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What data and metrics should we look at when measuring private equity performance? How should we compare studies and analyses across time and different data sources? Moreover, does adding value to investors also necessarily mean adding value to society?
On this episode of the Capitalisn’t podcast, hosts Luigi Zingales and Bethany McLean speak with two people who hold different views on PE’s merits: Chicago Booth’s Steve Kaplan and Johns Hopkins senior lecturer Jeffrey Hooke.
Steve Kaplan: Private equity is kind of ubiquitous around the economy. And, on average, they are adding value.
Bethany: I’m Bethany McLean.
Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?
Luigi: And I’m Luigi Zingales.
Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.
Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.
Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?
Luigi: And, most importantly, what isn’t.
Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.
Bethany: One of the important topics in our current economy is not only what is private equity, but is it pro-capitalism or is it a sign of the coming apocalypse, in the sense that it is capitalism on steroids? But I think these questions about not only what private equity does, but whether it ultimately adds value, both in economic terms and in societal terms, are really, really important, given the size and scale of private equity going forward. It’s never been bigger. Investors have never cared more about it or put more money toward it. And it’s going to be a force for years to come. So, it’s important to understand whether or not it’s a good thing.
One of the things I think about private equity that gets people confused is, what’s the difference between an LBO and private equity? And they’re actually the same thing. It’s just that somehow, over the course of the last couple of decades, what is now the private-equity industry managed to rebrand itself from the less-appealing term LBO. LBOs, or leveraged buyouts, came of age in the 1980s. And the idea was essentially that you used a lot of debt—hence the word leverage—in order to take a company that had been public private. And then you fixed it up, and you did all sorts of things to improve its strategy, and you eventually took the much-improved business public again.
But leveraged buyouts got a bad name after the Michael Milken scandal of the 1980s and the collapse of the market. And so, when the industry came roaring back in the 1990s and 2000s, it was no longer called the LBO industry. It was called private equity, which is a way more appealing name, but it’s essentially the same thing. It’s just that now they emphasize the equity and the private aspects of it instead of the leveraged and the buyout aspect of it.
Luigi: But there is another reason why we want to discuss this. There is increasing pressure at all levels to actually open up access to private equity to the average investor. Up to now, the industry has been the exclusive realm of so-called sophisticated investors, institutional investors. Those are pension funds, endowments, or very rich families. Now, all of a sudden, the average investor would be required to actually evaluate the performance of these entities. Even among experts, knowing how they have done and whether they’ve done well or not is not a piece of cake. And that makes it a little bit scary that unsophisticated investors need to make this decision. So, today, we did something a bit different. We actually asked two experts to debate under our eyes—or under your ears—the pros and cons of this. And then, as usual, Bethany and I will try to sum up at the end.
Bethany: One of our guests is Jeff Hooke. He’s a professor of finance at Johns Hopkins University. And he recently wrote a book called The Myth of Private Equity, in which he essentially argues that private-equity returns have not been that great and are not what they’re cracked up to be, and that the reason that big investors like pension funds are flocking to put money into private equity actually doesn’t have anything to do with their returns being so good.
Luigi: The other guest is my colleague at the University of Chicago, Steve Kaplan, who is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance. He’s really an expert on the private-equity industry. His dissertation, more than 32 years ago, was about the performance of management buyouts. And he has been following the industry very closely since then.
Let me start with you, Jeff. Private equity has a terrible reputation. Your book is not about private equity firing workers or even jacking up prices for consumers. You are simply saying that private equity is not a good investment, and that pension funds and endowments would be better off investing in the S&P 500 than in private equity. Can you explain why?
Jeffrey Hooke: Sure. Well, in the early days, when private equity was sort of just getting started, it was an interesting alternative for these big institutional investors like university endowments and pension funds. And if you look at the track record of the last 10 or 15 years, there’s a number of data services that track it. You’re pretty much seeing the last 10 years of private equity as about flat with the S&P 500, and maybe the last 15 years show a slight premium. So, you’re not really getting the performance that’s been claimed. Big institutional investors, I think, are better off with public stocks. They’re just more liquid, they’re less opaque, and the fees are above board.
Luigi: Steve, you have followed this industry for at least 35 years now. You have written some of the fundamental papers on how this industry should be evaluated and its performance evaluated. There is certainly a point of agreement with Jeff that, in the past, things were better in terms of returns. But what about the performance? Because I think the point of contention, if I understand correctly, is just what happened during the last 10 years.
Steve Kaplan: I think Jeff’s book looked at the Burgiss data. And the Burgiss data is the data I use. It’s probably the best data out there on private-equity performance, because they get their data from limited partners, so people like the University of Chicago, sovereign wealth funds, et cetera. It’s not selected. And so, even though no data set is perfect, it’s about as good as it gets. And I’m not sure where Jeff is quoting the performance from, but I went and looked at the most recent data. This is as of the end of September 2001. And I took all the US buyout funds from 2000 to 2017. And the performance of those funds is 4 percent a year higher than the S&P 500. So, saying that they didn’t outperform is just wrong.
Now, that’s 2000 to 2017. Perhaps you’d like to look post-global financial crisis, 2009 to 2017. They outperformed by 4.7 percent per year. It’s not clear, and I agree with Jeff, we don’t know going forward, because prices are higher and more money has come in, whether that outperformance will continue. And I have to say I’ve been surprised that the performance has been this good over such a long period of time. But to say that they have not outperformed since the turn of the century is just wrong. And the fact that so much money has come into private equity is consistent with the performance being good, rather than bad, because if all this money came in after the performance was bad, you would have to assume investors were really stupid. And I don’t think that’s the case.
