In a new episode of their podcast Capitalisn’t, Kate Waldock and Luigi Zingales discuss one of the most hated industries of America: private equity. Democratic presidential candidate Elizabeth Warren has a plan to curb its abuses, but can it work?
America will always have a love-hate relationship with its wealthy financiers, but lately there has been a resurgence of interest in the private equity industry. In HBO’s Silicon Valley, for example, venture capital partner Laurie Bream is a ruthless automaton who runs on egg whites and green beans; in Succession, another HBO hit, private equity prodigy Stewy Hosseini is too untouchable to bother concealing his cocaine habit. Whether through mechanical indifference or supreme arrogance, private equity investors can strike fear in the hearts of even the grizzliest CEOs.
Not all of that notoriety is deserved. While private equity managers seek to maximize returns for their investors, there are plenty of socially beneficial ways of doing so. There are also expropriative ways of doing so, like transferring value away from workers, customers, creditors, and the government. The private equity debate is fundamentally similar to the shareholder vs. stakeholder debate. Except that in the case of private equity there are only a few, concentrated shareholders, and they happen to be financial experts.
It’s impossible to argue, based on an extensive body of academic literature in finance, that private equity firms do no good. Investors in this space can generally be split into two groups: growth and buyout.
On the growth side, private equity firms allow start-ups to access capital and make investments without having to take on risky debt. They provide meaningful advice on everything from marketing to supply chain management, which may be especially valuable to entrepreneurs with limited experience in these areas. They have been shown to boost productivity and profitability.
The purpose of buyout equity is different. CEOs of mature, over-extended firms face a dilemma: it can be hard to downsize your own company, especially if it’s one that you founded. Buyout equity firms can add social value by reallocating resources away from these less productive firms and putting them to more productive uses, in some cases firing greedy or ineffective managers.
The Relationship Between Private Equity and Labor
Downsizing is also where private equity gets sticky. As the archetype goes, private equity firms come in and lay everybody off, fomenting anger and resentment within communities reliant on those jobs. How true is this?
This relationship between private equity and labor has been studied in several papers by Steven Davis and a group of co-authors. In a recent NBER working paper, they show that even within buyout firms, public-to-private deals are associated with a 13 percent reduction in employment while buyouts of already-private firms actually increase employment by the same amount. Wages tend to go down post-buyout, but wages also tend to go up pre-buyout. So much of the effect is a wash.
In addition, employment reductions in struggling industries are a symptom not a cause of private equity involvement. It is a painful reality that some industries need to be scaled down, either because they were made obsolete by new technology or because they over-expanded due to inaccurate forecasts. While private equity firms tend to do the dirty work, they’re not to blame for overall sectoral trends.
Even when a firm or a factory isn’t a viable business, however, layoffs en masse can have spillover costs. What makes these costs difficult to assess is that they vary by region and industry. The US labor market is strong right now, with growing wages and low unemployment. Still, there are parts of the country where labor markets are in stasis. Does this mean that private equity firms should be prohibited from laying off workers in these areas? We argue no: private equity might be particularly indiscriminate about cutting jobs, but the problem of spillover costs extends beyond the private equity world. We think that this issue is better addressed through improvements in job retraining programs and search assistance that are not arbitrarily linked to the private equity industry.
There are other groups that are made worse off by private equity firms. A working paper by Eaton et al., for example, shows that when private equity firms buy for-profit colleges, they rely more heavily on federal grants and loans while reducing instructional spending and thus student outcomes. While funds specializing in education may only constitute a small sliver of the private equity universe, this paper documents an egregious transfer from consumers (in this case, students) and the government to private equity owners without much evidence of societal improvement.
Students are not the only consumers who can be hurt by private equity—any time a buyout is immediately followed by an increase in prices, in the absence of any other changes, this is a direct transfer away from consumers.
