“Private Equity at Work” Rigorously Debunks Industry Mythology

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I must confess that I have been extremely tardy in discussing a tremendously important book on the private equity industry, Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work. I had hoped to showcase the book via an interview with the authors, which Andrew Dittmer, who is also has an intense interest in this topic, conducted over the summer. Although the interview has been transcribed, the conversation is so information-dense and at points technical that Andrew wanted to edit it to make it more accessible and turn it into a series of posts. He’s been waylaid by the start of the academic year at Harvard, where he is helped redesign the intro calculus course and is one of the instructors. Staffing issues have meant he’s been buried, but we hope to publish the interviews sooner rather than later.

In the meantime, the book is getting the attention it deserve via a glowing review by Bob Kuttner in the New York Review of Books, Why Work Is More and More Debased. The review is not yet online, and I will put it in Links when I see it there.

Kutter does an admirable job of giving an overview. The reason that that is not trivial is that Appelbaum and Batt have done an exhaustive amount of research, not only reading what appears to be every academic study done in the last two decades on private equity, but also compiling a large number of case studies on widespread practices in the industry.

For instance, one way that private equity overlords enrich themselves at the expense of the businesses they acquire is by taking real estate owned by the company, spinning it out into another entity (owned by the PE fund and to be monetized subsequently) and having the former owner make lease payments to its new landlord.

The problem with this approach is usually twofold. First the businesses that chose to own their own real estate did so for good reason. They were typically seasonal businesses, like retailers, or low margin businesses particularly vulnerable to the business cycle, like low-end restaurants. Owning their own property reduced their fixed costs, making them better able to ride out bad times.

To make this picture worse, the PE firms typically “sell” the real estate at an inflated price, which justifies saddling the operating business with high lease payments, making the financial risk to the company even higher. Of course, those potentially unsustainable rents make the real estate company look more valuable to prospective investors than it probably is.

Kuttner’s review focuses on the labor market impact of private equity, showing how, as he put it, “…the latest round of work degradation was set off by financial deregulation. The extreme case is the private equity industry.” I wish space had permitted him to highlight one study that Appelbaum and Batt discussed at length, which illustrates a issue they encountered a troublingly significant proportion of the time in the academic work they reviewed: that studies too often state high-level conclusions that do not accurately represent the underlying findings, and thus shade them in favor of the private equity industry.

One of the most striking is the authors’ discussion of an extremely extensive series of analyses on the employment impact of private equity ownership, conducted by Stephen Davis and his colleagues. The papers (a series produced from 2008 to 2013) rely on data from 5000 target companies and roughly 300,000 target establishments (an “establishment” is a single work location, such as a store or factory). For some of the papers, smaller subsets were used. But in each case, Davis et al. developed controls by matching PE owned establishments with ones that were as similar as possible in terms of size, industry, age, and other key factors.

One of the most widely publicized findings out of this extensive body of work was that employment shrank at private equity owned establishments at a greater rate than in the controls over comparable two-year periods. That would seem to be no surprise. The researchers found on an establishment level, half of the job-reduction risk was due to closure of those establishments, as in consolidation of operations.

Now consider this section (emphasis original):

Despite these findings regarding job destruction in establishments, Davis and his colleagues concluded that employment growth in PE target companies is only slightly less than in controls. They reported that “employment shrinks by less than 1 percent at target companies relative to controls in the two years after private equity buyouts.” To reach this conclusion, they first added together the numbers of jobs gained and lost at continuing establishments, jobs lost at establishments that shut down, and jobs gained at greenfield establishments…To reach the conclusion in 2013 that job losses were less than 1 percent at PE-owned companies relative to controls, the researchers also included the effects of acquisitions and divestitures of establishments on job creation. Since PE owned companies acquire more establishments than do publicly-owned companies, this calculation reduced the employment differences between the two types of companies. “Acquired” jobs, however, are not created by private equity, but are “inherited.” Jobs are transferred from the payroll of one company to another, with no net job creation to the economy as a whole.

