Private Equity Firms and Equity Markets: Impact on Capital Structure Inefficiencies

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Introduction

Almost every economic transactions taking place around the world involve private equity. For example, all new transactions conducted by major corporations around the world must in one way or the other encompasses private equity. Private equity firms have evolved to be prominent in the recent years such that the funds they offer to other corporations as well as the transactions they fund have doubled.

Besides, the companies that are being acquired by these equity firms have become a common name to the ordinary citizens. In fact, private equity has developed into an integral part of many people around the globe. Yet, majority of the people have been longing to know what private equity is, how it operates, what it means to the economy and most importantly its effect on the capital structures of publicly owned corporations.

These materialize to be the questions that this paper intends to answer. Particularly the paper will critically discuss whether leverage profits made by these companies’ lead to inefficiencies in the capital structure of public corporations.

Private equity firms, equity markets and capital structure inefficiencies

Many entrepreneurs always hold an ambition of starting and building successful business that overtime will be able to create jobs but majority fail to take advantage of their entrepreneurial potential. Despite the fact that various small and medium sized entrepreneurial businesses objectives are to grow overtime, very few often achieve this objective (Baker et al., 2000, p.2221).

Getting an enterprise off the ground as well as its expansion needs finance. Raising this finance is still a nightmare to most of these enterprises. In essence, the main barrier to business growth is the capital deficiency which cannot easily be overcome by regular sources of finance such as banks and financial institutions (Baker et al., 2002, p.5).

Private equity in addition to venture capital is currently becoming the most imperative source of finance to these enterprises and companies. Furthermore private equity is now a major source of finance to the overwhelmingly growing potential firms.

Claus et al. (2001, p.1640) asserts that the main objective of private equity is to ideally provide financial assistance to ambitious firms in order to achieve their growth potentials. Private equity firms similarly offer strategic advice as well as the essential information to the firms especially at some critical stages in their development stratum.

Although several savvy investors have generally become aware of the existence of private equity firms, a perfect understanding of its mechanism is still lacking. It is even more apparent to the deemed small and medium sized enterprises.

Fear of giving ownership to these firms through interchange of stocks for cash flows as well as lack of information has been sited as the major reasons why many companies do not opt for private equity firms. For instance, Chirinko et al. (2000, pp.416) argue that the possibility of losing control remains to be the most determining factor for not opting for private equity firms.

However, sundry companies who have approached private equity are reporting remarkable improvement in their business undertakings in addition to their budgetary and monetary monitoring. Investors have also increased their network of contacts which is regarded as an optimistic and constructive element.

It is further essential to note that private equity increases the firm credibility to their clients, financiers, suppliers and competitors (Baker et al., 2002, p.12). As a result, private equity is particularly indispensable for start up companies whose assets are often intangible and are obliged to provide voluminous guaranties in case of financing through commercial intermediaries.

Private equity definition

Private equity basically appertains to where the financial investors provide equity capital to the firms for either medium or long-term expansion and in most cases to non-quoted companies that show a greater growth potential. Not only the monetary requirements to create a firm are covered by private equity but also fulfilling the subsequent development financial needs (Chirinko et al., 2000, p.416).

Private equity usually involves buyouts where the finances are required by a team of management experts to purchase an already existing company from its present shareholders.

Private equity further includes the take over of private corporations with the intention of offering the founder members the essential capital to enhance performance to a higher level (Heaton, 2002, p.35). Such equity may embrace acquiring the corporation affiliate with an aim of offering the newly formed conglomerate a management focus and resources to attain a novel mission.

According to Frank et al. (2002, p.220) categorical claim, private equity involves buying out the shares of public corporation with the main objective of undertaking its improvement in terms of profits, management and infrastructure.

How leverages are used to make profit

Private equity companies are usually characterized by the use of leverages (debt) to improve returns on investment capital by the firms (Hovakimian et al., 2001, p.10). Normally the quantity of employed debt is determined by the acquired firm’s ability to service the same debt with money generated through business operations.

The firm’s ability to generate more cash enables the investors in the private equity to increase their leverage capability during business transactions. Because these companies are aggressively managed through debts, the cash flows these companies generate in their initials operations after the acquisitions are almost wholly being consumed by the leverage service (Hovakimian et al., 2001, p.10).

Moreover, the main purpose of the takeover is to grow the business and as usual growth normally consumes cash. Fama et al. (2001, p.18) cites this as the reason why the investors in private equity are keenly focused on the business cash flow.

