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Home Publications Blogs CEPR Blog Summers’ Review of Piketty’s Book Gets Private Equity Wrong

Summers’ Review of Piketty’s Book Gets Private Equity Wrong

Monday, 19 May 2014 10:49

Larry Summers in his review of Capital in the Twenty-First Century gives Thomas Piketty high marks for demonstrating “absolutely conclusively” that those at the very top – the top 1 percent, top .1 percent, and top.01 percent – have claimed an increasing share of income and wealth since 1980. Indeed, as Summers notes, the disparity between the top 0.1 percent and the rest of the top 10 percent has grown wider than the gap between the income of the top 10 percent and that of average income earners. As Summers acknowledges, this cannot be explained by a lack of worker skills.

What, then, does explain this growing income inequality? Summers begins by positing that much of what appears to be capital income going to those at the top is actually labor income. “[F]or example,” Summers writes, “some large part of Bill Gates’s reported capital income is really best thought of as a return to his entrepreneurial labor.” So, in Summers’ view, it’s really a question of understanding the large increase in labor income of the top 1 percent relative to the rest of us.  Self-dealing by executives of publicly traded companies, whose owners (the company’s shareholders) are too dispersed to effectively monitor them and whose directors are in bed with top management, is part of the story Summers tells. But this can’t be the whole story – productivity, he argues, must account for an important part of the income earned by executives. Summers knows this because the highest paid executives are, he claims, the ones chosen by “a single hard-nosed owner [who] is in control.” Summers bases his argument that executive pay reflects the productivity of CEOS on his assertions that the highest paid managers are not the top brass in publicly traded corporations but the “executives chosen by private equity firms to run the companies they control.” But private equity is notoriously private, and while CEOs of portfolio companies are highly paid, there are no data to show whether they earn more than other CEOs.  Moreover, as Summers observes, “the extraordinary levels of compensation in the financial sector” are a major contributor to the sharp rise in incomes at the top. And while he concedes that “over-financialization of the economy” may be a cause for worry, he is nevertheless certain that “much of the income earned in finance does reflect some form of pay for performance; investment managers are, for example, compensated with a share of the returns they generate.” 

This is an incredibly naïve, not to say disingenuous, view of how investment fund managers make their money – especially coming from Larry Summers who, after all, has held lucrative positions with Citigroup and the hedge fund D.E. Shaw, and has served on the boards of two start-up financial companies. Summers has earned more than $7 million working part-time on Wall Street since returning to his full-time faculty position at Harvard in 2011. Perhaps this infographic below of the private equity business model from our new book, Private Equity at Work: When Wall Street Manages Main Street, can help Summers understand how private equity works.

 The private equity business model is designed to funnel the lion’s share of income to the partners in PE firms who, as it happens, are the managers of the PE funds the firm sponsors.  CEOs installed to run the operating companies acquired by private equity know which side their bread is buttered on. Their job is to deliver results for the PE owners regardless of the effects – good or bad – on the productivity and competitiveness of the companies they were hired to manage. And they are richly rewarded for single mindedly serving the interests of the company’s PE owners.

fig 1.1 The Structure of Private Equity: Firms, Funds, and Portfolio Companies

As we show in Figure 1.1 of Private Equity at Work, which we adapted from Andrew Watt, the PE partners, who make all the decisions, contribute $1 to $2 for every $100 dollars that pension funds and other investors contribute to the private equity fund. The fund typically puts up 30 percent of the purchase price of a company it acquires, financing the other 70 percent with debt – debt that the acquired company, and not the private equity owners, must repay or face bankruptcy. Thus the PE partners have very little of their own money at risk – typically less than 1 percent of the purchase price of the companies their funds acquire. Yet these private equity managers typically receive 20 percent of the gain when the company is subsequently sold. This is a classic case of ‘moral hazard.’ The people making the decisions have very little to lose when deals go sour but much to gain if they succeed. The incentive to engage in risky behavior in this heads-I-win, tails-someone-else –loses environment is strong: and PE fund managers respond by loading acquired companies with excessive debt. It is this excessive debt and, contra Summers, not managerial performance in the generally understood sense of contributing to the growth of the economy as, say, Bill Gates has done, that is the source of the extraordinarily high incomes earned by investment managers. Moreover, the millions of dollars in management fees they collect from limited partners further amplify their earnings regardless of how the PE fund performs.

