Debunking Private Equity Stereotypes

Stereotypes abound in the business world, and few are more pervasive than the image of a predatory private investment firm. But now, more than ever, it is time to stop broad-brushing an entire investment firm industry.

As in so many areas of life, stereotypes impair our understanding. In the auto industry, stereotypes can close off alternate paths to renewal and foment discord and distrust—at a time when the need for renewal is at an all-time high.

If the industry doesn’t develop a better understanding of private equity (PE), automakers and their suppliers could lose a valuable resource as their need for consolidation and new investment increases. In the business world as well as everyday life, someone who fosters stereotypes often inadvertently hurts themselves more than those they misrepresent.

This couldn’t be truer for executives at all levels of the auto industry right now. With overcapacity still high and the industry still making its slow, arduous recovery from the depths of late 2008 and early 2009, huge problems are looming. Many struggling or ambitious suppliers could definitely use the help of two resources that PE firms can provide them: insight and cash.

About 124 PE firms are active in the auto industry, according to a study I spearheaded for BBK. Each is also a potential partner for a troubled or ambitious auto supplier. In their style and interests, they run the gamut, from bargain-hunters at one end of the spectrum to long-term investors at the other. Within this wide array, misconceptions run rampant.

Misconception No. 1: Private equity acquisitions are leveraged to the hilt. The conventional wisdom holds that PE firms invariably leverage their purchases to a high degree. The reality, however, is more nuanced. In our analysis of firms with automotive interests, the share of “owner equity” in the deals ranged from 11 to 89 percent. The average PE firm put up 41 percent of the purchase price in cash.

So it would be a mistake to say that PE firms don’t have “skin in the game.” To be sure, they are still interested in leveraging as a tool to increase profitability. After all, returns are still measured as a percentage of the original cash investment. But investors with anything approaching cash equity of 40 percent certainly stand to lose a lot if their venture does not succeed.

Misconception No. 2: Private equity investors always think short-term. The reality is that PE firms are not always interested in purely short-term investments. The BBK analysis found that PE firms typically owned their acquisitions from one to 11 years. The average investment term was 4.7 years—certainly enough time to make an impact on a supplier’s prospects.

Misconception No. 3: Private equity investors invariably fire a supplier’s top managers. The vast majority aren’t interested in removing the existing management, although they often add key managers to the supplier’s team. They frequently offer the advantage of a fresh look at a company’s operations. And if the public company is taken private, private equity may give both the old and new team the advantage of a medium-term—and not a quarter-to-quarter— view. Fresh insights and a longer view could prove to be the key to making successful investments for the future.

Misconception No. 4: Private equity investors are industry outsiders. The notion persists that equity investors are invariably outsiders without automotive expertise. The truth is that they are already part and parcel of the auto industry. Without fanfare, many are quietly guiding their acquisitions along the path to long-term survival and prosperity.

Moreover, a good percentage of PE firms have shown an abiding interest in the auto industry: our analysis showed that one-third of the PE firms with automotive holdings owned more than one auto supplier. These are precisely the firms that could play a big role in the much-needed consolidation of the industry—introducing synergies, rationalizing operations, and creating a critical mass.

Certainly, there have been—and will continue to be—bargain-hunters ready to strip off and sell assets. But that is hardly the whole story. The bottom line is that there are both good and bad private equity firms active in the market, and the good ones often help create high-performing suppliers. As the auto industry continues to recover, it is crucial for automakers and Tier One suppliers to develop a better understanding of the private equity community.

In an era of restricted lending, private equity can provide the capital that suppliers need to restructure and re-invest for the future. After a fall-off during the global financial crisis, equity funds are growing again, and at last count hundreds of billions of dollars were available for investment.

So when equity capital firms come knocking at the door, laying the groundwork to woo a key supplier, an automaker should know who they are and understand what they bring to the table— financial resources and industry insights. An automaker need not be the matchmaker. But it can at least point the private equity firm in the right direction.