Macro Roundup

“…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….”

HBS study finds overall PE improves firm productivity, employment at previously public firms shrinks 13%, but grows 13% in buyouts of privately held firms. Labor productivity rises 8% and average earnings fall 1.7%.

However where the investment falls in the credit cycle has a big impact on returns, “.. In particular, public-to-private deals proliferate in advance of credit market tightening, and their targets exhibit large post-buyout employment losses and poor productivity performance during aggregate downturns…“

“…Relative to control firms,employment at targets rises 13 percent in firms previously under private ownership (private-to-private buyouts) and 10 percent in secondary buyouts (sale from one PE entity to another).Employment falls by 13 percent in buyouts of publicly listed firms (public-to-private deals) and by 16 percent in divisional buyouts. The overall average employment impact of PE buyouts is a statistically insignificant -1.4 percent in our sample. After netting out post-buyout acquisitions and divestitures to isolate organic changes, the overall average impact is -4.4 percentage points The pace of intra-firm job reallocation at target firms rises relative to control firms post buyout. This pattern holds across all buyout types, and much of it reflects greater acquisition and divestiture activity by target firms. Labor productivity rises by an average of eight percent at target firms (again, relative to controls), a striking impact given that targets tend to be mature firms in mature industries. Productivity gains are concentrated in private-to-private and public-to-private buyouts….. Compensation per worker falls by 1.7% at target firms after buyouts, largely erasing a prebuyout wage premium relative to controls. Wage effects also differ greatly by buyout type. In short, the impact of private equity is more complex and varied than champions or detractors claim…Our results also reinforce concerns about public-to-private deals, which account for 10% of PE buyouts from 1980 to 2013 and 31% of employment in target firms. In particular, public-to-private deals proliferate in advance of credit market tightening, and their targets exhibit large post-buyout employment losses and poor productivity performance during aggregate downturns…We examine thousands of U.S. private equity (PE) buyouts from 1980 to 2013, a period that saw huge swings in credit market tightness and GDP growth. Our results show striking, systematic differences in the real-side effects of PE buyouts, depending on buyout type and external conditions. Employment at target firms shrinks 13% over two years in buyouts of publicly listed firms but expands 13% in buyouts of privately held firms,both relative to contemporaneous outcomes at control firms. Labor productivity rises 8% at targets over two years post buyout (again, relative to controls), with large gains for both public-to-private and private-to-private buyouts. Target productivity gains are larger yet for deals executed amidst tight credit conditions. A postbuyout widening of credit spreads or slowdown in GDP growth lowers employment growth at targets and sharply curtails productivity gains in public-to-private and divisional buyouts. Average earnings per worker fall by 1.7% at target firms after buyouts, largely erasing a pre-buyout wage premium relative to controls. Wage effects are also heterogeneous. In these and other respects, the economic effects of private equity vary greatly by buyout type and with external conditions…”

Steven Davis, John Haltiwanger, Kyle Handley, Ben Lipsius, Josh Lerner and Javier Miranda, “The Economic Effects Of Private Equity Buyouts,” Harvard Business School, 2019, https://www.hbs.edu/faculty/Publication%20Files/20-046_ceb00b98-e62a-45db-8d5f-9793ffd0226e.pdf