One of Donald Trump's advisors is Steven Schwarzman of Blackstone, a private equity powerhouse. Since he has the President's ear, and since private equity enjoys a considerable amount of political power while attracting a considerable amount of political criticism generally, I thought it would be valuable to take a look at what private equity is and some of what private equity does.
Private equity has, by and large, not been good to Rust Belt workers, i.e., the White Working Class, i.e., a big chunk of the folks who want to Make America Great Again, although it has been good for some Rust Belt companies from a bottom-line perspective. Private equity has it's merits, but generally those merits do not include boosting manufacturing union-labor employment.
Let me take a stab at breaking private equity down for you.
What's "special" about private equity is encapsulated in the first word of its name. Investors in a publicly traded company exercise considerable decision-making power through the board of directors of that company. Investors in a private equity firm do not have that much decision-making ability, if any. They put their money into the company, and the men or women running the company get to make all the decisions involving that money.
As you might imagine, this gives private equity firms the advantage of being able to move decisively and swiftly, and the disadvantage of not being able to be held in check, should they decide to make bad decisions with their investors' money.
The most common sort of action undertaken by private equity is to take over a company, make changes to that company (geared towards profitability), and sell the company off quickly. As such, private equity companies generally do not acquire other companies with the goal of running them - just "flipping" them, if you will.
The profit margins on this quick turnaround are much higher than the long-term profit margins that accrue to a company that buys the target company with the intention of holding on it and integrating it into the buying company's core business. From the Harvard Business Review (emphases added mine):
The benefits of buying to sell in such situations are plain—though, again, often overlooked. Consider an acquisition that quickly increases in value—generating an annual investor return of, say, 25% a year for the first three years—but subsequently earns a more modest if still healthy return of, say, 12% a year. A private equity firm that, following a buy-to-sell strategy, sells it after three years will garner a 25% annual return. A diversified public company that achieves identical operational performance with the acquired business—but, as is typical, has bought it as a long-term investment—will earn a return that gets closer to 12% the longer it owns the business. For the public company, holding on to the business once the value-creating changes have been made dilutes the final return.
So if you want to get rich quick, private equity may be the way to go, as opposed to a traditional publicly traded company investment. (That said, see disclaimers below.)
Quick turnaround isn't the only way in which private equity outstrips the traditional publicly traded company. In the United States, private equity funds do not pay taxes on capital gains, whereas publicly traded companies do.
I'd love for some finance guru to explain to me why that is the case. I'm an open-minded guy, and perhaps there's a very good reason! Or, perhaps, that tax advantage is wholly unfair and it simply hasn't been addressed by legislation because there is a lot of money at stake, and who wants to ruin a good time for those wealthy enough to invest in private equity, am I right?
Anyways: once a private equity firm has taken over a target company, the least profitable parts of the target company are frequently, though not always, given the axe (in jargonese, "spun off"), increasing the profitability of the target company, at which point the private equity firm sells off the target company, turning a profit. I'll get to the specifics of how that works tomorrow. For now, let's just point out that this is a big part of the reason people have come to fear and hate private equity. If the target company's inefficiencies happen to a be, for instance, an antiquated way of manufacturing industrial goods, then increasing the profitability of the target company may necessitate firing the workers doing the manufacturing, "spinning off" the division that employs these workers.
Private equity has a rep for generating unemployment. That's not necessarily fair. Private equity takeovers don't typically lead to net unemployment - they lead to "job polarization", which is a nice way of saying older workers with outdated skillsets get the axe, while newer employees are hired in different positions. These newer employees are typically non-unionized, and thus, less well compensated vis-a-vis salary and benefits than the older, shitcanned workers. These personnel moves might be economically necessary for the company doing the firing and hiring, but there's no denying that certain people lose their jobs and don't get them back in this sort of "flipping" operation.
Therefore, it is perhaps odd that Donald Trump's supporters have turned to Donald Trump in particular, given his chumminess with Stephen Schwarzman et al., to restore manufacturing jobs in this country.
Before we move on to the specifics of the leveraged buyout, by which private equity does its work, let's summarize private equity from the point of view of the investor: it is risky, but it is also quick and more profitable in general than investing in a traditional, publicly traded company. Or thus it is frequently said. How do reputation and reality square?
The emergence of public companies competing with private equity in the market to buy, transform, and sell businesses could benefit investors substantially. Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it’s managed. In compensation for these terms, investors should expect a high rate of return. However, though some private equity firms have achieved excellent returns for their investors, over the long term the average net return fund investors have made on U.S. buyouts is about the same as the overall return for the stock market.
Private equity fund managers, meanwhile, have earned extremely attractive rewards, with little up-front investment. As compensation for taking the initiative in raising money, managing investments, and marketing their benefits, they have structured agreements so that a large portion of the gross returns—around 30%, after adding management and other fees—flows to them. And that figure doesn’t take into account any returns made on their personal investments in the funds they manage. Public companies pursuing a buy-to-sell strategy, which are traded daily on the stock market and answerable to stockholders, might provide a better deal for investors.
This post is a bit long already, and I haven't even gotten to the most commonly criticized tool of private equity - the leveraged buyout. I think it best to pause here and come back to the LBO tomorrow. Let me just conclude by saying this for now:
There isn't necessarily anything intrinsically wrong or bad about private equity - well, unless you think making a quick buck is wrong or bad - but there isn't much to suggest that private equity is all that helpful in terms of restoring the middle class to its once-comfortable lot, and there is plenty of evidence that private equity can be quite bad for those people who may be, from a finance and economics perspective, "inefficient," i.e., the old-school, unionized, working class.