Archives For private equity

In criticizing Governor Romney’s involvement with Bain Capital, President Obama commented both on private equity and on profit maximization.  Most of the comments I have seen dealt with the private equity.  I thought a comment on profit maximization was important as well.

  • Updated May 23, 2012, 7:51 p.m. ET

A Tutorial for the President on ‘Profit Maximization’

Profits provide the incentive for firms to do what consumers want.


In justifying his attacks on Bain Capital, President Obama argues that “profit maximization” might be an appropriate goal for a private-equity firm, but not for more general public policy. This argument ignores one of the most basic premises of economics.

We economists assume that firms always maximize profits, and that profit maximization by firms (all firms, not just private-equity ones) is a very good thing. But this is not because profits are in themselves good. Rather, profit maximization is good because it leads directly to maximum benefits for consumers. Profits provide the incentive for firms to do what consumers want.

Consider what contributes to profit maximization. In simple terms, profit maximization means producing the products earning the highest returns, and producing these products at the lowest possible cost. Both are socially useful behaviors that benefit consumers.

Which products produce the highest returns? The answer is the products that consumers want and are currently underproduced. If there are excess returns (profits) to be earned in some market, that is because consumers are willing to pay more for those products than the current cost of production.

Profits are earned by producing more of these products—that is, by satisfying unmet consumer demands. Profit maximization means doing the best job of satisfying these unmet demands, and so providing benefits to consumers. If the unmet demand is for a currently nonexistent product that consumers will value when it is produced (Facebook, the iPhone, Google search), then of course even more profits can be earned.

A firm such as Bain that is involved in investing capital can only make money if it succeeds in satisfying consumer demands. Of course, its goal in deciding where to invest is to maximize returns for its investors, but that is a detail. It will only succeed in this goal if it does a good job of identifying and satisfying consumer demands for products.

The second trick to maximizing profits is to reduce costs as much as possible. This may involve eliminating some unneeded resources, which may translate into unemployment in the short run. It may involve recombining resources into more productive configurations, or restructuring governance of the firm.

The immediate purpose of reducing costs is to increase the profits of investors, but the ultimate result is to benefit consumers. In the textbook ideal of a purely competitive economy, cost reductions will immediately translate into lower prices for consumers. But in any market structure—competition, monopoly or oligopoly—profit-maximizing behavior translates reduced costs into reduced prices for consumers.

Consider the converse: What if a business does not maximize profits? Then it is either not making the products that consumers want the most, or it is not producing its products at the lowest cost. In either case, consumers are harmed. Any argument against “profit maximization” is an argument against consumer welfare.

Maximizing consumer welfare is the ultimate justification for an economy. Consumers are of course also workers and voters. Contrary to President Obama’s claim, skill at profit maximization does translate directly into skill at governing the economy. Failure to understand this simplest and most basic point is probably itself enough to disqualify someone from the presidency when economic issues are paramount.

Mr. Rubin is a professor of economics at Emory University and president elect of the Southern Economic Association.

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Jonathan Macey (Yale) defends private equity against nonsensical attacks from Newt Gingrich, Jon Huntsman and others (Rick Perry is spared by Macey, but not by Bainbridge) in today’s Wall Street Journal:

Mitt Romney’s candidacy is subjecting the entire private-equity industry—where Mr. Romney spent most of his business career—to vicious attacks by journalists and several of his rivals for the Republican presidential nomination.

Newt Gingrich’s political action committee is sponsoring a film called “When Mitt Romney Came to Town” that accuses Mr. Romney and his former company, Bain Capital, of taking over companies, looting them, and then tossing their workers out on the street. Jon Huntsman’s attacks on his rival include the description of private equity as a business that “breaks down businesses [and] destroys jobs, as opposed to creating jobs and opportunity, leveraging up, spinning off, [and] enriching shareholders.”

This is anticapitalist claptrap. Private-equity firms make significant investments in companies, mainly U.S. companies. Most of their investments are in companies that underperform industry peers. Frequently these firms are on the brink of failure.

