November 20, 2019 Reading Time: 4 minutes

On the eve of the 5th Democratic debate a number of issues have become recurring topics among the field of candidates vying for the 2020 nomination. Healthcare, the cost of higher education, tax policy, and the idea of a universal basic income are among the hot button topics. And recently entering the fray, but rapidly moving to center stage, is a new talking point: the business model known as private equity and its role in the economy. 

With this newfound prominence has come blistering attacks from several aspiring Democratic nominees, on the heels of years of critiques of private equity business practices from both sides of the political aisle. In an otherwise fractious and contentious political environment private equity seems to be an issue that both sides have grown to dislike equally. Quite a bit has been said and written regarding taxes, inequality, forecasts of economic growth and the like – all of which are closely tied to proposals for a wholesale restructuring of the U.S. tax code – so it makes sense that private equity would be caught up in the whirlwind. 

Even Taylor Swift seemingly has issues with private equity, although her broadside likely has more to do with a current contractual dispute than any intrinsic knowledge regarding the alleged effects that private equity has on various industries.

Headlines and bold statements make great political theatre, but just as often confuse and distract from underlying issues. In a political (and increasingly economic) landscape where a tweet, retweet, or a 30-second video can shake markets, it’s not surprising that complicated topics are painted with unduly broad brushstrokes. Political and personal views aside, in order to effectively address any issue it must first be properly understood. 

What is private equity?

So what is private equity? Sampling the business and media analysis of the subject one could very well come away saying it is either the perfect manifestation of crony capitalism or the single most important driver of economic growth in the United States. The reality, as with many things, lies somewhere in the middle. Private equity simply represents an ownership stake – represented by equity or some other mutually-agreed upon metric – that is not publicly traded. While there are numerous reasons why corporate entities may choose to remain private, there has at any rate been a sharp decline – by nearly half – in the number of publicly traded firms in the United States in the last 20-odd years. (There are several major hypotheses as to why.) 

So with incrementally less publicly-traded companies, it should be of little surprise that institutional assets are flowing toward alternative investments. Like gold and liberty, capital flows where it is treated best, and as financial markets decline in appeal, a logical corollary is that capital will follow investable assets into the private market spaces: not only private equity but venture capital, hedge funds, and so on. 

To be fair, private equity financing also plays a role in takeovers, M&A transactions, and leveraged buyouts that seem to flop as often as they succeed. That said, it is unlikely that a successful and profitable firm (like Coca-Cola), or even a firm hemorrhaging red ink but with potential for substantial future profits (like Netflix) will fall victim to a buyout or takeover. 

Markets thrive on competition, and competition in turn drives the development of continuously improving products and services that consumers enjoy worldwide. Knowing the likely consequences for failing to innovate, not delivering substantial returns to shareholders, and inadequately serving customers – in the aggregate, being poor stewards of investor capital – should keep executives awake at night. Those large private pools of capital, directed under the vigilant watch of private equity executives, managers and analysts, provide the fuel for much of that anxiety. 

Who benefits from private equity? 

The phrase private equity brings to mind images of crony capitalism, caricatures of greed, and other cartoonish depictions of ‘high finance,’ but those are misleading perspectives to say the least. Private equity firms may, at least at present, be associated with the shuttering of factories and layoffs, but none of this occurs in a vacuum: bloated payrolls, misallocated capital, and unproductive enterprises are symptoms of problems far beyond the activities of private equity firms. 

If an organization is innovative, competitive, and delivers value to its customers it will realize increasing revenue and market share; it will also, necessarily, be efficiently run and productively managed. When firms struggle, for whatever reason, market economies (absent intervention, of course) bring consequences which promote consumer responsiveness and best practices, driving growth and innovation in turn. 

Less publicized are tales of private equity’s success stories. Or that such phenomena as job losses and operational downsizing  – typically associated with private equity deals – are first and foremost the fault of complacent management (both on the “factory floor” and in the boardroom). For the most part: well-run firms have little reason to fear.

Amid a whirlwind of headlines and preparation for debates, some facts have been overlooked (or ignored). According to a report prepared by Ernst & Young for the American Investment Council, private equity-controlled firms employ 8.8 million U.S. workers earning an average of $71,000 annually, with these same firms generating over $1 trillion in economic activity (and, it bears mentioning in a time of runaway budget deficits, paying nearly $200 billion in taxes) during 2018 alone. 

These benefits do not simply accrue to a few individuals; pension plans, to name just one type of financial institution, are among the largest investors in the private equity space. In other words, the success of private equity-controlled organizations benefits the owners of those firms, their employees and managers, and hundreds of millions of Americans directly and indirectly exposed to the private equity sector through 401k or other retirement plans. 

The Takeaway 

Private equity, like any other business structure, is imperfect. And like the executives and directors in any other sector, those at the helm of private equity firms seek to make the landscape as favorable to themselves as possible. This is no different than any other large economic entity seeking to create an environment where it can succeed as easily as possible. 

It is certainly worth taking a look at the raft of incentives which they currently face (including but not limited to tax arrangements and takeover rules), but simply labeling an entire industry as destructive and evil is detrimental to the investors, communities, and hundreds of millions of people worldwide that benefit from its activities. 

Peter C. Earle

Peter C. Earle

Peter C. Earle, Ph.D, is a Senior Research Fellow who joined AIER in 2018. He holds a Ph.D in Economics from l’Universite d’Angers, an MA in Applied Economics from American University, an MBA (Finance), and a BS in Engineering from the United States Military Academy at West Point.

Prior to joining AIER, Dr. Earle spent over 20 years as a trader and analyst at a number of securities firms and hedge funds in the New York metropolitan area as well as engaging in extensive consulting within the cryptocurrency and gaming sectors. His research focuses on financial markets, monetary policy, macroeconomic forecasting, and problems in economic measurement. He has been quoted by the Wall Street Journal, the Financial Times, Barron’s, Bloomberg, Reuters, CNBC, Grant’s Interest Rate Observer, NPR, and in numerous other media outlets and publications.

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Sean Stein Smith

Sean Stein Smith was a Visiting Research Fellow at the American Institute for Economic Research, focusing on blockchain, cryptoassets, and the economic impact of these technologies. He is an Assistant Professor at the City University of New York (Lehman College), serves on the Advisory Board of Wall Street Blockchain Alliance, where he also chairs the Accounting Working Group, and chairs the Emerging Technology Interest Group of the New Jersey Society of CPAs.  His research has been quoted in dozens of scholarly and practitioner publications, and he is a regular speaker at accounting and technology conferences. Follow him on Twitter.

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