Kuttner in the interview calls Applebaum and Batt “scrupulously fair” in terms of highlighting private equity success stories. As the example above illustrates, they go to great lengths to be even-handed in describing academic studies of the private equity industry that look like exercises in porcine maquillage. In some cases, it may be the result of pressure on the researchers, particularly in the cases of high-profile studies like the Stephen Davis one.

But more mercenary forces are likely at work, particularly as far as the bastion of research on private equity is concerned, business school faculties. It isn’t simply that PE firms, both the businesses and prominent partners at these firms, are heavyweight donors to business schools. One can imagine that their role in funding would make taking a skeptical stance towards the industry a career-limiting option for a budding academic. It’s also that virtually all business school professors make more money consulting than they do at their putative day jobs. So if you are going to make a focus of studying private equity, it hardly makes sense to alienate prospective meal tickets. Finally, it’s extremely difficult to do research without the cooperation of the PE industry. Remember that wall of secrecy that we’ve regularly discussed? Only researchers deemed friendly to industry interests are given access to essential data sets.

This is why is it so disappointing to see reporters regurgitate industry talking points uncritically. Every journalist writing on private equity needs to read Private Equity at Work to be deemed competent to cover the topic.

For instance, Josh Barrow at the New York Times’ Upshot column gave a big dose of dubious conventional wisdom in defending CalPERS’ decision to continue to put a significant amount of retiree funds with private equity firms:

The question of whether investing in private equity is worth the fees is a matter of continuing academic debate. Private equity funds make illiquid investments whose true value can remain unclear for many years, and no agency centrally tabulates all funds’ performance; as such, measuring average performance is a challenge.

Historically, the consensus view has been that most private equity funds don’t beat the stock market after fees, but the top quartile of asset managers have shown an ability to repeatedly beat the market. More recent research has turned that view on its head: Perhaps private equity does beat the market on average and past manager performance doesn’t matter so much. Another finding is that some types of investors do much better at picking private equity funds to invest in: Endowments do well, banks do badly, and pension funds are somewhere in the middle.

That last finding is particularly instructive: If you’re a green investor, piling into private equity after a few years when private equity has produced strong returns for your peers, you’re likely to take a bath. But if you’re like Calpers, with an enormous asset base and longstanding relationships with top fund managers, it makes sense to keep your good thing going.

Yowza. First, and perhaps most important, Barro completely fails to mention that merely beating the S&P is not good enough to justify investing in private equity, even if the industry succeeded in doing that when properly measured. He completely omits that it is widely acknowledged that PE needs to beat comparable public market indices by 300 to 400 basis points to compensate for the illiquidity. Harvard, considered a very savvy investor, says that PE fails to meet that standard, and CalPERS’ reduction of its allocations to PE confirms the fact that returns have been flagging.

Second, the industry has managed to get many investors and academics to accept the wrong benchmark, the S&P (which is much larger capitalization and generally lower growth index than smaller cap indices) and the internal rate of return (IRR) which is flattering, particularly to the funds flows typical of PE, where the better deals pay a lot out comparatively early.

Third, the as we’ve discussed, the idea that investors can find and stay with those elusive “top quartile” investors, even if outperformance really were persisting (an idea that even McKinsey, which gets a ton of fees from private equity firms, has distanced itself from), is a fallacious investment strategy. As we wrote:

Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results. Needless to say, flattery is an easy sell. This dynamic is similar to another practice we’ve discussed regularly, namely, how CEO pay is set. Compensation consultants tell public company boards that all of them deserve above-average CEOs who must be paid above-average wages compared to their public company peers, thereby fueling ever-escalating CEO pay.

Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.

So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.

Contrast Barro with Applebaum and Batt:

Our review covers the most credible research by top finance scholars…They report much more modest returns to top private equity funds, with some showing that the median fund does not beat the stock market and others showing that the returns for the median fund are only slightly above the market. The most positive findings for private equity generally compare it to the S&P 500 and report that the median fund outperforms the S&P 500 by about 1% a year and the average fund by 2 to 2.5 percent. According to these studies, the higher performance is driven entirely by the top quartile of funds – and particularly by the top decile.

This hardly sounds compelling, now does it?

As you’ve probably now surmised, if you have an interest in understanding the private equity, Private Equity at Work is a wide-ranging, rigorous, invaluable resource. Go buy it now.