Jeffrey Hooke: Well, look, Steve, I didn’t just use Burgiss. I looked at three or four databases, PitchBook. And I didn’t use just one-year ends. I usually try to average three or four years, because as you know, end date and start date can really make things look bad.
Steve Kaplan: Jeff, it does not matter when you start. In fact, the worst case you can use is start vintages 2006 to 2017, and you get a 2-percent-per-year outperformance. It is incontrovertible, Jeff, in all these databases that you get outperformance over this period.
Jeffrey Hooke: If you look at the state of California, which is a big private-equity investor, if you look at their PE performance over the last 30 years, look at one of their reports. They say it’s flat with the public markets. If you go to the American Investment Council website, which is pretty much the lobbying arm of the PE industry, you look at the two or three reports they’ve had from the last quarters, they’re basically saying private equity—my book mainly covers leveraged buyouts—but private equity is pretty much flat with the public markets.
Steve Kaplan: But I would ask the next question, Jeff, though. You have to tell me why, if the performance has been so poor, these very smart people put a lot more money in. And you’re just saying that you are much smarter than they are. Is that the inference I have to draw?
Jeffrey Hooke: No. I mean, a lot of people ask me, why do investors keep investing in it? And so, the primary customers, I guess, are the big pension plans from state municipalities here in the United States. And one, it’s a corporate-governance problem that the people running these large funds probably realize that a 60-40 passive index—60 percent stocks and 40 percent bonds, for your listeners, which is “the gold standard” for institutional portfolio performance—there’s been enough out there in the last year or two that will say that most big institutions do not beat a 60-40 passive index.
So, rather than doing that, just indexing the entire portfolio, these institutional managers, in order to justify their high compensation, they think they have to follow the Yale model, which is to put a lot of money into these exotic alternatives, which have high fees, and put less money into public stocks and bonds. You have career preservation, which I think motivates a lot of these managers rather than looking at the facts or the scientific evidence, which I guess you and I dispute.
Bethany: Aren’t you two in a way talking past each other, in the sense that there is a ton more analysis out there proving Jeff’s point or at least backing up Jeff’s point? And I think what would be really interesting would be to take all of these studies and compare the methodology from one by AQR to one done by Dan Rasmussen at Verdad Capital, to another one done by the University of Oxford, all showing the same thing. But the difference is the use of leverage.
One is doing risk-adjusted returns. The other is not doing risk-adjusted returns. And I get that there’s an argument that simply doing a risk-adjusted return in private equity perhaps isn’t the accurate way to do it, given that PE firms often aren’t forced to sell their investment when there is a market downturn. So, perhaps there’s something in here about how stripping out the leverage isn’t the right way to think about this. But you have to account for it somehow, don’t you? Given that the average PE deal is roughly twice as leveraged as the S&P 500.
Steve Kaplan: Bethany, I’ll say, first of all, the Phalippou study, the Oxford study that you mentioned, uses the Burgiss data and is highly misleading. He includes real-asset funds and infrastructure funds, which are not buyout funds. And he uses the period that’s the worst period for private equity. And when he cherry-picks as much as he can, he gets performance equal to the S&P 500. So, again, I won’t say there are not other studies that find the opposite. Every study by an academic that looks carefully at the data finds outperformance. So, this—
Luigi: No, no, no, no, Steve, this is outrageous. Erik Stafford, who was a student of yours, just published a paper in The Review of Financial Studies showing that once you control—as Bethany was absolutely right—for leverage and for picking the right set of assets, because the comparison . . . You set the bar too low. I was waiting to bring this up. You set the bar too low by comparing with the S&P, because these guys pick generally smaller companies, which tend to have a higher return, and they leverage up. Once you control for those two things, Stafford shows that there is not. And so does a study from AQR. So, the industry suggests that once you control, it is not the S&P. So, Jeff, in my view, is not right here. But if you control properly, then in the last 10 years, you don’t see overperformance.
Steve Kaplan: Oh, no, Luigi. Now, here’s where you’re wrong. The Stafford paper goes way back to 1988, and he has a lot of stuff that’s not true today. Let’s take 2009 to 2017, since you brought it up. The S&P 500 has hugely outperformed the Russell 2000, and it’s even more hugely outperformed the Russell 2000 Value. So, if you did a PME calculation . . . I was being nice there using the S&P 500. If you use the Russell 2000, the outperformance goes up by another 200 basis points. The leverage thing is trickier, and that’s where there are some estimates of the beta. Beta, just for the people listening, is how the stock moves with the S&P 500 or for the overall market.
Most estimates of the beta of private equity are somewhere between 1 and 1.3. So, I think the AQR used 1.2. When you use 1.2 with the Burgiss data, you still get outperformance. And the beta story, your story that there’d be these huge betas, you would have thought that the vintages, the 2005 vintages, for example, 2006 vintages, which got hit by the global financial crisis, if you thought the betas were really high, you would have found that they would have underperformed the S&P 500. And, in fact, those vintages, ’06, ’07, ’08, are about equal to the S&P 500. So, the beta story is very strange. Sorry, go ahead, Jeff.
Jeffrey Hooke: One of the things you first learn, I think when you go to a prestigious university like Chicago, when you’re taking your first finance class, is that the equity of a leveraged asset should actually move up and down more than the stock market. Interestingly, the PE business, specifically the LBO business, has said, “No. We have a more leveraged asset, yet it moves less than those company stocks that have much, much fewer debts.” So, their essential second pillar of their marketing pitch, I think, contradicts classic finance theory that for the last 60 years has been unchallenged. You have, on the one hand, high returns that are claimed, and then, on the other hand, lower risk. I think that contradicts most of what you learn in finance courses at the University of Chicago. I think that would be the case at Hopkins and where I went to college at Wharton.
