Capitalisn’t: Is Elizabeth Warren right about private equity?

Nov 07, 2019

Sections Public Policy

Presidential candidate Elizabeth Warren plans to rein in and regulate private equity with her Stop Wall Street Looting Act. On this episode of the Capitalisn’t podcast, hosts Kate Waldock and Luigi Zingales look at how private equity really works, whether it’s bad or good for society, and how Warren’s proposed legislation would regulate these firms.

Kate: In the ’80s and ’90s, it was cool to hate on private equity firms.

Luigi: But trends always come back around. In the 2000s, private equity firms were cool again.

Kate: Enter Elizabeth Warren.

Elizabeth Warren: Anyone remember Shopko?

Audience: Yeah.

Elizabeth Warren: Yeah. You know why Shopko closed? Private equity. Anyone remember Sears?

Audience: Yeah.

Elizabeth Warren: Yeah. Sears, private equity. Toys “R” Us?

Luigi: Warren blames private equity, amongst other Wall Street institutions, for many of the issues in our economy.

Elizabeth Warren: And the idea over and over and over is, suck out the value, line the pockets of the private investors and leave the communities and the workers behind.

Kate: And she plans to rein in and regulate private equity with her new bill, “The Stop Wall Street Looting Act.”

Luigi: Pretty telling name. So, why all the back and forth over the years? Does private equity really deserve all the blame thrown at it, or does it get a bad rap?

Kate: From Georgetown University, I’m Kate Waldock.

Luigi: And from the University of Chicago, this is Luigi Zingales.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Kate: On this episode, we’re going to really explain how private equity works, whether it’s bad or good for capitalism. And we’re going to investigate Elizabeth Warren’s proposal to regulate these firms.

Luigi: Kate, we need to explain to our listeners what private equity is, exactly. Because this name is thrown around all the time, but what is the difference between private equity and public equity?

Kate: Private equity is equity, ownership, in companies that aren’t publicly listed. If a company is publicly listed, that means basically anyone with a brokerage account can invest in it. Whereas private equity is limited to a smaller number of elite, sophisticated buyers. These are usually people who pool their money together. They’re either really rich individuals or institutions like pension funds or mutual funds, and they designate a person to manage that money for them.

Now, that person picks private companies to invest in, and then eventually the fund will seek an exit strategy, like they’re going to sell their ownership to other private equity investors, or they’ll take the company public and then eventually return cash to the original pool of investors. Or, alternatively, if they don’t want to sell that private firm, they can just return shares of the private company to each of the investors.

Luigi: Private equity, in essence, is a form of raising equity without following all the disclosures imposed by the Securities and Exchange Commission.

Kate: One of the reasons that I’m a little salty about private equity is that I can’t invest in it. Even if I made enough money to be able to invest in private equity, to have access to the best funds and the best investment opportunities, you have to be pretty well connected.

And I just don’t have those connections. I’m also a little bitter about private equity because a couple of my ex-boyfriends from college work in private equity, and they’re not my favorite people.

Luigi: Actually, that’s a good example of how not to approach private equity, because the fact you hate them is not because they work in private equity, but because they’re your ex-boyfriends, right? And clearly, they’re losers because they’re ex- and they’re not with you anymore. But the point is, private equity is not responsible for that.

Kate: So, what are the strategies that private equity firms follow? The biggest two can be described as either growth or buyouts. 

Growth, these are private equity firms that really target young companies and try to invest in them to help them grow. Whereas on the buyout side, the idea is that you’re looking for companies that are either undervalued or underperforming. These tend to be later-stage companies, and often when these are bought by private firms, there’s a significant amount of debt involved.

Luigi: And I think that most of the bad rap is generally associated with the buyout private equity firms. People love the idea of venture capitalists who create new and successful companies.

Where the stuff is more controversial is when a private equity partnership actually buys existing firms, mostly with debt. So, they burden these firms with a lot of debt in buying the remaining equity and controlling the remaining equity. When they do a leveraged buyout, they tend to actually put a lot of debt on the company itself and use this debt as a mechanism to induce discipline in management.

Kate: The big-picture question that we’re interested in today is, do private equity firms create wealth, or do they transfer wealth away from other institutions or other people?

