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Home Publications Blogs Beat the Press Are Private Equity Firms Evil Doers?

Are Private Equity Firms Evil Doers?

Wednesday, 11 January 2012 05:59

The NYT had an article discussing whether private equity firms are good or bad for the economy. The piece failed to focus on the real issues.

The focus of the piece is whether private equity increases or decreases the number of jobs in the firms it controls. This is not really a good measure of whether the industry is good or bad for the economy.

If private equity firms were successful in making companies more efficient and lowering prices to consumers, then it could lead to more jobs in the economy, even if there were fewer workers directly employed in the firms under its control. (This does not really apply in the current economy, where inefficiency means more workers are employed. This is good in the context of a poorly managed macroeconomy with high unemployment.)

However private equity firms do not profit just by making firms more efficient. Private equity also profits by financial engineering. For example, it is standard practice for private equity firms to load their firms with debt. This means that interest payments, which are tax deductible, are substituted for dividend payments, which are not tax deductible.

Private equity companies also often force firms into bankruptcy to offload debt. This can often include pension obligations, which are then taken over by the Pension Benefit Guarantee Corporation. Insofar as private equity companies are drawing their profit from this sort of financial engineering, it is not providing a benefit to the economy. In fact, it is a direct drain on the productive economy.

Clearly private equity companies engage in both practices (increasing efficiency and financial engineering). There is no definitive study showing which is more important to its profits and whether the efficiency gains exceeds the waste associated with financial engineering.

At one point the article quotes R. Glenn Hubbard, the dean of the Columbia Business School and one of Mr. Romney’s economic advisers (who also played a starring role in the movie Inside Job), saying:

"private equity firms have an impact on productivity ... That doesn’t mean that people don’t lose their jobs. But the question of whether private equity adds value? It’s settled among economists."

It would have been helpful to include the view of a less partisan economist who could have told readers that this is not true.

Comments (6)Add Comment
Private Equity Firms Don't Make Stuff - They Just Make It Better, Low-rated comment [Show]
private equity have LBO'd the USA?
written by Blissex, January 11, 2012 6:25
«For example, it is standard practice for private equity firms to load their firms with debt.»

But usually not to the private equity purchasers, who usually have very little capital. They borrow most of the price of purchase, to goose returns on their own capital. "Private equity" often don't have that much equity invested.

«This means that interest payments, which are tax deductible, are substituted for dividend payments, which are not tax deductible.x

That's a weak point. in an LBO situation often the buyer loads the business with debt to pay out huge dividends (to companies, to turn them into capital gains). Also the purchased business usually takes on the debt used to buy it.

After whatever can be taken has been paid out (asset stripping) then the business is indeed often put into bankruptcy:

«Private equity companies also often force firms into bankruptcy to offload debt.»

Sure, but that often wipes out the buyer's equity interest. So it is done only after equity extraction in the form of huge dividend payouts or other trickery. Pure bankruptcy as in Chapter 11 reorg (instead of Chapter 7 liquidation) is often chose by management, not owners, because management usually survive it even if owners get wiped out. Chapter 11 is a fantastic option for management especially if they have paid out huge "dividends" to themselves as bonuses.

«This can often include pension obligations, which are then taken over by the Pension Benefit Guarantee Corporation. Insofar as private equity companies are drawing their profit from this sort of financial engineering, it is not providing a benefit to the economy. In fact, it is a direct drain on the productive economy.»

What if the whole USA have been financially engineered, quite deliberately, by "private equity" interests? Consider the following set of operations:

* Encourage borrowing to create huge asset bubbles and take over the government thanks to middle class losers thinking that they are becoming rich quick.

* During asset bubbles pump-and-dump old money assets so they can be sold to the middle class losers at very high prices, to cash in capital to offshore investment to high-growth/low-cost countries.

* On the back of the tax surge created by fake prosperity of the asset bubbles, take out huge dividends in the form of massive tax cuts for the wealthy, massive war spending, funded by enormous increases in borrowing and significant welfare cuts for losers.

* When the bubbles end, transfer private debt to the government, and then note that the government has got even more debt, and put it in effect into Chapter 11, saying that to repay debt existing obligations to losers must be canceled, and taxes must be cut to avoid wealthy people offshoring themselves following their assets.

Country LBOs have been done in the past by crony capitalists.

Sometimes I suspect that a large part of the story has been shale oil: it is the only major unmined resource left in the USA. But taking it out requires strip mining on a devastating scale. LBO'ing the USA has creating the right political and economic environment ("drill baby drill") where middle class losers desperate for their (remaining) pensions will enthusiastically vote to turn their own country into a wasteland to the benefit of asset strippers, hoping to get the crumbs.