Steve Kaplan: Jeff, you’d be clear. I didn’t say, and I would agree with you. It’s not lower risk. The one thing, though, that is interesting is that Phalippou, the Oxford guy, wrote a paper a few years ago where he looked at whether private equity provides diversification over and above having a portfolio of public stocks and a 60-40 kind of thing. And what he found, actually, is that large buyout and venture capital provided diversification. So, even if the returns were equal to the S&P 500—which they’re not, they’ve been higher—you would get some diversification benefit by having private equity along with your public securities. Then there would be a reason to have them.
Jeffrey Hooke: But remember, I think everybody has to remember that the private-equity managers basically get to mark to market their own inventory from year to year. And that’s much like an eight-year-old grading her own homework in third grade. I mean, it’s preposterous that they’ve been allowed to do that for the past 20 or 30 years with very little supervision and maybe some minimal help from their own accounting firms.
I used to be in the private-equity business as an executive. I worked with a lot of them as an investment banker. So, there’s always going to be that temptation to shade their year-to-year results, even if they do have higher leverage to make it look like things aren’t so great. So, I agree with you, diversification is probably a plus, not as big as, say, that Oxford paper, which I did read, suggested. But yeah. There’s probably some plus there. I have to agree with you.
Bethany: But even on a realized basis, isn’t there a little bit of a shell game going on? And I recognize that’s an overstatement. But in the past decade, the number of deals in which companies are sold to other private-equity firms has grown to about 50 percent now. And so, if what you’re doing is not improving a business and selling it onward to a strategic buyer, but instead flipping it to another PE firm, A, is that a real return? I recognize you could argue it both ways. But, B, if the whole promise of private equity is we improve this business, we make it amazing when it was just mediocre, then why is another PE firm buying it?
Steve Kaplan: First of all, one PE firm paying another, the PE firm that’s selling is getting money that’s going to their LPs or to their investors. It’s real money. So, I wouldn’t say it’s a shell game in that regard. And then, in terms of what they do, different private-equity firms do different things with their companies. I wrote a case on a company called Columbus Manufacturing, which is meats, like Boar’s Head meats. And their first buyout, bought it from the family, kind of professionalized it.
The next private-equity firm that bought it said, “Gee, there’s an opportunity to take this from a regional player to a national player.” And they had some ability to do that that the first buyout firm did not. They had relationships with the big supermarkets or delis. And they then took that company, took it national. And then, once they’d done that, then they sold it to Hormel. And the first private-equity firm made a good return. The second private-equity firm made a good return. And it appears to have been a good acquisition for Hormel. So, value creation all the way, and the value did end up going to the investors.
Jeffrey Hooke: No question some of these firms are improved under private-equity ownership. As family businesses, maybe they weren’t looking at the bottom line as much as corporate divisions. But no one is going to say that all the firms are improved. I mean, that’s sort of a fairytale that the private-equity or the leveraged-buyout business likes to pedal. But if a private-equity firm . . . and many of them are then buying from other private-equity firms, all those efficiencies, despite Steve’s anecdote, most of those efficiencies have already been squeezed out. You can’t do it more than once or twice. You’d have professional managers.
That’s a bad sign, I think. The company isn’t going public. It’s not selling to a strategic that can utilize synergies and boost the price. So, that’s one of the things I point out. A lot of these deals that are sitting on the shelf in inventory, it’s just a tough sale. It’s just a lot of tough sales in a market where you would think there’d be more strategic buyers. But they have to turn to LBO groups as the buyers because they just can’t find strategics at the price they need.
Bethany: Steve, I’m sure you’re going to have a response to this, but before you do, I’m going to toss in another piece of data so that you can expound on both pieces. And this is going back to the idea that private-equity firms don’t add value, that they do bad things. It’s basically just made up. And I’m thinking about this piece of analysis done by a firm called Verdad, where they compile the database over 390 deals, accounting for over $700 billion in enterprise value, the majority of the largest deals ever done, and then they analyzed it.
Bethany: And they said, “In 54 percent of the transactions we examined, revenue growth slowed, and for 45 percent margins contracted. And in 55 percent, capex spending as a percentage of sales declined. What happened is that PE firms doubled the amount of debt on the balance sheet from 2.5 times EBITDA to five times EBITDA.” And, in their analysis, that accounted for the majority of the returns.
Dan Rasmussen, the author of this study—he’s a former Bain private-equity guy turned skeptic—wrote, “The industry mythology of savvy and efficient managers streamlining operations and directing strategy to increase growth just isn’t supported by the data.” So, let’s go back to you and hear your data that would counter that.
Steve Kaplan: OK. First of all, Jeff sort of contradicted himself. He earlier did say that private-equity firms gross of fees outperform. So, they’re doing something if they’re outperforming gross of fees. And I would argue they’re adding value, on average. That’s how they outperform. And if 50 percent of the deals are private-equity firms buying other private-equity firms, they’re still creating value. So, that’s one.
Two, I have no idea who Verdad is. I have no idea who they are. When I look at research, I look at what academics do, who don’t necessarily have an ax to grind. The paper out there that’s probably the most comprehensive is by Josh Lerner and Steve Davis. One’s at Harvard, Josh is at Harvard, Steve is at Chicago. Plus, John Haltiwanger, plus someone at the US Census. They used US Census data, and they got as many of the buyouts as they could in that data, and they find productivity improvement, on average.
Bethany: I’m going to come back to that. But first of all, I want Jeff to respond to this idea that you contradicted yourself.