How the company values are affected by the capital structure

Capital structure is the way a firm funds its operations through a combination of the firm’s shares and borrowings (Korajczyk et al., 2003, p.105). The capital structure applied to each company is different from other companies. While one company may choose to finance its operations through equities another may prefer borrowings. In both cases, maximizing the market value remains to be the major objective.

Indeed the financial mix that involves minimizing the overall company costs of finance while maximizing the firm’s market value is known as the optimal capital structure (Korajczyk et al., 2003, p.105). The determination of the firm optimal capital has remained to be a matter of discussion.

Some of the predominant models and how they are discussing the contributions of private equity to the capital structure are presented below. In essence, these theories critically look at whether the firm leverage contributes to the inefficiencies in the capital structure.

Net operating income approach

This approach to the firm capital structure argues that the proportion of the company debt and equity does not have slight bearing on the very firm cost of capital. The Net Income Approach (NOI) assumes that keeping the cost of debt constant at all leverage levels show that the cost of equity is directly proportional to the leverage increments (Welch & Ivo, 2004, p.110).

Such an increment causes disproportional upsurge in financial risks to the firm as it raises the proportion of debt to the firm’s capital structure. The cost of equity will automatically rise as the shareholders expect greater returns that would be able to cover the incurred risk (Welch & Ivo, 2004, p.110).

Therefore, according to this approach optimal capital structure does not exist. There remains a constant rate of overall capitalization for the entire stages of financial leverage. For entire financial leverage, the rate of the firm’s debt is constant. This denotes that the equity rate increases proportionally with the increase in the financial leverage.

If what is being agued is applied practically then increasing leverage would have no use. Conversely, the investors are anticipating higher returns as the level of leverage increases (Korajczyk et al., 2003, p.110).

This is the usual expectations of ordinary shareholders in publicly listed corporations. Nevertheless, if the investors in the private equity raise leverages then there must be squeezed equity contribution to the total capital (Korajczyk et al., 2003, p.110).

Modigliani and Miller approach

After their ground breaking study, Modigliani and Miller changed the perception of financial managers towards maximizing the value of their companies. The original view was that the financial leverage and the capital cost relationship can only be explicated through Net Operating Income (NOI).

The argument was that the company value is immaterial of how its capital is funded even if it is through debt-equity combination (Frank et al., 2002, p.223). The argument did not factor in corporate taxation.

Graham and John (2003, p.1098) argued that in a situation where there is no corporate taxation the amount of finance the company generates through securities is equal to the amount generated through debt capital. The result is that firms can use as much leverage as they want because there is no effect on the value of the company.

However, companies have to factor in taxes when calculating the value of the company. Taxes have been identified as one of the essential parameter affecting the capital structure that cannot be ignored (Graham & John, 2003, p.1098). Even if taxes have to be taken care of, the main aim of the managers continue to be that of minimizing the cost of capital while on the other hand maximizing the company value.

The main advantage that debt financing has over equity is that taxes are funded once all the interests are paid. Hovakimian et al. (2001, p.11) further asserted that a rational manager would choose to pay interests over taxes which are highly costly for the capital funding.

In most cases firms would try to push leverage as far as possible up to such a point that it becomes risky for the business (Chirinko et al., 2000, p.416). As the cost of debt increases few lenders will be willing to offer loans and investors would decrease their investment. Therefore the costs of both equity and debt will rise. In this situation the need of efficient capital structure where the cost of capital is minimized must be sought.

According to the Modigliani and Miller theory it is needless to get the minimum cost of capital (Myers, 2007, p.86). Thus, financial managers should change the leverage level as they deem necessary.

This follows the fact that capital structure inefficiency does not arise with such kind of leverage adjustments assumed by the private equity firms. In fact, the same level of cash flow may be achieved by adjusting the leverages even without using private equity.

However, there are many concerns that must be attended to in the real world application in order to maintain the leverage at the industrial desirable levels (Heaton, 2002, p.37). More recent theories though not satisfactory have challenged the Modigliani and Miller theory.

The static trade off theory

Under this theory companies compare the cost of debt with the ensuing benefits. The cost of debt according to this theory consists of the potential cost of bankruptcy as well as the conflicting interests between the shareholders and the bondholders (Huang et al., 2009, p.8).

Similarly included in the cost of debt is the deductibility of interest expenses in addition to the organizational conflict arising from the shareholders and the managers. This theory further stipulates that firms should seek external financing when the debt they hold is above the anticipated leverage level (Renneboog & Szilagyi, 2008, p.798). This should also be the time they ought to issue equity to external financiers.