Luigi: Kate, you are often in New York. I’m sure you’re familiar with the pharmacy Duane Reade that is now part of Walgreen. It used to be a separate company, and it was bought out by private equity. And in that particular case, private equity did a very good restructuring of the stores, a very nice restyling of the image and succeeded in selling at a good price to Walgreen.

Even the New York Times had to admit that that was a successful buyout. What is important to understand is that buyouts generally are called for when the company needs to do a major restructuring.

Kate: There’s also a tax argument. The idea here is that there is a bit of a tax advantage to debt relative to equity, and yet CEOs are sometimes scared of debt. And so, when private equity firms come in, sometimes they try to increase the debt in the company, not to make it so risky that it goes bankrupt, but to actually capture some of those tax savings.

Luigi: And honestly, there is nothing bad in doing that. It is just a perverse incentive created by legislation. So, we cannot complain about private equity taking advantage of a form of legislation that has been around for decades. I think, and probably you, Kate, think that should be fixed. But there’s no particular appetite to fix it.

Kate: To be fair, you make it sound like it’s our legislators that have made some big problem, but this tax benefit of debt exists in most countries around the world.

Luigi: Yeah, it does. But that doesn’t mean it’s right.

Kate: That’s true.

Luigi: After a buyout, if you see the value of the company going up, is it going up because the private equity partnership put in a better system, because they created better incentives, or is it because they took advantage of this tax loophole, which is very profitable for companies, but it’s not really adding value for society? Or, even worse, because they extracted some surplus from other constituencies?

Think about a case in which, after an acquisition, you increase prices. You exploit the market power that you had in a more effective way. This is not a benefit for society overall. Or even another negative possibility is that they might extract some of the rents that are available for workers by firing workers or reducing their pension benefits, or so on and so forth. That is a pure form of redistribution, it is not creation of wealth.

From the perspective of the investor, when investors ask a private equity partnership how they add value, they want to hear how can they make more money. And certainly, stripping the pension system of their employees and distributing that in dividends adds to the value of the investors.

But we are concerned from a more societal point of view to see whether any intervention is justified. Because if the value creation that makes private equity profitable is also value creation from a societal point of view, then there is no need for intervention. On the other hand, if in part, or most of it, or all of it comes from transfer, then we have a form of rent-seeking that we need to regulate.

Kate: OK, so let’s dig into this question of, from society’s perspective, do private equity firms actually add value? Do they make the pie bigger, or do they transfer value away from other constituencies, including perhaps the government? Is there anything good that we can say about private equity?

Luigi: Yes. I think that the early studies . . . my colleague Steve Kaplan was one of the first to study the impact of buyouts that took place in the 1980s. And he did find significant increases in profitability that he attributes to an increase in productivity. And some other studies seem to confirm this initial view.

Kate: Yeah. I mean, look, I think it’s fun and kind of sexy these days to hate on the financial industry and private equity in particular, because they’re like the bad guys from “Succession,” if anybody watches that TV show. They’re going in and they’re looting companies, and they don’t actually know anything about the operating model, and they’re making the companies worse off.

But I do have to say as an economist that there is a ton of evidence that private equity firms are good. They help companies operate more efficiently, and I don’t just mean efficiently in the sense that they’re laying people off. I mean that they actually help companies be run well, right? They fire bad managers, they foster good ideas, they foster new connections to other companies that can help the company grow. We want firms to be efficient, and that’s what a lot of the literature on private equity has shown.

In terms of whether or not that’s good for society, it’s sort of a mixed bag. Is it good for society if a private equity firm shuts down a factory that’s not performing very well? Probably, if the people working in that factory can easily get new jobs, jobs at better companies, maybe get paid more.

But if a private equity firm employs a new technology, let’s say it adopts a robot that automates a lot of things, is that good or bad for society? It kind of depends. I mean, if that robot is enhancing the labor productivity of all the existing workers, that can be a good thing. But if it’s just firing everybody and those workers can’t find new jobs, then that can actually be a net negative.

