Private equity - friend or foe?

The topic of private equity firms and their role in the economy became increasingly popular during the past few months, particularly in the US. The subject became the main point of discussion due to its linkage to a certain American presidential candidate and to some extent due to the rising importance of the inequality debate and high unemployment in America. The private equity industry is depicted as one the main 'evils' of capitalism. No matter how absurdly this sounds, the people and the media were concerned that the existence of private equity firms can only harm the productive business environment. They are pictured as corporate raiders who "ride on the backs of businesses, ripping them off and earning a profit on their misfortune". The second main criticism is that their executives receive too much money (and don't pay enough taxes). (FYI, in the movie "Pretty Women", Richard Gere portrayed a typical private equity executive - just so you might get a better idea of who these people are, or at least how the public sees them).

Before digging in deeper into the subject, one should differentiate between two types of private equity firms: leveraged buyout private equity investors, which invest into poorly managed companies, repair them and sell them for a profit (like the character played by Gere); and venture capital firms which invest into start-up companies (like Peter Thiel's angel investment in Facebook in 2004). Unsurprisingly the leveraged buyouts are the ones under heavy public criticism of having an inexhaustible thirst for profits, and burdening the companies they buy out with too much debt. 

Let’s take a closer look at this criticism. Private equity firms take over poorly managed companies in order to make them more efficient and more productive before they sell them off for a profit. It invests into a company non publicly traded and with a limited access to capital (compared to bigger publicly traded companies) and it does so by raising capital (usually through debt) to buy equity (ownership) of a particular company. The company gets better access to capital and it gets help from its new owners in managing the company. The firm has a goal to maximize the value of the acquired equity (maximize the return to investment). It can do this by driving a company towards an IPO, sell or merge it with another company or it recapitalize it in order to make it more efficient. In each case the investor is looking to make a profit, which is a perfectly normal incentive for someone willing to take the risk of managing a falling company. 

The whole process often involves cutting jobs, but this needs to be looked at from a different perspective: they invest into weaker companies in the first place. A private equity firm replaces the old inefficient management and ensures a reallocation of labour and capital. This creates anger with those who lost jobs and were put in a worse-off situation but it is very likely the firm would have gone under anyway due to poor former management. The entry of a private equity firm isn’t a guarantee of success, but it does try to offer help to those firms who have the potential to succeed in a global economic environment but just happened to be poorly managed at one point in time. On the other hand it also speeds up the process of failure of those companies which were never really going to make it in the market, and were unable to adapt to market conditions and consumer demand. One can say that, essentially, private equity firms make the creative destruction process a bit quicker and less painful.

A recent NBER working paper by Davis et al (2011) tracked 3200 leveraged buyouts to compare the performances of acquired firms before and after the buyout. They found that private equity resulted in a rapid job destruction but also in a faster job creation. The net job losses were found to be less than 1% of initial employment:

"private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment. The creative destruction response mainly involves a more rapid reallocation of jobs across establishments within target firms." Davis et al (2011)

After all, the whole point of private equity firms isn't creating jobs (even though in the long run it indirectly does create more jobs by enabling the firms to expand and hire more people, create more value and create business for other sectors of the economy) – its main emphasis is improving efficiency, productivity and producing high returns. They bring in new ideas based on successful examples of previous restructuring which very often results in a successful venture, for both the company and themselves. 

Improving productivity is not always an easy process. This often involves cutting off the weakest performers and enabling the remaining ones to use the tools at their disposal more efficiently. One way to ensure this are performance incentives to the CEOs of the newly acquired companies. The performance-based compensation means that the CEOs had an extra incentive to make their businesses as efficient as possible. This is also tied up with the burden of high leverage and the fact that they needed to pay off the debt out of existing cash flows. Even though this is a big expense for a company it provides a good incentive for CEOs to keep up with rising productivity and efficiency.  

Finally, if their role is to speed up the process of creative destruction which always ensures that the net job and value creation in the economy are positive, then private equity firms should be striped of their negative connotations. People often fail to see the long term effects of things like leveraged buyouts; they only focus on the short term job loss figures. But the system of dynamism in an economy is bound to create and destroy jobs at the same time, and these forces are not to be tampered with. Both job creation and job destruction are important in a dynamic economy since sometimes the market send signals of resource misallocation, so a dynamic response should be an adjustment in terms of more busts and job losses, only to channel those resources into more productive activities and eventually more jobs.