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Private Equity’s Chicken Little Dance

posted by Adam Levitin
The private equity industry is lashing out at Senator Warren’s Stop Wall Street Looting Act with some pretty outlandish claims that rise to Chicken Little level. According to an analysis by the US Chamber of Commerce's Center for Capital Market Competitiveness, the bill will result in the $3.4 trillion of investment provided through private equity over the past five years entirely disappearing from the economy, along with as much as 15% of the jobs in the US economy disappearing.    
I cannot sufficiently underscore how laughably amateurish this claim is. I’ve seen some risible financial services industry anti-regulatory claims before, but this one really takes the cake for extreme hand-waving. I expected better from the Masters-of-the-Universe.
Here’s why the private equity industry’s claims are utter bunkum.
The Chamber's analysis assumes that any reduction in private equity investment will result in the complete disappearance of those funds from the economy, as opposed to being re-intermediated through other, less destructive financing channels. Let me state that again because it is a jaw-droppingly ridiculous assumption: if investment doesn't flow through private equity, it will not flow at all.
Thus, according to the logic of the Chamber, if the Stop Wall Street Looting Act resulted in a $1 trillion reduction in private equity investment, that $1 trillion would simply be withdrawn from the economy, rather than redeployed to other investment classes that would continue to provide financing to the economy, albeit without the abuses of private equity. In other words, we’re being asked to believe that if investors are faced with a more regulated private equity industry, they will take their money and hide it under their mattresses, rather than simply move it into other investment classes.   
The proper analysis about Stop Wall Street Looting Act’s impact would be to identify the marginal efficiency difference between financing the economy through private equity investment relative to other forms of investment. Only that marginal efficiency difference would be affected by a regulatory change that discourages private equity investment.
I am unaware of any studies showing the marginal efficiency difference between private equity and any other form of intermediation. (Don't be deceived by the Chamber's analysis referring to the "value added" by private equity—that's the term the study uses for "proprietor’s income," which is hardly the measure of value added by private equity investment.) 
I have trouble assuming, however, that private equity is generically more efficient (and throughout, I am referring to Kaldor-Hicks efficiency) than other forms of investment. Private equity has enormous management fees that aren’t present in other forms of investment. Unless private equity has concomitant managerial efficiency benefits, private equity is unlikely to be a more efficient method of financial intermediation.
Perhaps that’s why the private equity industry doesn’t want to discuss the marginal impact of private equity investment on the economy, but rather the absolute amount of financing that comes from private equity as if it were an irreplaceable resource. While private equity might be distributional very good for some of the 1% (who then grace the rest of us with occasional non-anonymous philanthropy), it might be completely socially inefficient. Unless there's some evidence private equity's social efficiency, no one should get worked up over legislation targeted at curbing some of private equity's very real externalities on workers, retirees, tax authorities, tort victims, and the environment.   



Private equity is not necessarily more efficient. It might show better returns, but it is significantly more levered, so when you adjust for leverage the returns are very similar. Some people claim that because they do not manage for quarterly earnings, they take a longer view that creates more value. Hard to tell. In any event, the claim that if taxed more, the industry will lose incentives is ridiculous, not very credible. Even if taxed more, the compensation for the managers will continue to be so outrageous that relative to other opportunities it will still be very attractive. Behavioral economics has shown us that it is relative, not absolute that matters.

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