Does Private Equity Create or Extract Value?

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Hal Weitzman: Critics of private equity say that PE firms squeeze profits out of companies they take over by cutting staff, lowering quality, and hiking prices. Defenders say that PE makes firms more efficient, profitable, and resilient. So does private equity create or extract value, and who benefits? Welcome to “The Big Question,” the video series from Chicago Booth Review. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Amy Christensen is a partner and cohead of healthcare at the Vistria Group, a private investment firm based in Chicago. She sits on the boards of several healthcare companies and she’s a Booth MBA. Steve Kaplan is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth. He’s an investor in several PE funds and coauthor of the book “An Advanced Introduction to Private Equity.” And Constantine Yannelis is an associate professor of finance at Chicago Booth. His research on private equity has been widely cited, including by President Joe Biden in his 2022 State of the Union speech.

Panel, welcome to “The Big Question.” Constantine Yannelis, let me start with you because you’ve done some, as I said, some research on private equity that’s been pretty widely cited. So tell us briefly what you found.

Constantine Yannelis: Absolutely, so there’s a very large body of research showing that there are efficiency gains of private equity on average in a wide number of industries. And my research has focused on industries characterized by features like low levels of competition and high levels of product opacity, things like education and healthcare, where consumers can’t actually tell if the product is high quality. And what we’ve found is that in these industries where there’s a misalignment of incentives between the firm, the consumer, and the taxpayer, private equity can create value for shareholders to the detriment of consumers.

Hal Weitzman: OK, so what does that actually mean in terms of education and—

Constantine Yannelis: Oh, that means essentially buying up for-profit colleges and nursing-home facilities and the like, charging more, capturing more government subsidies, and having inferior outcomes for students and patients. For example, more students dropping out, lower earnings, and more reliance on government loans.

Hal Weitzman: OK, so in those particular cases you looked at—which were for-profit colleges and nursing homes—correct?

Constantine Yannelis: Yes.

Hal Weitzman: Then you found that the outcome for patients or students had deteriorated, whereas the outcome for shareholders was—

Constantine Yannelis: That’s exactly correct. So in these industries—and I want to be clear that this isn’t the case in all industries—but in these industries that are heavily reliant on government aid and where it’s very hard for consumers to judge product quality, for example first-generation college students, they may not know which colleges and degrees provide high returns. In these cases, profit maximization can come at the expense of consumers.

Hal Weitzman: But . . . got it. But to be clear, you’re talking about . . . when you said the product opacity, you’re talking about healthcare in general, education in general, that would be—

Constantine Yannelis: Exactly, yes—

Hal Weitzman: It could also be . . . it could be true for other—I’m just wondering—other healthcare facilities. It could be true for other educational settings.

Constantine Yannelis: Oh yes, and it could be true in other industries too. We’ve seen investment in sectors like infrastructure and defense spending. Which, also, it’s very hard to judge product quality, and it’s quite possible that there would be similar effects there and more research needs to be done there.

Hal Weitzman: OK, thank you. Steve Kaplan, let me bring you in because you’ve done a vast amount of research on private equity over the years. So I know it’s gonna be difficult to summarize that, but just in terms of this question of whether private equity adds or extracts value, what would your, kind of, be the top line from your findings?

Steve Kaplan: OK, the top line here is that in every large sample study that looks at buyouts, the buyouts make companies more productive. And this is across the board. So Constantine’s paper, you know, on the education, they made the companies more efficient. It’s just because of, I think, bad regulation, where the government allowed people to get student loans kind of indiscriminately. The private-equity firms made money, and the consumers didn’t do so well.

Hal Weitzman: Just to be clear, what does more efficient mean in an educational setting?

Steve Kaplan: More efficient would mean, you know, more profitable.

Hal Weitzman: OK.

