February 28, 2007
Barbarians at the gates: the balance of pros and cons
The barbarians are again at the gates. The announcement this week of the largest ever private equity buy-out of a public company – the $45bn takeover of TXU, one of the largest utilities in the US, by Kohlberg Kravis Roberts and Texas Pacific Group – confirms the trend. To its defenders, private equity makes companies more efficient. To its attackers, its practitioners are financial manipulators and asset-strippers. So who is right? An obvious answer is that private equity is a growing activity in which willing sellers meet willing buyers. If it prospers, it must be profitable. If it is profitable, it should also be adding value. Where private equity finances start-ups or small and medium-sized companies, few would question this argument. The taking private of well-known public companies with huge numbers of employees is a different matter. Why, though, should the benefits of such deals be doubted? Do they not also fall under the broad category of beneficial transactions? To this there are three answers. The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free.
Willem Buiter: Since no-one has posted yet on this topic, I’ll indulge in a mega-post. Martin’s very interesting column raise a number of issues. I will take what I consider the most important ones in turn, and add a few as well.
(I). Private equity and excessive leverage.
Private equity and hedge funds are examples of highly leveraged financial entities. A good case can be made that excessive leverage is encouraged, across the board and not only for private equity and hedge funds, by the deductibility of interest from the corporate tax base. This makes bond finance cheaper than financing through new equity finance or retained profits. Countries with high corporate tax rates and interest deductibility, like the US and the UK (and Germany for just a little bit longer) encourage foreign-owned companies to do their borrowing there, in order to reduced their corporate tax burdens. This distortion can be eliminated either by ending the deductibility of interest (which should be done for all interest, and not just for interest paid on debt issued for specific purposes, such as LBOs), or by extending the deductibility of interest to dividends and retained profits, that is, by abolishing the corporate profit tax.
I favour the second course of action. All asset income, dividends, interest and capital gains, would be taxed at the level of the ultimate beneficiary and at a common rate – any differential treatment would be distortionary and would undermine tax revenues because of the ease with which one form of capital income can be transformed into another. Indeed, given the ease with which labour income can be transformed into capital income and vice versa (especially in the unincorporated sector), it is probably necessary, for revenue protection reasons, to tax all income at a common (but not necessarily constant) rate, regardless of its source and type. Any net revenue loss could be made up through higher personal income taxes, indirect taxes or, my favourite (and political lead balloon) a land tax.
Conclusion: action required (abolition of the corporate income tax) , but not directed specifically at debt issued by private equity funds.
(II). Private equity and short-termism.
The argument that private equity is more myopic than listed equity makes no sense. If anything, the curse of the quarterly reporting requirements makes it likely that listed equity will act more myopically. Private equity investors often have a longer investment horizon or holding period than institutional or individual investors in public companies.
Conclusion: one up for private equity.
(III). Private equity and conflict of interest.
(1) Managers and existing shareholders of listed companies
As devotees of Martin Lukes (Chief Great Leader of a-b glöbâl (UK)), will know, potential conflicts of interests exist when private acquirers ‘bribe managers’ (in the words of the other Martin) of listed companies to accept deals that are against the interests of the existing shareholders. This is a real issue. It can only be tackled by better corporate governance of listed companies – aligning the interests of the managers with those of the existing shareholders, and by the enactment and enforcement of laws and rules that make such practices illegal.
Conclusion: action required. One in the eye for private equity.
(2) Managers and the new shareholders.
As Martin (Wolf, not Lukes) points out, going private mitigates the inevitable conflict of interest that exists in public companies with dispersed ownership and managers with limited ownership interest. However, even after going private, the interests of the general partners and the limited partners are not perfectly aligned, and there is a clear incentive for the general partners to take risks that are excessive from the perspective of the limited partners. This incentive for excessive risk taking can be weakened through better corporate governance of the private equity vehicle – including greater transparency, more informative reporting and more effective means for limited partners to constrain and discipline the general partners. Each of these measures would, of course, make private equity more similar to public equity, and the cause the re-emergence of the associated “excessive regulation, costly shareholder suits and the tyranny of quarterly reporting”.
When the incentive towards excessive risk taking cannot be sufficiently mitigated, a properly paternalistic government should restrict the opportunity to invest in private equity, hedge funds and other highly leveraged investment vehicles, to those who can afford to lose their investment. Proposals for making private equity and hedge fund investment opportunities available at the retail level to small investors should be resisted. The argument that by investing in ‘funds of funds’ risks can be diversified away to the point that even Granny Jones can safely put her war widow’s nest egg in such instruments are delusional, since the herding behaviour of hedge funds makes for severely restricted diversification opportunities.
Conclusion: net impact of private equity on conflict of interest is ambiguous. Better reporting and greater transparency would probably help. Widows and orphans should be kept away from investing in highly leveraged vehicles.
(IV). Going private destroys public information
This is obviously correct. Whether it matters depends on the distributional and efficiency implications of the elimination of reporting requirements and other information provision that is a legal or regulatory requirement for listed companies but not for private ones. If following a successful LBO, minority shareholders from the formerly listed company continue as shareholders in the new private entity, they will have fewer rights and legal means of recourse than they had as shareholders of the public company. They should receive appropriate compensation.
Conclusion: action required
(V). Private equity and other stakeholders.
