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Mr. Obama, Stop the Attack on Private Equity

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
May 25, 2012
Financial Times

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Having hit the rich with the promise of a Buffett tax, the Obama campaign is rolling out its next populist gimmick: an attack on private equity. A series of lurid campaign commercials goes after Mitt Romney for his record at Bain Capital, a company that, in the advert's telling, behaves like a "vampire". "They came in and sucked the life out of us," a steel worker says in the first commercial. "It was like watching an old friend bleed to death," says another.

Never mind the emotional manipulation; the ad is factually wayward. In 1993, when Bain bought the steel plant in the commercial, it was a saviour: in the absence of a buyer, the plant would have closed. Bain provided a transfusion of $100m to update the plant's machinery – it was a blood bank, not a vampire – and its investment succeeded for a time. Only in 2001, two years after Mr Romney had left Bain Capital, did the plant succumb to foreign competition and go bust.

Confronted with these inconvenient truths, the Obama team has tried to float above them. On Monday David Axelrod, Mr Obama's chief political adviser, suggested private equity firms harboured "an economic theory that isn't the right theory for the country". But this insinuation, that private equity is a species of rogue capitalism, is worse than the tortured narrative of the commercial. Indeed, history may well judge Mr Axelrod's view to be absurd.

The president's team may not have noticed, but the alternative to private equity – that is, public equity traded on stock markets – has not been faring well. Since a peak in 1997, the number of companies listed on public US exchanges has declined by 38 per cent. Just as the internet allows teenagers to trade Nike Dunks on eBay, so it allows investors to trade private stakes in unlisted companies. So-called "grey markets", such as SecondMarket, offer many of the advantages of stock markets with fewer of the regulatory burdens. The recent listing of Facebook reinforces the suspicion that the heyday of public equity is over – and not just because the stock has tanked. Facebook delayed its public offering for as long as possible. It stated in its issue documents that "we do not have any specific uses of the net proceeds planned". And rather than nodding to the idea that shareholders are owners, it hawked stock devoid of normal voting rights. Public equity listings are supposed to mobilise needed capital and diversify ownership, but this one did neither.

The public company is in trouble because the relationship between owners and managers has proved so fraught. By granting stock or stock options to bosses, boards have tried to align managers' incentives with shareholders', but this approach has failed. Managers are prone to build empires rather than make profits, to spend on perks rather than dividends, and to gamble recklessly with shareholders' capital. If any reminder were needed on this last point, the recent trading loss at JPMorgan should do the job.

Private equity offers an escape from these problems. Research suggests that public companies are more productive and innovative after they are taken private. The improvement can be painful: private equity firms often destroy jobs. But they are also aggressive at creating jobs when there is a business case for them, so their net impact on employment is a wash. Ironically, the best criticism of the industry is that its clients get mediocre returns once managers' large fees have been deducted. But the fate of investors is not team Obama's stated concern.

The odds are that, 20 years from now, private equity and other rivals to the public company will be flourishing, while plain old public equities will be a dwindling force. Instead of clustering round old-fashioned stock exchanges, financiers will be trading yet more derivatives, such as new instruments to hedge the risk that a hurricane will strike, or that GDP will come in below predictions. Unfashionable though it may be to say so, markets price these risks less imperfectly than other methods. But when it comes to mechanisms of corporate governance, it is not so clear that markets maximise the value of the company.

If the president wants to go to war with private equity, he will have to explain why he is against companies such as Toys R Us and Burger King. Meanwhile, he should recall that he won the last election at least partly because his opponent seemed clueless on the economy. Before he launches another populist broadside, Mr Obama needs to ask himself: does he want to be the candidate who looks clueless this time?

The writer is an FT contributing editor and a senior fellow at the Council on Foreign Relations

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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