Private equity is back in the news with Dell’s announcement that it has accepted a $24 billion deal to go private. Private equity is hard for a lot of people to understand, so I thought I’d write an “economics for poets” post on the subject. This will mostly be descriptive—I’ll just lay out the basic idea of how private equity works. But then I’ll explore some normative connotations—I’ll try to advance the argument that, despite the negative connotations the things and ideas involved in private equity have right now, there’s good reason to believe that private equity usually creates value for shareholders and society.
First, what is private equity? The term most directly refers to ‘equity’ in ‘private’ companies. We all know how you can go to E-Trade and buy shares in a publicly-traded company. ‘Equity’ is just another term for shares of ownership. A ‘share of ownership’ of a company is a financial asset, because if you own a company—even in part—you can exercise control over its assets and you are legally entitled to some of the income it generates. A ‘private’ company is a company whose shares are not publicly traded, so it is not listed on a public exchange. (The distinction between ‘public’ and ‘private’ companies bears no reference to the distinction between the ‘public’ and ‘private’ sectors.)
Thus, ‘private equity’ just refers to an ownership stake in a private company. In that sense, then, venture-capitalists and angel investors—who invest in young startup companies, before they’ve gone public—technically own private equity in the companies they’ve invested in. However, when the private equity industry makes the news, it usually centers on private equity firms. What do private-equity firms do? Mostly, they’re so-named because they’re involved in buying, selling, and managing the ownership of private firms, outside of the initial angel investment stage. Their highest-profile activity, however, is buying out publicly-traded companies and taking them private.
This is what is happening to Dell. Its board of directors, who are legally required to represent the interest of the company’s shareholders, agreed to sell ownership of the company to a consortium of private-equity firms and individual investors. Dell’s current shareholders will receive, in return for their shares, a 25% premium over the price their shares had traded at for the last month. Through today, you could buy and sell its shares on the NASDAQ. Once the deal goes through, Dell will be delisted from the NASDAQ, and we ordinary people will not be able to own and trade its shares, because it will be owned by that consortium.
Why do private equity buyouts of public companies happen? Well, let’s answer this question by thinking about the parties to such a deal and what each party is hoping to get out of it. On one end, you have the owners (shareholders) of the company, and the board of directors who they’ve appointed to represent their interests. On the other end, you have the private-equity investors who want to take the company private. In order for the private-equity investors to take the company private, the board of directors must consent. So, first, why would a board of directors consent to a buyout? Well, the board is supposed to respect its ‘fiduciary responsibility’ to pursue the shareholders’ interests—that is, maximize the value of their shares. So if a private-equity consortium is willing to pay a significant premium over the current market price of the company’s shares—and the board has no reason to believe that the shares in the company will increase in price any time soon—then selling off ownership of the company to the highest bidder is exactly what they should do to maximize shareholder value. So if a public company whose stock price shows few signs of rising receives a buyout offer from a private-equity firm, the board of directors of the public company ought to negotiate for a high premium by shopping around for the highest bidder—whoever will pay the most to its shareholders. If it gets a good offer, the board should agree to take it.
What about the other side of the deal? Why do private-equity investors and consortia pay premiums to buy out publicly traded companies? Well, clearly they’re hoping to make a profit. Specifically, private-equity investors that take public companies private are often hoping to profitably ‘exit’ from this investment by reselling the company to the public at a higher price in the future. But how can they think that they can make a profit on such a deal, sufficient to compensate them for all the risk and legal difficulties involved? I want to cue my readers in that this is actually a challenging and interesting question. After all, the price of a company’s stock on a public exchange represents investors’ best analysis of what that company is actually worth. If it were obvious that a company were worth much more than its current stock price, investors would bid it up to the correct price. If private-equity investors had a good reason to believe that a company’s stock was undervalued, and that the broader investment community was just too bone-headed to see the obvious, then those investors could simply accumulate large shares in those companies in the public markets and use that controlling share to make the management do a better job of communicating the company’s true value to investors. This would be much less costly than structuring a private buyout and paying a premium.