Steve Kaplan: They made money. Now, the healthcare, I think Constantine way overstates the case. So first of all, in his paper, the companies that he looked at, the large deals that drive his sample actually lost money. So these are not . . . the typical buyout deal makes money. He’s looking at deals that lost money. He’s looking at private-equity firms that really no one’s ever heard of. These were . . . the drivers of his results are REIT kind of private-equity firms, so it’s a very specific—

Hal Weitzman: REIT? Do you mean real-estate investment—

Steve Kaplan: Real-estate investment. It’s a very specific and unusual result. I can tell you there have been other works on private equity in healthcare, and they don’t find the negative results. You do hospitals, for example. There are people who have looked at hospital deals and find, you know, nothing. There’s actually people who looked at the nursing homes in COVID and actually found that private-equity-funded nursing homes had lower fatality rates. So I think on the education thing, I think that’s a valid point. The healthcare, I don’t think so. And more generally, it’s just, it’s across the board. The results are that the firms are more productive, and that’s, you know, that’s why the private-equity firms have done so well. That’s why so much money has gone to private equity. Why has the money gone to private equity? Because the returns have been very high. And how do you get high returns? And this is something that is, like, really misunderstood, the view that, you know . . . and you had in your introduction where the private-equity firms go in, they cut, they hollow out the companies, which is sort of the Elizabeth Warren view. That just makes no sense because if you buy a company and hollow it out, you have to sell it. You have to sell it to somebody. You either take it public or sell it to a public company or sell it to another private-equity fund. And if you’ve hollowed out the company and you haven’t created value, you’re not gonna be paid. And the place where that maybe happened was in the nursing homes that Constantine looked at, and those investments were bad investments. That is not typical. The typical investment is actually quite successful.

Hal Weitzman: OK. So I’ll just let you respond quickly to this specific point before I bring Amy in.

Constantine Yannelis: Yeah, absolutely. The point that this is not typical on average in industries, that’s . . . I absolutely agree with that. In terms of healthcare, there are some studies that find other things. The issue is they’re worse quality studies in many dimensions. Namely, you have to control for patient selection. So both in education and in healthcare, one thing that institutions can do is change the students or change the patients that they’re looking at. So we have a strategy using differential distance of where people live, closer or further from a nursing home, so I think that’s why our study is higher quality in that regard. But I agree with the point. On average, there’s very good work by Shai Bernstein at Harvard, for example, showing that private equity increases efficiency in the restaurant industry. That’s an industry that’s characterized by high levels of product clarity and high levels of competition, right? If you walk into a restaurant, you know, if you like the food. You can tell if it’s dirty and cockroaches are coming out of the kitchen. So it’s really these industries where you have high levels of government subsidy, low levels of competition, and high levels of product opacity where you have these problems, and that’s what I focused on.

Steve Kaplan: Let me just add one counterexample to his: airports. Airports, you would think, are government, have government subsidies, have some of these problems. A paper by his coauthor, Sabrina Howell, just came out that found that private-equity investments in airports are incredibly productive. The airports get more productive. There’s lower wait times. They’re, you know . . . it’s just all positive in an area where there is a lot of regulation. So. Again, going back to my point, the . . . on average and the overwhelming evidence is positive. It’s not, you know, it’s not uniformly positive, and I think the education example is a good one, but it really is overwhelmingly positive. And what you read in the press or hear all the time, they pick out the negatives and they ignore the positives and, you know, I can give you a lot of positives, though my guess is Amy can give you some examples.

Hal Weitzman: Yeah, I wanna turn to Amy Christensen, but, and just to explain your earlier comment, Elizabeth Warren, Senator Warren is one of the people who has proposed legislation to clamp down on the activities or ability of private-equity firms to take over companies. Amy Christensen, you’ve got the industry expertise, so let’s hear from you. Maybe a more basic question: When you take over a company, a healthcare facility, what are you trying to do? What’s success for you?

Amy Christensen: Yeah, that’s a great question. So any time we go in, we think about a long-term value-creation planning strategy. Even before we make an investment, we’re partnering with management teams to outline what that looks like. And certainly, operational efficiency is going to be a part of that, and I do think, to Steve’s point, that drives value. But we’re also looking at what’s the impact that we’re making because we actually believe in the companies and the specific verticals of healthcare we invest in. If you’re providing scaled access to high-quality healthcare that’s getting good outcomes at a reasonable cost, your company will be more valuable. So it’s in our interest to make sure that the companies that we’re working with, we’re working on a plan on how they’re impacting their key stakeholders, inclusive of the patients, the health plans who pay for it, and the communities that they serve as well.

