American Enterprise Institute

November 27, 2007

[Edited transcript from audio tapes]

Tuesday,	November 27
1:45 p.m.	Registration
2:00	Welcome:	Christopher DeMuth, AEI
	Opening Remarks:	R. Glenn Hubbard, AEI and Columbia Business School
2:15	Special Remarks:	Private Equity, Venture Capital, and Modern Capital Markets
	Presenter:	Josh Lerner, Harvard Business School
2:50	Panel I:	Private Equity’s History and Impact on Corporate Governance
	Presenter:	Steven N. Kaplan, University of Chicago
	Discussants:	Kenneth M. Lehn, University of Pittsburgh
		John L. Chapman, AEI
	Moderator:	Alex Brill, AEI
4:15 p.m.	Panel II:	Private Equity’s Impact: Productivity and Labor Market Effects
	Presentation:	Steven J. Davis, AEI and University of Chicago
	Discussants:	Douglas J. Cumming, York University
		Kent Smetters, AEI and the Wharton School at the University of Pennsylvania
	Moderator:	Kevin Hassett, AEI
5:45	Reception
6:30	Dinner
7:00	Keynote Speaker:	Michael C. Jensen, Harvard Business School
8:00	Adjournment
Wednesday,	November 28
7:45 a.m.	Registration
8:10	Opening Remarks:	R. Glenn Hubbard, AEI and Columbia Business School
8:20	Panel III:	Private Equity’s Impact: Corporate Control, Capital Markets, and Entrepreneurship
	Presenter:	Karen H. Wruck, Ohio State University
	Discussants:	Annette B. Poulsen, University of Georgia
		Peter G. Klein, University of Missouri—Columbia
	Moderator:	Alan Viard, AEI
9:30	Panel IV:	European and Global Developments in Private Equity
	Presenter:	Mike Wright, Nottingham University Business School
	Discussants:	David Ravenscraft, University of North Carolina at Chapel Hill
		Adam Lerrick, AEI and Carnegie Mellon University
	Moderator:	Nick Schulz, AEI
11:10	Panel V:	Practitioner Panel: The View from the Trenches
	Presenters:	Brian P. Simmons, Code Hennessy & Simmons
		Tully M. Friedman, Friedman Fleischer & Lowe
		Thomas Puetter, Allianz Capital Partners
		Rick Rickertsen, Pine Creek Partners
	Moderator:	John L. Chapman, AEI
12:00 p.m.	Luncheon
	Introduction:	James Glassman, AEI
	Keynote Speaker:	David M. Rubenstein, Carlyle Group
1:15	Adjournment

Proceedings:

Welcome, Opening Remarks, and Special Remarks

Chris DeMuth:  Ladies and gentlemen, can we come to order please.  My name is Chris DeMuth.  I’m president of the American Enterprise Institute and I’m delighted to welcome you here this afternoon for the first session we are running this afternoon and also tomorrow through the noon hour in this conference on The History, Impact and Future of Private Equity. 

The backbone of capitalism, one might say its defining characteristic, is mechanisms for aggregating large sums of capital and deploying them efficiently in the production of goods and services.  The 20th century may be said to have been the century of public equity in capitalist system.  The progress of capitalism and of economic prosperity that resulted from it was importantly driven by the emergence of large, efficient, liquid public securities exchanges. 

If one had asked a sophisticated financial person in 1999, whether the public markets would begin to be displaced by what then would have seemed an older, less formal, less developed, more primitive form of financing of private equity, one would have found few takers.  And yet, 21st century so far looks like it might be characterized as the century of private equity in the history of capitalism, not by financial market share of course, but certainly by growth interest and innovation. 

The reasons for this startling development and the implications for the economy and for policy are to be the subject of our discussions here today and tomorrow.  One might have thought that these topics would be discussed in New York City, but in Washington we take a lively interest, not always an altogether wholesome interest in developments in private market, especially where very larges sums of money are involved.  And the true characteristics and purposes of this new phenomenon of private equity and the institutions, which are driving the growth of private equity have become a subject of enormous interest in Washington, in Congress and in the regulatory agencies of late.  We hope that those who are concerned with some public policy will be paying careful attention to our deliberations this week at AEI. 

I’m grateful to many people for bringing this conference into being.  First and by far the most important is John Chapman, my associate here at AEI who is a graduate fellow working on his dissertation in economics associated with our national research and initiative.  John conceived of this conference in the course of his research many long months ago and has been the mode of force all along in developing the idea, seeking out the people, and working with the rest of us here and keeping us all focused on bringing it into being. 

His chief collaborator in the effort has been Glenn Hubbard, dean of the Business School at Columbia University and Carson professor of Economics and Finance there and for many long and fruitful years, a visiting scholar with the American Enterprise Institute.  And I would like to say in the course of the two days, first and foremost, our thanks are due to the many accomplished academic students of finance and economics who are making presentations and many of the leaders of private equity institutions who are joining us for the discussions as well. 

With that I would like to turn the podium over to Dean Glenn Hubbard who will make some remarks and then we will move immediately to our first session.  Glenn –-

R. Glenn Hubbard:  Thank you very much, Chris.  I think the size of this audience is only one testament to the power of this topic.  Over the next day and a half, we will be discussing a number of ideas that I hope everyone in the room will find of interest.  As Chris had teed up in his remarks, buyouts and private equity has been a great growing part of the landscape of the American financial system and, increasingly, the global financial system over the past quarter century. 

It has also been a subject of continuing controversy as the industry’s growth has accelerated in recent years, so has that controversy.  This seems and is, I think, an appropriate time to bring together scholars to shed light on the role and the importance and issues surrounding the private equity in the modern economy and to look specifically at a number of questions involving corporate governance, the operation of our capital markets in economic growth and assess the future prospects of the industry.  There will also be comments I’m sure on recent issues from panelists regarding taxation and regulation of private equity. 

On the one hand, this is a small sector.  Even at its leverage best, it is perhaps 1/25th of the financial asset in the American economy.  But as our panelists and speakers will describe, private equity has played an outsize role in corporate governance, strategy, mergence and acquisition, and developments in capital markets.  As an economist, I think of this industry coming from the prospect of its potential to affect economic growth. 

There has been a lot of interest in my profession over the past decade in the American economy’s extraordinary record in productivity growth.  Victory, of course, has many, many fathers.  And the principal father studied the economics of that growth has been technology, which is an interesting story in explaining the time series changes in U.S. productivity growth.  It, however, cannot be completely true; probably it is not primarily true, because if one looks at the cross section of industrial countries, only the American economy benefited from a productivity boom over this period.

Economists have many reasons for this difference but surely a great among them is the idea that markets for risk capital in the United States had been different from some of our competitors, private equity being one of those differences.  At the same time, there is a growing body of research in economics suggesting that the adoption of certain management practices leads to improvements in productivity growth.  Indeed, recent work comparing individual firm data within industry across countries concludes that about half of the variation in firm level productivity growth might be explained by differences in management practices.  That body of research has started to pick up attention in the private equity field looking at whether the adoption of certain private equity practices play a role there. 

Now, I said that this has not been an area without controversies.  We will look at the controversies and questions.  For example, is private equity a new order of the ages, the reducer of agency cost or is it trading of ownership claims with no economic value added?  Is it improving the risk sharing liquidity and information services that make modern capital markets or not?  Is it an operational improvement or is it financial engineering from MBA students?  And questions:  If private equity and hedge funds are coming closer together, can we still believe some of the sources of value creation arguments in private equity?  Where, in fact, does private equity fall on a risk adjusted basis as an asset class?  Why and how do the great private equity firms - say, top private equity firms, top quartile returns - generate excess market returns especially since they are diversified firms, perhaps the conglomerates once pilloried?  What role does private equity play in actually producing entrepreneurship? 

We have the right team on this program with the speakers to sort this out.  You know, there is an old adage from venture capital that it is better to have an A team with B idea than the other way around.  We are going to trump that; we got an A team and we got A ideas for you to hear.  Our keynotes speakers are Michael Jensen and David Rubenstein.  We will have Josh Lerner in a moment for an overview.  Steve Kaplan will look at the past, present and future of private equity with descriptive statistics from the sector and look at the question of whether it is good for the economy. 

