In this age of firebrand political rhetoric and sniping from the right and the left, Wall Street has taken more than its fair share of criticism. One of the most significantly misplaced criticisms, however, derives from a gross misunderstanding of how the invisible hand of the market works and how certain mechanisms improve the health of firms and the market overall, delivering value for a broad swath of stakeholders—managers, investors, and employees alike.
In his 1965 “Mergers and the Market for Corporate Control,” Henry Manne describes how market competition helps regulate the behavior of managers. Managers that pursue objectives counter to profit maximization will find themselves in charge of a firm worth less than it could be, and when firms are publicly traded, lower stock prices signal that something is wrong.
Similarly to how prices convey information (Hayek 1945) in normal product markets, an underperforming stock can signal that the company would be better off restructuring or obtaining new management. The better the market for corporate control, the less it matters what decisions potentially delinquent managers might make.
Demsetz (1999, p.253) notes that “Manne recognized that corporate control is a commodity, or good, which, like any other commodity, has a market.” Manne not only made this important academic point about this underappreciated invisible hand mechanism, but made it before the massive growth in mergers and acquisitions over the past three decades. Fueling this growth has been one of the least regulated parts of Wall Street: private equity.
Often referred to as full of wheeler dealers or cowboy capitalists, the private equity industry became as big as it is in large part to avoid regulations associated with publicly traded firms or investment vehicles open to the public. A firm that is bought out by private equity historically avoids costly securities regulations that provide little value to investors.
The widespread lack of understanding or mistrust of Wall Street in general and private equity specifically set the stage for more regulation. After the Dodd-Frank Act, a new Financial Stability Oversight Council was given discretion to subject a non-bank financial company to the supervision of various regulators.
The Commodities Futures Trading Commission and Securities and Exchange Commission (2011) welcomed this new power, stating, “To that end, the Dodd-Frank Act amended section 204(b) of the Advisers Act to require that the SEC establish reporting and record keeping requirements for advisers to private funds, many of which must also register for the first time as a consequence of the Dodd-Frank Act. These new requirements may include maintaining records and filing reports containing such information as the SEC deems necessary and appropriate in the public interest and for investor protection.”
Now, any private fund with more than $150 million of assets under management has to register with the Securities and Exchange Commission. Private funds from outside the United States also have to register if they have more than 15 American investors. As of 2016, 28,290 private funds have had to comply with these new requirements.
Subjecting the private equity industry to these regulations has been a costly and substantial undertaking for these firms—and one that investors never requested.
Making money by helping to buy, restructure, and resell sub-optimally managed firms creates value. Further regulating the private equity industry is a mistake and interferes with one of the most crucial invisible hand mechanisms for enabling the smooth functioning of capitalism.
In effect, by maximizing utility and aiming to cut agency costs, private equity firms align their own interests with those of the company’s shareholders. Further, as Masulis and Thomas (2009) argue, “Even the best part-time independent directors are not the equivalent of full time, highly incentivized private-equity managers.”
One major agency cost can result from how many public corporations use their free cash flow. Free cash flow is what remains of operating cash flow after capital expenditures. This cash can be paid out as dividends, used for investments to increase shareholder value, or misused as a buffer to hide imperfect management performance.
Having more debt actually keeps a company on its toes and forces a company to give payments to investors (in this case debt investors). As Jensen (1986) explains, although a company with low debt may promise increased dividend payments, “such promises are weak because dividends can be reduced in the future.” Higher leverage thus forces private equity managers to pay out future cash flows through debt payments. Jensen argues that increasing leverage lets private equity firms reduce agency costs associated with free cash flow.
While some would argue that private equity acts on a short time horizon, the fact that a private equity fund’s limited partners (or investors) are obligated by the nature of the fund to maintain their investment for the life of the fund actually increases accountability. Accordingly, limited partners must prospectively consider a fund’s past performance and whether they want to commit their money to it. And because the private equity firm can rely on investors keeping their money with it, it is able to make fundamental and long-term decisions about the company’s financial and operational structure.
The proof is in the pudding: Private equity firms have grown considerably, implying that existing investors are returning to them and new ones are seeking their own involvement in private equity.
One of the major keys to the success of the private equity industry is that it has historically faced far less regulation than banks, mutual funds, and publicly traded firms. While proponents of the 2002 Sarbanes-Oxley Act and the 2010 Dodd-Frank Act said the laws would help investors, both have imposed many costly restrictions on publicly traded firms. Ultimately, the firms’ owners—the investors—bear those costs.
Taking a firm private was a way to avoid such regulations. Likewise, mutual funds and other investment vehicles open to the public have had to deal with many regulations since the Investment Company Act of 1940, such as constraints on short selling securities and leveraging investments. Another constraint forbids mutual fund managers from being paid on a performance basis and instead requires them to be paid based on a percentage of assets under management. These restrictions create the wrong incentives for fund managers and hinder their ability to compete in the market.
Private equity has the ability to align incentives between managers and the overall business and to increase job growth by restructuring companies and orienting themselves to the long term. Even the mere threat of a leveraged buyout is enough to force corporate management to add value. Private governance in this industry works.
Masulis, R., & Thomas, R. (2009). Does private equity create wealth? The effects of private equity and derivatives on corporate governance. University of Chicago Law Review, 76(1), 219–259.
Demsetz, H. (1999). Henry Manne: Scholar, academic entrepreneur, and friend. Case Western University Law Review, 50, 253–257.
Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4): 519–530.
Jensen, M. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2): 323–329.
This post comes to us from Edward Peter Stringham, president of the American Institute for Economic Research, Davis Professor of Economic Organizations and Innovation at Trinity College, and editor of the Journal of Private Enterprise, and from Jack Vogel, who studied under Stringham at Trinity College and currently works on mergers and acquisitions at a boutique Wall Street bank. The post is based on their recent article, “The Leveraged Invisible Hand: How Private
Equity Enhances the Market for Corporate Control and Capitalism Itself,” available here.