We examine thousands of U.S. private equity (PE) buyouts from 1980 to 2013, a period that saw huge swings in credit market tightness and GDP growth. Our results show striking, systematic differences in the real-side effects of PE buyouts, depending on buyout type and external conditions. Employment at target firms shrinks 13% over two years in buyouts of publicly listed firms but expands 13% in buyouts of privately held firms, both relative to contemporaneous outcomes at control firms. Labor productivity rises 8% at targets over two years post buyout (again, relative to controls), with large gains for both public-to-private and private-to-private buyouts. Target productivity gains are larger yet for deals executed amidst tight credit conditions. A post-buyout widening of credit spreads or slowdown in GDP growth lowers employment growth at targets and sharply curtails productivity gains in public-to-private and divisional buyouts. Average earnings per worker fall by 1.7% at target firms after buyouts, largely erasing a pre-buyout wage premium relative to controls. Wage effects are also heterogeneous. In these and other respects, the economic effects of private equity vary greatly by buyout type and with external conditions.
That is from a new paper by Steven J. Davis, John Haltiwanger, Kyle Handley, Josh Lerner, Ben Lipsius, and Javier Miranda. Via John Chamberlain.
Noah Smith writes:
In Japan, there is no big private equity industry, because it is very difficult to do a leveraged buyout of a company. The Japanese government allows companies to defend themselves from takeovers in ways that are illegal in America. Also, Japanese companies often hold each other’s shares, a practice known as “cross-shareholding”, which tends to prevent hostile takeovers. Cross-shareholding creates huge financial risks; however, many of the Japanese companies that engage in cross-shareholding are big banks that are backed by the government (much as ours are here in the U.S., but more explicitly), so this risk is assumed by the Japanese taxpayer. For a comprehensive primer on Japanese corporate governance, see here.
Upshot: In Japan, private-equity firms cannot buy companies and force them to restructure.
Fact 2: Japan has a productivity problem. We think of Japan as being super-productive, and in fact some industries (and most export-oriented factories) are. But overall, Japanese productivity kind of stinks. Since at least the 90s, Japan’s Total Factor Productivity has lagged far behind that of the U.S. Nor is this due (as Ed Presott has tried to claim) to a slowdown in technology; it appears to be a function of how resources are allocated within and between Japanese companies.
Excellent piece by Reihan Salam on private equity and how Bain fit into the larger picture of a dynamic economy.
The difficult truth that virtually no politician is prepared to acknowledge is that the road to job creation runs through job destruction.
…Chad Syverson, an economist at the University of Chicago’s Booth School of Business, found that what separates top firms from bottom firms is, typically, a large difference in productivity, with the top ones producing almost twice as much with the same measured input. This creates an almost irresistible temptation for investors. If Firm X, languishing at the 10th percentile in terms of productivity, could somehow be overhauled to match the productivity levels achieved by Firm A, at the 90th percentile, the potential for profit would be huge. Note, however, that halving “measured input” in order to double productivity will often mean shedding the weakest performers and giving those who remain the tools they need to do their jobs better and faster. Private equity does exactly this.
What Mitt Romney discovered was that American corporations sometimes had to be dragged, wailing and whining, into a state of efficiency. As a management consultant at Bain & Company, Romney had studied successful firms and then told other firms how to replicate their strategies. But those firms had come of age in the fat years of American corporate dominance, when many believed that the Japanese could do little more than manufacture cheap toys and textiles, and many were reluctant to accept his newfangled advice. It eventually became clear that if Romney and his cohort were going to remake American business, they’d have to raise money to make their own investments. Spurred by the senior partners at Bain & Company, Romney and his merry band of consultants established Bain Capital.
I wish Romney were as eloquent in his defense as is Salam.
Here is a very useful survey by Steven M. Davidoff, excerpt:
…in a separate paper, Steven Kaplan of the University of Chicago and Mr. Stromberg estimated that private equity-owned firms had a default rate of 1.2 percent a year from 1980 to 2002. That compares with Moody’s Investors Service’s reported default rate of 1.6 percent for all corporate bond issuers in the United States in the same time period.