Steve Davies will be looking at private equity’s impact on employment and productivity to variables of great interest in the real economy and also in Washington.  Karen Wruck will be looking on the impact of private equity on the very important market for corporate control - a key reason the American economy differs from its competitors.  And Mike Wright will compare and contrast the buyout phenomenon in the U.K., Europe versus the United States.  And finally, and I promise this, we would get a peek at where the sector is headed.  A lot of capital has come into the sector in the past three years and the question is what returns that capital will get and what will its economic impact be.  And of course, all of us in the program invite your close questioning of the panelists on these issues past, present and future. 

Before I introduce Josh Lerner, let me join Chris in thanking the National Research Initiative and Henry Olsen and John Chapman for putting together a fantastic program.  It is my privilege to introduce our lead off speaker, a long time friend and colleague, Josh Lerner, from Harvard Business School.  Josh’s underlying specialty is perhaps the most important in economics, looking at the sources of the economic growth from technological innovation and public policies that might affect the pace of innovation, studies of patenting and the innovation process itself. 

He is also one of the academy’s leading contributors to research on the structure and role as the organization and impact of private equity and venture capital organizations.  His venture capital and private equity course at Harvard Business School is among the most successful at the school.  He is also the founder of the National Bureau of Economic Research’s Entrepreneurship Program.  Josh is very heavily involved in the World Economic Forum on project on private equity as well, so we can get no better person to lead off today.  Josh, the floor is yours.

Josh Lerner:  Okay, well, thank you very much for the kind introduction.  I have been given the mandate to throw a bunch of stuff up in the air and sort of get the discussion working and going forward.  Do we have a clicker or maybe –- and as a result of the daunting [sounds like] challenge in the sense that there is just a lot of stuff going on in terms of the private equity in the private equity world.  Some of it bad news, you know, deals going south, problems and issues in terms of people who over-leverage themselves.  Some of it -- interesting new organizational forms and initiatives where they are talking about private equity groups going into other countries, strategic purchases of stakes by foreign governments, and then of course, the whole set of issues and concerns around regulatory issues and regulatory concerns, taxation and so forth. 

What I’m going to do here in the spirit of kicking things off is really highlight two sets of remarks.  First of all, let us just sort of step back and think about how we got to where we are today.  How did the private equity business come about?  And then secondly, let us tee up at least a couple of big issues that are likely to be the ones that we are going to be visiting again and again in the course of the discussion here and hopefully at least say a few things that are provocative enough to get the ball rolling and get some discussion going.  Again, primary important thing to emphasize is despite all the attention being given to private equity - you have a number of headlines generated in the Financial Times and Wall Street Journal and whatnot – this is still in many respect a very mysterious business where there is a lot which is not really understood about it and a lot of what seems to be understood is absolutely wrong. 

So let us start with where we have been and how we had gotten to here.  A key point to emphasize is the youth, the immaturity in the continuing change that very much characterizes this business.  If we think back to the World War II and at the time when the first private equity funds were established, there was a very real sense that the system as it existed, whether it was for funding an entrepreneur starting a new company or somebody who wanted to restructure an existing company, did not work very well.  The system, as much as it really existed, consisted of trotting entrepreneurs in front of rich people who would either write checks or would not write checks and, well, certainly people like David Rockefeller who were very successful in some of their investments.  There is a sense that there was a real inefficiency in terms of that process, but there was a real sense in the sort of finance perspective for an intermediary who could play this role much more effectively. 

Even though that was a very compelling academic case for this - in fact, faculty members from Harvard Business School and MIT were among the first people to really make the case and to lead the first private equity funds that were established after World War II - getting it to work in practice was very challenging.  And in particular, the challenge really had to do with raising the money.  When for instance, Georges Doriot who founded what many people regard as the first venture fund, American Research and Development, went to the Harvard endowment, they essentially slammed the door in his face saying, “This is way too risky.  Why should we be investing in these young startup companies?”  He was like, “Trust me, I’m a Harvard Business School professor, you can invest in me.”  They were like, “Oh, that is all the more reason not to give you any money from our precious endowment.” 

As a result, the only way that these funds could really be raised was the good old fashioned way, which is largely from widows and orphans.  You know, essentially there were floated various publicly traded closed-end funds that were marketed to whoever would sort of buy into this in the sense that there was going to be great promise there and as well as, you know, clearly later on a variety of government-based efforts as well.  So, essentially, we got intermediaries, but this process that did not work terribly well. 

The sort of real birth of the modern industry we can sort of trace back to 1978 when there was this sort of -- at the time was this [audio glitch] obscure [sounds like] shape bureaucratic restructuring of regulations regarding pension funds, something that at that time it did not even make the Wall Street Journal or The Washington Post, which had to do with the definition of what constituted the prudent man.  And in particular, what it did is it essentially said you do not need to look at each of the individual investments that you are making and apply a test of prudency.  You can essentially look at the investments as a whole.  So suddenly, investing in a venture fund which is investing in a bunch of kids with ponytails in a garage who are investing in a buyout fund that is coming in to some sort of very leveraged situation is okay as long as it is within this larger, larger pool. 

And what we got as a result was that many, many pension funds which previously had not touched this area - it had been very much dominated by individual investors, by a few university endowments - suddenly took a very small slice of their pie and put it into venture and buyout funds and that represented a huge increase in terms of the amount of money being invested in this industry. 

So for the first time you ended up seeing differentiation between early-stage funds, doing venture capital or start-up deals, later-stage funds doing buyouts and restructurings.  You started seeing funds not just in the United States, but in the UK and beginning to get early funds in Asia.  One also saw at that point the limited partnership replacing the publicly traded closed-end fund as a dominant organizational form by which these funds were set up.  So essentially, we had this sort of tremendous spike in terms of the level of activity from a very modest baseline.

Now, the industry that grew so fast, you had all these ugly things happening.  A lot of groups were set up where the people had no experience in terms of doing venture or buyout investments and squandered the money in an amazingly rapid time.  In other cases where groups had it done pretty well managing $20 million or $40 million, who suddenly raised to a quarter billion dollars or half a billion dollars and where all the sort of strategy and structure that they had that worked so well when they were doing million dollar investments just sort of broke down when they had to write these much larger checks and, again, the money which was largely wasted in terms of just putting into nonperforming investments.  So as a result, returns very much collapsed as a result of that first venture capital which had the initial wave.  And later on by the mid to late ‘80s in the buyout sector, and not surprisingly investors responded by pulling the funds back from these sectors.  So I guess there is a younger Henry Kravis in those days. 

So sort of a classic cycle that we have seen again and again in this industry, once the money started -- the fast money pulled out, the groups that were left there had much less competition.  They probably also had less resources so they could sort of invest in these top flight opportunities, and so suddenly returns started perking up once again.  One got, as a result of that success, a resurgence of interest in the private equity investment task [sounds like].  It is also fair to say that limits of partners, the pension funds and others became considerably more sophisticated in terms of bettering [sounds like] in advisers and so forth to advise them in the process. 

Then we get to relatively recent history, the late ‘90s where we saw the spike in terms of venture capital activity, clearly initially was largely driven by the fact that there had been these very positive shocks which created all these interesting technological opportunities and the fact that the groups who were there doing the investing in the mid 1990s ended up having very good returns.  Again, one saw lots of money coming in, lots of new groups raising money, new regions getting money, new stages of deals and, of course, also were kind of overheating that had characterized the earlier booms as well.  So you certainly saw corporations, incubators and various others jumping into this fence.  We all know how that turned out. 

While certainly there were lots of great companies funded during that period, there were also a lot of unhappy companies funded during that period.  Eventually returns deteriorated and investors pulled out.  And so you saw this very dramatic spike and then that sort of collapse in terms of the money being raised particularly by the venture funds, and this was not just a U.S. pattern but clearly a pattern that we saw in Europe, in Asia, even in Latin America. 

And then finally, we have the most recent period of really the ‘05 to ‘07 period where we saw a similar kind of explosion largely focused on buyout funds, later stage investors rather than venture funds but with much of the same characteristics of the boom that we saw in venture in the 1990s and in the buyout venture in the 1980s, and in fact if we look back even further at what went on in the nation’s private equity in the spring of 1960s.  So we saw this sort of spike of activity that really was unprecedented by the history of the industry.  This is even adjusted for inflation, which makes it even more extreme, largely being driven by the very large buyout funds. 

