The dance of private and public whirls on. But who's leading? Despite spectacular strategic bids such as US Airways for Delta or Freeport-McMoRan for Phelps Dodge, private equity continues to roll. Coverage ratios may be tight, regulators may be mulling collusion, junk markets may be wobbly, but cash-stuffed buyout funds are still bidding, and markets keep offering sweet terms. Clear Channel. Reader's Digest. Equity Office Properties. Meanwhile, public companies hoard cash and try to keep shareholders (read hedge funds) at bay with share buybacks. The gap between the two remains wide — and it's not just dreaded Sarbanes-Oxley or criticism of executive comp. The best explanation for senior managers' continuing perky interest in flying off to private equity Neverland is that the shareholder environment remains, at best, hostile.
So where do we go from here? Consider various scenarios. Say leveraged markets tank. A few big issues crater in the usual, or perhaps unusual, ways: hung bridges, crushing debt, insolvency. Credit derivative markets freeze; banks stop lending. A buyout fund or two evaporates in a litigious storm of scandal or incompetence, or both. Meanwhile, what's happening on the public side? Although there's been a divergence of debt and equity over the past few years, it's a lot to expect that a private bloodletting will not affect public markets. But posit, just hypothetically, that the two move separately. As debt and lending markets tank, stocks rise, IPOs flourish, and the relative attractiveness of public versus private swings back toward the public — toward equities. With stocks surging, hedge funds are less ornery. CEOs, empowered by more beneficent markets, opt for more risk: investing in new products, renewed M&A, even R&D. Result: fewer LBOs, more public M&A.
But is this scenario likely? While a private equity downturn will occur eventually, the notion that equities might be countercyclical to debt is far-fetched — or at least requires an explanation. In the past, private and public skipped into recession hand in hand, even as falling share prices eventually enticed buyout shops. The current divergence between debt and equity, private and public, may stem from a recognition that private has more efficient governance than "politicized" public companies. (Debt markets may also simply be indiscriminating as they continue to lay off risk.) That's not going away, no matter what happens in the macroeconomy. The real problem on the public side is growth. Stocks will move if the macroeconomy improves. Stocks that perform over the long term are those that show steady operating growth. But how do you grow if you're wary of assuming risk?
Over the longer term, there's also the problem of expectations. The great expansion of private equity has, thanks to ample liquidity and managerial skill, produced decent returns for institutional LPs of buyout shops. Given lackluster equity performance, the arbitrage between private and public has favored the former. On the public side, activists have tried to extract returns by demanding fairly radical options: restructurings, divestitures, auctions, buybacks, kill-the-CEO. This, of course, feeds the going-private wave. Still, even in an equity bull market — the kind that would presumably restore a traditional public-private balance — hedge funds face ominous limitations beyond the fact that there are too many of them. Even if companies kick-start growth, it's a rare stock that's going to see 20% annual growth for long — unless share values disengage from reality in a bubble or a transformative new technology emerges. But that's the kind of returns LPs expect from hedge funds.
So something has to give. On the public side, there's a mismatch between activist shareholders and what's possible, or probable, with large public companies. Hedge needs not only outstrip corporate growth potential, but the larger the company, the wider the gap. Restructurings and buybacks only produce a temporary rush of performance. And hedge fund agitation is not only maddening for management — a group, granted, that's difficult to feel sorry for — but invites the private option. (Besides, nobody stays in Neverland forever.) You can talk the perils of excessive debt or dividend recaps. But they're not going to drive the restoration of a "traditional" balance unless you banish active public shareholders, and that runs against the prevailing, exceedingly powerful, governance dogma. As a result, the kind of aggressiveness necessary to achieve acceptable performance occurs only among smaller public companies or on the private side. Why can't we see this? Probably because, as we chase the mirage of perfect shareholder democracy, we resist acknowledging the fallout of an unleashed public governance system. That's a problem.—Robert Teitelman
