The Agenda

Steve Kaplan and Ashwin Parameswaran on Private Equity

I have yet to post that critique I promised you, but here are two interesting takes on private equity that might be of interest.

Steve Kaplan makes a number of observations that might be of interest, e.g.:

Net job losses are concentrated in buyouts of retailers. This is not surprising given that Wal-mart, Target, Sam’s Club, and Amazon, among others, have put a great deal of pressure on retailers over the last two decades. In the analyses, in fact, Wal-mart and Target are competitors to private equity-funded companies. Given that competition, it is possible that employment would have declined in the private equity-funded retailers even if they had never received private equity.

If retail buyouts are excluded, the overall net employment change appears to be neutral or even positive. In other words, there does not seem to be a large net employment effect when compared to companies in the same industry.

Kaplan also addresses the argument from looting, raising one point we will revisit:

One complaint, uttered by Newt Gingrich, Rick Perry, and others, is that private equity investors are vulture capitalists who “loot” their companies. According to this view, private equity firms pay themselves dividends by having the company borrow additional money. These transactions are known as dividend recaps. If the company subsequently goes into bankruptcy, the private equity firm still gets to keep the dividend.

While it is true that the private equity firms get to keep the dividends, it is ridiculous to say that private equity investors actively loot their companies. As Steve Rattner (former Obama administration “car czar” and former private equity investor) pointed out recently, private equity firms can take cash out of a company only when banks are willing to lend more money. That happens only when the company has done well and is expected to do well in the future. In most dividend recaps, therefore, the private equity investors and the banks are positive about the company—the banks expect to be repaid, and the private equity investors expect their equity to be worth even more. When those companies go bankrupt instead, something unexpected (and negative) has usually happened.

In other words, private equity investors cannot systematically and purposely loot their companies. Banks do not purposely make bad loans. That just does not happen. [Emphasis added]

There is, however, another way to look at the willingness of banks to lend to private equity firms. Ashwin Parameswaran emailed me earlier this week with a recommendation (to read this blog post by the Epicurean Dealmaker) and to make the following observation:

The part of the private equity business which a lot of people are focusing on is the dividend recaps. The question is why banks would lend to enable such levering up — some people think that the banks were just stupid, but they ignore the fact that this sort of severely tail-risk heavy loan is exactly the payoff which maximises the banks’ and their employees’ own moral hazard rent extraction. If you think of rents as coming through a siphon from the Fed, then banks are the direct recipients but competitive dynamics can funnel these rents all throughout the economy — I wrote a post here describing hedge funds as an indirect beneficiary of rents, same argument applies to some private equity. And as we’ve discussed, the unlimited nature of this rent source in a fiat currency system means that “competition” without destruction simply implies more rent extraction.

In that last post I made a comment, “The only way to avoid inequality in the presence of such a commitment is for every single person in the economy to extract rents in an equally efficient manner – simply increased competition between hedge funds or banks is not good enough.” This is sort of my line of thinking these days — given that questioning the stabilisation itself makes people accuse me of risking systemic collapse, make it open-access instead to expose the fundamental insanity of the regime when taken to its logical conclusion. [Emphasis added]

If Ashwin is right, banks aren’t quite purposefully making bad loans. Rather, they are engaged in “moral hazard rent extraction.” The underlying problem here, however, is not private equity. It is the guarantee-regulate-bailout regime that encourage risk-taking via increased leverage. In addition, there is the favorable tax treatment of debt, which could be solved by “taxing corporations on their income before interest expenses,” as Josh Barro has recommended. 

One can maintain that private equity’s role in accelerating creative destruction is a very good thing while acknowledging that the financial sector suffers from structural pathologies. Many of these pathologies, however, can be traced to the effort to mitigate and contain risk, as Ashwin has consistently argued. 


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