Don't Close Gate on Private Equity 'Barbarians'
From the May 13, 2007 Sunday Times
May 14, 2007
by Irwin Stelzer
There are times when profound changes to our economic system proceed without notice. This might be one of those times.
Capitalism is once again doing what it does best – adapting to change. That’s what the wheeling and dealing of those billionaire private-equity funds is all about.
But the emergence of a class of nouveaux très riches entrepreneurs, with life-styles that make investment bankers look underprivileged, has Congress considering changing the tax rules to stem the tide of such deals.
As Andrew Roberts points out in his masterful History of the English-Speaking Peoples Since 1900, the development of the limited liability company – the modern corporation – “opened up the modern capitalist system that has brought prosperity to every society that has ever properly adopted it”. That system has gone through many phases. During the 19th century huge corporations, many having acquired monopoly power, made their appearance. The result was a reaction that produced the antitrust laws, stripping what Teddy Roosevelt called “malefactors of great wealth” of that power, and establishing the rules that linked competition to capitalism, creating the socially mobile meritoc-racy for which America is admired by such as Gordon Brown.
In the 20th century these companies grew by raising huge sums in small amounts from widely dispersed shareholders. This allowed companies to garner economies of scale but also created a managerial class independent of the scattered shareholder-owners. Unaccountable power inevitably produced abuses: executive pay that bore no relation to performance; mergers that aimed more to aggrandise the executives of the acquiring firm than to obtain efficiencies; more attention to executive perks than to enhancing shareholder value.
Enter Mike Milken and his corporate raiders, sharks, predators, greenmailers – pick the pejorative of your choice. Milken created the “junk bond”, an instrument that allowed entrepreneurs who did not share a country-club membership with their bankers to borrow money to finance the takeover of badly managed companies. These takeover artists ended up both owning and managing the companies they acquired. Faced with the burden of servicing the enormous debt they had incurred, they grounded corporate jets and sold off company wine cellars in order to increase profits and the value of their holdings.
Again there was a reaction: highly leveraged balance sheets fell from favour. Corporate managers regained control of their companies, once again relying on the dispersion of ownership to ensure their ability to engage in practices that at minimum did not enhance shareholder value, and at worst landed them in jail.
Enter private equity, described by its trade association, the Private Equity Council, as “partnerships formed to acquire large (often controlling) stakes in growing, undervalued or underperforming businesses”. Between 90% and 97% of the money comes from pension funds and individual investors; the rest comes from the entrepreneur, known as the general partner.
In addition to the 3%-10% stake that the general partner buys, he receives another 20% of the deals he engineers to compensate him for his time, knowledge and talent.
When the performance of the acquired company is sufficiently improved, it is put back in the public market – rather like a tired and obese athlete returning to competition after a stay at a rehabilitation spa. Nobody loves a revolutionary. Roosevelt was hated by entrenched business interests for passing the antitrust laws. Milken was hated by the corporocrats of his time for making it possible for social outsiders – many of them “young, aggressive and Jewish”, according to one description, and therefore ineligible for membership in the better clubs– to take over sleepy companies. Thanks to Milken, the barbarians were able to batter down the gates.
The new private-equity crowd, in its turn, is facing hostility – from three sources. The first is the corporate “establishment” with its usual hostility to the entrepreneurs who are the agents of “the perennial gale of creative destruction” that Joseph Schumpeter claims is “the essential fact about capitalism”.
The second group that feels threatened by private equity is the trade unions, which worry that takeovers will mean huge job cuts.
Finally, we have politicians, always threatened by forces they do not understand, and always worried about developments that increase inequality of income distribution. In the case of the Democrats who now control Congress, obligations to their trade-union supporters, and a strain of that disease, egalitarian redistributionitis, make them suspicious of organisations that spawn billionaires. But because these billionaires are big funders of Democratic candidates, Congress has decided to postpone consideration of any tax changes that would disadvantage these new wealthy.
That might change. Most of the private-equity crowd is supporting Barack Obama in his fight to wrest the Democrats’ presidential nomination from Hil-lary Clinton. Should she make it to the White House, they might find the tax code changing in ways so unpleasant that they will have to move offshore.
But the political turmoil created by private-equity funds is far less relevant than the economic upheaval.
We might, just might, be entering a new phase of capitalism. Firms taken over by private-equity funds will have to improve their performance; publicly owned firms competing with them will have to respond by improving their own profit-ability. Life at the top of corporate America will be less pleasant. Which is what dynamic capitalism is all about – change that discomfits the comfortable.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.