The Exaggerated Decline of American Investment
My favorite newsletter of late has been from the guys over at Verdad Capital Management. Their interns are smarter than me, as evidenced by their brilliant research in The Decline of American Investment.
As a private equity investor, this one hits close to home. The article references Elizabeth Warren’s Stop Wall Street Looting Act designed to limit some of private equity’s toolkit related to maximize investor returns (specifically internal rate of return or “IRR”) through dividend recaps using debt. Why? She feels as though companies owned by private equity have stopped investing capital in their companies, and thus public good, because they are too weighed down by returning capital to shareholders and paying back lenders.
Former AT&T CEO and current private equity tech, media, and telecom investor Leo Hindery wrote an op-ed piece in Fortune on the subject calling for change. In the July 24th issue of Fortune’s Term Sheet after some PE professionals were surveyed, one anonymous writer-in named “Jeff” had this to say:
“Mr. Hindrey’s op-ed is so loaded with factual errors and logical fallacies that it’s hard to know where to begin critiquing it. At the core, he rejects the American Way—the free enterprise system. If he has a better model for private equity, he should do the hard work of convincing LPs, of buying companies, and building a team that can repeat that over and over. He could use his success as a shining example and urge all to emulate. Instead, he wants to use government force to have central planners—without any capital of their own at risk—to force others to conform to Sen. Warren’s views of what is best. This type of busybody regulation has always reduced capital formation, which would in turn harm most of the very people he claims to champion. This is pure demagoguery.”
Personally, I do think Mr. Hindrey’s take is too vague to be taken seriously. Private equity firms do not usually “bleed companies dry,” though I am sure they do sometimes. The view that they “strap companies with debt and suck out the cash flow like vampires” is antiquated. They usually can only borrow up to 50% to 60% of the value of the company. If you paid $100 million for a company and could only borrow $60 million before running it into the ground, you would return $0.60 for every $1.00 you invested. In other words, you would suck too bad to stay in business as a professional investor. You would have to grow the Company at least somewhat for this to even start making sense. Take a look at my primer on how private equity firms structure their transactions for a better idea of how this works.
Most of the time, however, companies are done in by competitors and change. Toys R’ Us, for example, never stood a chance in the era of Amazon and WalMart without iteration into a more experiential model. That is hard to do with huge stores all over the country, but that isn’t Cerebrus’ fault. The demise due to an over-levered balance sheet is more of a symptom than a cause.
As with most things, the cure for demagoguery is nuance. Yes, part of a nuanced view includes acknowledging that there are idiots in private equity doing stupid, 2006-like things. It is also worth looking at the data to see if more nuance is available for extraction.
Our friends at Verdad cut to the quick with analysis of capital expenditures and R&D in U.S. companies pointing out four things:
Yes, capital expenditures have declined from 10% of annual company in 1980 sales to 6% in 2015, a 40% drop; *but*
Due to technological innovation, the average price of capital goods has decreased by… you guessed it… 40% since 1980; and
The US equity market cap was 18% healthcare and technology in 1980, compared to 34% in 2015, while industrials, energy, and materials have falled from 50% to 19% over that same period;
Corporations in America have more than doubled R&D investment as a percentage of annual sales from 1.3% to 2.7% since 1980.
Furthermore, unemployment is at an all-time low. People have jobs, companies have equipment, and they are investing in innovation. Thus, it is possible that corporate investment has actually been on the rise. Verdad fairly points out that concerned politicians aptly point out that shareholders would rather receive capital than invest it, and this may be due to the fear that historically, management teams are poor capital allocators.
I cannot comment here, but I can say that there is a culture of “cocktail napkin” numbers in private equity. This is a common cocktail hour storyline: “we bought this business for X, did a levered recap 1 year later and sold it in year 3 and got a 5x in 3 years.” There is little heed given to the company’s long-term competitive position and ability to thrive for its community and workforce, though it is often implied.
Even though I do not think private equity is the rapacious group of capitalists made out in the media and in politics, perhaps a positive change of culture is on its way in the investment world.
