Friday, June 1, 2012

Welcome Wonkupy

When I first started reading blogs a decade ago (I'm pretty sure the first blogpost I ever read was one of these Eschaton posts on Trent Lott) there was a distinctly truncated Left in the blog world, especially on economics. Just mainstream liberals, conservatives, and libertarians as far as the eye could see. Which, what else is new, right? Except that it really wasn't true of mailing lists, the predecessor medium, where you had super active lists like PEN-L and LBO Talk. I used to wonder if there was something specific about the formats that made mailing lists more hospitable to radical politics. Like, flatteringly, maybe we prefer collective discussions rather than one-man shows? Anyway, the question is moot now, because there's certainly no shortage of left/radical blogs now, economics-oriented and otherwise.

All of which is a long-winded introduction to introducing a new progressive economics blog, Wonkupy. It's by "Rotwang," a very sharp comrade who needs to remain pseudonymous for professional reasons. It bills itself as "Occupy for wonks," but my sense is it's going to be more the other way round; well worth reading either way.

That said, I have some disagreements with his current post, arguing that criticism of private equity is a distraction. I put them in comments there, but since it touches on some regular themes at the Slack Wire, I thought I'd post an abridged version here.

Rotwang's argument is that it's wrong to suggest that buyouts and takeovers of firms by private equity funds and the like have any systematic effect on the way those firms are managed: profit maximization at the expense of workers and the pubic is the order of the day whether the bosses are vulture capitalists or just the regular kind. (It's sort of a political-economic version of the Modigliani-Miller theorem.) Rotwang:
In [private equity] discussions, it is easy to focus on outright theft, abuse of borrowing, and inefficient government subsidies. We suggest this is not unique to PE, but is generic to Capitalism. One could imagine regulatory responses to such problems, but we insist the problems are part of the system, not tumorous growths on something otherwise fundamentally healthy. A narrow focus on PE glosses over the features it shares in common with Capitalism in general, now and throughout history. The narrow view plays to limited and ineffective remedies that fail to engage the long-standing, systematic problems of capital markets.
I disagree -- tentatively on the substance, but emphatically on this way of framing it.

Suppose for the moment it's true that the problems with private equity are no different from the problems with capitalism in general. I still don’t think that’s a valid reason to not talk about private equity in particular. After all, “X in general” is just all the specific instances of X. To the extent that the way productive enterprises are treated by PE firms like Bain is a representative example of why an economy oriented around the private pursuit of profit is incompatible with a humane and decent society, I don’t see what’s wrong with starting with it as a particularly vivid and timely example. Of course you have to then move on to a more general critique — there’s nothing that stops management at companies that aren’t subject to buyouts from acting like Bain, and many do — but a ban on discussion of particular cases doesn't smooth the way to that general critique.

The other question is, is it really true that there is no difference between what a firm like Bain does and what a “normal” capitalist firm does? Rotwang writes, “From the worker’s standpoint, it makes little difference if her life is ruined by PE or by old management," which is inarguable. But are we sure ruination is equally likely in either case?

It seems to me that while capitalist firms always pursue profit, and this pursuit is always ultimately inimical to the interests of workers, it’s not always equally single-minded. Managers want their firms (and themselves personally) to make money, but they also want them to survive, to grow, to gain market share, to be perceived as prestigious, cutting-edge, etc., and, in a non-trivial number of cases, to make genuinely good products by whatever objective standard of the business that they’re in. To the extent that finance exercises more active control of the firm, those other motives get subordinated to pure pursuit of profits. And I think that does tend to make life worse for their workers, and communities and customers, and everyone else who depends on the business as an ongoing enterprise.

No question, there is (or was; is Occupy still a thing?) a strong anti-finance vibe around OWS. There's nothing wrong with criticizing that -- especially in its weirder Ron Paulish forms -- but it seems to me this is a case where “Yes, and” is distinctly preferable to “no, but”. For some people, a criticism of private equity may be an alternative to a broader critique of capitalism, but for many more, I suspect, it's a starting point towards it.


  1. I think the main point is that PE LBOs are a particularly intensified case of the financialization of the management and operations of production companies generally. Of course, the B-school professors have long since studied and weighed in on the issue: if you would lever up the S&P 500 at 7 or 8 to 1, you'd get the same returns as PE LBOs do. So the claim to induce better, more efficient management of firms is bogus. Of, course, one can't borrow using equities as collateral to anything like that degree because equities are considered far too volatile, but you can borrow against the "physical" assets of a single firm, which is odd. And, of course, those LBO loans go into CDOs, so their provenance is dispersed.