It’s no secret that industry consolidation and price increases are a way to generate returns. While the drug store chain Walgreens’s acquisition of competitor Duane Reade that Luigi Zingales mentioned in our new Capitalisn’t episode seemingly led to operating improvements at the drugstore chain, Walgreens announced on Tuesday that it may be taken private in the biggest leveraged buyout in history. Given that the firm has been attempting other M&A deals for years, we think that antitrust authorities should keep a watchful eye on Walgreens and other firms like it.
Private Equity and Creditors
In the episode, we also touch on another stakeholder group that’s often passed over in the argument about corporate objectives: creditors. While it might not be obvious, private equity firms that pay themselves management fees out of their portfolio companies—especially when those companies have lots of debt and are in struggling sectors—are effectively siphoning wealth away from creditors.
Recently, they’ve been engaging in even more blatant forms of asset shifting, e.g. the 2016 move by retailer J. Crew’s private equity owners to transfer intellectual property assets such as its brand name away from creditors. Private equity firms can also disenfranchise creditors by making risky investments in distressed firms. In these scenarios, they capture the upside while leaving creditors to bear the downside. We argue that stronger fraudulent transfer laws can prevent some of these abuses.
There’s another reason to be concerned about the private equity industry, one that we didn’t get to discuss in detail on the episode: the growth of corporate leverage. Since buyout deals tend to involve a significant amount of debt, and this debt is placed on the portfolio company’s balance sheet, too many deals can mean a worrisome build-up of corporate liability. While this can amplify equity gains, it can also make markets fragile. How much debt is too much debt? Because the tax code is written in a way that favors a certain degree of leverage, debt is not a bad thing per se. Regular interest payments and monitoring by banks can also discipline overzealous CEOs.
One relatively recent development, however, is that Trump’s Tax Cuts and Jobs Act reduced the benefit of debt. A natural consequence might be that private equity buyout activity should slow to a trickle, and yet it continues with gusto. I think that this is a sign that private equity investors aren’t as smart as they seem, using backward-looking rules of thumb about leverage rather than fundamental principles of finance. Luigi Zingales has more faith in their sophistication, believing instead that the continued use of debt is a sign that tax benefits aren’t the whole story.
Elizabeth Warren’s Plan
Democratic presidential candidate Elizabeth Warren’s proposed Stop Wall Street Looting Act aims to curb private equity’s abuses. Some of its provisions are relatively innocuous—restrictions on early dividends should not make a huge difference and a tax on management fees might sting private equity firms but won’t destroy their business model. Certain provisions, like increased transparency, would obviously be beneficial, even if disclosures aren’t made public.
The biggest sticking point, and the one that seems to have drawn the most ire from practitioners, is the provision on limited liability. A literal reading of the bill suggests that it would hold private equity firms accountable for all debts and liabilities of portfolio companies, a move that would almost certainly put a halt to private equity deals, at least on the buyout side.
A more generous interpretation is that liability would be shared, and that the purpose of this section is to protect employee, pension, and litigation claims while discouraging excess leverage in buyouts. Even under the interpretation that the limited liability restrictions are targeted, the possibility that private equity firms might be fully responsible for all tort claims might significantly quell deal activity in many sectors.
What would happen if we banned private equity altogether? On the growth side, the consequences would be disastrous. Start-ups would have limited access to capital, they would be left to intuit skills that were outside their core competencies, they would finance themselves with debt, exposing patents and innovative ideas to manipulative creditors, and very rich individuals would dominate equity markets. Consequences for the buyout side might be less extreme, but it would shift the balance of power towards already-entrenched CEOs.
Private equity might be fun to hate, but wiping out the practice isn’t the answer. Certain stakeholder groups such consumers and workers in declining industries should be given a hand for reasons that extend beyond the influence of the private equity industry. As for abuses that are specific to the industry, we think that the Warren bill addresses many of the loopholes private equity firms seek to exploit, although it goes too far on issues of unlimited liability.
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