“An Unfair Advantage”? Combining Banking with Private Equity Investing

Original source: SimoleonSense.com .

By: Lily Fang, Victoria Ivashina, and Josh Lerner (Via Harvard)

Executive Summary:

Does the combination of banking and private equity investing endow banks with superior information that allows them to identify good prospects and garner superior returns? Or does the combination bestow banks with an unfair ability to expand their balance sheets, capturing benefits within the bank at the expense of the overall market and ultimately the taxpayers? INSEAD’s Lily Fang and Harvard Business School professors Victoria Ivashina and Josh Lerner examined nearly 8,000 unique private equity transactions between 1978 and 2009, looking in depth at the nature of the private equity investors, the structure of the investments, and the performance of the firms. Collectively, findings suggest that there are risks in combining banking and private equity investing. The results are consistent with many of the worries about these transactions articulated by policymakers. Key concepts include:

• The cyclicality of bank-affiliated transactions, the time-varying pattern of the financing benefit enjoyed by affiliated deals, and the generally worse outcomes of these deals done at market peaks raise questions about the desirability of combining banking with private equity investing.
• Investments involving both affiliated and nonaffiliated firms appear particularly vulnerable to downturns.
• Some information-related synergies, however, are captured internally by the banks. But banks’ involvement poses significant issues as well.
• The share of banks in the private equity market is substantial. Between 1983 and 2009, over one-quarter of all private equity investments involved bank-affiliated private equity groups.

These investments seem to exacerbate the amplitude of waves in the private equity market, leading to more transactions at precisely the times when the private and social returns are likely to be the lowest.

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