Responsible investors need to take into account how fund management and investment structures may be exacerbating wealth and income disparities, as well as systemic market risk. Raphaele Chappe and Delilah Rothenberg from the Predistribution Initiative have some suggestions for how PE could be adjusted in this regard and how building back better post-COVID-19 requires a more thoughtful private equity model.
COVID-19 has exposed fragility in our globalised economy that impacts workers, companies, and investors alike, but there were already strong signs of weakness prior to this health crisis. As of 2019, non-financial corporate debt had doubled since the Global Financial Crisis (GFC), with historically high average leverage ratios and much of it covenant-lite (“cov-lite”). High debt burdens not only put companies at risk of bankruptcy in cases of a slight drop in revenues or rise in interest rates, but they also put pressure on companies to cut costs like payrolls and benefits to service the debt.
In the U.S. many households were not prepared to withstand even a small financial shock – in 2018, the Federal Reserve found that about 40 per cent of Americans would have difficulty covering a $400 unexpected expense. This lack of resiliency is now having profound impacts on society as workers are laid off and companies wither. To “Build Back Better,” we must self-reflect on the investment and capital structures that weakened the foundations of our economy and identify a stronger path forward.
Given historically low interest rates that have declined over the past decades, private equity (PE) Leveraged Buyout (LBO) strategies and associated investment products including private debt, high yield bonds, leveraged loans, and collateralized loan obligations (CLOs) have grown significantly to meet corporate demand for historically cheap debt and investor demand for higher yields. Regulation that restricted bank financing also contributed to this trend.
Much of this debt has been used to magnify financial returns, including through strategies such as dividend recapitalizations (dividend recaps) in PE. In public companies, debt has often been used to fuel stock buybacks and dividends, and what some consider to be unhealthy M&A, leading to corporate consolidation that can squeeze out opportunity for SMEs, workers’ bargaining power, and consumer choice. As investor appetite for risk increased, so too, did corporate leverage ratios – at historical highs as of late last year – and credit ratings declined. July 2020 Moody’s data now highlights that over 50 percent of rated company defaults are LBOs.
Moreover, particularly in the case of PE, the contribution of high executive compensation to growing wealth inequality is concerning. In a recent working paper, Oxford’s Saïd Business School’s Professor Ludovic Phalippou found that for $1.2 trillion invested between 2006 and 2015, PE funds captured an estimated $230 billion in carried interest (profits from portfolio companies that fund managers make – typically after a threshold return), not to mention management and other fees. A few billionaire founders and executives – 19 new individuals with net-worth over $2 billion since 2005 – were disproportionately rewarded, mostly within large funds.
Professor Phalippou notes: “This wealth transfer might be one of the largest in the history of modern finance.”
Indeed, research by the New York Times and other sources – including public PE firms’ own 10-Ks – over the years have confirmed that annual compensation of executives at “mega fund managers” often exceeds $100 million. This compares to banking executives who receive average annual compensation around $20 to $30 million.
It is easy to see how the distributional impact of carried interest is problematic, particularly given increasing recognition that inequality is a systemic risk for the economy. And, the COVID-19 crisis has taught us that workers and communities often bear significant risks of business operations and create a lot of value. Why shouldn’t they also share in some of the profits captured by fund managers?
PE’s influence in the economy
These trends contributing to inequality and economic instability related to PE are important to consider given the growth of the industry and rising influence over society.
A recent McKinsey study notes that the industry’s, “…net asset value has grown more than sevenfold since 2002, twice as fast as global public equities.”
It goes on to highlight that there was over 100 per cent growth in US PE-backed companies, from 4,000 in 2006 to over 8,000 in 2017, while public companies fell by 16 percent during that period (46 per cent since 1996) to 4,300. In the US, the industry is estimated to support 26 million jobs and directly employ eight to 11 million people.
The growth of the industry is both a threat and opportunity. It is important to note that not all PE strategies are dependent on or facilitate significant leverage, and compensation structures can be modified. Moreover, PE firms often have stronger control over their portfolio companies and investment structures than investors in other asset classes. As such, they are well-positioned to integrate strong ESG standards.
With institutional investors increasing their allocations to this asset class in a low-interest rate environment, they might consider PE strategies and fund managers who are willing to adopt more regenerative growth structures that can still help asset owners and allocators meet their required rates of return and avoid further contributions to systemic risks.
The future of PE
Professor Phalippou questions the industry’s future potential, particularly in light of his and other studies that suggest PE offers investors comparable returns to public equities. He points out that outperformance depends on whether returns are net or gross of fees paid by investors and carried interest, the benchmarks used, and financial analysis techniques.
The devil, of course, is in the details. Additional research shows significant fluctuation in performance between funds, particularly different types (both size and strategy) of funds. While a more granular performance assessment would require data distinguishing a number of characteristics, including fund size, strategy (e.g. LBO, growth, VC), size of portfolio companies, and geographic exposure, limited available information makes it difficult to conduct such analysis. If the industry could reform to be more transparent, it might be easier to see which types of PE outperform and use the appropriate benchmark in doing so.
Outperforming public equity may also be a matter of timing market cycles. Homogenization of returns between private and public equity could be the result of more capital flowing into the asset classes, competition for deals heating up, and resulting increases in valuations.
In a COVID-impacted low-earnings economy, legacy PE portfolio companies may perform poorly, and value creation and attractive exits may be hard to come by. On the other hand, the combination of depressed equity valuations, a proliferation of cheap debt, and an estimated $1.5 – $2.5 trillion in dry power (capital available to invest) could see PE firms take on an ever larger share of our economy and influence in society. If this trend continues, it is critical to engage the PE industry in reform so that it does not – as Professor Phalippou apprehends – further exacerbate inequality.
A new and improved private equity
Many conclude that there is no good case for the PE industry’s existence. However, even Professor Phalippou is not opposed to PE. He acknowledges that PE can offer benefits including diversification for investors, and that growth strategies and adjustments to investment structure (e.g. improved alignment of incentives) have strong potential to generate attractive returns for all stakeholders.
At the Predistribution Initiative, we have been advocating for some time – particularly as investor demand grows for ESG and impact investing – that responsible investors need to take into account how fund management and investment structures may be exacerbating wealth and income disparities, as well as systemic market risk.
In the post-COVID-19 world, the industry should do more to be self-reflective about its core practices. Examples we’re evaluating include, but are not limited to:
- Simple adjustments to the standard PE model, such as sharing carried interest / profits with portfolio company workers. Properly incentivising workers, particularly when combined with lower management fees for large funds, has potential to produce stronger investor returns while reducing systemic risk stemming from inequality.
- Reduced use of high-risk leverage and more patient and thoughtfully structured growth capital could help institutional investors meet their required rates of return, while also providing more support for companies and stability for our economic system.
- The industry needs to be more transparent. Less criticism and stronger co-creation of solutions are possible when more information is available.
Robust solutions require input from diverse stakeholders, from industry actors to workers and communities. Building back better depends on thoughtful co-creation of these solutions and many more.
Raphaele Chappe is an economic advisor and Delilah Rothenberg is the founder and executive director of the Predistribution Initiative