Private equity-owned companies may have a lower general default rate because of the better debt terms that sophisticated private equity firms can negotiate. For example, Moody’s has found that an outsize number of companies owned by private equity firms avoided default during the financial crisis because they had so-called covenant-lite debt, which had fewer terms that could be violated.
Beyond default rates, evidence of the private equity industry’s ability to create value is still surprisingly uncertain, given that the industry has more than 30 years of history. One of the reasons is that private equity firms do not generally publicly disclose the performance of their buyouts.
…A new paper, however, finds evidence that private equity firms do add value. Adam C. Kolasinski and Jarrad Harford of the University of Washington examined 788 large private equity buyouts in the United States. They found that private equity-owned companies invested more efficiently than other companies, a fact the authors attributed to private equity firms’ greater access to capital. The authors also found that the payment of large dividends to private equity firms, a common practice, did not create future financial distress.
There is more of interest at the link. “Some positives, lots of uncertainty” would be a good description of the available evidence.
There is a recent two-part series by Steve Kaplan, arguably the leading researcher in the area. Here is part one and here is an excerpt:
Some, including presidential candidates Newt Gingrich and Rick Perry, criticize private equity for gutting companies and destroying jobs. The private equity industry and Mitt Romney argue that private equity creates jobs. The best empirical evidence—co-authored by one of my colleagues, Steve Davis—says the answer is that private equity both creates and eliminates jobs.3After a buyout, employment in existing operations tends to decline relative to other companies in the same industry by about 3 percent. Many of those job losses are undoubtedly painful.
At the same time, however, employment in new operations tends to increase relative to other companies in the same industry by more than 2 percent. Davis et al. conclude that “the overall impact of private equity transactions on firm-level employment growth is quite modest.”
Here is part two, which focuses on Bain.
Here’s today’s Op-Ed by Pat Toomey, praising private equity. I am tracking down sources on this topic and will pass along what I learn.
I do now trust at least one result: public firms will buy up targets without much discretion, but private equity has been making acquisition decisions in a more rational fashion:
We find that the announcement gain to target shareholders from acquisitions is significantly lower if a private firm instead of a public firm makes the acquisition. Non-operating firms like private equity funds make the majority of private bidder acquisitions. On average, target shareholders receive 55% more if a public firm instead of a private equity fund makes the acquisition. There is no evidence that the difference in premiums is driven by observable differences in targets. We find that target shareholder gains depend critically on the managerial ownership of the bidder. In particular, there is no difference in target shareholder gains between acquisitions made by public bidders with high managerial ownership and by private bidders. Such evidence suggests that the differences in managerial incentives between private and public firms have an important impact on target shareholder gains from acquisitions and managers of firms with diffuse ownership may pay too much for acquisitions.
Here is the paper.
Yes, Sarbanes-Oxley is one well-known reason but there are more reasons, most of all stemming from a shift in the balance of power toward founders, boosting their ability to raise private capital:
One such notable deregulation event has been the National Securities Markets Improvement Act (NSMIA), passed in October 1996. NSMIA has made it easier for both private startups and the private funds investing in them to raise capital. First, NSMIA exempts private firms selling unregistered securities under Rule 506 of Regulation D from state securities regulations known as blue sky laws (Rule 506 is one of the exemptions firms can use to issue private shares not registered with the SEC). As a result, NSMIA has made it easier for startups to raise private capital from out-of-state investors by exempting private firms from complying with the blue sky laws of every new state where they issue securities (public firms have long been exempt from blue sky laws). Second, NSMIA has made it easier for private funds such as venture capital (VC) and private equity (PE) funds to raise large amounts of capital by increasing the number of investors in a fund that force the fund to register under the Investment Company Act (ICA).2Registered funds have to regularly disclose their investment portfolio and face leverage and other restrictions, and so VC and PE funds tend to avoid having to register.
That is from a new NBER working paper by Michael Ewens and Joan Farre-Mensa.
The equity of 100% equity financed banks would be incredibly safe. 1/10 the volatility of current banks. It would be an attractive asset. The private sector really does not have to hold any more risk or provide any more money to an equity financed banking system. We just slice the pizza differently. If issuing equity is hard, banks can just retain profits for a decade or so.
Or, better, our regulators could leave the banks alone and allow on on-ramp. Start a new “bank” with 50% or more equity? Sure, you’re exempt from all regulation.
