“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.

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  1. Jim A

    At some level, I suspect that the managers of public pension funds are prone to the “singing horse” mistake that is prevalent in politics: It is better to promise the impossible than to not get the job.

    1. GlassHammer

      “It is better to promise the impossible than to not get the job.”

      Is there any penalty if they fail to meet those promises?

      1. Vatch

        Gosh, they might have to apologize. But most would try to get away with something along the lines of “mistakes were made” or the even less regretful “markets are volatile”.

  2. Left in Wisconsin

    I think there are two separate issues here. One is the returns to general partners generated by private equity. I know nothing in this area but I certainly would expect private equity to screw the GPs to the best of their ability. Why not? Maximizing returns (cash out, not financial statement returns) is what they do and why treat general partners differently than everyone else?

    The continuing health of the actual businesses they buy is an entirely different issue and here I have no doubt that private equity is vitually always bad for them, in the sense of managing or growing these businesses for the long term. My experience is in manufacturing dates back to the first leveraged buyout boom in the 1980s. After nearly a decade of trying to help union workforces survive leveraged buyouts (almost always unsuccessfully) and two more of close observation since, it is almost never the case that a manufacturing business acquired by private equity (that is, the specific locations and facilities bought) is in as good or better condition a decade later than it was at the time of acquisition.

    Studies that only go out 1 or 2 years can almost always be gamed, and studies that rely on PE financial statements tell you almost nothing about the health of the underlying business. (I haven’t read Applebaum and Batt so I don’t know if they do any longer term analysis.) It is almost impossible to follow the financial paper trail after a PE acquisition as it relates to specific businesses and facilities. But if you know the facilities and check in on them from time to time, the vast majority are shuttered or dramatically downsized over time. Mostly what happens is customer lists are bought, facilities are consolidated, no new investment is made, no new products or customers are sought, and eventually the entire operation withers away. There is the occasional LBO done by existing management with PE participation that tries to keep and grow the business, and some of the big PE players now have (hired) sufficient management expertise that they can keep operations running indefinitely. But in 90% or more of cases I would guess, there is no long-term vision, nor any willingness to sacrifice short-term cash returns in order to grow the business. To me, this is the real outrage of public pension fund investments in PE, esp funds run ostensibly to benefit unionized workers.

    One last note: both Applebaum and Batt come out of the old and almost dead academic Industrial Relations world, not traditional business schools. (I experienced the death of Univ. of Wisconsin’s once vaunted IR program first hand.) Perhaps that’s why they can write what they do.

    1. Left in Wisconsin

      Proving lack of knowledge about PE, when I wrote “General Partners” I meant “Limited Partners.”
      I second the recommend of the Dayen interview at FDL. One interesting claim is that most PE is in services now. I guess they have taken everything they can from manufacturing.

  3. digi_owl

    Hollywood Accounting comes to mind.

    there a studio will spin up a project company, that they then “lease” equipment and provide “services” to.

    Said project company is then the entity that is saddled with production costs and paying actors etc.

    This result in the movie, even if it goes on to be a blockbuster, going deep in the red financially. The studio is isolated from this via the shareholder veil, and also sit as one of its principle creditors.

  4. susan the other

    Private equity is a glaring symptom of a dying economy. An economy in which private capital is reluctant to participate unless all risk is covered. One diagnosis of the sick economy is that diminishing returns are a fact of nature, another is global warming, another is overpopulation, and etc. But to allow private equity to simply write the rules is obscene. There can be no sharing of the downside with “private equity”. Ever. It’s probably high time to look at that concept: “private” equity. Nobody every made it on their own. Nobody. So how did their equity suddenly become so precious?

    1. Wordsmith

      “dying economy” = necrotomy?

      I’m surprised that mainline economists haven’t been more inventive and playful in naming the stages of an economy. I vote for the above for the last, mordant stage.

  5. Min

    ” 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”

    Get these people to hire public school teachers. :)

  6. proximity1

    If you had a tag denominated “value extraction” or perhaps better yet, “vicious value-extraction” it could be applied to the themes covered here since that’s what is going on beneath all the PE analysis-driven decisions. Just this morning my “light-bulb” moment was all about the insatiable value-extraction that apparently constitutes the leitmotif of this particular species of capitalism. I think one could use it to help interpret and decrypt practically any aspect or set of aspects in the practical goings-on of the economy.

  7. proximity1

    London offers a living-laboratory view of this –to use a phrase I hate–“perfect storm” at work. The already existing gulf between those who have-everything-and-then-some and those who have-least-or-next-to-nothing continues to widen. At every turn, the interests of those who own and control are enhanced and enhanced precisely at the greater expense of those who have the least and control little and ever-less about their own lives.

    So, as public funds are cut in areas which were to the relatively greater benefit of the needier/est, they’re redirected to pork-barrel projects which enhance the living standards of the wealthy and privileged.

    ITEM : Housing estates–described as “unfit”–are cleared of their low-income renters and the property is sold off to developers for the construction of luxury apartments. (See: “Focus E15 Mothers” )

    ITEM : A street lined with modestly priced shops owned and run by local small business owners and frequented by the low-income residents of the neighborhood is targeted for clearance so that a major multibillion pound football franchise–absentee-owned by Middle Eastern oil potentates–can build a shiny new stadium.

    ITEM : Many millions of pounds are spent on planning studies and the quest for public authority approval for a wildly extravagant airport development for–again–the most privileged, crowded and over-priced southeast (read : “London”) area while other needier parts of the nation go begging.

    ITEM : Same basics as above for the mega-investment project “Crossrail.”

    ITEM : Same basics as above for “High Speed 2” (“HS2” for short) — a mega-project to build a high-speed rail from London to the English Midlands and Northwest.

    Though these projects will of course employ a certain number of construction laborers, much of that labor is the cheap-er imported variety that comes from outside the country and leaves lots of British people standing on the sidelines with their hands in their pockets. Much of the highly-paid gilt-edged jobs involved, on the other hand, do go to the engineers and senior porject managers who are just below the ranks of the upper tier elite–who, themselves, will enjoy rich opportunities in finance and consulting and management. In all the planning and development phases and in all the implementation decisions, the inevitable controversies were hashed out between various competing subsets of the highly privileged elite–the same people in upper business and government who always help themselves first and the general public last–or, more often, never. At no point did the needs and interests of these latter ever inconvenience the priorities of those who kept the system’s planning and design to themselves.

    Meanwhile, those parts of Britain’s social infrastructure intended mainly and primarily to serve health and education needs for the average person are being gutted and left in a state of ruin. Hospitals’ and schools’ are losing materials as their budgets are cut; their staffs are being cut and those remaining are being asked to do more and more with less and less.

    This is a picture of a viciously-driven and divided society, where an elite literally prey upon and cast off a defenseless underclass which is deemed expendable and disposable. This is how democracy of, by and for the rentier class and at the expense of great majority of the rest is done in Britain and in the rest of Europe, too. There’s nothing for the homeless or the mentall-ill, who are left to fend for themselves. Etc. Millions of Britons who work at jobs which pay wages at or just barely above the minimum wage–once intended as the exception to higher, sustaining wages, and now the norm for many employees–cannot afford to feed, clothe or house themselves or their families decently.
    BBC “Panorama” documentary program: “Workers on the Breadline”

    At its most recent party conference (the final event before the next general election in summer of 2015), the Conservative Party leadership announced their intentions to “freeze welfare payments for people of working age for two years starting in April 2016 if they are re-elected next May.”


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