Mitt Romney and the Public Problem of Private Equity
One of the things I keep hearing during the Mitt Romney private-equity pile-on is that private equity is "natural." This is narrowly true but not particularly interesting in and of itself, like saying that "water flows." It does, but we can control that towards our own interests. For instance: where does all that private equity come from? Not from private-equity firms; that's not how leverage works. Often, it comes from you and me, as Steven Kaplan of the University of Chicago and Per Strömberg of the Stockholm School of Economics write, in a handy overview of "Leveraged Buyouts and Private Equity" (PDF):
The Private Equity Analyst (2008) lists 33 global private equity firms (22 U.S.-based) with more than $10 billion of assets under management at the end of 2007. The same publication lists the top 25 investors in private equity. Those investors are dominated by public pension funds, with CalPERS (California Public Employees’ Retirement System), CasSTERS (California State Teachers’ Retirement System), PSERS (Public School Employees’ Retirement System), and the Washington State Investment Board occupying the top four slots.
First, it is not at all clear that those who invest in PE funds (not the PE partners themselves) do beat the stock market when a full accounting is done. Recent research shows that net of fees, private equity investors (pension funds and university endowments) would have been better off buying the S&P 500.
Kaplan and Strömberg came to a different conclusion, but not all that different:
Kaplan and Schoar (2005) study the returns to private equity and venture capital funds. They compare how much an investor (or limited partner) in a private equity fund earned net of fees to what the investor would have earned in an equivalent investment in the Standard and Poor’s 500 index. They find that private equity fund investors earn slightly less than the Standard and Poor’s 500 index net of fees, ending with an average ratio of 93 percent to 97 percent. On average, therefore, they do not find the outperformance often given as a justification for investing in private equity funds. At the same time, however, these results imply that the private equity investors outperform the Standard and Poor’s 500 index gross of fees (that is, when fees are added back). Those returns, therefore, are consistent with private equity investors adding value (over and above the premium paid to selling shareholders).
That recent research cited by Dean Baker above explains a bit more how that works:
We find that average net-of-fees performance is lower than that of the S&P 500 by 3% per year but gross-of-fees performance is above that of the S&P 500 by 3% per year. Adjusting for risk decreases performance by about 3% per year, bringing alpha net-of-fees to -6% per year.
So why bother? Kaplan and Strömberg make a number of suggestions.
One is that there's kind of a club, and that you have to go through the minors to make it to the big leagues: "It is thus possible that by participating in inexperienced and hence poorly-performing funds, investors tacitly obtain the right to participate in future better performing funds. This would be a first ‘learning channel’ that could explain observed average poor performance for this relatively young industry." (The authors also find that experienced firms do tend to do well versus the stock market.)
For private investors, their "objective may not be only to maximize returns.... These side benefits include consulting work (e.g. for M&As) and underwriting securities for debt or equity issues." Again, it's a club, and there are certain benefits to being in it.
So why should public funds bother? Kaplan and Strömberg have an interesting idea:
In addition, certain investors, most notably pension fund managers and government related agencies, use private equity to ‘stimulate’ local economies (see Lerner et al., 2007). For example, the European Investment Fund (EIF) invested in over 200 private equity funds with the objective to “commit to the development of a knowledge-based society, centered on innovation, growth and employment, the promotion of entrepreneurial spirit, regional development and the cohesion of the Union.”
As an example, here's a 2011 report on transportation from the Urban Land Institute and Ernst & Young (emphasis mine):
After more than 30 years of conspicuously underfunding infrastructure and faced with large budget deficits, increasing numbers of national and local leaders have come to recognize and discuss how to deal with evident problems. But a politically fractured government has mustered little appetite to confront the daunting challenges, which include finding an estimated $2 trillion just to rebuild deteriorating networks....
Despite the nation’s unemployment woes, the vast job-creation potential of infrastructure projects is being sidetracked by concerns about government spending appetites and potential cost overruns....
Real progress may still be possible if waste hawks concentrate more of the limited funding available on merit-based projects with significant national and regional economic benefits and government agencies are motivated to fashion workable partnerships with private operators through improved procurement protocols. The interest in gaining access to private capital and expertise through PPPs should accelerate as public funding sources diminish.
