Private Equity's Abuse of Limited Liability

One of the central features of the Stop Wall Street Looting Act that was introduced by Senator Elizabeth Warren and a number of co-sponsors is a targeted rollback of limited liability.

This provision, more than any other, has gotten some commentators’ hackles up, even those who are willing to admit that there are real problems in the private equity industry and welcome some of the other reforms in the bill. (See also here and here, for example.)

The idea that limited liability is a sine qua non of the modern economy is practically Gospel to most business commentators.  These commentators assume that without limited liability, no one will ever assume risks, such that any curtailment of limited liability is a death sentence for the private equity industry.

They're wrong. Limited liability is a substantial, regressive cross-subsidy to capital at the expense of tort creditors, tax authorities, and small businesses. Limited liability is a relic of the underdeveloped financial markets of the Gilded Age and operates as an implicit form of leverage provided by law. But it’s hardly either economically efficient or necessary for modern business activity. It's a fairly recent development in the western world, there are numerous exceptions to it, and a number of notable firms have prospered without it (JPMorgan & Co., Lloyds of London, American Express, and many leading law law firms).

In any event the Stop Wall Street Looting Act rolls back limited liability solely for private equity general partners in a surgical manner such that doesn’t affect limited liability more broadly. All the Stop Wall Street Looting Act will do is reveal which private equity firms have real managerial expertise, and are thus able to thrive without limited liability, and those that don’t and require the legal subsidy to be profitable. Far from undermining the private equity industry, it is a restoration of a central tenet of honest American capitalism: reward should be commensurate with risk.

Limited Liability

Let’s start with what how limited liability works, then turn to what the bill does, and finally why the critics are wrong. The first thing to understand is how limited liability works. Limited liability comes from state law. It means that an investor is liable only for the amount of his investment, not for the liabilities of the firm in which he invests.  

So, if I buy a share of IBM, I’m liable for the purchase price of my shares—they could loose all their value—but I am not liable for IBM’s obligations.  

Limited liability doesn’t only shield natural person investors, however. It also operates within corporate structures. Thus, IBM Corp. (the parent company) benefits from limited liability vis-a-vis its subsidiaries, as the parent corporation is the shareholder of the subsidiaries.  

Limited liability is a characteristic of modern corporations, as well as limited liability companies and limited partnerships and trusts (beneficiaries are not personally liable for the trust’s liabilities). General partnerships and sole proprietorships do not benefit from limited liability, and the general partner in a limited partnership does not benefit from limited liability.  

Limited Liability in the Private Equity Context 

Now in the private equity context, we’ve got several layers of corporate structure. At the bottom there is the target company that is acquired by a private equity fund. The acquisition likely takes place through a special purpose acquisition vehicle (probably a corporation), not the fund itself. So, the target is owned by the acquisition vehicle, which is owned by the private equity fund.  

The private equity fund is itself structured as a limited partnership. This means that it has both a set of limited partners, and a general partner. The limited partners are institutional investors, such as pension plans, endowments, insurance companies, funds of funds, etc.  The general partner is the private equity firm (e.g., Apollo, Bain, KKR, TGP, Thomas H. Lee Partners). The private equity firm will be the general partner in multiple private equity funds; the limited partners in those funds will not all be the same.  

The private equity firm may be structured in any number of ways. Some are publicly traded corporations, while others are various types of limited partnerships. The limited partners enjoy limited liability for the obligations of the private equity fund; the general partner does not. The GP is answerable for all of the private equity fund’s liabilities.  Transactions will generally be structured, however, so that there are few actual liabilities at the fund level. Instead, liabilities will be at the level of the acquisition vehicle, and the private equity fund (limited partners and general partner) will be shielded by limited liability through the fund’s ownership of the acquisition vehicle’s stock. What this all means is that it is at least a few of levels of corporate entities before one gets to an actual natural person.  

Why Limited Liability Is a Particular Problem in Private Equity

Here’s where the Stop Wall Street Looting Act comes in. The premise of the bill is that private equity firms have abused limited liability to engage in excessive risk-taking at the expense of American workers and communities, as limited liability creates a lopsided investment risk:  all of the upside, but only limited downside.

