Solving Economic Conundrums

Private Equity Funds – the economic miracle – cultivating beautiful gardens.

There is much debate currently in the business press about the potentially damaging impact of the massive transfer of capital from the public stock markets to various private equity and hedge funds. Despite the alarm being voiced by some journalists and reporters suggesting there is something evil afoot, this building tsunami actually provides for a wonderful rebirth for the economy.

Let me explain. As John Kenneth Gailbraith eloquently pointed out in his last book, the greatest risks to today’s economy are the people at the helms of corporations. This continues to be true. While there are many very strong, diligent and value-creating corporate leaders, there are also a number who are like bad weeds in a garden choking the life out of their organizations. They do this by allowing bloated bureaucracies and affording themselves and their cohorts unprecedented levels of compensation. This of course is all at the expense of the capital that belongs to shareholders.

Unfortunately, even the recent focus on corporate governance has failed to protect the shareholder. At the end of JK Galbraith’s life time, he witnessed the evolution of the mutual fund and pension funds in the 80’s and 90’s resulting in wealth and power being effectively transferred from shareholders and business owners to the traders and officers of publicly traded companies, lining each others pockets in the process. The overpaid executives are like weeds taking the life from the soil around them! Executives continue to sell the future of their employees and shareholders to deliver short term results to earn bonuses for themselves and the traders who reward them.

Today, traders for Canadian investment firms casually spend $10,000 on NBA playoff tickets in US cities, where they fly down with a bankroll for dinner and drinks with their clients and counterparts at the mutual fund companies. The mutual fund company traders go back to work the next day and take positions in companies that are clients of those Investment banks, more bonuses all around! The worst examples of these ‘criminals’ ( J.K. Gailbraith's description) are the ones who take 5% or 10% of a company’s revenue as their annual pay! ( Magna, NYSE ) to justify this absurd behavior they also reward those close to them with monstrous pay packages designed by their favorite compensation consultants to siphon off even more shareholder wealth.

What’s a shareholder to do? Of course, one can vote with one’s dollars and sell the stock, but this in and of itself doesn’t address the problem for the company or any of its stakeholders. Enter private equity. Private Equity has evolved from the days of the swashbuckling raider when Drexel Burnham would finance anyone with a pulse and cash flow with junk debt.

Imagine being a private equity owner and your favorite math is simple math. Company X has $1 billion in revenue and $50 million in profit. The top five executives take out $50 million in pay and another $10 million to $20 million for private jet rentals and other perks like NBA tickets. The market thinks the company is worth some multiple of $50 million relative to its peers (Who all employ the same compensation consultant).

The private equity owner sees a company with $50 million in profit and another $50 million in profit being taken out by useless distracted millionaires. They replace the distracted guys and remove their fingers from the till with some super bright Mckinsey type guys for a million or so each and grow the company like crazy with the extra $50 million able to pay for a $500 million acquisition. In a couple of years they have a $2 billion sales company with $200 million in profit.

The masters of the universe in the Private Equity and Hedge fund world have their own money on the line and they treat it seriously. Thankfully, everyday these Private Equity guys are running more and more pension money! Managers with a vested interest in long term performance, what a great idea! You now have a situation where some of the brightest people available are putting your pension money to work and eliminating the graft in the middle.

Private Equity funds act like the Thomson’s, the Desmerais and Warren Buffet, they take a long term view for the long term benefit of the shareholders (themselves) the company and ultimately the employees and their families. Who do you want framing employment opportunities for our children? Owners like the Thomson’s, Desmarais and Kravis? Or some bureaucratic backslapper who’s spends his time with his compensation consultant figuring out ways to qualify for his next bonus?

The rebirth of the capital markets represents a sign of the beginning of a new era. These PE funds have gathered their seeds and they have access to plenty of low cost capital with which to fertilize their crops. Only the weeds in the garden need fear!

Mark Slipp works as a partner at MCC Partners.