Chicago Booth Review Podcast What’s So Bad About Private Equity?

Steve Kaplan: Fifteen, maybe 20% of the economy, but it's a decent chunk of the economy is controlled or touched in some way by private equity.

Hal Weitzman: Private equity has a bit of a PR problem. If you heard that your company was being taken over by a private equity firm, you might well start worrying that job cuts will be coming soon, and the quality of work will be sacrificed in order to squeeze out more profits. But is that accurate? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I'm Hal Weitzman. Chicago Booth's Steve Kaplan is a world expert on private equity, and he thinks it's often unfairly depicted in the mass media. Kaplan notes that rather than cutting jobs and harming outcomes, PE firms frequently invest and grow companies more effectively than other owners. But does that justify their big fees? And could companies take the same actions without being taken over by private equity? Steve Kaplan, welcome to the Chicago Booth Review Podcast.

Steve Kaplan: Thank you for having me, Hal.

Hal Weitzman: Well, so we brought you here because we wanted to talk about a topic that I know you've done a lot of research on, private equity, which I think it's fair to say, Steve, doesn't have the best press, right?

Steve Kaplan: Certainly there is some controversy indeed

Hal Weitzman: Okay. Well, let's dig into that. First of all, remind us for those of our listeners who don't quite grasp it, what is private equity?

Steve Kaplan: So private equity is basically investments in private companies, and it has a wide variety actually of things that it encompasses, but it's known for one thing. So venture capital is a form of private equity because it's investments in private companies.

Hal Weitzman: Okay. So those people who give a few bucks to their son or daughter to start up a company, or whoever, they're friends-

Steve Kaplan: Well, venture capital, I not sure about that. SpaceX would be, or Tesla or Facebook would be venture capital. So venture capital is private equity in startups. Then there's growth equity, which is when the companies have made progress, things are going well, they need more money. That's what we would call growth equity, again, in private companies. And then where people really refer to private equity, I think is leveraged buyouts or buyouts of companies. And I think in the negative press part of the world, it's on the buyout side.

Hal Weitzman: It's all about that. It's not about the startups.

Steve Kaplan: Venture capital does... People tend to be pretty friendly to the Amazons, the Googles, although there's some controversy now that they've gotten so big, but venture in general is well regarded, and it's the buyouts that people, I think, have mixed feelings about, and there's certainly some people who are quite negative about them.

Hal Weitzman: Okay, well we'll get into that. So give us an example of what would be a typical private equity deal. Is it taking a company like a family company and taking it private, or is it taking a company that's been public private? What does it look like?

Steve Kaplan: So the buyout market really has several manifestations. So one is where you take a company private. So it's a public company, you go and you buy it, and then it becomes private and private equity owned. I wrote a case last year about Univar, which was taken private by Apollo. And that would be one example. Then you've got companies where, let's say, it's family run, it's private, and the family wants liquidity or doesn't want to run it any longer. And then the private equity firms will invest in those companies or buy those companies. So they're already private, but they've gotten money from the buyout funds or the private equity funds. And then they will be basically private equity owned.

Hal Weitzman: So that's what you'd call private to private.

Steve Kaplan: That's private to private. And then there's a third that is carve outs from public companies or private companies, it could be any companies, but where it's a division of the company. The company, for some reason, doesn't want to keep owning it and decides to sell it. There's one that I'll talk about later, TaylorMade, which is the golf company, which a lot of people probably recognize, was owned by Adidas. And it was losing I think a hundred million dollars a year. Adidas sold it to KPS.

Hal Weitzman: Okay. And so of those three scenarios, the carve outs, the private to private, the public to private. What's the most common?

Steve Kaplan: I think the most common by number is the private to private. Actually there's a fourth, which is private equity owned to private equity owned, which would be a fourth. But of the three generic ones or first ones, I would say in terms of number, it would be the family or private to private. In terms of dollars, it would depend on the year, but there are fewer public to privates, but when they happen, they're big deals.

