Private equity: A fee too far [pdf]
russellsage.org
russellsage.org
> One issue the regulatory agency raised was conflict of interest [… between managers and stakeholders]
combined with
> Mr Sudarskis argues that the most vulnerable parties are not the investors, who recieve a share of the fees and willingly sign a contract with their fund managers, _but portfolio companies._
This conflict of interest goes far beyond the monetary aristocracy!
Am i the only one who sees it between the interest of individuals vs society?! Is this question so darn complex or am i the crazy one here?
This article dares to speak about "extraction" but does not reflect one key metric: reinvestment/saving rate (down to the individual/per income). A household with small margins is much more impacted by greedflation and much more unlikely to not spend and hand down absurd wealth.
So i humbly cannot contain another dull question: Extracting from and to whom in general?
The reason why it bothers me so much is, you can see this elefant everywhere ... and the guys standing around, arguing what snake its tail might be.
Of course this would be a different story if private actors had to play by the same rules, but if you amass enough capital, you are „too big to fail“ for capitalism and your losses are paid by the public.
Too big to fail should nowadays be called „too big to exist“.
Isn't market intervention more like corporate socialism though? I mean that's literally not capitalism.
"Too big to fail" is crony capitalism.
I mean I'd argue the "too big to fail bailots" are a particularly ineffective bit of market intervention in the long term, but generally speaking "market intervention to save the health of the economy" is bog-standard neoliberal, capitalist ideology. The only whiff of socialism comes from recognizing that without guardrails the fully freed economy will destabilize, possibly from angry with pitchforks, angry they can't afford food, shelter, and the basics. So—it is still serving the ultimate needs of the capitalists who run society by not ousting them when they do destabilizing things.
Plus, if this weren't capitalism, no society in history would have been capitalist making it a bit of a useless word for sticking to extant political movements.
This is not about a question of ideology. It's about the wealthy being protected and fostered, by any narrative necessary. On sunny days, it's liberalism, on rainy days it's socialism.
> Mr Sudarskis argues that the most vulnerable parties are not the investors, who recieve a share of the fees and willingly sign a contract with their fund managers, _but portfolio companies._
In terms of effected people, i would not call investors the "most vulnerable". Have-nots can't spread risk to the degree a fund manager can and are bound much more to local monopolies.
"The most vulnerable ones to powerful individuals abusing their power to enrich themselfes, are portfolios."
Sounds weird, doesn't it.
- company is bought in a LBO by a PE company
- PE company has onerous fees as a part of the buyout agree (which the target company agrees to)
- the victim are institutional investors who pay these high fees, but were willing partners to the LBO
I mean it sounds like one group of people from Wall Street trying to rip off another group from Wall Street.
Can't the institutional investors just pull their investment if they think it's a bad deal? Can't they read the fine print on the LBO deal?
Do we need to somehow protect institutional investors who manage tens of billions of dollars? Are they a victim that needs protection?
How is it all that different from a company owned by a majority shareholder who makes bad business deals? What do institutional investors do then? Presumably they use their voting power to stop it, or else just exit their position?
I can think of a few reasons why they don't.
They need 'uncorrelated returns' which PE provides, and it might be worth paying extra fees for this. That does not mean the fees are fair, it just means there is not enough competition. Also institutional investors might not perfectly rational and informed, as the article notes some of these fees are somewhat obscured and investors might be looking more at direct management fees. Relatedly, there is probably an asymmetry of skills and power, as institutional investors are second or third tier firms whereas PE firms are top tier. Finally, there is the usual agency problem, institutional investors are not sufficiently incentivised to reduce fees, because the fees are effectively paid by people who put the money in the funds, namely you and I, via pension funds or sovereign wealth funds.
> Do we need to somehow protect institutional investors who manage tens of billions of dollars? Are they a victim that needs protection?
We need to protect the people who ultimately put the money in the funds, not the chain of asset managers extracting their rents on top of it. Historically for PE these were high net worth individuals, so nobody cared, but nowadays they are California's teachers and Japanese pensioners.
> How is it all that different from a company owned by a majority shareholder who makes bad business deals? What do institutional investors do then? Presumably they use their voting power to stop it, or else just exit their position?
It is a similar agency problem I think. It's easier if you're investing directly in companies, because there are many companies competing with each other to attract institutional investors' money, so they care more about making investors happy.
