Nottingham University Business School

MBA Programmes

BUSINESS ECONOMICS

Analysis of the private equity industry

in the UK through S-C-P paradigm.

Dmitry Solomatin
Student ID: 4177973
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Table of Contents

I Introduction…………………………………………………………… 3

II Methodology...………………………………………………………... 3

III Analysis………………………………………………………………... 3

IV Implications……………………………….…………………………. 10

V Conclusion…………………………………………………………… 11

References

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I Introduction

Worldwide, private equity (PE) funds manage about $1 Trillion of assets. ( Metrick and Yasuda,
2008). ‘Private equity is about starting, growing and fixing businesses’ (Walker, 2008). This
industry has changed for the recant decades significantly. It is no longer an alternative group of
assets as it was 20 years ago. Looking at the size of funds raised and the social and economic
effect on the economy, it is fair to say that PE market is a big part of the British economy.
In order to grow further, the industry is needed to get more attention, not only from the media,
but also from different institutions that have impact on existing regulations, that develop
strategies and recommendations for a PE organization and other stakeholders.
Since the PE industry established, there has been observed a high level of competition. ‘We face
competition in private equity both in the pursuit of outside investors for our private equity funds
and the acquisition of investments in attractive portfolio companies’. (Lazard, 2009:11).
This essay is aimed to analyze the industry through an economic tool with following
examination of the current problems in the industry and statement of measures that might be
implemented in order to develop this sector of economy in the nearest future.

II Methodology

The PE industry is an important element of the finance structure in the UK with the highly
competitive market. There has been a number of changes that affect the market and its
participants. This essay uses SCP paradigm (Structure-Conduct-Performance) in order to
perform an analysis of the market structure, company’s behavior and the PE sector performance.
According to FEWS NET (2008), this is a method used to examine how the market structure and
the behavior of vendors of goods and services influence the performance of these markets and, in
turn, country’s welfare. Consequently, through SCP framework, a number of questions might be
answered related to formulation of a strategy and key drivers to market efficiency.

III Analysis

Market structure

The PE sector of the UK economy has considerably contributed to British investment for the last
decades. The amount of investment into UK businesses accounting over £70 billion in 25.000
firms from 1984 to 2007. At the moment, this industry in the UK represents around 57% of
aggregate investment across Europe.
There is also the significant economic impact of the UK PE sector. It is a considerable
component of British financial service industry. UK PE companies take into employment more
than 9000 people. There is also a substantial infrastructure of organizations maintaining the
industry. The considerable turnover are produced by accountants, lawyers, banks and other
participants who actively involved in fundraising, investment and divestment interactions.
(BVCA, 2007).
Towers Watson (2010) pointed out that the UK PE market is the second largest in the world with
1.060 companies running their business actively. UK PE firms raised £33.1 billion in 2007,
£27.0 billion in 2008 and £4.6 billion in 2009. ‘It is very competitive market, especially in the
mid- and large-cap spaces’ (Towers Watson, 2010). Thus, UK private equity market might be

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defined as a marketplace with a high competition and there are a substantial number of firms to
create a variety of investment opportunities for investors.
The PE industry is a critical source of resources for start-up companies, small and middle-size
firms, organizations in financial troubles, and public companies seeking buyout financing. (Fenn
et al, 1995). Since 1980’s, it has been the growing element of corporate finance with PE capital
has matched funds raised by IPO’s and public high-yield corporate bonds.
There are three key players in the economy of PE: PE issuers, intermediaries and investors.
Issuers are companies that have problems to raise funds in the debt markets or the stock markets.
Intermediaries are limited partnerships organized in a certain way to raise funds from investors
and invest these money into businesses. A partnership usually has general partners and limited
partners. Primarily, the general partners involved in a partnership management company and
they act under the partnership agreement to serve limited partners who are usually institutional
investors such as public and corporate pension funds, bank holding companies, wealthy
individuals and other institutions.

Diagram 1. Organized private equity market

Source: adapted from Fenn et al (1995)

According to Private Equity International (2010), the world’s 50 largerst private equity funds
have raised above $551 billion from 2002 to 2007. At the same time, an aggregate amount of

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investments in the PE market globally is about $735 billion. Looking at Table 1, the five largest
firms have raised a total of $146 billion, consequently, concentration ratio of 5 largest PE
companies is equal to 20%.