Jeffrey Hooke: No, I don’t think I did. I mean, clearly, if they’re flat with the public markets, which I think has been the case, they’re flat, they’re creating a little value over and above public-market returns. But they’re not creating any value for their investors, their limited partners. Clearly, there’s been a huge transfer of wealth from their investors to the general partners of these firms. That’s obvious. So, the fees that have been extracted are going to the funds, but the funds are not providing their LPs with a huge rate of return. I hope we got some agreement on that. Now, I just want to say—
Steve Kaplan: And I was saying, first of all, let me just be clear what I said. I said there’s outperformance to LPs. I was saying on your end, you’re saying there’s not, but there is outperformance gross of fees. And you said the fees are huge, 4 percent a year, which means they are doing something real. It’s not a little outperformance. That is a lot of outperformance gross of fees. So, they’re doing something to the companies. Even your story says they’re doing something positive to the companies. And then the question where you and I disagree is whether any of that goes to the investors versus going all to the private-equity people. And I say it’s split, and you disagree. But we both agree they’re creating a fair amount of value.
Jeffrey Hooke: Yeah. I would agree with that assessment. Dan of Verdad, I think he’s a serious person. I’ve talked to him. I’ve read his stuff. So, I think there’s legitimacy in the way he poses things and does research. But there are a lot of firms that don’t have a lot of value. Perhaps in a leveraged-buyout portfolio, you’re looking at 20 percent or 25 percent of the companies to default. They go bankrupt. So, I can’t really say that all of them are creating a lot of value. When you go bankrupt, I don’t believe a lot of value is created, certainly not for the equity investors or the LPs. Not much for the lenders, I suppose. And, certainly, the employees usually don’t do too well in a Chapter 11. So, we’ve got a real risk situation in many funds where they have some serious problems with the amount of debt you referred to.
Steve Kaplan: I just have to say, I just looked at 195 large buyouts from 2010 to 2016. And I believe 12 defaulted. That is not 25 percent. That is more like 6 percent or 7 percent. So, some don’t work, but on average, they do.
Bethany: Well, I think there are some statistics that would perhaps counter that. And I think you can look at this data in a lot of different ways. But in 2016, 2017, two-thirds of the retailers that filed for bankruptcy were private-equity buyouts. Overall, 10 out of the 14 largest retail chain bankruptcies since 2012, 10 out of 14 were private-equity-acquired chains. In the second quarter of 2020, when we all know the market cracked, 34 US private-equity-backed companies filed for bankruptcy. More than half of the companies that defaulted in the second quarter were owned by private-equity firms.
But anyway, we can go to that. But I wanted to come back to this issue of performance, because I think there is one other big thing that we’re not taking into account, which is that if there is outperformance by private-equity funds, it is not necessarily due to any change or improvement at the company in a basically zero-interest-rate environment, because some portion of the return—and here’s where I could be wrong, because I don’t know how much of it has been—but it’s come from dividend recapitalizations, from the simple act of adding debt to a company and taking it in the form of often multibillion-dollar payment to the private-equity owners.
And that’s enabled by ultra-low interest rates. That has nothing to do with whether or not the company has been improved in any substantial way. It has to do with incredibly accommodative capital-markets environments. And I recognize that that’s a real return, right? That’s a real return to the investors. But it doesn’t say anything about . . . It’s no proof that the business has been improved in any meaningful way. It’s no proof that private-equity firms are adding value in any way. It’s just financialization.
Steve Kaplan: Bethany, it’s a way for them to partially get their money out. The large sample evidence is on an operating basis, so this is on operating cash flow, they improve, and they get more productive.
Luigi: I want to point out one fact. Adding value to investors does not mean adding value to society. And actually, one of our colleagues documented that. Private-equity ownership increased short-term mortality in retirement homes by 10 percent. They also increase prices. And this is not necessarily to the benefit of humankind. It’s to the benefit of investors. So, maybe they do add value by, in some cases, not all cases, but by skimping on services and quality, and increasing prices to Medicare—no, not Medicare, they’re fixed—but to other entities.
Steve Kaplan: In looking at large studies . . . although the paper you’re talking about, Luigi, was dominated by two private-equity firms. One’s a real-estate private-equity firm that is not, I think, typical of private-equity firms. You would have thought people would have looked at this in hospitals, which is a much bigger place where private-equity investors invest. And you don’t find anything negative. I mean, this is what Bethany said—
Luigi: Actually, there was a paper on the job market, they increased prices by 50 percent. They increased prices by 50 percent.
Steve Kaplan: That paper had some issues. And the paper that I’m talking about is one of our former students, Merih Sevilir, who’s at Indiana. Doesn’t find that. There are instances where . . . What I’m saying is, they’re making their companies more efficient. And there will be instances where, if the regulations are in place or the government has set up payments in a certain way, private-equity firms will take advantage. I think for-profit education, they did that. So, Constantine has a paper in for-profit education where they definitely took advantage of student loans to make money in a way that was probably not good for society. But these are small fractions of the private-equity business. Private equity is kind of ubiquitous around the economy. And, on average, they are adding value.
Luigi: Thank you, Steve. Thank you, Jeff.
Steve Kaplan: Very good. Well, thank you. This was fun.
Jeffrey Hooke: Thank you.
Luigi: The first thing is, there was a huge amount of debate, in my view, about very little, whether or not you beat the S&P 500, which is simply a comparison. But it’s not, in my view, the right comparison, because in finance, we do learn that you have to compare equal risk. By many metrics, the investments that they do are riskier, because of the type of investment, but in particular, because of the amount of leverage they put in.