Now, that is the case whenever one buys corporate stock (and there is much to say about that below), but private equity firms have taken this to a new level by combining limited liability with extreme leverage. First, there is the leverage in the acquisition of the target company—the private equity fund might put in only 20-40% of the acquisition price, with the rest borrowed by the target company itself and secured by the target company’s assets.  But then there is additional leverage in the structure of the private equity fund.  The private equity firm itself contributes only a small amount of the capital to the fund, but gets a much larger slice of the return. This extreme leverage, when combined with (1) limited liability and (2) corporate control produces an incentive for private equity firms to saddle target companies with extremely high and often unsustainable debt burdens. 

This is a totally different situation from when I invest in IBM. First, I usually have to pay full freight for my IBM stock. I don’t get it at 20-40¢ on the dollar. Even if I buy on margin, I’m still going to pay at least 50¢ on the dollar, and likely far more.  Second, when I buy the IBM stock, I don’t get the extra leverage that exists from the private equity GP structure. Third, my acquisition of IBM stock is not inherently connected with IBM taking on massive debt itself. And fourth, I don’t have control over IBM, such that I’m not able to loot the company or starve it of R&D resources  or reinvestment to pay the LBO debt, etc.  

So to recap, the problem with private equity isn’t limited liability per se. The problem is limited liability combined with other unique and unavoidable features of private equity. Limited liability plus extreme leverage means that there is a seriously lopsided risk/reward tradeoff that incentivizes excessive risk-taking. This means that if you are serious about curbing private equity abuses you have to do one of two things. Either you curtail limited liability for private equity GPs (increase risk) or you impose leverage limitations on private equity acquisitions (reduce reward).  

The Stop Wall Street Looting Act:  Curtailing Limited Liability for Private Equity General Partners

The Stop Wall Street Looting Act provides that general partners of private equity funds have joint and several liability for all liabilities of a target firm, just for the liabilities of the fund itself. It also provides that the control persons of the general partners have joint and several liability for all liabilities of a target firm. That means that the ultimate natural persons (i.e., .0001%ers who control the GP) are personally liable.  Thus, Eddie Lampert would be personally liable for Sears' liabilities.  

Critically, under the Stop Wall Street Looting Act, the limited partners in the private equity fund continue to have limited liability, as long as they remain passive investors. Your pension fund will not have increased liability for its private equity investments.    

Leverage Limitations:  the Road Not Taken

Another route to fix private equity abuses is to limit acquisition leverage. If target firms are less leveraged, they won’t have to go on starvation diets to service their debt at the expense of R&D and reinvestment in stores, etc. Leverage limitations are easier said than done.  First, how does one define leverage? What sorts of debts count? Trade debt? Tax debt?  How is that defined? Second, once one defines leverage, what is the proper level of leverage? The issue is a lot like usury laws—there isn’t an obvious answer and it might well vary by industry, etc.  

Even if one can legislate an acquisition leverage limitation, it's an incomplete solution because it doesn't address all of the leverage that affects GP incentives:  there is also the leverage inherent in the fund structure itself. So, to really address incentives via leverage limitations would also require limiting GP returns. A surgical curtailment of limited liability is a much simpler and more administrable solution. It’s easier to “level up” risk than to “level down” reward.  

The Sacred Cow (or Golden Calf) of Limited Liability

Now that we’re clear on what the Stop Wall Street Looting Act does and why it’s doing so, it’s time to address the concern that curtailing limited liability is a death sentence for private equity. Commentators assume that private equity cannot function without limited liability because they believe that limited liability is essential for modern financial markets. That’s just wrong.  

(btw, notice the assumption baked in here—that a death sentence for the private equity industry is obviously a bad thing. I'm agnostic. Unless we think there’s clear social benefit from private equity, then the industry should sink or float like every other industry—without a massive, regressive subsidy through law via limited liability.)  

In any event, would a loss of limited liability for private equity general partners spell the end of private equity? The answer is no. It would doom the posers in the private equity industry—the firms that have no real managerial expertise, but are simply buying purchasing diversified portfolios with massive leverage and then looting those portfolio companies—but the good private equity firms—the ones with actual expertise would continue to thrive (and would face less competition for investments). The stupid money will fail, the smart will rise, even without a regressive cross-subsidy.   

