Sunday, June 10, 2012

Private equity stories; gains, losses, heros and villains..

Wow.  What a title.  

Several days ago I linked to this blog post and this one, by Noah Smith in Noahpinion, which in general is one of my favorite economic blogs.  It’s a fun blog to read, and Smith sometimes grazes in the higher meadows, which is also fun.
 I talked about the argument presented in the first of these as an example of the kind of economic storytelling, or of economics as a kind of storytelling, that the second of these references criticized.  If economics is only storytelling, then we can all select the story we like and cling to that.
His post was all about Private Equity (PE) firms like Bain Capital, which is already a controversy in the presidential campaign.  The story he tells about PE (private equity capital, and primarily hostile takeovers) is that they increase efficiency, both in the firm that is taken over and in the general economy in which it operates.   Dr. Smith argues that Japan is filled with the kind of ossified, highly inefficient firms that would benefit from a big dose of hostile takeovers.  Here’s his description of a typical Japanese company:
“Employees sit idly in front of their computers waiting for the boss to leave so they can go home, or make busy-work for themselves, copying electronic records onto paper (yes, this is real!). Unproductive workers are kept on the payrolls because of lifetime employment, with high salaries guaranteed by the system of seniority pay. To this, add endless meetings, each of which must be exhaustively prepared for in advance. Layer upon layer of bureaucracy with poorly defined accountability. Pay based entirely on tenure rather than merit.”
This Japanese work culture, he argues, could be cured by the application of PE managers with their cold-eyed focus on efficiency and on getting rid of deadwood in the pursuit of company profits.  But even apart from the issue of any possible salutary impact of private equity capital firms like Bain, I find this description of Japanese management fascinating; I remember a couple of decades back when the business world was awash in books like this or this or this, about how we should all emulate the superior Japanese management methods.
This vision of private equity as a kind of stimulant to economic efficiency, and a kind of recycling agent restoring life to run-down firms, is one story about how PE operates, but it isn’t the only one.  I’ll tell three stories here.  The first is the most like the Noahpinion version, although I think Noah Smith is far too smart to accept this classical version in its pure state as I tell it here.
But here goes.
The first PE story sees private equity managers as risk-takers very like the venture capitalists who fund startups, except that the ventures they embark on and invest in are established companies that need to be refreshed, renewed, or redirected.  They are the story’s good guys---admittedly greedy good guys who make huge profits, but still good guys.   These good guys take over a (possibly wobbly) existing business and improve its operations enough to stabilize it by finding and ending inefficiencies, by making better product and publicity decisions, by replacing a complacent, overpaid and uninspired management, and so on.   The value of the company rises, both the company’s shareholders and the deserving private equity managers reap their justified and hard-won rewards, and the latter move on to save other companies.  It’s true, even in this version of the PE story, that often the process of improving efficiency is full of “hard choices” (in quotes because the choices aren’t necessarily hard for those who make them; it’s a word used to describe decisions that impose losses on others).  Sometimes people must be fired, plants must be closed, wage or pension contracts must be renegotiated, but PE managers sometimes argue that the alternative is to have the company bumble along until it is bankrupt, which would mean that all of its employees would be unemployed rather than only some of them, and all would suffer reduced income, and loss of pensions.   Or, at a minimum, they argue that the efficiency they gain more than compensates for the costs they impose, meaning that the gainers gain more than the losers lose.  They, the PE managers, are making tough but necessary choices.   The surgery is hard but they are saving what they can so that the patient can live and prosper in the future.  And if the employees really are worth the wages they were being paid before the takeover, then they will not have to accept a wage cut because other companies will offer them the wage they are worth, and they will simply move to other jobs instead of accepting lower income.
There are other things to say about the impact of this process on its participants.  Let’s tell the other stories first, but I do want to come back to the impacts on those who lose, and on those who gain.  You may have noticed, for example, that it’s the employees and suppliers who lose, and the existing and new shareholders who gain.  There’s a lot to talk about there.  Maybe I’ll do that another day, though.
The second story I want to tell is the very opposite of the PE manager as a good guy: in this version he’s the bad guy.  This is the story Rick Perry and Newt Gingrich tried to tell about “vulture capitalists”.  In this story the private equity investor isn’t looking for a company to save; he really doesn’t care much about what happens to the company in the long run.  Instead, he looks for a company that has good credit, or large amounts of retained earnings, and when he finds one he raises money using junk bonds to buy it---and then uses the company’s own credit or retained earnngs to pay the junk bonds off, so the transaction costs him little or nothing, and he ends up owning the company!  And the story goes on from there: the equity capitalist can use what remains of the company’s retained earning or credit to borrow large amounts of money which he keeps for himself, or for his investors, as a “management fee”.  And now the company, which was healthy before the PE firm discovered and attacked it, is in debt and in trouble. In this story, the PE manager is not looking for a company to save; he’s looking for a company to loot.  But what will he do with this company that he owns, now that he has used up its retained earnings and its credit?  Well, he can then try preserve some value by making all those “hard choices” we talked about in the first story, by renegotiating pension contracts or just capturing and using the retirement fund, or by firing workers or lowering their wages.  But now the shareholders of the original company are among the losers: they had a good investment, and their employees had good, secure jobs, all of which is wealth.  The private equity firm invests very little of its own money, ends up pocketing huge management fees, and extracting a large part of the wealth of the firm, before it sells its shares and leaves the company to wither under the burden of its new debts.
