By Peter Scheer
One of the great strengths of the American economy has been the openness, relatively speaking, of its largest national corporations.
Since the advent of federal securities regulation during the New Deal, big businesses have been required—as a condition of their gaining access to U.S. capital markets—to disclose gobs of information about their financial condition, performance and prospects. Mandated disclosures have opened a wide window into American corporate management.
“Transparency” has been a boon not only to investors—who are able to more accurately value companies’ shares—but to other stakeholders in the firms’ prospects. These include, most notably, the companies’ employees: Most of what they know about their employers—their financial health (or lack of it), their plans for growth and new capital investment, compensation of executives and of their fellow employees, etc.—they know because of disclosures required by federal law. The same is true for residents of cities and towns where companies’ operations are located: Without securities regulation, their only source of information about a company’s plans would be its self-serving and platitudinous press releases.
But the latest trend in the capital markets leads in the opposite direction. For an expanding list of companies—including, most recently, carmaker Chrysler Corp. and student loan company Sallie Mae—the information spigot is being turned off. It is being turned off because the formerly public companies have been acquired, not by other public companies, but by private investment firms riding the tidal wave of “private equity.”
Using capital supplied by private investors (typically augmented with lots of debt), private equity firms are in the business of finding and buying companies that they think are undervalued. The process of “going private,” by substituting private investors for public ones, substantially frees these public companies from the requirements of federal securities laws—including the key requirement of disclosure.
This effect is not trivial. The alternative universe of private equity now controls approximately 10 percent of the value of the companies listed on the New York Stock Exchange (according to a recent McKinsey study). At $281 billion so far this year, new private equity deals are running at a rate three times higher than in 2006 (says Thomson Financial), which was itself a banner year for buyouts. And private equity transactions involve ever-bigger companies, including First Data Corp., Alltel, Tribune Co. (publisher of the Los Angeles Times), Hospital Corporation of America, Equity Office Properties Trust, and Kinder Morgan. Private equity deals in the $30-40 billion range, unthinkable just a few years ago, are now commonplace.
The upsurge in private equity is a hot debate topic in political and economic circles. Unions and other critics on the left argue that private equity deals accelerate corporate downsizing and the outsourcing of jobs. However, there is little evidence for that proposition (and more than a few counter-examples of companies that have grown rapidly following their sale to private equity owners).
The investment community, in defending private equity deals, claims that shutting off the spigot of information, at least temporarily, is a good thing. The argument is that “taking private” a previously public company, by insulating it from Wall Street’s obsession with short-term results, frees management to make the kind of strategic changes and capital investments needed to set a company on a path for long-term growth.
Perhaps. But let’s remember that today’s defenders of private equity are the same people who, a few years back, extolled transparency as capitalism’s holy grail. During the 1990s’ boom, these champions of free enterprise and open competition argued that only with transparent markets and financial statements revealing all material information can individual businesses, and the economy as a whole, reach their full potential.
The investment community, it seems, favors full disclosure in all cases–except, that is, when investors have to do the disclosing. As buyers, professional investors insist on transparency so they can be sure not to overpay. But as owners, they favor a respite from the scrutiny of analysts and government. So-called “alternative investment” firms—private equity, venture capital and hedge funds—resist mightily any government regulation that would make them more transparent regarding the investments they make and the fees they charge. Most are secretive to the point of obsession about revealing firm profits.
Alternative investment firms’ hypocrisy about disclosure may be due to fear of a political backlash if the public finds out just how much money they make. The pending IPO by Blackstone Group, one of the most successful private equity firms, is instructive. The firm’s $4.75 billion offering, which will make a billionaire of firm chairman Stephen Schwarszman, has unleashed bills in Congress to tax the proceeds of such IPOs at corporate rates, rather than the much lower tax rates applicable to partnerships. Other legislation under consideration would raise taxes sharply on alternative investment firms’ “carried interest”—their share of profits (typically 20%) on private equity investments.
Transparency in corporate affairs is still the best policy. Public companies acquired in private equity deals should maintain full disclosure even in the absence of government disclosure requirements. Self-imposed (that is, voluntary) transparency is in the best interest of all concerned—including the dealmakers in private equity firms who would prefer to operate in secrecy.
Peter Scheer, a lawyer and journalist, is executive director of CFAC