There Are Lots of Exceptions to Limited Liability

As an initial matter, limited liability is not nearly as absolute as commentators often assume. There are numerous statutory, equitable, and contractual exceptions to limited liability.  

Among the statutory exceptions, there is no limited liability vis-a-vis the federal government for employer failure to withhold taxes. The Consumer Financial Protection Act’s “related person” liability makes shareholders who materially participate in the conduct of a covered firm liable for the activities of the firm. Likewise, the PBGC’s single-employer plan lien slices right through limited liability within the holding company structure (see here regarding the application to private equity). So too does the source of strength doctrine for bank holding companies. Affiliated insured depositories are all co-liable with each other to the FDIC. And historically, shareholders in national banks were liable for twice the amount of their stock. These are example just from statutes I regularly encounter; I suspect others exist in other fields of regulation.  

There are also equitable—that is non-codified—exceptions to limited liability. Corporate veil piercing is the best known, but there is also successor liability and substantive consolidation (a bankruptcy doctrine).  

Finally, limited liability is waived all the time as a contractual matter. It’s just waived selectively for financial creditors and occasionally tax authorities. Corporate cross-guaranties are standard in loans and bonds—virtually the entire corporate group will guaranty borrowing done by just one member. That’s a waiver of limited liability as to that financial creditor. Likewise, corporate tax sharing agreements accomplish the same vis-a-vis tax authorities. And springing guaranties from control persons (I’m looking at you, Jared Kushner…) are par for the course in real estate finance. In short, there are all sorts of exceptions to limited liability that suggest that all sorts of businesses manage to operate without it.  

Limited Liability Is Actually Pretty Recent

Many commentators assume that limited liability has been around since time immemorial, that it is foundational to capitalism. It ain’t. Limited liability is a relatively recent invention, much less in its current form. While one can point to older English antecedents (East India Company, e.g.), the first modern limited liability law for general business corporations was from New York in 1811. Prior to that statutory, creation of a limited liability corporations required a special act of the legislature or were allowed for very limited classes of entities (libraries, turnpikes, colleges, etc.).  

Although the possibility of limited liability existed in the 19th century, there just weren’t many limited liability entities (or incorporated businesses of any sort) until the 20th century. Larger businesses were often organized as trusts (hence “anti-trust”), which had effective limited liability for trust beneficiaries, but trustees themselves were personally liable for the trust’s obligations until well into the 20th century.

Critically, limited liability, as first created, protected only natural person shareholders. This limited existed for a simple reason—corporate holding structures did not exist until New Jersey laws from the late 1880s and 1890s authorized them. (In the absence of corporate holding company structures, trusts were used for controlling conglomerates—again, “anti-trust".)  

All of this is to say that a huge amount of industrial development in the Western world was done without limited liability of any sort and certainly without intracompany limited liability, which is really what’s at issue in the Warren legislation—the shareholders in a publicly traded private equity firm do not face liability under the bill. In other words, intracompany limited liability just isn’t so critical to business activity as casual observers assume.  

Limited Liability is a Vestige of Undeveloped Financial Markets

What we should see from the history of limited liability is that it is a historically contingent development. Consider when limited liability developed (again, the first modern limited liability law was 1811). It developed at a time when there were only primitive financial markets. Investors could not protect themselves adequately through insurance and derivatives. Yes, one could buy insurance, but the solvency of 19th century insurers was always a dodgy thing. Would we come up with limited liability from scratch today? I’m not so sure. It’s a legacy that might well have outlived its usefulness.  

Major Firms Have Operated Without Limited Liability

The ultimate proof that limited liability is not necessary for modern business activity is the leading US financial firm from the late 19th and early 20th centuries—JP Morgan & Company. JP Morgan & Co. was a plain old handshake partnership (with Mr. J. Pierpont Morgan Sr. as the head partner), without limited liability of any sort. That did not stand in the way of it underwriting the largest loan ever made at the time (Anglo-French loan in WWI) or financing the Panama Canal or the US railway system. For most of Lloyd’s of London’s history, its Names were personally liable for the hazards they insured. California corporations had unlimited pro rata liability for shareholders until 1929. American Express had unlimited pro rata liability for shares into the 1950s. Indeed, even today, Wachtell, Lipton, Rosen and Katz, the US law firm with the highest profits per partner, is a general partnership—no limited liability. So too were many other Big Law firms into the 21st century.  (There's an interesting argument that freely transferrable shares requires limited liability, but the empirical evidence suggests otherwise.) 

