Editor’s note: I’ve asked my friend and colleague Arpit Gupta, a PhD student in Finance and Economics at Columbia GSB, to offer a critique of my recent article on private equity and job destruction. Briefly, I’ll note that I find his analysis persuasive, particularly his observations on how to think about employment levels and financial engineering. Some critics have suggested that I was wrong to neglect the financial engineering aspect of the private equity industry; I felt that it was beyond the scope of the article. But I’m gratified that Arpit has offered a thoughtful discussion of the issues below.
Reihan’s article on private equity for the National Review places private equity firms like Bain Capital at the nexus of the wrenching transformation of American industry:
President Obama has highlighted the productivity challenge facing education and other government-dominated sectors. In an interview with Bloomberg Businessweek at the start of his presidency, he offered the following observation. “The last lunch that I had, I guess we had the CEOs of Xerox, AT&T, Honeywell, and Coke. We talked about the fact that, in the 1980s, when everybody was afraid Japan was going to eat our lunch, a lot of companies did a 180 in terms of quality improvement, efficiency, increasing productivity. There was a change in corporate culture that significantly boosted corporate productivity for a long time and helped create the boom of the ’90s. What they pointed out was, there were a couple of sectors that were resistant to that: health care, education, energy, and government.” With this in mind, the president suggested that government-dominated sectors needed to undergo a similar cultural shift.
But this “change in corporate culture” didn’t come from roundtable discussions. It flowed from the private-equity-driven reallocation of resources — the messy, disruptive process of shutting down inefficient factories and firms and shifting their resources to innovative new models that can withstand competition. And when the “change in corporate culture” came, the business establishment didn’t embrace it; in many cases, it howled in pain. The change came from outsiders universally derided as “corporate raiders” who used debt financing as their weapon of choice to force old-line industrial companies out of complacency. Innovative business models have since emerged in education and health. Yet at every turn they run into regulatory barriers and opposition from public-sector unions and their allies in government. What these sectors need, Romney should argue, is the same data-driven transformation that saved America’s industrial economy.
Reihan is right to emphasize the role that painful creative destruction has played in America’s economic performance for the last several decades. Though in many ways the growth during this period has undershot expectations, the economic landscape would likely have been far worse without the dramatic investments we’ve seen in efficiency and productivity. Such continual growth at innovation’s edge has substantially contributed to America’s steady and sizable per capita income lead over comparable developing countries, in the face of economic logic that might predict a narrower gap over time.
Private equity has played a critical role in this growth process to the extent that activist investors have shaken up dysfunctional public corporations. Too often, publicly listed companies don’t invest in innovation, coddle management, and offer miserable returns to shareholders — who include pension funds and insurance companies. Shareholders are frequently too dispersed to mount a serious direct challenge to management, and so — in Albert Hirschman’s classification — express protest largely by exiting and selling their shares. Activist investors shook things up by introducing new forms of relationship finance that combined ownership and management.
Since the private equity era began, we’ve seen higher CEO turnover rates and greater competition. Activist hedge funds, which aim at owning large stakes but rarely overturning management, have also pushed for greater operational improvement and firing management. These shocks to corporate governance have hit all firms, including those worrying about takeovers themselves or firms competing with private equity-owned companies, justifying Reihan’s focus on how the broader economic landscape has shifted due to private equity.
Still, it’s possible to take a broadly positive view of the role of private equity in fostering innovation and competition, while also worrying about the financial engineering aspects of such companies. For instance, Reihan doesn’t directly address the issue of dividend recapitalization, in which private equity firms finance the extraction of firm dividends from new debt. The implication, as raised by private equity critics such as James Surowiecki and James Kwak, is that private equity transactions simply leave target firms burdened with debt, while the original investors cash out and move on. That is, leveraged buyout private equity deals may more closely resemble the crony capitalist deals that Reihan critiques rather than genuine corporate value-adding restructuring.
