Macro Roundup

Sai Krishna Kamepalli, Raghuram Rajan and Luigi Zingales, "Kill Zone," National Bureau Of Economic Research, May 2020, https://www.nber.org/papers/w27146

“…Venture capitalists talk about a “kill zone” created by acquisitions, such as those by Facebook and Google, in the start-up space. This idea seems at odds not only with standard textbook economics, but with logic itself. Why should the prospect of being acquired at hefty multiples discourage new entry? In this paper we construct a simple model that rationalizes this result. In the presence of network externalities, early adopters generate an important externality: they facilitate the adoption by less sophisticated customers, helping the market converge to the platform with the superior technology.These early adopters, however, face significant switching costs, thus they will switch only if the benefit of switching is reasonable large. This benefit is given by the product of the technological difference and the time this difference will persist. Since a merger immediately transmits the superior technology to everybody, it reduces the payoff to early adoption. The prospect of mergers then reduces switching, makes it harder for entrants to acquire customers and offer network externalities for any given technological superiority, and thus reduces the price at which they can be acquired.This then reduces their incentive to innovate. We test this prediction using data on investment in startups. We show that VCs significantly reduce the number of deals and the amount of money they invest in markets near one where Facebook and Google have made a large acquisition, after the two giant digital platforms have made those acquisitions. … We collect data on the number of deals and dollar amounts invested by the venture capitalist in specific sectors, after major acquisitions by Facebook and Google are announced. We find that normalized VC investments in start-ups in the same space as the company acquired by Google and Facebook drop by over 40% and the number of deals falls by over 20% in the three years following an acquisition. In comparison, a similar calculation for other acquisitions in the software industry suggests that normalized VC investments in start-ups in the same space as the company acquired goes up (not down) by over 40 percent, while the number of deals goes up slightly in the three years following an acquisition. The software industry seems to follow the standard economic argument…..while the platform acquisitions seem very different. We consider alternative explanations of these results, including the possibility that most (if not all) the start-ups similar to the ones acquired by Google or Facebook were created with the only objective of being acquired by Google or Facebook. Thus, when a tech giant chooses another target, the potential alternatives lose their likely buyer and thus financing. To address this concern, we only look at startups that are in a similar space, but not too close to the space of the acquired ones (so that they cannot be considered perfect substitutes). Our results are if anything stronger. We also consider the possibility of the acquired start-up being a complement rather than a substitute to the incumbent platform….While an outright prohibition of acquisitions may reduce welfare, the model provides alternative welfare-improving forms of intervention. The most important message, though, is a simple one: it is dangerous to apply twentieth century economic intuitions to twenty first century economic problems. Our paper suggests one reason why….”

They suggest that platforms require new economics versus standard models as the economics of digital platforms differ from even other intangibles like software“The most important message, though, is a simple one: it is dangerous to apply twentieth century economic intuitions to twenty first century economic problems"

New Kamepalli/Rajan/Zingales observe that large tech firms acquiring smaller possible competitors (so in the way FB purchased Instagram) have reduced VC investment as the incumbent (likely) has a powerful moat that (implicitly) raises the hurdle rate discouraging new investment: “We find that normalized VC investments in start-ups in the same space as the company acquired by Google and Facebook drop by over 40% and the number of deals falls by over 20% in the three years following an acquisition. In comparison, a similar calculation for other acquisitions in the software industry suggests that normalized VC investments in start-ups in the same space as the company acquired goes up (not down) by over 40 percent, while the number of deals goes up slightly in the three years following an acquisition

Peter Q. Blair and Shad Ahmed, "The Disparate Racial Impact of Requiring a College Degree,"Wall Street Journal, June 28, 2020, https://www.wsj.com/articles/the-disparate-racial-impact-of-requiring-a-college-degree-11593375171

The Disparate Racial Impact of Requiring a College Degree

In response to the senseless and brutal killing of George Floyd, major brands are flooding social media with statements in support of the black community. Bank of America followed up with a $1 billion philanthropic commitment. As of June 18, Fortune 100 companies had pledged more than $2 billion to demonstrate that they are listening and responding.