And so, especially when it comes to this question of the relationship between private equity and labor, it’s hard to really tell whether private equity firms are benefiting society by making things more efficient or there are spillover costs from labor markets and people being unemployed that actually make it a net negative.

Luigi: The best evidence I know on the real effect of private equity is a recent paper with six coauthors, so we cannot name them all. We’ll start with the first one, Steve Davis. In this study, they actually look at 6,000 buyouts, and they’re able to match these buyouts with information coming from the Census Bureau, and they can measure the number of employees and the wages paid to those employees very precisely.

They can look at a measure of productivity, they can look at a measure of wages, a measure of employment. This is a paper that just came out as a National Bureau of Economic Research working paper.

Kate: And I think one of the most striking findings of this paper is that the effect of private equity not only depends on what the strategy of the private equity firm is, right? So, is it a growth firm or is it a buyout firm? But it depends on whether the company was previously publicly listed or it was previously private before that private equity firm got involved.

If you look at target firms that used to be public and then were taken private by private equity firms, then employment shrinks on average 13 percent over the two years following that buyout, which is pretty significant. But then, if you look at firms that were privately held before the buyout, it expands actually by the same amount, by 13 percent.

And so, there are huge employment consequences of private equity involvement. But it really depends on which strategy that you’re looking at.

Luigi: But we need to warn our listeners, especially those who have listened to our previous episodes on how the sausage is made, that you cannot really take a causal interpretation of these results. Because if I say that after they go to the doctor, people tend to lose weight, it is not that the doctor causes the loss in weight. It is that, when they go to the doctor, the doctor tells them that they probably are overweight, and as a result, they start to diet, and the diet makes them lose weight.

In the same way, it is likely that public companies that are acquired in a buyout are companies that need to go through a diet, that need to shrink. And private equity is just the most effective instrument in which this dieting is taking place.

Kate: On the question of automation, there’s also an interesting paper by Olsson and Tåg looking at Swedish data. So, yes, the Swedish economy is a little bit different, but they still have private equity there. And they find that even though, on net, the involvement of private equity doesn’t have a huge, huge impact on unemployment, that it depends on the sort of company that the private equity firms are targeting.

If they’re targeting companies that have routine sorts of labor involved or easily offshorable tasks, then private equity firms do tend to increase automation that removes or eliminates these jobs. And so, unemployment increases a lot in these easily automatable industries.

Now, fortunately in Sweden, most of the people who were unemployed, maybe not directly causally, but associated with the involvement of private equity, they were able to find new jobs within a relatively short period of time. But it’s not necessarily clear that the same result would hold if we were looking at the United States.

Luigi: Yes, but remember in the United States we are at full employment. It’s not necessarily that people don’t find jobs, it is that they don’t find jobs at the same wages. So, the problem here is to what extent the private equity industry has contributed to reducing the wage of workers or to keeping down the growth of the wages of workers.

The paper we cited does show that compensation per worker falls 1.7 percent at target firms after buyouts, largely, or they claim, erasing pre-buyout wage premiums relative to controls.

Kate: If we had to summarize the effect of private equity on labor, what would you say, Luigi?

Luigi: I think that on average, it is probably negative. But the question is a bit like the doctor. Is private equity the messenger of something bigger, or is it the cause? In many of the situations, private equity gets involved because you need a restructuring that probably will lead to loss of employment and maybe even a reduction in wages. Is private equity responsible for that? No.

In the same way, I think that private equity plays a very negative role in the trend toward consolidation of industries. I used the example of Duane Reade before. Now, notice Duane Reade was sold to Walgreen, increasing the concentration of pharmacies in the New York area. At the local level, the market has become less competitive as a result of private equity. Is this necessarily the fault of private equity? I would say the fault is of an antitrust authority that is not enforcing competition.

Private equity is simply a way in which this result is achieved. Without private equity, it probably would have been achieved in the same way, but taking longer or in a more costly way.

Kate: OK. Well, so, if you’re so sympathetic toward private equity firms, Luigi, what do you think about this one? There’s a paper that looks at the effect of private equity firms getting involved in higher education.

They’re actually buying colleges that are privately owned, for-profit colleges. And when this happens, the colleges get better at capturing some of the subsidies that the government offers to these colleges. So, low-interest loans that go to students or grants that go to higher education.