And, in case you forgot, we live in the era of minuscule interest rates — negative in parts of the world; and sky high equity valuations. All the macroeconomic prognosticators are still bemoaning a “savings glut.” A scarcity of investment capital, needing some sort of fine pizza slicing to make sure just the right person gets the mushroom and the right person gets the pepperoni does not seem the key to growth right now.
He chose the excellent title “Tyler: Equity financed banking is possible!” Do read the whole thing, it is a very good and useful post.
I would add a few points in response. First, I think equity banking would have to be very tightly regulated to remain as such, more than the status quo. There always would be incentives to take on more off-balance sheet risk for higher returns. Second, a much bigger commercial credit sector would have its own maturity mismatch problems. It might be better than the status quo, but it too likely would end up with a lot of bad regulation, or maybe it would become a no-less-dangerous form of shadow banking. In general, I don’t think our current form of government can precommit to “no regulation.” Third, money market funds work pretty hard to maintain fixed nominal value for their depositors. Admittedly this is a theoretical puzzle, but that we don’t understand the prevalence of debt at various levels (and that prevalence is all the stronger outside the U.S.) does not lead me to think we can alter it as we might wish. That the theory of capital structure is so weak I do not take to mean that capital structure is so remarkably flexible. Finally, I don’t think the savings glut is all that relevant for SMEs, and traditional banks still seem to be more efficient at matching borrowing and lending at the local level. Again, this is a phenomenon we do not understand very well (Fama 1985), but I am not so confident we can undo it. I also don’t think the savings glut will last much longer, given Asian demographics.
That all said, I would gladly experiment more with equity banking and indeed have written as such in the past. I am less sure it will do away with our current regulatory dilemmas. I don’t think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate.
Danielle Douglas-Gabriel at the WashPost writes that Purdue is going to run an experiment with income contingent loans.
This week, Purdue University [partnered]…with Vemo Education, a Reston-based financial services firm, to explore the use of income-share agreements, or ISAs, to help students pay for college.
Through its research foundation, the school plans to create ISA funds that its students can tap to pay for tuition, room and board. In return, students would pay a percentage of their earnings after graduation for a set number of years, replenishing the fund for future investments.
The Federal government already offers an income based repayment program for student loans but private plans would likely be more flexible and generate more useful information.
Douglas-Gabriel makes a useful point:
Say a student agrees to pay five percent of her income for five years on a $10,000 agreement. If that student lands a $60,000 job after graduation, she could pay $15,000 by the time the contract is up, more if she gets raises along the way. Yet if that same graduate loses her job during that time, she wouldn’t be forced to find the money to pay.
But then concludes with an odd criticism:
Either way students would have to be pretty informed about the earning potential in their field before signing up.
What the example illustrates, however, is that being unlucky or uninformed is less damaging with an income share agreement than with a traditional loan. Loans have the greatest burden when a student overestimates their potential earnings and is poorer than expected. Thus, the loan offers no relief when relief is most needed. In contrast, payments under an income share agreement fall when income falls. An ISA does cost more than a loan when a student underestimates their potential earnings but in this case the student is richer than expected and can easily bear the extra burden. Thus, ISAs offer income insurance.
Douglas-Gabriel also writes:
Some observers worry that students pursuing profitable degrees in engineering or business would get better repayment terms than those studying to become nurses or teachers.
Actually, that is part of the point. An ISA is about improving idiosyncratic risk sharing. To the extent that engineers are reliably expected to earn more than nurses, they should pay a smaller share of their income so the total payment for an education is about the same for both engineers and nurses (fyi, business is not a profitable degree).
Indeed, one of the prospective benefits of ISAs is that differences in prices will better reveal which are the degrees, programs and schools that most generate value-added.
Hat tip: Kevin James.
Addendum: See previous MR posts on this topic.
Luigi Zingales has a good op-ed on education in today’s NYTimes:
… scholars like me…work in the least competitive and most subsidized industry of all: higher education.
We criticize predatory loans by mortgage brokers, when student loans can be just as abusive. To avoid the next credit bubble and debt crisis, we need to eliminate government subsidies and link tuition financing to the incomes of college graduates…Just as subsidies for homeownership have increased the price of houses, so have education subsidies contributed to the soaring price of college.
