Wednesday, February 15, 2012
Private Equity: Fact, Fiction and What Lies in Between
What good is private equity, anyway?
As its critics see it, these investment pools make money the wrong way -- buying "target companies," slashing jobs, piling on debt and selling the prettied-up remnants, which by then are doomed to fail. To make matters worse, private equity firms get a stunning tax break, paying 15% on profits instead of 35%.
But the industry and its defenders, including presidential candidate Mitt Romney who made his fortune in PE, say it is a strong creator of jobs and value, and a vital source of outsized returns for pension funds, university endowments and other investment pools that serve ordinary people.
Which is true?
While there is fodder for both views, academic research finds that the truth for the industry as a whole is not so dramatic. If the entire PE industry were to disappear overnight, the economy probably would not feel much effect, positive or negative. "In the absence of private equity firms and funds, there are a lot of other types of capital that are trying to do very similar types of things," says Wharton accounting professor Wayne Guay.
Adds Wharton finance professor Richard J. Herring: "The question of whether they add value, in my mind, is really one of whether they only undertake financial restructuring ... or whether they replace management and the board, and undertake an operational restructuring that improves the efficiency of the enterprise."
Financial restructuring, he notes, "usually means withdrawing equity and leveraging the firm's balance sheet, and has very dubious social value." But operational restructuring "can really add value to the economy."
Executives both in and outside of the PE industry say that pure financial engineering is less common than in the past because lenders are pickier, and investors in PE funds are less eager to take the risk that comes with leverage. Adding borrowed funds to the investment pool can increase returns, but also amplifies losses when bets go wrong. While some leverage is still widely used to boost returns, most experts say the goal in most PE investments today is to grow the target firms.
"Private equity firms seek out companies in which they believe they can unlock significant value by changing the business strategy, investing new capital or injecting new managerial talent," says an industry trade group, the Private Equity Growth Capital Council, responding to the recent wave of criticism. "Private equity ownership fosters a climate in which companies can do what is necessary to achieve increased profitability over the long run."
Private Equity versus Hedge Funds
Private equity firms form investment pools with contributions from limited partners, largely pension funds, university endowments, wealthy families and the occasional sovereign wealth fund. The general partners, or owners and managers of the PE firm, typically contribute as well, and many funds, though not all, also borrow to increase their investment resources. A typical fund operates for 10 or 12 years and may or may not distribute some profits to investors along the way before a payday at the end. Limited partners -- LPs -- thus tie their money up for the duration, and they typically have little say in the general partners' investment decisions. Big PE firms run multiple funds at the same time, smaller firms only one.
Worldwide, the industry is estimated to have about $2.4 trillion under management, although minimal reporting requirements make assessments difficult. The Private Equity Growth Capital Council says about 2,300 PE firms are headquartered in the United States, and that they have stakes in 14,200 companies with 8.1 million employees.
PE investments are long-term bets on illiquid assets. Hedge funds, in contrast, tend to make comparatively short-term bets on liquid assets such as stocks, bonds, commodities and derivatives. Venture capital firms, a subset of the PE industry, invest in young companies, while PE firms specializing in leveraged buyouts generally look for businesses that have been around for some time. This may include privately held companies with founders ready to retire, or firms that need growth capital but -- because of poor credit ratings, jittery lenders, low cash flow or other impediments --cannot get it from traditional sources like bank loans or bond issues.
Because investors tie their money up for so long, they expect returns to exceed what they could earn with liquid investments like stocks. Whether the average PE fund achieves this is debatable.
The industry claims enviable returns. "As of September 2010, private equity outperformed the S&P 500 by 11.4 percentage points, 7.3 percentage points and 19.4 percentage points for one-, three- and five-year periods," according to the Private Equity Growth Capital Council. But those figures cannot be verified because the industry is secretive, and findings of academic studies vary.
An oft-cited study by Steve Kaplan of the University of Chicago and Antoinette Schoar of MIT found that PE funds did not produce outstanding results during the 1980 to 2001 period. According to Herring, "it showed that the returns earned by limited partners were more or less equivalent to what they could have obtained by investing in the [Standard & Poor's 500] index once you netted out the substantial fees that were paid to the general partners."