And then, Steve, in every possible form or shape, tries to bring down this number, because once you control for the assets they pick and you control for how much leverage they put into the company, the performance of the private-equity industry seems to be pretty much in line with benchmarks. So, there is no evidence of overperformance. And this is very important, because it also explains, in my view, why they sell so well in spite of not being so good in performance. If I were to borrow and invest in the S&P 500 in the same way in which private-equity companies buy existing companies with leverage, I would have a much higher return. However, I would have gigantic daily swings in my valuation.
If I am the manager of the endowment of the University of Chicago, I would be fired if, when the market goes down 20 percent, my endowment goes down 40 percent. Now, the “beauty” of private equity is that they don’t mark to market. This information is not released. So, if I manage the endowment of the University of Chicago, I can invest in private equity and not have a headline in my newspaper the next day: “Endowment drawback 40 percent.”
So, one interpretation—and I’m not saying this is the only interpretation—but one interpretation is they charge a very high fee to hide the pain from your eyes.
Bethany: I think I 100 percent agree with that. And I think that is also the heart of my disagreement with what Steve said. At the heart of Steve’s justification of the business is this argument that the business wouldn’t exist if the returns weren’t good, that the fact that it is big and continues to grow is proof that the returns are good. And I don’t think it’s any such thing. I think one component of it is exactly what you said, that they offer this prospect of returns moving that is wonderful for these state pension funds. And, actually, a great statistic in Jeff’s book—which I wish he had brought up—but he noted that when the stock market fell 19.6 percent in 2020’s first quarter, the buyout industry claimed its collective portfolios dropped just 8.9 percent, despite the industry’s high leverage. So, proof of the very point that you’re discussing, Luigi.
I also think you can’t separate the huge amount of money flocking into buyout funds from the desperation on the part of pension plans in an ultra-low-interest-rate environment, that buyout funds promise the sun, the moon and the stars. And pension plans are desperate to make returns. And if the industry can market itself on the basis of past performance that includes very different times than today, then desperate people are going to take advantage of that.
And then I think there’s one more component I would throw in there, which is that, yes, some pension funds are extraordinarily sophisticated and know exactly what they’re doing and look at the numbers and think through it. And other pension funds are not sophisticated at all, and they are completely swayed and seduced by the expensively suited and attired and fast-talking people coming from New York with the promises of offering the sun, the moon and the stars. And so, the proof that a pension fund gives a private-equity firm money is proof of nothing other than that the pension fund gave the private-equity firm money.
Dividend recaps have become a sticking point of mine. And I get that there’s a way you can think about it in which I’m wrong, right? They’re enabled by the capital markets. They can do it. It’s a way of getting returns to investors. But I see it almost . . . I would want to see the returns of the industry done ex the dividend recaps, because to my mind, once again, that has nothing do with the core promise of the industry. The industry doesn’t market itself as, “We are engaging in financial engineering in order to give you these returns.” The industry’s core marketing is, “We are investing in companies for the long term and improving them and adding strategy.” And I would want to know what portion, how . . .
One way you could think about how true that is by looking at the returns ex the dividend recaps, because those are enabled solely by an environment of cheap credit and falling interest rates. And if we didn’t have those, if we’re heading into an environment where rates are rising, then the dividend recap as a tool of getting money to investors goes away. And so, if I had the capacity to do this, I would want to do a study looking at returns ex the dividend-recap amounts.
Luigi: First of all, I’m with Steve here. I don’t see anything bad about a dividend recap. Maybe this is my finance background. But if I am an oil company and I’m full of cash, it’s actually very healthy if I do a leverage recap, and I pay the cash to my investors, because the alternative is I might invest more in my business. And investing means digging for oil, creating more gases. So, leverage recap is also a form of discipline to take away money from managers and distribute it to investors.
And sometimes, if you’re doing it in a business that needs a lot of R&D, et cetera, that’s a terrible thing. But in businesses that don’t have a lot of future—think about tobacco, think about oil—that’s a way to do it. I think that we should not be necessarily linked with the idea that all businesses need to survive, because progress is about businesses becoming obsolete and also technology moving away.
So, this said, I am 100 percent with you that the current environment, especially the environment after 2020 with COVID, tremendously benefited this investor. I don’t think that the data are actually so updated to the last couple of years. So, I don’t think that this impacted their data. But definitely, they received a benefit from it. To your point of to what extent this is a negative consequence of income distribution, I think that’s a very valid point.
Bethany: So, that’s an interesting . . . This is anecdotal. And so, I don’t know. I would also have loved for somebody to do a study of how often, what percentage of the firms that went bankrupt in 2020 second quarter, in the misery of 2020 second quarter, those 34 PE bankruptcies, what percentage of them had done dividend recaps? Because what looks like a savvy decision at the time to return money to investors may not look like a savvy decision, because it leaves the company with no resiliency. And so, I know for sure, Neiman Marcus and J.Crew, two of the companies that did go bankrupt during that period, did do dividend recapitalizations.
And then, to go back to your point, the question is, even if a company is dying, if this is the end of it, if the dividend recap delivers money to the investors in a private-equity fund, and most of all to the executives at that private-equity firm, I can’t sign off on that. It seems to me, because it exacerbates inequality to such a dangerous degree, shouldn’t some portion of that money then go to the workers who are being left without jobs? It feels like raping and pillaging to me. And I get it. Look, the argument of that would be that the returns are going to pension funds, who themselves are individuals. And so, it’s complex. But there is something about a huge dividend recap followed by a bankruptcy and the layoffs of employees that doesn’t sit well with me.
Before you jump in, I am going to apologize, because everybody can hear this really crazy noise in the background. And it is my daughter’s cat. To listeners, you usually hear dogs barking in the background. This is a cat. I never would have believed they could be as disruptive as a dog. I thought cats were these quiet, meek creatures. But I’m being proven wrong. I am feeling like crazy cat lady here, by the way. And just for our listeners, I’m not crazy cat lady. I’m a dog person.
