Friday, February 23, 2007

Hutton on Private Equity and Sinclair's Law of Bad Guardian Articles

For now he has given up on spouting ignorance about China and getting angry about private equity is, apparently, Hutton's 'thing'. This article is about as bad as the last one.

"It is time to come to the defence of the public limited company, one of the great Enlightenment gifts to western civilisation. Increasingly capital, in the quest for higher returns to make vast personal fortunes, is going private to escape the demands of public accountability on stock markets. If uninterrupted, the long-term adverse consequences of this privatisation of capital for our economy, society and democracy will be profound."

Again this bizarre idea that stock markets ensure public accountability. They hold firms accountable to the objective of making the fortunes of investors just as the shareholders of private equity firms do.

"Even six months ago, very few outside the City or the readers of business pages had come across the idea of private equity. Today, as Sainsbury's is stalked by a club of four private equity firms allegedly plotting a £10bn bid and the GMB has ignited a campaign against job losses incurred in private equity restructurings by comically embarrassing one its leading lights - Damon Buffini, the boss of Permira - private equity is news. It is even becoming an issue in the contest for the deputy leadership of the Labour party."

Job losses, while unpleasant for individuals, are a part of how the economy adjusts to changing technology and consumer tastes. If private equity firms can run a firm effectively with fewer employees that is a pure efficiency gain and those employees can be employed elsewhere where they are more useful. This transition can be particularly difficult for those with specialised skills, set in their ways or in a troubled labour market but the solution is to get better at moving those laid off into more productive employment rather than have them continue in jobs which are no longer required.

"The story, as recounted by consensus opinion from the shadow chancellor, George Osborne, to the CBI, and eagerly rehearsed by the private equity industry itself, is that the emergence of more than 700 private equity companies deploying saving and borrowing power of more than £1 trillion is crucial to wealth generation. By taking public companies out of the public arena of accountability, regular reporting and scrutiny, they can instead enjoy the benefits of engaged, committed ownership.

Too many companies, they allege, are just not trying hard enough to maximise their profits, indulged by disinterested pension fund and insurance company shareholders. They need the managerial alchemy of private equity investors who, aiming to make "life-transforming" money for themselves, will give them the necessary managerial and strategic shock treatment."

This is an utterly ignorant caricature of the role private equity firms play. It is the kind of logic that flies on the pages of the Guardian to a readership not versed in finance.

A recurring problem for stock markets is that ownership is so dispersed that each individual owner has such a small stake in each firm that the costs of actively monitoring its management, which can be significant, are not worth paying for marginal changes in results; it is preferable for each investor to free ride off the monitoring efforts of others who might be more conscientious. This leaves managers with a particularly strong hand in avoiding shareholder control of activity that might not be in shareholder interest, whether paying higher wages than are profitable or blowing piles of money on business jets. This problem is partly overcome by large groupings of investors such as the Association of British Insurers and by the threat of takeover. However, private equity avoids these problems entirely as ownership is concentrated and there is, therefore, active monitoring of management. Their improvements to firms financial performance are far from alchemical.

"One truth about private equity shines out: the extravagant management fees and annual "carry" (the share in profits) certainly means life-changing fortunes. Researchers at Manchester University's ESRC Centre for Socio-Cultural Change recently got hold of the internal management accounts of one fund with up to £8bn of funds under management. After five years 30 full partners expected to make between £25m and £50m each."

Can we call it Sinclair's Law that all bad Guardian articles will eventually make a shameless statement of envy?

"The rest of the industry's claims about creating jobs, investment and exports do not bear close scrutiny. Much of the alleged managerial alchemy is no more than old-fashioned financial engineering - that is, leveraging up returns by incurring lots of debt. One study by Citigroup showed that if pension funds and insurance firms had borrowed money themselves and invested in a basket of companies in which private equity groups invested, they would have made higher returns than even the best-performing private equity firms."

If your case is that these firms don't make sufficient returns to be a good investment then this isn't a political issue and we can leave a solution to the market which will stop investing in private equity funds if they don't get results.

"Mortgaging the future to capture gains for personal enrichment in the present is easy - as one chief executive of a well-known public company told me recently, the task of the good manager is to resist it. Managers have to balance the interests of today's shareholders with tomorrow's shareholders. Private equity drives a coach and horses through the proposition. And as Paul Myners, the former chairman of Marks & Spencer and chairman of Guardian Media Group, has remarked: "The one party that is not rewarded is the employees, who generally speaking suffer an erosion of job security and a loss of benefits.""

If a firm is irrationally rewarding employees with job security and benefits that they don't earn in terms of production then that will be competed away, possibly from overseas, anyway. Private equity just speeds the process. If they do earn their benefits then it won't be in the financial interests of the firm to lose them.

