Private Equity, Risk, and
Government:
The Great Challenge
Josh Lerner
Harvard Business School
My argument
• The single greatest challenge that the PE
industry faces is not…
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Market cycles.
Overleveraged existing portfolio companies.
Access to debt.
Limited partner nervousness.
• But rather overactive and ill-informed
regulators.
My argument (2)
• Much of the proposed regulations appear
profoundly ill-conceived.
▫ But it doesn’t seem to matter!
• The private equity must be more creative in
responding!
Central issues
• In aftermath of economic crisis, many questions
regarding regulation:
▫ How did regulators miss the antecedents to the
financial crisis?
▫ Does institutional approach to regulation still
make sense?
▫ Should regulators’ reach be expanded to all
institutions that pose systemic risk?
Widespread regulatory proposals
• Broad array of regulatory changes proposed in
both U.S. and Europe, as well as various
multilateral bodies:
▫ Precise shapes of legislation remain uncertain.
▫ But seems clear something will happen.
”[PE and hedge funds] are, in short, a major challenge
to financial stability, and, unless regulated, they are
likely to contribute to future crises.”
”The big private equity funds have proven to be a
menace to healthy companies, to workers’ rights, and
to the European Union’s Lisbon Agenda.”
”Leveraged buy-outs leave the company saddled with
debt and interest payments, its workers are laid off, and
its assets are sold. A once profitable and healthy
company is milked for short-term profits, benefiting
neither workers nor the real economy.”
Paul Nyrup Rasmussen, ”Taming the Private Equity Locusts,” Europe’s World, 2008.
Private equity is not exempt
• EU Alternatives Investment Fund Managers
Directive:
▫ Long-running legislative process specifically focused
on private equity and hedge fund industry.
 http://ec.europa.eu/internal_market/investment/altern
ative_investments_en.htm/
• Dodd bill may or may not contains provisions
directly addressing private equity, but begins
process that is ultimate likely to ensnare PE:
 http://www.financialstability.gov/docs/regs/FinalReport
_web.pdf
EU Proposals
Source: Oliver Wyman [2009].
US Proposals
U.S. Proposals
Source: Oliver Wyman [2009].
“Would everyone check to make sure they have a
lawyer? I seem to have ended up with two.”
Thinking about the justification
• Extremely complex problems pose policy
challenges.
• To what extent are proposed private equity
regulations justified?
• Little evidence one way or another, except
anecdotes.
Differing perspectives
• Private equity leads to better operations:
▫ Industries with more private equity backing
should do better.
• Or private equity as asset strippers?
• Private equity has “deep pockets”:
▫ PE-backed firms can do better in downturns.
• Private equity is over-leveraged and cyclic?
▫ PE-backed firms will do worse in downturns.
The WEF 2010 project
• Look at all buyout and private
equity investments around
world.
• Look at evolution of industries
at national level:
▫ Revenues, employment,
profitability, etc.
▫ 26 countries and 20
industries.
• Use data from OECD,
CapitalIQ, etc.
The sample
• 8,596 country-industry-year observations
between 1991 and 2007.
▫ PE industry = at least one PE investment in
industry last 5 years
▫ Low (High) PE = fraction of total imputed PE
investments last 5 years divided by total
production smaller (larger) than the median
(conditional on non-zero level of PE investment).
▫ Quartiles of PE investment / production
• Look at deviations from average growth rates at
the industry-year level
Two key questions
• How does more PE investment in past five years
impact industry performance in a given nation?
• Is the pattern the same in times of industry
shocks, particularly downturns?
▫ E.g., if more PE investment in Swedish steel
industry than Finnish, does industry performance
differ…
 In general?
 In downturns?
The basic story
Basic regression results
• Lagged PE-investment is associated with
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Higher growth in production (0.9 percentage points)
Higher growth in value added (1.1 pp)
Higher growth in total wage compensation (0.7 pp)
Higher growth in number of employees, but mostly for
moderate levels of PE investment
▫ No significant effect on capital formation / investment
• Also true when look at continental Europe alone.
Looking at cyclicality
• If anything, PE investment seems to dampen
industry shocks
• Particularly consistent for employment and
labor costs:
▫ 5% increase in total labor costs in a given year 
PE industry will experience 5.576% increase
▫ 5% decrease in the wage bill 
PE industry will experience a 2.394% decline
Worrying about causation
• Does PE cause or chase growth?
▫ Do PE funds choosing faster-growing or less
volatile industries?
• Results unchanged if we only consider the impact of
PE investments made several years before on
industry performance.
• Also go through when look at pension policy
changes that drove PE fundraising.
• Seems to be PE driving growth, not vice versa.
Key conclusions
• Industries where active PE funds in the past 5
years grow more rapidly:
▫ True if measured using total production, value
added, or employment.
▫ Few significant differences between industries
with low and high PE activity.
• Activity in “PE industries” no more volatile in
the face of industry cycles, and sometimes less
so.
 Bernstein, Lerner, Sorensen and Stromberg [2010].
But it doesn’t seem to matter!
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Pressures to “do something.”
Lack of patience of policymakers with details.
Hard to sympathize with private equity titans.
Regulatory creep:
▫ What starts as a modest regulatory regime almost
invariably expands.
You have logic, I have Reggie.
© Charles Barsotti. All Rights Reserved
Some thoughts about carry tax
• A philosophical conundrum best left to taw
professors!?
• Uncertainty as to who will bear tax and
consequences:
▫ LPs: Fewer capital commitments?
▫ GPs: Even fewer incentives to “do the right thing”?
 Metrick-Yasuda results.
Carry tax (2)
• Other questions:
▫ How much revenue will this collect really?
 Difficulty of distinguishing between entrepreneurial
and private equity contributions.
▫ Distinguishing between venture capital and
private equity funds: mission impossible?
 The weakness of holding period as a criteria.
▫ The desirability of enterprise taxation provisions?
A modest proposal
• PE must become much better at making a case
for intelligent regulation.
▫ Widespread consensus that regulation that is
piece-meal and institution-specific just opens
doors to “gaming” and arbitrage.
▫ Moreover, private equity is likely to suffer
disproportionately due its visibility.
• Should be encouraging independent voices to get
the word out about these issues.
An example from Europe
• Proposed limitations on leverage in private
equity deals:
▫ Why should PE funds be limited but not…
 Sovereign wealth funds?
 Family offices?
 Companies themselves?
▫ Likely to lead to huge disruption and poorer
investments.
Another modest proposal: “Green
shoots”
• Governments world-wide
eager for growth and
employment:
▫ Numerous subsidy schemes
geared toward venture capital
and new ventures.
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Australia
Canada
China
India
New Zealand
United Kingdom
United States
…
Many recent examples
Private equity is likely to be part of
the solution
• Tool kit is very relevant:
▫ Experience screening potential investments.
▫ Skill at overseeing firms making operating
improvements.
▫ Abilities to help firms access additional financing.
 Track record of growth equity sector.
 More general evidence presented today.
• But industry has not been engaged in a proactive
manner.
One of few exceptions
Wrapping up
• Regulation is real and only likely to intensify.
• Many of the concerns about PE seem
misplaced…
▫ But it doesn’t seem to matter!
• The industry must be much more pro-active and
creative in its response to these challenges.
Josh Lerner
Rock Center for Entrepreneurship
Harvard Business School
Boston, MA 02163 USA
617-495-6065
josh@hbs.edu
www.people.hbs.edu/jlerner