ICYMI // WSJ: Populists Don’t Know Much About Private Equity

Yesterday, the Wall Street Journal published the following op-ed from University of Chicago law professor M. Todd Henderson and University of Chicago entrepreneurship and finance professor Steven Kaplan who push back against critics of private equity by discussing how the industry improves the performance of businesses in finance, governance and operations. Read the full op-ed here.
 

Populists Don’t Know Much About Private Equity
The Wall Street Journal
By Professors M. Todd Henderson and Steven Kaplan
June 30, 2020

Wall Street has never been particularly popular in the American imagination, but the recent growth of conservative populism threatens to erode its position even further. A case in point is a new think tank, American Compass, run by Oren Cass, a former policy director for Mitt Romney. One of its first major projects—“Coin-Flip Capitalism”—concludes that investment funds, like private equity and venture capital, are socially wasteful.

A primer on Coin-Flip Capitalism, published in May, reviews the returns of various funds over the past decade and concludes that “most fund managers are generating the results that one might expect from an elaborate game of chance—placing bets in the market with odds similar to a coin flip.”

The report laments that “the nation’s top business schools have sent nearly thirty percent of their graduating classes into finance,” where these people “invent, create, build, and provide nothing.” Barack Obama has made a similar point, writing in the Economist that “too many potential physicists and engineers spend their careers shifting money around in the financial sector, instead of applying their talents to innovating in the real economy.”

There is a fatal flaw in this analysis. Consider the case of private-equity buyout funds, one of the targets of right-wing populists. While Mr. Cass and company claim they are interested in social value, they look at returns net of fees, that is, after paying the fund managers for their services. While this is the appropriate metric for the decision about whether an individual should invest, what matters for society is how much wealth they create above the next-best alternative.

If a company would be worth $100 million in five years under current management, but a buyout fund takes over, improves the management, and increases the value to $120 million, an additional $20 million of wealth has been created. To the extent that company is more efficient, this means the extra $20 million will be invested elsewhere in the economy.

The data are clear that private equity has created enormous social value. While returns net of fees have modestly exceeded the return of the market over the past decade, gross returns have averaged more than 5% a year better than the market over this time. This means that the roughly $300 billion invested in private equity deals in 2018 will generate an excess social return of more than $100 billion over the average seven-year life of these investments.

Private-equity firms create this value by improving a company’s performance in finance, governance and operations. When a private-equity fund buys a company, it can put in place better incentives and a more sustainable capital structure, install more competent management, and improve operations with a focus on long-term value creation. Managers of companies owned by private equity have more skin in the game—the CEO typically gets about 5% of the equity and the management team about 15%, compared with less than a few percent in publicly traded companies. Boards are smaller and tend to monitor executive performance more closely. Operational teams make detailed plans to improve performance.

The results are seen in numerous studies. Companies backed by private equity are subsequently 8% more productive than their industry counterparts, one National Bureau of Economic Research paper found last year. Other studies have found fewer health and safety violations, lower rates of workplace injuries, and more expansion into new regions and product lines. Being public doesn’t work for every company or at every point in a company’s life. The ability to buy out shareholders and make improvements that wouldn’t otherwise be possible is an essential tool in a thriving economy.

The news isn’t rosy for everyone. The study cited above on productivity also finds that employment growth in companies backed by private equity is 1% to 4% lower than in other firms in the same industry. Compensation is about 1.7% lower. Much of this is driven by the retail industry, raising questions about how gains in society are being distributed.

If anything, the benefits described here undervalue the importance of private equity. After all, the threat of a buyout, which usually results in a management shake-up, provides an incentive for all companies to improve their performance. No wonder the U.S., which has the oldest and largest private-equity market in the world, is home of the world’s best-managed companies.

It’s worth scrutinizing the costs and benefits of various investment strategies or questions about how a society deploys talent. It matters where society allocates scarce resources, but it also matters that analysis of these questions is based on the facts.

Mr. Henderson is a law professor and Mr. Kaplan a professor of entrepreneurship and finance at the University of Chicago.


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