Luigi: But of course, your daughters have become cat daughters, just to be oppositional.
Bethany: Would you expect any different?
Luigi: But paradoxically, I think that the risk of bankruptcy is not a bug, it’s a feature, in the sense that if you are in an area where the future is grim, you want to take money off the table as soon as possible. And, if you want, the abusive aspect of the leverage recap is that you might leave somebody else holding the bag. In fact, there is a thing called fraudulent conveyance that says that if you take out too much money and then you go bankrupt soon afterward, then the creditors can complain and then bring you to court for the damages. So, there is some form of protection. Now, I’m not a lawyer. I don’t know how effective this protection is. But I think that that is a discussion from a societal point of view. Maybe they overdo it.
But, look, one sector that has been affected by private equity a lot is the newspaper sector that you know very well. And I don’t think it’s a coincidence. It’s because the newspaper sector is going through a dramatic crisis. And in a lot of places, you need to close down or restructure what you have. And the process is very painful, and you don’t do it unless you have very strong incentives. And so, it is true that people are paid a lot, but it’s also true that if you don’t pay people a lot, you let things slowly die down, consuming a lot of time and resources. So, there is, to me, a value of private equity, and that exactly is the high-powered incentive to restructure that you don’t see very often in public companies.
Bethany: I suppose that’s a valid point, that a benefit of it is to hasten the demise of something that should be dying anyway. I think the quibble I would add is, then where should the proceeds of that go? And I think it would be healthy for the private-equity industry’s longevity if they were a little bit more, perhaps a little bit more thoughtful about that. I recognize that’s not the way the business is set up, and that’s not the way fiduciary duty works.
I am definitely biased, because I’ve been spending a lot of time looking at hospitals. And the number of hospital chains that were owned by private equity throughout the last decade, and that did huge dividend recaps in order to pay their private-equity owners, and then were left basically going bankrupt, crippled by immense amounts of debt heading into the pandemic, it did not make our country healthier. And I think it’s an example of private equity doing immense damage.
On a broader note, I also think it offers a very large quibble to Steve’s point that these private-equity investors are all incredibly savvy and competing with strategic buyers. They would never buy a company unless they knew they had a way to add value, strategic value, above and beyond what a strategic buyer could add. They will absolutely buy a company when they have no value to add, as long as they can do something financial-engineering-wise that the strategic buyer can’t do, whether that is a dividend recapitalization, whether that’s separating the company from the value of its underlying real estate and doing the sale-leaseback transaction. But none of that has anything to do with adding value to a business in the way I think, societally, we would want to see somebody add value to a business.
Luigi: No, I agree. I think that Steve is right and that the paper he cites is, I think, a very important paper that, on average, you see productivity increases after a buyout. So, I think we need to keep this in mind. Now, you have to be careful, because productivity very often is the product of price times quantity. So, you don’t know whether quantity goes up, or they’re better able to price higher, and maybe the previous owners were mispricing. But maybe they are exercising in market power, because I think that there is evidence that after an acquisition, you do try to use your market power more aggressively.
I think that the hate or the distrust of private equity is misplaced, because private equity is not the problem. It’s everything else that is the problem. Private equity is basically capitalists on steroids because the incentives are very strong. When capitalism doesn’t work because it confronts a situation where the rules are not set up properly, et cetera, then this leads to a complete disaster.
So, even Steve recognized that, for example, in private education where there are a lot of government subsidies, private equity is a disaster. Why? Because universities are inefficient. And so, they don’t take full advantage of the government subsidies at a not-for-profit university. While private universities, especially private universities held by private-equity guys, they maximize the extraction of subsidies from the state with a disastrous effect.
When it comes to hospitals or retirement homes, I think we have the same issue, because on the other side, there is either the government or there are other institutions that end up being too complacent in paying up. But I think that the argument should be that we should protect these people better. Maybe we should require some severance payments to workers or stuff like that. But this stuff is also done by non-private equity. It’s not like normal corporations are so much better.
It’s not obvious that your hospital owned by a publicly traded company is very different. They might have the same narrow objective to maximize shareholder value. I don’t think they can legally take into consideration the health of the patients. They might smuggle this in with the notion of, oh, this is good for the long-term benefits of the shareholders, blah, blah, blah, exactly like Larry Fink has done in this last letter. And it’s a problem of capitalism broadly, not private equity.
One aspect we did not discuss, which I think is extremely important, is the fact that—and here Jeff is right—the lack of transparency of the returns and the fees, that is problematic today, but potentially even more problematic in the future, as we’re opening up these types of investment to a broader and broader set of people. Even for institutions, I have advocated, even in a paper a long time ago, we need to have more mandatory disclosure in private equity. If pension money is invested in private equity, we want to make sure pension money is well invested. And if I cannot benchmark my return against other people’s returns, I don’t have a sense of who’s doing well, who’s doing poorly.
And so, part of the reason why competition has not driven down fees is that there is a lot of noise in the process. And this is interesting, because Steve said that, basically, there is no persistence in returns. So, basically, I should pick any private-equity fund. There is no sign that KKR is better than Blackstone and vice versa. And so, I should get the cheapest one. So, competition should drive prices down, and it doesn’t. Part of why it doesn’t is because than the notion of performance like IRR is something that is manipulated—legally, but manipulated—and is not standardized, so that I cannot, even as a relatively sophisticated investor, compare the IRR of KKR versus the IRR of Blackstone.
