Private equity, risk & incentives

The tendency to demonize private equity is mistaken, according to this new paper (ungated pdf here):

Industries where PE funds have invested in the past five years have grown more quickly in terms of productivity and employment…It is hard to find support for claims that economic activity in industries with private equity backing is more exposed to aggregate shocks.

This corroborates other evidence, such as this pdf and this pdf, which suggest that private equity actually improves firm performance.
One way in which it does this is by putting the boot up management’s jacksy. When share ownership is dispersed, as it is typically in publicly quoted firms, no owner has a big incentive to scrutinize management, so bosses get sloppy. Private equity concentrates ownership and so improves control.
Which brings me to a little puzzle. It this. In most walks of life, there’s a trade-off between incentivization and risk reduction. Reducing risk reduces incentives; having airbags in cars rather than metal spikes leads to more dangerous driving. What point do we choose on the trade-off between risk and incentives?
In the labour market, many people favour big incentives and little risk-pooling. Unemployment insurance, they say, reduces people’s incentive to find work, whilst big wage inequality encourages them to work harder.
However, when it comes to the market for corporate ownership, things are different. The dominant form - measured in pounds if not the number of companies - is dispersed ownership. This generates good risk-spreading but weak incentives.
You can see my puzzle. For workers, risk and incentives must be sharp. But for capitalists they must be blunt. Strange, huh?

Comments

[ajay]

It's a question of who's seeing the benefits. Accepting arguendo that PE-owned firms perform better, it's not as though there's an agent called "the firm" which decides "I think I shall become PE-owned in order to improve myself". The decision's made by PE funds and by company management. And, for management, the incentives point the other way - witness that (anecdotal only, sorry) management at delisted firms tend to get massive payoffs when the firms pass from being listed into PE control. They wouldn't demand and get those payoffs if it were more lucrative for them to be managers of a PE-owned firm.

Points:
or maybe they're just exacting a rent from their powerful position as management, and would get big payoffs when the deal goes the other way too - I don't know if this is the case;
alternatively, we can conclude that a PE-owned firm is both more successful and less easily looted by its management than a listed firm. Which would make sense, as the whole idea of PE control is tighter owner control to shut down the principal-agent gap, which is where the looting happens.

[Giles Wilkes]

"You can see my puzzle. For workers, risk and incentives must be sharp. But for capitalists they must be blunt. Strange, huh?"

Um, but is this the case? What is the typical volatility of worker's annual wage? Compared to a typical share?

I agree that the dispersed ownership model has its disadvantages - witness the recent shafting that bank shareholders have been given by their bonus-demanding staff. But enjoying blunt incentives does not seem to be one - powerlessness more the problem

[ajay]

Don't forget that, IIRC, an average 14% of jobs disappear every year. That's some volatility of wages there - all the way down to zero and back up again.

[Giles Wilkes]

I don't think people changing jobs and jobs disappearing are the same. A redundancy followed by a person working in some other job is really not the same as a crushing bankrtupcy and equity wipeout. I would be nervous about using that to prove that the workers have it so much more volatile than the capitalists.

[Pat]

Surely this is another illustration that capitalism is disliked by capitalists- taking a capitalist as someone who has already made money, rather than as a believer in the system.

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This is a measurement thing to a large degree.

In many governance boards, the measures presented to them are measures that bear no relation to anything that matters to customers.

Often they are activity measures, have many of X, Y, Z

Often they are shown against the budget or plan

Often they performance measures that do not relate to what matters to customer against targets.

This tells the board nothing about the true experience of performance in the organisation operationally. The board does not see the damage that targets cause in the system. Especially because the activity measures look fine. Bonuses are then paid on activity measures that look good but do not reflect true performance.

Because bonuses fuel more and harder behaviour that meets the activity measure, your business is in serious trouble before you know it.