A Physical Manifestation of the Lopsidedness of Limited Liability

If you've read this far, indulge me in an aside: Worldwide Plaza on 8th Ave. in New York was the longtime location of the leading law firm of Cravath, Swaine & Moore (which is now moving). When Cravath moved into the building in 1988 or so, it had the firm’s name carved above the doors—nice and centered. When Cravath converted to being an LP around 2003, it had to etch the in the additional letters, such that the name was longer centered: a physical manifestation of the lopsidedness of limited liability.  

Private Equity Firms Are Able to Adjust Their Pricing to Account for a Lack of Limited Liability

Indeed, the idea that limited liability is necessary to attract investment is suspect as a matter of economic theory. Shouldn’t limited liability just be part of a trade-off relative to rates of return? That is, if private equity GPs were to lose the protection of limited liability, why wouldn’t they just demand a larger share of the pie—effectively a greater return on their investment? On a diversified portfolio of investments, they should come out just fine, especially given that the GP has substantial control over the liabilities incurred.  

Bankruptcy Law Still Exists as a Type of Limited Liability

Moreover, even without state law limited liability, there is another form of limited liability that the Stop Wall Street Looting Act does not eliminate: bankruptcy. Bankruptcy is, in effect, a form of liability insurance. The natural person control persons of the GPs always have bankruptcy as a type of liability insurance. If Eddie Lampert, for example, finds himself liable for, say, $20 billion (a sum that exceeds his assets), he can file for bankruptcy, keep whatever property he has that is exempt, pay the rest to his creditors, and the remaining balance will be discharged. Thus, if Eddie is worth only, say, $5 billion, he will keep his Florida homestead, some tools of the trade, etc. and will get out of $20 billion in debt for just $5 billion. Personal bankruptcy is a form of limited liability. (Take note, Bloomberg editorial board...) It won’t protect all of one’s wealth, but will keep one from starving based on being a bad businessman or simply because of bad luck. 

Limited Liability Is a Massive, Regressive Cross-Subsidy of Capital 

Finally, let’s not lose sight of the distributional picture. Limited liability is a zero sum game, meaning that limited liability is a giant, legalized risk externalization from shareholders to non-adjusting creditors (tort victims, tax authorities, some trade creditors). In other words, limited liability is not Pareto optimal. There’s no obvious social welfare benefit from limited liability.  Instead, there is simply a redistribution from the vulnerable to the wealthy.  

It’s hard to see why such a policy is sacred, other than that it creates substantial implicit leverage and thus gooses returns in all equity investments. This might be a policy that makes sense in cases where private investment is not forthcoming because of the enormous and unpriceable risks involved in an enterprise and where there is huge social value, such as the system of liability channeling for vaccines. But that’s the exceptional situation. Why the iron works and the dry cleaner, much less the private equity baron need limited liability (as opposed to paying for insurance) is not clear.  

Good Private Equity Doesn’t Require Limited Liability, Only the Posers Do

Limited liability has been a backdrop term to American capitalism only about a century. Its expansion can be seen as a remnant of the Gilded Age, and it remains a subsidization of capital at the expense of tort victims, tax authorities, and small businesses that cannot adjust their pricing for lack of market power. The “free market” is in fact deeply subsidized by the legal system. What’s clear is that limited liability is absolutely not necessary for most business activity. It’s just a regressive cross-subsidy of capital, plain and simple.  

The Stop Wall Street Looting Act doesn’t pick a fight with limited liability generally, however. Thus, it doesn't really matter if you agree with me generally about limited liability. It only takes issue with a very narrow application of it, in a context where it has been systematically abused and where the abuses have created palpable harm for American workers and communities.  