Hal Weitzman: Now how do you . . . so I guess my question is: How do you balance efficiency, which often means cutting costs—usually means cutting costs—with improving outcomes for patients?

Amy Christensen: Yeah, I think we’ve demonstrated that we can do both. Our returns have been really, really phenomenal, but I think we’ve built really great businesses that are serving patients and getting good, high-quality outcomes, which are measured in the industries that we invest in. People keep very tight track on what quality outcomes look like. I also think the function of how companies get valued, it’s EBITDA, yes, which goes to operational efficiency and growing EBITDA and doing all of those things, but we also have a multiple that gets paid on that EBITDA. And I think that multiple factors into some of what Steve is talking about, which is if you’ve gutted a company or if you’ve smashed a bunch of companies together to get EBITDA, no one’s gonna pay you a high multiple for that. You really have to systematically figure out how to integrate companies, build out corporate infrastructure processes, systems that someone says, “Yes, I would like to “make that investment. I would like to “pay a high value for that because I can see “that it has long-term sustainable value.”

Steve Kaplan: And let me . . . I’m gonna jump in on that. When you survey private-equity funds, and I’ve had two papers, you know, one 2012 survey, one a 2020 survey, and you ask the private-equity firms: When they make an investment, where do they expect to get value? Cost cutting is a distant second. The No. 1 place where private-equity firms look for value is growing the business.

Amy Christensen: That’s right.

Steve Kaplan: By a wide margin. And leverage is a distant third, after the efficiency. So you know, to Amy’s point, you can, you know . . . if you grow cash flow by cutting costs, it’s good, but you’re not gonna get paid for it. You get paid if you can increase the growth trajectory of the company, and that is what they’re very much focused on.

Hal Weitzman: OK. So I was wondering if there was a contradiction between building a company for the long term, where you would really buy it and hold it and own it, as opposed to building it for a point at which you’re gonna exit, where you sort of want that to be the maximum value point? But you’re saying that there’s no contradiction between the two. The one leads to the other.

Constantine Yannelis: This is something that is often claimed, that there are short-term strategies in private equity. My sense is that there’s very little evidence of this. Moreover, a lot of the exits are to other private-equity funds and that, to me, suggests that there is some, at least, medium-term to long-term value because you’re convincing other sophisticated investors that there is a value proposition over at least the medium term.

Steve Kaplan: And I can give you a good example. I wrote a case on a company. It was a buyout of a food company called Columbus Foods, and the—Columbus was a family business—private-equity firm bought it, sort of, you know, professionalized it, then they sold it to another private-equity firm, Arbor Investments. And Arbor’s run by a Booth alum, Greg Purcell. And what Arbor did was they actually invested quite a bit of money in new plants and they took what was a regional brand and they nationalized it. Created a lot of value. EBITDA went up, but the value was that it was nationalized now or, yeah, geographically nationalized. And then they sold it to Hormel, and now Hormel runs it and Hormel brings, you know, additional efficiencies because they have, you know, they have a lot of meat, and it’s a meat business. So it went from, you know, family to private equity, professionalized value increased, to another private-equity firm, nationalized it or brought it national, created value, to a strategic acquirer who created additional value. So you see the value chain. And it’s growth. It wasn’t cost cutting.

Hal Weitzman: Right. Given all this, it all sounds very positive, Constantine Yannelis, and your research is not so positive. So I’m just wondering, is it—and you said it’s very specific to these industries, which are opaque, which have government subsidies—how generalizable, even within those industries, is your research and how generalizable is it across the economy, do you think?

