Plain Talk about Private Equity

January 15, 2012

There is clearly a role for private equity in the US economy. Successful companies too small to go public that are having difficulty raising capital for expansion  to capitalize on their success may turn to private equity for the infusion of capital they need to make acquisitions or to grow organically. Publicly traded companies that are doing okay but lag the industry’s leading firms can benefit from an influx of management know-how as well as capital if they are taken over by a private equity firm that includes among its partners managers with experience operating companies in the industry. Unfortunately, adding value and selling companies at a fantastic profit is not the only way that the partners in a private equity firm make fantastic amounts of money.
Private equity is part of the large shadow banking system in the US. It raises huge unregulated pools of money – not only from pension funds and endowments but from sovereign wealth funds like the Abu Dhabi Investment Authority and the China Investment Corporation – and spends these funds out of view of agencies responsible for assuring the stability of the financial system and out of sight of the American people. Incentives favor the high use of leverage – the borrowed money that is used to finance private equity transactions – and raise the odds of bankruptcy or other financial distress.  First, and most importantly, responsibility for repaying the debt incurred when the private equity firm borrows money to buy a company falls on the company that was acquired – not on the private equity firm.  The only money the private equity firm and the investors in its investment funds have at risk is the initial equity they put up as a down payment. Not surprisingly, they would like this to be as small as possible. Second and following from the first point, greater use of leverage magnifies the returns to private equity from its successful investments while minimizing the losses from its unsuccessful efforts.  Thus, a private equity fund can have strong returns even if some of the companies in its portfolio perform poorly or even go bankrupt. And third, the US tax code treats debt more favorably than equity since interest on the debt can be deducted from income.  In what might be called tax-payer funded capitalism, the reduced taxes from the higher interest deduction increase the firm’s value and returns to investors without creating any new value. My colleague at CEPR, Dean Baker, provides a simple example.
Managers in acquired companies that have been loaded up with too much debt face a situation with its own perverse incentives. The managers have been handed a debt structure by their private equity owners and have been told what return these investors expect. The promise to the managers, who typically have been given a huge equity upside, is this: If they can deliver, they will be richer than they ever dreamed possible.  The average time that private equity holds a company in its portfolio before exiting the investment is 6 years. What happens after that is of no concern to the private equity firm – or to the company’s managers, who will cash out when the company is resold. Managers of companies whose debt burden precludes them from investing in new technology, worker skills or organizational improvements have a strong incentive to downsize jobs. In the short term, at least, this will boost profit margins and make the company appear attractive to prospective buyers. This kind of downsizing is facilitated by the fact that in the US companies are not required to provide severance payments based on years of service to workers who are let go. An employee with a sterling record of performance over 20 or 30 years can be let go with little or no notice and without a severance package that recognizes his or her investment in valuable firm-specific skills. Executives expect a generous severance package and CEOs get golden parachutes, but there is no requirement for similar treatment of workers. Downsizing is costless to the company – at least over the short term.
The brouhaha over Mitt Romney and his time at Bain Capital has led to a lot of misinformation about private equity being bandied about by people who do – or should – know better. Credible research on the industry can help clarify what private equity does.
Misunderstanding  #1
“Private equity firms like Bain often seek to fix firms that have failed to adjust to economic change. This can mean downsizing, increased automation, offshoring, and the like” claims Josh Barro in Forbes.
A large-scale NBER study by a group of prominent researchers carefully matched establishments and firms owned by private equity with other establishments and firms in the same industry and with similar characteristics – firm age, firm  size, single or multi-establishment. The 2011 version of the study included 150,000 U.S. establishments and examined employment growth in these establishments over a period that extended from five years before a private equity buyout to five years after. As the study’s authors note (p. 17), Figure 5b shows employment growth was stronger in businesses acquired by private equity than in other matched establishments over the five year period before the private equity buyout.  Private equity may seek out firms that are undervalued, but it is clearly not true that private equity usually buys companies that are in trouble.  
Misunderstanding  #2
Employment in private equity-owned firms “maybe grows a tad less than in other companies” according to Steven N. Kaplan of the University of Chicago.
Kaplan is referring to the large scale NBER study referenced above.  As the authors of that study note, “there is a clear pattern of slower growth at [private equity] targets post buyout ….These differentials cumulate to 3.2% of employment in the first two years post buyout and 6.4% over five years” (p. 17). [Results reported by these authors in their 2008 paper of the same name, which includes an additional year of data and a much larger total of 5,000 firms and 300,000 establishments, are even more unfavorable towards private equity’s record of job creation)]. In the 2011 NBER paper, they go on to note that “[s]lower growth at private equity targets post buyout entirely reflects a greater pace of job destruction” (pp. 17-18).  So, how do these authors reach the conclusion that the difference in employment growth between target businesses taken over by private equity and other similar businesses (same industry, same size, same age) is less than 1%? When private equity buys smaller, privately-held companies, it grows them by acquiring other businesses and their employees. At the end of the day, more workers are employed at companies owned by private equity, but these are not new jobs and clearly these jobs were not created by private equity (see Table 7, p. 49 of the NBER paper for details).