But actually, the tuition goes up significantly for students. They end up with a lot more debt. And the quality of their education goes down. Do you think that that’s just a loophole that private equity firms are exploiting, or do you think that they’re actually doing something bad, in that instance?

Luigi: The two things are not in contradiction. They are doing something bad for society, there is no question about it. But they are exploiting a loophole that exists, even for non-private equity firms. If your way to fix the problem would be just to attack private equity and not to fix the loophole, you’re going to let a lot of other companies do exactly the same thing under a different form.

Kate: Another group of stakeholders or constituencies that I think is often forgotten, because they’re also financial, is creditors. Now, in some sense, maybe we care less about creditors because, at least for distressed firms, they also tend to be sophisticated investors, like hedge funds, but we care about making sure that creditors can’t be screwed over by equity holders.

Because if they are systematically screwed over, then that means that credit markets might start to be less efficient, and the cost of borrowing will go up for companies over time.

Luigi: This is the legal term, screw over.

Kate: Screw over, yeah, that’s what I teach my students. Is there another term I should use, Luigi, rather than screw over?

Luigi: Take advantage, exploit, yeah.

Kate: Yeah. How might private equity firms exploit creditors? Well, one way is that they can pay themselves lots of fees. It’s not clear necessarily how paying themselves fees from the portfolio companies would hurt creditors. But the idea here is that if you’re a private equity firm, you go in, you buy a private company, you monitor it, and then you give it advice. And in exchange for that advice, you actually force that company to pay you fees.

Now, it seems a little strange, because if you’re holding the equity of that company, then why do you need the fees in the first place? Because if the company does well, then you’re going to do well as an equity holder.

The idea is that if that company then eventually becomes distressed, then those cash flows would have gone to creditors first. But the equity holders or the private equity firms, by establishing this pattern of fees, they’re kind of slowly sucking cash out of a business that might down the road go to creditors if the company becomes distressed.

And there is evidence that private equity firms do this quite a bit. In fact, a study looking at about 600 portfolio companies worth about a trillion dollars showed that $20 billion of fees have been extracted from those companies over the past 20 years.

Luigi: And this is part of a dangerous strategy that some private equity firms play, which is basically to gamble with a company’s asset. If I take a lot of debt on a company and I retain just a little of the equity, if things go well, I gain a lot. If things go poorly, the cost is borne by the creditors and not by myself.

And that’s a reason why, if I start to take a lot of management fees out of the company, even if I own 100 percent of the equity and you think that I’ll just pay with my right pocket into the left pocket, in fact, what I’m doing is taking advantage of the creditors, because if the business goes poorly, then they’re left with nothing in the company.

I’m not trying to forgive them, but when we come to think about how to fix the problem, I don’t think that the problem is fixed by banning private equity, because by banning private equity, you throw away the baby with the bathwater. A lot of private equity firms are doing a great job, and you have a few doing a terrible job. The solution is not to ban private equity or to make it nonviable. The solution is to prevent the bad companies from getting away with murder.

Kate: Let’s get into this question of, how do you regulate a private equity firm properly? Going back to the Warren bill, right? Her proposal isn’t that we should just eliminate this asset class or this industry altogether. She has some very specific things that she wants to do to private equity.

One of them is to get rid of these transaction fees or monitoring fees. She doesn’t want private equity firms to be able to extract dividends within two years of buying a company. She wants them to share responsibility over legal judgments. She wants to close the carried-interest loophole and then have more disclosure to the SEC, which is always a good thing.

And none of these suggestions imply that she wants to end private equity altogether.

Luigi: No, no, you’re right. Let’s go in step because . . . Let’s first start with the carried-interest loophole. This is something that even President Trump wanted to abolish. He has not done it so far. So, what is this loophole? It is the fact that the general partners in a private equity partnership, when they receive their compensation, rather than treating it as ordinary income, they are allowed to treat it as a capital gain, and so it is subject to the capital-gains tax rate, which is much, much lower.

