What's the point of private equity?

What is the ideal objective of private equity in the American economy?

Private equity plays an important role in the American economy by pooling capital and efficiently allocating it to companies that need it. In nearly every investment it makes, the industry has a singular objective: To create value. This is the case for investments in promising companies that are poised for growth and expansion just as it is for investments in troubled companies badly in need of being turned around.

There is no question that the business model has evolved over time and the evolution has trended away from financial engineering and toward improving operations and increasing productivity. That is a good thing -- the days of so-called "strip and flip" are long gone. According to a report by the Boston Consulting Group: "The days when private-equity firms could create value primarily through leverage are long over. ... In the future, private equity's ability to generate operational value will depend less on bottom-line improvements and more on a firm's ability to develop and grow the business and improve the top line of its portfolio companies."

Today, private equity firms create value by injecting fresh thinking, a new business strategy, managerial expertise, and a relentless focus on increasing things like sales and marketing, R&D, production, distribution or sourcing. When done correctly, private equity creates substantial value for a wide array of stakeholders, including the companies in which it invests, the employees at those companies, the communities in which the companies operate and the U.S. economy as a whole. In addition, the investment returns that private equity firms generate flow largely to average Americans through public and private pension funds, university endowments and charitable foundations.

How is private equity designed to meet that objective?

They key to private equity's success in increasing value at portfolio companies lies in the ownership, incentive and corporate governance structures it puts in place: Ownership: Often times a private equity acquisition replaces a large public block of shareholders with a much smaller ownership set that includes the PE firm and its investors, as well as the company's management. This eliminates the traditional disconnect between shareholders and managers and serves to better align the interests of the company's owners with that of the executives running the business.

Incentives: Private equity managers maximize their returns when they improve a company and earn an investment return that is above the "hurdle rate." Managers, on the other hand, have a direct stake in the success of the company because they are often required to invest alongside their PE partners.

Corporate governance: PE firms don't simply acquire a company and then put it on autopilot. They sit on the Board of Directors, hire senior management, bring in operational and managerial expertise, and contribute to key decisions with respect to sales and growth strategies. This hands-on approach produces a more nimble operation and empowers managers to execute strategies and improve the business.

All of these structural changes add up to a tangible advantage: a sharper focus on how capital is allocated across the business. Everyone has a shared objective to grow the company's value. And without the pressures from outside shareholders looking for short-term gains, owners and managers can focus in a laser-like way on what is required to improve the medium to long-term performance of the company.

Please give examples of both how it has lived up to and failed to meet that objective.

There are myriad success stories that prove the value of private equity. There are also many instances in which private equity investment is not able to improve a company's performance. But that is how capitalism works. These firms undertake substantial risk, every single day, when they put up their investor's money to acquire a company that is underperforming or on the brink of failure. Often times they succeed. Sometimes they fail.

But looking at individual transactions misses the larger picture. There is a growing body of independent academic research on the industry that is beginning to bring some basic conclusions into focus. The first is that private equity has a proven track record of boosting the value of businesses and that those businesses outperform their industry peers even after the PE firm has exited the company.

The second is that industries that benefit from private equity investment grow faster than industries that don't -- a fascinating discovery by a research team from the Stockholm School, Harvard and Columbia University. Lastly, the private equity creates jobs at the same rate as other forms of ownership. This is remarkable when one considers that the main study that supports this finding also finds that the majority of companies in which PE invested were already losing jobs at a faster clip than their industry peers before the PE firm invested in them.

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