Professor Macey ends with a sharp, and I think wholly appropriate, note:

Assaults on the private-equity industry really are attacks on economic freedom, because the private-equity process is nothing more and nothing less than free-market capitalism at work. Shame on all the people, particularly those who claim to be friendly to capitalism, who attack Mitt Romney because of his association with the U.S. private-equity industry.

There is, of course, another angle to evaluating the attacks against Romney’s private equity experience.  As Larry Ribstein was fond of pointing out, for example here and here:

I understand what the OWS crowd will make of this story.  But they need to persuade me why this story should make Romney look worse than the typical presidential candidate who has spent his life in politics and whose job history has consisted mainly of engineering wealth transfers from weak interest groups (e.g., taxpayers) to more powerful ones (e.g., big banks).

Larry’s critiques, unfortunately, should be mandatory reading not just for the “OWS crowd,” but for the Republican candidates — especially the few that claim to be market-oriented.

Via Professor Bainbridge, I read today about the nonsense surrounding Mitt Romney enjoying firing people.  I’m late to the this one, but here is the quote in context for anybody who missed it:

“I want individuals to have their own insurance,” he said. “That means the insurance company will have an incentive to keep you healthy. It also means if you don’t like what they do, you can fire them. I like being able to fire people who provide services to me.

“You know, if someone doesn’t give me a good service that I need, I want to say I’m going to go get someone else to provide that service to me.”

Bainbridge explains why, even if one was to take this quote and extend it to Romney’s days at Bain Capital, the ability to fire people who are are failing to provide a needed service is a feature of a well-functioning market for corporate control, not a bug:

In many cases, restoring a business to efficiency and profitability thus requires the kind of shakeup occasioned by a corporate takeover, such as the sort of LBOs in which Romney specialized, which brings in new managers who are willing to fire people.   LBO specialists who like to fire people thus played — and still play — a critical role in ensuring that US corporations are sufficiently lean to compete effectively in a pitiless global economy.

The economic point goes well beyond the market for corporate control.  The ability to impose sanctions on an economic partner is fundamental to modern contracting.  In nearly every treatment of the economics of contracting, one begins with the notion that the transacting parties potentially have at their disposal both reputational capital — that is, self-enforcement — and written enforcement as means for assuring contractual performance.  Klein & Leffler (1981) is the model that comes to mind.  The key insight is that parties do not have to rely upon imperfect court enforcement, but can create self-enforcement mechanisms were performance is assured not by litigation, but by threat of termination of the economic relationship.  The costs imposed on the non-performing party are not damages, but the loss of the expected premium stream from the economic relationship. In the economic literature, self-enforcement has been used not just to explain economic relationships in which court enforcement is entirely unavailable, but the complementary nature of written terms and reputational enforcement in a wide array of complex contractual arrangements including franchising arrangements, tying, resale price maintenance and exclusive dealing.  I discuss the distinction between standard economic approaches to contract that ignore these complementarities and the Klein (and also Oliver Williamson) approach to self-enforcement here.

The role of termination in facilitating well functioning economic relationships is critical in not just the market for corporate control,  but it all kinds of product and service markets.   It is hard to take these arguments against Romney seriously — even harder than the arguments disparaging his role at Bain.   In context, what Romney actually said is unremarkable.  How many of us don’t want to be able to terminate our economic relationship with the restaurant that feeds us low quality food or the service person who we find out shirked and provided shoddy quality work after the fact?  Our ability to do so constrains economic opportunism.  Perhaps the real objection is not that Romney talked about termination, but that he expressed a preference for terminating shirkers with whom he has economic relationships.   Not only does he fire people, but he likes it!  Perhaps the appropriate response then, from an economic perspective, is not to pillory him for it a la Huntsman, but to thank him for allowing us to free-ride on his efforts.