The fact -- it is also clearly driven by the fact that we have all these new institutional investors whether public pension funds or sovereign wealth funds or many other institutions which had not invested in this area until now, who, attracted by the success that the Harvard endowments, Yale endowments and others had had with venture capital, with buyout, with other alternative investments sought to emulate their strategy.  And that is surprisingly just a sort of underscore.  We have seen the same kind of boom and bust where there is a huge influx of money that typically had been associated with big drops in terms of returns. 

Now I guess one interesting question that I will just sort of tee up here, since it will be the focus or at least the key point in terms of what Steve is talking about, I will leave it for him to sort it out, is where we are today historically in terms of where the buyout industry is.  As I mentioned before, this certainly is not the first boom that happened in this industry and if one goes back to 1980s, one sees that the kind of excesses that characterized the market for private equity in the last couple of years was very much also in evidence there, whether sky high evaluations, whether increasing reliance on capital structure that had more and more debt in them.  On the other hand, there are probably things that we can point to that are really quite different about the industry today and I think I will just sort of tee it up as an issue that we will want to talk about and dig into more in terms of what are going to be the short-run prospects for the industry and how the current downturn and credit crunch are going to play themselves out in terms of the process. 

What I’m going to do in my remaining few minutes is rather than focus on short-run dynamics in terms of how the business is going to play itself out over the next year – two years, even three or four years – how would this sort of fact that there was so much of aggressive deal making and over leverage is going to manifest itself, I’m instead going to sort of tee up three broader changes that we are seeing today in the business that I think are much more longer run transformations.  Because, I think, as the earlier remarks suggested, the cyclicality, this boom and bust that we have seen in the last couple of years had been part and parcel of the private equity industry from day one. 

That, in some sense, is old news.  It may have some different manifestations this time but essentially this is a story we have seen many times before.  What I’m now going to argue is that there are some other transformations taking place which are really newer in some sense, likely to be longer reaching in terms of their implications, in terms of affecting the business. 

The first of this is this sort of rise and also the challenges that what I termed the bulge [sounds like] bracket or the very largest private equity groups face.  When one looks at the statistics in terms of private equity being raised, what one has seen particularly over the last five years is a very dramatic increase in terms of concentration.  The share of capital which the very largest groups, the Blackstones, the Carlyles, the KKRs of the world, represent in terms of the pool money that has been raised.  And you can certainly tell stories for why that has happened.  Deals are more complicated and more likely to be global in terms of their scope today.  So it is not surprising that you would want to have big pools of capital to be able handle a complex multi-country deal. 

Another example of what may be driving it is the mix of investors, particularly if we think about some of the situations involving some of the government investment funds.  If you are in this situation where you got a pool of capital of $900 billion to invest, you are not going to be in this situation where you can really write too many small checks.  A million dollars here, a million dollars there, it is going to take you a long time to invest $900 billion.  So clearly, this emergence of very large pools of capital and the existing pools of capital has increased willingness to play in this arena -- has created a lot of opportunities and a lot of appetite for writing large checks and opportunities for groups who can take those large checks and bundle them together, probably also to a certain extent, has put more emphasis on brand name and brand name recognition. 

One analogy that we might sort of say, given the kind of changes that are taking place here, is to sort of step back in time and think about investment banking.  If we think back, the investment banking industry in the 1950s, it was sort of a business where there were larger groups and smaller groups, but there was not an enormous differentiation between the bulge bracket or leading groups and the sort of mid or even smaller groups.  And what one saw, particularly during the ‘60s and early ‘70s, was this incredible differentiation that took place where one essentially had the large groups becoming much more systematized in terms of how they work, much more substantial in terms of the scale, and much more profitable while many of the niche groups, the smaller focus groups remained largely the way they were. 

And I think we can look at lots of statistics in terms of how this differentiation occurred and how dramatic it was without belaboring that.  You know it is not hard to imagine private equity going through very similar kind of situations today where we can essentially have one set of group which is the Morgan Stanley and Goldman Sachs and JP Morgan equivalents, and then many other perhaps potentially very profitable groups that are staying much more nearly focused on particular areas.  But at the same time it is very natural to ask, “Is private equity like investment banking?”  In other words, it does not really work to get a sort of huge complexes with lots of big groups of people and capital together, or is this instead such a business which is so people-driven that it does not really work that well to get this agglomeration where essentially there are some sort of limits to the benefits of scale? 

Some of the empirical stuff we have done suggest that there does seem to be a real trade-off where getting bigger seems to translate into lower rates of return, that there are some real cost to growth in this business which might give us some degree of caution.  It is hard to attribute, to know what exactly to attribute it to.  This is sort of the confusion hypothesis that there are just too many lawyers running around, I realize in Washington, so that is probably not a theme I should dwell on for too long and let us just press ahead. 

Just to wrap up here, we might think that these kinds of challenges are likely to be particularly manifested during the private equity bust.  Certainly when you look historically back to the 1980s, you can say, “Which are the groups that had the most problems with the bust that occurred in the late 1980s?”  In many instances, it was the very largest groups that suffered the most market declines in terms of returns and the challenges that they faced as well. 

That is one theme -- let me quickly do or at least touch on two other themes up in the air.  The second of these relates to the tension between investors in private equity funds, the limited partners, the pension funds, the university endowments, the insurance companies and the private equity groups themselves.  In some sense, private equity has a bit of a paradox.  And the one hand we got very good oversight on the part of the private equity groups overseeing the portfolio companies.  On the other hand, there is relatively limited oversight of a private equity groups by their investors. 

So on the downstream side, we got all sorts of -- we know that corporations can engage in all sorts of naughty behavior.  So here they are saying, “I realize gentlemen, $30 million is a lot of money to spend.  However, it is not real money and, of course, it is not our money either.”  And the point that I think what Mike and Steve and much of the other pioneering work on the private equity industry emphasize is that private equity seems to be really good at solving this problem of stepping in, of sort of managing where the money is going in terms of limiting what we call agency problems in firms. 

But when you look upstream, it is very different.  In other words, the controls that the investors in the private equity funds have over the private equity groups themselves, it is very hard for them to get their money back unless the private equity groups do something really outrageous.  They do not have a lot of governance, provisions; in fact, they cannot even have them if they want to preserve their limited liability status.  In some respects, it may not even make sense because there are so many surprises in terms of the investment process.  It may be in many cases that even if you as an investor wanted to control -- in some sense in a theoretical level want to control the groups, it would not make sense because there is going to be new investment opportunities you cannot really anticipate coming down the pike.

Now, the way in which this problem is generally addressed in the private equity world is essentially through what we alluded to before as limited partnerships.  In other words, funds are raised by private equity groups for a set period of time, typically 10 to 12 years.  They keep the money for that period; they invest it.  As they get returns from the money, they cannot go and reinvest it.  They got to give the money back to their investors and then go out and raise another fund.  And at least as this has been sort of postulated in theory, the idea was that people would get a little bit of money out of the management fees, from running the fund, but that the bulk of the return they would get would be from the carried interest, from the share of profits, the typically 20 percent share profits that would go to the private equity investors. 

The idea was, this is great because this is going to solve these problems, people know they are going to have to go back to their limited partners to raise money, so they are going to be responsive and be cautious in what they do.  Yet they are also going to have this powerful carrot of saying we are going to get 20 percent of the profit which is going to give us -- the private equity investors give them very good incentives to simply do the right thing and maximize returns.

But we can worry that this system, which was really set up in the era when people raised funds of 10 or 20 or 30 million dollars, whether it really fits as much what we see today.  And in particular, we can argue that given how much larger that we are talking about here of $20 billion funds as opposed to $20 million funds, whether the kind of fee income leads to sort of whether it still has the desired incentive effects.  Moreover, whether it leads to pressures to just do the safe thing rather than doing the right thing because then one can go out and raise an even bigger fund two years from now based on not disastrous but not spectacular returns either.

And so this is just sort of illustrating this point which is -- some picture just taken on one of my camera phone from one of the limited partner meetings that I was speaking on.  The question was:  Which was the car of the LP and which was the car of the general partner at the meeting?  Just to illustrate this point once again, this is from a paper that two of the stars of the working private equity group have done, where they essentially calculate the net present value of payments over the life of a typical buyout fund.  These are not payments in aggregate but payments per partner.  There is just a couple of things to sort of note, one is $35 million is a lot of money for at least most of us here. 