Constantine Yannelis: So one takeaway that people often take from my research is that private equity needs to be regulated more as a whole or banned from certain industries. That’s not my personal view. My view is that private equity is very good at increasing efficiency for shareholders. In some cases, there can be a misalignment of incentives between shareholders and customers, often through government programs and regulatory incentive schemes. My view is that, particularly in cases where there’s a lot of government subsidy, the government needs to work hard to make sure that subsidies and other payments are aligned with the incentives of consumers because that’s where the problem is. And Steve is absolutely right: there’s very good work showing that in airports, a lot of outcomes improve for the consumers. But we don’t see that in education. My view is that, at least in the nursing-home sector, we don’t see that in healthcare. And the takeaway is not that private equity should not be allowed to make acquisitions. The takeaway is that there are these incentive problems, which are probably present across all ownership classes. Private equity is just much better at exploiting them because they’re generally more efficient in terms of profit maximization. So I think the sectors where we have problems from private-equity acquisitions shed light on those sectors more generally, and the government should work harder to reform incentive structures there.

Hal Weitzman: OK. And to be fair to Joe Biden, when he mentioned your research, he didn’t say we want to ban—

Constantine Yannelis: Absolutely.

Hal Weitzman: —private-equity firms from taking over, but he’s suggesting perhaps there’d be some smarter regulation of the outcomes, in a way that I’m guessing you would be perfectly happy with—

Amy Christensen: Yes.

Hal Weitzman: Amy Christensen.

Amy Christensen: I think that’s right and I think it’s challenging to extract one very small subsector of healthcare to the broader healthcare industry. It’s a multitrillion dollar TAM. It’s a very big category. The reality is most of healthcare operates under what we’re calling the shift from fee for service to fee for value, and what that means is that a lot of people who provide healthcare in this country are now going to be paid on the outcomes that they generate. And so, from a private-equity perspective, we’re always looking for the companies that are doing things quote, unquote the right way because ultimately those are the companies that are gonna get the reimbursement dollars from the government and those are gonna be the companies that grow and are profitable. So we have clear alignment of incentives, at least in the subsectors of healthcare that we invest in. You know, getting to good quality outcomes, you’ll get paid for getting to good quality outcomes, and so everybody’s sort of rowing in that direction, and we’re very supportive of that.

Hal Weitzman: OK, Steve Kaplan, you’re not a big fan of more regulation, but you did say in this, in the case of education, you feel there was a regulatory—

Steve Kaplan: So education, and I think they changed some of those regulations so that, you know, does not happen any longer. I think, going back again to the healthcare, the nursing-home businesses, those investments lost money.

Amy Christensen: Right.

Steve Kaplan: And that’s key and that’s not something that’s in his paper and that’s important. If . . . the education, they made money, and so there, it’s a real good example. The nursing-home thing, they won’t do those deals again, even under the current regulatory environment, because they lose money. And the deals Amy’s doing, they make money because they’re creating value, and you get paid for that.

Hal Weitzman: So just to be clear, just to be clear, you don’t think there’s any need for more regulation based on the outcomes for students or the outcomes for patients?

Steve Kaplan: I think the students, there was a problem—

Hal Weitzman: But you . . . that’s been resolved.

Steve Kaplan: And that’s been resolved. And healthcare, again, you know, got this one little example. Most of healthcare, it’s actually, the results are more positive. So I’m not, you know, I wouldn’t be convinced on that.

Hal Weitzman: So I’ll just come to you quickly, Amy.

Amy Christensen: I would just add, in a company level, if you’re not providing good quality care, you’re not going to stay in business for very long, right? You might be able to do that in one location, but you’re certainly not gonna be able to grow in scale unless you’re providing those good quality outcomes.