Here's one example of that you might be familiar with:
Few investments look as appealing as those blessed by government dollars. As part of the $787 billion federal stimulus package signed into law in February, the government has earmarked $29 billion to patch crumbling roads, bridges, and schools. Thanks to Uncle Sam, the infrastructure investing trend is picking up. The states' cash crisis is also sparking interest. "With states facing real economic trouble, you will see further pressure on them to hand over infrastructure to private firms," says Ben Heap, co-head of infrastructure in UBS's (UBS) private equity group. There were 127 infrastructure funds in 2008, up from 91 in 2006, according to research firm Probitas Partners.
When Sadek Wahba, investment chief at Morgan Stanley's (MS) $4 billion infrastructure fund, goes shopping for deals, he follows two main principles. First, invest only in public necessities. Second, make sure the concerns of local citizens are heard—to minimize political problems later. In December, Morgan Stanley and a group of investors paid $1.15 billion for 36,000 parking meters in Chicago. Wahba is converting the old coin-operated devices to electronic pay machines. "These assets are a good hedge against inflation, because you are providing a basic service," says 43-year-old Wahba.
I keep saying it over and over again: the city, unwilling or unable to raise rates and modernize the parking system its own self, privatized not just the meters but the political risk (some of it, at least). And where'd that $1.15 billion come from?
[A] Chicago News Cooperative investigation has found that investment arms of the oil-rich Abu Dhabi government hold more than a 25 percent stake in the company that privatized the city’s 36,000 parking meters.
According to the most recent filings, partnerships assembled by Morgan Stanley have a 50.1 percent stake in the parking company through capital provided by entities like the Teacher Retirement System of Texas, the Victorian Fund Management Corporation of Australia and Danish pension fund company PKA. The other 49.9 percent belongs to a company almost evenly divided between Allianz and Tannadice Investments LLC.
Tannadice is a “wholly owned subsidiary of the Abu Dhabi Investment Authority, which is a public institution wholly owned by the Government of the Emirate of Abu Dhabi,” according to city records. Another fund of the Abu Dhabi government owns an additional 3 percent stake through one of the Morgan partnerships.
So the Texas TRS, PKA, and Tannadice are all gummit money. The Victorian Fund Management Corporation? "A government owned investment manager." A lot of the action in private equity comes from public money, which is increasingly being directed by private companies to buy public infrastructure. It could be "natural" in the sense of evolution, or "natural" in the sense of a snake eating its own tail. Which is even more depressing if you think that private-equity firms are "vile job crushers," (or a "vulture capitalist," if you prefer Rick Perry's phrasing) since that means they're vilely crushing jobs with our money at our behest.
Which raises the question: how can we stop hitting ourselves? Divestiture is one option. At Yale, students followed Brown in convincing the university to get out of the private-equity fund HEI, as Chicago labor organizer/writer Micah Uetricht reports in The Nation:
HEI is a private equity fund that purchases and operates hotels. The company has expanded rapidly since it was established in 2002. After purchasing a hotel, HEI “adds value,” according to Riddhi Mehta-Neugebauer, a researcher for the hotel and restaurant workers union UNITE HERE, by lowering labor costs which sometimes involves the violation of basic labor laws. This allows the company to profit when the hotel is subsequently sold. Last year in Irvine, California, for example, non-union workers at the HEI-owned Embassy Suites went on a wildcat strike, then filed and won a suit against their employer over denial of legally-mandated breaks when a state Labor Commissioner hearing officer ruled that HEI violated the law by denying the breaks and ordered HEI to pay back wages.
Since the fund’s inception, HEI has sought university endowments as major investors. Such funds are massive, especially at elite schools.... Yale students estimate their school’s holdings at $119 million.
That's one option: pulling money out of private-equity funds on a case-by-case basis. Nothing wrong with that, but it's complex and requires lots of oversight and a lot of public effort that's not always forthcoming. It would be nice, for lazy people like myself, if there were some way of making sure private-equity firms' hearts, or at least their dollars, were in the right place.
Speaking with Mike Konczal, Josh Kosman, author of The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy, has some ideas. Konczal asks:
The tax code is set to overlever firms, which require increases in earnings to go toward debt payments instead of research and development, expansion, and other things that build the firm. What could we change to generate different outcomes?