So, again, why would I pay a premium (plus all the legal expenses of structuring the deal) to take a company private? Necessarily, I would only do so if I believed that I could add value to the company by taking it private. If the market is currently valuing a company at $80 million, and I pay a premium of 25% (i.e., buy the company for $100 million), and then resell the company (either to the public, by relisting it on a public exchange, or to other private-equity investors) one year from now for $120 million, that’s a 20% return on investment in one year. That’s how I can make a profit despite paying a premium to buy out a public company. I shouldn’t bear the risk of a private-equity deal unless I have reason to believe I can increase the value of the company by a large amount (in the example I used I had to increase its value by 50% just to earn a 20% ROI), by taking it private.
But this raises another question: how can you add value to a company by taking it private? Or, to put this another way, what is it that a company’s status as a publicly-listed company prevents you from doing something that can add substantial value? I warn again that this is actually a theoretically challenging question. After all, self-interested shareholders of publicly-listed companies should want the company’s management to do anything and everything it can to maximize the company’s value. Theoretically, they shouldn’t stop anything that will increase the firm’s value.
So how does public ownership hold you back? There are a couple of ideas on this. First, shareholders in public markets can have an overly short-term focus and react emotionally to news that they misunderstand. As a result of this, managers of public companies feel under pressure to, e.g., put a lot of effort into ‘earnings management’ so that their quarterly reports will show smooth and steady increases in earnings, each and every quarter, even when this ‘management’ is not ideal for the long-term value of the company. To use a simplified example, suppose a firm wanted to sell off a lot of assets that it no longer had much use for. This would be a good decision for the firm’s long-term value. But suppose that, because of the way they’ve accounted for deterioration of these assets, the ‘fair value’ (the real market price) of these assets is below the ‘book value’ (the value contrived for accounting purposes). In this case, selling these assets would force the company to recognize a loss in its quarterly report, which would cause some investors to sell it off, hurting its stock price, which would upset stockholders and directors who would have some of their wealth wiped out. So shareholders might support and reappoint directors who prevent management from doing these things. Similarly, managers of public companies often feel that they can’t make risky moves, acquisitions, or re-brandings that would increase the firm’s value in the long term, because investors are too risk-averse. Additionally, because the board of directors has to sign off on a lot of management decisions, if different board members have very different (even if equally good) ideas for the future of the company, they can put a company in ‘gridlock,’ voting against each other, preventing the company from moving swiftly and authoritatively in one direction or another.
So, in sum, taking a company private can allow it to be managed in a way that is riskier, more authoritative, and less caught up in short-term appearances. This can increase its value. If private-equity investors can increase the value of a company that they’ve taken private, they can subsequently sell it at a profit.
Other, somewhat sketchier reasons to do a private-equity buyout have to do with what we call “regulatory arbitrage.” Publicly-listed companies face more stringent regulations and requirements on information they must disclose than do private companies. So if your plan to add value to a company involves doing something that you don’t want the public to find out about, you might take the company private for that reason… Finally, profits to publicly-traded companies face ‘double taxation’—i.e., they are taxed once as corporate income and then again when they are returned to shareholders as dividends. So, in theory at least, a private equity investor might stand to profit by taking a corporation private (as opposed to just accumulating its shares in public markets), even without a huge value-add proposition, if (s)he can get a big tax advantage from doing this.
But in general, private-equity deals are struck through the shared interest of the two parties: a private-equity consortium will only get together to finance a buyout of a publicly-traded company if it has a good reason to believe it can improve and add value to the company by taking it private; a board of directors should only agree to the deal if it will compensate shareholders with the best value they could reasonably expect to get on their shares. So the typical private-equity deal should be a win-win for a company’s shareholders and society as a whole.
What does this all mean? Well, first, there should be some apparent normative connotations to what I’ve written here so far. The very closing of a private-equity deal itself counts as evidence that value has been created for shareholders and that more value will be created for society as a whole (in the form of a company that has more value by virtue of its ability to do a better and more efficient job at satisfying our needs and wants). In general, a private-equity deal won’t get closed unless these two conditions are met; and the continued existence of the private-equity industry is evidence that those conditions do get met frequently enough. So I’d say we have good reasons to generally feel pretty positive about the private-equity industry.