And then secondly, we can sort of note that the incentive aspect of it, the carried interest which is supposed to be that sort of powerful driver to get people to work hard is actually a relatively small slice of the overall pie; that is essentially their monitoring fees, management fees, and so forth.  Is this really what the way the system was really set up to work?  I think the answer is probably not. 

The third and final thing I will throw out here in terms of issues, the sort of long running issues we are likely to see playing themselves over the next few years or playing themselves out even more intensely over the next few years has to do with regulatory pressures.  This essentially is the scene from Korea, where the Korean police removing the computers from Lone Star private equity group.  Their main offense seems to have been making too much money in the privatization of a state-owned bank. 

But I think, more generally we can think about lots of examples both here in Asia and particularly in Europe of private equity groups coming under scrutiny, whether it is regulatory pushes for more disclosure, whether it is proposals around changing the tax treatment of the way in which private equity groups works, whether it concerns around anti-trust issues and so forth.  This is really a global issue which clearly in large part where organized labor has played an important role in terms of bringing these issues to the forefront.

Now, in some sense you can say this is inevitable.  Private equity in some sense has existed in a regulatory bubble.  The primary regulation governing is the ‘40 [indiscernible] named for the fact that it was enacted in 1940.  And we know in 1940 private equity was not exactly a major industry; so as a result, it is not surprising that there was not a lot of attention spent regulating it.  It was largely sort of cut out from the regulatory scrutiny.  And perhaps in some ways, it is inevitable that as the business grows up and becomes a larger and more important actor, that scrutiny and regulatory pressure is more likely to be there.  

But I think at the same time, there is very much a paradox that is going on here in the sense that we, as academics, have been studying the private equity industry for now somewhere on the order of 25 years.  If things there remain to be studied and open issues and so forth, much of the research that we are talking about today represents cutting edge efforts to look at some of the unstudied issues. 

But I think it is fair to conclude, looking across that literature, as a whole, the picture of private equity is pretty good.  Whether we think about the impact on governments, whether we think about the impact on financial performance, it is true that certainly a lot of that evidence is from the 1980s but some of the more recent stuff we have done, for instance, in the context of the World Economic Foreign Project that Glen alluded to as well as the National Bureau of Economic Research Project that a number of us in the room are involved in some shape and form, I think it largely paints a consistent picture. 

Yet, when we look at the perception of the industry, it seems to be much more negative in many respects.  So this is just from the Gray Lady, The New York Times.  I think it is sort of representative of sort of general depiction of sort of how private equity is seen in a lot of circles.  I’m not going to belabor this; we can sort of look at lots of evidence out there in terms of the role of private equity.  I will just throw a couple of charts up here just to sort of tee up at least a little bit of discussions.  One thing we can certainly look at for instance is how well do companies that private equity groups take public do afterwards? 

If you read Forbes and Business Week and sort of take it to heart, your basic conclusion would be that they do terribly.  The private equity guys are just engaged in a pump and dump scheme and are just over valuing these things and then push them at the door to the sucker individual investors.  When you look at the evidence, when you look one year, two years, three years, four years or five years and compare the returns of the private equity backed IPOs, the companies that go public after having private equity invest in the green [sounds like] versus market as a whole, they seem to have a significant degree of outperformance.

Again, another example you can throw out is investments in long run investments.  Again, a lot of loose talk out; there are claims saying private equity guys are really short term.  They are going to get special dividends for themselves; they are going to quick flip LBOs; they are not making long run investments.  We have done some work looking at essentially the innovations and investments innovations.  And again, whether one looks at measures of impact and sort of fundamentalness and so forth, it seems to pay the quite positive look at pipe-for-pipe [sounds like] positive view of the private equity industry.

I guess one thing to say is why is not a lot of this information out there?  I think we have to sort of share at least a significant fraction of the blame to the industry itself, from having spent more time that I would care to in Washington last six months talking about private equity.  I guess I have been somewhat struck by the sort of Keystone-cops approach that the industry has taken in the sense of having with over 75 different lobbyist running around with uncoordinated messages about the impact of the private equity industry.  I think the industry has a lot to learn from pharmaceuticals and also of some other places which seem to have gotten their communications strategy down to much more of a science.

So anyway, just to sort of end up, this is a young industry.  It is changing.  It is dynamic.  That being said, while there is a lot of attention to this sort of short run cyclicality, and we will come back I know today and later on to sort of what is happening in the market and how it is going to play itself out; there are also some sort of more fundamental changes taking place, both in terms of the structure of who the players are, what the relationship between the players are and what the relationship with the government is.  And I think as a result, it is going to be a challenging period both for the industry itself as well as for policy makers.  Thanks.

R. Glenn Hubbard:  Thanks Josh.  I think we have time for at least a couple of questions and still be not too off schedule.  If you want to ask a question, please identify yourself and then probably microphones floating around, anyone would like to start?  Sir?  There is a mic coming right behind you.

Warren Miller:  I’m Warren Miller [phonetic], Techno [phonetic] Research, Lexington, Virginia.  I’m a private equity analyst.  And my concern is about the pending changes in financial reporting, particularly fair value, and how you anticipate that is going to impact an industry that at least in my experience does have what I call “cowboy valuations?”

Josh Lerner:  So the question really relates to saying, how is the industry thinking about valuation?  How is the tightening in terms of valuation standards going to affect how things play out?  I think the premise that you raise is exactly right.  The industry has been sort of very casual, in some sense historically, about valuation in the sense that you hear the industry describe themselves as conservative which means to say let’s go back and look at whatever the last valuation was and just use that, unless of course you are raising a fund and having some difficulty raising money, in which case you go write things up as aggressively as you can. 

But normally the industry is sort of taking this view of -- say let’s sort of look at whatever we paid for which is fine, one month or two months after transaction.  But we are talking about a deal which is three years ago, four years ago or five years ago.  That book value is going have very little relation to what is going on in terms of fundamentals of the business. 

And I think that you can answer this in two ways.  One of which is that on one level, clearly the industry can do a much better job in terms of valuing stuff than they do now.  That essentially and particularly when we think about buyout investments as opposed to venture capital, there are some pretty clearer metrics that one can do in terms of figuring out what the appropriate valuations are and so forth.

The broader question though is in some sense, does the emphasis on fair market valuation in some sense distort some of stuff that makes private equity so successful in the first place?  And in particular, I think if you go back to, for instance, some of Mike’s work, he argued and said, “One of the things that is so important about private equity is the fact that you are behind this curtain where you can go and do whatever the stuff is that private equity people do without having the shareholders leaning over you, the quarterly reporting, the hedge funds calling you up every 15 minutes to say what is going on in the company.” 

And the question is whether the sort of increased pressure for transparency is in some sense going to lead to changes in the fundamental way in which this business works.  And I think that is still very much an open question in this very real kind of aspect.  I mean, I think with some sense, we are conditioned in some sense to regard transparency as a good thing.  But in some sense I think it is fair to say that lack of transparency also has some potential benefits as well.

R. Glenn Hubbard:  Other questions?  Yes sir, in the back.

Robert Trailer:  Hi.  I’m Robert Trailer [phonetic] with International Investor.  Forgive us, we came in a minute late, if you already covered this, but can you give us some sense of proportionality here?  For example, if you were to combine all these elements that you are discussing - private equity, venture capital and hedge funds - in comparison to let’s say the public equity markets or public bond markets. 

Josh Lerner:  Well, I think one of the challenges in terms of doing these kind of calculations is always that one has to sort of deal with the fact that there is what you see and there is sort of the ancillary stuff.  So if you think about private equity, you essentially have a lot of borrowing which is associated with the firms, the private equity firms invest in.  So the question becomes how do you do the kind of calculations to really back out what is the overall share of the private equity stuff? 

I think the hedge funds raise a whole set of sticky issues that I think will take us a good 20 minutes to discuss.  And since they are a little bit off target, I think I will just focus here on the venture, in the private equity side.