Bethany: I think that’s a really fair point. And I wish Jeff had brought this up. There were some really interesting stats in his book that of 33 state pension funds with PE investments, only six disclose their fees. And that, in many states, there are actually laws that have been passed that allow state pension plans to keep private-equity fee arrangements secret. And I think that that is extraordinarily complicated, and it’s particularly complicated and important because of the increased complexity in the breakdown of fees—not just the calculations of IRRs, but the ways in which firms make their fees. And one portion of this does contradict a bit of Steve’s argument, in the sense that now fees don’t just come from your excess return, from the 20, the famous 2 and 20, the 20 percent over a benchmark. That’s not where fees come from. Fees also come from the fees that private-equity firms charge their portfolio companies, the ongoing management fees. That’s a portion of it, too.
And so, again, I get it. That’s giving money to investors, yes. But that contradicts the industry’s argument of, we are earning our fees because we’re so good at this. If you’re earning your fees because you’re so good at this, then why do you need to stiff your portfolio companies with all these additional fees for your services? That didn’t use to exist in the past. You shouldn’t need that. That shouldn’t be part of the deal.
And then there’s another component here. And I don’t have the numbers in front of me. But an increasing portion of the earnings of the big private-equity firms comes not from the 20 percent, it comes from the 2 percent. As they’ve gotten bigger and bigger and bigger, a lot of their money comes from their assets under management, not from the returns they’re generating for investors. So, their incentives are no longer entirely aligned with those of investors.
And back to Steve’s point that a private-equity firm wouldn’t put money into an investment unless they saw ways they could add value and be strategic. Well, no, not necessarily, because you don’t get to start collecting that 2 percent until you’ve put the money to work. And so, if your incentive is to get the 2 percent of fees on assets under management, because now you’re so huge that that’s real money, you are going to put money into a bad deal, because you can collect a lot in fees from having that money put to work before the company blows up.
And so, I think all of this gets to my biggest point of all, which is the industry is not what it was. This is an industry that has undergone radical changes from its founding as LBOs. Nobody has still been able to explain to me, how did LBOs become private equity? Somebody, some marketing consultant somewhere, thought of this, and was like, “LBO? That doesn’t sound so good. That’s a dangerous name. Let’s rebrand. Private equity.” But I’ve asked people in the industry, and nobody knows how it happened. It’s really quite a clever sleight of hand, if you think about it. So, if anybody’s listening to this and you know how LBOs became private equity, I want the answer to that.
But I think that this all gets at what, to me, is the biggest point, which is that this industry is not what it was. It’s very, very different than what it once was in terms of the composition of its fees, why people get rich, where the money’s coming from, where the industry adds value, where it doesn’t. The growth of these private credit funds is just part of the equation. But this is not your grandfather’s LBO business. It’s a completely different animal.
Luigi: Certainly, the industry has matured a lot. One of the questions that Jeff and Steve debated, and there is not a good answer, is why competition has not driven down the returns and the fees over this period, because what they’re doing, by and large, is not rocket science. I think that at the beginning, it was novel, and there was some financial engineering that was novel. But by now, this has been taught in business school forever.
On the issue of the fees charged to the portfolio companies, it’s true, it’s problematic. However, in most situations, they do disclose them. When you are an endowment, for example, and you invest in a private-equity company, they tell you whether they’re going to charge fees for that or not. And so, it’s a bit buyer beware. And if they can deliver a good return even after all those fees, to some extent, kudos to them.
Now, one question you should ask is, why do they need to do that? Why don’t they increase and jack up the fees in one dimension where they’re more visible? And that’s a very important question, that’s my big concern, especially if we open up the access to the mom-and-pops, because I think that would be quite devastating. We know that people are not very sensitive to fees, and especially if they’re not disclosed very well. And the fear is that as the private-equity hype is fading, then we open up access, so we dump all the bad deals onto the average investor and we let them hold the bag, that would be the worst possible scenario.
Bethany: Well, typically in the history of financial markets, the opening up to retail investors has never been a sign of something that’s about to be fantastic. It’s usually been a sign of desperation. But I think I wasn’t clear. That was the point I was trying to make, which is that if the private-equity firms are doing so much to improve companies, and that’s where the returns are coming from, then why do you need to layer in all these additional fees? And why are these in order to generate the returns? And why aren’t you upfront and transparent about these additional fees?
Luigi: I actually have an even darker side of private equity that was disclosed to me by a CEO of a fairly large company. He was offered to make a personal investment in some private-equity fund with the implicit understanding that they give him a good deal, but they are going to be on the other end of transactions with him in the future. So, as a CEO of a company, I can divest a division to your private-equity firm, Bethany, where I happen to also be a small limited partner. It’s not even clear I have to disclose a conflict of interest, because I’m not a controlling investor. But that generates a pretty big conflict of interest.
Bethany: Oh, my God! It’s Andy Fastow metastasized, because that’s how the whole . . . That’s not the whole of the Enron story, but a portion of the Enron story was Andy Fastow, the former CFO, running private-equity funds that did all their business with Enron. And this is like the metastasized version of that.
Luigi: So, I think that, in my way, there is a very simple solution, which is the old sunshine. This is an industry that clearly has some benefits. However, there is too much shadow in this space. And even if you are Steve and you believe that everything is shining, you should not be afraid to have more sunshine. In fact, you want more sunshine to show beyond a reasonable doubt that things are so clean.
Bethany: I mean, in a sense, private equity, by keeping this information private, does contradict itself in a very big-picture way, in that when the Paycheck Protection Act, the program, was passed in the spring of 2020, private equity lobbied for a share of the bailout money, because they said, “Look at what a huge percentage of the US economy we are, how important we are to the overall functioning of the US economy, what percentage of jobs are supplied by our portfolio companies.” And, OK, good. But if you’re that important to the functioning of the US economy, then you don’t get to be secret anymore.
