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It's hard to get good information about private equity
Here's today's Op-Ed by Pat Toomey, praising private equity. I am tracking down sources on this topic and will pass along what I learn.
I do now trust at least one result: public firms will buy up targets without much discretion, but private equity has been making acquisition decisions in a more rational fashion:
We find that the announcement gain to target shareholders from acquisitions is significantly lower if a private firm instead of a public firm makes the acquisition. Non-operating firms like private equity funds make the majority of private bidder acquisitions. On average, target shareholders receive 55% more if a public firm instead of a private equity fund makes the acquisition. There is no evidence that the difference in premiums is driven by observable differences in targets. We find that target shareholder gains depend critically on the managerial ownership of the bidder. In particular, there is no difference in target shareholder gains between acquisitions made by public bidders with high managerial ownership and by private bidders. Such evidence suggests that the differences in managerial incentives between private and public firms have an important impact on target shareholder gains from acquisitions and managers of firms with diffuse ownership may pay too much for acquisitions.
Here is the paper.
Posted by Tyler Cowen on June 22, 2007 at 07:03 AM in Economics | Permalink
Comments
I'm a little suspicious of his op-ed simply because of his focus on opposing p.e. income taxes. Is the gain from taking companies private simply due to tax arbitrage? I'm against corporate taxes and capital gains taxes anyway, but treating p.e. income as capital gains is a step towards a high-tax, high rent-seeking world, not a step towards efficient low taxes.
Posted by: DK at Jun 22, 2007 8:24:55 AM
I believe the paper's results also.
It's one thing to buy a company when the main incentive is to gain by making it more profitable. It's something else entirely to do it as an ego trip, which is too often the reason public companies make acquisitions. My impression is that the generally poor outcomes of most acquisitions by public companies are well-documented.
Among other things, it's more fun for the CEO to hang out in New York acting like a big shot with investment bankers than to be back home in Peoria figuring out how to increase sales, or whether building that new plant is really a good idea.
Posted by: Bernard Yomtov at Jun 22, 2007 9:03:36 AM
The difference is between a strategic and financial buyer. A public firm is usually a strategic buyer, by that I mean they extract value (ideally) from synergies, operational efficiencies and financing efficiencies. A financial buyer typically only extracts value through better operational and financial management. As such, a strategic buyer, when available, should always be able to outbid a financial buyer since it can extract those synergies. Investment Banking 101.
Posted by: Aschkan at Jun 22, 2007 10:03:33 AM
Aschkan,
The trouble is that the phrase "strategic acquisition" is often used as a substitute for "I really want to buy this company, but am having a hard time justifying the deal." So the buyer starts manufacturing all kinds of synergies (you know - claiming that 2+2=5) to rationalize the deal. Of course that means that the "strategic" buyer will often outbid what you call the "financial" buyer, because the financial buyer is more realistic about the possibilities.
Human Behavior 101.
Posted by: Bernard Yomtov at Jun 22, 2007 10:13:23 AM
About a week and a half ago I was in London. One of the hot topics in the press--and apparently in Parliament--was increased regulation of private equity firms. (Part of this arose in the context of Ford's shopping Land Rover and Jaguar, for which p.e. firms were identified as the mmost likely buyers.) A large part of the discussion focused on alleged asset-stripping/wage-and-benefit depressing activities of p.e. firms, which would then allegedly flip the remaining parts of the firm back through IPOs. (Similar things have been known to happen in the US.) In the UK, labor unions and executives of publicly-held companies tended to support tighter regulation.
Posted by: Donald A. Coffin at Jun 22, 2007 11:33:26 AM
Both Bernard and Aschkan are correct.
(1) "Strategic" buyers typically do have more synergies than "financial" buyers. Obviously a strategic can shut down at least the top managers and some back-office functions. Generally strategic buyers are willing to share some of this value with sellers, so strategic should outbid financial when all else is equal. Synergies don't have to be cost savings - e.g. FedEx's acquisition of Kinko's from CDR.
(2) Incentives and accountability appear to be stronger for private company management teams than for public management - option packages notwithstanding. So public company management teams are more likely to do deals when few synergies actually exist.
Posted by: Timothy at Jun 22, 2007 12:22:30 PM
The Congress is losing this argument through their own incompetence and by allowing the PE apologists (I count myself as one) to redefine the debate. This shouldn't be, as Toomey argues, a discussion about taxation of PE firms, but rather about the preferential tax treatment of the earnings that accrue to the employees of those firms.
The taxation of partnerships is fine as-is and the role of PE firms is, as so many have pointed out, a healthy one. The issue is that the employees of these firms receive capital gains tax treatment without putting their personal capital as risk (traditionally a prerequisite for capital gains treatment). If we are comfortable with this, for instance because “of the value they create,” why are we not also comfortable with applying lower tax rates to other high value occupations (e.g. teachers, fire fighters, police officers, etc.)?
Posted by: mike at Jun 22, 2007 12:24:32 PM
It must be noted that our elected representative are fiscal morons that cannot balance a checkbook and lack the disciple to even attempt.
The government is looking at this as a tax arbitrage and is figuring they are getting screwed because they are getting their piece of the action. (The taxing authorities remind me more and more of pimps lying awake at night wondering if there getting there fair share of the action from the streets) Well, they are. They get 15% before it goes to the shareholders and than another 35% from the shareholders. The tax raise from 15% to 35% will actually result in only a 13% over all increase in revenue following the stream back to the investors. (meaning a 13% lower yield to investors) Who are those investors, oh wait its your pension fund, and your insurance company those are the big investors in private equity! So lets see you'll make less on your pension fund so you'll have to work longer to get enough money to live when you get old, and your insurance premiums will go up to make up for the loss the insurance company can't make on their investments. Its worse because since the pension funds for the public employees can't make more on their investments they will need to raise your property tax to compensate for the loss.