If private equity firms really have managerial expertise as they claim, however, their business model should not depend on limited liability. Smaller PE shops that have deep industry expertise are likely to do just fine, for example. The Stop Wall Street Looting Act’s curtailment of limited liability will merely separate the wheat from the chaff in private equity. Those firms that have real expertise will thrive and prosper, and work real managerial magic, and the firms that are only able to profit because of a rigged heads-I-win-tails-you-lose gamble will be out of business, as they should.  

The Stop Wall Street Looting Act restores honest American capitalism, in which reward is commensurate with risk, so that private equity will profit from its talent, not from a lopsided financial gamble facilitated by a regressive legal cross-subsidy. 

Comments

[Ebenezer Scrooge]

The main problem with limited liability is inherent in bankruptcy law: non adjusting creditors don't get priority. Adjusting creditors get what they bargained for. Rational bankruptcy priorities would go a long way to fixing the problem. The Merit Management case, which enabled fraudulent conveyance actions, also helps.
The strongest argument for limited liability is that it facilitates anonymous equity markets. A shareholder in a limited liability world doesn't have to worry about the financial position of other shareholders, as s/he would under joint & several unlimited liability. (I said "facilitates", not "enables." Joint stock companies were anonymously traded, as well, as were double liability banks before the Depression.). This argument, however, does not apply to PE vehicles, which are privately held.

[Dee Fissure]

Well there certainly seems to be a dearth of empirical evidence of an existence of a problem in need of solving or even any apparent connection between the presumed problem and how the bill addresses it. Managerially challenged accumulators of diversified securities portfolios regressively cross-subsidizing capital at the expense of tort creditors? Is anyone complaining besides PI lawyers? And how seriously can one take a bill with the words “Stop ... Looting,” which are obviously intended to inflame without even creating an acronym that recapitulates the title, like “Frivolously And Knowingly Elizabeth Leads Attack on Wall Street” Act.

[Adam Levitin]

Ebenezer: my instincts were to subscribe to the argument you make (pioneered by Susan Woodward, with a later intervention by Woodward and Armen Alchian)—that limited liability is necessary for anonymous equity securities markets. But the empirical evidence that exists (and I linked to two studies in the post) indicates that it isn't the case. For what it's worth, negotiability accomplishes much the same as limited liability, although it isn't quite as broad.

For Dee: it sure seems that you have your priors. You question whether there is empirical evidence of a problem. Um, Toys R Us, Sears. The US retail industry has been in the midst of an apocalypse over the past three years at a time when the economy is booming, and most of the failing retailers are loaded down with LBO debt. If you're looking for an academic study, yes, there's that too. Read Eileen Appelbaum's work, for example.

As far as the connection, it's not real complicated: PE firms are incentivized to pursue excessively leveraged acquisitions, which are thus more likely to fail and the collateral consequences are borne by parties that cannot readily adjust or diversify their economic exposure. Put bluntly, PE barons get rich, while working folk and retirees get shafted. That's a problem.

As for how seriously one should take the bill, let's just say that Senators don't have their staff put together 100+ page bills unless they are very serious about the issue. The bill isn't going to move with this Congress, but it is going to define the terms of the debate and will be the starting point if there's a change in government.

[Matthew Kretzer]

This article would be a lot easier to follow if an abusive example were given in detail.

[Adam Levitin]

Matthew--fair enough. Let’s take Toys R Us. Toys R Us was already having trouble in the retail toy business in early 2000s. In 2006 a club bid of several PE firms lead by KKR and Bain bid $6.7B to buy Toys R Us, paying a 63% premium over the stock price. Only $1.3B (19%) of the acquisition price was paid by the PE firms. Another $1B came from TRU’s own cash, and the remaining $4.4B was borrowed under four facilities. Critically, the borrower was TRU, not the PE sponsors. That $4.4B of LBO debt was in addition to TRU’s existing $2.3B of debt, so the post-acquisition leverage was a multiple of about 8.6x EBITDA.

What happened next? Toys R Us continued to struggle in the toy retailing business, particularly in the face of Amazon. But Toys R Us’s ability to reinvest in its stores and its on-line presence was hampered by the enormous debt load it was carrying thanks to the LBO. It’s hard enough to compete with Amazon without servicing debt at 8.6x EBITDA (firms with EBITDAs over around 7 or so fail at a much higher rate, fwiw, but I can’t find the recent study on this offhand). TRU limped along for several years, during which time its PE owners paid themselves handsome management fees. And we know how it ended. Stores closed, assets liquidated piecemeal, employees lost their jobs.