Krugman on private equity

Larry Ribstein —  10 December 2011

Paul Krugman, writing in Thursday’s NYT, sees Romney as a real life version of Oliver Stone’s Gordon Gekko in the film Wall Street.  He characterizes Romney and his private equity ilk as job-destroyers, and argues that they should be taxed (and presumably also regulated) accordingly. He contrasts this with the supposed position of the GOP “to canonize the wealthy and exempt them from the sacrifices everyone else is expected to make because of the wonderful things they supposedly do for the rest of us.”

I earlier wrote on the NYT’s previous attempt to make political hay out of Romney’s business career.  The story focused a lot of unfavorable rhetoric on one of Bain’s deals.  I pointed out that, clearing away the rhetoric, although there was some short-term job and salary loss, the restructured company ultimately

became an industry leader, just as Bain Capital had intended. With its overseas acquisition, the company’s labor force swelled to 7,400 workers. The business invested in and refined products, like a test that rapidly detects whether a heart attack has occurred, that became widely used. From 1995 to 1998, Dade’s annual sales rose to $1.3 billion from $614 million. Its assets grew to $1.5 billion from $551 million. But another number was climbing just as fast — Dade’s long-term liabilities, which surged to $816 million from $298 million.

There was a bankruptcy after Romney was no longer associated with Bain, but

In 2007 it was sold to Siemens for $7 billion — 15.5 times the price paid in 1994 for an “ailing” orphaned division of a big corporation. The article concludes with the suggestion that the “painful” layoffs “ultimately worked.”

In short, the story’s details don’t support its slant. Romney’s “brand of capitalism” seems to have worked in this instance, even if its success was colored by events that occurred after he left Bain. Although I’m not suggesting that Romney should or would run the country the way he ran Bain and Dade, I’m also not troubled by his history as a deeply invested owner and manager of Bain. True, he and the other “elites” at his firm made a lot of money. But if every deal was like Dade, it’s not clear society as a whole, including the working class, came out worse.

Now along comes Krugman with his own take on Romney-the-job-destroyer. Krugman seeks to support his point by comparing Romney to a fictional character. 

Now, I’ve spent more than a little time deconstructing Hollywood’s anti-capitalist bent in general and Oliver Stone’s fanciful Gekko invention in particular.  One would think that a Nobel laureate could do a little better than to draw support for his criticism of an industry from a cartoonish portrayal of it, even if the laureate in question has traded academic journals for the editorial pages. 

In fact, Krugman does do a little better by citing a “recent analysis of “private equity transactions” as concluding that, while they both create and destroy jobs, “gross job destruction is substantially higher.” Based on this evidence Krugman concludes:

So Mr. Romney made his fortune in a business that is, on balance, about job destruction rather than job creation. And because job destruction hurts workers even as it increases profits and the incomes of top executives, leveraged buyout firms have contributed to the combination of stagnant wages and soaring incomes at the top that has characterized America since 1980. * * *

The truth is that what’s good for the 1 percent, or even better the 0.1 percent, isn’t necessarily good for the rest of America — and Mr. Romney’s career illustrates that point perfectly. There’s no need, and no reason, to hate Mr. Romney and others like him. We do, however, need to get such people paying more in taxes — and we shouldn’t let myths about “job creators” get in the way.

There are a number of holes in this “analysis.”  Let’s start with the evidence Krugman relies on.  Curiously, he omits one of the main findings of the paper.  In the paragraph immediately following the quote about gross job destruction the authors observe:

While noteworthy, these results make up only part of a richer and more interesting story about the employment effects of private equity. Using our ability to track each firm’s constituent establishments, we estimate how employment responds to private equity buyouts on several adjustment margins, including job creation at greenfield establishments opened post buyout. This aspect of our analysis reveals that target firms create new jobs in greenfield establishments at a faster pace than control firms. Accounting for greenfield job creation erases about one-third of the net employment growth differential in favor of controls. Accounting for the purchase and sale of establishments as well, the employment growth differential is less than 1 percent of initial employment over two years.