However, private equity firms are no more likely to default relative to comparably levered firms and are less likely to default than firms in general, suggesting that Investment Bank lawyer Epicurean Dealmaker is right in characterizing these payouts as a reflection of greater profitability in acquired firms, rather than purely destructive financial engineering. Moreover, any proceeds from private equity transactions (whether from dividends or firm liquidations) are released to shareholders, who are then free to invest productively elsewhere. Much of Reihan’s piece focuses on the dynamic aspects of economic organization, in which failed firms, fired workers, and liquidated capital are systematically re-deployed to other sectors of the economy. As he writes,
In a healthy economy, failing firms fade away, and their assets — including their work forces — get reallocated to more promising ventures. Over time, job creation has outpaced job destruction just enough to accommodate a growing population, and, in flush times, to create tight labor markets. The decline of the Rust Belt during the early 1980s was followed by a boom in the Sunbelt. Textiles and petrochemicals suffered, but Silicon Valley prospered. In the late 1990s, it was the long-moribund retail sector’s turn to be shoved into the churn, as Walmart drove firms to either sharpen their games or get pushed out of business. Job destruction was constant, but so was the creation of new opportunities.
Though this churn is obviously not painless, it is fundamental to the process of economic growth.
More troubling aspects of private equity center on the extent to which private equity firms take advantage of tax regulations and the financial landscape. Firms can write off interest expenses from paying down debt, while equity payouts typically face greater levels of taxation. The differential treatment of debt versus equity pushes firms to pile up greater leverage then they otherwise would. Steve Kaplan, a private equity expert Reihan quotes elsewhere, suggests that the tax benefits from higher leverage ratios since the 1980s have added as much as 10 to 20 percent of firm values.
Reassuringly for LBO firms, the debt contribution to private equity deals has been steadily declining more recently — however, the pre-recession boom in private equity saw firms steadily bidding up firm values while delivering lower returns. It’s possible that the low-hanging fruit, so to speak, in private equity has largely already been captured, and remaining firms are operating more on financial engineering to deliver value. If so, credit crunch conditions may have had some value in disciplining private equity firms to focus on value-creation, much as the presence of debt itself is thought by some scholars to discipline the functioning of firms.
Private equity also takes advantage of another highly-criticized portion of the tax code — the tax treatment of carried interest, which permits the managers of private equity firms to receive income taxed at the capital gains rate (15% for long-run investments), rather than at the individual income tax rate. While such tax treatment is appropriate for the investors in private equity firms, it amounts to a major subsidy towards those directly working in financial management fields, like private equity and hedge funds, who are clearly engaged in a labor managerial role, and ought to pay the regular income tax rate. Even the Epicurean Dealmaker finds no justification for this law.
Now, as Avik Roy has pointed out here in the past, it may be difficult to alter laws on carried interest without also threatening other critical features of the tax code — such as protection for sweat equity by investors who themselves work in limited partnerships. But regardless of whether private equity compensation could be reformed without damaging other critical portions of the investment ecosystem, the fundamental point is that problematic features of the tax code explain important features of the private equity industry. Reihan makes a persuasive case for the economy-wide beneficial functions of private equity; but it’s also true that private equity firms employ aspects of financial engineering that are troubling on their own. And if private equity really is generating enormous value, the industry should continue to thrive when playing on an even playing field.
In addition to the governance aspects of private equity, Reihan emphasizes their impact on employment:
The difficult truth that virtually no politician is prepared to acknowledge is that the road to job creation runs through job destruction. Yet it is a truth that workers and voters must understand — and Mitt Romney carries the almost impossible burden of explaining it. The controversy over Bain Capital won’t blow over. The only way forward is to show how his work at Bain contributed to growth, and how the excessive regulation and crony capitalism his fiercest critics advocate is a recipe for stagnation.
Here, Reihan implicitly draws on the work of Ashwin Parameswaran, who has argued:
My fundamental assertion is that a constant and high level of uncertain, exploratory investment is required to maintain a sustainable and resilient state of full employment. And as I mentioned earlier, exploratory investment driven by product innovation requires a constant threat from new entrants.
