson, provides an in-depth academic exploration of "buyouts," the most controversial sector of private equity. Axelson analyzes how private equity functions, the controversies surrounding it, arguments for and against the model, and a critical review of empirical evidence on value creation, employment effects, long-term investments, and financial risks such as leverage.

Key Discussion Points & Insights

1. Setting the Stage: Why Private Equity at LSE?

• Howard Davies (Director, LSE) opens by celebrating both Abraaj’s donation and the launch of a Master’s in Finance and Private Equity.
• Private equity, particularly buyouts, is described as a highly controversial yet vital area within capital markets.
• Recent reports have critiqued private equity for relying heavily on financial engineering and layoffs rather than genuine wealth creation.
• The LSE aims to inject academic rigor into these debates.

2. Defining Private Equity and the Buyout Model

• Ulf Axelson emphasizes the breadth of private equity, but focuses mainly on "buyouts."

• Buyouts typically involve general partners raising substantial "blind" investment funds (investors do not know specific targets), using a typical structure of 30% equity and 70% debt (leverage).

• The typical profit split follows the “2/20 rule”—general partners receive a 2% annual management fee and 20% of any profits ("carry").

• General partners have significant latitude on investments with limited partner input, but only a fixed time—funds generally last ten years.

  "[Buyouts are] using other people's money to buy companies, using a lot of debt. And that's basically what it is." — Ulf Axelson [14:20]

3. The Controversies: Criticisms of Private Equity

Axelson summarizes mainstream criticisms:

• Excessive Leverage: High debt exposes firms (and employees) to bankruptcy risk, threatens economic stability.

• Short-Termism & Asset Stripping: General partners are accused of prioritizing quick returns, stripping assets, firing workers, and neglecting long-term investments like R&D.

• Systemic Risk: Overreliance on leverage could destabilize the broader economy.

  "They asset-strip them and destroy them in the search for profits... they’re only interested in short term gains."
  — Ulf Axelson, summarizing critics [18:43]

He notes that Poul Nyrup Rasmussen, former Danish Prime Minister and a leading critic, will speak at LSE, promising a robust public debate.

4. The Arguments For: Why Buyouts Might Benefit Society

• Financial Intermediation: Private equity addresses core economic problems—information asymmetry and moral hazard—better than public companies or family firms.

  • Public firms lack strong monitoring incentives for small shareholders; boards are often weak.
  • Family firms concentrate risk but may lack management expertise.
  • Private equity offers intensive monitoring and active management through concentrated ownership.

• Leverage as a Positive Force:

  • Allows skilled general partners to control more assets ("leverages their expertise").
  • High debt creates urgency for CEOs to perform, potentially increasing firm efficiency.

  "Putting a lot of debt onto a company ... could make the CEO of that company work much harder than otherwise because there's going to be this sense of urgency to pay off the debt."
  — Ulf Axelson [24:20]

• Alignment of Incentives:

  • Pooling investments within a fund and deferring carry until the end ensure that general partners cannot benefit from risky one-off bets.
  • Regular need to access debt markets acts as an external check.

• Term Limit Incentives:

  • Fund tenures (usually ten years) force timely action and provide discipline—poor performance impedes future fundraising.

5. Empirical Evidence: Does Private Equity Create Value?

a. Operational Performance

• Early studies (e.g., Steve Kaplan’s analysis of the 1980s) show significant improvements in operational performance.

• Recent international research suggests industries with more private equity see stronger growth rates.

• Some positive spillovers observed in public markets due to competitive pressure from private equity.

  "It looks like industries with more private equity activity tend to do much better in terms of growth. It’s almost too impressive to be true, I think."
  — Ulf Axelson [34:12]

b. Employment and Long-Term Investment

• Employment: PE-owned firms do fire more workers, but they also hire more; net job effect is approximately zero ("creative destruction").

  • European studies (e.g., French deals) indicate employment gains in smaller firms.