The real truth - this type of financial entrepreneurship unfettered by public company regulations is very efficient and very profitable for the participants. It will not go away, but it will leave the US and so will most of the mid and lower level jobs that support the industry. For the first time ever, in this year, the developing economies have a greater GDP than the developed nations!
Bad ideas from Demicans and Republicrats...
Posted by: Burke at Jun 22, 2007 1:21:51 PM
(1) I don't question the ability for managers or their bankers to manufacture fake synergies, but if a financial buyer wins a bidding war against a strategic buyer, almost by definition they will be overpaying.
(2) The dichotomy isn't between public and private ownership teams, but rather, one between management ownership and the lack thereof. One of the lessons the public companies have learned from private equity is that you need to align interests of management and shareholder very tightly, thus the renewed focus on equity, options, and long-term comp as a percentage of CEO pay packages. Fact of the matter is, if management has enough stake in the game, they'll spend much less time empire building and much more time value creating.
(3) Employees and managers of private equity firms oftentimes have almost all of their personal capital tied up in the fund itself, and as such, decidedly at risk. They invest in the fund alongside all the limited partners, even at a very junior level, and why not. Wouldn't you if you worked there?
(4)This is nothing more than extortion for campaign contributions, and the end result is that if it passes, the lay investor will remain out of private equity while HNW individuals continue to thrive. An excellent plan for solving income inequality. Moreover, it'll just send more capital and private equity funds elsewhere.
Posted by: Aschkan at Jun 22, 2007 2:23:44 PM
(3) Employees and managers of private equity firms oftentimes have almost all of their personal capital tied up in the fund itself, and as such, decidedly at risk. They invest in the fund alongside all the limited partners, even at a very junior level, and why not. Wouldn't you if you worked there?
That's disingenuous. Gains from the capital tied up at risk are and should be treated as capital gains. Gains from the 20% portion of a 2-20 agreement are not capital gains, they are payment for services, but the current tax treatment is as if they were capital gains. mike's argument earlier is exactly on point. Taxing private equity gains per se is foolish and should be objected to strongly.
Taxing the income of private equity managers as income is appropriate and should have been done from the very beginning.
There is also no double taxation on this money as Burke suggests, they are expenses and as such are not part of the income on which the limited partners pay taxes. Double taxation also only arises if congress decides to pass some special tax on private equity gains, which is not a proposal that deserves serious consideration.
Posted by: Michael Sullivan at Jun 22, 2007 4:50:52 PM
Aschkan, per your point (3) ... how should we treat gains on "personal capital" when the capital is provided through non-recourse loans or management fee offsets?
Posted by: mike at Jun 22, 2007 6:10:49 PM
Aschkan,
I don't disagree with your points 1 and 2. My opinion is simply that in many cases the rewards, financial and psychic, accrue to managers for making deals, period, whether they are good or bad.
Posted by: Bernard Yomtov at Jun 22, 2007 6:25:40 PM
I just read Toomey's article. It says private equity does some useful things and therefore shouldn't be taxed. That's it - about the level of analysis you'd expect from the "Club for Growth." I don't understand why Tyler even linked to it.
There is this gem, though:
The former head of Morgan Stanley, Phil Purcell, has highlighted another role private equity investors play. "They try to reduce excess capital — capital tied up in inventory, payables, receivables, and other forms of working capital. When a portfolio company is sold, the capital is reallocated to opportunities with higher returns. The result is rapid reduction of capital in mature industries and increased investment in growing industries."
Someone tell Purcell that payables don't tie up capital, they provide it. Someone tell him too that when a company is sold the assets don't mysteriously turn into cash. They change hands, and some cash goes in the opposite direction.
Posted by: Bernard Yomtov at Jun 22, 2007 6:37:00 PM
The problem with PE isn't that the carried interest should be treated as ordinary income: it shouldn't. The problem is that PE managers get a huge tax break at fund formation.
Trying to make carried interest ordinary income is just a silly Congress idea. It is capital gains. I can't imagine a reasonable definition of CG that would exclude the carried interest. If Congress tries some patch, it will probably result in a wasteful war between tax lawyers and the IRS over a long succession of avoidance devices.
The real problem is that the fund manager should be taxed when they receive their partnership interest in exchange for their management services. That is textbook OI. The reason they don't is because of an IRS ruling that allows managers to value their partnership interest at liquidation value, rather than fair market value. When the fund is formed, LV is 0, so no tax. That's the tax problem. Managers own a financial instrument that they purchased with their labor. Any income they receive from it should be CG. But they shouldn't be able to evade taxes on the services that earn them the interest.
Of course, there are practical problems with slapping a huge tax bill on fund-formers on Day 1: they might not have cash, their fund might be a loser, it might discourage entrepreneurs, etc. But those can all be fixed. Maybe value the interest at FMV, but only require the manager to recognize income as he receives distributions. Or maybe some sort of analog to a non-qualified option.
Posted by: Robert Beard at Jun 23, 2007 12:39:29 PM
I agree with Robert Beard that the carried interest should be taxed as ordinary income. A useful way to think about it is to imagine it being paid in cash, rather than an ownership interest, with the manager then investing the cash in the fund. No one would argue that the cash payment is anything other than OI.
Does that mean that the manager has to take some of the cash and pay taxes? Yes. But if I want to invest part of my income I have to do it with after-tax funds also. What's the difference?
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