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The herd mentality in private equity

Private equity as a form of financing for businesses is in the spotlight. The magnitude of this type of investing is progressing in waves.

It seems as if the private equity market is taking a breath for a moment after a period of high flying. In his dissertation Private equity acquisitions Ward van den Berg researches takeovers of private equity funds and looks at what strategies the private equity firms used to put out their investments.

Investors watch each other closely, and one corporate takeover often prompts another. Van den Berg will defend his dissertation on Thursday 20 September 2007.

With regard to the recent fierce debate, private equity (investing in companies that are not listed on the stock market) seems like a new economic phenomenon. Yet this important source of business financing has been around since the beginning of the 1980s. Private equity is an important source of financing for start up businesses, medium sized private businesses that are undergoing restructuring, and businesses that want to terminate their stock market listing.

Wave patterns can be discerned in the magnitude and progression of this type of investing; periods of expansion alternate with periods of retrenching. In the United States, for example, in the 1980s cumbersome conglomerates of companies were bought up with private equity, with the intention of structuring these businesses more efficiently. But the tough competition for a limited number of deals drove up the price of takeovers and returns on investments diminished.

Because of the high expectations, the available assets turned out to exceed the playing field and sources of financing scaled back their supply. At the beginning of the 1990s the private equity market in the US dried up.

These sorts of wave patterns seem to occur time and again, and both on the leveraged buyout market (takeovers of full grown companies with stable cash flows) and on the venture capital market (investments in new young companies). One acquisition seems to invite another. What strategies do private equity firms use in putting out their investments? In private equity not all the players have access to the same information. Private equity is also characterised by a high degree of uncertainty about the value of the investment and limited liquidity; you are bound to your investment for a long time. These characteristics prompt investors to look at each other’s investment behaviour in order to limit the risks. It can also lead to herd mentality however, when financiers invest in businesses unscrupulously.

Van den Berg uses three models to describe how acquisitions seem to prompt each other. The announcement of a takeover and the initial bid awake the interest of a second party, and this already can drive the price up to a point that stops this second party from taking part in a bidding war. An investment in a buyout can also unveil information that other financiers use in their own investment decisions. This attentiveness to the behaviour of others can lead to a wave of private equity investments. Finally in the consolidation of a branch of business the value of every successive takeover candidate increases, to the extent that more companies have been bought up. This too leads to a new wave of investments.

Yvette Nelen | alfa
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