Private equity firms have enjoyed a perfect storm over the past year. This was the consensus of three industry leaders speaking last Thursday at a forum hosted by the Conference Board and the Week magazine. Low interest rates, enormous global liquidity, receptive capital markets, and a continuing flow of money into the sector from corporate pension funds have meant rapidly growing coffers and nonstop activity. Private equity firms raised $250 billion last year and are projected to gather more than $300 billion this year. Larger and larger corporations are being targeted by these investment groups, which frequently now form opportunistic partnerships in order to pursue ever-bigger deals.

Will the government leave them alone?

A co-founder of Silver Lake Partners, Glenn Hutchins, says record-low interest rates in many countries combined with rising corporate profits are providing nearly unlimited funds for private investors. As a corollary, low interest rates mean an unprecedented number of deals can achieve required rates of return. Also, the founder of JANA Partners, Barry Rosenstein, pointed out that pension funds, those perennial Johnny-come-latelies, are still raising the portion of assets targeted for alternative investments, including private equity.

The principal reason for their growth, though, has been their ability in recent years to yield superior rates of return. While this performance is partly the byproduct of low interest rates, the CEO of Clayton, Dubilier & Rice, Donald Gogel, also attributes the industry’s success to an emphasis on long-term investing. While hedge funds report on their performance monthly and to a large degree invest for the very short term, private equity funds typically invest over several years, with a five- to 10-year horizon.

The best private equity firms partner with companies, injecting money into operations to improve manufacturing, marketing, or research, with success measured over years, not quarters. This capability was spotlighted by the panelists, who rightly see this as a differentiating element in their success. The average corporate manager does not have the luxury of investing for the future.

In the public company realm, analysts and investors readily trash the stocks of companies whose earnings fall short of projections. Heaven forbid that a move to modernize manufacturing calls for a temporary slump in output. Out of the question! A necessary buildup in a company’s sales force could mean lower earnings for six months. Don’t even go there!

Mr. Gogel says many managers today jump at the chance to run a private company. The reporting requirements of Sarbanes-Oxley, which are viewed as excessive and wasteful by many managers, are just another reason CEOs may be lured away from public posts. Also, the glare of the public spotlight is uncomfortable. Imagine having your compensation reported in the paper and then your worthiness publicly under review. Most likely this is the kind of experience that tends to shorten the average tenure of the CEO, who today typically serves only three to five years.

By contrast, Mr. Hutchins says his firm is eager to reward management. “We won’t do a transaction unless management can build net worth.” How refreshing.

While the attractions of the “private life” to industry participants are obvious, it is surprising that the government has not moved to oversee the growing private equity sector, especially as the targets of private equity firms have grown in size. When hedge funds were required to register, the legislation was purposefully written so as to exclude private equity firms, by excusing funds which require more than a two-year financial commitment from investors. Because private equity firms tend to draw down their funds over several years, such a “lock-up” as it is called, is commonplace.

Most likely the government will not step in until there is a major problem, meaning a large-scale bankruptcy. While the majority of firms are run by seasoned investors, inevitably the high returns being reported will attract too much money, and some newcomers will overreach. An “inevitable collision between a slowing of the economic cycle and over-leveraged balance sheets” is worrisome.

Though established funds have the ability to wait out periods of lesser opportunity, living off their reputations, newcomers may feel compelled to invest in order to establish theirs. Over the past two years, corporations considering strategic acquisitions have repeatedly found themselves outbid by private firms for whom no natural synergies existed. In other words, it would appear that access to funds may be overwhelming realizable returns in motivating some buyers.

The risks of a large bankruptcy in private equity are not considered high today, but the potential costs of a failure are growing. In one of the bolder moves by the industry, last year a consortium led by Kohlberg Kravis & Roberts bought Denmark’s largest telecom operator for $15.3 billion. This purchase would appear to raise a public policy issue. Can customers assume that the interests of management and customers whose businesses depend on uninterrupted and secure service are perfectly aligned?

An even odder transaction along similar lines was the purchase by the Carlyle Group of a sizeable stake in QinetiQ, a former unit of Britain’s defense ministry. This was the offshoot of the operation portrayed by James Bond creator Ian Fleming as managed by the perpetually exasperated “Q,” who turned out sophisticated and expensive spy ware that was mucked up by 007. Imagine selling such a property to private investors – and foreigners at that! Interestingly, it wasn’t until the Carlyle Group turned around two years later and sold it back to the public at several times the purchase price that the British expressed any real outrage.

As the industry grows, chatter about regulation will grow. Ironically, it may reach a head just as two emerging trends lessen its importance. First, four firms – Blackstone, Carlyle, KKR, and Texas Pacific – have apparently had very early discussions about forming some sort of industry association, perhaps to educate regulators and legislators about the merits of private equity investing. The upshot might also be some effort at self-regulation, a preemptive strike against intervention.

Second, KKR has indicated its intention of raising $1.5 billion in an IPO on the Euronext exchange. Monies raised will be invested in KKR’s funds, presumably shining brighter light on the operations of those entities. This is not the first such venture and, as private equity firms look for further sources of capital, it is unlikely to be the last.

Meanwhile, the panelists agreed on several points, including a universal aversion to investing in Russia. Why? Because of limited rule of law and lack of transparency. Hmmmm.

peek10021@aol.com