The Wall Street Journal’s defense of private equity (“Populists Don’t Know Much About Private Equity”) is an impressionist masterpiece of market fundamentalism, relying on the unexamined assumption that fees paid to private-equity partners represent “social value.” One can simply step back and gawk in amazement, but true appreciation requires poring over each brushstroke.

The op-ed, by University of Chicago professors Todd Henderson and Steven Kaplan, responds to American Compass’s Coin-Flip Capitalism project and represents a “best shot” on behalf of private funds—coming more than a month after the project’s release; appearing in the Journal; co-authored by Kaplan, a leader in the field. And so its non-denial denial of the Coin-Flip critique may be a more searing indictment of high finance than anything American Compass could have published itself.

They begin:

Wall Street has never been particularly popular in the American imagination, but the recent growth of conservative populism threatens to erode its position even further. A case in point is a new think tank, American Compass, run by Oren Cass, a former policy director for Mitt Romney. One of its first major projects—“Coin-Flip Capitalism”—concludes that investment funds, like private equity and venture capital, are socially wasteful.

A primer on Coin-Flip Capitalism, published in May, reviews the returns of various funds over the past decade and concludes that “most fund managers are generating the results that one might expect from an elaborate game of chance—placing bets in the market with odds similar to a coin flip.”

No link to American Compass or the Coin-Flip Capitalism project.

The report laments that “the nation’s top business schools have sent nearly thirty percent of their graduating classes into finance,” where these people “invent, create, build, and provide nothing.” Barack Obama has made a similar point, writing in the Economist that “too many potential physicists and engineers spend their careers shifting money around in the financial sector, instead of applying their talents to innovating in the real economy.”

President Obama and The Economist get a link. The Journal appears less concerned with losing traffic than with risking its readers’ exposure to our side of the argument.

There is a fatal flaw in this analysis. Consider the case of private-equity buyout funds, one of the targets of right-wing populists. While Mr. Cass and company claim they are interested in social value, they look at returns net of fees, that is, after paying the fund managers for their services. While this is the appropriate metric for the decision about whether an individual should invest, what matters for society is how much wealth they create above the next-best alternative.

Right from the start, Henderson & Kaplan narrow their focus to private-equity buyout funds, abandoning on the field the venture capital and hedge funds that perform even worse. Do these “best” funds do any better for investors than would an index fund? Well, no, as Coin-Flip Capitalism shows, and H&K choose not to rebut. Instead, the professors say not to worry: that might be important to you if you were an investor, like the pension funds and endowments that the industry claims to work for, but it’s not “what matters for society.” (Incidentally, if all the returns captured by the funds are “paying the fund managers for their services,” then shouldn’t the payments be reported and taxed as ordinary income?)

What does matter for society, say H&K, is “how much wealth [buyouts] create above the next-best alternative.” What kind of wealth, measured how, and for who? Be patient.

If a company would be worth $100 million in five years under current management, but a buyout fund takes over, improves the management, and increases the value to $120 million, an additional $20 million of wealth has been created. To the extent that company is more efficient, this means the extra $20 million will be invested elsewhere in the economy.

This is a very nice story. And let’s stipulate that this can happen, and (depending on the nature of this improved management) society should be glad when it does. But then let’s also note that none of these things necessarily happens.

  • Does the buyout fund “improve the management” or simply slash investment to boost cash flow? Does the fund even raise the value of the company, or does it merely lever the company up with debt and then extract cash, leaving the operating entity worth less but the fund flush? All these cases might appear as the same $20M gain—to be paid in fees, as H&K acknowledge, not returned to investors.
  • Supposing the fund has genuinely increased the company’s value by $20M, this is of course a ­gross rather than net increase. If there are two companies, each potentially worth $100M, and the one operated by the fund takes market share at the other’s expense, so that one’s value reaches $120M while the other’s lands at $80M, how much wealth has been created for society? Same $20M in fees for the fund managers.
  • Or perhaps the fund has achieved this “efficiency” and created this “value” by squeezing workers, suppliers, and customers. Maybe it raised prices, fired people, and cut wages. (More on this later…) Does any of that create social wealth? The efficiency could be terrific, if someone else hired the workers into other new and more productive jobs. But then… wouldn’t that be the creator of the wealth?

Across all of these scenarios, the $20M generated is not necessarily a result of the company’s value increasing from $100M to $120M, nor does it mean that any new social wealth has been created, nor that an “extra $20 million will be invested elsewhere,” nor that actual investors are sharing in the gain. All we know so far is that assets have changed hands and fund managers have received $20M in fees.

The data are clear that private equity has created enormous social value. While returns net of fees have modestly exceeded the return of the market over the past decade, gross returns have averaged more than 5% a year better than the market over this time. This means that the roughly $300 billion invested in private equity deals in 2018 will generate an excess social return of more than $100 billion over the average seven-year life of these investments.

Try to follow the chain of logic: if fund managers get an extra $20M, they have “created” wealth; the creation of that wealth is equivalent to “social value.” And, because many such fees were earned over the past decade, we know that the deals done in 2018 “will generate” (past performance apparently now a guarantee of future success) an “excess social return” of over $100B. But if we are extrapolating from past results, virtually that entire $100B will be paid to fund managers.

In passing, with no attempt at quantification or citation, and no importance assigned, H&K also try to assert here that investor returns have “modestly exceeded” those of the market. In 2016, incidentally, Kaplan described PE performance since 2006 as “about the same as public markets” while suggesting investors should demand a higher return given risk and illiquidity. The Coin-Flip Capitalism data, unquestioned by H&K, show the same through 2019. “The real question is,” Kaplan said, “is it beating the public markets, and if it’s not then it’s not worth it.” Indeed.

