Chapter 3 - Effects of private equity on capital markets
3.1
Regulatory bodies such as the Reserve Bank of Australia (RBA) and the UK
Financial Services Authority discussed the possibility of private equity
reducing the quality and depth of capital markets.[1]
The RBA did however indicate in the Financial Stability Review that to date
this had not been the experience in Australia.
3.2
The committee's terms of reference ask it to assess the effects of
private equity on capital markets. The committee received limited evidence on
this matter. However, testimony from the regulatory agencies and other
witnesses suggests that there are limits to the growth of private equity that
will mitigate against significant equity market effects.
3.3
Capital markets also encompass debt markets. The evidence suggests that
activity in debt markets has a greater impact on private equity than the
converse. This chapter considers these capital market effects.
Equity markets
3.4
The same economic conditions that have expanded capital markets, and
mergers and acquisitions more generally, have driven the escalating numbers and
value of private equity transactions. These conditions include low interest
rates, high levels of liquidity and low volatility. Private equity provides
capital for companies to grow and consolidate; it is therefore in competition
with public capital markets to provide these funds. Consequently, some of the
concerns about the continuing growth of private equity relate to the
implications for the quality, depth and efficiency of public capital markets.
3.5
Some of the ways in which private equity can potentially affect
stockmarkets include removing companies from and relisting companies on stock
exchanges, as well as by indirectly affecting the quality of the markets
through precipitating defensive behaviour by listed companies that are seeking
to avoid a private equity buyout.
3.6
Hypothetically, these impacts may raise concerns about whether private
equity will reduce overall capital market efficiency, but in Australia the
relative size of the private equity industry, in combination with an
anticipated slowing of private equity activity, suggests that there will not be
significant effects on capital markets.
Stockmarket capitalisation
3.7
Theoretically, falling stockmarket capitalisation could lead to more
limited non-intermediated investment choices for investors, difficulties
raising capital, removal of larger companies from the market as private equity
deal sizes increase and increasing risk for investors due to fewer
opportunities to diversify portfolios.
3.8
Internationally, there is some evidence that changes to stockmarket
composition are occurring. For example, the value of stockmarket
capitalisation, after abstracting from changes in prices, is estimated to have
fallen in 2006 in continental Europe, the United Kingdom and the United States.[2]
However, it is difficult to attribute such effects solely to private equity
activity, despite the fact that private equity is more developed in those
markets than it is in Australia. While private equity does remove public
companies from stockmarkets, companies also delist for various other reasons.
Additionally, there are other explanations apart from delistings for falls in
stockmarket capitalisation.
3.9
In the United Kingdom, the funds raised by private equity in the first
half of 2006 exceeded new capital raised through initial public offerings
(IPOs) on the London Stock Exchange. There is also concern that in addition to
falls in market capitalisation, an increasing proportion of companies with
growth potential are being taken private. Consequently, the growth potential of
those companies that are listed may have been fully exploited and this could
then affect the quality of the stockmarket overall. Furthermore, the
development of a secondary private equity market, may lead to fewer private
companies going public.
3.10
Despite these developments, the UK Financial Services Authority
considers that while they could be meaningful in smaller markets, to date both
public and private markets appear to be deep, liquid and encompass high growth
potential companies.[3]
3.11
The evidence received by the committee suggests that private equity is
not a threat to the public capital markets in Australia.[4]
There are four main reasons. Firstly, despite the surge in private equity activity
in 2006, public company buyouts as a proportion of the overall equity market is
small — Australian leveraged buyouts (LBOs) in 2006 were equivalent to
approximately one per cent of the equity market.[5]
3.12
Secondly, the market is in the process of adjusting to changed
conditions, the effect of which is likely to be a slowing in the number and
value of LBOs. The Reserve Bank advised the committee that the global boom in
LBO activity has been a consequence of the low cost and ready availability of
debt. At the same time, returns on equity have been very high, and consequently
there has been a large financial incentive to replace equity with debt. The RBA
provided the committee with the following graph to illustrate this disparity in
yields:[6]
3.13
However, the unusually large gap between returns on equity and debt is
starting to close. This is occurring because the cost of debt is rising
primarily as a consequence of the problems in the US mortgage market in recent
months. The spreads on corporate debt and lower rated debt have widened so it
is becoming more costly for investors to raise debt in the US (which is the
source of a significant proportion of LBO financing). Globally therefore, the
source of funding for these buyouts is starting to dry up and the conditions
that gave rise to the surge in private equity in 2006 have receded.[7]
3.14
At the same time, the earnings yield on equities is falling. Mr Ric Battellino,
Deputy Governor of the Reserve Bank, suggested that this is because the
existing owners of listed companies are starting to ask a higher price in order
to be prepared to sell and this pushes down the yield:[8]
So the returns on equity and debt are coming back more into
line. Our feeling from that is that basically we have seen the surge in LBO
activity and it is unlikely to continue at the pace we saw last year. I think
the market has equilibrated.[9]
3.15
Additionally, there are other limits that will restrict how large a
proportion of the market private equity can become. For example, Mr David Jones,
Chairman, Australian Private Equity and Venture Capital Association Limited (AVCAL),
told the committee that private equity can only be relevant in certain
circumstances.[10]
He suggested that most businesses already attract adequate capital and
management attention, and it is only in a minority of situations where private
equity can act as a catalyst for change and propose a new direction for a
business to its owners that it will become involved in an organisation. This
limit on the size of the sector is borne out by the fact that it comprises only
around 20 per cent of mergers and acquisitions, approximately 1.4 per cent of
the enterprise value of the Australian Stock Exchange in 2006, under three per
cent of bank lending, and less than five per cent of superannuation fund investments.