A study by David Robinson of Duke and Berk Sensoy of Ohio State covered more recent performance, from 1984 through 2010, finding that PE investors earned 18% more over the life of the fund than in the S&P 500. While that is a good margin, an 18% edge over 10 or 12 years is not jaw-dropping rewardfor tying money up for so long.
Other research shows that, in contrast to the mutual fund industry, past performance in PE is an indicator of future results, as PE firms that are successful with one fund tend to be successful with the next. If so, investors who stick with the top funds can indeed get outsized returns.
The future, of course, is cloudy. Many PE executives and outside experts warn that while returns may beat the public markets, they are likely to come down as competition in a growing PE industry makes it harder to find good target companies. Reduced leverage may also take a toll. And although PE may be profitable for its investors, critics say the cost in lost jobs and destroyed target companies is too high. This issue flared up in the presidential campaign, with Republican candidate Newt Gingrich describing PE as "exploitative" and job-destroying, and attacking Romney -- a founder of private equity giant Bain Capital who is now worth in excess of $200 million -- for his role in it. Some top PE executives have become billionaires.
Wealth Creation versus Wealth Transfer
The issue is whether PE firms create wealth or merely transfer it from target companies to themselves. One of the most recent studies, by Jarrad Harford and Adam Kolasinski at the University of Washington, looked at 788 large U.S. PE buyouts from 1993 through 2009 and found plundering was not the rule. "All of our evidence is consistent with value creation," the study reported.
"We test and reject the hypothesis that on average private equity sponsors transfer wealth or damage the portfolio company's long-term value," the authors write. "We also test the hypothesis that private equity sponsors extract capital through special dividends and leave the target firm in distress," they add, referring to payments from portfolio firms to the PE fund that are often derived from having the target firm take on new debt. "First, despite the impression given by the public press, we find that special dividends are rare. Second, those that occur are uncorrelated with future portfolio company financial distress."
A look at portfolio firms with publicly traded debt found only 42 special dividends issued in 2,435 firm years, with the issuers and non-issuers showing the same return on assets.
One way for PE firms to extract value is by skimping on research and development and other needed investment at portfolio companies, and then using the savings to pay down debt to improve short-term results. The fund can then sell the firm before the underinvestment comes back to haunt it. But again, Harford and Kolasinski found no evidence that PE firms are damaging their portfolio firms in this way, while they did find evidence that PE ownership tends to reduce damaging over-investment. The results, the authors said, suggest PE ownership mitigates destructive "agency problems," where a portfolio firm's executives put their own interests ahead of the firm's.
PE funds make the bulk of their returns by selling portfolio firms at a profit. The Harford/Kolasinski study noted that only about 10% of these "exits" involved sales to the public through stock offerings. The most common exit was to a "strategic buyer," such as a corporation wanting to add a new unit, and about a third of exits were sales from one PE fund to another. This means most portfolio firms are sold to sophisticated buyers, who could be expected to shun the market if the typical target firm was a gutted shell destined to fail.
But are PE funds and their portfolio companies profiting at employees' expense? Is the industry creating jobs or destroying them? In what they say is the most comprehensive study of the question to date, researchers from the University of Chicago, Harvard, the University of Maryland and the U.S. Census Bureau found that private equity "catalyzes the creative destruction process in the labor market, with only a modest net impact on employment." In other words, change took place faster at portfolio firms than among companies in a control group, but the net job loss among PE firms was only slightly higher -- about 1%.
The study, titled Private Equity and Employment, looked at 3,200 target firms in PE transactions from 1980 to 2005. "Relative to controls, employment at target establishments declines 3% over two years post buyout and 6% over five years," the study reports. "The job losses are concentrated among public-to-private buyouts, and transactions involving firms in the service and retail sectors. But target firms also create more new jobs at new establishments, and they acquire and divest establishments more rapidly. When we consider these additional adjustment margins, net relative job losses at target firms are less than 1% of initial employment."
Control firms were selected for factors like size, age and industry, but the study did not consider whether controls and target firms were in the same financial condition. Because PE firms scour the market for targets with unrealized value, it is possible some of the targets were overstaffed relative to the controls. If so, greater job losses would be expected, but there is no way to know for sure. Of course, many jobs are shed at firms that are not owned by PE funds, some by necessity and some through mismanagement. Most of the millions of jobs lost in the U.S. since the financial crisis were at firms that were not owned by PE funds.