In other words, private equity doesn’t destroy jobs, but reallocates them from less productive uses to more productive uses in new, or “greenfield,” businesses.  This point is emphasized in the abstract of a much more recent version of the paper Krugman chose to ignore, released last summer (emphasis added):

Private equity critics claim that leveraged buyouts bring huge job losses. To investigate this claim, we construct and analyze a new dataset that covers U.S. private equity transactions from 1980 to 2005. We track 3,200 target firms and their 150,000 establishments before and after acquisition, comparing outcomes to controls similar in terms of industry, size, age, and prior growth. Relative to controls, employment at target establishments declines 3 percent over two years post buyout and 6 percent over five years. 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 percent of initial employment. In contrast, the sum of gross job creation and destruction at target firms exceeds that of controls by 13 percent of employment over two years. In short, 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.

Krugman’s analysis has other holes in addition to its evidence deficit.  First, it is fair to say that private equity’s objective isn’t to create jobs but to make money.  One hopes that the two will go hand in hand, but there are many reasons why they may not, including government policy.  In other words, there’s a problem when employing people costs firms money, but private equity is only the messenger. The point of my earlier blog post on this is that Romney’s experience restructuring firms gives him a lot better idea than many politicians, including the current president, of what government needs to do to fix the underlying problems.

Second, Krugman seeks to leverage his analysis of private equity into criticism of the 1%, concluding that “we do. . . need to get such people paying more in taxes.” Even if you are willing to conclude that private equity destroys jobs and shouldn’t get any breaks, this is far from killing the argument that business as a whole would thrive if less burdened. This could include some of the businesses that Bain profited by restructuring.

The bottom line is that one shouldn’t read Krugman without a grain, or perhaps a whole tub, of salt.

The NYT on Romney @ Bain

Larry Ribstein —  13 November 2011

A long front page article in today’s NYT tries to make political hay out of Romney’s time at private equity firm Bain Capital.  The article supports the White House’s efforts to, as the article says, “frame Mr. Romney’s record at Bain as evidence that he would pursue slash and burn economics and that his business career thrived by enriching the elite at the expense of the working class.”

To do this, the NYT picks one transaction, medical company Dade International, from the 150 handled by Bain during Romney’s 15-year tenure (financing Staples as a startup is mentioned in passing).  The Times says the “deal shows the unintended human costs and messy financial consequences behind the brand of capitalism that Mr. Romney practiced for 15 years.”  The Times summarizes the transaction as follows:

At Bain Capital’s direction, Dade quadrupled the money it owed creditors and vendors. It took steps that propelled the business toward bankruptcy. And in waves of layoffs, it cut loose 1,700 workers in the United States, including Brian and Christine Shoemaker, who lost their jobs at a plant in Westwood, Mass. Staggered, Mr. Shoemaker wondered, “How can the bean counters just come in here and say, Hey, it’s over?”

Apart from the question of whether the Dade transaction was typical, what does the Times show about the Dade transaction?  Let’s review the facts in the NYT story.

In 1994, Bain led a buyout group in purchasing the Dade, which the Times describes as “ailing” and “rife with problems,” from Baxter International. 

Romney himself was “quite knowledgeable about the business” according to Dade’s then CEO. The article describes how Bain imposed the discipline on Dade that was a key innovation of the private equity industry. I summarize the incentive mechanisms that private equity employed here and in Chapter 8 of Rise of the Uncorporation. The Times article suggests this is how Bain operated in running Dade:

Dade employees could always tell when Bain Capital executives were in town: their bosses worked longer hours. “The thing Bain brought was urgency,” Mr. Brightfelt [a former Dade president] said. “It was 24 hours a day. It never stopped.” At Dade’s headquarters, the men from Bain — young, nattily dressed Bostonians — exerted themselves in ways big and small as the new owners. They took a majority of seats on the board of directors. They interviewed candidates for high-level jobs. They negotiated crucial contracts with suppliers. And they requested reams of data.