Meanwhile, at the direction of the hard-nosed PE owners who are in control, private equity’s hand-picked company executives have agreed to issue junk bonds and load their companies with even more debt in order to pay dividends to the companies’ owners. These so-called dividend recapitalizations repay private equity partners for most or all of their initial equity investments even before the companies are sold. Loyal to the PE firm that hired them, these executives sign contracts to pay excessive fees to the PE firms for dubious monitoring and advisory services, as recent SEC investigations have revealed. PE firms continue to collect these fees even as their portfolio companies head toward bankruptcy. And they collect the fees even after the company has been sold, for services they will never provide.

Leverage and a business model that funnels gains up from the operating companies at the bottom to the private equity firms at the top that are expert at extracting value are behind the high incomes of the private equity titans. It is leverage, not the greater scope that technology and globalization offer superstars – presumably including these high paid investment managers – that explains the latter’s membership in the 1 percent.

One of the lessons of the financial crisis is that leverage is dangerous to the stability of the financial system, especially when its use is not transparent and its effects are only poorly understood. Summers argues that there is more that can be done to raise middle class incomes and limit wealth accumulation than Piketty recognizes, and we agree. Limiting the use of debt would be a good place to start.

Tags: California | private equity

Comments (3)Add Comment
written by B, May 20, 2014 10:39
This article is premised on the ideological assumption that PE firms are evil parasites. Summers is not wrong, managers are paid according to their ability to generate returns on company assets - including the use of leverage. There are too many stakeholders involved for this business model to be as horrible as claimed by the article.

"Moreover, the millions of dollars in management fees they collect from limited partners further amplify their earnings regardless of how the PE fund performs."

Limited Partners have a small appetite for losses and large investment funds demand significant returns. Any PE fund that lost money for its limited partners over an extended period would quickly go out of business - they must be profitable in order to attract new capital and retain investors. Clearly, a fund with poor performance would lose its clients, earning no management fees.

"PE firms continue to collect these fees even as their portfolio companies head toward bankruptcy."

Some businesses fail, but the majority of PE investments avoid bankruptcy. Again, if PE firms drove their investments into bankruptcy, two things would follow: 1) limited partners would stop investing; and, 2) banks and creditors would stop lending. Given that creditors are willing to buy the debt (or banks are willing to lend it), the logical assumption is that the majority of the PE firms investments are successfully able to manage the debt service.

There are many more economic problems within this article.

Most PE investments are able to: 1) service the debt, 2) reward limited partners, 3) reward general partners, and 4) maintain stakeholder relationships.

Next time, just come out to say that you feel ideologically that PE firms are rentiers who's behavior is repugnant because it steals. However, you don't even say who you feel is being damaged in this arrangement. You only lament that the 1% managers are getting richer and that the PE investments serve only the PE firm's goals. In most cases, however, the businesses in which PE firms invest would likely cease to exist without that investment - meaning all the stakeholders(employees, community, suppliers, managers) would be let go. So what is the problem that PE firms service their own interests? Are we not all in the business of maximizing our utility?
Remarkable how industry defenders find these post
written by Yves Smith, May 20, 2014 5:27
Unlike the author of the first comment' I've read most of Appelbaum's and Batt's work, which is a remarkably thorough compilation and analysis of information about the private equity industry. It is most decidedly not ideologically driven but data and research based.

The book documents how fewer PE owned companies went bankrupt in the last cycle because the PE firms have been able to engage in "amend and extend" otherwise know and "amend and pretend" strategies. And if you do the math, as other writers on PE have done, PE firms profit even when they drive firms into bankruptcy and deliver losses to the limited partners.

The book, as well as a recent report by McKinsey (which has every reason not to be critical of the industry, since it is a major source of fees to the firm) have pointed out that investors are in fact becoming disenchanted with PE as returns have flagged.

A particularly devastating section of the book discusses performance measurement. The most credible studies of PE performance show modest or no outperformance relative to investing in a comparable risk stock index. That means investors are being undercompensated for the illiquidity risks they are taking.

So the person who looks to have the ideological bias is the initial commentor. Textbook case of projection.
Why is this even legal?
written by Argosy Jones, May 22, 2014 4:09
There are too many stakeholders involved for this business model to be as horrible as claimed by the article.

There were a lot of stakeholders in the 2000s housing bubble as well. This argument is badly flawed.

The fund typically puts up 30 percent of the purchase price of a company it acquires, financing the other 70 percent with debt – debt that the acquired company, and not the private equity owners, must repay or face bankruptcy.

I don't understand this. If the private equity guys acquire the portfolio firm, why aren't they on the hook for the debt like any normal loan? How is this not some kind of scam?

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