Economics, U.S. Economy

Jack Welch vs. Joe Biden on private equity

Jack Welch attempts to illuminate Vice President Biden on how private equity works:

Let’s start with what private equity firms do, which is actually very simple. They buy troubled companies with the intention of fixing them up. In time, they hope, that will result in a big payday when the new-and-improved business goes public or gets sold to an eager strategic acquirer. Yes, sometimes these turnaround efforts fail, and companies and jobs are lost. And yes, on occasion PE firms have bought in and overleveraged a business’s assets. Then, as a result of an economic downturn, the company has tanked, while the PE firm has gotten out whole.

But the norm is different. Typically, that’s not what happens. It’s just not. Indeed, research conducted under the auspices of the World Economic Forum in 2010 shows the practice of “strip and flip” during PE-led turnarounds is rare. What’s far, far more common is this: PE firms buy “orphan” divisions that no longer are a good fit with their big corporate owners and have been left to fade away, or they snap up stand-alone businesses that have lost their way and are almost in the throes of death.

The key point here is that PE firms virtually never buy jewels – happy, fast-growing companies with glistening profits. After all, such companies have access to other kinds of capital; they don’t need private equity. And frankly, private equity is generally not in the business of polishing things up for a low-multiple return. It’s in the business of reinvention and rebirth, with fireworks at the end.

During this kind of overhaul, do jobs get lost? Unfortunately, in the early stages, they often do. It’s nearly impossible to massively improve productivity by keeping everything the same. But are companies saved? Again, yes. That’s the whole point of private equity. You’re trying to get a business from terrible to terrific, from dying to thriving. In the process, some jobs may go, but in the best-case scenario, with success down the road, many more will be created. And by preventing a company from going under, jobs will certainly be saved.

And here is the conclusion from that WEF study Welch refers to:

• Industries where private equity funds have been active in the past five years grow more rapidly than other sectors, whether measured using total production, value added or employment. In industries with private equity investments, there are few significant differences between industries with a low and high level of private equity activity.

• Activity in industries with private equity backing appears to be no more volatile in the face of industry cycles than in other industries, and sometimes less so. The reduced volatility is particularly apparent in employment.

• The aforementioned patterns continue to hold in continental Europe, where concerns about these investments have been most often expressed.

• It is unlikely that these results are driven by reverse causality, i.e. private equity funds selecting to invest in industries that are growing faster and/or are less volatile. The results are essentially unchanged if we only consider the impact on industry performance of private equity investments made between five and two years earlier.

It really helps if all your knowledge about private equity doesn’t come via Oliver Stone.

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