How can a small group of people get so rich so quickly without doing anything remarkably clever or even taking huge risks? This is the real question behind the storm that has blown up over the amazingly lucrative “private equity” business which now employs, by some accounts, almost a quarter of the British workforce.

The answer is actually quite clear, but it has never been heard from either the detractors or defenders of the private equity business. The real origin of what trade unionists regard as this industry’s excess profits is not the lack of regulation of private equity. It is the overregulation of pension funds, public companies and other investment institutions.

Trade unionists and old Labour politicians will never make — nor even understand — this argument. For them, demanding extra regulation to control the likes of Damon Buffini, the head of Permira, is the automatic response .

But the financial institutions that are making money by the truckload from private equity transactions have different incentives. If they want to defend this franchise, they will have to become simultaneously more straightforward and more sophisticated in explaining the sudden wealth it has produced.

It is not good enough merely to quote statistics about the broadly positive effects of private equity deals on profits, productivity and even jobs — impressive though these are. The most extensive study of what happens when private equity companies take over businesses has been conducted by the Centre for Private Equity Research at Nottingham University. The research shows not only that investors in these deals over ten years on average made profits 22 per cent above the market index, even after paying the seemingly exorbitant fees of the merchant bankers and lawyers. More surprisingly it shows that employment, after dipping by an average of 5 per cent in the first year after a buyout, rose by 21 per cent after four years; also that productivity almost doubled in this period, that product innovation increased and that companies showed evidence of more entrepreneurship. Most surprisingly of all, the Nottingham study — financed in part by City institutions — “found higher levels of employment, employee empowerment, and wages” after these deals.

But why could these gains be secured only by taking companies private, instead of just buying their shares in the stock market in the usual way? And why did the financiers and managers who arrange these buyouts make profits far in excess of the modest extra returns earned by the shareholders who put up the money? Both these questions have essentially the same answer.

Private equity financiers generate huge profits mainly because they buy companies on the cheap and then find ways of financing them even more cheaply. But how do the private equity entrepreneurs manage to swipe undervalued companies from under the noses of large corporate investors, such as pensions funds and other public shareholders? After all, private equity buyers normally pay substantially more for a company than it would command in open trading on the stock exchange.

This issue is really the nub of the private equity conundrum, and the explanation is surprisingly simple. The companies bought by private equity funds tend to be undervalued because investment institutions, especially British pension funds, have been told by regulators that they have too much money invested in the stock market and have been strongly encouraged or even forced to sell their shares in public companies. Instead, they have been urged to put their money into a combination of supposedly ultra-safe bond investments, spiced up with a sprinkling of “alternative assets”, of which private equity and hedge funds are the most prominent types.

The reasons for these regulations — supposedly to make our pensions safer — need not detain us, but their net result has been clear: In the past five years, as more and more pension funds have succumbed to this fad of deserting the stock market, many good companies have been sold for well below their true values.

Meanwhile, the pressure on pension funds to put their money into supposedly safe fixed-interest investments has pushed down interest rates and made the financing of private equity deals very cheap.

Moreover, this bias against stock market investment has not been confined to Britain. US regulators have pushed their pension funds in the same direction and, more recently, the bias against public equities has been given a further push by another powerful group of players — the Asian and Middle Eastern central banks.

China, Japan and other Asian countries now have more than $3 trillion of foreign exchange reserves, with oil-producing countries, including Russia, adding another $1 trillion. This enormous reserve accumulation has shifted control of a large slice of global saving from American and British private savers, who tend to invest in stock markets, to Asian and Middle Eastern bureaucrats, who are usually forced by law to invest in nothing but bonds and other “guaranteed” assets.

A natural consequence of this nationalisation of global savings has been to push down interest rates on corporate debt to very low levels. At the same time, ministers, embarrassed by the meagre profits on their huge reserves, have been demanding higher returns from their central bankers.

But how could this be achieved without exposing their national patrimonies to the “casino” of stock market investment? The obvious answer has been to follow American and British pension funds: ginger up their portfolios with spicier assets that look like safe bonds. Creative people in the financial markets have been happy to devise new types of investments to give their customers what they want, coming up with ever more complex financial instruments with esoteric names such as private equity mezzanine debt, credit default swaps and resettable payment-in-kind bonds. This has given private equity firms a huge pot of money to draw on.

A very similar process in the late 1980s launched the first generation of American private equity buyouts, when Wall Street created the “junk bond” market to satisfy the appetite of US insurance companies and building societies for equity-type profits when regulators only allowed them to invest in bonds, or at least assets that looked like bonds.

That first wave of buyouts was controversial and created some corporate scandals, but it had an electrifying effect on US business and arguably launched the productivity revolution of the next decade — as well as making unprecedented fortunes on Wall Street. With luck, something similar may now follow in Britain. There’s certainly no doubt about the fortunes.

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