And Kosman responds:
The big fix I’d encourage is an end to interest-tax deducibility for leveraged buyouts. The tax system encourages companies to borrow as much as they can. For certain industries, like telecom, these deductions might make a lot of sense. But it was never intended for financing leveraged buyouts. If you put a cap on this you would find buyouts and private equity firms that were much more focused on building companies.
This is why I think Mitt Romney is in a bit of a pickle as a private-equity-fund manager for reasons besides "job destruction." One of the most significant issues of the Great Recession is how government policy and business strategies encouraged individuals to take on massive amounts of debt; as Amir Sufi of the University of Chicago has argued, household debt was a significant driver of high unemployment. That debt was then magnified throughout the banking system, leading to bailouts and all sorts of unpleasantness. Romney's in the business of debt; it's not a good business to be in right now, at least in terms of PR value.
Anyway, regarding Kosman's suggestions, European countries are tightening their tax rules:
Germany and France are two of the most notable examples to have taken up the Commission’s cause at the member state-level. Take Germany for example: since 2008 private equity firms operating in the country could offset no more than 30 percent of a company’s earnings with tax-deductible interest payments if the net interest expenses exceed €3 million (subject to difficult exceptions)....
Prior to the reform, debt interest deduction rules were “rather favourable” in France, says Latham & Watkins tax partner Olivia Rauch-Ravisé. Ongoing market volatility however has meant a change in attitude, with France also considering “further restrictions on tax-deductible interest payments for next year as well”, adds Rauch-Ravisé. Already “the second amended 2011 Finance Law voted in September placed tight restrictions on the use of carry-forward tax losses to offset future profits, impacting once again the tax leverage of many French private equity transactions”.
France and Germany are by no means an exception. Italy, the Netherlands, and the UK have all recently implemented or reformed their respective thin capitalisation rules in light of market developments.
Sweden in particular is becoming a more vocal critic of the tax benefits offered by leveraged buyouts. Sweden’s finance minister, Anders Borg, hinted the government would review debt tax shields in the near future, according to an October report from Sweden daily Dagens Industri.
And the EU is involved (from a post entitled "How the public misses out on how fights over bank regulations affect them"):
The EU has decided it does not like the nasty propensity of PR funds to lever up corporations, pull out a lot in the way of special dividends, and too often overdo the cash extraction and leave a bankrupt hulk in their wake. The EU has been working on a proposal to restrict investors in the EU from putting funds in private equity and hedge fund firms outside the EU, and also limit the ability of foreign investors to buy European companies.
Here, not as much, though a late, legendary Chicago pol, not particularly known for his unfriendliness to capital, did give it a shot:
In 1987 the chairman of the House Ways and Means Committee, Rep. Dan Rostenkowski, after congressional investigations of the first wave of LBO disasters, proposed to close the tax loophole that rewards takeovers with borrowed money. But that was the year of a stock market crash, and Congress was in a mood more to restore confidence than to reform the abuses.
Maybe it would help matters if a private-equity firm ran a beloved sports franchise into the ground:
Who benefits from all this? In the case of Manchester United it is certainly not the fans - the customers; the players - the employees; or the management -Sir Alex Ferguson and his staff, whose opportunity to share in the increase in equity value they built was flattened when the club was taken private.
The beneficiaries have been the Glazer family and the bankers, lawyers and accountants. (Just the banking fees for last week's bond offering equates to more than half of what Manchester United paid for Wayne Rooney).
In some ways, this is a long explanation of why I get het up when I see some aspect of capitalism described as "natural" (and check for my wallet when I do). Fire and cancer are natural forms of "creative destruction" that we nonetheless have an instinctual and overwhelming need to restrict and regulate, even if we accept them as probably inevitable.
And it's also frustrating to see this boiled down to Mitt Romney and a need to answer for Bain Capital. The problems and promise of private equity are much greater than that, and in some ways—some more directly than others—Romney and his peers are doing less the bidding of nature than civilization.
Related: Kosman with Chris Hayes on Up With Chris:
Photograph: Dave Delay (CC by 2.0)