    What PE LBOs amount to in the first instance is tax arbitrage. It's true that public companies get the same interest deduction, but they aren't going to increase "operating leverage" to anything like that degree, because it would endanger the continuing viability of the firm and thus lower stock prices. But more fundamentally what PE LBOs are all about is financialized rent extractions from past productive investments, asset stripping, which verges, de facto, though with fancy lawyering not de jure, on bankruptcy fraud, "fraudulent conveyance". Though the cash flows and operating margins might be temporarily spruced up through cut backs, in the end, the burdens of debt servicing will hamper operating margins and depress needed future productive investment to ensure the competitive survival of the firm.

  2. (Cont.) And PE LBOs are not investing in start ups,- (thasat's venture capital funds), nor generally in rapidly expanding firms, (which won't have appealing stock prices), but generally in long established, mature, non-expanding firms, often in niche markets. So Bain bought that KC steel company producing IIRC specialty piping, which was already running successfully. But it was also in the capital goods sector, which is highly cyclical and needs to be managed financially counter-cyclically. It was easy to spruce up in goods times, but, of course, when hard time come, then it lacks the wherewithal to survive. But by the time crunch time arrives, the PE boys have already sold off, while having paid themselves hefty dividends from further borrowing, and are long gone, or at least so they're hoping. The real puzzle here is why the end investors in LBO loans put up with this. But likely its sufficiently dispersed and obfuscated and even their returns are fairly juicy before the whole economy heads south, when Keynes' dictum about "sound bankers" holds sway.

    So the upshoot is that I think Rotwang is all wet here. PE LBOs are not just another example of capitalism in general, but rather a monadic crystallization of highly finacialized rent-extracting dis-investment in actual production. A starting point for further critique of the highly financialized U.S. economy along the lines of Bruce Wilder's claims that signs of dis-investment are wide-spread, even pervasive, in the U.S. economy in recent (or maybe even not-so-recent) times.

  3. Thanks for the mention and thanks to JCH for the comments. Will take a while to digest.

    -- Rotwang

  4. Rotwang - a lot to take issue with in your piece on PE.

    1. PE is not a subset of hedge funds. There are SPVs involved in both, and resemblances of a sort but they have fundamentally different strategies (and usuually quite different remuneration schemes).

    2. What borrowing fundamentally does is create an investment which is in a different place in the risk/reward space from that which people can access by simply buying a public equity security. If the EMH were correct, the profile would indeed be no different from buying a public stock with borrowed money - but PE firms believe they are able to handle the downside risk better - ie lose money less often.

    2a. Note that the interest deductibility accrues to the seller, not the buyer. Since the seller knows the PE will not need to pay as much tax thanks to the borrowings it will have, it will hold out for a higher price. So the 'benefit' can be as often relevant to a corporate seller or public shareholders than to the PE itself.

    3. PE has no asymmetric ability to 'stick' the financial cost of a failed investment on other people. If they buy a firm worth 100 with 70 of debt and 30 of their own money, and the asset turns out to be worth 60, then sure, the lenders will lose some of their investment but the PE will be wiped out. Of course there are horror stories of PE-backed firms collapsing under the 'weight' of the debt, but the metaphor is often misused. The two relevant flow variables for the viability of the firm are cash flow and the wage bill. If the PE equity investment has been wiped out, this means that by definition there has been lower cash flow than expected, which has probably put pressure on the wage bill, but there is no way for the debt burden itself to diminish what the cash flow coming out of the business (the "cash flow for debt service", as we say) would be. The one exception is where the business has cut back on capex to a dangerous extent, but I do not believe this is common, since ultimately to do so damages the value of the business: there is no point in a PE hacking too far into capex to eke out a few more quarters of cash flow to service debt, if the business will break down in a few months. There is one classic example in the UK where a private hospital chain was under-invested leading to terrible healthcare outcomes; I would argue this reflects a dire failure of regulatory scrutiny, as well as an atypical and irrational approach by the PE.

    3a. PE does usually take management fees along the way, even if an investment is underperforming, but these are small in the overall scheme of the company's cash flows, and form part of the annual compensation, not the huge potential for capital gains which motivates PE professionals. Yes of course annual PE compensation is far too big but this is part of a wider financial sector problem - not PE specific.

    4. On the morality of it, I would agree that PE is entirely amoral, like most of the private sector. If it will help grow profits to downsize the workforce, PE will not hold back from firing people and paying them purely the minimum statutory amount it needs to - but would General Electric do any differently?

    If you don't like the unattractive aspects of PE, it would be quite simple to fix by (a) abolishing / phasing out the interest deduction, and (b) increasing the benefits payable to sacked workers. With those two fixed, I see nothing objectionable left in PE.

    Best wishes

  5. Not to get into a nitpicking argument, but does Anders actually believe in the EMH? Points 2-3 can be readily countered through considerations of information asymmetry and actual incentives. (E.g. it's insider managers that are being bought out and not shareholders in general, and the former don't know except vaguely the plans and leverage that the PE is applying, while the PE firm is playing all sorts of legal shell games and is "bankruptcy remote").