Everyone Benefits From Private Equity's Value Creation | Opinion

Nearly 20 years ago, I was teaching American business law to professors in a summer program in Genoa, Italy. Being highbrow Europeans, many of my students looked down on the material. However, one aspect of American capitalism was a well of deep envy—private equity. These academics pointed to private equity as one of the key differences that make the American economy the most innovative and productive in the world.

After all, European workers are just as capable, just as smart and just as creative as Americans, but American companies are universally acknowledged as the world's best. This isn't patriotic pride talking. In a famous study, Nicholas Bloom and John van Reenan, two British-born academics, demonstrated that U.S. firms are the best-run in the world, on average. Better management matters because it generates more wealth from the same stock of inputs. The average American firm generates more social surplus—the sum of producer and consumer surplus—out of every dollar, every hour, every idea and every molecule invested. That is more wealth for all of us, which can be used not only to purchase more goods and services, but also by government (through taxes) to create public goods. Efficiency drives progress.

Where does better management come from? Bloom and van Reenan show cross-country differences are explained largely by the lack of poorly run companies in the U.S. There are extremely well-managed companies in every economy, but the U.S. has few laggards compared with every other country—even high-performing ones, like Germany and Japan.

This is where private equity comes in—it is a key mechanism for bringing up the bottom. Here is how this works.

Imagine the lifecycle of a typical company. It is founded with a good idea, a solid capital base and motivated employees who own the business. The founders run the business, and their fortunes rise and fall with the decisions they make. It creates wealth and jobs, and it benefits its communities. The business grows. After a while, the founders cash out, retiring somewhere warm. Managers are hired. Shareholders are no longer running the business. This means that there is an inevitable wedge between the interests of managers and owners—what economists call agency costs. Agents (in this case, managers) may make decisions that benefit themselves, and not their principals (in this case, owners). Conservatism seeps into decision-making, replacing risk-taking, and it is taking risks that create wealth. Competitors have better products and lower costs. The company survives, but it becomes bloated and sclerotic. The resources it is using—labor, capital and physical stuff—could be used better somewhere else, but they are stuck because of inertia and some residual goodwill. Society is poorer because its scarce resources are trapped in uses worth less than their potential.

There are two possibilities. The business can die. If it died quickly and its resources were immediately redeployed to more productive uses, this might be a good option. But bankruptcy is expensive (the lawyers and bankers must be paid), and the disruptions it causes—lost jobs, assets sold off, brands retired—are real.

The other possibility is that the business can be saved and reinvigorated. This is a better choice if there is value to be tapped in the business, as it exists. If costs can be cut, processes improved, new products introduced and markets reached, and efficiencies can be found, the business can remain a valuable use of societal resources. This option is unlikely, however, because it is difficult to move the owners—millions of shareholders dispersed across the globe—to action, especially with risk-averse managers in charge.

Enter private equity. In the typical private equity investment, an investment fund uses money raised from wealthy individuals, pension funds and endowments of universities and charities to buy the company. The fund borrows money from a bank, using the assets of the company as collateral. It takes over the equity from the dispersed shareholders, returning the company to the place where it was when it was founded—managers as owners, instead of agents. The CEO of a typical company owns one percent of the company, if that. The private equity fund installs management with many times that stake. CEOs of private equity-funded companies routinely get five percent of the company, with the management team owning as much as 15 percent. The fund owns all the rest. Again, the fortunes of the company are linked with the fortunes of the managers. Private equity managers put operational teams in place across the business, and they develop detailed plans to improve performance. The result is returns that are at least five percentage points better than public companies.

This extra return goes to the pension funds and universities and religious institutions, as well as wealthy individuals. They all put it to use, investing in jobs, inventions, cures for diseases and such. Government takes a chunk of the extra money and spends it on things for the public, too.

But there is more benefit than just this extra return.

Public companies have a host of obligations that companies taken private can avoid. Meeting quarterly earnings expectations is thought to encourage short-term thinking instead of long-term investment; private companies have no Wall Street mobs baying at them. The government requires public companies to disclose thousands of pieces of information, much of which is not valuable to shareholders, the supposed beneficiaries. For instance, public companies are required to disclose whether their supply chains contain any product that uses minerals designated as "conflict minerals." A study found that we all pay at least $700 million per year for this information. And to make matters worse, academics who have studied the impact of conflict minerals disclosures find that it has had no beneficial effects. Private companies avoid this waste.

Board meeting in the 1990s
Board meeting in the 1990s Getty Images

More generally, being able to "go private" provides a check on mismanagement, whether it is by the C-suite or by K Street. Managerial slack and government overreach are both constrained by the existence of a private alternative. In this way, the value of private equity is an iceberg. The few companies that are taken private every year, and the excess returns they make, are the bit above the water: big and important, but hardly the whole story. The giant mass below the surface is the companies that have better management because of the threat of being taken over (and the management ousted and replaced by private equity executives). Bad companies in America get eaten, and every other company sprints faster, knowing the savannah is ripe with predators. Private equity is the great discipline of American capitalism.

The same logic works for government regulation of public companies. The U.S. has seen a 50 percent decrease in the number of public companies in the past two decades, in significant part due to the increasing costs of government regulation. Companies that go private not only can increase efficiency by avoiding this regulation, but also send a bill to government that limits potential regulatory overreach.

One could argue that the same benefits could be achieved by companies merely staying private in the first place. This is true and is also happening. But it isn't enough. Companies aresometimes most efficient when they are private, and sometimes when they are public. All companies start out private, and many grow to the point where selling shares to the public makes sense, as it allows them to lower their cost of capital. But things change, and some of these public companies become less efficient in that form and would benefit from becoming private again. The doors of capital must swing both ways. Private equity funds provide an invaluable service by completing markets and letting firms maximize their value in all states of the world.

Takeovers don't always work. While private equity-backed companies outperform their private market competitors and, studies show, perform better on worker safety and other non-monetary dimensions, sometimes they take on too much debt and die. In these cases, a liquidation would have been better. But that private equity buyouts aren't foolproof doesn't mean they aren't socially valuable. Not only does the average fund return significantly more than similar money invested in public companies, but the threat of private equity provides an essential service in motivating every company to be better. The result of that is that American businesses are the envy of the world, from Genoa to Guangzhou.

To outsiders, the private equity world may seem like a waste. Villains in business movies are often investment types, as opposed to builders of things. Before he was redeemed by the prostitute with the heart of gold, Richard Gere's character in Pretty Woman was a private equity guy. Then he decided to build boats, instead of buying and breaking up companies. But while it is easy to criticize those who grease the wheels of capitalism and envy the outsized incomes they earn, the envy of my students in Genoa is much closer to the mark. American society devotes substantial resources to the private equity industry, but the return is paid back many-fold by increasing the productivity of every business. We all benefit from that.

M. Todd Henderson is professor of law at the University of Chicago Law School.

The views expressed in this article are the writer's own.

Everyone Benefits From Private Equity's Value Creation | Opinion | Opinion