Private Equity: A View from the Left and the Right

The growth of private equity has naturally been accompanied by a growth of its critics.  There are two main lines of criticism, one from the right and the other from the left.  Both need to be considered.

The criticism from the right is financially sophisticated.  What one could call old fashioned financial commentators regard the private equity companies as guilty of taking a financial profit without adding any value.  The financial profit arises largely from the higher debt ratios of private equity funds. It is argued that financial leveraging of this kind can never add real value, since the risk incurred matches the benefit to the equity itself.  The private equity managers are seen as people who take large fees for imposing high risks on the business.

There must be something in this line of argument.  The present state of world markets may well make higher leveraging attractive, but that is because interest rates are relatively low and world trade is relatively good.  Yet this will not always remain the case.  Since the Second World War, the old ten year cycle of recessions has continued to operate;  some of the recessions have been mild and some severe.  One may well ask how many private equity concerns would have been able to survive the interest rates of the great inflation of the 1970s.  Negative equity was a feature of the British housing market in the early 1990s.  Both hedge funds and private equity would be vulnerable to negative equity if financial conditions combined higher interest rates with a collapse of earnings.

Yet it is not the right wing critique which is attracting the greater attention.  The left wing critique accepts that private equity does add value;  indeed that is what the left objects to most, since they believe that value is added at the expense of the trade unions and of workers generally.

Public companies are not able to maximise their profits because they are subject to public pressures.  They are subject to regulation and to high levels of taxation.  They have to negotiate with Governments, which often want there to follow uneconomic policies for social or political reasons.  If they are taken out of the public arena, managers can concentrate on their proper business, which is profit maximisation.

In the United States, there is at least some constituency which puts higher productivity ahead of other considerations.  American workers do not like to lose their jobs to down-scaling, any more than workers in other countries, but at least they understand the argument in favour of a high efficiency economy.  In Europe, down-scaling is often regarded as an example of capitalist greed.

The European unions are in general weaker than they used to be, particularly in Britain, but even the British unions see private equity as inherently hostile to their interests.  In Germany, the unions have great influence even with a Government led by the nominally conservative Chancellor, Angela Merkel, who would, at the furthest, be regarded as a moderate Democrat in the United States.

These labour pressures, and the political pressures for more regulation, apply both to private equity and to hedge funds.  I have a third worry.  Easy money attracts second rate operators.  The first stages of any new financial development are led by people of exceptional skills, but as time goes on the easy money attracts operators who do not know what they are doing.  I expect the returns on private equity to fall and the blunders to get bigger.  Magic profits are not easy to maintain.

William Rees-Mogg
for The Daily Reckoning Australia

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