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2015 Sep/14
The role of private equity in the evolving financial system Survey Papers 15-07 PDF
This study aims to conceptualize private equity as a new financial intermediary channel, and to confirm the efficiency of private equity’s financial intermediary role through economic performance achieved by portfolio companies. To better observe what kind of economic efficiency private equity creates by serving the innate function of financial intermediation that provides venture capital to the real economy, this study views private equity from the standpoint of financial intermediation. In a broad sense, private equity takes the form of indirect finance and has some things in common with mutual funds. But its singularity is derived from its position, lying in between relationship banking and market finance. Private equity carries a market finance aspect by investing in securities, while its post-investment management that enables relation-specific adjustments between investors and portfolio companies works like a loan agreement in relationship banking. Such “hybrid” financial intermediation contains the merits of both market finance and relationship banking, and thus serves to enhance the efficiency of financial intermediation. From the perspective of the real economy, private equity is directly connected to the provision of venture capital. Private equity provides the real economy with much-needed venture capital that invests in non-listed shares of growth capital and shares of mid- to long-term projects over long investment horizons. Therefore, an analysis on financial performance of the portfolio companies in which private equity firms invest will provide a glimpse on whether private equity raises corporate values, provides capital to the real economy, and serves to play a financial intermediary role efficiently or not. The existing literate on the economic impacts of private equity proves that private equity is positive for profitability of innovative investments, efficiency of business processes, etc. Also, it is not negative for employment: Although a slight decline in employment is observed after private equity participation, its overall impact on employment is positive from the perspective of the labor market dynamics where new jobs replace existing jobs. This study examines economic performance of listed companies invested by Korea’s private equity funds (Korean PEFs). After the participation of Korean PEFs, the portfolio companies showed some changes: On average, their investments increased, debt ratios fell, employment shrank, and productivity rose. Although those trends are statistically insignificant and thereby have little economic significance, it is hard to conclude that Korean PEFs’ ten years of history was all bad for corporate growth. For Korean PEFs to pursue long-term growth of portfolio companies just as private equity firms do in developed countries, Korea needs policies to implement prudential frameworks and facilitate PEFs. In order to strike a balance between the two somewhat conflicting policies, Korea’s regulatory philosophy should shift away from direct regulation that undermines dynamics toward indirect regulation that pursues prudential frameworks without compromising dynamics. Fortunately, Korea’s plan to reform PEFs in 2014 appears to be in line with the direction, and thus viewed as more helpful to shape a sound, active market than any other policies released in the past. An overhaul of market infrastructure is the last remaining challenge. More specifically, improvements are necessary, e.g., improving valuation and verification schemes for private equity assets, and developing a private equity benchmark index for higher market transparency and predictability. Given Korean PEFs’ investment strategy of holding illiquid assets for a long period to reap liquidity premiums, another policy action necessary is to establish a secondary market that meets the liquidity demand arising from the mismatch between portfolio firms’ maturity and PEFs’ investment horizon.