Mr Jones advised the committee that these proportions are not markedly
different to those in the more developed private equity markets of the United
Kingdom and the United States.
3.16
Thirdly, private equity is not a perfect substitute for public equity[11]
and there remain many advantages for institutional investors to hold their core
equity investments in listed companies,[12]
thereby limiting the volume of funds that will be invested in private equity.
The key advantage is liquidity. Although institutional investors are often the
source of private equity funding, it would be too risky for them to lock away
large parts of their portfolio in private equity investments which can tie up
funds for up to five to ten years. Mr Battellino suggested that the requirement
for liquidity will act as a natural limit on the extent to which institutional
investors are prepared to put money into private equity.
3.17
Finally, one of the methods by which private equity firms exit their
investments and realise their gains is by listing shares on the stock exchange
in an initial public offering (IPO). Over the last five years, approximately 40
per cent of exits out of private equity took place through an IPO.[13]
The Investment and Financial Services Association Limited (IFSA) submission
suggests that 'it is possible to view private equity as a facilitator of public
listings rather than a raider of publicly listed companies posing a threat to
the exchange.'[14]
In its submission, AVCAL states that private equity complements and enhances
the operation of the ASX by building many businesses to a stage where they can
be listed.[15]
3.18
In conclusion, there does not appear to be any evidence to suggest that
the Australian stockmarket is being adversely affected by the growth in private
equity. Over the last four years, the market capitalisation of the ASX has
increased 130 per cent, from $0.6 trillion to $1.4 trillion. Over the same
period, the number of listed entities grew by 34 per cent to 2,029.
Furthermore, in the last financial year, it is estimated that private equity
raisings in Australia equated to only 10 per cent of the amount of new equity
raised in the same period.[16]
Defensive behaviour of listed
companies
3.19
One effect of private equity on capital markets may be in the defensive
behaviour of listed companies which try to make themselves less attractive to
private equity overtures. To do this, companies increase their gearing, buy
back shares, make a large purchase or otherwise draw down cash reserves.
Additionally, the increased LBO activity may encourage other companies to take
on additional debt in an effort to increase their own returns by replicating
aspects of the private equity model. While this behaviour may increase a
company's risk, the Reserve Bank's view is that in aggregate the effect on the
stockmarket is limited. However, the Bank considers this particular effect of
private equity activity to have greater significance than any impact on
stockmarket capitalisation.[17]
Debt markets
3.20
The evidence received by the committee suggests that activity in the
debt markets influences the level of activity in the private equity market
because private equity is heavily dependent on ready access to cheap credit.
This state of affairs is most clearly illustrated by the increasing returns now
being demanded by investors in debt instruments based on the US subprime
market, and the attendant spillover into debt markets more generally, which is
reportedly having an impact on private equity deals.[18]
3.21
The debt financing for private equity transactions is generally
initiated by banks (in Australia, the bulk of the financing comes from overseas
banks). The banks subsequently securitise or sell the debt into the market and ultimately
the exposure is held by hedge funds and a few other investors. The following graph
illustrates this trend by showing changes in the composition of the global
investors in leveraged loans over the past 12 years:[19]
3.22
The graph shows that over the period the bulk of the debt is now held by
hedge funds and the share held by banks is down to about 20 per cent of the
total. So, although the banks initiate the loans, hedge funds and a few other
investors are the main ongoing source of funding. While these practices have an
effect on debt markets, it is not possible to separate the impact attributable
to private equity activity from that attributable to financial market activity
more generally.