If you are to sort of say let’s look at the pool of assets whether the equity or debt in the hands of professional investors, so essentially the capital which professional investors have and let’s look at the slice that private equity represents.  Of course that is not taking into account, for instance, real estates or stocks or bonds in the hands of families, but let’s just focus in on that.  Private equity is still today, despite that kind of growth we saw on those pictures, quite tiny.  That we are talking about based on various estimations somewhere in the order of 1/20th to 1/30th of the assets represented by private equity would represent only something on the order of that share.  So we are really talking about something despite its substantial growth that remains a very small slice of the total pool of investable assets that are out there.         

R. Glenn Hubbard:  Okay let’s have one more question and then a heads up to the next panel will be next.  Yes, sir?

Barry Wood:  Barry Wood, Voice of America.  In the context of the boom and bust that you speak of, how would you assess the current credit squeeze impact on the industry since August?

Josh Lerner:  That is one which I promised to leave to Steve.  Always a safe answer but I will take one stab out of it and he can feel free to disagree with me.  I think that in many respects when we look at the past spot [sounds like] and try to calibrate what is going on here, I guess I will argue that it is sort of very consistent with what we have seen in previous corrections, which is to say it is going to take a while to work itself out.  It is not going to be painless in terms of the kind of returns the private equity is going to have.

On the other hand, I do not think it is going to be the end, the death knell, for the industry and I do not think that if you look at the firms which are going to get in trouble simply because they are over leveraged, that it is going to be the end of the world for them either.  While there is clearly going to be some real cost associated with it, to sort of view it in apocalyptic or world historical terms would be rather misleading.

R. Glenn Hubbard:  Okay, thanks for that subprime answer Josh.  And thank you for that excellent presentation.  And we will now move to the next panel where Steve Kaplan will be the presenter, so the people can come on up.  We will change over really quickly here.

Panel I - Private Equity’s History and Impact on Corporate Governance

Alex Brill:  Good afternoon.  My name is Alex Brill.  I’m a Research Fellow here at the American Enterprise Institute.  For the next 75 minutes I will be the moderator.  We are scheduled to wrap up at 4:00 PM so that we can have a little bit of a break to check voice mails and BlackBerries.  So we will be going about 70 minutes.

As my daughter, Rachel, who is five, reminded me, she sang to me this morning in the car something that I think is relevant as we kick off what I think has already been a really good conference this afternoon.  She said, “Let’s start at the beginning, the beginning is a very good place to start,” from the Sound of Music as she sung Do-Re-Mi.  The title of the first panel this afternoon is Private Equity’s History and Impact on Corporate Governance.  And it really is always good to start with a history lesson or two to know where we have been before we think about where we are and where we might be going.  And that is what this first panel is about this afternoon. 

We have three distinguished panelists, a presenter and two discussants.  Our presenter is Steve Kaplan, who is the Neubauer Family Professor of Entrepreneurship and the director of the Polsky Center for Entrepreneurship at Chicago University’s Graduate School of Business.  All of the bios for our panelists today and tomorrow are on the packets that were handed, so I will move very quickly. 

Ken Lehn, we are very fortunate to have Ken here.  He is the Sam McCullough Professor of Finance at the University of Pittsburg and has done work not just in this area but also in the economics and professional sports which is deserving of an AEI conference as well. 

And our second discussant is John Chapman who is an NRI Fellow.  I think Chris mentioned him in his opening remarks earlier.  John is the conference’s organizer today and tomorrow and he is the AEI resident expert in private equity as he works on his dissertation and a book and a number of articles and this conference and a whole lot of other things related to private equity. 

So with that, I’m going to turn the mic over to Steve who has about 30 minutes, and then we are going to split up the rest for Ken and John. 

Steven Kaplan:  Great.  Thank you, Alex, and thank you for having me here.  Glenn and Josh did a terrific job of teeing up some of the issues that I’m going to talk about.  And as Josh alluded to, I’m going to put a little bit more flesh on some of the bones that he started us with.

So what am I going to talk about here?  Well, as Josh showed, a second or maybe third private equity wave has just ended, but it was not the first.  And there are seven questions that I will talk about.  First, what exactly is private equity?  Why is it controversial?  And we have heard a little bit about that; you will hear some more.  How does this wave compare to the first one?  And here, there are some similarities and differences. 

Then I’m going to talk about what do these transactions really do?  And that is a bit of a history lesson.  And talk about why they do what they do and whether they are good or bad for the economy.  Then we will move into returns and returns are different from what the transactions do for the companies, and I will explain why.  And then we will circle back and look a little bit more at the recent wave relative to the previous one.  And then I will put in some opinions about what will happen next and as opposed to Josh who was maybe -- now, Josh gave an opinion, but I will give a stronger opinion about what we are going to end up seeing.

So what is private equity?  Private equity -- and I’m going to focus more on buyouts in private equity rather than venture capital which is really more on the early stage side.  So private equity basically is when a private equity partnership agrees to buy a company.  If the company is public, there is usually a premium involved of 15 to 50 percent over the current stock price.  And the partnership buys the company, generally with a lot of debt.  It can be 70 percent, 80 percent, 90 percent debt and then with a chunk of equity, say 15-30 percent.  Net equity is private equity because the company is no longer public.  So that is on the company side; that is what a transaction is like. 

Now, how about on the partnership side?  This is where Josh talked about how that had evolved over time, and I will go into just a little more detail here.  You have two groups; you have the general partners who are the Blackstones, Carlyles, KKRs, et cetera.  And then you have the limited partners who are the pension funds and the endowments and the GPs who raise the fund and we will call it BCC1.  The limited partners commit to fund a certain amount of investment, so let’s say it is $5 billion, and then over the next three to five years the general partner invests that money into companies.  Now, after the investment period you have got somewhere between five and 10 years to get the money back, and that is the fund. 

Now, what is the compensation?  The compensation is the annual management fee which is generally about two percent a year and it is two percent on the entire capital commitment, so that would be two percent of 5 billion would be $100 million a year.  And then there is the carried interest which is usually 20 percent of the profits and, therefore, if that $5 billion turns into $15 billion, the buyout fund would earn 20 percent of the $10 billion profit which would be $2 billion.  And then in addition, there are these deal fees, monitoring fees, which tend to be smaller than the other two components.  So that is how a fund works. 

And what happens is that the money is invested usually over three to five years.  And then the general partner does not stand still; the general partner goes off and raises another fund.  So call that BCC2, maybe it is bigger as Josh mentioned.  It is $10 billion dollars and then they invest that while they are working on the companies that they invested in fund one.  So that is what it looks like. 

Now, why is this controversial?  I think one source of controversy is conflicts of interest.  So there is this question how can the companies be bought?  Why are not the CEOs, particularly of public companies, doing more as public company CEOs?  Why do they have to take it private?  Second, there is limited information when the companies are private. 

Third, there is view that it has a negative effect on workers and that is certainly, I think, pushed by some of the unions.  There is a worry that we are seeing right now about the systemic effects of so much leverage.  Does it somehow hurt the economy when these companies are too leveraged?  And then, finally, there is the money side; these are very big numbers.  There is a perception that the private equity investors enjoy low tax rates and that also creates a lot of controversy.  So that is private equity, that is why it is controversial and from an academic, that is why it is interesting. 

Now, how does this wave compare to the first one?  And Josh showed a somewhat different picture.  This is more or less the picture Josh showed where you look at commitments to private equity over time and what I like to do is rather than just look at the dollar amounts, look at the dollar amounts relative to the total stock market.  And the reason for that is you are buying companies, what are you are buying?  You are buying things in the stock market; let’s see how it compares.  And when you do it that way, you really see these waves. 

So you see the first wave and that is 1987.  And this is money committed to the private equity funds.  This is that $5 billion that is going to the fund and then there is no money; then there is money again in the late ‘80s; then there is less money; and then last couple of years, unbelievable amounts of money; and 2007 will be pretty much like ‘06.  So this is the money committed. 

How about the money spent?  And so this is public-to-private volume.  Again, this is not scaled by anything.  Let’s scale it by the overall market and, wow, it turns out that this recent wave which is right here is actually not greater than the ‘80s.  Why is that?  This is RJR.  RJR Nabisco was a $30-billion transaction at a time when the stock market was one-sixth the size it is today.  So that was the equivalent of a $200-billion deal which we have not seen.  So except for RJR, probably the activity in the ‘80s is similar to the activity in the last couple of years, which is why I look at that and say there have really been two big waves, the ‘80s and today.

