TO ITS DEFENDERS, private equity is a new and purer model of capitalism: a different asset class which delivers sustainably superior returns, irrespective of the behaviour of stock markets. In its preferred narrative, private equity creates growth, sustains jobs and leaves better-performing companies in its wake. By contrast, TUC general secretary Brendan Barber described the phenomenon last week as too often the work of ‘amoral asset-strippers after a quick buck’.

Which is it? The answer matters. Last year private equity (PE) funds splurged $440bn on buying publicly traded companies and taking them private. This year investors, including banks, pension funds and insurance companies, will add an estimated $500bn (pounds 250bn) to PE war-chests. The funds are swelling and the prey is getting larger. This month a US real-estate company was taken private for $39bn. Sainsbury’s, at pounds 11bn, is in PE’s sights. Industry figures suggest $50bn and even $100bn deals are only a matter of time, potentially putting almost every company in the world ‘in play’.

But as PE stretches towards the biggest prizes, its claims are coming under fire. Business Week, hardly anti-capitalist, entitled its October 2006 cover story on PE ‘Gluttons At The Gate’, charting ‘a story of excess’ in which the fast-money mindset was leading to ploys at the edge of legality. An important US academic study found that while some PE funds provided high returns, when the enormous fees were stripped out, on average investors would have done better putting their money in the S&P.

Now a group of UK academics at the Centre for Research on Socio-Cultural Change (Cresc) casts further doubt on the official line. In two working papers, Karel Williams, Julie Froud and others describe a PE business model almost entirely based on the mathematical effects of leverage and, instead of benefiting the mass of investors, is designed to enrich a tiny minority of partners who set up and run the funds.

Private equity is the smart new name for the 1980s technique popularised as the leveraged buyout. Here’s how it works. Funds raise money from wealthy individuals and institutions, which is used to buy a portfolio of operating businesses. A vast global pool of cheap capital allows the purchase to be highly geared, the fund putting up no more than 30 per cent of the purchase price and borrowing the rest. Returns on the debt (which is often sold on) are capped, so that when the company is sold or re-floated, the gains accrue to the PE funds as equity-holders. When the fund is wound up after 10 years or so, investors get their capital back plus a share of any profits.

The CRESC authors suggest that this model is not about value creation but value capture. PE is about ‘selling used companies’, says Williams, usually after having subjected them to a sharp cost haircut by closing factories or cutting the workforce, selling off freehold properties, or requiring them to pay a special dividend. Sometimes such measures impose discipline on lazy managers, in other cases it simply reduces the business’s future options. But in any case, what really makes the difference is leverage: shorn of its arithmetical magic, buyout funds would have underperformed public equity over the past two decades, the writers show.

What is special to PE, on the other hand, is the exceptional rewards it affords to the tiny group which runs the funds. These come from an annual management fee of up to 2 per cent of funds managed, and a 20 per cent share of the profits (the carried interest, or ‘carry’) when the fund is wound up. For a $15bn fund with a 10-year lifespan, management fees could total $3bn (irrespective of performance), while for a successful fund the carry could be several billion.

For two funds whose accounts the authors inspected, UK partners stood to take home pounds 7.5m and US partners $72m – each – after just five years. After 10, it could be much more.

There are two disturbing conclusions to be drawn. The first is that the official PE story is threadbare. As Michael Gordon, chief investment officer of Fidelity Investment, notes, PE ‘provides little real diversification from equities over time comes with higher risks because of leverage has far less transparency than a portfolio of listed stocks – and [commands] premium fees’. Like the buyout boom of the 1980s, it is a bubble that will end in tears – although whose is unclear, since no one knows who holds the ultimate debt that has funded the spree. Our pension funds, perhaps?

But the second worry is what PE leaves behind. Its hijack is confirmation that the traditional configuration in which the City existed to provide services to clients has been well and truly reversed. It is now the function of clients to make an ever more dominant City oligopoly richer through ‘an economy of permanent restructuring’. When a German politician described PE funds in 2005 as ‘locusts’ he was mocked. But by and large he was right.

The Observer, 25 February 2007