Hal Weitzman: Okay. So just tell us, I know you're an expert on the history, but just give us a brief overview of, for people who haven't really been following this, what is the history of private equity? How fast has it grown?

Steve Kaplan: So the history goes back to the 80s. Where it started KKR was the real innovator. KKR started by buying companies and many public companies that were well-known [inaudible 00:05:57] RJR and taking them private. And in those days the leverage was something like 90%, it was 85, 90% debt, 10 or 15% equity. So they were known as leverage buyouts and they were really leveraged. And those deals did very well for a while. And then in the late 80s they got too leveraged, and many of them failed, and you had a debacle in the... Or not failed, many of them went bankrupt and had to restructure. And that's another point. When you go bankrupt doesn't mean the company is disbanded, it means you restructure the debt, and generally the companies live on.

And then in the 90s it grew a little bit, but the real growth has been since the early 2000s, and it's been, I think there was maybe, I want to see if I have my numbers right. In the early 2000s, and this is private equity, private capital in general, of which buyouts is the biggest fraction, it was under a trillion dollars under management. And today it's somewhere over 12 trillion. So it's grown by a factor of 10, 12 times. And the buyout market probably is, roughly, I think half of that. It's grown quite a bit.

Hal Weitzman: Okay. So can we say what part of the US economy is private equity?

Steve Kaplan: Well, part of the company's in buyout. So I've estimated that if you look at how much money is allocated to buyouts each year in the United States and then make some calculations about leverage, how it's deployed, you come to a number that buyout funds control somewhere around 10% of the US economy. And then if you tacked onto that growth equity venture capital, there's also real estate private equity, you'd be somewhere, 15, maybe 20% of the economy, but it's a decent chunk of the economy is controlled or touched in some way by private equity. And buyouts would be, I would guess 10% would be my best guess for buyouts.

Hal Weitzman: So this is a big part of the economy. It's obviously important. It's obviously still growing pretty fast right now. And as we said at the beginning, the growth has come with this negative popular perception. I know you take a dim view of that criticism, so I'll get into that. But maybe just as a general point, what do we get right and what do we get wrong? And when I say we, I mean the popular view about private equity.

Steve Kaplan: I don't know... If the popular view is negative, I don't know that it gets anything right. I think perhaps what it gets right is that the popular view, I think, is the view that private equity goes in, they cut jobs, they got the company and then the company fails. And that's just almost completely wrong. The only part that's not wrong is yes, some companies fail. But that's true of public companies. Companies fail, companies fail all the time. Some companies succeed, some companies fail. I think the thing that's a complete misconception is that you can go into a company and gut it and then still expect to make money, because the way you make money in a buyout or any transaction is you create value and then you can sell it to somebody else, or you might continue to reap that value if you don't sell it.

But if you sell it, somebody's got to buy it because there's value there. If you go into the company and just gut it and there's nothing left, well you can't sell it, and you will lose money. And most of the examples, when you see the negative examples in the popular press, those are often the companies that failed. So Toys R Us gets a lot of press because the company actually, when it defaulted, actually went out of business. It's a very unusual outcome. Because the typical outcome is actually a successful deal, the press, and I think part of the negative reaction comes from deals that fail. You can point to, "Oh, it failed because it was bought out." And that tends to attract a lot of attention. What they tend not to see is all the deals that are successful, and those don't get a lot of attention.

Hal Weitzman: So you think it's just an issue that it's not newsworthy when things go well, it's only newsworthy when things go badly, and people can blame PE for that?

Steve Kaplan: I think that is a big part of it, yes.

Hal Weitzman: Okay. So tell us, you talked about creating value, and that makes sense. I guess the criticism on one hand is that private equity firms are full of fat cats who go in and make ridiculous amounts of money. And so if that were the case, if that criticism is true or if that perception is true, then they would have to be successful. So I take that point that they can't be unsuccessful and still be making a lot of money. So that makes sense. But tell us, more realistically, what does happen when a private equity firm takes over a company? Let's go particularly for the example you talked about. If you say private to private deals are the most common, and a private equity company takes over a company that has been privately held but not by another private equity company, what typically happens? What's the next steps?

