Private Equity Moguls and the Common Good
Can Wall Street corporate raiders cure creaking capitalism?
This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the July/August 2012 issue of Dollars & Sense magazine.
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[In May], the Obama administration unveiled an attack ad against Mitt Romney’s old private equity firm, Bain Capital.... But the larger argument is about private equity itself, and about the changes private equity firms and other financiers have instigated across society. Over the past several decades, these firms have scoured America looking for underperforming companies. Then they acquire them and try to force them to get better.
Most of the time they succeed. Research from around the world clearly confirms that companies that have been acquired by private equity firms are more productive than comparable firms.... [And] the overall effect on employment is modest.... Private equity firms are not lovable, but they forced a renaissance that revived American capitalism.
—“How Change Happens,” by David Brooks, New York Times, May 21, 2012
The Obama campaign may have launched an attack against Romney’s record at Bain Capital, but Vice President Biden and President Obama have been careful not to challenge the legitimacy of the private equity (PE) business or to take on Brooks’ larger argument that the PE business has been good for the U.S. economy, not just its owners.
But is the private equity business legitimate? Do private equity moguls create wealth, or do they merely transfer wealth to the richest of the richest 1% by sucking dry the companies they take over? And has creating wealth for themselves and their investor revived American capitalism as Brooks maintains? Before we can assess the record of these PE firms, we need to look more closely at how they go about making their money.
Inside Private Equity
Private equity is the new name for what used to be called “leveraged buyout” firms. PE firms are private partnerships that raise money from large investors, including pension funds, other investment funds, and wealthy individuals.
PE firms then use that money to purchase other companies, typically with the intention of selling them off within three to five years. That’s the “buyout” part of a leverage buyout.
But PE firms also borrow money, usually lots of it, from investment banks to pay for the companies they buy up. (The investment banks in turn package the loans into commercial mortgage-backed securities and sell them to other institutions.) PE firms’ extensive reliance on debt is the “leveraged” part of the buyout.
But taking out so much debt comes with a twist. PE firms make the companies they take over responsible for repaying the loans. That way, the PE firm and the investors in its funds risk only the money they put up as a down payment.
As the defenders of private equity tell the story, PE firms acquire underperforming firms and make them more efficient by jettisoning a company’s bad investments, cutting costs, and pushing the company into more productive investments. PE moguls, including Romney, like to think of themselves as engaged in an act of “creative destruction,” the phrase famed Austrian-born Harvard economist Joseph Schumpeter used for breaking the eggs necessary to make the omelet of innovation.
The result, when it works, is a more valuable company. The PE firm then sells the company back to the public, paying off its debt and making a profit. In addition to the profits from selling off a company, the PE firm partners collect a 2% to 3% management fee paid to the investors in the fund, as well as 20% of any returns to the limited investors that exceeded an agreed upon standard, usually about 7% or 8% a year.
This sounds plausible. But in fact,the story of Wall Street takeover artists whipping self-indulgent Main Street managers into shape to the benefit of all of us has some awfully big holes in it.
Holes in the PE Story
To begin with, it is not at all clear that PE firms take over “underperforming corporations.” For instance, average employment growth was actually stronger in businesses acquired by private equity in the five-year period prior to a buyout than in similar businesses, according to the very study that Brooks uses to argue that the effects on these takeovers on employment is modest. Similarly, economists Bo Becker and Joshua Pollet found that more profitable public firms are more likely to be taken over than less profitable public firms.
Nor is it clear that a PE takeover boosts the productivity of the companies they acquire in a sustained way. Several studies confirm that labor productivity of companies after they have been taken over by PE firms is higher than in other similar companies. Also these companies under PE management are much more likely to close divisions of their business with lower productivity than were similar companies not taken over. But as economists Eileen Appelbaum and Rosemary Batt rightly maintain in their thoroughgoing primer on PE firms, it is not possible in these studies to distinguish productivity increases due to greater investments in employee skills and new technology from those due to management’s intensification of work for fear of their company being downsized or closed.
Beyond that, these findings pertain to the time period when the target firms are managed by the PE firm, and have not assessed if those productivity gains are sustained after the firms are sold off. There are real reasons to doubt that is the case. With a heavy debt burden and pressure from their PE owners to boost profits in the near term, managers have every incentive to downsize jobs and to forego investments in new technology and employee skills. Two well-known studies of U.S. leveraged buyouts during the 1980s, one conducted by economists at the Brookings Institution and another by economists at the National Science Foundation, found that research and development expenditures in post-takeover corporations declined at the same time as research and development expenditures in other large corporations increased. That pattern surely seems to be at odds with a management strategy that would boost productivity for the long haul.
But the issue that most of us care about is whether PE firms create or destroy jobs. While PE firms surely create some jobs and destroy others, the net effect of PE takeovers in job destruction is hardly modest, as Brooks claims in his column.
Brooks bases this claim on the widely cited large-scale study conducted by Steven J. Davis and four other economists. Their study, “Private Equity and Employment,” surveyed private-equity transactions between 1980 and 2005. They conclude that, “employment shrinks by less than 1 percent at target firms relative to controls [comparable firms not taken over] in the first two years after private equity buyouts.”
But a closer look at the study suggests that the effect of PE takeovers on employment is far less benign than what Brooks and even Davis and his co-authors maintain.
For instance, their study also reports a “clear pattern of slower growth at [private equity] targets post buyout”—a difference of 3.2% of employment in the first two years post-buyout and 6.4% over five years. In the words of BusinessWeek reporter Peter Coy, that means “having your company acquired by a private equity firm is like living through a national recession.” So how do Davis and company nonetheless reach the conclusion that employment growth at private equity-owned firms is only slightly slower than at other similar companies? They include in their jobs total not only the net effect of employees hired and fired by the private equity owned company, but also add in any employees in businesses that the company acquired while the PE firm owned it.
Counting jobs created by PE investment in new ventures is reasonable enough. But the authors of the paper also add in the jobs in already-established companies the PE firm acquires. Those jobs might be new to the PE firm, but, as economists Appelbaum and Batt emphasize, they are not new jobs for the economy, and should not be included in any accurate tally of the jobs created by PE takeovers.
Despite their dubious employment record, PE partners benefit from the “carried interest” tax loophole, which will cost the federal government $13.5 billion in tax revenues over the next ten years, according to Obama administration estimates. This provision allows private equity capital managers (and hedge fund and other financial managers as well) to have their fees and share of profits treated as capital gains and therefore taxed at the 15% marginal tax rate, versus the 35% top tax bracket for wage and salary income.
But unlike the profits of other investors, carried interest is profit paid to PE partners for putting other people, not their own money, at risk. In addition, much of the earnings of PE firms, the majority of their earnings according to some studies, come from their management fees, paid to them by investors regardless of performance. And to its credit, the Obama administration has proposed repealing the carried interest tax loophole.
PE vs. The Public Interest
The truth is that the record of private equity managers is long on cost cutting, amassing debt, and destroying jobs as they enrich themselves, and short on creating jobs, fostering innovation for over the long haul, and paying taxes on the millions they accumulate. If being good for the economy and in that way serving the common interest is what makes a business legitimate, then not just Romney’s Bain Capital but the PE business as a whole has failed the test.