This clearly wasn’t a slash-and-run takeover.  Bain expanded Dade rather than just firing the workers and selling out for a profit, based on Romney’s desire to “double down on Dade.” As a result, the company

became an industry leader, just as Bain Capital had intended. With its overseas acquisition, the company’s labor force swelled to 7,400 workers. The business invested in and refined products, like a test that rapidly detects whether a heart attack has occurred, that became widely used. From 1995 to 1998, Dade’s annual sales rose to $1.3 billion from $614 million. Its assets grew to $1.5 billion from $551 million. But another number was climbing just as fast — Dade’s long-term liabilities, which surged to $816 million from $298 million.

So what’s the problem?  While the article wants to make a lot of the overleveraging of Dade, during Romney’s tenure debt apparently increased in line with assets. The firm also cut some salaries.  But the article doesn’t discuss aggregate salary data, just the reduction of one particular employee’s salary, and the replacement of his “generous pension plan” by a 401(k) — a common practice in industry at this time. 

The biggest horror story in the article was layoffs in a plant owned by one of Dade’s acquisitions.  Although the story focuses on one worker’s personal tragedy, a former Dade SVP is quoted as saying, “It’s not done because they love cutting jobs. It ultimately made those companies stronger.” If layoffs and salary cuts make the business stronger, workers as a whole can benefit even as some suffer.  The owners hurt themselves if they make the business weaker by depreciating the labor force. 

The article concludes with a discussion of a transaction that occurred in April, 1999, two months after Romney retired from Bain, in which “it pushed Dade to borrow hundreds of millions of dollars to buy half of Bain’s shares in the company — and half of those of its investment partners.” Romney evidently benefited from this transaction via an increase in the value of his 16.5% interest in Bain.  We are not told whether he had any role in approving in the increased debt.

We learn that Dade cut more jobs in 1999, evidently after Romney had left.    Three years after Romney’s departure, when Romney no longer had a financial interest in Bain, and after other events weakened Dade (increased interest rates, declining euro, delays in constructing a new distribution center), Dade filed for bankruptcy.  But Dade left bankruptcy two months later and went public. In 2007 it was sold to Siemens for $7 billion — 15.5 times the price paid in 1994 for an “ailing” orphaned division of a big corporation.  The article concludes with the suggestion that the “painful” layoffs “ultimately worked.”

In short, the story’s details don’t support its slant.  Romney’s “brand of capitalism” seems to have worked in this instance, even if its success was colored by events that occurred after he left Bain.  Although I’m not suggesting that Romney should or would run the country the way he ran Bain and Dade, I’m also not troubled by his history as a deeply invested owner and manager of Bain.  True, he and the other “elites” at his firm made a lot of money. But if every deal was like Dade, it’s not clear society as a whole, including the working class, came out worse. 

I understand what the OWS crowd will make of this story.  But they need to persuade me why this story should make Romney look worse than the typical presidential candidate who has spent his life in politics and whose job history has consisted mainly of engineering wealth transfers from weak interest groups (e.g., taxpayers) to more powerful ones (e.g., big banks).

It’s been over four years since the heyday of the last boom when I first discussed what I called “privlic equity” in an article about Blackstone’s proposed IPO.

So here we are post-bust, and according to the WSJ, they’re baack:

Apollo Global Management LLC became a public company in late March. Last year, KKR & Co. began trading on the New York Stock Exchange. * * * There is more to come. Oaktree Capital Group LLC is planning to sell $100 million of shares, while private-equity powerhouse Carlyle Group LLC is expected to come public in the next six months or so. Meanwhile, hedge-fund investor William Ackman is expected to sell public shares of a new hedge fund.

For those who were skeptical about this business form back in 2007, it’s worth noting that “skeptics acknowledge there is little evidence that being public crimps returns. Blackstone recently raised a $15 billion new fund despite the rough economic period.”