Yes, the PE firms lost their investment (but they recouped at least some of it through management fees). But the point to see here is that the lopsided gamble—unlimited upside, but downside capped at $1.3B—gave the PE firm an economic position equivalent to a call option, and Black-Scholes teaches us that a call option’s value increases with volatility. How does one increase the volatility of an investment like TRU? If you have control, you engage in higher risk business strategies, including trying to keep the company afloat while looting it through fees.

[Adam Levitin]

For more color on TRU, here's a good story:
https://www.theatlantic.com/magazine/archive/2018/07/toys-r-us-bankruptcy-private-equity/561758/

[Dee Fissure]

Certainly Solyndra is a great example of how well da Gubment handles investment, and it’s well understood that the S&L crisis and the Great Recession were triggered by decisions made with other people’s money by our oh-so-wise Solons in D.C. You will deny this, of course, and perhaps Toys R Us failed due to leverage, but Sears suffered at least as much from operational as financial mis management, and you don’t prove business failure due to limited liability of PE investors simply because it exists at the same time as a bankruptcy. When I started at GMC, it owned 50% of the U.S. auto market, but managed to go bankrupt without the help of PE investors, along with hundreds of other Fortune 100 companies over the decades that failed to keep doing what got them there. Against Toys R Us and Sears, there are Amazon, FB, Google, Uber, and dozens of other unicorns or former unicorns that received investments from investors with limited liability.

[Adam Levitin]

Dee--no one is arguing for government investment, etc. This is just an issue about limited liability for the GPs in private equity firms. Most of what you write is irrelevant to that issue. For what it's worth, though, while the government certainly had a hand in exacerbating the S&L crisis, the Great Recession stemmed from bad lending funded by the private-label securitization market. Government's only involvement was from lack of regulation.

Yes, there are lots of ways to kill a business. Businesses failed for centuries before PE. But that doesn't mean that PE isn't a particular problem, and more importantly, it's one that can be fixed legislatively. You can't legislate good business sense or prohibit stupidity. But you can legislate to fix misaligned incentives.

As for Sears, it wasn't an LBO (ESL isn't a PE firm, although it behaves much like one)--the problem there was post-acquisition looting: the Searitage spin-off, the Lands End spin-off, etc. The Stop Wall Street Looting Act is drafted broadly enough to capture the Sears problem, but Sears is somewhat unique. If you want another LBO leverage + looting story, look at Caesar's Entertainment. The LBO levered up the firm so heavily that it couldn't handle a downturn in demand for gaming. Once the hand-writing was on the wall, the PE sponsors went to work with the looting, including sweetheart asset sales to their affiliates, etc.

[Ebenezer Scrooge]

Adam:
Dee Fissure mentioned Solyndra. His implicit argument is that the government is incompetent if any of its loans go sour. Do not feed the trolls.

[Jamal]

Adam:

There's a lot I disagree with here, but I'd like to highlight just one aspect: your claim in the comments and in your post that private equity investment structure (combined with limited liability, etc.), is a net-negative present value structure. Citing Sears, retail businesses, and other private equity-backed ventures, is in no way an illustration of this point. The entire point of private equity is to leverage, and so highlighting blowups is begging the question.

If we wanted to know whether private equity was a net-positive present value proposition, we should look at all private equity deals (good and bad), and then see if the blowups and successes tallied up result in a net positive. Unless you cite empirics relating to this, it seems your examples are rather useless.

[Adam Levitin]

Jamal—you’re framing the question the wrong way. Net positive PV is a sensible way for an investor to look at an investment, but it doesn’t tell us about distributional issues. Even if PE is net PV positive, the misalignment of the rewards (PE firm) and risks (non-adjusting creditors) is a problem. I don’t hear you proposing a serious tax and redistribute system to protect non-adjusting parties. As things stand, even if PE is net PV positive, it is not Pareto efficient.

Also net positive PV lumps together high and low leverage LBOs. The Stop Wall Street Looting Act is primarily a disincentive high leverage deals.