…These subsidies also distort the credit market. Since the government guarantees student loans, lenders have no incentive to lend wisely. All the burden of making the right decision falls on the borrowers. Unfortunately, 18-year-olds aren’t particularly good at judging the profitability of an investment…
Last but not least, these subsidized loans keep afloat colleges that do not add much value for their students, preventing people from accumulating useful skills.
Instead of subsidies Zingales, drawing a page from Milton Friedman, proposes income-contingent loans.
Investors could finance students’ education with equity rather than debt. In exchange for their capital, the investors would receive a fraction of a student’s future income — or, even better, a fraction of the increase in her income that derives from college attendance. (This increase can be easily calculated as the difference between the actual income and the average income of high school graduates in the same area.)
As I wrote about earlier, Bill Clinton received a loan like this from Yale’s law school and later created a national program but it didn’t get very far (although Obama wants to expand the program). Australia, however, implemented an income contingent loan program in 1989. Australian students don’t pay anything for university when they attend but once their income reaches a certain threshold they are charged through the income tax system. Many other countries are experimenting with income contingent loans.
One point that Zingales doesn’t examine is adverse selection – an income-contingent loan will appeal most to people who want careers with low-income prospects, say in the non-profit sector. (Redistribution of this type was one of the reasons for the Yale law school program.) Thus, the program works best when incomes differ due to luck. My guess is that the adverse-selection problem can be handled if education venture capitalists are left free to price.
Varun, a loyal MR reader, asks me:
I do have a fairly simple question on tax policy I’ve never really seen a good answer to: Why do we treat interest payments differently in terms of taxation? Why are interest payments tax deductible?
Clearly a zero corporate tax rate is best, but why do we offer tax shields for highly levered companies? All of private equity, and much of banking etc. is built on this tax arbitrage. Wouldn’t treating interest payments on par with dividends and corporate profits (hopefully at a lower tax rate) unlock a great deal of value, drive an increase in (stock) investment, while significantly un-levering businesses? Why do we borrow when we can seek investment?More importantly, isn’t it odd that few advocate such a simple policy change: to treat debt and capital investment identically.
Contrary to common impression, the tax deductibility of interest payments does not give a tax advantage to borrowing, not if the return to savings is taxed. What you save by borrowing and writing off interest payments you pay back tax on your more liquid asset holdings; admittedly there are complications and wedges when lending and borrowing rates are not the same. Therefore tax-deductible interest payments makes tax law roughly neutral in intertemporal terms, with lots of qualifications tacked on to that claim, including the possibility that some corporations can avoid the taxes on liquid asset holdings altogether.
The tax deductibility of interest payments operates in a highly imperfect manner, but at its core it is a piece of what an ideal (roughly) neutral tax system would look like, not a deviation from such neutrality.
China bent the curve, Italy bent the curve and I believe that the curve is bending in the United States. Suppression is working and the second part of the strategy of test, trace and isolate will start to come into play in a few weeks. The states are gearing up to test, trace and isolate and several large serological surveys are already underway which will gives us a much better idea of how widely the virus has spread. Ideally, we will move from test, trace and isolate to a situation where we can conduct millions of tests weekly which will take us into the vaccine time.
Before testing is fully operational, however, we will need to follow safety protocols. We can learn about what works from what essential workers are doing now. Green Circuits in CA, for example, redesigned the shift schedule:
His first move was to redesign the plant’s work schedule. The company, owned by the Dallas-based private equity firm Evolve Capital, always had the first and second shifts overlap for a half-hour. That allowed workers arriving in the afternoon to confer with colleagues as they handed off duties.
But O’Neil said they realized that would risk their whole workforce getting quarantined for 14 days, if someone got infected by the coronavirus and spent time at the factory as part of this larger group.
The solution was to create three separate teams of 40 workers each. The first shift now ends at 2 p.m., and then there’s an hour when the workspaces, tools, and breakrooms are sanitized. The third team does not work at all, but rather is held in reserve and available to jump in if an illness hampers one of the two other teams of workers.
Other safety protocols include:
- Shift work for white collar workers as well as for blue collar workers. Including spreading work over the weekends.
- Senior shopping hours.