Table 1. Top-50 world’s largerst PE companies in 2007

1 The Carlyle Group $32.5 billion

2 Kohlberg Kravis Roberts $31.1 billion
3 Goldman Sachs Principal Investment Area $31 billion
4 The Blackstone Group $28.36 billion
5 TPG $23.5 billion
6 Permira $21.47 billion
7 Apax Partners $18.85 billion
8 Bain Capital $17.3 billion
9 Providence Equity Partners $16.36 billion
10 CVC Capital Partners $15.65 billion
11 Cinven $15.07 billion
12 Apollo Management $13.9 billion
13 3i Group $13.37 billion
14 Warburg Pincus $13.3 billion
15 Terra Firma Capital Partners $12.9 billion
16 Hellman & Friedman $12 billion
17 CCMP Capital $11.7 billion
18 General Atlantic $11.4 billion
19 Silver Lake Partners $11 billion
20 Teachers' Private Capital $10.78 billion
21 EQT Partners $10.28 billion
22 First Reserve Corporation $10.1 billion
23 American Capital $9.57 billion
24 Charterhouse Capital Partners $9 billion
25 Lehman Brothers Private Equity $8.5 billion
26 Candover $8.29 billion
27 Fortress Investment Group $8.26 billion
28 Sun Capital Partners $8 billion
29 BC Partners $7.9 billion
30 Thomas H. Lee Partners $7.5 billion
31 Leonard Green & Partners $7.15 billion
32 Madison Dearborn Partners $6.5 billion
33 Onex $6.3 billion
34 Cerberus Capital Management $6.1 billion
35 PAI Partners $6.05 billion
36 Bridgepoint $6.05 billion
37 Doughty Hanson & Co $5.9 billion
38 AlpInvest Partners $5.4 billion
39 TA Associates $5.2 billion
40 Berkshire Partners $4.8 billion
41 Pacific Equity Partners $4.74 billion
42 Welsh, Carson, Anderson & Stowe $4.7 billion
43 Advent International $4.6 billion
44 GTCR Golder Rauner $4.6 billion
45 Nordic Capital $4.54 billion
46 Oak Investment Partners $4.06 billion
47 Clayton, Dubilier & Rice $4 billion
48 ABN AMRO Capital $3.93 billion
49 Oaktree Capital Management $3.93 billion
50 Summit Partners $3.88 billion

Source: http://www.privateequityinternational.com/pei50

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Amongst these 50 firms there are more than a dozen of British companies which follow a general
trend in terms of concentration in the market. It is unlikely that the concentration ratio for UK
companies could differ considerably because in London there are many offices of multinational
funds as well as UK private equity funds. Yet, PE funds primarily run their business across the
world, therefore they follow same trends, similar regulations and exist in the environment
influenced by almost identical factors.

Conduct

Campbell (2008) argued that from economic point of view any model of organization that
captures market share in a free market economy tends to have a beneficial economic impact.
Adam Smith’s “invisible hand” of the market regulates new innovative forms of business
functioning: efficient models are adapted by the market – inefficient forms merely disappear.
Thus, if PE firms operate in free markets, the economic impact should be positive.
The general partners in PE companies act in different markets: they raise money in the financial
markets, they buy and sell companies in the market for mergers and acquisitions, the labour
market supplies specialists to run businesses and they are also involved in the market for goods
and services.
More or less these markets could be defined as the free markets. Customers are satisfied with
value for money, otherwise they would go away to alternative suppliers. If the employment is not
attractive, the employees could get jobs at other companies. Superior returns allow current
investors not to switch on other financial vehicles, In turn, PE firms raise additional funds. Thus,
according to Adam Smith’s “invisible hand”, it is clear that private equity has the positive
economic impact.
Looking at a variety of investors in PE funds, it is notable that a large percentage of them
originated as institutions that are highly involved in the delivery of pension schemes. (Diagram
2).

Diagram 2.

Source: Alternative Investment Expert Group (2006)

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Such institutions as pension funds, banks, insurance firms are interested in investments in the PE
market. In many cases, these investors have a lack of in-house competences and professionals to
operate in this specific market, therefore they delegate operations to select investments,
implementation and management of these investments to specialists. In turn, the experts have
developed the process that might deliver value creation to their initial investments. ( Alternative
Investment Expert Group, 2006).
Institutional investors make decisions that are based on optimization investment returns, taking
into account portfolio risk approach which would be appropriate to their long-term objectives
and requirements in terms of sustainability.
Looking at transnational nature of PE industry and the way fund managers control their
investments, it is fair to say that internationalization of businesses they are interested in has
increased dramatically. Diagram 3 illustrates differences in the domicile of the fund and the
destination of investments across Europe. ( EVCA, 2006).