The underlying question is why aren't PE firms competing with each other to provide lower management fees to attract more institutional money. This has happened in public market funds, with Vanguard for example providing very low fees. But for some reason it doesn't seem to happen in private markets. PE firms compete on where to put the money, trying to win deals against each other, but do not seem to compete that much on where they get the money. I don't know why. It could be that quantitative easing made money so abundant that they had more money than deals to spend it on, so there was no reason to compete.
Edit: to be fair this seems to be happening somewhat now [1]
[1] https://www.ft.com/content/05b0d935-678b-418c-8a86-b1a99bb04...
> They need 'uncorrelated returns' which PE provides, and it might be worth paying extra fees for this.
I get they need "uncorrelated investments" as a part of their portfolio management, but that's an institutional investor decision. If their clients demand it, then you make it clear "ok, but you need to realize the fees are ridiculous". Or make alternative investments. All of this is in the control of the institutional investor.
But clearly they can make an informed decision if those fees are reasonable? I would disagree a huge institutional investor has a asymmetry of skills and power - CALPERS has a huge team of financial experts with experience across the financial industry. They can hire in house lawyers to go through contracts to their hearts delight - and negotiate (if they can) different terms. And i would argue institutional investors are heavily incentivized to reduce fees because they directly impact the returns they can get, which is linked to compensation. These aren't mom-and-pop organizations buying penny stocks, they are some of the most sophisticated investors out there. They turn down investments all time because they don't make sense.
> We need to protect the people who ultimately put the money in the funds, not the chain of asset managers extracting their rents on top of it.
But that's the fiduciary duty of the institutional investors. If they can't do the required due diligence, they shouldn't be investing on behalf of the individuals they represent. And as mentioned above, their compensation is directly related to making good returns.
> The underlying question is why aren't PE firms competing with each other to provide lower management fees to attract more institutional money.
It's because they don't need to. It's a problem as old as the history of PE. The old 2 & 20 has been an issue for a long time. If you have a product with high demand and low supply, you can set the terms. It's a sellers market. There are plenty of other investment vehicles that have onerous fees and lack transparency. Presumably institutional investors decide whether those fees are worth it or not.
I have a hard time feeling sorry for highly sophisticated investors complaining about the terms of an investment they had complete free will over investing or not.
It's sounds more to me that institutional investors "want their cake and to eat it too". They want access to LBO PE investments, but want better terms that they can't actually get themselves.
Agreed, but they're facing KKR and Apollo, who are even more sophisticated. PE is a small proportion of CALPERS portfolio. They can't be the top expert everywhere, and they can't be better at PE than PE firms.
> They turn down investments all time because they don't make sense.
But can they turn down a whole asset class?
> If you have a product with high demand and low supply, you can set the terms. It's a sellers market
Maybe we can agree that PE firms are not competing enough on the liabilities side, which makes it difficult for institutional investors to negotiate fees down?
> I have a hard time feeling sorry for highly sophisticated investors complaining about the terms of an investment they had complete free will over investing or not.
To me that sounds like the typical free market fallacy, "no reason to complain or ask for regulation because you can just buy the product elsewhere if you're unhappy". Sure, that works fine when there's enough competition, but I'm not convinced it's the case in PE.
A few comments:
- The target company doesn't "agree" to the fees. The PE fund owns the target company outright, so they can manage it however they like. It would be like saying that when you cut the grass on your own lawn (even if you cut it in onerous ways, to stretch the metaphor), the lawn doesn't have to "agree" to be cut. Of course not. You own it, you can do with it as you please.
- You are correct that the victims were the institutional investors (LPs), because the extra fees reduced the profits in the fund (less money was distributed from the portfolio companies to the fund, which the LPs would get, because some of the money was paid in fees directly to the managing PE firm). I say "were" because LPs have absolutely become aware of this problem. This is old news. The article is from 2014. Today, all partnership agreements state that the fee charged to the portfolio companies enter into the fund's waterfall. Problem solved.
- "Do we need to somehow protect institutional investors who manage tens of billions of dollars? Are they a victim that needs protection?" This is a super important point, and something that is often overlooked in PE discussions. It's like all the hand-wringing about the "poor creditors" who lose out when PE deals go bad. Guess what, these "creditors" are investment banks, like Goldman Sachs. However you otherwise feel about GS, there is no reason to ever feel sorry for them.
In the end the business is worse off, and the customers are paying more for less (or exactly the same before PE stepped in).
Luckily the days of cheap/free debt are over, but some few earned billions.
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It's sad that people's jobs get eliminated. But we have accepted (for good reason) that jobs are never guaranteed. So that's life.
Everything else here is basically just fear-mongering.
> If they make a profit then they're actually adding value.