Steve Kaplan: So When... The buyout firm goes in and looks at the company to buy. They are generally looking at the deal with some other potential buyers. So there's competition here. And in order to buy the company in what is a competitive market and still make money, you have to change the company, you have to improve it. And so when a buyout investor looks at a deal, they're looking, "Okay, what do I have to pay? And then what can I do with the company in order to make it better?" Generate... Make it better, means grow it, and usually generate more profit out of it. "What can I do in order to make it more valuable?" And some of the levers that they use, I'll give you some examples. I was a judge for many years of a deal of the year competition. And so these were the successful deals.

These are not the unsuccessful deals that the press tends to focus on. And you looked at what they did with the companies, and what... At least a quarter of the deals, and often more than half, what were the things they did? They would bring in new management. They would create new products. They would invest in new plant. They would change how the company did sales. They were doing things that had to do with growth rather than this view, they were gutting the company. Now they also, to some extent, did get more efficient. So getting more efficient is cutting costs. So that was part of it, but it was all these other things that were designed to grow the company that you saw in these successful deals. And then when you ask... I also did a survey a number of years ago, actually survey in 2020 and also in 2012 of a lot of private equity firms, roughly somewhere between 40 or 50% of the capital in the industry responded to the surveys.

And we asked them, "When you invest in these companies, what do you try to do to create value? Do you cut costs? Do you replace management? What do you do?" The number one thing that they said, the thing that was most important was growing revenue. So when they go in, they're not looking... Cutting costs is okay because it increases your profits, but the way you create value is by growing the business. Because when it comes time to sell, what is your value based on? Your value is based on what are your earnings today and how much are they going to grow over time? And so if you can increase that growth rate, you increase the value by quite a bit, more than you do if you cut costs. So that's the thing that is not so well understood, that they really... You get paid for growing the business, not gutting it.

And a few examples, again, you have these negative examples out there of deals that didn't go well, and that's what gets reported. In some of the books, there are books in the popular press, they all look at the same deals. It's the same three or four deals that get repeated time and time again. So let me give you some good ones. There was a company called Aldevron that EQT and I think TA bought. And that business, they transformed into a manufacturer for MRNA vaccines. And the value went from 3 billion to 9 billion while they owned it. And that company was a big supplier to the vaccine manufacturers. Well, did you ever read about that? I don't think so. That's part of the reason we have vaccines is because of a private equity investment. There was another one, [inaudible 00:16:06] which also was a big supplier to the vaccines.

Actually, Danaher, which is a well-known company, ended up buying Aldevron. TaylorMade, so I was talking about that earlier, TaylorMade, which if you're a golf fan, you see TaylorMade, somebody's wearing the TaylorMade logo in every foursome probably, that business was losing a hundred million dollars under Adidas. KPS bought it, and by the time they sold it, I think it was making 150 or 200 million dollars a year. And what did they do? I think they had some retail outlets. They got rid of it. They brought in new products. They changed how they marketed it. And they turned a big money loser into a big success, which is now a very well-known brand.

Hal Weitzman: Carry the two is the show that pulls back the curtain to reveal the mathematical and statistical gears that turn the world. Co-hosts Katie Witkowski and Ian Martin bring unique perspectives from the fields of mathematics and statistics to convey how mathematical research drives the world around us. With each episode tackling a different topic, subscribe to Carry the two, part of the award-winning University of Chicago podcast network.

So Steve, you talked about three levers that PE firms pull when they take over a company. One is management, one is efficiency, and one is investing for growth. I guess the question is why couldn't they do that as a public? Why couldn't the company do that as a public company? Does it have to be private? Is there something they can do privately that they couldn't do publicly?