Diagram 3. Country of destination of investment (€ billions) & Location of fund management

team (assets under management, € billions), Top 8 EU Member States in 2005

Source: EVCA (2006)

It is clear from Diagram 3 that the UK dominated because London has been historically an
invariable headquarter for the largest European funds over recent decades.
General partners (GP) and limited partners (LP) are mutually interconnected partners that
contribute to a partnership differently, however, cannot be without each other. Examination of
their nature provides important insights into mechanism of functioning the PE fund.
Metrick and Yasuda (2008) explained the relationship between GP and LP in terms of
origination the total value of the investment. It can be illustrated from Figure 1.
The relationship between general and limited partners is a complex issue. LPs use a mechanism
of the partnership vehicle rather than direct investments in order to hand over responsibilities of
selecting, managing and closing down PE investments. However, the efficiency issue arised in
terms of how effective GPs could protect LPs’ interests.

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Figure 1: Equilibrium Framework for Private Equity Fund*

Source: Metrick and Yasuda (2008)

There are two aspects emerge from the nature of partnership. Firstly, partnerships have limited
lives and in order to remain in business, fund managers need to raise fresh funds which could be
less expensive for firms having better reputation. Secondly, rewards of GPs depend on
performance of the PE fund. ( Fenn et al, 1995).

* This figure illustrates the equilibrium condition for an investment that is worth $1 to a passive investor. $b
represents the expected present value of the value-added services that private equity fund managers (GPs) provide
over the investment holding period. $a represents the expected price discount that GP receive when they purchase
the asset. The LP Cost represents the investment cost plus the present value of the pro-rata share of management
fees. The GP Value represents the present value of all variable revenue that GPs expect to receive from the

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investment. The LP Value represents the leftover value of the investment that accrues to LPs, i.e., LP Value = Total
Value (V) – GP Value. GP% represents the expected percentage of V that belongs to the GP.
Performance

There are 1,300 firms in the UK which get PE investment every year. These companies have
shown the significant growth and have considerably impacted on the UK economy. (BVCA,
2007). Annual growth in sales for companies with PE financing was 8% from 2002 to 2007, in
comparison to FTSE 100 with 6%, and FTSE Mid-250 with 5% (Figure 2).

Source: BVCA (2007)

PE firms tend to perform better than other asset groups. (Table 2.)

Table 2. European private equity performance (combining all data since records began)

Source: Alternative Investment Expert Group (2006)

* the top quarter Internal Rate of Return (IRR) is the pooled returns of funds above the upper quartile. The return pattern of private equity and
venture capital funds is specific to the asset class. Investments in private equity tend to loose value during the first years of investment and
increase steeply after the fund has reached maturity, i.e., after it has completed the investment phase and is well into the divestment phase. Early
losses in the first few years of the life a private equity fund – expressed as negative Internal Rates of Return (IRR) – are normal and do not
necessarily reflect a lack of profitability of the private equity fund. They correspond to the period in which investments are being made in
portfolio companies (from the investor's perspective cash-flows are negative because downs are being made and management fees being paid).

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It is clear from Table 2. that “top quartile” companies have shown considerably better results. In
spite of differences in the market sectors, which depend on structural reasons, an aggregate
performance is better than benchmarks.
Reputation plays an important role in PE markets. Therefore, to measure performance there is a
number of quantitative methods as well as qualitative ones. Internal rate of return (IRR) is the
most common measure used to assess whether investments are managed efficient. ( Fenn, 1995).
It can be calculated on different stages of partnership’s life. However, on early period of fund’s
functioning, IRR depends more on accounting methods which take into account values of
companies’ assets with low liquidity. It is also difficult to interpret and evaluate “young” firm’s
performance because of a broad spectrum of the accounting returns that are usually fairly
changeable.
Thus, prospective investors and their consultants carry out thorough empirical analysis of fund’s
returns before making an investment decision.
Amongst the indicators that might be examined is the individual investment returns distribution
in order to reflect separate returns which could be a matter of concern in case of a very low
return or an exceptional one.
An analysis of the distribution of returns is a critical to evaluate PE fund performance, but more
important to assess the relationship between individual investment returns and investment
attributes, for instance, industry, scale and geographical position of the portfolio companies. It is
also worth to examine the relationship between the performance and GP who is responsible for
managing the investment, particularly, if there have been changes in personnel recently.
Another technique to measure performance is to assess quality of fund’s management skills. This
assessment is possible if there has been an opportunity to co-invest in cooperation with previous
partnership, consequently, the potential LP could observe GP’s skills.
Generally speaking, in order to collect and analyze information about partnership and their
investment returns. Potential investors spend a substantial amount of money. Therefore,
institutional investors highly rely on advisors to assess prospective partnerships. As a result,
consultants play a crucial role in creating new approaches to measure PE performance.

