The Dark Side of Private Equity

Guy Hands, one of the few household-known private equity executives, recently provided an honest assessment of the industry – which I found to be quite refreshing. Hands’ firm, Terra Firma, is best known for its $4.73 billion purchase of EMI in 2007, which took place at the peak of the buyout boom. In an interview by DealBook’s Andrew Ross Sorkin, Hands reveals the dark side of the private equity industry.

Hands criticized the fee structure that provided executives with very little incentive to provide returns. Known as “2 and 20,” private equity firms receive 2% of the fund’s assets under management each year, plus 20% of its profits. According to Hands, firms grew to be so big that the 2% management fee was often more than the 20% performance fee. As a result, success had “less to do with performance or risk management, and more to do with bulking up,” he said.

Furthermore, individuals were investing so much money in private equity firms that they were “really investing in the same thing.” Accordingly, their capital was competing against itself, driving up prices. On the other end, Hands alleges that some firms formed consortiums to buy businesses from one another because it was easier than going “through the pain of gaining internal consensus to something contrarian.”

According to Hands, neither the banks nor private equity firms will admit that they made mistakes. As a result, firms will “live as zombies,” incapable of growing their businesses. Banks will try to recover as much as they can in fees and “postpone recognizing the full extent of the losses of their underwriting decisions.”

Nevertheless, it is certainly possible that some private equity firms will make terrific strategic decisions now and will be come out stronger when the economy improves.

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