By Matt Bevington
We’re all familiar with public image of the private equity industry: a group of eye-wateringly rich executives who buy up vulnerable companies, sell off their assets, cut pensions for workers, enact mass lay-offs and run firms into the ground before sailing off to their tax havens.
Like all industries, however, the reality is more complex.
There are genuine concerns about private equity ownership. The CMA, for instance, recently highlighted high debt levels among PE-owned children’s care providers, making them potentially more vulnerable to economic downturns. The CMA has also recently fined several private equity firms tens of millions of pounds for conspiring to drive up prices for several drugs bought by the NHS. Private equity has far from a clean slate.
There are also public-interest concerns over private ownership. According to the government’s recent Listings Review, the number of publicly listed companies in the UK has fallen by around 40% since 2008. This is the result both of more listed companies being taken private and fewer private companies being listed. According to Preqin data, in 2017-21 some 39 UK companies were taken private, up by 50% on 2012-16. By contrast, the number of private companies taken public (via IPO) was just 34, down by more than 50% in same period. The result is significantly less transparency and accountability.
Nevertheless, there are potential opportunities for policymakers in harnessing private equity investment if the industry is regulated appropriately. While most media coverage focuses on multi-billion-pound deals done by mega funds buying high-profile companies, most of the industry, in fact, invests in SMEs. To use the jargon, large- and mega-cap deals — investments in companies worth several hundreds of millions or more — represent only a small part of the industry’s activity. According to the BVCA, in 2020 there were 44 large- and mega-cap deals and almost four times as many (174) small- and mid-cap investments (generally worth up to £100m). In other words, investments generally directed at SMEs made up 80% of industry activity.
The divide is even starker at the European level. According to Invest Europe, in the first half of 2021 there were 44 large- and mega-cap deals and more than 13 times more (601) small- and mid-cap deals. Investment targeted at SMEs made up more than 90% of activity.
Why does this matter? First, because SMEs generally find it more difficult to attract investment and finance their growth, so private equity investment is an important source of capital. And, second, because the characteristics of private equity investment in SMEs generally differ from mega deals.
SMEs generally have fewer assets than large companies, so there may not be much to sell off, even if that were the intention. These firms usually require more investment in their capital assets for investors to make a return. Moreover, employee headcount almost always needs to grow if revenue and profit are to increase substantially, which is the aim. When it comes to SMEs, private equity investors are also generally looking to add assets and capabilities in order to make a return, not hollow out these businesses. This often involves acquiring other SMEs that have additional capabilities or an established presence in overseas markets.
Perhaps most importantly, investors’ ultimate aim is to sell these businesses on at a return, often to other private equity companies. That means ensuring that there is compelling future growth potential to attract the next set of investors. Hollowing out an SME and disposing a shell makes little investment sense.
None of this is to say we should be naïve about private equity firms. They are in it to make profits, and ideally large ones. But there are important public-interest benefits that derive from this activity nonetheless. Whether it’s job creation, tax revenue, funnelling investment into the UK, improving UK corporate competitiveness or generating investment returns that support our pension funds, there are numerous upsides to society. As a result, the balance of risk versus public goods is significantly more favourable among SME investors than the large- and mega-cap end of the industry.
Ultimately, we all have an interest in these funds producing sustainable returns. That’s because by far the biggest single investor into UK private equity funds is pension funds. Private equity is an important place for institutional investors to allocate capital, especially in a low interest-rate environment. Policymakers need to help pension funds and other institutional investors to make wise and responsible investment decisions. That means requiring more disclosures and transparency by the private equity firms that receive their investment. Reforms currently being pursued by the Securities and Exchange Commission (SEC) in the US are a good example to follow.
For Labour, some parts of the private equity industry are more closely aligned with the party’s agenda than may be expected. Keir has pledged to reform the priority duty of directors to reshape UK corporate culture to focus on the long term. Private equity is already much better aligned with that ambition than their public-market counterparts. Whereas executives at the latter are often focused on quarterly returns growth, private equity funds take ownership for, on average, six years. Moreover, given future investors need to be convinced that a business will remain profitable, they have a self-interest in their businesses’ longer-term growth beyond their period of ownership.
On the ‘everyday economy’ agenda, too, there is potentially a close alignment of interests. Rachel Reeves has highlighted sectors such as social care and retail as being priorities of a future Labour government. These are sectors in which private equity investors have long been active, with — despite some notorious failures — plenty of success in helping to scale up SMEs. A Labour government that makes these sectors a priority will only increase investor interest in them. Notwithstanding necessary regulatory reform, Labour should make a partner of the midmarket industry to help achieve these ambitions.
Ultimately, the private equity industry should be treated with caution, but it shouldn’t be written off. It could play an important role in supporting Labour’s ambition for a more long-term-minded corporate culture focused on supporting SMEs in previously underinvested sectors.
Matt Bevington, Senior Associate, Global Counsel