As always Norquist is a prophet:

«The 1930s rhetoric was bash business — only a handful of bankers thought that meant them. Now if you say we’re going to smash the big corporations, 60-plus percent of voters say “That’s my retirement you’re messing with. I don’t appreciate that”. And the Democrats have spent 50 years explaining that Republicans will pollute the earth and kill baby seals to get market caps higher.
And in 2002, voters said, “We’re sorry about the seals and everything but we really got to get the stock market up.»
There are two different types of private equity operations
written by Blissex, January 11, 2012 7:06
«Clearly private equity companies engage in both practices (increasing efficiency and financial engineering).»

Part of the confusion in your discussion of "private equity" is that there are two very distinct types of private equity businesses and private equity firms rarely do both: venture capital and leveraged buyouts.

VCs have lots of equity to invest, buy underperforming companies with good business fundamentals and put in capital and usually new management to raise their efficiency, and the goal is to either create a stream of earnings or to resell the company at a higher price. The less ventureful type is Berkshire Hathaway, which buys into undercapitalized companies with good management; the more ventureful type are Silicon Valley investors, which usually put in both management and capital.

Some VCs extract earnings from the company by lending it money, but that's rare because in general the goal is to cash in capital gains. The lending money tax avoidance is more often done by family owners.

LBOers instead tend to have very little equity, and borrow most of the capital to buy into undervalued companies with bad business fundamentals. The companies are undervalued because they still have valuable assets that are discounted because of the bad business prospects.

The goal of the LBOers is to separate the valuable assets from the bad business prospects: the valuable assets to themselves, the bad business prospects to employees, pensioners, creditors. They do this by buying a company with lots of debt and little of their own capital, installing management that they control, an via that management liquidating the valuable assets and paying themselves the proceeds with dividends (or less savoury mechanisms, but the goal is not tax avoidance, just tunneling), and transferring the acquisition debt to the company itself.

The two "private equity" businesses tend to be done by different firms because firms with a lot of capital have little interest in leveraging it and have to use it up by injecting into their purchases, and those without a lot of capital don't have enough to inject, and therefore lever it to gain control of a company and tunnel out what capital it has left. Thus usually firms with lots of equity to invest are "turnaround" specialists, and those with less equity are "stripping" specialists.

When some credit bubble is booming some LBOrs try to get into the "turnaround" business, but it usually ends badly (in the sense that they don't even get to end being able to do "stripping").

The LBOers business model is in effect thinly veiled bankruptcy
fraud, and my usual Tocqueville quote that this has been a Real
American tradition for centuries:

«Consequently, in the United States the law favors those classes that elsewhere are most interested in evading it. It may therefore be supposed that an offensive law of which the majority should not see the immediate utility would either not be enacted or not be obeyed.
In America there is no law against fraudulent bankruptcies, not because they are few, but because they are many. The dread of being prosecuted as a bankrupt is greater in the minds of the majority than the fear of being ruined by the bankruptcy of others; and a sort of guilty tolerance is extended by the public conscience to an offense which everyone condemns in his individual capacity.»

In some ways even LBOers raise productivity, by "liberating" assets from companies with bad businesses and letting them go bankrupt, thus realizing the "destruction" part of "creative destruction". But they make a lot of money by solving a problem of institutional friction, not an economic one.
interest payments are tax deductible?
written by Union Member, January 11, 2012 7:43

..."There is no definitive study showing..."

Would it be a cost effective use of taxpayer's dollar's to fund such a study?

Not only could such a study lead to more efficiency and greater productivity, it might also reduce global warming by reducing the amount of gas and hot air in the economy.
Of course who would conduct such a study should be decided in a general assembly of Occupy Wall Street, because -unlike Washington - the issue will get a full and open hearing.
The "Economy"
written by Jeffrey Stewart, January 11, 2012 9:17
There are at least three prior questions needing answers before whether private equity capitalists are good or bad for the "economy."

First, what is the "economy" but the society's people? The purpose of an "economy" is producing and distributing the means for satisfying human needs and wants.

Further, capitalist society is generally divided into two main classes: the capitalist class and the working class. Thus, the question is whether private equity capitalists benefit the capitalist class or the working class. This answer is obvious even to a neoclassical economist.

Second, what is profit's origin? This question needs to be answered before one discusses its distribution among financial and industrial capitalists. However, this is a question neoclassical economists (e.g., University of Michigan economics Ph.D.s) don't even ask because they have no answer.

The neoclassical economic position is that profit is the opportunity cost of capital. It's the cost to the "firm" of having a private owner. It's the profit that could be received if the money capital was invested in a different company rather than the current one. However, this doesn't even come close to answering the question of its origin.

Last, productivity is just another word for making workers work harder (intensifying labor) or firing some workers and replacing them with machines causing unemployment. Thus, the other side of the "economic productivity" coin leading to lower commodity prices is the effect on the working class, i.e., the newly unemployed.
written by ezra abrams, January 11, 2012 8:03
Dr Baker:
the pension fund looting has always seemed to me the only really usable argument against bain/romney; in the real world, where most votes are still decided by the mainstream media, you need a really simple, simple story with a clear victim
looting pension funds is that story
why on earth havn't people gotten onto this ?
PS: can you do something about your captcha, which is way way to hard ?

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.