- Temperature checks, perhaps via passive fever cameras at work and public transport.
- Mandatory masks for public transportation.
- Masks for workers.
- Sanitation breaks for mandatory hand washing.
- Quarantining at work for essential workers, as the MLB is thinking of doing despite not being essential.
- Reducing touch surfaces (even with simple things like propping up bathroom doors) and copper tape for hi-touch surfaces that cannot be eliminated.
It will take longer to reopen restaurants, clubs and sports stadiums but I believe that applying these protocols will allow many of us to work safely. We aren’t ready yet but now is the time to plan for our return.
Jerry Taylor has made some positive noises about her on Twitter lately, as had Will Wilkinson in earlier times. I genuinely do not see the appeal here, not even for Democrats. Let’s do a quick survey of some of her core views:
1. She wants to ban fracking through executive order. This would enrich Russia and Saudi Arabia, harm the American economy ($3.5 trillion stock market gains from fracking), make our energy supply less green, and make our foreign policy more dependent on bad regimes and the Middle East. It is perhaps the single worst policy idea I have heard this last year, and some of the worst possible politics for beating Trump in states such as Pennsylvania.
2. Her private equity plan. Making private equity managers personally responsible for the debts of the companies they acquire probably would crush the sector. The economic evidence on private equity is mostly quite positive. Maybe she would eliminate the worst features of her plan, but can you imagine her saying on open camera that private equity is mostly good for the American economy? I can’t.
3. Her farm plan. It seems to be more nationalistic and protectionist and also more permanent than Trump’s, read here.
4. Her tax plan I: Some of the wealthy would see marginal rates above 100 percent.
5. Her tax plan II: Her proposed wealth tax would over time lead to rates of taxation on capital gains of at least 60 to 70 percent, much higher than any wealthy country ever has succeeded with. And frankly no one has come close to rebutting the devastating critique from Larry Summers.
6. Student debt forgiveness: The data-driven people I know on the left all admit this is welfare for the relatively well-off, rather than a truly egalitarian approach to poverty and opportunity. Cost is estimated at $1.6 trillion, by the way (is trillion the new billion?). Furthermore, what are the long-run effects on the higher education sector? Do banks lend like crazy next time around, expecting to be bailed out by the government? Or do banks cut back their lending, fearing a haircut on bailout number two? I am genuinely not sure, but thinking the question through does not reassure me.
7. College free for all: Would wreck the relatively high quality of America’s state-run colleges and universities, which cover about 78 percent of all U.S. students and are the envy of other countries worldwide and furthermore a major source of American soft power. Makes sense only if you are a Caplanian on higher ed., and furthermore like student debt forgiveness this plan isn’t that egalitarian, as many of the neediest don’t finish high school, do not wish to start college, cannot finish college, or already reject near-free local options for higher education, typically involving community colleges.
8. Health care policy: Her various takes on this, including the $52 trillion plan, are better thought of as (vacillating) political strategy than policy per se. In any case, no matter what your view on health care policy she has botched it, and several other Dem candidates have a better track record in this area. Even Paul Krugman insists that the Democrats should move away from single-payer purity. It is hard to give her net positive points on this one, again no matter what your policy views on health care, or even no matter what her views may happen to be on a particular day.
All of my analysis, I should note, can be derived internal to Democratic Party economics, and it does not require any dose of libertarianism.
9. Breaking up the Big Tech companies: I am strongly opposed to this, and I view it as yet another attack/destruction on a leading and innovative American sector. I will say this, though: unlike the rest of the list above, I know smart economists (and tech experts) who favor some version of the policy. Still, I don’t see why Jerry and Will should like this promise so much.
Those are some pretty major sectors of the U.S. economy, it is not like making a few random mistakes with the regulation of toothpicks. In fact they are the major sectors of the U.S. economy, and each and every one of them would take a big hit.
More generally, she seems to be a fan of instituting policies through executive order, a big minus in my view and probably for Jerry and Will as well? Villainization and polarization are consistent themes in her rhetoric, and at this point it doesn’t seem her chances for either the nomination, or beating Trump, are strong in fact her conditional chance of victory is well below that of the other major Dem candidates. So what really are you getting for all of these outbursts?