So that is the history.  Now let’s talk about what do these transactions actually do?  And the first thing that the early investors - KKR, Forstmann Little, Clayton Dubilier were among them - discovered the benefits of LBOs and those benefits are now applied in most of these transactions.  What are those benefits?  First and foremost call it financial engineering, and I do not say this in a disparaging way. 

What does it mean?  Well, they discovered that if you give a lot of equity to management and give them more of the upside than in public companies, that changes how managers behave.  And if you looked at 1980’s public-to-privates which I looked at in my doctoral dissertation, you found that the median CEO went from about one-and-half percent to six-and-half percent post-buyout.  The management team had a similar increase in how much they owned and that was something that the original buyout investors thought was important.  At the same time that they gave a lot of equity to management, they also put a lot of debt on these companies obviously.  The theory there was that if you have a mortgage to pay, you will behave differently than if you do not have a mortgage to pay and in particular, you will be a lot more careful with how you spend your money.  So financial engineering was really the first thing that the buyout investors did.

And the second thing that they do is what I call governance engineering, where the private equity investors control the boards, they work closely with the CEO and the management of their companies, and they are very much on top of those companies more so than a public company board was in the 1980s.  And these are probably the two innovations that the early buyout firms discovered, financial engineering and governance engineering. 

And the question is do they matter?  And this is where Josh was absolutely right, virtually all the empirical evidence that any academic has done, and a number of them are here today, has been positive.  For deals in the ‘80s, I and others found that operating margins went up by 10 percent or 20 percent; cash flow margins went up by 40 percent; employment went up rather than down although slightly less than the industry; they economized on capital expenditures; they paid lower taxes; and there were substantial increases in value. 

And for deals in the ‘90s and the early 2000’s, the evidence is pretty similar.  You find improved operating margins in the U.K. and France, no difference in employment, although lower wage growth in the U.K.  Cumming, Siegel and Wright in a survey article - and two of them are here; actually, all three of them are here - there is a general consensus across different methodologies, measures and time periods regarding a key stylized fact, LBOs and especially MBOs enhanced performance and have a salient effect on work practices.  Josh mentioned his paper on reversed LBOs which is also quite positive.  And there is a recent paper by Edie Hotchkiss who looks at deals in the ‘90s and early 2000’s public-to-privates and she finds smaller increases in operating margins, although she finds increases and she also finds very high investor returns.

So, the bottom line again from this research is the empirical evidence on portfolio companies is positive.  You know, it is funny Josh put up the cartoon from Andrew Sorkin.  I was talking to him about this and I said, “You know, the empirical evidence is uniformly positive.”  And he was in shock, he said, “You know there is nobody in my newsroom who would have believed that.”  Well, you know, it is The New York Times.  But those are the facts and, yes, in academics, if you got a different result, it would probably be easier to publish the paper; you just do not see different results.  So that is the operating performance and we think driven by financial and governance engineering. 

Now, let’s talk about returns.  And here is where there is potentially a difference because even if the portfolio company improves, you have to pay a premium to buy the company and you have to pay fees. 

So let’s look at returns and this is a look at returns from venture economics, and again, you see a pattern similar to what Josh showed.  This is the same pattern but it looks at firms by quartiles.  So the higher line is the top quartile firms, the middle line is the median firm, and the lower is the lower quartile firm.  And again, you know, high returns, low returns, higher returns, lower returns, higher returns, which is the pattern Josh talked about.  Multiples, which is just how much money you get out versus you getting in, similar picture. 

So those are nice pictures but you have no idea from these pictures whether private equity returns beat the public markets.  You have no idea from these pictures whether good GPs are the same ones, meaning if you have good returns one time, you have good returns the next, and you have to look at the data to see how performance affects whether the GP survives and the amount of money they raise.

So, I’m going to talk about a paper I wrote with Antoinette Schoar a few years ago that looked at returns, and this was really through 2000-2001 but the patterns are going to turn out to be similar after that.  So this is just basically data on returns through 2000, and we have got 169 funds in one sample, over 300 in another, and we are going to look at basically two measures of return: the internal rate of return and how these funds did relative to what you would have done if you had put the money in the stock market.

Now, let me just see if you are awake.  There are two investments here, one you invest $10 million and it returns 20 in three years; the other investment, you invest $10 million and it returns $10 million in three years.  Which of those investments is better?  So let me ask, how many of you like investment one better?  And how many of you like investment two?  Okay, nobody likes investment two. 

So for the general partner for the buyout firm, investment one is clearly better, they make $10 million, you get 20 percent of that, you get $2 million in your pocket.  But for the limited partner, it is not so clear because it matters when you made that investment.  If you made that investment in 1997 and sold it in 2000, you did worse than if you had put it in the S&P because the S&P went up; and in fact after fees, you know, gross of fees, you did a little bit worse; net of fees, you did a lot worse.

For investment two, if you did that in March of 2000 and sold it March of 2003, it was spectacular because the S&P went down by 40 percent.  So you did 70 cents better.  Now, why am I telling you all these?  Because the industry does not do a good job of describing returns. 

Let’s look at Blackstones S1.  Blackstones S1 says, “Our performance from January 2002 to December 2006, 26 percent; the S&P over that period, 6 percent.”  Looks like fantastic performance but they did not invest all that money in January of 2002; they invested that money in 2002, 2003, 2004.  If they had measured their performance relative to the S&P in January of 2003, well, the S&P went up by 20 percent a year from January ‘03 to December ‘06, and 26 percent a year looks good but it does not look as good 26 versus 20 as it does 26 versus six. 

And the truth is probably somewhere in between, but returns are generally portrayed as 26 versus six rather than what they really are.  And when we looked at this over a broad sample, we actually found that net returns to private equity were roughly equal to the returns on the S&P 500.  That is bad in a sense that it is not what people tell you happens.  The good news is gross of fees, they beat the S&P 500.

So the bottom line there is on the portfolio company level, performance looks very good.  Once you look at the fund level, it is not so clear.  One thing was clear though is that the best performing firms, the ones on the top quartile, did do better than the S&P 500 net of fees.  So if you were in the top quartile, you were both doing a good job at the portfolio company level and beating the S&P net of fees.  So I do not know whether the S&P 500 is the right comparison here.  I do not adjust [sounds like] for leverage.  And we do not have 2001 to 2004 which will end up looking good for buyouts, although, again, the S&P did very well.  So the bottom line on returns is it is less of a good story than you might believe, or should I say it is mixed.

Next question:  Are there good general partners?  And here is where the evidence is actually extremely strong is that there is a lot of persistence in returns across funds of the same general partner; meaning that if you have good returns in one fund, you are very likely to have good returns in the next fund.  And this result is much stronger for private equity than it is for mutual funds where it is basically non-existent, and it is much stronger than it is for hedge funds where the evidence is mixed.

Last point about performance:  Money flows into specific GPs related to past performance, so if you perform well, you raise money; if you do not perform well, you do not raise money.  Now, the second part of that is when the industry is doing well, a lot of people can raise money, not just the good performers.  And when extra money comes in, that leads to poor performance.  So this is repeating, I think what Josh said earlier, there is a boom-and-bust cycle in this industry.  A lot of money goes in, returns are bad; money stays out, returns are good; a lot of money comes in, returns are bad.  And that is the pattern that we have seen over time.

So now, let’s talk about the recent wave and let’s talk about what is going to happen in the future.  So comparing the ‘80s versus the last few years, prices were actually higher, so you might view that as bad and these are prices relative to cash flow.  On the other hand, debt levels were lower.  Debt levels in the ‘80s were 90 percent of the value of the deal.  The last couple of years are more like 70 percent.  Earnings were high relative to interest rates, so what does this mean?  This means that in the ‘80s, earnings relative to interest rates were high.  In this wave, earnings are high and that means you have earnings to make your interest payments.  And that is just another way of looking at the same thing. 

So what does that mean?  Earnings were high relative to interest rates, debt levels were lower and, actually, if you look at the ratio of cash flow to interest, much higher in the recent wave than in the ‘80s. 

Now this is just interest.  You also had to repay debt and in the ‘80s, you had to repay principal more quickly than in the recent wave and when you put that together, what you see is in the late ‘80s, you actually had 70 cents cash flow for every dollar of debt service you needed to make, whereas the deals in the last couple of years, you are well above one, so the debt repayment terms in the recent wave is substantially looser.