The term ‘stakeholder’ is popular in some circles and deeply unpopular in others, because it points to the possibility that parties other than the owners or shareholders of a company could share in the residual control or decision rights over the company. Economic theory suggests that in the interest of efficiency, all those who have a stake (an investment or net open position) in a company and possess private information relevant to the success of the company should be involved in its management. Since the traditional economic model of the firm viewed labour as a variable factor (the worker has no (human) capital at stake in the firm that employs him/her), and did not view the worker as possessing private information relevant to the performance of the firm, this model of the firm offered no efficiency arguments for involving labour in managerial decisions. More modern theories of the firm view the employment decision as, in part, an investment decision by the worker, and one that is costly to reverse. So the worker is a stakeholder. In addition, in a modern knowledge economy, information relevant to firm-wide performance is widely dispersed throughout the work force. These two features together make, in principle, for a managerial role for labour. The nature and extent of this role, and the institutional mechanisms through which it is expressed can, of course, range from full co-determination and worker control of a board that has veto power over certain strategic decisions (including de-listing) to the ‘right’ to be told ex-post what has been decided by others.
The stakeholder universe of the modern corporation has been extended, in some approaches, to include not just the shareholders, other creditors and workers, but suppliers, customers and the local or regional community in which the enterprise is located. The legitimacy of such claims, from the point of economic efficiency, depends again on the answer to the following two questions: (1) is the candidate stakeholder indeed exposed to the enterprise (does (s)he have something at stake)? and (2) does the candidate stakeholder have private information that is relevant to the performance of the enterprise?
The world where shareholders are the only stakeholders is gone – if it ever existed. Private equity has not been very astute at recognising this reality and is now at risk of paying a heavy price for it, in the form of excessive (Sarbanes-Oxley-style) regulation and ill-thought-out punitive measures through the tax system. Private equity has to identify for each target company who the relevant stakeholders are and how they can be brought on board. The private equity community will either do so voluntarily or it will be done for them.
Not all stakeholders have legitimate claims. In continental Europe (and perhaps most spectacularly in the Netherlands) staggeringly blatant poison pills have shielded ‘insiders’ - incumbent managers (no matter how incompetent) and incumbent workers (no matter how feather-bedded) - against the threat of any kind of hostile takeover, including by private equity.. It is indeed remarkable that the President of the Nederlandsche Bank (the Dutch central bank), Nout Wellink, who is (subject to EU consent) capable of refusing permission for bank mergers, takeovers and break-ups in his jurisdiction, has ‘done a Fazio’, by coming out in opposition to attempts by an activist hedge fund to force the break-up of ABN-AMRO. I cannot judge the merits of the proposals for a break-up, but the knee-jerk response of the regulator at this stage of the game is indeed remarkable.
Conclusion and recommendation: private equity should recognise the reality that there may be stakeholders other than shareholders that have legitimate claims on the resources of the firm, and who should be consulted when a de-listing is proposed. At the same time, it must also be recognised that private equity is often the natural instrument for expropriating the rents appropriated by illegitimate stakeholders (‘insiders’, that is, inefficient incumbent managers and feather-bedded employees who have managed to shield themselves from effective competition from ‘outsiders’) and to return these rents to more legitimate stakeholders, including shareholders as well as managers and workers recruited through open, competitive processes.
(VI). Size
When private meant small, the lack of transparency and limiting reporting requirements characteristic of private equity did not matter much. When $50bn deals are in the air, de minimis arguments just don’t cut it.
Conclusion: stop dreaming. Size matters. Private equity must become more public – in the sense of transparent and accountable. Self-regulation will no doubt be the preferred outcome, but it may be too late for that, at least in Europe, where a number of would-be regulators are chomping at the bit.
Posted by: Willem Buiter, London School of Economics | March 2nd, 2007 at 1:21 pm | Report this commentMartin Wolf: Willem has posted a response to my column on private equity that is 50 per cent longer than the original! I agree with almost everything he has written. But let me still make three comments.
First, I think Willem presents the simplest alternative on taxation. The only question is what to do with foreign owners of shares in domestic companies. The simple answer is to levy a withholding tax at the common rate of tax. If the government wishes to keep corporation tax, however, it can make dividends deductible from that tax and taxable to the recipients at their normal marginal tax rate. Finally, I agree on the land tax. I have written many columns in its favour.
Second, Willem makes a very important point about the interests of stakeholders. One of the “advantages” of a takeover for shareholders is that it makes it easier to break implicit contracts with stakeholders, after the fact. While it may indeed be in the interests of shareholders (present and prospective) in a given company to “cheat” in this way, it is not necessarily in the interests of companies in general. This is because it will make it more difficult to persuade workers (or suppliers) to make company-specific investments. Implicit contracts may then have to be made explicit, which is costly and, in some cases, may even be impossible.
If one compares two economies that have strong competition in product markets, one might even find that the one where take-overs are difficult is, overall, more efficient than the one where they are easy. This is an empirical question. At the least, the former country should have a comparative advantage in activities in which investment in company-specific capital is important. Think of Toyota’s suppliers. If they are to become dependent on one purchaser they must have deep trust in the promises of the latter’s management. That is possible with Toyota. Is it possible with any US company?
Finally, let me underline the last point: size matters. The idea that any government would allow much of its corporate sector to disappear, unregulated, behind the private-equity veil is naive, to put it mildly.
Posted by: FT Forum - Martin Wolf | March 6th, 2007 at 7:41 pm | Report this comment