• Long-term Investment:

  • Recent research using patent data shows no decline in innovation post-buyout; if anything, investment is more efficiently allocated.
  • Improvements under PE ownership often persist after firms return to public markets.

  "Private equity owners don’t sacrifice long-term investment. They do invest for the long term."
  — Ulf Axelson [38:10]

c. Investor Returns

• While general partners reliably make money (due to fees and carry), returns for limited partners (investors) are only on par with or slightly below the broader stock market in "buyout" funds; higher returns observed in venture capital funds.

• Top quartile funds perform much better than average, but outperformance is not widespread.

• Much of the value created flows to managers and the selling shareholders, rather than limited partners.

  "It's not so clear on an average that it makes the limited partners rich."
  — Ulf Axelson [41:00]

d. Leverage and Systemic Risk

• Private equity firms average about 70% debt in deals (reverse of public companies).

• High leverage has positive roles (see above), but can pose risk when credit markets are "overheated," as seen in the credit booms of the late 1980s and 2004–2007.

  • Research shows that leverage levels are driven mostly by credit conditions, not by the nature of the target company.
  • Deals with excessive leverage during credit booms tend to yield poorer returns.

  "We basically couldn’t find any type of firm characteristic that explained why you would choose a particular leverage... The only thing we found that drove leverage was how easy it was to get credit."
  — Ulf Axelson [47:10]

• Despite high leverage, empirical evidence suggests bankruptcy rates are similar to public firms, and when buyouts default, the value is often preserved post-restructuring.

  "It didn’t seem like a lot of value was destroyed, it's just that they had too much debt."
  — Ulf Axelson [52:10]

6. Potential Solutions and Ongoing Research

• Improved regulation of lending practices (banks as gatekeepers) might curb excesses.
• Allowing limited partners more say on highly leveraged deals could check reckless behavior.
• Many 2004–2007 deals haven’t yet exited; future research will monitor potential defaults/long-term effects.
• Calls for more transparency and rigorous academic study, especially on fund returns.

Notable Quotes & Memorable Moments

• On the industry’s controversy:

  "Buyout guys go out, buy a firm, strip it of its most valuable assets, fire all the workers to just make profits."
  — Ulf Axelson (summarizing critics) [18:48]

• On the alignment of incentives through fund structure:

  "If you do a very bad deal... that’s going to eat up your profit from another good deal... [this] creates some internal discipline."
  — Ulf Axelson [26:34]

• On market discipline:

  "As a general partner ... you have to actually go out and raise a lot of debt to do [a deal]... that gives an extra external check."
  — Ulf Axelson [28:30]

• On creative destruction:

  "Private equity owners do fire more people ... but also hire more people, and the net effect is basically zero."
  — Ulf Axelson [36:50]

• On risk of industry-wide excess:

  "When you saw these deals that really levered up a lot, that typically was associated with significantly lower fund returns."
  — Ulf Axelson [48:06]

Important Timestamps for Segments

• Introduction & Opening Remarks – [00:00–03:36]
• Defining Private Equity/Buyouts – [03:36–14:20]
• Criticisms of Private Equity – [14:20–21:30]
• Arguments for Private Equity – [21:30–28:30]
• Empirical Evidence on Value Creation – [28:30–42:00]
  • Performance improvements, employment, innovation, persistency
• Investor Returns Discussion – [42:00–44:10]
• Leverage and Risk Analysis – [44:10–53:00]
  • Historical evidence, agency problems, data from 2004–2007 boom
• Conclusion & Looking Forward – [53:00–end]

Conclusion

Axelson concludes that private equity buyouts, despite notable excesses and controversy, have demonstrated robust value creation and efficient corporate governance without significant harm to workers or long-term investment. The industry is cyclical and susceptible to credit bubbles, and future research, especially on investor returns and the aftermath of the 2004–2007 boom, is needed. Neither panacea nor menace, private equity is likely to endure, but wise regulation and greater academic scrutiny will be vital.

"The private equity model will endure because it actually makes economic sense."
— Ulf Axelson [54:30]