Value Creation and Value Extraction
in Private Equity
Eileen Appelbaum, PhD
Senior Economist
Center for Economic and Policy Research
Japan Conference on
Financial Institutions for Innovation and Development
July 31, 2015
Ritsumeikan University
1
Overview of Presentation
Motivation: changes in financial institutions/ products/
strategies =>decline in labor share, increase in inequality
• Financialization
• Corporations: Value Creation vs. Value Extraction
• Private Equity
– Business Model
– Operational Improvement vs. Financial Engineering
• Financial Engineering: Value Extraction by PE Firm
• Is Japan Different?
2
Financialization of U.S. Economy
(Fligstein 1990; Krippner 2005; Epstein 2005)
• Profits accrue primarily through financial channels
rather than trade or production of goods and services
• For non-financial firms: Increasing revenue from
portfolio income – interest, dividends, realized capital
gains on investment
• For financial firms: An upward trend in profits
generated in financial sector compared to non-financial
sector of economy
3
Financial Revenues for Non-Financial Firms
(Krippner 2005)
4
Profits in Financial vs. Non-Financial Firms
(Krippner 2005)
5
Value Creation vs. Value Extraction
U.S. Corporations (Lazonick HBR 2014)
• WWII to late 1970s – retain & reinvest => value creation
• Late 1979s – downsize and redistribute
– Reduce costs, distribute freed up cash to shareholders
– Workers wages stagnant, income growth to top 0.1%
• Via stock options, stock buybacks, dividends
– Maximize shareholder value
•
•
•
•
Bolstered by agency theory of the firm (Jensen & Mckling 1976)
Distribute cash flow to shareholders
But retained earnings are basis of investments in innovation
=> Value extraction, not value creation
6
Value Creation vs. Value Extraction
Private Equity
• PE emerged in 1979 - first LBO of publicly-traded firm
–
–
–
–
Financial deregulation
Changes in pension law opened up large pool of capital
Rationale for LBOs: Overcome decline in profits in 1970s
Hostile takeovers, split up conglomerates to increase profits
• Maximize shareholder value (MSV)
–
–
–
–
Principal-agent theory provided rationale for LBOs
Ignores interests of other stakeholders in name of MSV
Reduce costs, distribute freed up cash to PE firm, investors
Also => wages stagnant, income growth to top 0.1%
7
8
PE Business Model: Moral Hazard
Private equity firm
 Uses other peoples’ money
 Takes lions’ share of profits
 Externalizes risks to portfolio company, labor, creditors,
limited partners
 Incentives for high risk embedded in PE model
 For PE firm: Low risk, high rewards
9
PE & Public Corporations: How Different?
Private Equity
Public Corporations
Capital structure
70% debt/ 30% equity
30% debt/ 70% equity
Regulatory oversight
Low
High
Transparency
Low
Higher
Accountability
Low
Higher
Risk taking
High
Low
‘Moral hazard’
High
Lower
Use of junk bonds
Considerable
Low
Asset sales
Proceeds go to PE owners
Proceeds go to company
Dividend recaps
Frequent
Rare
Fees
Key part of PE firm earnings
No advisory fees
Taxes
Capital gains rate
Corporate income rate
Reputational effects
Low
High
10
How Structure Drives Strategy & Outcomes
Capital structure 
Debt level
(company size,
financial distress)
Strategy

Operational
strategies
Financial
engineering
strategies
Enterprise outcomes
Cash flow
Exit strategy
Jobs
Sustainability
11
How PE Makes Money: Financial Engineering
Transfers to PE firm from:
 Portfolio companies (Monitoring/advisory fees, Dividend
recaps, OpCo/PropCo)
 Workers (Wage & job loss, work intensification)
 Taxpayers (High debt lowers taxes, tax arbitrage)
 Creditors (Debt exchange, bankruptcy for profit)
12
PE Effects on Jobs and Wages
Best econometric study: PE vs. Publicly traded companies
• Data: 3,200 firms, 150,000 establishments (1980-2005)
• Capital IQ data matched to US Census longitudinal business data
(Davis, Haltwinger et al., 2011)
PE-owned companies: jobs & wages fall post-buyout
• Buyout year: Job growth in target firms is 2 % higher than controls
• Post-buyout: PE owned establishments had 3.2% lower growth after 2
years; 6.4% over 5 years
• Retail: employment fell 12% in PE-owned establishments relative to
controls
• Wages higher before buyout, fall relative to controls
• Productivity increases => growing inequality as gains captured by PE
13
Japan: Limits to Investment Fund Activity
(Katsuyuki Kubo 2014)
• Shareholder Value
– Manager survey: Should large company prioritize shareholder interests
or give equal priority to all stakeholders?
• . All stakeholders – Japan 97%, US 24%, UK 29.5%
– Reduce dividends or lay off workers?
• Japan – reduce dividends, U.S. and U.K. – lay off workers
• Unlike U.S., senior managers receive only small reward even
when high shareholder returns
– No incentive to manage firm to maximize shareholder value
• Cross-holding of shares (firms hold each other’s shares)
– Difficult to acquire firm through hostile takeover, very rare
• Public policy encourages FDI, but purchase of Japanese firms
by investment funds is discouraged
14
Japan – Labor Market Regulation
• PE Funds
– few LBOs 1998 to 2011, only 24 exits structured as IPOs
– PIPES (buying shares in public companies) more common
– Target firms - LBOs & PIPES – smaller than other listed firms
• Labor market regulation
– With advance notice, worker can quit or be fired
– But, judicial principle: Principle of Abusive Dismissal
• Provides regular employees with protection against dismissal
• Discourages downsizing after LBO
– Still, study finds employment decreased significantly compared
to controls after investment by PE
15
Is Japan Changing?
• WSJ: Hiromichi Mizuno recruited from London PE
firm to run Japan’s $1.1 trillion public pension fund
– Will invest in PE if fund finds compelling deals
• WSJ: Sumitomo Mitsui Banking Corp. is buying GE’s
European PE-finance business for more than $2 billion
– ‘sponsors unit’ – finances LBOs in Europe
16
Smart Regulation
• Limit leverage to limit risk to workers, creditors, others
• Hold PE firms and funds accountable as employers
– WARN Act, 363 bankruptcies, ERISA
• Increase transparency
17
References
• Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street
Manages Main Street, RSF Press (2014)
• Gerald Epstein, Financialization and the World Economy, Edgar Elgar (2005)
• Neil Fligstein, Transformation of Corporate Control, Harvard U. Press (1990)
• Michael Jensen and William Meckling, ‘Theory of the firm: Managerial behavior,
agency cost, and ownership structure,’ J. of Financial Economics (1976)
• Greta Krippner, ‘The Financialization of the American Economy,’ SocioEconomic Review (May 2005)
• Katsuyuki Kubo, ‘Japan: Limits to Fund Investment Activity,’ in
Gospel/Pendleton/Vitols (eds.) ‘Financialization, New Investment Funds, and
Labour,’ Oxford U. Press (2014)
• William Lazonick, ‘Profits Without Prosperity,’ Harvard Business Review
(September 2014)
18
References
• Gillian Tan and Ted Mann, .Japan’s SMBC nearing deal for GE’s European
private-equity finance unit,’ Wall Street Journal, http://on.wsj.com/1C3wkbM,
June 29, 2015
• Eleanor Warnock, ‘The man who must fund the retirement of the oldest
wealthy nation,’ Wall Street Journal, http://on.wsj.com/1ScKxVt , July 13, 2015
19