III Implications

According to Fenn (1995), the angel capital (PE on the earliest stage of business life) and
unofficial PE markets are much larger than the regulated PE market. Moreover, the angel capital
is needed as an important source of initial capital.
Nevertheless, the shortage of an organizational infrastructure to assist these markets has negative
impact on reliability and comprehensiveness of information related to them.
In order to attract more investors in UK PE funds, it is beneficial to PE market that no VAT
(value added tax) to be paid on management fees. ( EVCA, 2010).
In order to survive in the highly competitive market, PE firms should concentrate on strong
reputation, relationships and performance records. ( Celerant Consulting, 2009).
A lack of transparency issue arises, looking at sources of information about operation of PE
firms. These circumstances might reflect undesirability of funds’ managers to spread information
because of cross-border transaction in order to reduce tax. On the other hand, it could be harmful
for the consumers who want to know ‘who they are dealing with, what the company ethics are
and more importantly whether the model can be sustained’ (NTL World, 2010).
In order to develop further PE market, national policymakers should use a whole range of the
levers available to them. Officials in the government who are responsible for functioning
financial markets should learn from positive experience outside and create the supportive

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conditions to make possible the development of this part of financial markets. Institutional
investors should be protected from random and out of date regulations based on numerical
restrictions. ( Alternative Investment Expert Group, 2006).
Policymakers should also take into account characteristics of the PE market when having the
intention to review existing legislation or propose the new law. It is crucial to examine from
different perspectives these characteristics in order to avoid unintentional implications of
government’s initiatives on the PE market. On the other hand, if there is the intended impact, the
proposals should be initiated with consideration of the key aspects of the industry so that these
measures will achieve the desirable goals.

V Conclusion
Looking at the results of the analysis conducted by S-C-P framework, it is clear that the structure
of PE market in the UK shows a presence of a sufficient number of firms to provide that market
with a high level of competition, and a low level of concentration, consequently, there is no
company that has significant market power to dictate any policies.
Since all participants of the market operate in competitive environment, their behavior is
motivated by attempts of others to improve their way of acting, therefore a majority of
companies is likely to choose as efficient model of behavior as possible, yet, this might be
accepted by the market.
In conclusion, taking into account arguments mentioned before, SCP-paradigm might be valid in
case of PE industry. In order to maximize social efficiency in this market, policymakers should
take into consideration characteristics of the market fairly carefully with following proposals that
might assist PE market to develop effectively.

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References

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British Private Equity & Venture Capital Association (BVCA) (2007) [online]. The Economic
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Campbell, D. (2008) The economic impact of private equity, The Ashridge Journal, Spring, 1-5.

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European Private Equity & Venture Capital Association (EVCA) (2006) [online]. Press Release:
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Fenn, G.W., Liang, N. and Prowse, S. (1995) The Economics of the Private Equity Market,
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FEWS NET website (2008) [online]. Structure-Conduct-Performance and Food Security.

Available at: http://www.fews.net [Accessed 23 December 2010].

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[Accessed 23 December 2010].

Metrick, A. and Yasuda, A. (2008) The Economics of Private Equity Funds,

Review of Financial Studies, 23 (6), 2303-2341.

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http://homepage.ntlworld.com/herring1/pequity.html [Accessed 23 December 2010].

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http://www.prnewswire.co.uk/cgi/news/release?id=196487 [Accessed 23 December 2010].

Towers Watson website (2010) [online]. UK - Saturated or Scope for Outperformance?

Available at: http://www.towerswatson.com/research/2168 [Accessed 23 December 2010].

Walker, S. at the London School of Economics – interview (2008) [online]. Private Equity under
the scrutinizing eyes of the public. Available at:
http://www.bvca.co.uk/assets/features/show/PrivateEquityunderthescrutinizingeyesofthepu
blic [Accessed 23 December 2010].

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