So now what does all this mean?  What does the history lesson say?  There are three questions:  Was the private equity explosion temporary or permanent?  What is going to happen to returns?  And if there is a downturn, will there be a meltdown/disaster?  And there is a negative story and a positive story, so let me tell the negative one first.  This is something that Chris might have said in his opening remarks, where this is the private decade.  The last share of publicly traded common stock owned by an individual will be sold in 15 years if current trends persist.  Well, it was not this year; it was 1989. 

I look with discomfort on the dangerous tendency of LBO partnerships bolstered by their success to take more compensation in front-end fees rather than in back-end profits - Josh made that point.  That was Mike Jensen in 1989.  And LBOs work because the people doing them command a huge advantage over the stockholders from whom they are buying the company.  They work because the people who do LBOs know the true value of assets of every kind in every different mode and the market does not, and they work because management has willfully deceived the market.  That was Ben Stein in 1987, you know, of Ferris Bueller fame.  And this could have been Steve Schwarzman this year but it is Ross Johnson in 1989. 

So basically this is a repeat performance of the late ‘80s.  The same complaints, the same amount of attention, and the same concern about fees, the same concern about the debt markets being out of whack, it was the high yield market in the late ‘80s, it was the CLO or CBO market today and you see a pattern here where the money going into LBOs really tracks these earnings relative to interest rates or said another way when earnings are high relative to interest rates, money comes in.

So now, what does this all mean?  This market is very cyclical and if you look at returns relative to funds raised, what you find is a very negative relationship that the more money committed to private equity, the lower returns; that is what that negative 26 is.  Where are we in that cycle?  We are at the absolute peak and when you put those numbers together with historical relationships, you actually get a prediction that the LBO funds raised in 2006 will end up having returns of -19 percent.  And, of course, it was not a good sign that these partnerships were selling equity in themselves because these are very smart people who typically do not sell when prices are low. 

So this is the negative story and I’m not sure how you take that completely seriously, but it does not look so good.  Now so, how can there be positive story?  Well, there is and let’s give the positives.  First of all, who expanded?  As Josh said earlier, the expansion basically went to the persistent funds.  The expansion went to the people who generated the highest returns and we know that they tend to earn higher returns in the future.  Secondly, these firms continue to do the financial and governance engineering, but what they also do which is basically something that has accelerated only in the last 10 years is something called “operational engineering.” 

What is that exactly?  Well, most of these firms have a much more systematic focus on adding operational value than they did 10 years ago.  What does that mean?  They are organized around industry; the industry expertise helps them to identify improvements that they can put into the company, and it helps them to find deals where the improvements are available.  Secondly, most of these top firms have internal operating and consulting groups that identify the opportunities and then help to implement them. 

And then, finally, most of these firms have operating executives who are either at the firm or in their network, who are also are there to help identify and implement operating improvements.  That is actually quite a difference and quite a larger investment in operational engineering than was true in the ‘80s.  And what I would expect is that the combination of the financial governance and operational engineering is likely to continue to drive operating improvements/efficiency gains at the portfolio companies.  So that is good news. 

And then, finally, if there is a downturn, I’m of the mind that you will not see the large number of defaults that you saw in the early ‘90s.  I think there has been quite a debate about that, there are some people who say, “Oh, it is going to be a disaster if we have a recession,” and obviously it will not be good if there is a recession, but I would not expect to see anywhere near the number of defaults that you saw in the early ‘90s, and the reason for that goes back to the graphs I showed you earlier.  These capital structures are much safer than they were in the late ‘80s.  You have got more of a cushion in terms of cash flow to debt repayments and that should make a difference.

Lastly, what is going to happen going forward?  I think CEOs of public companies are much more receptive to private equity than in the past and private equity will remain attractive, and it is the public company executives who in the end decide whether to do private equity transactions.  Why is private equity attractive?  Well, there is less grief from regulation, from litigation, from the media, from activist share holders, the private equity investors are now the partners not the raiders.  They were considered the raiders in the ‘80s.  I think hedge funds are considered the raiders now.  And private equity firms provide more upside still today than they did than public companies do, and if the attack on CEO pay continues, that difference will only get wider.

And lastly, about whether private equity is temporary or permanent, the question was asked of Josh:  What will happen with the credit crunch to private equity?  Answer number one, on the deals that they have already done, those deals are going to be less likely to default.  On new deals, it will take some time before the debt markets come back.  They will come back and then you will see deals, you know, on the order of deals you probably saw on 2004 and 2005.  But until the debt markets come back, the private equity firms are not going away and you will see them do smaller deals.  They would probably do deals with less leverage, and they will do experiment with other kinds of transactions.

So let me summarize, how does the recent LBO wave compare to the first one?  It is kind of similar in terms of deals done, more money committed.  What do these transactions do?  Overall, the empirical evidence is very favorable with regard to what they do to the companies.  Why do they do what they do -- combination of financial governance and operational engineering? 

How good have returns been?  Historically, about equal to the S&P 500 net of fees; gross of fees, higher and the reason is, well, the firms add value, they take it in fees and they also pay a premium to buy the companies.  Is the current wave different or like the previous one?  It is alike in some ways.  It is different in that one important way and that the capital structures are less fragile.  What is going to happen next?  Is the PE explosion temporary or permanent?  Some of it was clearly temporary but some of that increase is permanent. 

Private equity is going to be with us for some time, and in a downturn I think you will see things will not be so bad as they were in the early ‘90s.  What is going to happen to the deal volume?  It will not be as high as it was in ‘06 and ‘07 but it will not go away and returns, however, will not look so good for the vintages, those recent vintages. 

I think I will stop there and thank you very much.

Alex Brill:  My hope is to hold the questions until the end unless you sort of have a point of clarification.

Male Voice:  [Inaudible]

Steven Kaplan:  In order to pay off your debt, no.  What these firms do is they go private, and they have debt that they have to pay, and they pay that debt out of cash flows.  And in fact, that is what you saw in the graphs; the cushion in terms of cash flow to payments is, you know, looser or there is more to cushion than there was in the late ‘80s.  In order to actually get your money out, as a private equity investor, at some point you have to sell your equity.  How do you do that?  Well, one way is to go public, and one way is to sell the company to a strategic investor, and the third way is you could sell it to another private equity investor.

Alex Brill:  Okay, thanks.  In general I want to do the discussants and then we are going to come back and we will do a Q&A for everybody in the end.  Ken?

Kenneth Lehn:  Sorry?  I push the top button here?  I am the most technologically challenged presenter here.  Right there?  I did, we should have it -– oh, sorry about that. 

While we are setting up, I would just like to thank AEI and especially John Chapman for arranging this very timely conference and for inviting me to participate.  Thank you Steve, I could not have done that, sorry -– inviting me to comment on Steve’s paper or presentation which is always a pleasure.  We had a Thanksgiving in the household, yes -– I undid your work here, see?  Okay, there we go -– which button do I push?  Okay, here we go.

Steve’s presentation as always provides a great overview of the private equity market.  He has an uncanny ability to write in ways that is of interest to people that do not have a lot of expertise in the area but also the people that do work in the area.  And during Thanksgiving, we had about 40 people, family and friends this past Thursday, and one is a friend of mine who works in a private equity industry.  He was treated alternately as a rock star who made a lot of money and probably threw great birthday parties. 

Some people view him sort of like a CIA agent, you know, you work in private equity, we do not know much about it.  And finally people kept asking, “What do you do?”  He told me he was getting tired of answering that question and so I have a great presentation I just got yesterday for a conference and between the pumpkin pie and the football game - Steve they were passing your presentation around - so, never let it be said the Lehns cannot throw a great party.

The first thought I had in reviewing Steve’s presentation is as Yogi Berra would say déjà-vu all over again in terms of the policy issues.  These are essentially the same issues, at least in the public policy arena, that were raised about 20 years ago during the first wave of large private equity deals, then called leverage buyouts or LBOs.  And the issues, of course are, do private equity deals create wealth, or do they just redistribute it from another stakeholder such as debt holders, employees, communities and so forth?  Are employees harmed with private equity deals?  Are there conflicts of interest in private equity deals and so forth?