Misunderstanding #3
Financial engineering by buyout firms “were common in the 1980s” according to Kaplan and his co-author Per Strömberg, but they belong to the bad old days. Things are different today.
According to Kaplan, “At the end of the day, in order to make money, you have to sell the company to somebody, and if the company … has been looted and is unproductive, nobody is going to buy it.” Yale University law professor Jonathan Macey puts it even more strongly in the editorial pages of the Wall Street Journal: “Because private-equity firms are, by definition, equity investors, they make money only if they improve the performance of their companies. Private equity is last in line to be paid in case of insolvency. Private-equity firms don’t make a profit unless their companies can meet their obligations to workers and other creditors.”
It is not necessary to deny that private equity firms can and do improve the performance of companies they acquire for their portfolios in order to acknowledge that sometimes they do make money via financial engineering or even by looting the companies they acquire. Financial engineering is alive and well and very much at work when private equity firms acquire a department store chain or a chain of nursing homes. Such companies typically own valuable real estate where their stores or nursing home operations are located.  A common model in such cases is to split the acquired company into two companies, both owned by the same private equity fund – a property company that owns the acquired business’s valuable real estate assets and an operating company that runs the stores or the nursing homes and now must pay rent to the property company for the use of the facilities that it previously owned. The department store or nursing home chain is acquired with equity put up by the private equity fund and with a high level of debt secured by the assets now held by the property company. After holding the real estate assets for a year or more to take advantage of the capital gains tax break, the property company sells the real estate. Certainly during the real estate boom of the 2000s, the sale usually took place at a high enough price to pay off the loans that were secured by these assets, repay the private equity investors for their initial equity investment, and even enable them to make a handsome profit.  Whether or not the department store or nursing home chain was made more efficient and value was created, the private equity investors will reap a positive return on their investment.  The Southern Cross nursing home chain in the UK, which made high returns for private equity company Blackstone, but went bankrupt a few years after Blackstone exited the investment, is a case in point.
Dividend recapitalizations, in which the equity owners recover their initial equity investment in advance of exiting the investment by paying themselves dividends out of the cash flow of the acquired company or by loading even more debt onto it, is another form of financial engineering that continues to be practiced by some private equity firms.  Such dividend recapitalizations appear to contradict the argument that PE returns come from building value in a portfolio company and derive from the difference between the price PE paid to acquire the company and the price at which it exits the investment.  Dividend recapitalizations are a transfer of resources from the acquired company to the company’s PE shareholders that may weaken the portfolio company by limiting its ability to invest in operational improvements.
‘Looting’ refers to the practice of bankrupting a company for profit. It occurs most frequently in circumstances in which the government can take over the company’s liabilities or can guarantee its obligations (see ‘Looting: the Economic Underworld of Bankruptcy for Profit’).  It may be perfectly legal. The bankruptcy of Friendly’s, the iconic ice cream restaurant chain, appears to be an example. A private equity fund sponsored by Sun Capital bought Friendly’s in 2008. In fall 2011, Friendly’s declared bankruptcy and sought to use the bankruptcy proceedings to write off debt and to rid itself of its pension obligations to its 6,000 employees and retirees and to transfer responsibility for these pensions to the Pension Benefit Guaranty Corporation (PBGC), a government agency. Another Sun Capital affiliate emerged almost immediately as the ‘stalking horse bidder’ for the bankrupt Friendly’s company.  The PBGC made clear its view that this was a transparent attempt by Sun Capital to keep Friendly’s but rid itself of its pension obligations and, in an unusual move, vowed to fight this. As Kaplan observed on NPR (see quote above), if a company has been looted, nobody is going to want to buy it. And indeed, no other bidders came forward at the auction in December to buy Friendly’s. Judge Kevin Gross approved the sale of Friendly’s from one  Sun Capital affiliate to another, and Sun closed out 2011 allowed to “buy” Friendly’s in a “credit-bid” sale. That is, Sun Capital got to hold onto ownership of Friendly’s just by wiping out a $75 million loan it had made to Friendly’s and assuming some of Friendly’s liabilities. Sun Capital got a partial write down of Friendly’s debt and expects to shed Friendly’s pension liabilities.
Misunderstanding #4
Pension funds and other limited partners, on average, earn much higher returns by investing in private equity than by investing in the S&P 500.
