Making their case

The kings of capitalism have started to respond. The main defence offered by private-equity firms is that they are good for the companies they own and for the economy as a whole. Henry Kravis of KKR claimed last year that private-equity investing “leads not only to value creation, but also to economic and social benefits, for example, increases in employment, innovation, and research and development”.

The past three years have been extremely good for private equity with returns for all but the smallest funds comfortably beating the S&P 500 index. Long-term performance also looks strong, at least at first glance. From 1980 to 2001, the average fund generated higher gross returns than investing in the S&P 500.

Given the obsession of investors with yield, no wonder so much money has poured into private equity. There are now some 2,700 private-equity firms, managing assets of $500 billion. They are led by a number of giants. Only two years ago the largest fund was worth $6 billion, but some reports say Blackstone's fund is now worth some $20 billion.

What makes a top performer? Here are some characteristics: the expertise to analyse deals and add value; the ability to attract the best executives and other talent to companies; and a strong network to search for deals, sometimes avoiding auctions.

Some suspect that success is all about higher levels of debt. Private-equity firms borrow heavily to buy companies.

In the early days leverage was responsible for most of the superior returns. Moreover, the easy credit of the past three years has helped. (An arguably worrying development has been the rise in “leveraged recaps with equity dividends”, whereby a recently acquired company borrows heavily in order to pay a large dividend to its new owner.)

On the other hand, since the mid-1990s private-equity firms have taken every opportunity to stress that they do not depend on financial engineering—a technique that they say is now widely imitated by public companies and thus no longer a source of advantage. Instead, they prefer to draw attention to other ways in which they improve the firms they own.

One is corporate governance. Unlike the owners of public companies, who tend to be too remote and thinly spread to spend time and money closely monitoring a business, private-equity firms have big stakes. Because their people's careers are on the line, they have a powerful incentive to keep a close eye on things. There is also a strong incentive to maximise long-term value—which is what stockmarket investors are valuing in an initial public offering (IPO). Asset stripping is rarely the best long-term strategy. Even when they sell—at least in an IPO—private-equity firms often retain a significant shareholding for years after.

Those firms that were owned by private equity for less than a year performed relatively poorly, suggesting that “buying and flipping” back to the market—increasingly common nowadays—is a less useful role for private equity than building improvements into the business over a few years.