Some may wonder why “private equity” wants to go public.  The WSJ story points to the “irony. . . that many private-equity firms tell potential acquisition targets that becoming private through a sale to these firms will allow their businesses to prosper.” The article ineptly responds by parroting the privlic equity hype that “operating privately works best for companies undergoing change, but their investment businesses already are strong and can thrive as public companies.” Yeah, whatever.

I have a more cogent explanation, which I’ve discussed in several places, including the University of Chicago Law Review and my book, Rise of the Uncorporation.  I argue that the important feature of what I call “uncorporations,” including private equity firms like the ones noted in the WSJ article, is not whether they’re public or private but their form of governance. In a nutshell, uncorporations substitute partnership-type incentives for corporate-type monitoring.  The elements of partnership-type governance include making managers true owners and giving the owners greater access to the cash.  This can make sense for both publicly and privately held firms.

Here, for example, is my description of Blackstone in the Chicago article (304-05, footnotes omitted):

[T]he owners of the managing general partner of the publicly traded Blackstone Group own equity shares in the funds and will continue to receive directly a share of the carry. The Group, in turn, owns controlling general partnership interests in the funds. As in other publicly traded partnerships, taxing earnings, whether or not distributed, to the owners should make them more averse than corporate shareholders to earnings retention. Managers who retain earnings on which the unitholders are taxed are likely to be judged harshly in the capital markets and thus face constraints on future capital-raising.

As a tradeoff for partnership discipline and incentives, “privlic” equity firms eliminate the monitoring mechanisms that characterize the corporate form. The Blackstone Group prospectus thus correctly calls itself “a different kind of public company.” Blackstone Group unitholders get almost no formal control rights. The LLC that manages the Group is controlled by a board elected by the LLC members, not by the Group or its unitholders. The prospectus makes clear that the unitholders “will have only limited voting rights on matters affecting our business and . . . will have little ability to remove our general partner.”

Privlic equity firms also sharply restrict managers’ fiduciary duties. For example, The Blackstone Group limited partnership agreement provides that the general partner may make decisions in its “sole discretion” considering any interests it desires, including its own. The general partner may resolve any conflict of interest between the Group and the general partner as long as its decision is “fair and reasonable.” A unitholder challenging the decision has the burden of proof on this issue, and a decision approved by independent directors is conclusively deemed to be fair and reasonable and not a breach of duty. In addition, since the Group is a Delaware limited partnership, courts are likely to enforce these limitations on fiduciary duties.

This uncorporate structure is not for all firms.  As discussed in Rise of the Uncorporation, the form makes a lot of sense for the standard publicly traded partnership, which manages “natural resources, real estate, and other properties as these firms can commit to making distributions without compromising long-term business plans.” It may make less sense for more entrepreneurial firms that have a lot of business opportunities and need to give their managers control of the cash.  Private equity is somewhere in between.

My discussion of privlic equity in this early-2010 book ended on a bleak note appropriate to the times, noting that “privlic equity shares have melted down with the rest of the market” and “the  possibility that the firms will repurchase their newly cheap shares and become private again. It is not clear whether the privlic model ultimately will be seen as a short-lived fad of the financial boom, will make a comeback when the market does, or be seen as a transitional structure that will give rise to the publicly held uncorporation of the future.”

I also suggested that privlic equity might be the harbinger of a “convergence of corporate and uncorporate forms or some sort of reconfiguration of the divisions among large firms.”

It’s not clear from the WSJ article exactly what is happening in this resurgence of privlic equity. Among other things, I don’t know whether the new IPOs will use Blackstone-type techniques to avoid restrictions on partnership taxation of publicly traded partnerships, or will be tax corporations.  If the former, it would seem the firms will face pressures to make distributions, since the owners will be taxed on the income whether distributed or not.  Yet the WSJ article suggest the firms will have corporate-type “capital lock-in” (to use Margaret Blair’s term): “Mr. Ackman’s IPO would give him capital for investments that can’t be yanked by investors if they sour on him or the market.” 