Martin Skrelli. [0]
Please tell me what and where his added value is. And please no fear mongering about the rich getting poorer.
If Y>X then the best thing to do is liquidate the company.
An example might help: imagine you have a steel mill, and it makes just $1000 a year. Someone from Canada comes to you and says "I'll give you 50m for the mill, I want to take all the equipment to Canada where there is a shortage of steel". He will fulfil more demand at a better price by doing that (hence he will offer 50m for a steel mill that only makes a pittance in the USA). And you can't ake the 50mil and build something people actually need (like a refinery since gas prices are really high etc).
Does that make sense?
It's about allocating resources. And stopping them being allocated to things people won't actually pay for (steel production when no one wants steel) so that they can be allocated to things people do want (more gas during a gas shortage).
Resource allocation is actually really really critical both in general and in high efficiency, capital intensive economies like ours. Doing this well is basically why capitalism beats communism in terms of growth.
Obviously profit is not everything. And we should help people made unemployed. But continuing to waste resources just makes everyone poorer. It's just quite an oblique way of doing what amounts to central planning but with no need for a single centre and doing it faster and smarter...
When you tilt the pinball table so companies that make nothing and promise the future are valuable (theranos, wework, TSLA for a long time, anything Kathy Wood buys) while under-valuing companies that make and do stuff now, you wind up hollowing out the use of resources on real things people need and spending it on stuff like NFTs.
How many billions has google spent on projects that never saw the light of day? How many hospitals and bridge repairs could we have had for that money?
Benchmark rate intervention is hailed as saving the economy from crises, but all it did was prop up the paper-value of people's retirement funds while suffocating businesses that actually make and do useful stuff.
For instance when you said "profit is not helpful to society" you were correct. But profit is the reward people get for doing things useful to society. It's the signal that the things they are doing ARE useful. And profit pays to continue and expand those actions.
A more general theme is your distinction between "real" things and the alternative. You're not wrong an NFT is a total waste of time in my opinion. But if people actually want NFTs more than steel, that is ok. Give them NFTs. And many many people DO want those things. (There is something ironic that we have ended up here as the ussr concentrated on metrics like steel production while people grew more and more discontented because they wanted vacuous things like jeans and washing machines, not steel...).
That is not the fault of the profit motive or the market or capitalism. That's people wanting the "wrong" things. That won't change under any other system...
Do you know what the FOMC is/does?
Except maybe there's a need for steel where the $1,000 plant is, too, and now they have to buy it more expensively from the moved plant. (Maybe it was a co-op.) The assumption that breaking even always means no demand is incorrect.
This sometimes forces us to confront hard truths (people want perfume and hamburgers and NFTs, not ever larger amounts of steel). But that's actually the big strength of capitalism: people get what they want not what people think they SHOULD want...
this is not true in many cases -- a commodification of ordinary (and valuable) things drives a price down, with motivated agents seeking "bargains" or plunder. Secondly, kindness is mistaken for weakness. Abundance with a gift economy and manners is replaced with rent seeking with punishment for offenders, and constant constraints imposed to increase price.
The market is not making the most public goods, it is making the most effective jails and most addictive products as a natural result of profit maximization and command-and-control exchanges.
"makes just $1000 a year" just means people are paying roughly the cost of production, unless you meant it to be revenue instead of profit.
There are plenty of things people won't pay for that they still want/need. I couldn't pay for a heart transplant without insurance, even if I'd die without.
It's true, resource allocation is very important. But is the free market more important than for example the declining life expectancy in the US?
I don't think, you will find a solution besides regulation or education to my example problem. I think you have to realize, that the market incentives are causing it, that the free market should be exempt from certain basic needs, where better resource allocation (a free market) will only degrade in a race to the bottom, and will not (as you described) find a better optima for the required resources (because there might be none).
I will call it market mongering.
EDIT: To refine your mill example: What if the steel buyer does not do anything with the steel, except driving price up?
The free market does not know or care. It takes the preferences of all the people and the government they elected and combines them. If people choose health they get it. If they choose the opposite they get it. That's sort of the point here.
It might be surprising that people prefer being fat and watching TV to long, educated, lives. But it does seem to be their preference.
I am all for trying to change that. But people were lazy and gluttonous long before Private equity (a tiny part of the wider system) ever reared it's head...
Incomplete picture. The missing part is imbalance of power of the agents.
The case of the greedy manager or the price driving steel trader again...
Im out now. Have nothing more to say.
Perhaps the decline of the free market in the US might be exactly as important as the decline of life expectancy in the US.
Only if you use a particular definition of "best thing."