The lack of transparency in private equity, the unevenness in reporting results (successful fund results may be more likely to be reported than unsuccessful), and the self-reported nature of the data make it difficult to evaluate claims about returns.  A 2005 study by Steven Kaplan and his coauthor Antoinette Schoar  of returns to buyout and venture capital funds using data from Venture Economics (one of the commercial datasets), found that returns to limited partners in private equity buyout funds, net of fees and the carried interest collected by the private equity firm, were on average slightly less than what would have been earned by investing in the Standard and Poor’s 500 index.  The authors found that, on average, private equity investors earned 93% to 97% of what they would have earned by investing in the S&P 500 index. The authors focused on funds that had reached the end of their life cycle and were liquidated by 2001. Importantly, returns in this study are calculated based on actual returns to the limited partners and not on the subjective estimates of interim returns for funds not yet liquidated. The authors also found that fund returns vary widely. Returns for funds at the 25th percentile are less than two-thirds of the return of the S&P 500, returns at the median are four-fifths those of the S&P 500, while returns at the 75th percentile are 12 percent higher than those of the S&P 500. On a size-weighted basis, the returns are 72 percent at the 25th percentile, 83 percent at the median, and 3 percent higher at the 75th percentile. Returns for funds whose performance places them in the top quarter of funds outpace the market for publicly traded companies.  The problem for limited partners in PE funds is that not everyone can be an investor in the top quartile funds.  Most investors will not be able to gain access to the top funds with proven track records, especially investors that are new to private equity.  Reasons for this poor performance for fund investors include the high premiums paid to acquire companies and the high fees charged by private equity firms. Uneven reporting by private equity firms raises caveats about these findings. Only about half of private equity funds are included in the Venture Economics sample on which the analysis is based, so there is an unknown selection bias. It seems unlikely that the funds that report results to Venture Economics have, on average, poorer performance than those that do not report results.
In 2011, arguing that VE data on returns used in the earlier study understate buyout fund performance, Kaplan and a group of colleagues (in an unpublished paper) again examined returns to limited partners. This time the researchers used self-reported data from those limited partners that use Burgiss systems for record keeping and fund investment monitoring. Again, this is an incomplete sample that introduces an unknown selection bias.  The Burgiss data include the estimated value of any unrealized investments as of the reporting date as part of fund distributions at that date.  The authors report that unrealized investments are less than 3% for the median fund in pre-1999 vintages, but rise to 10% for the median 1999 fund, to 38% for the median 2000 fund, 55% for the median 2002 fund, 71% for the median 2003 fund, and exceeding 80% for vintages after 2003 (p. 15). Thus, the bulk of the fund distributions for 2002 and later vintages are estimates based on the performance of publicly traded companies selected by the limited partner as the benchmark for its companies in the fund’s portfolio.  It would seem that there may be a temptation for pension funds and other limited partners to choose the benchmarks they use to value their assets in a manner that places their investments in the best possible light. The exercise of valuing assets that are not publicly traded is inherently subjective and certainly there is no guarantee that companies in the fund’s portfolio could be sold at the price of the publicly-traded companies used as benchmarks. Using the Burgiss data to examine the performance of private equity buyout funds relative to the performance of public markets, the authors find that returns from investments in buyout funds exceeded stock market returns on average in every year from 1984 to 2008 with the exception of 1985, 1992, 1996, 2006 and 2008.
It is important to note that for the 2000 and later vintages these PE returns are largely based on estimates. In contrast to the earlier study, they are not based on returns that pension funds or other limited partners can take to the bank. Performance results in the 2011 paper are reported by size of the fund, but – again in contrast to the 2005 paper – results are not reported separately for each quartile of funds based on fund performance.  
The unknown, but possibly important, biases that result from the lack of transparency and public reporting requirements and the use of estimated values for companies still in the portfolio make it difficult to draw conclusions about how well investments in private equity perform for pension funds and other limited partners. It is anything but clear that these investments, on average, yield superior returns.
Let me conclude this discussion of private equity by reiterating that the debate is not over whether private equity has a role to play in the US economy; it can play an important role in providing operating companies with access to capital and to managerial talent. Clearly, some companies emerge from private equity ownership more successful than before they were acquired by private equity investors. There are lessons here for other companies, and work and employment scholars should study the successful transformations and share the knowledge gained of specific mechanisms for improving performance more widely.  But there are also widespread misunderstandings about private equity, and opportunities for high returns to private equity investors that do not depend on improving performance and creating value.
The debate over private equity should be over the rules of the game under which private equity firms operate.  Private equity firms may choose to pursue maximum returns for themselves and for the investors in their funds. But should they be able, under cover of the unregulated shadow banking system, to raise huge pools of capital and allocate them out of sight and without scrutiny? Or should there be requirements for transparency and oversight and clear rules that guide the behavior of private equity firms? Perverse incentives in the current context in which private equity operates can lead to overburdening portfolio companies with debt and increasing the risk to them of financial distress. High debt loads can leave managers of portfolio companies feeling they have no alternative but to downsize employment. As long as workers who are laid off do not have to be paid a severance package based on their years with the company, executives who expect to cash out in three to five years when the company is sold will too often have an incentive to choose downsizing over making the investments necessary to improve efficiency. The disparate treatment of debt and equity in the tax system that favors the use of debt, as well as the fiction that the share of a fund’s profits paid to a private equity firm’s managers is not income but capital gains, provide further perverse incentives. The lack of transparency and the absence of oversight and reporting requirements make it difficult to evaluate the returns to private equity investors and may distort the allocation of capital in the economy. We need to get on with this debate.

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