Steve Kaplan: And then, again, and selling it, again, someone buying it is gonna see that, and you’re not gonna be able to make money, which is what happened in the nursing-home deals. It’s—

Constantine Yannelis: Well, one problem, to push back against that a little bit, one thing that you’ve seen, both in the education and the healthcare sector, is essentially rebranding. And especially a lot of private-equity funds, they own a lot of different brands. There’s a scandal with one for-profit college because authorities or the media figure out that outcomes are terrible and then suddenly effectively the same institution pops up with a different name. And one thing that we’ve noticed in our research is that these schools spend much more money on sales and advertising relative to other institutions. So I think that is the core of the problem. You have a lot of misinformed consumers relying on government subsidies, and PE funds can take advantage of that. So I agree with . . . I’ll push back a little bit against what Steve had said. I would say that things have gotten better in the education sector. I wouldn’t say that the problem is solved, and I think the government can do a lot more in terms of tying profitability to actual student outcomes in a very smart way because it’s actually a very hard problem because some students are just more challenging than others, and you don}t want to discourage schools or healthcare providers from not taking on those challenges.

Hal Weitzman: Mm-hmm. I wanted to ask you a more macro question about private equity, more generally, is playing a bigger and bigger role in the economy. Is that, is there a natural limit to that? I mean, it’s grown exponentially. Is there a kind of a natural point at which there are a certain number of private-equity-owned companies and there are a certain number of public companies, or is there no real limit?

Steve Kaplan: So I mean, that’s a really hard question to answer. I don’t know the answer to that. I can tell you the forces that have pushed that are No. 1, you know, I think the private-equity model is more efficient in terms of creating value and the creating value, increasingly, is from growth, which we talked about. No. 2, the regulation on the public side has gotten increasingly onerous. So if you’re at a public company, you know, you have to spend a lot of money on compliance, a lot of money. Sarbanes-Oxley, which is, you know, auditing, you’re . . . you know, you have to deal with ISS, which is, you know, Institutional Shareholder Services, which pressures you. You have activists. It’s actually very unpleasant relative to 30 years ago to be running a public company. On the other hand, you go run a private-equity-funded company, you don’t have to deal with a lot of that, plus you get help from the private-equity firms who have invested a lot. And this is something that is, probably the last 10 years, has really accelerated. Most of the private-equity firms, and Vistria is one of them, have operating partners or people with operational expertise, not just the financial engineering deal people. And those people, they have, you know, real skills in helping the companies and adding value to them, whether it’s, you know, digital transformation, whether it’s help with sales, whether it helps with cost cutting, and you get real help as a CEO if you go work for the private-equity fund. So if I’m a, you know, a talented CEO and I have a choice, public company or private-equity-funded company, other things equal, I’m gonna want to work for the private-equity-funded companies because they also, actually, on average, get paid more than a similar size public company because there’s value creation. So I think all those factors have been a tailwind for private equity. And, you know, will that continue? I don’t know. There’s, you know, depends on regulation from what happens from the government. So the SEC has proposed actually very onerous and costly disclosure on climate, potentially, and so you put more costs on being public—

Hal Weitzman: That may apply to private companies as well, so—

Steve Kaplan: It will be, but it’ll be less onerous on the private companies than on the public companies. And that, again, all these things that are more onerous for public companies help private equity.

Hal Weitzman: Do you have a view, Constantine, on, like, the sort of natural limit of private equity?

Constantine Yannelis: I mostly agree with Steve here. I think it’s not obvious what the natural limit is, and it’s a hard question to answer. I don’t think we’ve reached it in the current climate, but I strongly agree that a lot of these factors, particularly regulation, are hard to predict. And that could lead to effects in either direction. If there’s more regulation on public companies or on private equity, that could cause the industry to shrink or grow.

Hal Weitzman: OK, shrink or, Amy, I was going to ask: Do you or your colleagues ever take a company private and then think, “Oh, we won’t sell it to another PE firm; we’ll take it public?” Does that ever happen or are those days gone?

Amy Christensen: We haven’t done that, but what I would say, building off of the points that have been made here, is the other difference with a public company is the timeline. You are needing to meet or beat earnings every quarter, and that means, if we’re talking about long-term value creation, you can’t necessarily make decisions around the investments that are good for the long term because you’re managing to short-term earnings, and I think that the luxury that we have in private equity is, candidly, a longer timeline. We can make investments in technology. We can make investments in people, if we believe that those are the investments that’ll pay off over time. And so, for that reason, I think private equity continues to be an attractive place for CEOs to come and for companies to sort of think about because they have less regulation on the public side—

Hal Weitzman: And that’s a really significant driver in your mind.