Consider a nonprofit. It raises funds and buys meals for people who are food insecure. No money is created for its investors. It has a brand that people like and feel good about. Now imagine the board of this nonprofit decides that making $0 is not their favorite thing so they halt all of their programs and sell their brand to Kraft, who uses the brand on some of their products to capitalize on the popular brand without giving any food to the poor.
Kraft's stock goes up because they are selling more stuff.
Is the world really more valuable now?
Or an even simpler example. Consider a pharma company that sells some lifesaving medication. They charge $X for it. They do some math and determine that if they charge $10X for it, that half of their customers will no longer be able to afford the product and half will continue purchasing it to stay alive. Their revenue increases by 5X. Stacks on stacks for their investors.
Is the world really more valuable now? This company has more money but only half as many people are protected from their life threatening disease.
Non-profits create high-status jobs and spend massive amounts of money on marketing so they are not incredibly neutral in terms of "no value created for investors".
As easy early-stage growth tapers, which is typical, the more r&d is needed to figure that out. The company likely still has that in their DNA. But... that also makes it easy to flip the books on margin & profitability by firing all those seasoned product, dev, r&d, etc people, which can easily be 20-40% of the company. Likewise, replace much of the remaining expensive staff with folks not from the home company country. Founders cashing out and PE & replacement CEOs taking over changes a lot.
I'm not sure that kind of profitability is all that great from a taxpayer and economics perspective. Replacing cultures of excess and immature management does sound like value... but that is a fig leaf over what is going on in reality. There are similar questions about VC pump-and-dumps also not being good for society, despite similar reasoning. It's a hard topic - I couldn't find it, but Matt Stoller's newsletter on modern anti-monopoly economics & legislation news touches on these areas periodically.
Daraprim is a very old drug used by about 2k people in the US! So the narratives by the media that gives one the feeling he kills millions is wrong.
97% in the US have health insurance + you get depending on the state your living in an extra charge by the IRS if you don't have one. Martin Shkreli gave the drug away for free if a person could proof that they could not afford it.
People are still dying because of daraprim every few years. But as I said it is a very old drug and has not improved since its inception in the 50s.
The price hike had not the goal that he and his investors could get rich quick (which would be there right as free human beings). The research of a drug and especially the clinical trails can cost several hundred millions of dollars, thus a price hike was necessary to discover a new and better form of daraprim.
There is a reason that rare disease drug sometimes cost a few 100k when only a handful of people need it.
Pharma is a long term game. He can sell daraprim for much more in the future than the $750 of the current version. In the long run he and his investors profit enormously but also the patients that need it since it is more safe.
When you develop a live saving drug, that only 2k people use, you have the right to charge whatever price you desire. People need to see that pharma is a business like any else and is not excluded from free-market and capitalistic principles.
Ìn addition, once you had your daraprim course you are fully healed - you "loose" the customer. Therefore a high price is needed even more to offset the cost and to profit.
Pharma companies put private resources into effort (capital, infrastructure, expertise etc.) for developing a rare disease drugs. Nobody has the right to demand anything from them nor condemn them.
US capitalism has been extremely productive but the gains in productivity have disproportionally distributed to shareholders, and employees got the short end of the stick. [1]
And this isn't capitalism problem btw. This is a corporate culture problem.
If people want a nonparasitic system, they need to implement a tax system that supports that.
Permitting or banning or any other restriction on private equity won't solve inequality. Redistribution of capital, education and healthcare, proper infrastructure and more opportunity in general will.
Maybe it shouldn't be.
People have to understand that a 'PE' fund and also other alternatives like a 'hedge fund' is simply a private partnership / specific legal vehicle. The term 'Private Equity' and 'Hedge fund' does not even exist in legal terms, it is market jargon. Not only will there never be any regulation but there can't be any. You can't just regulate a certain field of activity that operates solely in the legal world. The private partnership has an agreement to acquire companies, but it could also be about anything else! Giving the fund enough freedom to buy companies, buy land, buy art etc.
A PE fund and a hedge fund are NOT REGULATED by the SEC, they are REGISTERED with the SEC. Their filings are also never checked for correctness, thus only accredited investors (wealthy - e.g. income above 200K) are allowed under law to invest in such private entities if the fund markets itself!
You can not regulate a private investment vehicle in a country takes certain economic and free-market principles and incentives halfway serious. And if the public goes on the nerve of these management companies they just rebrand 'Private equity' to something else.
And don't forget, they OWN the portfolio company. There is no serious argument for regulation that prohibits a legit owner of a company to do a certain activity.