So, just what is private equity? Private equity (PE) firms offer ways for individuals and institutions to invest in purchases of companies. The PE firm then looks to buy companies where they believe there are untapped opportunities for growth. This could be because an aging owner has been reluctant to reinvest, management has become stagnant, market opportunities have not been sought, tax savings have not been pursued, untapped operating efficiencies have emerged, or the PE firm has the potential to run the company better. Not infrequently, the PE firm believes that it can reduce employment at the firm without harming output or that the company can make more money if it employs a more single-minded focus on profits. In healthcare and veterinary services, for instance, PE firms have pushed the companies they bought to focus more on financial and performance metrics, even if that means limiting the time professionals spend with patients or pressuring professionals to do more tests. Of course, there is a lot of variation in private equity firms. While some are singularly focused on returns on investment, others take a more pro-social or pro-employee approach.
PE firms solicit money from wealthy investors and institutions with the promise of returning their money (plus gains) generally within ten years. The PE firms then scout out potential companies to buy with that money. If a target company is public, they may begin acquiring shares. If it’s privately held (as is more common), they approach the owners with what is often a hard-to-resist proposition: cash on the barrel for their entire business.
PE firms often replace some of the managers with their own people or at least want seats on the board. The goal, almost invariably, is to increase the profitability of the company and sell it in three to seven years, often to another PE firm or a larger company, at a considerable profit. Investors expect returns well above what they might get from investing in the stock market.
PE firms can be very profitable. The usual practice is for a fund to take 2% of every dollar that its investors put in, plus20% of any profit they earn from their portfolio companies over an agreed-upon baseline. PE firms usually use debt to buy a company, but the debt shows up on the company’s books, and the company has to repay it. So, if the company fails, the PE firm does not have to repay the debt, although its investment in that company won’t be worth much.
A 2019 study by two business professors at California Polytechnic State University found that companies owned by PE firms went bankrupt at ten times the rate of similar publicly traded companies. They might also pay themselves large dividends from the company. And, finally, they can charge a hefty management fee. They can characterize a lot of what they take out of the company as “carried interest” and pay capital gains on what are really fees charged to the company.
Some PE firms have endeavored to share ownership more broadly. KKR has closed multiple deals in which employees end up with about 5% of the equity in the firm, and in cases where these companies have been sold, employees have received tens of thousands of dollars each. Some other PE firms have pledged to follow this model.
PE firms have a reputation for eliminating jobs through layoffs and other cost-cutting measures. Advocates for private equity, on the other hand, argue that their purpose is to invest in high-potential businesses and unlock their growth potential. So, what does the research show? The most comprehensive study was a 2019 analysis by Steven Davis of the University of Chicago and his colleagues, which examined nearly 10,000 private equity buyouts between 1980 and 2013. Half the buyouts were of privately held companies; the rest were sales of divisions of public companies. The researchers found that employment was 13% higher in the two years after thebuyouts in private companies but fell 13% in the case of public company buyouts. Overall, jobs fell1.4%, while average compensation per worker fell 1.7%(including 6% at private companies). A second major study byJonathan Cohn and colleagues in 2017 looked at 244 public company buyouts and 316 private company buyouts between 1997 and 2007. It found a 13% average reduction in within-establishment employment levels relative to peer establishments in the four years following a buyout.
All this stands in contrast to what happens when an ESOP buys a company. Debt is used here as well, but ESOP companies have a vanishingly small rate of default on their loans, one far, far lower than PE firms. ESOP companies also receive tax benefits, but these benefits have universal political support, in large part because employees broadly benefit from them and because ESOP companies generate significantly more new jobs and fewer layoffs than other companies. Imagine an economy in which most of the buyouts done by PE firms were done by ESOPs instead.