Steve Kaplan: So this is a question people always ask, and the private to privates, maybe they're not big enough to go public. Maybe you don't want them to go public right away because they don't have the systems in place. The ones where it's a public to private, that's a harder question. I would say there are a couple examples, or not couples... There are a couple of answers to that. Number one, in some cases they could do it as public companies, but they don't. So why don't they? Maybe you don't have the right management. Maybe you don't have the right incentives. And one of the things that private equity firms do is they give very strong incentives to their management teams to grow the business and grow value. I think a third thing, which is I think true in some cases, is it's hard to make big changes while you're public and have the markets understand what you're doing.

So the example of that, I think Dell is an example of that. Michael Dell thought the company should go in a particular direction. He would do it, the stock price would go down, he'd get complaints from his investors. And so he said, "I'm going to take the company private." He took it private, he made a lot of changes to that business and got it to where he thought it was in the right place. Then he took it public again. And as we've seen recently, that's done spectacularly well. So I think there are some cases where it's hard, if you make big changes, particularly changes that are going to cost in terms of revenues and cash flow, you may have a harder time doing that as a public company because you will get press that'll say there are problems, and you have some chance of, I think, affecting employees and potentially customers. So that third one I think is not true in every case, but it's certainly true in some cases.

Hal Weitzman: Okay. I wanted to take you back to the media coverage of private equity, because obviously... You talked about the media tend to focus on cases where the company "failed" or went into bankruptcy or whatever, but even in the cases where companies are financially successful, some of the press coverage, at least negative press coverage has been about poor outcomes that come from private equity ownership. I'm particularly thinking here of hospitals and care homes and colleges where you get things like higher patient or customer costs, or more student loan defaults, or patients get more hospital acquired conditions or infections or they fall more. So those are the kinds of things that we've heard about. And the headline would be whatever, "Private equity nursing homes basically have higher mortality rates," or whatever. What about those cases where the financial outcomes are good, but the outcomes for patients and customers are not so good?

Steve Kaplan: So first of all, though, in the nursing home paper to which you're referring, which has got a lot of attention, and it was... One of the co-authors is a colleague, those deals did not do well. So that's the thing that's a bit misleading. And the result they found is that in nursing homes that were private equity owned, the outcomes were worse. Those deals, I went and looked at the deals that drove their results, those deals lost money. And they were actually done by, in some cases, real estate private equity, which is a little different from the buyout firms we've been talking about. So those were mistakes. And what they write in the papers, "Oh, you can make money even if you do something that's socially harmful," well, they never showed that those deals made money. So I discount that paper in that regard.

I think there are some other papers, the education paper, I think there's a stronger argument that on the for-profit education, some of those deals did make money, and they ended up having people take loans who shouldn't have. And that's the case where are the private equity firms doing things wrong or is the regulation wrong? Well, the regulation has been changed subsequently and now it's very hard to do that. The nursing home example I think is not a good example because they didn't make money. The education one took care of itself. And then the healthcare papers, there are some healthcare papers out there that purport to find negative results. And I think when you look at them carefully, first of all, if people find no results were positive results, they tend not to publish. So you tend to get this selection bias in what gets published.

And even what gets published, this paper that I think got a fair amount of press that found the following, that after private equity firms take over hospitals, they find that the number of falls and I think infections go up. Okay, so now you say, "Oh gee, that's bad." Well, at the same time they find that fatalities actually are flat or go down. It's in the paper, it's not what the press reported, the press reported just the falls and the infections. So the fatalities actually, which is probably what you care about more, really bad outcomes, those were actually flat or better, number one. Number two, and the thing that's more problematic in that paper is all the action in terms of the change that they find is from the year before the deal to the year of the deal. Meaning... And if you look at actually three years before the deal to one year after the deal, both sets of hospitals look exactly the same in terms of falls and infections.

