Hedge funds and Private Equity - PES

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1.3 Asset extraction 36 and innovation
We have no interest in demonising PE funds. We are on the contrary insisting on a nuanced
picture, based on our comprehensive analyses and case studies.
Private equity funds, especially venture capital funds, have been very helpful in providing investment
in some innovative start-ups. Furthermore, they have sometimes paved the way for
successful processes of corporate restructuring, i.e. processes improving governance and/or
the long-term competitiveness of the acquired companies, even saving some companies from
insolvency. Finally, there are a number of examples where private equity funds have been
genuinely helpful to some companies, particularly family firms with succession problems and
companies with serious liquidity issues.
Nonetheless, there is a major trend in strategies of certain private equity funds – especially LBO
funds -that has been detrimental to the long-term economic viability of companies. Financial
investors pursuing leverage buy-outs are following a set of strategies that seem quite similar from
our case studies, connected to this report (annex):
LBO funds frequently buy into businesses by acquiring the debts owing to creditors. The investor
does not pay the seller the full amount of the debt, but rather a reduced price, such as
40 percent. The funds generate revenue by charging interest on the debts that they acquire
and/or by selling the debts on at a higher price than they paid for them.
In another variant, buyers attempt to convert their amounts owed into participation, i.e. to become
shareholders. The shares in the business are then sold on to third parties.
LBO funds known to fall into this category of investors are US firms such as Cerberus, Citadel,
Oaktree, Lone Star and Apollo. They are often supported in the restructuring process by banks
specialising in this type of business 37 .
LBO funds have a short investment horizon when compared with strategic investors. This has
a negative impact on the sustainable and innovative development of target enterprises. Where
technically complex or challenging products are concerned, the time for necessary research and
development often exceeds the investment period of such funds. This bears the risk that LBO
funds will limit or cut out altogether investment in innovations and development that are likely to
bear fruit only after the end of the period of involvement of the fund, clawing back the money
thus saved into the fund. PE funds are seduced into withdrawing from the enterprise financial
resources held in reserve that could be used for future or unforeseen innovation. Such resources
may include reserves for R&D, investment funds which are not required for the day-to-day running
of the business or undervalued investment objects. Instead of investing in long-term effective
innovation, LBO funds tend to engage in value extraction or asset stripping.
LBOs increasingly tend to recover their investment in a company not just by its sale after restructuring
but by immediate special dividends out of new debt, recapitalisations and very high
consulting fees. This has a negative effect on the capital base, the cashflow and the creditworthiness
of the company. From this follows the danger of under investing in productive assets,
markets and R & D undermining the long-term prospects of the company.
Today it is not unusual for a leverage buy-out to be financed by 20% share capital and 80% debt
capital. Some part of the debt capital is very quickly paid back by dividends of the target
company.
36 Splitting up a business which has been taken over by selling off parts or individual assets.
37 Cf. Die ZEIT of 12.5.2005, p. 28.