Most people know what a public company is. Many come in contact with one daily as they purchase shares (ownership) on an open market using their bank’s app on their smartphone. But the term “private equity” elicits confused looks from even the most educated. Such confusion is partly due to the over-use of the term, but also results from not realizing that a considerable number of the businesses you interact with are privately held.
The following paragraphs argue that the primary function of a private equity (PE) manager is the identification and management of people. PE managers, thus, need the virtues of humility and magnanimity. If they exhibit these virtues, their companies will grow, increasing human capital and wealth.
To grasp private equity, we first need to define some basic terms.
Debt is the right to receive periodic payments of principal and interest, until the original amount borrowed is paid in full.
Equity, simply put, is the right to all residual cash flow of an entity after all other liabilities and debt have been satisfied; but it also is the basic form of ownership. Equity equals ownership.
Public securities are freely traded debt or equity (“shares”) based on information generally available. The value of shares is set every moment by thousands, if not millions, of investors freely interacting based on available information.
Private equity (PE) is often used to describe every other form of investment or ownership. Everything not publicly traded is, by definition, invested in by private individuals or entities in the form of debt or equity. Something private is not readily bought or sold by the general public. Thus, investors risk not being able to convert their investment interest into cash quickly and easily. This is known as illiquidity. Detailed information, especially financial, about private companies is hard to come by, even when it’s theoretically available. This is known as information asymmetry.
Therefore, referring to private equity as an industry is not the same as discussing the overall world of private investments. Private equity is a sub-segment of the financial sector in which sums of money are pooled and managed for the purpose of investing in private companies in the form of ownership, not necessarily debt. Building and growing these companies is a key component of a working free market economy.
But does the private equity industry serve human dignity and the common good?
How the PE Industry Functions
Based on media coverage, the average person might define PE along these lines: it is a bunch of dirty rotten scoundrels who flip, strip, and destroy companies to enrich only themselves; a modern-day reverse Robin Hood. However, Metrick and Yasuda argue that the primary purpose of PE is to act 1) as a financial intermediary that 2) invests in private companies and 3) takes an active role in monitoring and helping the companies to 4) maximize the financial return to investors through an appropriate exit. In private equity, these practices work to solve the problems of information asymmetry and illiquidity.
The manager of a private equity fund (PEM) has active control. In contrast, public company investors often deal with established management teams and, as a result, have limited influence with respect to hiring or firing.
When you invest in a public company, you can base your decision mostly on publicly provided financial information and financial analysis. However, private companies provide notoriously unreliable data, if they provide anything at all. Thus, PE must be able to dig into and dissect the information of a company. In other words, PE bridges a wide information gap.
PE goes beyond financial analysis. It also identifies and retains management talent, dealing intimately with day-to-day management of the company. This requires identifying management teams able to exploit the different level and type of optionality of a smaller, privately owned company. Due to a different competitive market, smaller privately held companies can change course or markets faster, but with more risk. Since they are illiquid, they also have less support. They cannot turn to public markets to raise more capital or to provide their own currency. Additionally, privately-held companies require the need to manage, identify, and retain fund employees. These employees may be future fund partners, but also future competitors.
There is another large structural issue: private equity funds have fixed lives, which force a liquidation point in the future. In other words, there is a discrete sum and a known beginning and ending. The inability to withdraw funds early is matched with a difficulty to raise additional capital. The liquidity that is provided is limited in time and scope, creating a definitive window of time to learn from mistakes and to hire the best management team. Time is money and they are on a fast clock to invest and produce a return.
How the PE Industry Serves the Common Good
PE managers are not traditional agents in a direct principal-agent relationship. Rather, they are professional scouts who must actively draft and trade management talent, both in portfolio companies and within the fund entity. This includes mere financial management, but also involves human capital. PE managers are managing people on two levels: the company and the fund.
But the common good? The nature of this work requires virtues to be an integral part of a good PE manager. In full disclosure, my long-term research thesis relies on this view. I hope to draw a relationship between top quartile performance of private equity fund managers because of demonstrated virtues, primarily magnanimity and humility, and not despite it. Humility in this instance recognizes the individual strengths, weaknesses, and potential of not only oneself but others. PE managers must also possess these virtues in their roles to become financially successful, but also to serve the common good.
Capital formation arises from the human capacity to create new value. Capital markets serve the common good by funneling capital formed in society to their productive uses. Markets then help build new financial capital in a virtuous cycle that grows the productivity of our economy. (We create economic value not by reduction but by production). There will always be a system of capital allocation, call it socialism or capitalism. But a healthy and sustainable system must increase capital, not just reallocate it or—worse—destroy it.
What does private equity have to do with this? Private equity, rightly practiced by its managers, is not “flippers, strippers, raiders, or financial engineers.” Done right, it is an active agent serving in the key purpose of a capital market. By practicing humility in their hiring decisions, managers feed the growth in human capital, which leads to growth in financial capital. By exhibiting magnanimity, they aim for goals and purposes greater than themselves.
The output of such a system should enhance human dignity and well-being, as well as the common good. This includes not just the PE manager, but employees of the portfolio company and society as a whole. The current system has already contributed to the growth of human and financial capital. If PE managers possess virtue, especially humility and magnanimity, the returns to the common good will be increased.