The only difference is the year before the deal, the falls and infections in the buyout hospitals are actually lower. And then in the year of the deal, the falls and infections are the same. Well, it's kind of hard to believe that the falls and infections go up in the year of the deal, because half of those deals happen in the second half of the year, and there's hardly time for anything to change. The deals that happened at the beginning of the year, maybe. But it's a very weird result that it happens in year zero and then nothing happens after that. So that result, which got a lot of attention, I discount. So you have to be very careful with these papers. And there's a summary paper of private equity deals in healthcare that basically finds the results are mixed overall. And with a publication bias for results that are negative, I would say the evidence there is not particularly convincing overall.

Hal Weitzman: It sounds like people, you think, cherry-pick-

Steve Kaplan: Absolutely.

Hal Weitzman: ... their data. So if you think that the-

Steve Kaplan: Because you get attention if you have a negative result.

Hal Weitzman: So if the media are also reporting things that are negative and not positive, it sounds like academia's often doing the same thing.

Steve Kaplan: I think you're more likely to get a paper... Let's put it this way. If you write a paper where you get a significant result, you're more likely to get it published than if you don't have a significant result. And I can tell you, people, I've heard from people who, "Yeah, I looked at that, I got nothing significant, so I didn't publish it." And again, let me just be clear too, I didn't say a couple of things which are worth saying. On the large sample evidence, where you look at large samples of buyout deals, and you look at winners and losers, and you aggregate over a lot of deals, you invariably find productivity improvements or efficiency gains or cash flow gains. So there are winners, there are losers, but invariably you find overall, or on average, the results are positive. You can always find negatives.

And what you want to know is over a large sample, do the positives outweigh the negatives? And again, that is common sense. You don't make money unless you get positives. And now the next thing that also is a bit misleading out there is what the performance of the buyout funds has been. So in... There's some, you read this every so often or regularly in the press, because it gets pushed by, there's a professor at Oxford who pushes this, is that private equity has performed the same as public markets. And looking forward, I can't predict what will happen, but looking backward, looking at the buyout funds, net of fees, they've outperformed public markets over the last 20 or 30 years. And post the great financial crisis, venture capital has also outperformed the public markets. And so the view that that's not the case is also something that's wrong.

And I think what some of these people do is when they look at private equity on the performance side, they'll stick in their real estate, they'll stick in their infrastructure, they'll stick in their natural resources, and then they'll compare that to the S&P 500. Well, you shouldn't be comparing real estate performance to the S&P 500. You shouldn't be comparing infrastructure to the S&P 500, or natural resources, which would be energy, to the S&P 500. There are other indexes that you'd rather compare it to. For buyout funds, the S&P 500 or the Russell 2000, that's perfectly appropriate because you have a large sample of companies. So if you compare apples to apples, you find that net of fees, the performance has been very good, which by the way means gross of fees the performance has been terrific. And the private equity firms or the buyout investors take some of that performance and that's why they make a lot of money. Because the performance is actually there.

Hal Weitzman: So it seems you're talking about fees, because that is a big area that people would say even if they do better, that the fees they take are outrageous. Are the fees reasonable? Just maybe remind us how to PE firms get paid in the first place.

Steve Kaplan: So the fees, this is true, this is true in venture, it'd be true in growth equity, be true in buyout. It's a little bit... The levels are a little bit different in some of the other asset classes, but there's usually a management fee. So if you raise a fund that's a billion dollars, there's a management fee, that's one and a half to two and a half percent, call it 2%. So you get a 2% management fee, which on a billion dollars would be $20 million a year, and is sizable relative to what you'd get managing public money. And then they get 20% of the profits. So if a billion dollar fund turns into $3 billion, which would be a good performer, they'll get 20% of that 2 billion profit, which is $400 million. So you can make quite a bit of money for this, and that's where the market has been since it really started. And net of fees, the performance still beats the public markets, and that's why they've been able to continue to raise money with those fees. But the fees are substantial.

Hal Weitzman: Yeah. Okay. But they're substantial, but you're saying even after the fees, everything is going, everybody benefits.

Steve Kaplan: Even after the fees, looking historically, everyone has done well.

