Debunking the private equity myth, Part II

NEW YORK (Fortune) -- Every trend in the business world follows an all-too-predictable hype cycle. The current hoopla over private-equity buyouts of public companies is no exception.

To avoid losing sight of what's actually going on, it's helpful to step back for a moment and put the excitement in perspective. The short version of the column to follow: The situation isn't quite what today's Masters of the Universe would have you believe.

Early in any boom, business journalists write features and profiles explaining the whys and wherefores of an industry that is on the ascendance. As the industry isn't overheated yet, the stories focus on why the sector is interesting, who the personalities are, and detail the risks and opportunities the new hot thing presents. Coverage of the tech boom worked this way. The commentary on the latest coming of ethanol has too.

As things heat up, articles begin to poke holes. The risks become the story. Then, before the enthusiasm for the trend is completely lost, contrarians chime in on why the naysayers are wrong. This third group nearly always gets it wrong. Momentum just isn't in their favor.

A perfect example of this third stage is a column last week by the distinguished political reporter and television personality Alan Murray, now a columnist for the Wall Street Journal. Attending the World Economic Forum in Davos, Switzerland, where private-equity honchos captured the annual gathering's imagination, Murray opined that the backlash against private-equity investors might be misdirected. It is public shareholders, he argues, who are to blame for forcing managers into the hands of deep-pocketed investors who are willing to take private their sterling companies.

After establishing that private-equity deals are suffering from public disapproval lately, and using stymied takeouts at Cablevision (Charts) and Clear Channel (Charts) as examples, Murray recounts his conversation with Cristobal Conde, CEO of SunGard Data Systems, a tech company that was taken private in 2005 by several private-equity firms for more than $11 billion. Conde makes several points about the virtue of private ownership, each of which Murray swallows whole. They're worth exploring one by one.

Management is incentivized to make the deal work. The way Murray words this is telling. Conde argues that being private allows the company to push change through the organization. No examples are given, but Murray writes, "That is particularly true of top managers, who were given twice the ownership stake in the company than they had when it was public." The operative word here is "given." In other words, top managers didn't start trying until their ownership, in the form of a gift, was doubled? How must that make the previous shareholders feel?

Besides, management ownership is no panacea. Witness Bob Nardelli at Home Depot (Charts). As a clever observer said to me, "We've got an increasingly pouty and petulant executive class that insists it can't do its job properly unless it's given a huge equity slice? Do ER nurses think like this? Or teachers? What about cops?"

Private-equity firms have a lot to teach. Conde's example is purchasing, which really made me scratch my head. With no offense intended to Silver Lake, Blackstone, KKR and other SunGard owners, if a bunch of financiers are teaching a seasoned chief executive about purchasing, one wonders what the CEO was doing in the job before the buyout.

Private investors aren't obsessed with quarterly earnings. This is Conde's strongest point. It's true that when a company is private it doesn't need to play the silly games public companies do in order to mollify public shareholders. Where the argument falls down is that nearly all of these companies will go public again some day, just as Hertz and Burger King already have, following their short sojourns as private companies.

People conveniently forget that the private-equity players are investors. They expect to sell out. It's what they do. In fact, it's their duty to their investors. All their rejoicing of life as a private company will cease the moment their investments become public again - and they've got to sell shares on the evil, incompetent, inefficient, Sarbox-ruined public markets. (I do believe, by the way, that the private investors exert positive influences on the formerly public companies. It's shameful the previous boards of directors can't do the same. Still, examples are in short supply. Care to share some with me?)

Murray ends on an odd note, suggesting that public-market investors are to blame for not recognizing the value of their companies, adding that public-market returns have been "lousy." Um, really? In the last four years the S&P 500 index has returned 16 percent, 5 percent, 11 percent and 29 percent, in reverse chronological order. That's without the risk associated with private-equity funds or the fees required to invest in them.

Where Murray is dead-on is that public companies ought to be willing to take on their own the financial engineering steps the private-equity firms are taking after the buyout. (In the 80s this meant firing workers; today it means borrowing more aggressively at low interest rates, among other things.) CEOs like Conde seem to be arguing that they can do things as private companies they wouldn't have been allowed to do when they were public.

What he's really saying is that managers, despite their obscenely rich compensation packages, don't feel empowered to make moves that will hurt the stock price in the short term. They are as guilty of the short-termism they accuse their Wall Street investors of practicing. It's a sad state of affairs.

It will end badly, by the way, when interest rates rise and debt-heavy buyouts cease to be so attractive. Then you can expect corporate executives once again to be singing the praises of public equity markets because that's where the capital will be.