The WSJ article indicates there’s still confusion about what’s going on with these firms.  But since going privlic may be here to stay, it’s time to try to understand their financial significance.  I suggested in the conclusion of Rise of the Uncorporation that this could be the harbinger of a new type of hybrid firm:

For example, regulators may insist that firms adopt uncorporate discipline before they can waive such important corporate features as shareholder voting and fiduciary duties. Also, publicly traded uncorporations arguably have the same need for inflexible rules as publicly held corporations. Regulators therefore might mandate features such as limited terms or regular distributions for firms that seek to opt out of standard corporate features. In short, the publicly traded partnership could become a distinct type of firm that straddles the corporate-uncorporate boundary.

In other words, we might finally have to face the failure of standard corporate-type governance and the need to replace it with something that works better than shareholder democracy and the business judgment rule.

Jason Zweig wrote Saturday in the WSJ about how companies are hoarding their cash. Microsoft, Cisco, Google, Apple and J & J “added $15 billion in cash and marketable securities to their balance sheets. Microsoft alone packed away roughly $9 billion, or $100 million a day. All told, the companies in the Standard & Poor’s 500-stock index are sitting on more than $960 billion in cash, a record.” The proportion of earnings paid as dividends is at the lowest level since 1936.

What are they planning to do with the money?  Well, MS paid almost precisely all of its additional cash, $8.5 billion, for Skype.  Zweig asks, “[w]as that torrent of cash burning a hole in Microsoft’s pocket?” 

The hoarding may be because firms don’t see opportunities in an uncertain, highly taxed and increasingly regulated economy.  But whatever the reason, Zweig is right in saying, following Benjamin Graham, that if they don’t have good uses for the cash they should give it back to the shareholders. Zweig notes that Graham proposed that investors insist on payouts of inappropriately hoarded cash and set formal dividend policies, with leading companies paying out two-thirds of their earnings.

But managers generally have the final say over dividend policies.  So what to do?  Well, as Henry Manne proposed long ago, takeovers can solve this problem.  More specifically, the kind of takeovers that turn publicly held corporations into private-equity managed uncorporations.  As I’ve pointed out in numerous articles (e.g.) and in my Rise of the Uncorporation, the uncorporation replaces often-ineffective corporate-type disciplines like fiduciary duties and shareholder voting with financial discipline centered on debt and distributions, which restricts the amount of cash managers have to play with. 

The uncorporation is not for all firms.  But, alas, it may be for an increasing number of firms, even former growth firms, this economy has beached. 

Meanwhile it would be nice to find away to create the kinds of growing firms that do have opportunities and might actually be able to use the corporate form.

I’ve written often, particularly in my Rise of the Uncorporation, of the upside disciplinary effect of uncorporate management.  This includes the salutary role of private equity (e.g., this recent post). But detractors argue that private equity-backed leveraged buyouts, by replacing equity with debt, make targets vulnerable to the disruption of bankruptcy. 

A recent paper by Stromberg, Hotchkiss and Smith, Private Equity and the Resolution of Financial Distress (also in the Harvard blog), relates to that claim.  Here’s the abstract:  

In order to understand the role of private equity firms in the restructuring of financially distressed firms, we examine the private equity ownership of 2,156 firms which obtained leveraged loan financing between 1997 and 2010. The economic downturn beginning in 2007 is associated with a marked increase in defaults of these highly leveraged companies; approximately 50% of defaults involve PE-backed companies. However, PE-backed firms are no more likely to default during this period than other firms with similar leverage characteristics. But defaulting firms that are private equity backed spend less time in financial distress and are more likely to survive as an independent reorganized company versus being sold to a strategic buyer or liquidated. The ability to restructure more efficiently seems to be affected by the PE sponsor’s financial as well as reputational capital. In contrast, recovery rates to junior creditors are lower for PE-backed firms.

In other words, analysis of private equity needs to look beyond the debt to the benefits of uncorporate governance in managing that debt.

Jets and LBOs

Larry Ribstein —  1 May 2011

I have written about the disciplinary effect of the uncorporate form, particularly in LBOs.  See, e.g., here and Chapter 8 of my Rise of the Uncorporation.