So why does the private-equity industry have such a negative connotation? A couple things come up frequently.
-First, in general, I think people often imbue economic terminology with normative connotations, without thinking deeply about the underlying reality. My sense is that when people read that a company, having been taken private, is “spinning off” divisions or “selling off assets,” they have an image in their minds of an exhausted old man just giving up. But it’s wrong to anthropomorphize companies like this. In reality, becoming leaner by spinning off divisions and assets—selling them to another firm that can make use of it better than you can right now—can just be a really smart thing to do, and good for society as a whole. Indeed, the fact that another firm would be willing to pay you a good price for a division that you want to spin off would stand as evidence that they can make better use of it than you can.
-Second, more specifically, during the 2012 presidential campaign, attention was drawn to how private-equity takeovers of firms often resulted in job losses and layoffs. I don’t want to lack sympathy for laid-off workers. But I’m not sure that this is a problem of private equity per se. After all, publicly-listed companies also lay off and abuse employees. More, in order for our economy as a whole to function well, some people need to lose their jobs sometimes. This is rough on those individuals. But in the long run, we all benefit from this process of “creative destruction,” where old industries become streamlined and more efficient, and their workers move into new industries that actually require their labor. In fact, private-equity, by improving the efficiency of a number of industries, also creates a lot of jobs, too—perhaps more, all things considered, than it destroys.
-Third, people point to potential kinds of abuse. For example, suppose a public company was holding a lot of cash. You might worry that a private-equity consortium could go in, take over the company, take it private, use that cash just to pay itself lots of dividends, load the firm up with even more debt, and then sell it off once again for a profit. In this story, the value of the company was destroyed while the private-equity consortium laughed all the way to the bank. But, if you think about it, this kind of manipulation actually couldn’t happen in a world with basic good corporate governance and disclosure. First, if a company is sitting on a lot of cash (1) that should be reflected in its stock price, since equity owners would be entitled to a share of it and (2) a good board of directors would have pressured management to employ that cash wisely anyways, either investing it where it could earn a good return, or returning it to shareholders directly in dividends and share repurchases. Second, if you’ve loaded a firm up with lots of debt just before selling it off, this information should be disclosed to prospective investors, who would subsequently not be willing to pay as much for the firm. So loading a firm up with debt to pay your private consortium lots of dividends will just hurt the resale value of the company—meaning you won’t profit overall. So if deals like this actually do happen, it’s a problem of deceit, and basic failures of regulation and corporate governance, not of private equity per se. And if we had transparency and good governance in place, these deals couldn’t be profitable to private-equity consortia unless value was actually created.
Do I seem way too rosy about private equity? I’ll raise one concern, then. If we want to look for a way in which private equity per se is problematic, we should look for ways in which a private-equity deal can be profitable for its dealers without adding value. Are there any such things?
As I see it, the main potential for abuse is the possibility of self-dealing by managers. Think of it this way. Suppose your company is trading at $50 million in public stock markets. Suppose you, as a manager, have insider information that suggests that in reality your company is worth $100 million. Now, as a manager, it is your fiduciary responsibility to help your shareholders. What you ought to do is publicly reveal the information that shows that your company is worth $100 million, and then watch the stock price rise. But you have another, corrupt, option. You could work with some other senior managers, and get funding from a bank to do a leveraged buyout yourself. You could buy the company for, say, $60 million (a 20% premium); then, when the time came to resell the company to the public, you could reveal your insider information, and sell it for $100 million. Your original shareholders get screwed out of $40 million worth of their shares, and you capture all of that profit, without creating any new, real value. So management-led private equity deals can be profitable for managers, but harmful to shareholders, because the management can profit from good timing and concealing information, rather than from adding value.
So private-equity deals led by a company’s management should be the most suspect deals. But again, even here, the problem goes deeper than private equity—such a manager would be violating his fundamental fiduciary responsibilities, and actively deceiving and withholding information for the public. That’s not just private equity’s problem.