Predators and scavengers play vital roles in healthy ecosystems by culling weak individuals. But the process can be pretty repulsive to watch at times.
Similarly, private equity firms and corporate raiders can play vital roles in market economies by reorganizing or shutting down businesses that fail to create value. This frees up resources for other uses. But it isn’t pretty, either.
The role of private equity has come to the fore as part of the ongoing bloodletting among Republican candidates over the record of Mitt Romney and his former investment firm, Bain Capital. But the issue is much broader than one executive or company and of longer term than one primary campaign.
There are times when such firms destroy value for society as a whole, even though they themselves benefit. The knotty problem is that it often isn’t easy to tell what is happening in any specific case, even after the fact. Did a given restructuring or liquidation cause a net benefit to society as a whole or a net loss?
Recognize that some companies inevitably get into trouble because they are badly managed or because circumstances change so drastically that activities that worked at one time no longer do. If their managers cannot make necessary changes, then someone else must do it.
If the company in question is a corporation, the theory is that stockholders, acting through the board of directors they elect to represent them, can hire new managers to turn the company around.
Boards themselves are often part of the problem, however. And existing stockholders may prefer to bail out of their investment, taking whatever cash they can rather than wait for an uncertain outcome.
All this means that the best option often is for someone else to take over the troubled company. The likelihood that outsiders will have a better perspective on what is needed is high.
Such reorganizations or turnarounds usually involve financial restructuring, such as negotiating debt reductions, raising new capital or going through bankruptcy. They may involve selling off unneeded assets. And they usually mean firing employees.
Many of those laid off naturally see themselves as victims of the new owners. Some realize the firm might have gone under without drastic changes. But it is natural to resent someone who is the visible proximate cause of your hardship.
The new owners may make a pretty penny if their efforts are successful. But often they have assumed much risk. Many deals turn sour. If the takeover or turnaround business is sufficiently competitive, economic theory says the returns will be justified.
In this scenario, which often occurs in the real world, the outcome is positive for society, even if adverse for those laid off, for original stockholders who lost most of their investment and for former suppliers, customers or others affected by the changes. Needed changes have been made and resources end up being used more efficiently.
However, one also can identify myriad cases where a takeover is good for some parties to the deal but does much greater harm to others, and with a negative overall outcome for society as a whole.
To those with quasi-religious faith that markets never fail, this outcome is impossible. However, there is enormous evidence in the real world that markets can and do fail. And “principal-agent problems” are a frequent source of market failure in contemporary corporations.
These occur when incentives faced by “agents,” those hired to do a job for the owners or “principals,” are not necessarily in the best interests of these owners. In corporate governance today, such mismatches between what is good for top managers and what is good for stockholders constitute an enormous problem. And it has been exacerbated by innovations like “flash trading” for extremely short-term gains.
Reviewing business in recent decades, it is obvious there were many deals, particularly in the leveraged buyout mania of the 1980s and 1990s, in which buyout tycoons and small groups of managers benefited enormously from short-term gimmicks that drained cash and other assets from viable businesses that were subsequently dumped. The losses of shareholders and employees might have been much greater than any gains, but that was irrelevant to events.
Some takeovers clearly are necessary and benefit society as a whole. Some clearly are rapacious acts representing gross market failure. But most fall into a gray area between where overall costs and benefits are hard to determine.
© 2012 Edward Lotterman
Chanarambie Consulting, Inc.