The Debate on Private Equity in 1989, Peter Róna addressing Jensen

Pema Levy has an excellent piece on the differences between private equity and venture capital that I recommend checking out.

Since there’s going to be more discussion of private equity, it would be useful to get some more specifics on what criticisms of private equity have looked like historically.  We discussed the tax preference for debt with Josh Kosman here.  I’ve been reading about the debate over leveraged buyouts (LBO) and the shareholder’s revolution as it played out in the finance journals of the 1980s.  For all the romantic talk about “creative destruction”, the virtues of vultures and the harsh medicine involved in saving dying firms, the real story here is a battle over various stakeholders in the control of the firm.

First, something did change during the 1980s, and LBO was part of this overall shift.

JW Mason:

The blue line shows the after-tax profits of nonfinancial corporations…the solid red line shows total payout to shareholders, that is dividends plus net share repurchases…In the pre-neoliberal era, up until 1980 or so, nonfinancial businesses paid out about 40 percent of their profits to shareholders. But in most of the years since 1980, they’ve paid out more than all of them….In 2007, earnings were $750 billion, dividends were $480 billion, and net stock repurchases were $790 billion. (Yes, net stock repurchases exceeded after-tax profits.)…

It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancings to pay for extra consumption. What nobody mentioned was that the rentier class had been doing this longer, and on a much larger scale, to the country’s productive enterprises.

This is predicated on the idea that Wall Street and the capital markets know how to invest better than managers at firms.  Recent events should give you pause on this: reflect on the fact that most of the stuff you like (your Apple products, for instance) are developed by managers at established firms under constant pressure to release cash, and the capital markets and Wall Street’s grandest achievement was to create trillions of dollars in housing investment that is now worthless or sitting in a quasi-foreclosure state rotting.  They failed at their main job – allocating capital in a productive way.

What did the arguments against LBO and shareholders revolution look like in real time?  This recap from Doug Henwood’s book Wall Street (available for free as an e-book) starts us off.  For all that’s been written about Wall Street in the past 3 years, Henwood’s book really stands out even though it was written in 1997.  I’ve seen very little coverage on corporate control, for instance, which his Chapter 6 is all about.  Henwood:

Starting in the mid-1970s, Michael Jensen, Chicago-school fellow traveller now at Harvard, began developing a finance-based theory of corporate governance that would become influential in the 1980s…Jensen’s (1986a) answer was to load up these firms with debt…As the decade wore on, Jensen celebrated the advent of a new form —the LBO (leveraged buyout) association (Jensen 1989a)…

Back, though, to Jensen and his manifesto. It drew a blizzard of responses, mainly from anti-Jensenites. One, from Peter Róna (1989), head of the IBJ Schroder Bank & Trust in New York, made several points worth quoting — and Róna’s position as a financier rather than an industrialist makes his comments especially interesting. First, Róna argued that Jensen grossly overstated the shareholders’ case. In return for limits on their liability (they can see the value of their stock wiped out, but the rest of their assets can’t be attached), shareholders give up the right to dispose of corporate property on their own; they can sell the shares, but not the firm’s assets. By making the shareholder sacrosanct, Jensen preempted any “thoughtful analysis of the very question that is at the heart of the issue —what should be the rights and privileges of shareholders?” Second, the LBO is based on the redistribution today of cash flows expected tomorrow and beyond; if these estimates are wrong, then the public shareholders who are bought out in an LBO have the cash and “everyone else is left with a carcass.” But shareholders are in the game only to maximize value; having consummated this goal, “they take pretty much the same view of the corporation as the praying mantis does of her mate.” Finally, Jensen assumed that shareholders are better judges of capital projects than are managers and corporate boards — an “ideologically inspired assertion that lacks empirical support.” As Róna says, it’s hard to imagine how one would go about testing this empirically, but “the burden is on Jensen” to take on the task, “since he has already reported the results.

The 1989 Róna response to Jensen in Harvard Business Review is fantastic, though sadly not online.  It’s worth quoting at length.  First, the privileges of shareholders should be subject to debate, since it’s a legal creation that excludes many of the responsibilities that come with ownership:

As the author admirably sums it up in a rhetorical question: “Who can argue with a new model of enterprise that aligns the interests of owners and managers, improves efficiency and productivity, and unlocks hundreds of billions of dollars of shareholder value?”

Well, let me try. To begin, as a matter of settled corporate law, shareholders are not “owners” of the enterprise in any sense of the word. In exchange for these significant limitations on liability, shareholders give up virtually every significant right normally associated with ownership-notably, the right to operate and manage; the right to sell, dispose, pledge, encumber, or hypothecate; the right to create lesser titles in interests, such as leases, licenses, easements, or covenants; and the right to bequeath. Of course, they can exercise all of these rights with respect to their shares but none as to the corporation or any of its assets. So quit calling them “owners” of the corporation, for, in doing so, not only are legal principles violated but also thoughtful analysis of the very question that is at the heart of tbe issue -what should be tbe rights and privileges of shareholders-is preempted.

Here’s the crux of the argument that this is really about a battle between stakeholders:

The very foundation of tbe LBO is the current actual distribution of hypothetical future cash flows. If the hypothesis (including the author’s net present value discounted at the relevant cost of capital) tums out to be wrong, the shareholders have the cash and everyone else is left with a carcass. “Creating shareholder value” and “unlocking billions” consists of shifting the risk of future uncertainty to others, namely, the corporation and its current creditors, customers, and employees…

The notion that underleveraging a corporation can cause problems is neither new nor unfounded. What is new is the assertion that shareholders shouid set the proper leverage because, motivated by maximizing the return on their investment, they will ensure efficiency of all factors of production. This hypothesis requires much more rigorous proof than Jensen’s episodic arguments… although Jensen denies it, the maximization of shareholder returns must take place, at least in part, at someone else’s expense. And the conflicts are not just the obvious ones between creditors, shareholders, labor, and management. The scientist whose research budget is cut, devastating his hopes for a Nobel Prize, may seem like an “inefficient layer of management” to Jensen or to shareholders, and he may well be, in the sense that his future Nobel Prize has no present value. But to that scientist, the decision is rank betrayal. No creative taient will work for organizations that think this way.

If this is the new system, and it appears from the vantage point of 2012 it is, why do we allow shareholders to continue to have limited liabilities?

On the technical level, the question is whether shareholders are entitled to earnings or cash flow, and my view is that opting for the latter amounts to conferring on them life-threatening powers. If they are to have such rights, exemption from liability no longer makes sense, since it is precisely the general availability of cash flow against a variety of risks, known and unknown, together with shareholders’ lack of control over its management and disposition that justifies the exemption.

There were many other responses in that issue of Harvard Business Review.  We’ll continue to discuss them in upcoming posts.