The Dual Effect of Private Equity

Private equity (PE) investments help and support companies with promising prospects, which have several positive impacts on society as they help create jobs and build successful businesses. PE firms provide capital for companies, encouraging them to grow and become more competitive. However, critics argue that these investments typically force small companies out of business and can be detrimental to them in some respects. Overall, PE has both positive and negative implications and can be a boon to society, but a threat to startups in certain situations.

Private equity (PE) firms play an important role in the financial system by providing much-needed capital to companies. PE firms usually invest in companies and hold them for an extended period, during which they work to improve the company's performance. These firms can exit their investment after a few years by selling the company to another investor or taking it public.

Over the past five years, global PE investments have increased significantly from USD1,617 billion in 2017 to USD2,350 billion in 2022. As of June 30, 2022, the overall private market AUM stood at USD11.7 trillion.

Positive impacts of PE investments on society include the following:

• Job Creation – PE firms offer the requisite capital and expertise that companies need to expand and grow, leading to the creation of new jobs. Research shows that PE-backed companies create an average of 1.5% more jobs per year than non-PE-backed companies.
• Expert Handholding – PE firms are sophisticated investors with knowledge and expertise in managing a diversified portfolio of investments, and their involvement can largely benefit the target companies. They also have access to capital that may not be available to other shareholders. In addition, PE firms are typically more active in corporate management, which could help improve performance and lower agency costs.
• Impact Investing and ESG – A growing number of PE firms are focused on investments that have a positive impact on society and the environment. These firms are known as environmental, social, and governance (ESG) investors. They believe companies that operate sustainably and responsibly are more likely to be successful in the long term.
• Readiness to Face Downturn – PE investors carefully monitor economic activity to identify potential investment opportunities. This allows them to make informed decisions that profit their portfolio companies in the long term. PE investors are also better equipped to meet economic downturns due to their resources and expertise.PE has weathered two significant recessions since 2000: the dot-com crash and the Great Recession. Though majority of companies were affected by the economic decline, iCapital reports that less than 3% of PE funds posted catastrophic losses, whereas 40% of public stocks saw such losses. A study conducted by Kellogg School of Management found that PE-backed companies weathered the Great Recession better than comparable companies that were not backed by PE.
• Resilience – PE investments can help businesses succeed by providing the necessary resources to compete in their respective markets. PE firms provide capital, strategic guidance, and operational support to help companies improve their products and services, expand their customer base, and boost profitability.According to the Cambridge Associates LLC US Private Equity Index, which tracks the performance of ~2000 companies, PE-backed companies have outperformed public markets over the long term. From January 2000 to March 31, 2022, PE investments generated an average annual compounded return of 18.3%. In comparison, Russell 2500 companies had an average return of 9.2% during the same period.
  PE-supported companies tend to be more innovative and agile as PE firms encourage companies to take risks and invest in new technologies and markets. As a result, these companies are more likely to succeed eventually.

While PE can provide capital and opportunities for companies to scale, transform, and succeed, the significant debt load and short-term focus associated with the model have raised concerns about the target companies' long-term sustainability and well-being.

1. High debt burden:
   • PE firms are said to exploit healthy companies by loading them with debt and stripping their assets.
     
   • A PE-based business model relies heavily on debt and focuses on enhancing the value of the target companies and ultimately exiting. However, the high levels of debt can sometimes burden the companies, leading to challenges such as high-interest payments that restrict their ability to invest and remain competitive.
   • Additional loans may have to be taken to pay dividends to PE investors, further increasing the financial obligations of the companies.
2. Short-term goals:
• Critics argue that PE's main focus is on generating short-term returns and making money quickly rather than ensuring the long-term health of the target companies.
3. Loss of management control:
   • When partnering with a PE firm, there are potential downsides beyond financial considerations. One major concern is loss of control over important aspects of the business, including strategic decision-making, employee management, and choosing the management team. The PE firm's increased stake in the business often amplifies this loss of control, particularly regarding its exit strategy, which may involve selling the business against the owner's intentions.

Conclusion

Therefore, PE has both a positive and negative impact on companies. Each company operates in a unique context with its own set of challenges and opportunities. While some businesses may benefit significantly from the injection of capital and expertise provided by PE, others may find their long-term goals better served through alternative financing options or organic growth strategies.

Ultimately, companies must critically assess their strategic objectives, financial position, and risk tolerance before deciding to pursue a PE partnership. A thorough evaluation of potential benefits and risks, coupled with a clear understanding of the company's vision, would help ensure a well-informed decision that aligns with the organization's long-term interests.