THE rulers of the capitalist roost change remarkably often. Consider just the past two decades. In the 1980s Michael Milken and the small crowd of deal-making junk-bond financiers who followed in his wake seemed to be the kings of capitalism. In the early 1990s, the crown passed to the traders of Treasury bonds, who helped to terrify even President Bill Clinton into fiscal prudence. By the end of the decade, investment bankers appeared to occupy the throne, as they brought hot initial public offerings of shares to stockmarkets and their analysts, such as Morgan Stanley's “internet queen” Mary Meeker, touted them to eager buyers.

And today? The candidates are unusually publicity shy. Hedge funds—private pools of capital that can invest, long or short, in whatever they please—regard themselves as capitalism's top dogs, and yet they already seem past their prime. There is talk of a hedge-fund bubble, as billions of dollars pour into these funds even while their performance slumps. Besides, it is not clear that, in the scheme of things, hedge funds really matter much: they provide useful liquidity to the financial markets but, essentially, they are mere speculators who profit from correctly anticipating market movements rather than by shaping the fundamentals of the business world. That, increasingly, is the role played by a different sort of secretive pool of capital: private equity.

Private-equity firms are those which purchase other firms or take big stakes in them (and often take public firms private by purchasing most of their publicly traded shares) in order to reshape their businesses, and then sell these holdings for a profit. Private equity comes in two main forms: venture capital, which aims to help young firms grow; and buy-out capital, which is used to improve established firms. Private-equity firms now wield much of the transformational power at the heart of the capitalist system. Although they rarely seek the limelight, the sheer clout of leading private-equity firms such as Blackstone, the Carlyle Group and Kohlberg Kravis Roberts (KKR) has attracted attention, and sometimes controversy.

Many a household name—from Burger King to Jimmy Choo shoes—is owned by a private-equity firm. Many big mergers or takeovers now involve private-equity firms. Even if they are not acting as buyer or seller, their potential interest is, at a minimum, putting a floor under the deal price. Five firms are jointly planning the biggest private-equity deal yet in Europe: a $14 billion purchase of Auna, a Spanish telecoms group. Last week's merger of Sears and Kmart, two big American retailers, was led by Kmart's private-equity owner, Edward Lampert's ESL Investments (one of a growing band of hedge funds that are also doing private-equity deals). Here is one crude measure of the rise of the industry: in the Wall Street Journal, New York Times and Financial Times, the use of the term “private equity” this year is up by around 60% compared with just two years ago, and by over 3,000% in the past ten years.

Yet if private equity is now king, is that something to celebrate? Are private-equity firms using their power wisely? Do they really create economic value for anyone but the people who run them? And is it really desirable, in this age of transparency, for such secretive firms to have so much power?

As is explained in our survey of private equity published in this issue, it is frequently a force for good—in many ways a superior model of capitalism to that based on firms traded in public stockmarkets (though neither model can thrive without the other). In private equity's infancy in the 1980s, firms such as KKR and Forstmann Little, though derided as “corporate raiders”, pioneered efficiency-enhancing innovations that are now standard business practice: a focus on cash flow; the better use of debt; and equity-based pay as a way of offering incentives to managers to act more in the interests of shareholders. Today, private-equity firms often seem to provide better corporate governance than is generally found at many public firms, whose shareholders usually own too small a stake to keep management in line. (Ironically, the recent wave of new corporate-governance regulations has made more people in public companies yearn to go private.) Despite their early reputation as asset-strippers, private-equity firms increasingly help companies to maximise their long-term value by protecting them from stockmarket pressure.

In the 1980s and 1990s, private-equity firms helped to break up America's many badly run conglomerates, taking neglected non-core businesses off their hands, polishing them and finding more suitable owners. They hope to repeat this trick in other places where inefficient conglomerates are rife, starting with continental Europe—especially Germany. The efficiency gains for Europe's economies could be huge. Private-equity firms are also pioneering restructuring in Japan, starting with its wretched banking system. Private-equity firms have high hopes of spreading cutting-edge business practice to nascent economic superpowers such as China and India as well—though it remains to be seen if they can pull this off.

Yet not everything about private equity is wonderful. Greater transparency is needed. This is not because many of these firms are part of a scary political/military/industrial complex, as some critics (along with the re-makers of “The Manchurian Candidate”) fear, but simply because growing amounts of pension-fund money are being invested in them, and the beneficiaries of these funds have a right to know how their savings are being used. The challenge for private-equity firms is to meet this legitimate demand without giving away commercially useful information, or succumbing to the short-term financial pressures they have sought to escape.

Another risk is that too much money will flow into private equity, creating a bubble—just as may now be happening in hedge funds. As private equity grows, and its leading firms become even bigger, there is also a danger (perhaps it is already becoming a reality) that they will lose their edge. If that happens, it will be time for capitalism to crown a new king.

Copyright © 2004 The Economist Newspaper and The Economist Group. All rights reserved.