For Reihan and Ashwin, jobs must be created or fostered, ideally through a hands-off policy encouraging innovation by new firms. For others on the left, jobs are instead better secured though government regulations and innovations. All sides seemingly view employment is something much like GDP; an independent economic outcome whose success is predicated on optimal policies by firms and governments.
But unemployment is just the mismatch between how much people are willing to work, and how much work employers demand. In some important sense, employment isn’t a function of innovation policy or government investment, not really. It’s purely a reflection of how much the labor market has broken down; of how many wedges have been introduced between workers and employers that prevent wages from adjusting such that the labor market clears to full employment.
One way of looking at this is to consider how employment rates vary across levels of country income. Poor and rich countries have, more or less, similar levels of unemployment — doubling income or innovation doesn’t double employment. Or, any level of income or innovation is perfectly consistent with full employment. America could stagnate for decades, or it could experience unprecedented economic growth — both scenarios are perfectly compatible with either both full employment or high unemployment. Higher levels of labor demand, over the long-run, do encourage higher levels of wages, but typically not higher levels of employment.
What drives unemployment, over the long-run, are instead imperfections in the working of the labor market. For instance, France went from roughly 2% unemployment in the 1970s to 10% unemployment in the 1990s. France saw an unbelievable rise in productivity and innovation during this period, yet new distortions in the labor market prevented those productivity improvements from translating into higher employment. In the future, no amount of product innovation will help France deal with a problem that is fundamentally about onerous labor regulations.
I’m not just making the point here that labor market regulations are important in determining unemployment levels, an idea many people accept. I’d say it’s useful to think about the extreme point — that rigidities in the labor market in some sense completely determine unemployment over the long run.
In that sense employment, as a market shortage, is exactly equivalent to other types of shortages caused by imperfectly working markets. The Soviet Union, for instance, saw chronic shortages of bread. The problem wasn’t any sort of innovation gap in bread production or retail, but rather simply the lack of a functioning price system to appropriately match bread demand with bread supply. Higher bread production may have momentarily cut bread lines, but not for long. Instead, the moment that bread was priced more efficiently, Soviet bread lines disappeared.
The problem of unemployment, in important aspects, is identical to the problems of Soviet bread shortages. If the labor market were working in a fully flexible sense, we would always have full employment, regardless of what the rest of the economy was doing, because people would always find work at some wage. In a fully flexible labor market, this would be true in recessions as well — though firms would have a lower demand for labor during downturns, they would simply lower everyone’s wages by a few percent, rather than laying off some fraction of workers.
To be sure, bread markets aren’t entirely like hiring markets. While bread shortages have simple solutions that work to create functioning markets, it’s harder to conceive what sorts of frictions and problems lay behind persistent labor unemployment. Regulations like unemployment insurance and minimum wage have some role to play, and it also appears that wages are “sticky” in the sense that wage demands tend to be inflexible downwards. The sticky wage idea is somewhat unsatisfactory, and doesn’t enjoy a great deal of evidence, but it seems that a complex web of frictions in the labor market are the major reason why we see persistent unemployment. It’s not obvious that labor markets can be made to be fully flexible like bread markets have been, though I’d recommend strategies like Chilean unemployment insurance, wage subsidies, and waiving taxes for the long-run unemployed if unemployment is the concern.
The takeaway from the pure labor market point of view is that it’s not obvious if greater activist investor fueled innovation will actually spur employment. As Reihan notes, many new employers, like Apple or Facebook, employ relatively few people. Future innovative investments — perhaps in education or healthcare — may similarly be employment-light; for instance if taped lectures replace human lecturers, or diagnostic machines replaced doctors. Those would be amazing inventions; but would with at substantial direct employment losses. The role of private equity and destructive innovations in general shouldn’t necessarily be to create new jobs; but rather to boost the economy in general, and help create the economic ecosystem in which any new jobs, wherever they are created, will pay higher wages.