But if corporate executives want to address systemic racism, they can do more. In addition to philanthropy, they should change their hiring and management practices to focus on job skills, rather than continuing to privilege college degrees. This change would increase diversity in the workforce and expand economic opportunity without sacrificing quality.

Research from Harvard Business School shows that “degree inflation” in job postings is pervasive. Example: 67% of postings for new production supervisors in 2015 included college-degree requirements, though only 16% of existing production supervisors had bachelor’s degrees.

Degree inflation is a barrier to entry for would-be employees of any race: Among workers over 25, only 40% of non-Hispanic whites and 26% of blacks have a bachelor’s or higher. Given the racial gap in college attainment, however, degree inflation has a disparate impact on black Americans. The impact is amplified today by the effects of Covid-19 on public health, the job market and access to college.

Nonessential degree requirements aren’t race-neutral. They embed into the labor market the legacy of black exclusion from the U.S. education system—namely, the antiliteracy laws that made it illegal for blacks to learn to read, the separate and unequal schools that kept them from catching up, and the limited progress since then on policies designed to remedy racial discrimination.

This spring, we and six other colleagues wrote a National Bureau of Economic Research working paper that questioned the fundamental assumption undergirding the proliferation of degree requirements: that workers without four-year degrees who earn low wages are low-skilled.

For the 71 million U.S. workers who have a high-school diploma but not a four-year degree, we used the skill profile of their current jobs as a proxy for their employability for higher-wage work. Their job experience suggests they are skilled through alternative routes, so we call them by the acronym STARs. They make up 60% of the active U.S. workforce.

Our research found that 16 million STARs have the skills for high-wage work, defined as earning more than twice the national median. Yet 11 million of them are currently employed in low-wage or middle-wage work. This suggests an extraordinary market failure: U.S. companies are systematically overlooking talent. Further, African-Americans are underrepresented among the five million STARs currently employed in high-wage work. Employers are missing out on talented workers without bachelor’s degrees, and black workers in particular.

Our research suggests there are changes companies can make to address this problem:

• Hire for skills and work experience, not degrees. Rather than using the degree requirement as a default, employers should examine the skills that their jobs require and then use skill requirements for job postings, screenings and assessments. IBM adopted this type of skills-based approach with its New Collar initiative, launched in 2017.

• Look for talent where STARs work and learn. Many STARs learn critical-thinking and complex problem-solving skills from work in overlooked sectors such as retail sales and child care. Companies should expand recruiting pipelines from these sources, reassess referral processes to close what LinkedIn calls the “network gap,” and develop programs to bring STARs on board. Workday’s Opportunity Onramps and Salesforce’s Pathfinder programs are early examples of this approach.

• Invest in STARs to support their career advancement. Such efforts improve efficiency, boost retention and enhance skills. Walmart, for example, offers educational benefits for its employees through its Live Better U program. Even if STARs change employers, their training benefits the local labor market and improves their earning potential.

These recommendations are only a start. Last August, 181 CEOs of the Business Roundtable agreed that the purpose of the corporation is to “promote an economy that serves all Americans.” If the goal of the recent surge in corporate engagement is to dismantle systemic racism and fashion a more inclusive economy, companies should heed the words of STARs like LaShana Lewis, a self-taught coder and CEO of her own company. Ms. Lewis calls on businesses to “look past the pedigree and look more at the skill base.”

This call to action doesn’t diminish the role of college degrees or public investment in improving the skills of the U.S. workforce. It suggests that businesses can take the lead.

Black workers face extraordinary barriers to economic mobility. By valuing skills over degrees, companies can improve the way the labor market functions for black STARs—a necessary step to ensure that the economy works for all.

“…For the 71 million U.S. workers who have a high-school diploma but not a four-year degree, we used the skill profile of their current jobs as a proxy for their employability for higher-wage work. Their job experience suggests they are skilled through alternative routes, so we call them by the acronym STARs. They make up 60% of the active U.S. workforce.Our research found that 16 million STARs have the skills for high-wage work, defined as earning more than twice the national median. Yet 11 million of them are currently employed in low-wage or middle-wage work. This suggests an extraordinary market failure: U.S. companies are systematically overlooking talent. Further, African-Americans are underrepresented among the five million STARs currently employed in high-wage work. Employers are missing out on talented workers without bachelor’s degrees, and black workers in particular….”