Amy Christensen: I think it’s one of the factors that allows the private-equity model to be more oriented toward long-term value creation than a public company.

Hal Weitzman: So the only thing that would change that, as Steve said, is if private companies had to report more, public companies had to report less.

Amy Christensen: I mean, certainly that would be a factor, but I think you don’t get rid of the fact that, with a longer time horizon, you’re able to make some strategic decisions that might require short-term earning dips. Sometimes what we do is we take the EBITDA down because we think that’s the right thing to do. We would think those are the right investments to make in order to take the EBITDA up over time.

Hal Weitzman: Mm-hmm, OK. I wanted to turn to a controversial topic about private equity, which is carried interest. Steve Kaplan, carried interest has been attacked by lots and lots of people who say that it’s basically a way for private-equity partners to avoid paying taxes by characterizing their income as capital gains rather than as what the rest of us would consider to be income, and thereby, you know, cutting their tax in half or whatever. What’s the defense for the current system?

Steve Kaplan: So the, so, and the carried interest is the 20 percent profit share that private-equity firms get on their funds, so they get 20 percent of the profits, and it’s taxed today as capital gains rather than ordinary income, and so, on a theoretical basis, you can argue it both ways. So if you’re an economist, you can say, “OK, it’s a long-term investment. They have to hold it “for three years, so it should be capital gains.” On the other hand, like, it’s their job, right? So they’re, they should be paying ordinary income. And so, you know, it could go either way, and I think that’s why people discuss it. As a practical matter, here’s why I think, you know, you’re better off leaving it alone. Because if you were to change the rules and tax it as ordinary income, you’d actually be hurting the venture capitalists more. The venture capitalists would have to pay ordinary income on their gains and, you know, that would be what would happen. The private-equity funds, because they create new companies when they make their investments, will have ways to get around it, legally. As long as there is a difference between ordinary income and capital gains tax rates, which they’re not talking about eliminating, private equity will be able to structure around it. And so what you will do in the medium run, if you change this law, is you will penalize venture capitalists and you will actually make . . . the private-equity firms will actually be better off, and you will hurt the limited partners.

Hal Weitzman: And your point there about venture capitalists is what? That would hurt entrepreneurship or innovation or—

Steve Kaplan: So you’re gonna hurt that and you’re gonna hurt your LPs and the private-equity firms will structure around it.

Hal Weitzman: OK. Constantine Yannelis, you have a view on this?

Constantine Yannelis: If I were designing a system from scratch, I probably would not introduce this tax absorption from the carried interest. Having said that, again, as a practical matter today, I don’t think eliminating the carried interest tax deduction would raise much revenue for exactly the reasons that Steve said. I think it would lead to funds spending more time focusing on tax advantages and accounting gimmicks rather than creating value. So I think this isn’t such a big deal in terms of raising revenue and—

Hal Weitzman: Well, I think it’s done more for the sense of injustice, isn’t it, for the sense of there not being a level playing field, rather than necessarily being a revenue raiser. I mean—

Constantine Yannelis: Well, I—

Hal Weitzman: Doesn’t any tax change get the argument that the people will go around it? I mean, isn’t that by definition—

Constantine Yannelis: Look, I care about incentives and raising revenue from taxes. You know, a lot of people think it’s unjust that billionaires don’t pay 95 percent tax rates. Of course, that’ll be bad policy because they would all be . . . move to Switzerland or the UK, so—

Steve Kaplan: Or they wouldn’t have invested in the first place.

Constantine Yannelis: Yeah, no, exactly, that’s an even bigger point. So I care about efficiency and raising revenue, as an economist, not a sense of justice and the popular opinion.

Hal Weitzman: OK. Well, this has been a fascinating discussion, but unfortunately, our time is up. My thanks to our panel, Amy Christensen, Steve Kaplan, and Constantine Yannelis. For more research, analysis, and commentary, visit us online at chicagobooth.edu/review and join us again next time for another “The Big Question.” Goodbye.