A Morning Edition segment today told listeners (sorry, no link yet) that "there's no doubt that private equity firms create value," which it then justified by referring to the high returns earned by those who invest in private equity (PE) companies. This is WRONG!!!!!!!!!!!!
First, it is not at all clear that those who invest in PE funds (not the PE partners themselves) do beat the stock market when a full accounting is done. Recent research shows that net of fees, private equity investors (pension funds and university endowments) would have been better off buying the S&P 500.
Furthermore, even if the PE investors did come out ahead, this does not mean it created value. Investors in Bernie Madoff's fund, who got out, made money too, but Bernie Madoff did not create value.
Much of what private equity does is financial engineering. For example, it is standard to load up the companies they purchase with debt. The resulting interest payments are tax deductible. This increases profitability but creates no value for the economy. It simply transfers money from taxpayers to the private equity company.
To take a simple example, suppose a public company (let's call it Gingrich Inc.), has $1 billion a year in profits. If Gingrich Inc. paid taxes at the full 35 percent rate (fat chance), it would have $650 million [thanks Robert] a year to either keep as retained earnings or to pay out as dividends to its shareholders.
Now suppose that a PE company (we'll call it Romney Capital) steps in. The current price to earnings ratio in the stock market is around 14, so Gingrich Inc. would have a pre-takeover market value of approximately $9.2 billion (14*$650 million). Romney Capital then arranges for Gingrich Inc. to borrow $6 billion which it pays out as a dividend to itself. This means that the Romney Capital has just gotten back almost two-thirds of its investment.
Suppose that Gingrich Inc. pays 5 percent interest on its debt (closer to the 5.20 Baa rate than the 3.80 Aaa rate). This means that before tax profit falls by $300 million. This leaves Gingrich Inc. with $700 million in before tax profit. Deducting the 35 percent tax, Gingrich Inc. now has $455 million a year to distribute to Romney Capital, 70 percent as much as before ($455 million/$700 million) even though Romney Capital has already recovered two-thirds of what it paid for Gingrich Inc.. In this case, the benefit to the Romney Capital came at the expense of taxpayers, not through the creation of value.
Now suppose that the Romney Capital arranges to sell off some of Gingrich Inc.'s assets, such as real estate or a highly profitable subsidiary, and then uses the proceeds to make a payment to the Romney Capital rather than leaving the money under the control of Gingrich Inc. Such sales may allow Romney Capital to recoup the rest of its investment and possibly more. Gingrich Inc. is then left as a highly indebted company with few assets.
In this story, Romney Capital may have earned a substantial profit on a limited investment (it recouped most of its money almost immediately when it loaded Gingrich Inc. with debt), without doing anything to improve the operation of Gingrich Inc. If Gingrich Inc. manages to stay in business and generate profits, then this will increase the return. Romney Capital may be able to resell the company and treat the whole sale price as profit.
On the other hand, if Gingrich Inc. goes bankrupt, this will primarily be a problem for creditors, since Romney Capital has already gotten its investment back. In effect, Romney Capital might have secured large gains entirely by financial engineering, while creating no value whatsoever.
The sort of asset stripping described here, which harms creditors by taking away potential collateral for their loans, violates the law. However it is extremely difficult to prevent, especially with private equity companies that have to make few public disclosures. If Gingrich Inc. were to fall into bankruptcy, this is the sort of thing that would likely be contested in the bankruptcy proceedings. Of course the resources used in fighting out this sort of legal battle are a pure waste from an economic perspective.
Anyhow, these are the sorts of issues that are raised with private equity. It is flat out untrue to say, as NPR does:
"Here's what private equity firms like Bain Capital do: First, they go out and find a few large investors — usually pension funds, university endowments and possibly wealthy individuals. Then, says Ohio State professor Steven Davidoff, they take that money, borrow a lot more, and buy companies — usually companies that are in trouble or undervalued.
'They buy them in hopes that they can increase the value of the companies and sell them at a fantastic profit,' Davidoff says."
Private equity companies absolutely do not have to increase the value of a company to make a profit. They can end up making a profit on their investment even if they take the company into bankruptcy and leave it much worse off than it was before the takeover.