Private equity is often seen as an agent of creative destruction, helping resources to be reallocated to more productive uses. Private equity firms help improve the financial performance and operational efficiency of the companies they acquire, and plenty of academic studies report evidence in support of this “bright side.” Buyouts have, for example, been shown to lead to sizable improvements in management, productivity, innovation, and accounting profits. One notable “dark side” is that some of these improvements may come at the expense of workers who lose their jobs.
But what about more long term consequences of buyouts? In a recent paper, we explore whether private equity could, inadvertently, impose a major externality on the economy, by undermining the hard-won consensus in support of shareholder capitalism that has emerged in Anglo-Saxon economies over the past 100 years: in return for participating in the gains from corporate activity, shareholder-voters lend their support to business-friendly policies.
Our focus is on one particular type of private equity transaction: acquisitions of stock market listed companies by private equity firms. In the U.S., such public-to-private buyouts account for an estimated 45% of PE transactions by value. What makes them of particular interest to us is that they contribute to a reduction in the number of listed companies and hence in the size of the stock market.
Since 2000, private equity firms have been involved in 9.2% of all delistings in the U.S. by number and 14.6% by value. Buyout activity reached its peak in 2006, when public-to-private buyouts accounted for 23.3% of delistings by number and 47.9% by value—meaning that this type of buyout activity amounted to 1.9% of stock market capitalization and 2% of U.S. GDP that year. Once delisted, companies rarely return to the stock market.
As a consequence, the size of the U.S. stock market has fallen dramatically in recent years. The number of listed companies peaked at 7,428 in 1997 and has since declined almost monotonically. By December 2014, it stands at 3,773—half the 1997 count. A direct result is reduced stock market participation, which tracks the number of listed companies fairly closely. After rising from below 10% of taxpayers at the end of World War II to a high of 26.4% in 2000, stock market participation in the U.S. has fallen to 18.8% in 2013 (the latest year for which figures are available).
As we point out, a decline in stock market participation affects the electorate’s incentives to vote for parties that support business-friendly policies. Shareholders in public firms do not internalize the wider economic consequences of their decision to sell out to private equity firms. After selling out, their exposure to corporate wealth creation is reduced and as a result, selling shareholder become less likely to vote for business-friendly political parties. This leads to the business climate deteriorating over time, resulting in reduced investment, lower productivity, and less job creation in the economy. The biggest losers are the privately held firms in the economy.
What can be done about this trend? At the simplest level, government may consider taxing private equity activity involving delistings or subsidize venture capital activity involving new listings (though whether such interventions create more problems than they solve is an open question). More subtly, current government policies may aggravate the problem we identify, insofar as tax breaks enjoyed by private equity firms (such as the tax deductibility of interest payments on the debt used to fund their buyouts or the generous tax treatment of their profits as capital gains rather than income) contribute to an excessive level of buyout activity.
Similarly, policies intended to improve disclosure, transparency, or governance standards at listed firms may be desirable from the point of view of protecting investors but can also increase the cost of remaining listed and so can have the unintended consequence of triggering delistings and a shrinking of the stock market. Our analysis suggests that policy-makers should take this consequence into account when balancing the pros and cons of different regulations of stock market listed firms.
The preceding post comes to us from Alexander Ljungqvist at New York University and the National Bureau of Economic Research, and from Lars Persson and Joacim Tåg, both at the Research Institute of Industrial Economics (IFN). The post is based on their article, which is entitled “Private Equity’s Unintended Dark Side: On the Economic Consequences of Excessive Delistings” and available here.