And this is a loophole, because in ordinary companies, whenever you receive compensation for your labor services, this is deemed to be ordinary income and treated as ordinary income. And there is no doubt, in my view, that this is compensation for your labor service, because they are not receiving that as a result of an investment they made. They receive it as a result of their managing this company, so labor service.

And so, it should be treated as ordinary income, but in fact it is treated as capital gains. So, on this front, I think Elizabeth Warren is right, and that loophole should be fixed.

Kate: Another element of her bill is that there should be a 100 percent tax on monitoring fees. These are the fees that private equity firms, again, extract from the companies that they own. A 100 percent tax would effectively make those fees disappear. So, the question is, how fundamental are those fees to the business model?

I personally think that if you own the equity of a company, then you’re already participating in the upside. So, if you pay yourself a fee now or you get the equity upside later, it shouldn’t matter too much. The only difference is that if you’re paying yourself cash earlier, if you’re extracting the cash from the business on a regular basis, then maybe you’re advantaging yourself relative to some creditors.

At the end of the day, I don’t think this would really affect private equity firms that much. I mean, it tilts the spectrum a little bit more in favor of creditors rather than private equity firms, but I don’t think that it really makes a huge difference as long as the private equity firms are doing the right thing and trying to keep the company alive.

Luigi: My natural inclination would be to make the so-called fraudulent conveyance stronger. This idea that it is potentially dangerous to pay out a lot of dividends or a lot of fees to companies that could go bankrupt subsequently is a very old idea. And in common law, but also in civil law, for what matters, there is a way to prevent this, giving the right of the creditors to sue the shareholders if they do something like that.

And now, Kate, you know much more about bankruptcy law than I do, so why is this not working today in America?

Kate: I think this is difficult because what constitutes a transfer is getting more and more complicated.

When these laws came about hundreds of years ago, if you own a failing business and that business owns a piece of real estate property, and the equity holders sell the real estate property to themselves for zero dollars, and then they just own the title to it, it’s obviously a fraudulent transfer out of a failing business. And so, fraudulent transfer law does a pretty good job of protecting very obvious transfers.

But now that things are more complicated, now that we have assets like intellectual property and brands that aren’t necessarily covered under contracts as specific collateral for loans, it’s becoming harder and harder for companies to know—and judges, by the way—exactly what a transfer is.

I think that this will all get worked out within, let’s say, the next decade or so, but right now we’re undergoing a battle on fraudulent transfer grounds about what constitutes fraud. And so far it seems like that battle is actually favoring the private equity firms rather than the creditors.

Luigi: And I think that the risk, of course, is to overshoot in the opposite direction. In Italy, traditionally, buyouts are relatively rare precisely because fraudulent conveyance is so strong.

If you were to ask a private equity guy, do you prefer a much stronger fraudulent conveyance or no dividends within two years of the transaction and no monitoring or transaction fees? I think probably he will opt for no dividends and no transaction fees. He will do so kicking and screaming in the sense he prefers that nothing changes, but I think between the two, Warren’s solution is probably the less problematic.

Kate: I think the last element, and maybe the most controversial element of the Warren bill, is this idea of unlimited liability. That private equity firms, by laying on a lot of debt, make these companies riskier. Sometimes they push them into bankruptcy. And so, the private equity firms should be responsible for paying the other claimants in bankruptcy.

My sense of the Warren bill is that she’s really more interested in liabilities that arise from, let’s say, legal judgments. So, people who hurt themselves as a result of working for that firm, or they got cancer and so they’re owed some money through the court system. Or, let’s say, pension violations, workers of that firm for a long time who were owed a pension, but then when the company goes bankrupt, they don’t get that full pension amount.

And so, I think the bill is really geared towards having private equity firms be responsible or be on the hook for these particular types of claims, but not necessarily all claims. So, if a financial creditor is not paid 100 percent as a result of a bankruptcy, I don’t think that this bill would force the private equity companies to pay them. I just think that Warren wants to elevate the priority of groups like pensioners or people who are hurt by their firm and got a legal judgment over the private equity payouts.

Luigi: I think this is potentially the most problematic one, because the way I understand it, the big issue is mostly tort liability. So, if I create an environmental damage, is that damage junior or senior? Junior or senior is a technical term to say who is paid first and who is paid after.