Sounds pretty aweful.  But here’s the third story: it’s the one that is told by Andrei Schleifer and Larry Summers in the paper, or book chapter, referenced in the Noahpinion blog post I linked to above.  I looked it up and read it.  This paper remarks that “corporations represent a nexus of contracts, some implicit, between shareholders and stakeholders”.  This sounds a bit like the way I described households a few blog posts back, and it is: any organized collection of people, like households and businesses, and also like clubs and churches and charities, represent a nexus of contracts, and the truth is that most of those contracts are implicit because drawing up signed paper contracts for every last thing would be exhausting and prohibitively expensive.  The contracts Schleifer and Summers are considering are embedded in culture, both national culture and corporate culture.  The idea is that when, for example, a company hires a new employee, and keeps the employee through some conditional period, there is---or was, when I was young---an expectation of sorts on both sides.  The employee expects that his job will have at least some job security, that the company will do its best to survive over the long run, if there is a retirement system he or she will get a share of it, and so on; and the company expects some loyalty and personal investment from the employee.  This is an implicit contract, an item of trust, which binds the employee and the employer together, and based on that trust, based on the sense of security and continuity the company has implied is valid, the employee may “put down roots” in the company’s vicinity and in its goals and culture.  He or she may buy a house and enroll children in costly local schools, he may make friends and join churches or other groups, he may take training that is valuable specifically to that company or that area, and so on.  All of these things take an investment of time and money, and all of it is wealth of a sort, non-financial wealth, to the employee.  Similarly, a supplier of resources to the company may make specialized capacity investments that increase their capacity to produce the resources the company needs in the area in which the company needs it, based on an expectation that the company will be a continued customer for a substantial time, at least for enough time to make the investment worthwhile.  These implicit contracts all provide value, or wealth, to both sides, and they are part of the reason that people who have choices choose the way they do; without these implicit handshake contracts companies might have to pay higher wages or higher prices for inputs to compensate employees and suppliers for having to endure higher risks.  The story Schleifer and Summers tell about hostile takeovers is this: the wealth that is gained by the private equity firm’s shareholders when a hostile takeover happens is not necessarily due to improved efficiency or better management.  That wealth may be a pure transfer of value from stakeholders (employees and suppliers, for example) to shareholders that is gained simply by violating all of those implicit contracts that looked good when they were made, and may still be good for the company in the long run, but which can generate short run visible improvements in profits.    For example, the new management can drastically reduce investment in R&D, or can eliminate jobs in areas that may be important but don’t show up quickly in the bottom line.  They may “raid” retirement funds, if there is any legal way they can get at them, because at least some of the expectation that retirement fund management will be honest and that the funds will be used entirely to secure the retirements it is supposed to provide, can be an implicit contract, a contract that binds the company’s existing management but which does not bind the new management under the new PE owners. The pre-takeover shareholders of the company, if they are smart insiders who see this entire process happening, may sell their shares, and take home a profit.  But suppliers and employees suffer outright losses, and those losses may become the shareholders gains.  In this story the PE managers are not greedy good guys or psychopathically greedy bad guys, they are just ruthless business people whose profits come from transferring wealth from trusting workers and suppliers who had foolishly depended on the good word of the company’s prior management.  The PE managers transfer value to themselves and to other shareholders by raiding the value contained in implicit contracts.  They are not exactly robbing the poor to pay the rich, since it can be argued that the wealth the suppliers and employees felt was all a mirage based on na├»ve trust.  But they are mining the value that can be extracted from trust relationships, and they are taking that value from people who are powerless to prevent it.   And in the long run, since they have completely spent all the trust the company had, the new management may have to pay more for inputs of all kinds, and spend much more on creating costly but explicit, legally binding contracts.  For this company, under this new management, a handshake won’t work anymore, and that is actually a true loss of wealth: but that loss won’t show up in the bottom line for several years.
Which of these stories about private equity is true?  I think the answer to that is “yes”.  Yes, at one time or another, in one deal or another, private equity firms have behaved in all of these ways, sometimes even in all of these ways at once.  And the fact that each of these stories is true at one time or another, with one firm or another, may have some implications about the impact of PE on the general economy.  Because if either of the latter two stories is even partly true then the economy as a whole has lost something when a takeover happens.  In the first story the PE firm can argue that there are those who lose and those who gain, but the gainers dominate, and the economy improves on the whole.  They can even claim, as Dr. Smith was claiming, that the presence of takeover companies will induce increased efficiency in firms that are never threatened with takeovers, simply because they know they could be subjected to a takeover bid if they relax too much.  But in the middle story the economy as a whole has lost a healthy company that simply failed to defend itself sufficiently from wolves.  In the last story, the company has lost the trust of its suppliers and employees, but these same suppliers and employees will be slow to trust any other company too.  And Schleiffer and Summers paper presents some evidence that this has happened.
At the end of the Noahpinion post, as a postscript, Dr. Smith links to this post in Paul Krugman’s blog, which has a good discussion of whether the relaxation of business rules in roughly 1980 that allowed much wider scope for hostile takeovers increased or decreased the efficiency of the U.S. economy. Krugman offered this chart:

Krugman’s comment in looking at the graph above was this:
"Let’s look at how trends changed after 1980 or so, when the underlying rules of American business (and politics) shifted. Start with productivity – I use a log scale, so that the slope of the trend represents the rate of growth. See the big acceleration? Neither do I – productivity growth has actually been slower since the rise of Bain-type operators.”
For the record, I don’t see any big acceleration around 1980 either.  This doesn’t prove that the PE has failed to instill greater efficiency in the economy as a whole.  But it certainly does not provide any evidence of success.

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