Hal Weitzman: Except there are efficiencies as you point out. So some people lose their jobs.

Steve Kaplan: Some people lose... Again, this is where-

Hal Weitzman: Lose their jobs with public [inaudible 00:30:40]

Steve Kaplan: Some people lose their jobs with public companies when there's an acquisition. So in fact, I think with acquisitions, if a public company buys another public company, which might be the right comparison actually for a public to private deal, because the alternative for a public to private deal is probably the company being acquired by another company. I would guess the job loss is greater in an acquisition than it is in a buyout.

Hal Weitzman: Take private. Okay. Interesting. So you are very bullish, obviously, on private equity. So it sounds like it's a good thing that it's such a significant part of the economy. Should it be a greater part of the economy if everything is more efficient, more profitable, more growth? That's a good thing, right?

Steve Kaplan: I think this comes back to the question you asked earlier, could they do it on their own or not? Some companies are well run as public companies or as family run companies, and private equity doesn't necessarily make sense for them. Some companies need the help. I should say the other thing that the private equity firms have done over time, which is a real change, is back in the 80s and the 90s, they didn't necessarily go in with a thesis, "I'm going to make these changes," and they also didn't necessarily help the companies with those changes.

What's changed is today most of the buyout firms have operating partners or operating advisors. They've got people affiliated with them who are actually executives and have industry experience, they may have functional experience. And in many cases they actually help the companies make changes that they think should be made. And that wasn't true 20 or 30 years ago. I think they have to do it now because it's gotten more competitive, and you have to add value in some way. But that's the thing that I think is useful for some companies. And again, some companies who are already doing what they need to do and are run well or don't need a strategic change, then a buyout where private equity is not necessary for them.

Hal Weitzman: But do you see private equity continuing to grow at this pace?

Steve Kaplan: The answer... I don't have, I don't have a strong strong opinion on that. I think it depends on a number of things, depends on whether their capabilities are sufficient to help enough companies. I think it also depends, to some extent, people look at the historical returns, whether they're beating public markets, and if that should change, and it may change, the deals they did in 2020 and 2021, there was a lot of buyout activity in 2020 and 21 at what look today like high prices. And so those returns for those funds may very well not beat public markets. That will dampen the demand for them. So that's why... What's the right amount? I think the right amount is not zero, the right amount is not a hundred percent. Could be anywhere else in between. I would guess where it is today is probably not a crazy number.

Hal Weitzman: Okay. I wanted to ask you, there's always discussion in the US about closing the tax loophole, the carried interest provision that enables private equity firms to pay themselves, pay their partners effectively lower income tax rates. I'm guessing you wouldn't be a fan of changing that system, and why not?

Steve Kaplan: I think the carried interest that is... Right now, the carried interest that 20% of the profits is taxed as capital gains, one argument is they're investing, it's an investment, should be capital gains treatment. The counter argument is they're working for a buyout firm or a venture capital firm, so it's earned income, so should be ordinary income. And theoretically you could go either way. So I don't have a strong opinion one way or another. Now, as a practical matter, what would happen if you tax the carry as ordinary income, I think you would definitely hurt the venture capitalists, and you would probably get less venture capital, because the venture capitalists have no way to structure around that. As a buyout investor, because you're creating a new company every time you invest, you have, I think, some ability to structure around whatever law is passed. And so that's the question. If you want to penalize the venture capitalists, and at the end of the day you will not penalize the buyout investors as much or they'll be able to structure around it, that's a policy issue. I'm not sure you want to do that,

Hal Weitzman: But the result, you're saying, could be lower innovation or less entrepreneurship.

Steve Kaplan: You'll get less venture capital, which I think would not be a good thing. And yeah, you probably get less buyout investing, although I think that I'm not sure that's the case.

Hal Weitzman: Okay. Well, Steve Kaplan, thank you so much for coming on the Chicago Booth Review Podcast.

Steve Kaplan: You're very welcome.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research. This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.