Private equity eco-system is fluid and market specific, says Professor Cyril Demaria
Private equity has changed substantially since the 1980s, says AIF professor Cyril Demaria.
Having worked in different roles within the private equity eco-system, from investor, to consultant, founder and managing partner of venture capital funds, Professor Cyril Demaria has come to believe that while the core structure of private equity remains unchanging, the eco-system is constantly evolving, and differs from market to market.
Cyril originally set out to study a business degree, but his studies were interrupted by his mandatory military service, which was spent working in transmission at the cryptology department in the French Prime Minister’s Cabinet. By the time he returned to business school to complete his final year of studies, he had realised that he found administration too static for his liking. He was accepted to study entrepreneurship at HEC Paris, where he tried to come up with a business idea of his own. He couldn’t find something he believed was going to work, so he decided to put his business school background to good use by working with entrepreneurs.
“I knew I could help them to understand finance, to provide them with advice, and essentially be part – indirectly – of their big adventure,” he recalls. “The great thing about that is that you can be involved in multiple ventures at the same time.” After qualifying, Cyril found an internship in a venture fund, which led to his first job and ultimately a career-long exploration of the complete private equity value chain.
Today Cyril is an independent CIO service provider for family offices and financial institutions, and a private equity expert who combines his academic expertise with practical experience, lecturing at top academic institutions, including EADA Business School in Barcelona and EDHEC Business School in Nice. He has authored best-selling books, including Introduction to Private Equity and Private Equity Fund Investments. Cyril received his PhD in Economics and Business Administration from the University of St. Gallen, Switzerland and has a Master’s degree in European Business Law from Université Paris-V, a Master’s degree in Geopolitics from Université Paris-VIII, and a Master’s degree from HEC Paris.
Cyril says there are many myths about private equity that persist, but two of the most pervasive are that it doesn’t create real value and that private equity is about buying massive conglomerates and selling off the individual components, stripping the company for value.
“When people say private equity investing doesn't really create value, they’re usually referring to transfer of ownership,” he says. “In the case of a leveraged buyout (or LBO), you would put some money on the table, you would borrow the rest. Then you would buy a company and, the company being profitable and stable, every time it pays you dividends, you will refund the debt and pay the interest. A lot of people believe that the only way you make money is because you borrow that initial amount very cheaply. And the company pays you dividends, which are much ‘fatter’ than what you have to repay, and ultimately you make money. But it's been demonstrated time and again that this is not true. It would be too risky to do this kind of transaction and just wait and see, and not change anything.”
He says that perhaps a third of the profit generated comes from this situation, but two thirds will be generated from what an investor does to improve the way the company operates and how profitable it is. “When you buy this company, you're going to change it so that when you sell it or you put it on the stock exchange, it's worth much more money.”
When it comes to the second myth – asset stripping – he says this may have been the case in the 1980s, when massive conglomerates existed with subsidiaries doing different things that had no relation to one another. But the world has changed since then. “It's very hard to find this kind of conglomerate, which has, for example, biscuits, and tobacco in its stable, which was the case of RJR Nabisco,” he says, referencing one of the largest LBOs in US history. “Today, I would be hard pressed to give you an equivalent of a conglomerate like that that has not already been refocused, changed or adapted. That's the nature of capitalism now.”
Major market differences
“The US has a different definition of private equity than Europe,” he says. “I include in the European definition, the financing of startups (venture capital), the financing of fast growth profitable companies (growth capital), and the support of existing established companies in their strategic evolutions (leveraged buyouts).”
Cyril says that whereas businesses in the US seeking funds tend to seek out investors, in Europe, they’re more likely to think of bank-based financing first. The US also has a longer history of private equity, particularly in venture capital, as evidenced by the tech start-up boom of the 1990s that yielded major successes, like Google, Cisco and Amazon. Venture capital has been less prevalent in continental Europe until more recently, which Cyril says is due to several factors. The economies and their structures are different, regulation in Europe was not traditionally geared towards venture capital, and the risk appetites across markets are also different.
“That's why some of the strategies in the US are still not present on the continent in Europe (they're present in the UK but not in Europe),” he says. “The three investment strategies I referred to earlier are complemented by a fourth one in the US, where you can buy the debt of companies in distress, and basically help them to get out of trouble. On the continent, because regulations are fairly different, this only barely exists.”
Challenges of modern capitalism
Cyril says that in the broader sense, private equity investing faces the same challenges as any other form of business. This includes finding ways to balance profits with sustainability. While he believes it’s been shown that it’s possible to make profit while also pursuing a social or environmental purpose, however, it becomes harder when there is tension between realising profits and pursuing noble goals.
“Let’s say you’re against using underage workers, but all your competitors are doing so. If you don’t do the same, your financial performance will suffer. Do you get rewarded for your virtuous stand or not? Perhaps in the long term, but can the business afford to wait for the world to catch up with your stand?” he says. “We have a lot of work to do in addressing these tensions, which are not unique to private equity. And, often, we want to find solutions before actually formulating the problem in a clear and organized fashion, which is where we should start.”
Cyril presents a Private Equity short course at the Amsterdam Institute of Finance. Find out more.