After a record long period of low inflation and high profitability, the world economy is awash with cheap capital. One of the unforeseen consequences of this is that we have a new mainstream asset class to get excited about – private equity (PE). Some analysts looking to the near future, forecast a world where the typical portfolio contains a 5-15 percent weighting in private equity. But are they right, and just how did private equity rise so far and so fast and what is all the fuss about?

Before setting out the case for private equity, it’s worth understanding the uncomfortable truth that public markets aren’t quite as good as we think they are. Stock markets have four intractable problems; large numbers of inactive shareholders, large shareholdings by fund managers who value instant performance over long-term investment, rising compliance costs in corporate social responsibility, reporting and media activity and finally, ‘free cash flow dispersion.’

The last point is perhaps the most crucial of all. Back in 1986, Michael Jensen, now a Professor at Harvard Business School, theorised that the managers of public companies when generating more profits than they can reasonably invest in their industry, instead of returning the cash to shareholders, all too often hold on to the cash and diversify. These new investments are typically aimed at a new field where they have less expertise and generate lower returns. This trend, the dispersal of cash flow by vested corporate interests, arguably, has led to the rise of the underperforming conglomerate, so idealised in the 1950s as the benevolent corporation.

The initial backlash to this corporate sloth occurred in the early 1980s, led by financiers funded by the cheap debt of the day, junk bonds. Their aim was to asset-strip (or reallocate) the conglomerates’ assets and return the value back to the shareholders in cash. This continued until the late 1980s when a slumping economy and rising interest rates put paid to their financing by cheap debt.

Twenty years on, private equity financiers are again drawing down debt, re-tuning businesses and starting new ones. Asset-stripping is not a principal activity of theirs, far from it.

But what private equity financiers do do, which is virtually identical to the 1980s is to take an ‘active investor’ role. Back in the 1980s, James Goldsmith defined the active investor as the following: “An active investor is not a manager, not a particularist, he’s not a man who thinks he can double-guess management, he’s not a person who thinks he can do a better job of management than the management he can hire. An active investor has to ensure that the right management is in place, the right management is properly motivated, the right management, properly motivated, then runs the company according to a reasonable strategy and doesn’t chase industries it knows nothing about. That is the job of an active investor. If he does not consider the management is right, he fires it and replaces it.”

So some of us can see that active private equity investors are far more of a corporate tonic than having a couple of fund managers on your back. The resurgence of private equity is the quite right and proper claim of capital to reassert its interest against the onslaught of political and regulatory distraction.

PE critics meanwhile point to the “major transparency and accountability gap” outlined by the Walker Report which they say needs closing. They seem all to ready to ignore that businesses, as long as the law is obeyed and competition is free, need only be transparent and accountable to their owners. And private equity has long done this far better than any public company.

Moreover, as the number of easy deals declines in the Anglosphere, PE will start to reach out much further afield. And be under no doubt, a global private equity boom will be unleashed when cosy corporatist nations like Japan, France and others feel the whip of the active investor.

Japan, more than anywhere else in the world could benefit from aggressive private equity. Many companies hold underperforming assets in property, all too often, one of the largest assets on the balance sheet. Private equity could be the divine wind that shakes corporate Japan to its core, igniting the animal entrepreneurial spirits the country so desperately needs. Still today, many Japanese companies seem to think that their company is run for the workers and managers, while shareholders are only entitled to a bond-holding interest.

The truth is that PE is an obvious example of how business succeeds with lower taxes and minimal political interference. London in the meantime, has a chance to make itself a world leader in private equity by cutting tax on carried interest still further. Politicians and trade unionists should either shove off or join the ride.
The global private equity revolution has only just begun.

Dan Lewis is Research Director of the Economic Research Council www.ercouncil.org