[Jamal]

"net positive PV lumps together high and low leverage LBOs. The Stop Wall Street Looting Act is primarily a disincentive high leverage deals." That's exactly the problem with the empirics you cite: you can't say that high-leverage deals are bad overall if you are only looking at the deals that blow up. You must look at all deals in aggregate, and see if on average they result in an efficient outcome.

You are correct that looking at NPV would only tell us whether it's Kalder-Hicks efficient for an equity holder, and would not take into account the costs of negative externalities imposed on third-parties. However, this is where it seems the rubber meets the road: how would you adjust that number (NPV of s/h equity investment in these deals) to come up with a financially-rigorous analysis of whether this type of structure is efficient overall to society? In short, how would you quantify these negative externalities? We'd first have to agree on what they are.

in that vein, I don't see the negative externalities that you and others seem to point out. Creditors - the creditors issue these bonds to the company knowing the leveraged position they are taking. They are fully aware in making these bets, and so it seems odd to discuss junk bond creditors as somehow facing the negative externalities of these deals. Employees are merely agents of the company, and are not entitled to an income stream. It is not the company's job to provide salaries for unnecessary employees, it is the job of the company to act towards the best outcome for shareholders. Cutting employees and losing unnecessary jobs is not a negative externality, it is economic efficiency at play in the market.

In short, I don't think using NPV for s/h when looking at all these deals in aggregate would be that far off from the economic reality of whether it is efficient. (Of course, I am assuming Kalder-Hicks efficiency; hardly any investing activity will ever be Pareto efficient, so it seems odd that you bring that up.)

[Jamal]

One quick addition:

I would be willing to make an adjustment for uncompensated involuntary tort creditors. Your post is largely discussing limited liability, and so if we wanted to see whether PE leveraged deals are inefficient as a result of the limited liability the GP faces, we would have to adjust our aggregate data for the costs that were not imposed on the s/h because of the limited liability. But that is the only adjustment that I think makes sense, since it is truly a negative externality.

But again, my driving point was this: only until you or someone else can show that number can any of us say whether private equity high-leverage structure is efficient. Admittedly, it runs both ways! I can't really come out and say it is efficient until I have adjusted for tort creditors myself. But my intuition is that such adjustments would be minor, given how rare it is for these types of deals/investments to blow up because of tort lawsuits.

[Adam Levitin]

(1) Yes, Kaldor-Hocks is pretty close to positive NPV, but that's the whole problem with Kaldor-Hicks--it doesn't require any actual redistribution, only that there be aggregate surplus. But unless there is an equitable division of that surplus, it's irrelevant to the short-changed parties that there is a surplus.

(2) Your supposition seems to be that unless there is ironclad empirical proof of a problem that there shouldn't be a regulatory response. I can't accept that. It's actually rare that we'll have really good empirical evidence on policy problems, much less definitive evidence. It might be what we'd want for publishing an academic study, but if that's the level of proof required for policy making, little policy will ever be made, and that itself is a decision with important distributional ramifications, as it reinforces current power/wealth distributions and commits us to a laissez-faire approach.

So let me ask, why is the burden of proof on the pro-regulatory position? I think I've outlined at least a prima facie case of (a) misaligned incentives and (b) negative impacts on vulnerable populations. I think the burden of proof is on PE showing that it is socially beneficial _and_ then coming up with a method for compensating non-adjusting creditors.

(3) I'm not shedding a tear for bondholders here, and this isn't a bondholder protection bill. Bondholders are presumed to be adjusting creditors, even if empirically that's suspect.

The non-adjusting creditors are (a) tax authorities, (b) small vendors without market power, (c) pensioners, and (d) tort victims, and we can lump in employees as a similar problem.

Tax authorities don't change tax rates depending on tax payer risk. Small vendors lack the market power to price for increased risk; they're happy just to have business. Pensioners have performed their end of the bargain and then get stiff, and tort victims didn't want to be creditors.

As for employees: they are particularly vulnerable because they cannot diversify their income. They get hired by a company at time 1 when the company is reasonably leveraged; they cannot price for or insure against the possibility that the company will become over-leveraged by an LBO and then go on a starvation diet to service the debt.

