What is Creating the Emergence of Private Equity Funds?

The emergence of private equity funds is being stimulated by the governance shortcomings of the other two types of capital markets.

Public capital markets will always be appealing to both investors and companies seeking funding. This is partly because a substantial pool of global financial savings is available but, more importantly, because investments are highly liquid. That is, investors can easily enter and exit with their cash savings. And this efficiency with pooled, risk-shared and liquid investments creates broad diversification that translates into a minimal extra price premium to purchase an equity position.

A shortcoming of public capital markets is that investment managers may behave impatiently and be somewhat fickle in choosing which stocks to buy and sell. Examples are the dot-com bust of 2000 and former U.S. Federal Reserve Chairman Alan Greenspan's famous warning of "irrational exuberance." An impediment to full attainment of profit potential is the legal separation of a company's ownership from its management. Investment managers rarely have access to internal managerial information that the company's managers have. Yet, at the extreme, we observe young, recently minted MBAs at investment banking firms pressuring and influencing accomplished executives to make decisions favoring short-term financial results when relatively better decisions could result in much higher long-term financial outcomes. Finally, because recent Enron-like scandals have inspired regulatory burdens such as the Sarbanes-Oxley Act, publicly owned companies incur significant out-of-pocket expenses for regulatory compliance.

Internal capital markets can yield better financial performance because the executive leadership has access to internal information, marketing plans, return on investment analysis and projections. On the downside, however, similar to public capital markets, internal capital markets also impede the ability to attain full profit potential and maximize a company's market value. But the explanation is for a different reason: "corporate socialism." What I mean by this is that executives tend to patiently tolerate underperforming operating divisions. Further, they may be reluctant to starve an old colleague heading a division of his or her capital requests even though a sober and objective assessment would recommend it. Politics and personal favoritism are present. Strong divisions often subsidize weak ones.

In addition, executives tend to tolerate inefficiencies and fat that privately owned companies would be more ruthless to address and remove. They tend to universally apply standard performance measures that are not tailored to the unique traits of a division's industry. In short, some publicly owned company executives are simply too slow at restructuring or divesting a division that is not living up to its full potential.

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