Now here’s more evidence:  Edgerton, Agency Problems in Public Firms: Evidence from Corporate Jets in Leveraged Buyouts.  Here’s the abstract:

This paper uses rich, new data to examine the fleets of corporate jets operated by both publicly traded and privately held firms. In the cross-section, firms owned by private equity funds average jet fleets at least 40% smaller than observably similar publicly-traded firms. Similar fleet reductions are observed within firms that go private in leveraged buyouts. I discuss assumptions under which comparisons across and within firms provide estimates of lower and upper bounds on the average treatment effect of taking a firm from public to private in a leveraged buyout. Both censored and standard quantile regressions suggest that results at the mean are driven by firms in the upper 30% of the conditional jet distribution. Results thus suggest that executives in a substantial minority of public firms enjoy more generous perquisites than they would if subject to the pressures of private equity ownership.

The study controls for the factors that cause firms to select into PE-ownership. 

Note that the study finds that “jet fleets in [non-PE private] firms look more like those in publicly-traded firms than those in PE-owned firms.”  The author suggests that these are founder-owned firms.  Buyouts cause reductions in agency costs in these firms that are similar to those in publicly owned firms.  In other words, as I’ve written, following Jensen, this is a story about PE-type governance, not closely vs. publicly held.

Acharya, Gabarro and Volpin’s Competition for Managers, Corporate Governance and Incentive Compensation has interesting insights and data on both corporate governance and executive compensation debates.  In the final analysis, I think it’s most interesting for what it says about the uncorporation.  Here’s the abstract: 

We propose a model in which firms use corporate governance as part of an optimal compensation scheme: better governance incentivizes managers to perform better and thus saves on the cost of providing pay for performance. However, when managerial talent is scarce, firms compete to attract better managers. This reduces an individual firm’s incentives to invest in corporate governance because managerial rents are determined by the manager’s reservation value when employed elsewhere and thus by other firms’ governance. In equilibrium, better managers end up at firms with weaker governance, and conversely, better-governed firms have lower-quality managers. Consistent with these implications, we show empirically that a firm’s executive compensation is not chosen in isolation but also depends on other firms’ governance and that better managers are matched to firms with weaker corporate governance.

Some particularly interesting points in the paper:

  • Pay-for-performance compensation is greater in firms with weaker governance, thus indicating that these are substitutes.  Another reminder of the dangers of putting on blinders when evaluating and regulating corporate governance.
  • Executive compensation depends not just on a firm’s own governance, but on the governance of the firm’s competitors of comparable size.
  • Managerial quality also depends on firm governance. When a firm gets a better CEO, the quality of its governance decreases, and vice versa,

This paper shows that corporate governance and executive compensation are much more complicated not only than regulators’ simplistic assumptions, but even than some leading theories, such as Gabaix & Landier on the effect of firm capitalization (Why Has CEO Pay Increased So Much?, 123 QJE 49 (2008)) and Hermalin & Weisbach on CEO power (Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, 88 American Economic Review 96 (1998)).  The authors note that the offsetting effects of governance and managerial quality “may explain why it has proven so hard so far to find direct evidence that corporate governance increases firm performance.”

Of particular interest for my work is this final observation in the paper:

A notable exception is the link between governance and performance found in firms owned by private equity: Private equity ownership features strong corporate governance, high pay-for-performance but also significant CEO co-investment, and superior operating performance. Since private equity funds hold concentrated stakes in firms they own and manage, they internalize better (compared, for example, to dispersed shareholders) the benefits of investing in costly governance. Our model and empirical results can be viewed as providing an explanation for why there exist governance inefficiencies in firms with dispersed shareholders that concentrated private equity investors can “arbitrage” through their investments in active governance.

This is another testament to the governance implications of the uncorporation.  For explanations of these implications, see my Rise of the Uncorporation, Chapter 8, and Partnership Governance of Large Firms.