While you say that cutting unnecessary jobs is economic efficiency, that again depends on the lens. From a shareholder perspective, yes. But from a social perspective, one has to account for inefficient labor markets. Labor has mobility frictions, and older employees face particular problems finding new jobs.

[Jamal]

On K-H efficiency: We can't say that there needs to be a change until we can show the status quo is inefficient. You reply that K-H "doesn't require any actual redistribution, only that there be aggregate surplus. . . . [Thus] unless there is an equitable division of that surplus, it's irrelevant to the short-changed parties that there is a surplus." But again, we have to first show there is NOT a surplus, taking into account all externalities, before we can say there needs to be a redistribution/regulatory change.

On employee risk diversification: I agree employees can't have their risk diversified in the way that a s/h can, and this presents a problem. But assuming PE leveraged deals are, on average, positive NPV propositions, even after taking into account inability of employee diversification and the negative externalities in inefficient labor markets, then the solution should look very different from Warren's. We should in that case keep the existing system, since it creates NPV for society, and find other ways to reduce those externalities, and force PE funds to bear the costs of those externalities. Force PE Leveraged buyouts to pay that cost in a rational and efficient way. Warren's bill, instead of doing this, would just blow the whole structure up, edifice and all, even though it may be a net gain to society, despite it's ill effects.

Alternative: Why not tax these leveraged buyouts based on expected layoffs or at the time of layoffs? Calculate the cost of these labor market risks to employees that can't be diversified, and force them (PE GP acquiror) to shoulder that cost through some tax. The tax could go to re-investment in the labor market for Americans, or some sort of unemployment fund for laid-off workers. This would result in efficient decision making for society by PE actors, and doesn't require blowing up limited liability, nor something as radical as putting the GP on the hook for debts of portfolio companies.

On status quo: this is a much deeper regulatory philosophy debate as you've pointed out. As you can tell, I believe in a Burkean approach: the status quo is there for a reason, and we should respect that status quo unless we have cause to change it. I won't get into this debate (as interesting as it may be) since I don't think this forum is conducive to such a discussion, but I will say this: your citation of a *couple* of bad blow-ups is a uselessly small amount of data. (Also citing *one* company's corporate structure that was abandoned 70 years ago is now enough evidence that limited liability isn't needed for liquidity of shares today? Really?) I am not asking for a rigorous empirical analysis conducive to academic study, but some (lean) meat-on-the-bone numbers; I don't think that's an unreasonable burden, regardless of your philosophical approach to regulation. Good policy is built on (at least somewhat) decent academic literature; advocating dramatic changes to corporate and financial regulation is not something that should be done haphazardly. Besides, we could extend your logic (re: putting the burden on PE) to everything in finance: Why not blow-up our entire SEC disclosure system for public companies until they can show it's socially beneficial? Why not blow-up our entire banking-regulatory structure? Why not blow-up limited-liability all together until companies can show it's socially beneficial? The status quo has evolved the way it has for a reason, and though there are certainly inefficiencies, we should be at the very least be thoughtful in our changes.

[Adam Levitin]

I'm not ready to accept your assumption that status quo is right unless proven otherwise. Status quo is the result of past power balances. Refusing to budge from it just extends those power balances. We're seeing harms from PE. Here the harms are very hard to measure and quantify, so a tax and redistribute move is unlikely to get it right. We've never gotten this right with trade adjustment, and there's no reason to think we'll do better here. Making GPs fully exposed to the risks of their portfolio companies allows PE to continue while removing the incentive for excessive risk. The risk-reward trade-off is changed, but there's no inherent right to the existing trade-off, which is a function of the particular features of regulation (e.g., tax structure, application fraudulent transfer law) that were not built on a thoughtful study of LBOs.

Irrespective of that philosophical point, however, limited liability shouldn't get any deference for its antiquity because it hasn't been status quo for most of human history. There's no Hayekian social learning mystery at issue. Limited liability is a pretty recent invention, and its application to parent corporations is even more recent.

Also, I didn't just cite one company's corporate structure. I cited two separate academic studies on share liquidity plus gave examples of three leading financial institutions (JPM, Lloyds, and Amex) plus the major US law firms until less than 20 years ago plus one major law firm today all of which did not opt for limited liability.