When I add all that up, she seems to have the worst economic and political policies of any candidate in my adult lifetime, with the possible exception of Bernie Sanders (whose views are often less detailed).
I do readily admit this: Warren is a genius at exciting the egalitarian and anti-business mood affiliation of our coastal media and academic elites.
If you would like to read defenses of Warren, here is Ezra Klein and here is Henry Farrell. I think they both plausibly point to parts of the Warren program that might be good (more good for them than for me I should add, but still I can grasp the other arguments on her behalf). They don’t much respond to the point that on #1-8, and possibly #1-9, she has the worst economic and political policies of any candidate in my adult lifetime.
For Jerry and Will, I just don’t see the attraction at all.
That said, on her foreign policy, which I have not spent much time with, she might be better, so of course you should consider the whole picture. And quite possibly there are other candidates who, for other reasons, are worse yet, not hard to think of some. Or you might wish to see a woman president. Or you might think she would stir up “good discourse” on the issues you care about. And I fully understand that most of the Warren agenda would not pass.
So I’m not trying to talk you out of supporting her! Still, I would like to design and put into the public domain a small emoji, one that you could add to the bottom of your columns and tweets. It would stand in for: “Yes I support her, but she has the worst proposed economic policies of any candidate in the adult lifetime of Tyler Cowen.”
5. “When thinking about whether new generations can or cannot afford housing keep in mind that the currently existing stock of houses will all be sold to a new generation.” — That’s Alex T. on Twitter!
Yes, the Sam Altman of Y Combinator and Open AI. We even got around to Harry Potter, James Bond (and Q), Spiderman, Antarctica, and Napoleon, what is wrong with San Francisco, in addition to venture capital and the hunt for talent. Here is the transcript and audio. Here is one excerpt:
ALTMAN: I think our greatest differentiator is not how we identify talent, although I will answer that question, but the fact that we treat our own business — we run Y Combinator in the way that we tell our startups to run as a successful startup, which almost no venture capital firm does.
Almost every venture capital firm gives advice they never follow themselves. They don’t build differentiated products. They are not network-affected businesses. They don’t try to build a brand and a community. And they don’t try to make something that gets better the bigger it gets and have the scale effects that anyone would tell you they want in a business.
We at Y Combinator always say we want to get a lot bigger because this is a network effect, this is a network that matters. Most venture capital firms will say out of one side of their mouth, “Oh no, smaller is better,” because they don’t want to work more. Then they’ll tell all their businesses, “The network effect is the only thing that matters.”
Many people are as smart as we are, think about the world in similar ways. But I think we have internalized that we run our firm the same way we tell our startups to operate, and we view the most important thing that we do is to build a network and a network effect.
COWEN: Let me play venture capital skeptic, and you can talk me back into optimism.
ALTMAN: I might not.
COWEN: Let’s say I say, tech has had a stream of big hits: personal computer, internet, cell phone, mobile. You’ve had a lot of rapidly scalable innovations become possible in a short period of time. We’re now in a slight lull. We’re not sure what the next big thing is or when it will come. Without that next big thing, won’t the current equilibrium require a higher rate of picking the right talent than venture capitalists are, in fact, able to do?
ALTMAN: I will talk you out of that one, happily. The most expensive investing mistake in the world to make is to be a pessimist, and it’s a common one. I think that’s actually the most common mistake to make in life. It is true that we are in a lull right now, but it is absolutely, categorically false that — unless the world gets destroyed in a very short term — that we will not have a bigger technological wave then we’ve ever had before.
COWEN: Why can’t I be an optimist but not an optimist about VC? I think new ideas will come through established companies. They’ll be funded by private equity. They’ll happen in China. But the exact formula where you can afford to make so many mistakes because the hits are so big — to what extent does VC rely on that kind of rapid scalability that may not come back?
COWEN: Young Napoleon shows up. What do you think after 5 minutes?
ALTMAN: How young? Like 18-year-old Napoleon or 5-year-old?
COWEN: Before he’s famous, 21-year-old Napoleon.
ALTMAN: From everything I’ve read that would be a definite yes. In fact, the best book I read last year is called The Mind of Napoleon, which is a book of quotes about his views on everything. Just that thick on Napoleon quotes. Obviously deeply flawed human, but man, impressive.