A Scary Thought: Congress May Try to Fix Private Equity and Performance
Reporting
Thomas Franco,
Chairman + CEO, Broadgate Consultants Inc., New York
Chair, IR Practice, Public Relations Organisation International, Inc.
August 25, 2003
The six most unsettling words that any business executive can ever hear from
Capitol Hill are "Something needs to be done about..."
Fill in the blank with any number of catchphrases-many of which helped drive
Sarbanes-Oxley into law. Unfortunately, private equity professionals may start
to hear these six words emanating more often from inside the Beltway.
Transparency and disclosure are not new issues for private equity. They were
around in the mid-1980s when pension and endowment funds-which had public reporting
obligations to constituencies far beyond what sponsor organizations were used
to dealing with -started to seriously invest in the asset class.
Today transparency and disclosure issues have been reignited by Enron, Worldcom
and HealthSouth, to name just a few. In our scandal charged environment, "private"
automatically means "bad."
Sounds like a prelude to Congress jumping into action. The situation today
in private equity resembles a difficult period for the industry when Congress
wanted to address the wave of debt-financed buyouts and takeovers that were
turning Corporate America on its head in the late 1980s. There may relevant
lessons for us today from that public positioning battle, which threatened the
very existence of the industry.
It is far from clear that the transparency and disclosure debate confronting
private equity today represents a potential threat of the same magnitude. My
point, however, is to sound an alert. Political fallout could prove to be more
significant than the merits of the case presently being argued by industry participants.
Let's go back to the 1980s for a minute...
Legislation seemed almost inevitable in the wake of the legendary RJR Nabisco
buyout. Politicians were already roused by a frenzy of buyout activity and fears
of an explosion of leverage, massive layoffs, community dislocations and excessive
multimillion-dollar fees. Moreover, congressional leaders got an earful from
entrenched corporate leaders who were beginning to feel the heat from the raiders
or what one senator memorably referred to as the "fourteen-karat pirates
motivated by greed."
The heat that was turned on corporations had two aspects. First, companies
with depressed share prices were sitting ducks with top managers looking ripe
for unemployment. Second, the so-called raiders seemed to have a financing advantage
in making deals with what Ted Forstmann called "the fake wampum of 1980s
finance."
Congress was determined to do something-almost anything-about the leveraged
deal mania but found answers in shorter supply than indignation. The creative
lobbyists for the Business Roundtable came up with an argument guaranteed not
only to get Congress mad, but also to give them ammunition to do something once
and for all about LBOs. The argument was that the U.S. Government-at a time
of huge deficits, tax hikes and program cutbacks -was providing gigantic subsidies
to buyout artists through a quirk in the tax code. The answer: Get rid of the
tax deduction that acquirers enjoyed on the interest they paid on their borrowed
funds. Yikes!
This was serious. Takeover activity ground to a halt. Sensible private equity
firms were laying low on the deal front because they did not want to throw fuel
on the fire. But some of the most important firms became active on another front-government
relations. Henry Kravis, Joe Rice, George Roberts, Ted Forstmann and Martin
Dubilier-the most fiercely entrepreneurial and anti-political bunch you could
ever imagine-began a coordinated push to reposition the battle that pitted Main
Street against Wall Street. It was the first and, perhaps, last time the industry
was unified about anything.
Believe it or not, they organized and recast the debate. Here's how...
They funded a campaign to change public perception. And the industry's top
leaders were directly involved. They recognized the importance of acting in
concert to tell a more positive story and provide corrective context. The repositioning
involved making the case that buyouts were the driving force for constructive
change in the U.S. economy at a time when our competitiveness as a nation was
in jeopardy (at the time Japan's star was still in its ascendancy).
Studies were commissioned and academics like Michael Jensen made a real impact
by writing about the positive reality of buyouts. Partners at private equity
firms testified before Congress and used a blizzard of data showing that buyouts
revitalized undervalued and poorly managed companies into global competitors.
To refute critics, they brought along evidence that showed that their portfolio
companies increased productivity and operating profits without cuts to R&D,
capital spending and employment.
The point is that the political debate was successfully recast away from the
extreme position of Byron Dorgan, a member of the powerful Ways and Means Committee,
who characterized junk bonds as the evil engine driving destructive hostile
takeovers and lining the pockets of dealmakers, to a debate over the value of
buyouts to the economy.
The campaign demonstrated that by changing the tax code Congress risked doing
more harm than good. As one lawmaker observed about the proposed interest deduction
cutback: "If you thought the problem was bad, wait till you see the solution."
It's not every day that Congress recognizes the error of its ways. At the end
of the day, the evidence that the buyout firms assembled was sufficiently compelling
to persuade lawmakers that buyouts were facilitating the much needed corporate
restructuring that would improve U.S. competitiveness.
How does this relate to the transparency and disclosure debate confronting
the private equity industry today? Well, this could very well become the second
threat to unify the industry.
There is some risk that those agitating for common disclosure and valuation
standards could unwittingly become the catalysts for those chilling words "Something
needs to be done about..."
The ingredients are there for a politically-driven public relations problem:
broad-based concerns about corporate governance, stories of wide-spread value
destruction causing pain among pensioners, lack of sophistication about the
private equity life cycle, and growing media pressure for disclosure that is
fuelled, in part, by commercial interests that eagerly want to publish the information.
It is not too early to begin thinking about repositioning the transparency
and valuation story. Otherwise, we may have to face the consequences.
What are the key elements of this repositioning? It has to recognize that:
1) private equity firms already provide an enormous amount of information about
portfolio company performance to their investors; 2) comparing private equity
investments to public equities is deeply flawed; and 3) interim valuations are
often very poor indicators of exit values.
Public confidence about what is in the corporate closet is at an all-time low.
We can all agree on that. If this confidence isn't rebuilt, there will inevitably
be more regulatory oversight. There are already signs of increased regulation
in the private equity context-the new Patriot Act's provision on money laundering;
new privacy rules; the SEC's investigation into hedge funds-all reflect incremental
oversight.
The broad challenge is repositioning private equity itself. There needs to
be more focus on equity and less on private. The essential difference between
public and private equity is not a matter of privacy, but a matter of control.
Perhaps we would be better off talking about "control equity" instead
of "private equity."
Private equity is often a very messy matter. There's no such thing as a microwaveable
solution. It's hard work. It's a commitment to the long-term. This needs to
be more broadly understood.
This is not an argument for non-disclosure. It is more a plea that we need
to start shifting the argument -not dissimilar to what happened during the interest
deduction debate in the 1980s-to promote a better understanding of how the asset
class really works. Otherwise, we should all be ready for those immortal words
from inside the Beltway: "Something needs to be done about..."
The author, Thomas C. Franco, is the chairman and chief executive officer
of Broadgate Consultants Inc., a firm that provides strategic counsel and specialized
communications services to private equity sponsor firms and their portfolio
companies, as well as other private equity market participants. He is also Chair,
IR Practice, Public Relations Organisation International, Inc.