And during the first wave, I was at the SEC and I would say easily at least one third of my time was spent dealing with the very same issues that people are talking about today and certainly much staff time at the SEC was spent on that.  There were more than a dozen congressional hearings on basically the same issues, GAO reports, all sorts of media stories, and so forth.  And I recall one request from Senator Regal, who was the chairman of the Senate Banking Committee at that time with a laundry list of all these questions and the SEC submitted a tome that basically surveyed all the academic literature, including Steve’s.  And basically, I think the answers today are essentially similar to what the answers were 20 years ago.  So for those who were in the public policy arena in D.C., it might be worthwhile to go back and just look at some of the work that was done 20 years ago to address some of the concerns today.

You know, the first issue again is that private equity deals generally do create value.  They do not simply redistribute it from other stakeholders, and there is plenty of empirical evidence on that.  As Steve indicated, the sources of that would be improved operating margins especially reductions in cost structures, although also some revenue increases in some cases.

Dramatic improvement in working capital, Steve was among the first to document that.  Some colleagues and I are actually examining improvements in working capital management more generally in the U.S. economy during the last 20 years.  And if you just track measures of working capital management, working capital sales and especially inventory of sales, you see a dramatic decline during the last 20 years.  When you associate that with valuation multiples, you find empirically that there is a very strong relationship between working capital management and valuation multiples for public companies.  And then the question is:  What is the source of this dramatic improvement in working capital, which I would think has contributed substantially to the increase in equity values during the last 20 years.  Twenty-some odd years ago, the Dow was around 2,000; now it is around 13,000.  Who knows how much, but I suspect the non-trivial portion can be traced just to working per capital improvements.

And then third is the curtailment of value reduced [sounds like] in investments, basically Mike Jensen’s brilliant Agency Cost of Free Cash Flow theory that a lot of firms that are sitting on a lot of cash tend to overspend on value-reducing projects, and leveraged buyouts are one way to discipline and constrain them from doing so and there is plenty of evidence on that.  And then I think as a general point, it is possible but very unlikely that this industry could have attracted so much capital if it did not create value.  That is a circumstantial point but I think one worth mentioning.

On the issue of workers and how they are affected in private equity deals, you know, Steve indicated on average, they are not likely to lose jobs and compensation in these deals, although certainly in some cases, they do.  But I think it is also worth pointing out that pensions and retirement accounts own a large proportion of equity in publicly traded companies.  And at least in the private equity deals involved in public companies, significant premiums are paid and that means that the recipients of those premiums, to a large extent, are also the pensions or retirement accounts, so workers benefit in that way.  It is also my understanding that pensions own about 40 percent of the limited partnership interest in the private equity firms, in which case they stand to benefit as well. 

And then one frustration that we always faced 20 years ago is that it is hard to measure employment gains elsewhere as capitals redeploy to more productive uses that when premiums are paid to public companies in private equity deals, those premiums presumably are reinvested, which means capital now flows to other companies, which creates employment opportunities.  Now politically, there is a real-life symmetry that people that do lose their jobs are visible, people who gain jobs indirectly are not visible and they are hard to find to come to testify at congressional hearings.

And then thirdly, you know there is no evidence, as far as I know, that stockholders fare worse in management-led private equity deals versus other private equity deals.  I and a couple of co-authors, Tom Bolton and Steve Seagull last year did a study of management-led private equity deals versus third-party private equity deals.  And we actually found that the one-day stock return, the residual return in the management-led deals was 20 percent versus 14 percent for the third-party deals. 

One question prompted by one of Steve’s graphs is why the surge in commitments to private equity partnerships, especially during the period of 2003 to 2006, and I think Josh had similar data on that.  And one cannot help but ask whether or not Sarbanes-Oxley has contributed to that.  Sarbanes-Oxley tends to get blamed for a lot of things, kind of like global warming in that respect, but it is hard not to look at that graph and ask the question.  And we have actually done a little bit of work on this. 

One of the direct costs to Sarbanes-Oxley is audit fees and the compliance cost, especially with Section 404.  And my co-authors and I have done a little work on this, running regressions.  We look at audit fees as a function of firm size and then a dummy variable for post-Sarbanes-Oxley.  And the coefficient on the post-Sarbanes-Oxley variable is about 0.45, indicating that after you have controlled for size, there is about a 45 percent increase in audit fees after Sarbanes-Oxley. 

If you take that number and then assume that that number will persist in perpetuity, you can get a handle on what the present value of the incremental audit fees are.  And then for firms that go private, you can express the present value of those incremental audit fees as a percentage of the premiums that were paid to see how much of the premium might be financed by avoidance of those Sarbanes-Oxley costs.  And they do turn out to be fairly large for small deals; about 20 percent to 30 percent of premium can be explained just by that incremental cost.  For big deals, it is a miniscule percentage, but those are just the direct costs.  Getting a handle on the indirect costs, such as chill effects on risk taking and so forth, is a more daunting task, but at least there is some evidence that that has contributed to some of the private equity deals.

You know, also, could it be the growth in federal class action securities litigation?  You know, over the past 10 years, there has been a dramatic increase in the number and more importantly the value of settlements in federal class action securities litigation.  This is a unique U.S. phenomenon.  No other country has that type of litigation.  And it effectively serves as a tax on public companies. 

You know, one trivia point of the Dow Jones 30, 21 of those 30 companies have been defendants in federal class action securities litigation during the past eight years -- so 70 percent, including Procter & Gamble and Intel, Disney, companies that generally have pretty good records of creating shareholder value.  One-third of the NASDAQ Biotech Index has been a target of such a suit, one-half of the NASDAQ Internet Index.  So again, I raise this question as to whether or not that is contributing at least to some of the growth in private equity.

And related to, I think, one of the questions that was asked of Steve, this is a double-edged sword, that if we have excessive regulation, litigation against public companies, perhaps at the margin that can explain some of the growth in private equity activity for public companies, but it also reduces the attractiveness of one of the big exit strategies which is the IPO.  So this is a double-edged sword in that regard.

And then finally, could the growth be spawned by financial innovations, two types perhaps?  One would be financial products such as credit derivatives that more finely slice financial claims, facilitate the management and capital structure and debt and so forth.  Second would be the development of secondary markets and private equity assets which gives more liquidity to the trading of those assets that can and also increase the appeal of that.  But I thinks it is still an open question and a terrific question to ask, why that surge during the period of 2003 to 2006? 

Steve alluded to some of the thorny problems in measuring returns in this industry and this is a problem that has plagued this area for a long time.  But the two main problems are the selection bias in reporting of returns, and then second is how do you measure risk?  And one thought I had, inspired by this conference was that we have some interesting but limited evidence from the fact that Blackstone did an IPO on June 22nd of this year and equity in Blackstone is not the same as a limited partnership interest in Blackstone, but nonetheless there is some information contained in this. 

So we only have one company, only 108 trading days, but I’m an academic so I ran a regression.  And the regression I ran was just a basic market model where I ran Blackstone’s daily stock returns on the daily returns to the S&P 500 and then a KBW; this is Keefe, Bruyette & Woods Bank Index.  This is basically a bank index with the large banks:  Bank of America, Citigroup, JPMorgan and so forth, and I did over two periods. 

The first was June 25th through November 21st.  They went public on a Friday, June 22nd, so the first day of which you have returns is the 25th.  So this is a full period during which they have traded and that is often problematic because usually during the period after an IPO there is a lot of noise in the trading, so I also replicated it from the period of August 1st through November 21st, which not only gets you a little bit away from the IPO period, but it also gets you very much into the subprime period.  I think the subprime problems began in late July.

And a few things -- you know, again, it is very limited, it is one company in a short period, but a couple of things: One is that the constant, the alpha, is negative but not statistically significant.  So despite the fact that there are a lot of headlines about how Blackstone has tanked since the IPO, after you have control for movements in the S&P and the Bank Index, there does not appear to be any statistically significant negative return. 

Second is the coefficient on the S&P 500, the 1.169 or 1.122 is of course the beta, and you know it is not an excessively high beta, which perhaps is not surprising when you think of the sources of cash flow for Blackstone, the fees that Josh and Steve talked about, may not have that much market risk.  The carried interest presumably would, but in some sense this beta would be a blend of the two and it is not frankly