New Book on Private Equity Tackles Myths About the Industry

May 16, 2014

The private equity industry is often at the center of a debate over whether it saves failing businesses or undermines healthy companies at the expense of creditors, vendors, workers and retirees. This should not be surprising. Since modern private equity got its start with the first leveraged buyout of a publicly traded company in 1979, the industry’s complex organizational structures allowed for little oversight and government regulation. Much of the analyses available on PEs are positive accounts by industry insiders and slightly more modest takes by finance economists, and as a result, it has been difficult to assess the economic impact of this $3.5 trillion dollar industry.

Noting this lack of transparency, the Securities and Exchange Commission (SEC) recently began an investigation of industry practices. Since 2012, SEC staffers have reviewed roughly 400 PE funds and the results are striking. Of the firms reviewed, general partners at 200 firms collected fees and expenses from the companies they managed without disclosing or sharing these fees with investors.

While the SEC examinations focus on the need for greater oversight of the industry, Private Equity at Work: When Wall Street Manages Main Street, by CEPR’s Eileen Appelbaum and Cornell University’s Rosemary Batt offers a broader and more comprehensive examination of the private equity business model and its impact on the U.S. economy and labor market. Their analysis draws on original cases, interviews with PE and pension fund managers, legal documents, bankruptcy proceedings and academic scholarship.

A big takeaway from Private Equity at Work is that the financial engineering inherent in the modern private equity business model creates a classic case of moral hazard. PE partners make all of the strategic decisions in acquiring companies and restructuring them, but have little to lose. The companies are typically bought with 30% equity and 70% percent debt, usually made up of the company’s assets as collateral. Private equity firm partners put up $1 to $2 of equity for every $100 contributed by pension funds and other investors – or less than 1% of the price to acquire companies. Despite this small financial investment of their own funds, PE partners collect 20% of any gains.

The PE firms are essentially wagering that the company will be sold at a profit, in which case the high level of debt magnifies returns. When the bet doesn’t pay off and a company goes bankrupt, the costs fall on companies and their stakeholders and not the PE firm. These bankruptcies rarely get much attention, however, because industry reports often show high rates of return. Appelbaum and Batt point out that these reports are problematic because they are based on a flawed measure of investment returns and not compared to alternative investments like the stock market. Over the course of 2013, for instance, PE funds did well but were outperformed by the far-less-risky S&P 500. As well, the bulk of research by finance economists looking at fund performance found more modest returns than the industry reports. Despite this, investors and other limited partners still pay millions of dollars in management fees each year under the impression that they will see gains that significantly outperform the stock market.

Private equity investments, as the authors demonstrate, sometimes have positive effects on acquired companies and their employees, PE investments can provide access to funding and management know how to upgrade operations, technology and HR systems and to create jobs.  For the most part, however, job destruction outpaces job creation once establishments and firms are acquired by private equity.

This leads to important contradictions for the unions and public pension funds that are major investors in private equity.  The mediocre returns they can expect to realize raise questions about whether this is their best investment strategy.  Moreover, union members and public sector workers may question whether it is in their best interest to invest in private equity, given its negative overall effects on jobs, wages, and inequality.

Private Equity at Work shows that the current private equity business model encourages risky behavior that can lead to financial distress and even bankruptcy. The authors point out that this does not have to be the case. Smart regulation can discourage PE’s use of rent-seeking strategies – extensive use of debt and financial engineering — that enrich PE partners at the expense of other stakeholders.  And it can encourage them to engage in improving the business strategies and operations of companies they acquire. This, after all, is what private equity firms say is their goal.

You can read more about Private Equity at Work here.

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