Private-equity firms create this value by improving a company’s performance in finance, governance and operations. When a private-equity fund buys a company, it can put in place better incentives and a more sustainable capital structure, install more competent management, and improve operations with a focus on long-term value creation. Managers of companies owned by private equity have more skin in the game—the CEO typically gets about 5% of the equity and the management team about 15%, compared with less than a few percent in publicly traded companies. Boards are smaller and tend to monitor executive performance more closely. Operational teams make detailed plans to improve performance.

This is a great list of things that a private-equity fund “can” do. Is it what they do? And is it how they create value? Not in evidence. But rest assured, “operational teams make detailed plans to improve performance.”

Fortunately, evidence on these questions does exist. Writing in American Affairs, private-equity veteran Daniel Rasmussen asked and answered the question, “Do Private Equity Firms Improve Companies’ Operations?” If the industry’s claims are true, he writes, “we should see results in the financials of the portfolio companies, such as accelerated revenue growth, expanded profit margins, and increased capital expenditures. But the reality is that we see none of these things. What we do see is a sharp increase in debt.” In most transactions, “revenue growth slowed” and “capex spending as a percentage of sales declined.”

“There is a new paradigm for understanding the PE model,” concludes Rasmussen, “and it is very, very simple. As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management.”

The results are seen in numerous studies. Companies backed by private equity are subsequently 8% more productive than their industry counterparts, one National Bureau of Economic Research paper found last year. Other studies have found fewer health and safety violations, lower rates of workplace injuries, and more expansion into new regions and product lines. Being public doesn’t work for every company or at every point in a company’s life. The ability to buy out shareholders and make improvements that wouldn’t otherwise be possible is an essential tool in a thriving economy.

The news isn’t rosy for everyone. The study cited above on productivity also finds that employment growth in companies backed by private equity is 1% to 4% lower than in other firms in the same industry. Compensation is about 1.7% lower. Much of this is driven by the retail industry, raising questions about how gains in society are being distributed.

Finally, data. The 8% productivity figure is worth pausing on, because it is not, as one might think, a measure of actual productivity growth. Rather, it measures revenue per worker. So, for instance, the firm might fire a bunch of workers. Or it could raise prices. The study says revenue growth drove more of the gain than workforce reductions, but it cannot decompose that growth into actual output gains versus price increases.

Meanwhile, as “productivity” rises, compensation… falls? This is the record-scratch moment of the op-ed. The operational changes that purportedly create “enormous social value” are cutting jobs (according to one of the cited studies, by Cohn et al., “one of the most salient observable within-establishment changes after buyouts for which there is clear evidence is a substantial reduction in employment”), getting the same or more output from the remaining workers, and then paying less for the purportedly more productive efforts. The resulting gains to ownership from squeezing labor in this way are paid as fees to fund managers, not returns to pension funds.

Incidentally, here is the conclusion of another Cohn et al. study from several years earlier: “We find little evidence of operating improvements subsequent to an LBO.”

If anything, the benefits described here undervalue the importance of private equity. After all, the threat of a buyout, which usually results in a management shake-up, provides an incentive for all companies to improve their performance. No wonder the U.S., which has the oldest and largest private-equity market in the world, is home of the world’s best-managed companies.

This invented narrative has no supporting evidence. At least, an honest accounting would likewise consider the ways private equity’s benefits might be overvalued—for instance, because it places firms at (as much as ten-fold) higher risk of bankruptcy. The claimed link between the depth of America’s private-equity market and the quality of its management is cringe-inducing. One may as well write, “No wonder the U.S., which has the oldest and largest private-equity market in the world, is home to the greatest number of opioid overdoses.” That’s no more fair or sensible, but it isn’t any less fair or sensible either.

It’s worth scrutinizing the costs and benefits of various investment strategies or questions about how a society deploys talent. It matters where society allocates scarce resources, but it also matters that analysis of these questions is based on the facts.

I am pleased that the authors accept Coin-Flip Capitalism’s premise that high finance should be scrutinized for its social value rather than merely its profits. I’m also pleased to see they challenged none of Coin-Flip Capitalism’s evidence or analysis (surprising, seeing as “Populists Don’t Know Much About Private Equity”). And I appreciate their contribution of additional facts about the way fund managers benefit at the expense of workers. By their own standard that “what matters for society is how much wealth [funds] create above the next-best alternative,” they have a long way to go in defending the allocation of so much top business talent to the effort.

Most importantly, though, I am alarmed that two thoughtful and esteemed professors could so badly confuse the extraction of massive fees by fund managers with the creation of social value. In some situations that identity may hold. But their casual assumption that the two concepts are equivalent perhaps helps in understanding how our economy and its business culture have drifted so far off course.

Oren Cass
Oren Cass is the executive director at American Compass.
Recommended Reading
Populists Don’t Know Much About Private Equity

Responding to the Coin-Flip Capitalism project, University of Chicago Professors M. Todd Henderson and Steven Kaplan say to leave investors out of it: the fees to fund managers prove the social value.

Coin-Flip Capitalism: Q3 2020 Update

Commentary on developments in private finance and the Coin-Flip Capitalism debate as of Q3 2020

Critics Corner with Steven Kaplan

Oren Cass is joined by private equity expert Steven Kaplan to discuss leveraged buyouts, bankruptcy, and the effects on workers.