Under the current legislation, most of the creditors tend to be paid before the tort liability. You might discuss whether this is the wrong or the right solution, but this is a general solution for every company. So, I would be very reluctant to change it just for the private equity firms.

This might be tantamount to stopping most private equity acquisitions, because I think many creditors would be very leery to lend you money when they know that they can be overtaken by some random liabilities, especially at a time when environmental liabilities of various natures can be very large and very unforeseen.

Kate: I think a good example of where tort liabilities can be really complicated is in the case of PG&E, the electricity company in California and all the wildfires that they’ve caused and have now had to pay out for. So, if PG&E and the equity holders of PG&E were to have to pay everything, all damages related to all forest fires, everyone who was injured or died as a result of the forest fires, they have to restore all of the area in California.

If they really had to pay out 100 percent of the damages that they caused, then PG&E would no longer exist, right? They would no longer be providing electricity, because this would just overwhelm the whole business. But at the same time, especially now that PG&E is doing these targeted blackouts in certain parts of California, it’s obvious that people rely fundamentally on this business, and a lot of people want it to continue.

And so, the question is, where is the tradeoff between the continuation of this electricity business versus all of the money that they owe to people who were hurt by the wildfires? This is the sense in which if the Warren bill were to force equity holders, let’s just say broad equity holders, to pay for all the damages before they could continue the business, that might lead to some inefficient liquidations that could end up hurting people that relied on the company.

Luigi: OK, Kate. What do you think private equity is? Capital-is or capitalisn’t?

Kate: I think we’ve covered a lot of stuff on this episode. Going back to the big question, right? Are private equity firms increasing the size of the pie, or are they adding wealth to themselves or their portfolio companies by taking advantage of other stakeholders or other constituencies?

I think that it seems like the answer is definitely both. We’ve presented some evidence about various constituencies that has suggested there is some level of extraction. So, on the employee side, private equity firms might lead to slight increases in unemployment, slight reductions in wages. On the creditor side, it seems like there is a lot that private equity firms can be doing to extract wealth from creditors. And as you mentioned, Luigi, when it comes to the antitrust element or the consolidation element of private equity, it seems like when a private equity firm comes in, they might raise prices, which can hurt consumers. These are all various stakeholders that are in some sense losing out to private equity.

But at the same time, we mentioned a ton of reasons that private equity can be good. So, at the end of the day, I think that private equity should stick around. It does lead to increases in efficiency. It especially helps small companies that are growing. But I think that we need to do a better job of closing the loopholes that allow private equity firms to extract wealth from these other stakeholders. 

What do you think, Luigi? Capital-is or capitalisn’t?

Luigi: I think it’s mostly capital-is. I think that the biggest risk, in my view, is to destroy the entire industry and make it impossible to have restructuring in various lines of businesses.

With the entry of an increasing number of countries in the global arena and increasing capacity of production of countries like China, but now even Vietnam and so on and so forth, inevitably, some businesses are difficult to conduct in America. And this is not an issue of not trying, it is not an issue of not paying attention to workers, it is an issue that there is competition at the international level that forces the United States to move to more advanced sectors.

In Sweden, where workers are paid well and things work relatively well, you do have private equity closing down plants that are inefficient. And we should do the same in the United States. I think it would be a big mistake if we wanted to freeze the economic structure as it is today, preventing this innovation and turnover, which are essential.

Do we observe some distortions? Absolutely. Do we observe some fraud? Absolutely. We should fix those, but I don’t think that this is a reason to criticize the entire private equity industry in just one shot.

Kate: Do you think that the Warren bill goes far enough in fixing these problems?

Luigi: I think that on some issues it goes too far and some others not far enough. I think that certainly, if you analyze it seriously, it looks less threatening than the title. In reality, they are trying to fix some loopholes. Most of them are good ideas to fix those loopholes.

We might discuss how dangerous it is to expand the equity liability. That, I think, is the most controversial part of the bill that might kill the entire private equity industry. And, in my view, maybe sort of excessive vis-à-vis the rest.

But overall, I think it is a step in the right direction. I would like to see this followed or joined by much stronger antitrust enforcement.