In addition debts are duty-bound to be issued only when the debt leverage is lower than the target. In essence, corporations must note that debt and equity should be issued proportionately to remain close to the target (Huang et al., 2009, p.8).

Generally the static trade off theory mainly focuses on the balance between the benefit and the cost of debt. Evidences that support the theory suggest that target leverage is not very essential. Other studies also suggest that higher profitability results in decreasing leverage. This observation is inconsistent with the prior theory prediction that profitability reduces tax liabilities (Ernst et al., 2009, p.12).

Studies further find that firms with high profits and fairly liquid with low expected costs conservatively use their debt or rarely go for debt financing. This clearly indicates that such firms tend to be cautious towards target leverage.

Other studies suggest that the major determinant of the market leverage appertains to the prior returns on stock (Ikenberry et al., 1995, p.189). That is, they measure the leverage by the use of the market value of stocks. This does not necessarily mean that firms offset the effect of these returns on their capital structure.

Pecking order theory

This theory proposes that investors will buy risky securities at a discount when there is lack of appropriate information between the company managers and external investors.

Managers will therefore opt for internal sources of finance and will only go for external funds when the internal sources have proved to be insufficient (Chirinko et al., 2000, p.416). In case firms have to look for external finance they would prefer both convertible and straight debts more than equity implying that equity financing is always considered as the last resort.

Though asymmetric information could be the major reason cited in this model, other reasons could be the transaction cost and managerial optimism. Optimistic managers will not be willing to issue external equity for the fear of being undervalued (Heaton, 2002, p.37).

Most of those who have issued their external equity hold the belief that their stocks were undervalued. This theory predicts that the financing through external debt is dependent upon internal financial deficit. Accordingly more profitable firms would be less levered (Huang et al., 2009, p.8).

Market timing theory

Both the pecking order and the static tradeoff models obliquely assumed strong market efficiency. But market efficiencies normally exist at the firm level and have serious implications in corporate financing (Huang et al., 2009, p.8). Market inefficiencies also exists at both industrial and market levels.

For instance, at the market level the stocks volume of publicly quoted companies traded in the security market correlates directly to the inflation adjustments level of stock market.

The most important determinant of private firms going public is the market-to-book ratio of the industry in which they are operating (Loughran et al., 1997, p.1784). The total market returns from the aggregate securities emanate from the portion of equity that has in total been issued from the securities forecasts.

Furthermore, the volume of shares traded is partly dependent on the indirect investor sentiment. Practically, majority of large firms executives are actively engaged in market timings before making their financial decisions (Huang et al., 2009, p.8).

Effects of securities on the capital structure

Corporations are capable of regulating their capital structure using both internal and external funds. The pecking order model has an assumption that internal funds are less expensive than the external funds and external debt is less costly than the external equity (Frank et al., 2002, p. 223).

Hence, security issue particularly the equity should be very occasional unless they have positive material impact on those firms lacking internal funds. Market timing model give the security issues some leverage to have a significant part in influencing the capital structure.

Static tradeoff model proponents argue that securities are dispensed majorly to help companies modify their target leverage though this must be accompanied with some costs (Frank et al., 2002, p.223).

Conclusion

It is true that various theories have been put forward to explain the relationship between the firms leverage and the capital structure. Market timing theory that is constructed from the variations in comparative cost of equity offer a good account for the annual oscillations of external equity and debt. The theory does not fully support the assumption of stronger efficiencies as in pecking order theory.

In market timing model, the external funds are more or less expensive than internal funds and equity issues are not all that expensive than the debt issues. In fact in this model the rarity of equity issues is not predicted.

When equity issues are experiencing the low prices many firms tend to issue the equity within that short period of time. The decisions to issue equity are subject to the time-varying cost of equity. Organizations tend to finance bigger amount of their deficits using the external net equity when the anticipated price of equity market risk premium is lower.

Empirical studies indicate that many companies would be more willing to issue equity rather than debt. When the cost of equity risk premium is low there is high returns on the first day of IPO, less close-end-fund discount, low future market returns, higher future realization of the value factor as well as the greater expected default spread.

At the company level those firms that underperform easily offer equity. Furthermore, market timing model gives equity and debt issues more leverage in determining the capital structure.

Finally, the market timing theory has been found to best in accounting for the external financing decisions of the publicly quoted firms. It also takes into consideration the efficiencies and inefficiencies in the financial markets arising from the leverages of private equity firms. Empirically, there is very little correlation between the firm’s capital financing and the inefficiencies in the capital market for the publicly quoted firms.

References

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