The study is a strong challenge to critics' claim that PE is a massive job destroyer, and it does not support the industry's claim to be a large job creator.
The second issue concerns the tax treatment of private equity earnings known as "carried interest," the general partner's share of the fund's profits. Carried interest is taxed at the 15% long-term capital gains rate rather than as ordinary income, at rates as high as 35%.
While terms are subject to negotiation with the fund's limited partners, PE firms typically receive an annual fee equal to 2% of the capital the LPs have committed to the fund, plus carried interest equal to 20% of the fund's profits. Often, the carried interest applies only to profits exceeding a given annual "hurdle rate," or rate of return on the fund, such as 7% or 8%.
The PE industry argues that the 15% tax on carried interest is consistent with the rate all investors get on long-term capital gains, or profits on investments owned longer than a year. But critics focus on a key difference: Carried interest is profit paid to general partners on money put at risk by the limited partners; with ordinary investments, people get the capital gains rate only for risking their own money. For the general partners, carried interest is a gain without an offsetting risk.
"It's a fee for service," says Wharton accounting professor Jennifer Blouin, rejecting the argument that carried interest is an investment return. "How can you make the argument that that's [the GP's] capital at risk?" Carried interest, she notes, is income the GPs receive for running the fund -- for research, analysis, management and all the other work it takes to find target firms and improve them. "It doesn't look like an investment," she notes. "Those are attributes for which you generate ordinary income" that is taxed as income, not capital gains. When people are compensated for know-how, the compensation is income, she adds.
Critics say carried interest is like other compensation linked to performance and taxed as income, although some of them concede that the general partners are entitled to the low long-term tax on any of their own money put into the fund. Limited partners enjoy the long-term rate and have not been targets of criticism, because they clearly put their own money at risk.
Democratic Congressman Sander Levin of Michigan has been trying since 2007 to get carried interest taxed as income. His measure has passed the House four times but has stalled in the Senate. He has said he will try again this year and may perhaps get a boost from the issue's higher profile.
Legal definitions of income and capital gains aside, the tax break on carried interest can be seen as an incentive, like a tax break to spur oil exploration, to find new medications or to encourage people to save for retirement or to buy homes. "Having lower taxation on long-term capital gains, on long-term investments, is probably a good thing," says Wharton accounting professor Gavin Cassar, arguing it encourages investors to tie their money up. "You make these longer-term projects that require more capital investment more attractive."
But it is difficult, he adds, to disentangle the costs and benefits of applying lower rates to specific types of investments. And even economists, he says, tend to have dogmatic positions on how tax rates affect the incentive to work. In private equity, it is the limited partners who contribute the bulk of the fund, and no one is suggesting they lose the incentive to invest provided by the long-term rate.
Do talented people need a tax incentive to work at private equity firms? Clearly, a higher after-tax income would make any job more appealing. On the other hand, many of the top people in PE are so wealthy that it is likely they have non-monetary reasons for continuing to work, such as satisfaction, prestige and excitement.
To say that tax rates are key to job selection is "a false argument," Blouin states. "The story is that you are there because profits are high, not because tax rates are low." Guay sees carried interest as a type of bonus, because it is paid only after the fund exceeds set performance levels. Bonuses are taxed as ordinary income, he notes.
A study by Andrew Metrick, a former Wharton finance professor now at Yale, found that carried interest makes up only about 30% of PE profits. The rest comes from the 2% annual fee on committed funds. Because the fee income is already taxed as ordinary income, raising the rate on carried interest would affect less than one-third of annual pay.
The broader question is whether there is any need to use tax policy to encourage the private equity industry. Would society suffer if PE were smaller or did not exist at all?
PE firms do make it easier for pension funds, endowments and wealthy individuals to invest in collections of privately held companies, just as mutual funds allow small investors to hold diversified baskets of stocks. But there are many other ways for investors to acquire privately held companies. Wealthy individuals and groups can buy firms, corporations can acquire them, and small companies can merge on their own.
Whatever contribution PE is making, it is not irreplaceable, Guay concludes: "If there are inefficient businesses out there, capital will be drawn to them, whether it's in the form of private equity or in the form of something else."