Private Equity Captures Rather Than Creates Value | Opinion

A perplexingly common mistake among market evangelists is the assumption that wealth amassed represents value created. "There is one sort of labour," wrote Adam Smith in The Wealth of Nations, "which adds to the value of the subject upon which it is bestowed: there is another which has no such effect. The former, as it produces a value, may be called productive; the latter, unproductive labour."

Wealth can be a sign that tremendous value has been created for investors, customers and society more broadly. But wealth can also be captured rather than created. And while that works well for the capturer, the game is zero-sum, or even value-destroying, in aggregate. The private equity industry offers a fascinating case study in the importance of distinguishing between these scenarios.

What Is Value?

Suppose a private equity fund pays $100 million to acquire a closely-held family business that treats its workers with generosity while earning the owners a healthy annual profit of $10 million. The fund managers slash compensation, renegotiate supplier contracts and move production offshore. These "operating improvements" save $5 million annually, boosting profit and delivering an "exit" price after five years of $150 million. The fund takes $20 million in "management and advisory fees" and returns the rest to investors, yielding them roughly what they would have earned had they placed their money in an index fund over the same period.

What wealth has been created? What value? Investors are no better off than had the whole process never begun. Customers continue to pay the same price for the same product. The eventual acquirer has a more "valuable" company for which it had to pay a commensurately higher price. Suppliers and workers are worse off and receiving less income than in the past, while the fund managers now have $20 million more. No wealth or value has been created. There is no new capital to be invested. Resources that previously flowed to local businesses and families were rerouted to private equity partners and their lawyers and bankers in New York.

Of course, this is just one hypothetical. In other stories, funds capture value through financial engineering or arbitrage, aggressive litigation or lobbying, the careful increasing of prices or the dumb luck of rising multiples, or the outright looting of pensions. In still other stories, funds create real value, investing in process improvements and new product development, finding synergies and expanding sales. Anecdotal examples abound for whatever story one might prefer. I like the one about the funds getting hammered as their bet on the profitability of "surprise medical billing" comes under regulatory pressure. The $28 million spent on an advertising campaign to preserve the practices may yet succeed, but how socially valuable are the "returns" on that "investment?"

The vital point is that an increase in cash held by a private equity fund does not demonstrate the creation of value, let alone "enormous social value." Nor do the good (or bad) works of any particular fund validate (or invalidate) the contributions of the industry as a whole. Only aggregate data that depicts how deals are done and businesses managed can yield real insight into the industry's broad economic and social consequences.

What Does Private Equity Do?

Fortunately, such data exist. In American Affairs, private equity veteran Daniel Rasmussen asked and answered the question, "Do Private Equity Firms Improve Companies' Operations?" If the industry's claims are true, he writes, "we should see results in the financials of the portfolio companies, such as accelerated revenue growth, expanded profit margins and increased capital expenditures. But the reality is that we see none of these things. What we do see is a sharp increase in debt." In most transactions, "revenue growth slowed" and "[capital expenditure] spending as a percentage of sales declined."

"There is a new paradigm for understanding the [private equity] model," concludes Rasmussen, "and it is very, very simple. As an industry, [private equity] firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management."

Studies that Professor Henderson has relied upon to defend private equity tell a related story: After an acquisition, fund managers try to reduce head count while maintaining or expanding output, thereby raising productivity. "One of the most salient observable within-establishment changes after buyouts for which there is clear evidence," writes University of Texas Professor Jonathan Cohn, "is a substantial reduction in employment." But the productivity gains are not shared with the workers—instead, compensation falls.

Shuttered factory in Connecticut
Shuttered factory in Connecticut Spencer Platt/Getty Images

This should be the industry's record-scratch moment. It is cutting jobs, getting the same or more output from the remaining workers, and then paying less for their purportedly more productive efforts. The resulting gains to ownership from squeezing labor in this way are paid as fees to fund managers, with little to no excess return remaining for the endowments and pension funds that provide the capital. "We find little evidence," Cohn writes in another study, "of operating improvements subsequent to" a leveraged buyout. In a particularly bizarre sign that "operating improvements" may not be the order of the day, about half of all private equity exits are now "secondary buyouts," that is, sales to...other private equity funds.

A new study by Oxford University Professor Ludovic Phallipou concludes that all this transacting has generated $230 billion in management fees over the past decade for performance no better than an index-tracking fund. "This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance," he told the Financial Times.

What Does Private Equity Do for All of Us?

The question before us is how much social value the private equity industry creates. Notwithstanding Professor Henderson's claim in The Wall Street Journal of the industry's "enormous social value," the processes by which it reallocates so much wealth to so few people plainly offers nothing of the sort. But on top of this failure, or for anyone assuming rosily that at least some good must come from so much financial sound and fury, broader social effects deserve scrutiny too.

One such effect is the redirection of talent. "What matters for society," Henderson writes in the Journal, "is how much wealth [funds] create above the next-best alternative." There, he was comparing the investment of capital in private equity deals to alternative uses, but what about human capital? As Wells King explains in American Compass' "Coin-Flip Capitalism" project, the nation's top business schools now send nearly 30 percent of their graduates into finance. At Harvard, the figure is now 29 percent, as compared to six percent in the 1960s. "The most lucrative jobs were no longer in general management—which involved leading people, building or­ganizations and creating products and services—but instead in professions that acted on behalf of or in service to shareholders," writes Sam Long in American Affairs, "especially fund managers who pooled capital and became large shareholders of major corporations."

Massive paydays have drawn entrepreneurs and managers, who might once have built, into the game of buying and selling. Meanwhile, performance in the real economy—among the operating companies they buy and sell—has degraded. Economic growth and dynamism have slowed, productivity growth has come nearly to a halt and wages have stagnated. Bizarrely, with so much "investment" going on, actual investment has plummeted. Assets get shuffled and reshuffled, profits get made, but relatively little flows toward actual productive uses. "Net private domestic investment," observes a report from Senator Marco Rubio's Project for Strong Labor Markets and National Development, "fell from nearly a tenth of U.S. Gross Domestic Product as late as the mid-1980s, to less than half of that amount by the end of 2018. As a percent of corporate profits, it declined from nearly 100 percent in the early 1980s to less than 40 percent today."

Finally, there is the matter of risk. The private equity strategy of leveraging an acquisition with a high level of debt works well when everything is going well. But the business' margin for error shrinks and the result is frequently bankruptcy—firms acquired by private equity funds are ten times more likely to go bankrupt—which can be disastrous for employees and their communities, though not the fund managers themselves, who often come out ahead. The trend has become so prevalent that when Brooks Brothers recently announced its bankruptcy, CNBC had to explain that "unlike many retail trailblazers, Brooks Brothers is not buckling from debt leftover from a private equity-led leveraged buyout that left its owner unable to invest in the storied brand."

The concept of private equity—investors acquiring a business—is itself harmless and, indeed, necessary. In their early history, leveraged buyouts may even have provided a necessary corrective to lax management practices. Certainly, they earned massive returns. But in its current incarnation, the industry fails on its own terms to deliver results for investors, and fails in its broader obligation to create value for society. As funds amass ever-larger piles of money and compete over fewer targets, their search for value to capture and their techniques for capturing it will grow more desperate.

Oren Cass is the executive director of American Compass, which recently released its "Coin-Flip Capitalism" project scrutinizing the venture capital, private equity and hedge fund industries.

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

Private Equity Captures Rather Than Creates Value | Opinion | Opinion