3.23
The debt is often structured into various tiers such as senior, junior
and subordinated debt which can be securitised and spread throughout the market
by being repackaged and sold, including to retail investors. The Australian
Securities and Investment Commission (ASIC) is alert to the fact that retail
investors, while cognisant about the degree of risk attached to equity and
business investments, are often confused about the amount of risk that can be
inherent in fixed interest investments. These investments could include the
financial products that might flow into the market from private equity deals:
...there is some risk there, but consumers will misinterpret or
misprice the risk that is involved and merely take at face value that it is a
fixed interest investment and therefore you cannot lose your money and you are
going to be paid that level of interest.[20]
3.24
ASIC told the committee that it is vigilant about the quality of
disclosures in the prospectuses for selling these instruments to ensure that
they inform retail investors about the degree of risk that is associated with
the debt. The risk will be dependent on the complexity of the transaction,
where the debt ranks in the transaction and the level of security that is
attached to the particular debt offering.[21]
The Committee notes ASIC's related evidence to the Parliamentary Joint
Committee on Corporations and Financial Services where representatives emphasised
that its responsibilities in this area relate to ensuring adequate disclosure,
and that it does not make judgements in relation to the business that is being
carried on.[22]
3.25
Clearly, the existence of active secondary, and leveraged loan markets
for debt instruments is very important to enable private equity deals. Hypothetically,
if the banks could not remove their exposures from their balance sheets, they could
become more reluctant to lend for private equity transactions.
3.26
Recently there have been reports about private equity entities pulling
out of certain deals as a consequence of the reappraisal of risk in the US
subprime market.[23]
Additionally some corporate capital raisings have been postponed and there have
also been difficulties for banks in placing certain loans from large private
equity buy-outs in the capital markets.[24]
There are two aspects to these developments. Firstly, as credit spreads have
widened, the cost of debt — especially the more risky tranches — has increased as
investors demand a premium for more risky securities. This may mean that a
private equity deal potentially will not be as profitable as initially anticipated.
Secondly, issuers of securities may be finding some resistance in the market.
Nevertheless, the capital markets seem to be in the process of adjusting to
changed conditions and these most recent developments may not continue.
Predictions about this dynamic area are well beyond the scope of this report.
3.27
In summary, private equity transactions have an impact on debt markets
by increasing the supply of debt instruments. However, the attendant supply of
financial products is only a subset of the broader pool of instruments issued
in financial markets more generally. The greater impact is from debt markets which
have a more significant effect on private equity activity through the cost of
borrowing and the level of demand for the debt instruments that are created
from the deals.
Other effects
3.28
Private equity practices may enhance capital market efficiency in
different but related ways. These enhancements include widening the
availability and source of capital to companies, increasing the accuracy of
company valuations (for example, factoring in their growth potential),
enhancing the efficiency of corporate capital structures, and facilitating
corporate development and transformation.[25]
3.29
According to AVCAL, private equity has helped to develop the debt
markets in Australia by attracting more international banks to participate in
them.[26]
Its submission states that the entry of new lenders into the market has
increased the availability of funding for Australian businesses and investment
products for investors. In addition, private equity activity has helped to
build in Australia a liquid market in subordinated debt. These effects have increased
the efficiency of Australia’s capital markets.
3.30
Private equity, and mergers and acquisitions more generally, also
contribute to increased economic activity when they lead to the release of capital
that has been tied up in the companies that are taken over. A portion of the
released funds will be invested by the ex-shareholders.
3.31
IFSA also suggests that private equity imposes a competitive discipline
on public market operators, such as the ASX, to ensure that the cost of
compliance with market rules as well as listing and other fees are competitive.[27]
Conclusion
3.32
The committee concludes that although potentially private equity can
affect equity markets if it becomes large enough, there are certain
characteristics of the sector that should limit its size relative to the public
market. At the present time private equity is not having a significant effect
on the Australian stockmarket. Additionally, private equity transactions have
an impact on the debt markets but it may not be possible to disaggregate these
effects from other activity in the markets. Of greater significance is the role
that debt markets play in influencing private equity activity.
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