Read this over the weekend on how DARPA works, some neat factoids and a great quote from former director on being constrained by ideas. For a risk seeking organization surprising high success rate btw 5-10%, and only 10% of program are killed early.

"...DARPA is relatively tiny and flat. As of April 2020,DARPA has 124 staff and three layers of management. That number is right around Dunbar’s Number - just small enough for one person to know everyone in the organization. The small organization means that there are no “group projects” so every PM is directly responsible for the program they’re working on and you can’t have slackers. Small size also helps keep PM quality high by removing pressure to hire a lot of people.... DARPA Program managers have a tenure of four to five years. This transience is important for many reasons. Transience can inculcate PMs against the temptation to play it safe or play power games because there’s only one clear objective - make the program work. You’re out regardless of success or failure..... Only 5-10 out of every 100 programs successfully produce transformative research, while only 10% of projects are terminated early. Shifting the risk from the performers to the program managers enables DARPA to tackle systemic problems where other models cannot.... DARPA is ~0.5% of the Department of Defense Budget and ~12% of that is basic research…. at its height, Bell Labs’ budget was only 5% of AT&T’s revenue…A lot of DARPA’s budget is spent on actually assembling weapons and vehicle systems. So the math works out that only ~$400m is actually being spent on ‘basic research.’ … in the years 2018-2020among DARPA programs not focused on assembly and production the minimum budget was $2m, the maximum budget was $31.4m, and the average budget was $12m. …These raw numbers raise the question - is there a ‘minimum effective budget’ to generate outlier results? If so, what is it? DARPA is more ideas limited than money limited. This excerpt is gold: “I never really felt constrained by money,” (former DARPA director) Tether says. “I was more constrained by ideas.”…”

Ben Reinhardt, "Why does DARPA work?," Benjaminreinhardt.com, June 2020, https://benjaminreinhardt.com/wddw

“…While returns net of fees have modestly exceeded the return of the market over the past decade,gross returns have averaged more than 5% a year better than the market over this time. This means that the roughly $300 billion invested in private equity deals in 2018 will generate an excess social return of more than $100 billion over the average seven-year life of these investments…..The results are seen in numerous studies. Companies backed by private equityare subsequently 8% more productive than their industry counterparts, one National Bureau of Economic Research paper found last year. Other studies have found fewer health and safety violations, lower rates of workplace injuries, and more expansion into new regions and product lines.….”

M. Todd Henderson and Steven N. Kaplan, "Populists Don’t Know Much About Private Equity,"Wall Street Journal, June 30, 2020, https://www.wsj.com/articles/populists-dont-know-much-about-private-equity-11593557292

Populists Don’t Know Much About Private Equity

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

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

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

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

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

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

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

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

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

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

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

Mr. Henderson is a law professor and Mr. Kaplan a professor of entrepreneurship and finance at the University of Chicago.

Well-trod ground new NBER research finds no evidence that buybacks reduce investment though there is a negative relationships btw payouts and investment, firms in the top 10% of payout distribution had higher returns than firms in bottom 90%.

