May 23, 2012

Private Equity and Extractive Institutions

Chris Hayes sparked a debate on Twitter last night with the following debate proposal:
Resolved: Bain Capital is bad for America. Or Resolved: It would be better if there was no private equity industry.
Which prompted Noah Smith to leap to private equity's defense:
Anyway, I generally support private equity. Why? Because of Japan.
Fact 1: In Japan, there is no big private equity industry, because it is very difficult to do a leveraged buyout of a company. The Japanese government allows companies to defend themselves from takeovers in ways that are illegal in America. Also, Japanese companies often hold each other's shares, a practice known as "cross-shareholding", which tends to prevent hostile takeovers. Cross-shareholding creates huge financial risks; however, many of the Japanese companies that engage in cross-shareholding are big banks that are backed by the government (much as ours are here in the U.S., but more explicitly), so this risk is assumed by the Japanese taxpayer. For a comprehensive primer on Japanese corporate governance, see here
Upshot: In Japan, private-equity firms cannot buy companies and force them to restructure. 
Fact 2: Japan has a productivity problem. We think of Japan as being super-productive, and in fact some industries (and most export-oriented factories) are. But overall, Japanese productivity kind of stinks. Since at least the 90s, Japan's Total Factor Productivity has lagged far behind that of the U.S. Nor is this due (as Ed Presott has tried to claim) to a slowdown in technology; it appears to be a function of how resources are allocated within and between Japanese companies.
And Matt Yglesias to theatrically scratch his head:
From where I sit, what we've actually been having is an extremely confused and confusing debate that has almost no content beyond affect.
But let's try to bring some substance to the debate. Noah Smith has an interesting laudatory post about private equity, suggesting a lack of leveraged buyouts explains some of Japan's problems, but the specific policy content is to disparage the huge legal tools the Japanese legal system gives incumbent managers to prevent their firms from being bought by outsiders. By contrast, Eileen Appelbaum and Rosemary Batt did a very disparaging policy report (PDF) for the Center for Economic and Policy Research back in February. They conclude that based on this that there ought to be more economy-wide limits on the permissable degree of leverage, and also that we ought to reduce the tax arbitrage opportunity represented by the deductibility of debt. They don't advocate adopting Japan-style rules to protect incumbent managers, and Smith specifically sites the tax arbitrage issue as a real one that should be curbed. Which is to say that Smith, who likes private equity, and Appelbaum and Batt who dislike it don't appear to have any policy disagreements.
Jay Gould, the
"Mephistopheles of
Wall Street"
I think Hayes is sort of mistaken in trying to point to any individual industry or business or company as being "bad for America." Surely Smith is right that it's eminently possible for businesses to become rotten, sclerotic, and dysfunctional, and that sometimes a buyout and restructuring can serve as a much-needed clearing out of dead wood. However, it's at least possible for Hayes to be right about Bain. Surely amoral rich people are more than capable of taking control of a good, functional business, and sucking the life out of it through financial trickery, or abuse of political influence, or manipulation of tax loopholes. Jay Gould was famous for doing this back in the Gilded Age. And while Countrywide was no one's idea of an honest business, Angelo Mozilo was still looting it back during the housing bubble.

I find, again, Why Nations Fail's extractive/inclusive spectrum to be useful here. When we're talking about whether private equity is bad or good, I think the relevant metric is whether they're (broadly speaking) serving as good faith entities, which play by the established rules of the market and try to make tangible improvements in businesses (which may lead sometimes to failure and mass layoffs, of course), or whether they're buying companies only to strip out their value into their own pockets. Smith's examples look like a different kind of extraction, where incumbent company managers use the law to protect their own position, which quickly turns into propping up tottering, failed companies.

I don't think we can a priori draw clear distinctions about what kind of law or business will be guilty of this. Hayes is wrong in that he draws too small a circle. As WNF says, all elites are potentially extractive (though I'd say due to their position astride the money streams financiers are more susceptible than most). From what I've read about Romney's time at Bain, they seemed to be on both sides of this spectrum.

That was a long time ago, and in my opinion the entire financial sector has become largely extractive since then, but in any case when we talk about the societal worth of financial companies this is what we're talking about.

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