More on Private Equity Firms: What Are they Good For?

May 24th, 2012 at 3:30 pm

I’ve very much enjoyed the recent debate over Bain Capital and the role of such private equity firms in the economy, not for partisan reasons, but because it’s far too rare that we step back and ask about the societal costs and benefits of opaque mechanisms like PE. 

I mean, if I showed you a barber shop, a school, a car factory, an accounting firm—you’d quickly get what they were doing here. But PE is different, and absent explanation, it’s easy to get stuck on one end of the “vampire/vulture-to-capitalism’s-savior” continuum.  In that regard, here’s one of the more nuanced, and thus worth reading, pieces about private equity and its role in the larger economy.

Note, for-the-record, that I’m not talking here about this week’s debating point as to whether PE experience is relevant to the job of president—the main point I and others have tried to bring to that debate is: whatever the merits and demerits of private equity, job creation is not part of the mix.  If profitability meant laying off workers, that’s what the PE firm would do, and visa versa.

In this post, I’d like to add two points to the discussion: 1) job growth and profitability, and 2) the tax implications of debt financing. 

As stressed in the NYT piece:

The business of private equity firms is buying and selling companies, all done with the goal of earning big returns for themselves and their investors. Sometimes that means jobs are created; sometimes it means jobs are lost.

This begs the question about the relationship between “big returns” and job growth.  Statistically, they’re both cyclical variables, and both tend to go up in expansions and fall in recessions.  But to what extent is job growth a function of profitability?

Theoretically, it’s not as simple as you’d think.  Profits=revenue-costs, and labor is a cost.  So, depending on underlying demand and the level of productivity, profitability might be enhanced by hiring more people or firing more people (the micro-theory says you hire up to the point where the value added of the last person hired equals the revenue they produce, but that’s too vague a guide in practice).

Like everything else in economics, the relationship between profitability and job growth must be evaluated empirically.  The figures below compare this relationship across three different periods using yearly private sector job growth and corporate profits as a share of national income.  Both variables are indexed to 100 in the base period; the profit share increase represents percentage points over the base year.

In the 1990s, profits relative to income went up a few percentage points—about an average recovery—but job growth was quite strong.  In the 2000s, profit growth accelerated but job growth slowed quite sharply.  And most recently, in the great recession and its aftermath, profits have more than recovered while employment is only slowly climbing back. 

It’s quite remarkable, given how damaged the economy and especially the financial sector were after the crash, how quickly profits reversed course.  Of course, part of this was due to Wall St. bailouts—financial sector profits have led the way.  It’s also the case that globalization enables American multinationals to ratchet up foreign profits even while the US market remains sluggish.  But the larger point is that solid profit growth in the current recovery hasn’t given much of a lift to jobs.

Turning to debt financing, here’s where I think PE as it has evolved in America (and elsewhere, though less so because of less favorable tax treatment) is truly problematic.   As I stressed here, because interest on their borrowing is tax deductable, debt financing and PE are locked in a symbiotic relationship that distorts incentives and leads to levels of indebtedness that can cripple otherwise stable companies. 

And the tax incentive is huge.  According to the Treasury Dept:

..the effective corporate marginal tax rate on new equity-financed investment in equipment is 37 percent in the United States. At the same time, the effective marginal tax rate on the same investment made with debt financing is minus 60 percent—a gap of 97 percentage points. This compares to an average difference of about 51 percentage points for other G-7 countries…

And they use it.  According to this academic study, the median PE deal in the 1990s and 2000s was 70% leveraged (h/t: MG).

At the end of the day, I don’t have a global position as to whether PE deals, on average, add value or not.  Their existence in certain cases looks to me like it imposes a discipline on management that is useful in discovering efficiencies that would otherwise have gone untapped.  In other cases, they seem to extract value for themselves and their shareholders in ways that do more harm than good to the company, its workers, and its community. 

Either way, they’re not net job creators and they sure don’t need that crazily huge, hugely distortionary tax break.  And if a former PE guy or gal were to run for president, I’d like to hear them emphasize those two points.

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5 comments in reply to "More on Private Equity Firms: What Are they Good For?"

  1. Jill SH says:

    Would it be possible to regulate how much a PE firm could finance in a PE deal? Bain stories on NPR cite two cases where Bain put in $5million down and financed $35million, and another 6.5 million down and 43 million financed.

    What if regulation required that a PE firm put up minimum 50%? Or maybe not get the tax break on financed funds that exceed that?

  2. perplexed says:

    Dean Baker posted a link to this recent CEPR paper on PE:

    Data causes so many problems for these myths. Its no wonder the republicans hate all this science stuff.

    • perplexed says:

      BTW, here’s just one excerpt from that study:
      “In the case of Friendly’s, Sun Capital sought to use the bankruptcy proceedings to write off debt and to rid itself of the company’s pension obligations to its nearly 6,000 employees and retirees, while continuing to own the restaurant chain. Immediately after Friendly’s entered bankruptcy, another Sun Capital affiliate announced its intention to acquire Friendly’s. With less than two months between the bankruptcy announcement and the date set for the auction of Friendly’s, no other bidders came forward. Sun Capital was allowed to “buy” Friendly’s in a “credit-bid” sale – that is, Sun Capital could hold onto ownership of Friendly’s by wiping out a $75 million loan it had previously made to Friendly’s (Brickley 2011) and assuming some of Friendly’s liabilities. A key part of Sun Capital’s restructuring plan is to shift liability for Friendly’s pension plan to the federal government’s Pension Benefit Guaranty Corporation (PBGC). Generally, PBGC does not require companies to make good on pension plans they can no longer afford. But in an unusual move, PBGC announced that it will fight Sun Capital’s attempt to stick U.S. taxpayers with the bill. PBGC objects to what appears to be a transparent effort by Sun Capital to take advantage of the bankruptcy process to abandon pension obligations while continuing to keep its ownership of Friendly’s (U.S. Bankruptcy Court 2011, Abelson 2011).”

      It looks like we really need an accounting of what the “efficiencies” behind PE deals are costing the PBGC & the pensioners that now take the reduced amounts for the pensions they worked for so many years to accrue. Possibly some of these pensioners could have used the extra cash to make loans to their children to fund their educations like Romney suggests.

  3. Paul Papanek says:

    So — a possible society benefit from PE (private equity) ventures is an additional “discipline” on company management, beyond what the market or a Board of Directors might otherwise impose.

    That’s IT? That’s ALL? . . . as if the market, with its own discipline of supply-and-demand, isn’t enough?

    (And, frankly, Professor, I think you’re right — that really IS all there is on the benefit side.)

    So — in your analysis above, PE (private equity) ventures provides very little benefit to society as a whole. But they do bring huge risks of job loss and dislocation. The fact is that concentrated capital makes contracting inherently unsymmetric, and therefore in need of regulation as a matter of fair play.

    Furthermore, we have also seen that concentrated capital can make mincemeat out of what previously seem to be well guaranteed contract rights, such as pensioners’ benefits. Must good companies spend more money on lawyers to make such worker benefits secure from the future predations of concentrated capital? More pay for lawyers, to protect against future PE predators? That’s not good for society.

    So, in sum — there is plenty bad with the Bains of the world, and not much that’s good for the society as a whole. The next step for principled leaders is obvious: major constraints on the predations of venture capitalists.

    We really do not need the Romneys of the world as our political leaders.

  4. Michael says:

    Nah, it’s just vampire/vulture. A symptom of the end of Fordism.