“….In this paper, we show that payouts in the 2000s are sharply higher than from 1971 to 1999, whether we look at constant dollar aggregate payouts or firm-level payouts. The increase in payouts comes about both through an increase in payout rates and through an increase in funds available for payouts. Thirty seven percent of the increase in aggregate constant dollar payouts is explained by an increase in constant dollar aggregate operating income while sixty-three percent of the increase is explained by an increase in the payout rate…. The companies in our sample pay out almost $10 trillion from 2000 to 2017 - gross payouts are $10,823 billion and net payouts, which net out equity issues by repurchasing firms, are $9,862 billion. In the 2000s, annual aggregate real payouts average roughly three times their pre-2000 level. Aggregate net payouts as a percentage of aggregate corporate assets also increase substantially, averaging 2.7% from 1971 to 1999 versus 4.1% from 2000 to 2017. When we examine the ratio of aggregate net payouts to aggregate operating income, we see a similar increase; the average ratio increases from 18.9% to 32.4%. The year 2018 stands out, as aggregate net payouts as a percentage of aggregate corporate assets are 6.2% and aggregate payouts as a percentage of operating income are 48.4%. We show that payouts increase both because firms’ capacity to pay increases and because their willingness to pay increases. Specifically, in the aggregate, 38% of the increase in payouts is due to the fact that firms earn more and 62% is explained by the fact that firms have a higher payout rate. To explain the increase in payouts, it is therefore essential to explain why the payout rate increases. … Dividends average 14.4% of operating income from 1971 to 1999 and 14% from 2000 to 2017. In contrast, net repurchases average 4.8% of operating income before 2000 and 18.3% from 2000 to 2017….The aggregate level of payouts in the 2000s can be explained well using a model available in the literature estimated on data from 1971 to 1999 to predict payouts in the 2000s conditional on actual determinants of payouts in the 2000s. For instance, this model estimated with data from 1971 to 1999 overpredicts payouts in 2017 by 6%. As documented in Kahle and Stulz (2017), firm characteristics change substantially over time. Specifically, firms in the 2000s are larger and older than firms over the period 1971-1999. Larger and older firms have higher payouts, so changes in firm characteristics imply an increase in payouts and payout rates….We find similar results for aggregate net payouts. In 2018, ten firms account for more than 25% of the aggregate net payouts in our sample. Fewer than 10% of firms make 90% of the aggregate net payouts. For example, before 2000, on average, the net payouts of 338 firms amount to 90% of the net payouts of all firms. In the 2000s, 90% of net payouts come from the top 248 payers. Another way to see that aggregate net payouts reflect the actions of few firms is to look at the net payouts of firms who pay out more than $100 million in 2017 dollars. In 2018, these firms represent 21.7% of the firms in our sample…To investigate how much of the increase in payouts can be explained by changes in firm characteristics, we estimate payout rate models on data from 1971 to 1999 that relate payouts to firm characteristics. We then use these models to predict payout rates in the 2000s given actual firm characteristics. Models estimated from 1971 to 1999 predict an increase payout rates for the 2000s because of changes in firm characteristics, but they do not predict an increase as large as the actual increase. For the firms for which we have adequate data to predict the payout rate, the payout rate increases from 12.9% to 20.2% from before the 2000s to the 2000s. Changes in firm characteristics explain 71% of that increase.Models estimated with data from 1971 to 1999 are less successful in estimating the increase in payout rates for firms that have payouts. For these firms, the payout rate increases by 10.8%. Of this increase, changes in firm characteristics explain 49% of the increase. However, the predicted average payout rate for firms with payouts is always below the actual payout rate in the 2000s. We investigate whether the underprediction can be explained by the tax law changes that affect multinationals and by cross-market arbitrage. We find that both tax law changes and cross-market arbitrage explain part of the large prediction errors of our models. The question this paper tries to answer is whether payouts in the 2000s are abnormal. The answer is that much of the increase in payouts can be explained by known determinants of payouts. However, these models do a better job in explaining the evolution of aggregate payouts than they do in explaining the payouts of individual firms. A plausible explanation is that aggregate payouts reflect the payouts of the largest payers. These payouts may be more predictable over time. There is evidence that part of the increase in the payout rate can be explained by the fact that firms are more sensitive to determinants of payouts in the 2000s. In other words, if a firm’s payout rate is positively related to a firm characteristic before 2000, it is more strongly related to that firm characteristic in the 2000s. An increase in the sensitivity of payouts could be a positive development if it means that firms are less likely to hoard funds internally that could be invested more profitably outside the firm. Alternatively, however, such an increase could be problematic if it means that firms are more reluctant to take advantage of valuable internal investment opportunities. However, while our study does not provide tests that would establish or reject a causal relation between capital expenditures and payouts, it is noteworthy that even if one were to argue that firms decreased capital expenditures to increase payouts, this effect would explain little of the increase in payouts given the weak relation between capital expenditures and payouts….”