For this week’s capital-is, capitalisn’t, we decided to discuss the situation in Ukraine.
Speaker 10: Our top story today, President Biden says as many as 150,000 Russian troops are still surrounding Ukraine. Claims from Moscow that it’s withdrawing some forces are being met with skepticism in the West.
Bethany: And it’s not only a question for the shape of our society, for the lives of a lot of people, for whether or not we’re going to go to war, but it’s also a question for the markets and what’s going to happen to the price of gas and oil. So, Luigi and I thought we would talk about it from the perspective of a capital-is or capitalisn’t.
Luigi: There is also quite an interesting economic side of all of it. I’m sure you know, since you are an energy expert, Europe massively depends upon the gas coming from Russia, in particular Russia and Germany. They’ve built two pipelines together with the specific purpose of bypassing Ukraine, having gas flowing straight from Russia to Germany. One is called Nord Stream 1, and the other is Nord Stream 2.
Speaker 11: The United States and Germany have struck a deal to resolve their dispute over the Nord Stream 2 project. Washington has long been opposed to the gas pipeline connecting Russia to Germany. The Biden administration has now agreed to allow its completion without imposing further sanctions.
Luigi: And here there is an interesting side, because there is a long tradition in, if you want, liberal thinking, going back to Montesquieu, saying that trade diffuses war. And so, the question is, to what extent are these economic relationships that are very intense between Europe and Russia going to be an obstacle to an escalation of the war, to what extent are they going to be a tool to prevent the war, to what extent are they going to be the cause of the reason why we’re going to war?
Bethany: It’s funny. When I was promoting my last book, Saudi America, about fracking, I was in Houston. And I gave a speech, a lunchtime speech, to the Petroleum Club of Houston. And someone from Ukraine came up to me afterwards, and he said, “Nord Stream 2 is going to send the world to war. And you need to write about this, because if the US government allows that pipeline to become operational, Russia will try to take over Ukraine. The need for Ukraine to get gas to Europe is the only thing protecting Ukraine.”
And so, this situation we’re in was obvious to people years ago. And what I don’t pretend to understand are the politics behind it, and why it is that Germany so desperately wanted this pipeline and was willing to bow to Russia’s demands in order to make the pipeline operational, and why it is that the Biden administration decided eventually to go along with that. The Trump administration was standing in the way of it and was threatening sanctions and saying, no way we’re doing Nord Stream 2. And Biden came in and cut a deal to get it done.
And I think the defense of that that I read at the time, which plays to your point, was that, well, if we have to impose sanctions in order to prevent Nord Stream 2 from getting done, that’s a bad thing. So, we’ll just allow it to go forward. But now, we’re ending up in a place where we’re talking about preventing war by imposing sanctions. So, it seems to me we’ve squared the circle in a way.
Luigi: I think that the reason why Germany feels very strongly about it is because Germany chose to give up nuclear power in 2011 and wants to make a transition to a friendlier production of energy, especially giving up coal, which was the traditional source of electric power in Germany. They can’t do it without Russian gas. This is where the beauty of the green movement conflicts with the reality of geopolitics. If you don’t have energy independence, or you don’t have a path to energy independence, you are basically in the pocket of the producers of the energy that you need. And I think Russia is in that situation.
And when Nord Stream 2 bypasses that, you can be collateral damage or something else. So, imagine that Ukraine could blackmail Russia by stopping the passage of the gas, or could blackmail Germany into that. Now, this is unlikely to happen because it generates a lot of money. One of the side effects of Nord Stream 1 and 2 is that Ukraine is going to be poorer, because Ukraine today gets a pretty hefty royalty for the passage of the gas. And with a new Nord Stream 1 and 2, they will not.
Now, there is also a more cynical aspect. The SPD, the party that is in power now in Germany, has always been a fairly close party to Russia, actually to the Soviet Union. And there was always some close contact. And let’s not forget that the former chancellor, Schröder, is the last chancellor from the SPD and is now on the board of Gazprom, which is the Russian company that built Nord Stream 1 and 2. So, at some level, if Germany had the courage to say, “If you invade Ukraine, we won’t open up Nord Stream 2,” I think that would be a pretty powerful mechanism.
What I fear is that Putin is going to get the first victory without fighting, which is Nord Stream 2 will become, “We are happy to have Nord Stream 2 if you don’t invade Ukraine.” So, basically, what was controversial and potentially subject to sanctions, et cetera, has become the first gift we give to him.
If Putin is not crazy, he can obtain so many benefits by not fighting the war. It would be hard to imagine that he goes into the war.
If I step down now, I have Nord Stream basically assured for the rest of his life, and a lot of money coming into Russia, and probably, I suspect, a lot of money coming directly into Putin’s pocket, because one of the dirty secrets of these contracts is they’re negotiated in the dark, and some small fees are deposited in Swiss accounts of all the negotiators. There’s a lot of money for both sides. And the alternative is they don’t sanction Russia in general, they sanction all the properties that Putin and Putin’s cronies have around the world. That trade-off seems to me a trade-off that should say no war. But if you’re crazy, you’re crazy.
Bethany: Human nature or human motivations are always the variable factor that no one can figure out or anticipate in advance. What happens to a man when he gets his way? What happens to a man when others fold before him? Does that breed a sense of complacency? Does that breed a sense of, I’ve gotten enough and now I can stop? Or does that breed I need to get more? And I think you never know until you’ve given it to him.
Luigi: And I get a sense that you are not using man generically for human, but man as men.
Bethany: OK. I’ll just say OK.
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