Tuesday, July 28, 2020

A Very Harsh (and accurate) Critique Of Private Equity

From Newsweek, July 22:

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.....
.....MUCH MORE, including a couple more statistics that hammer home the fact that PE is a racket of the highest order.
racket: noun
3) an organized illegal activity, such as bootlegging or the extortion of money from legitimate business people by threat or violence.
4) a dishonest scheme, trick, business, activity, etc