"The catalogue of firms thus financially engineered is endless. A consortium bought the car rental company Hertz in 2005, packaged up the car fleet in blocks of tradeable assets that could be bought and sold by banks, and sold the weakened company back to the stock market. Others have bought media outfits such as PanamSat in the US or EirCom in Ireland - not to develop a free media that holds truth to power but, as Columbia University's Eli Noam argues, to weaken that capacity while remaining unaccountable owners themselves.

In Britain Debenhams was bought, its stores sold off to be leased back by the enfeebled company, which was then sold back to the stock market. And other public companies, including ICI, Amec and EMI, are being stalked, and adjusting their strategies accordingly. The shadow of private equity falls everywhere, making the gamut of British business hyper short-termist."

This misses the point that, while Hertz may make larger earnings through maintaining ownership of its cars, for that to be a good investment is has to make sufficiently larger earnings to offset the opportunity cost of capital that is inherent in maintaining ownership of large stocks of capital like cars. If private equity firms can earn more by selling those cars and then leasing them back (reductions in Hertz's earning capacity will be reflected in its share price which costs private equity firms). Unless Hutton can point to some kind of irrationality which would cause the market to not take account of the harm to Hertz's earnings power of no longer owning cars he has no case that it will be in the interests of private equity to do so unless owning cars is a less productive use of capital than some alternative. If there is a more productive alternate use of capital it is in all our interests that it capital is directed towards that alternative.

"This is not pro- but anti-wealth-creation. In this respect the attitude of private equity closely mimics that of the Chinese communist party. Both conceive of companies as networks of contracts between capital and labour that generate revenue streams to be manipulated by whoever has central control for personal or political advantage. Neither has any conception of companies as Enlightenment institutions that incorporate real-life human beings into a joint enterprise, in which being publicly scrutinised and held to account helps managers make better decisions. The foundation of a durable business, as James Collin and Jerry Porras argued in their famous book, Built to Last, requires vision, values, leadership and purpose around an organisation's "reason to be" - the antithesis of everything private equity stands for."

Private equity firms have a very precise vision: shareholder value. A very definite set of values: they value money. They pay closer attention than other firms to leadership thanks to not having the free riding shareholder problem. Finally, their purpose is clear: make money.

By putting capital to its most productive use they ensure that our economy adjusts more quickly to new priorities, new technologies and new challenges.

"So if we want such companies, shareholders have to give managers room for manoeuvre and back long-term business strategies. But British shareholders are not required by law to take their ownership responsibilities seriously (it would be a "burden on business"). Nor are British companies required to give them the range and quality of information that might help them. As a result, British shareholders are extraordinarily neglectful of their ownership responsibilities."

Require shareholders to take their responsibilities seriously by law? How exactly?

A legal responsibility for firm performance on the shoulders of shareholders would end the stock market's potential to raise funds from a wide range of sources as it would remove the legal separation between ownership and management which is the true purpose of that "Enlightenment institution". Not being legally responsible for its conduct allows shareholders to invest without monitoring the company's day to day operation. If they have to monitor a company day to day most investors won't be able to invest outside their own narrow sphere of expertise and geography. Modern capitalism and large scale enterprise would suffer massively as it would be impossible to raise capital on the necessary scale.

"Pension funds and insurance companies are myopic and short-term enough, but because takeover is so easy in Britain private equity has been able to carry short-termism to new extremes. This is said to raise productivity and performance. I would argue the opposite. The chief reason British business remains at the bottom of the international league tables for innovation, research and development, and productivity growth is because of too much takeover and too much private equity. Innovation lowers short-term profits."

Where is the evidence for this short-termism? There are plenty of other plausible explanations for Britain's problems with innovation (also, don't overestimate the degree of these problems); weak science education is a good place to start (has been a problem since well before the First World War). There may be a big focus on share prices but, unless Hutton is going to actually discuss why markets might be myopic, these should reflect expected future earnings as these affect future dividends and, hence, the earnings of any potential purchaser.

"The answer is obvious. Private equity cannot be outlawed; in any case it can do a good job. Rather, the perverse incentives in Britain that favour takeover need to be removed. We need to defend the public company and create conditions in which it can prosper. But who is going to do that? Not the Conservative party, in thrall to private equity, and not, judging by its legislative record, the government. Our politicians are confused. There is more to wealth creation than constructing a plutocracy of private equity partners."

Takeover is one of the most effective means by which managers are held to account for poor performance. Britain's low regulatory bar to takeover is the reason why much fewer of our firms than those in other countries are run as the personal fief of management. Managers can be prideful, selfish and flawed just like all other human beings and Hutton's call to inhibit an important source of market discipline upon them is one to ignore.

1 comment:

John Page said...

Can we call it Sinclair's Law that all bad Guardian articles will eventually make a shameless statement of envy?

That would be green politics, then.