Introduction
In recent years, private equity investing has emerged as a formidable presence in the financial realm, gaining considerable attention. Although it holds the promise of advantages for investors and businesses alike, it is essential to recognize the accompanying drawbacks and evaluate their societal ramifications. This article aims to delve into the critical pitfalls linked to private equity investments, shedding light on how they can impact society at large.
Some of these issues are largely unique (i.e. Hospitals) to the US however many others are common on a global basis. The maturity of private equity, in different markets, means that the relative impact of these drawbacks varies by jurisdiction.
If you have clients that are socially aware you need to consider these factors when making your recommendations. At a minimum, you should disclose these potential social impacts.
1. Job Losses and Restructuring:
One of the primary concerns surrounding private equity investing is its impact on employment. When a private equity firm acquires a company, it often aims to maximize profitability by restructuring operations. This frequently involves cost-cutting measures, such as layoffs, outsourcing, and streamlining processes. While these actions may enhance financial returns for investors, they can have a detrimental effect on employees and their families. Job losses and reduced job security contribute to social and economic instability, with potential ripple effects throughout communities. Research from the NY Times talks about the direct impact but also the indirect impact. As US-based PE firms seek to operate in other markets they have bought with them the same outcomes.
In the last decade, private equity management has led to approximately 1.3 million job losses due to retail bankruptcies and liquidation. Beyond the companies directly controlled by private equity, the threat of being the next takeover target has most likely led other companies to pre-emptively cut wages and jobs to avoid being the weakest prey. (NY Times www.nytimes.com/2020/07/02/opinion/private-equity-inequality.htm )
2. Short-Term Focus and Value Extraction:
Private equity firms typically have a short investment horizon, typically three to seven years, during which they seek to generate substantial returns. This time frame often encourages a short-term focus on profitability rather than long-term sustainability. To meet their financial goals, private equity investors may prioritize cost reductions, asset sales, or excessive debt financing, sometimes at the expense of long-term growth, research and development, and investment in human capital. This narrow focus can hinder innovation and hinder a company's ability to contribute positively to society through product development, job creation, and technological advancements.
"Private equity's relentless pursuit of short-term gains can undermine the long-term sustainability and value creation potential of businesses, stifling innovation, job creation, and societal progress."The Private Equity Stakeholder Project (PESP)
3. Lack of Transparency and Accountability:
Another significant downside of private equity investing lies in the lack of transparency and accountability. Due to their private nature, private equity firms operate with limited public scrutiny, which can lead to potential abuses or questionable practices. This opacity may hinder the detection of unethical behaviour, including excessive leverage, tax avoidance strategies, or aggressive cost-cutting measures that adversely affect employees, suppliers, or the environment. Limited accountability mechanisms raise concerns about corporate governance and overall societal welfare. The loading of company balance sheets with debt, that is not used to grow the company but to remunerate the PE Firm is a classic example of this issue.
This quote, from CALPERS, is a good example of the lack of transparency in the PE space. Most of the large US names in this space were fined by the SEC in 2015 for hiding fees.
"The problem is not subpar performance: At the fund’s Juneinvestment committee meeting, Eliopoulos cited the asset class as one of the fund’s best sources of return in an otherwise lackluster environment. The problem istransperancy." Private Equity’s Other Transparency Problem | Institutional Investor
4. Some industries Don't Suit:
Healthcare:
Private equity investment in the healthcare industry has raised ethical concerns due to its potential impact on patient care and access to essential services. Profit-driven strategies and cost-cutting measures employed by some private equity firms may compromise the quality of care provided to patients. Moreover, the focus on short-term financial gains can lead to closures of healthcare facilities in underserved areas, exacerbating healthcare disparities. Prioritizing patient welfare over profit maximization is crucial in an industry that directly affects people's well-being.
This is an excellent panel discussion on the topic of private equity in healthcare if you are interested in learning more about this topic.
Education:
Education is another industry where the involvement of private equity raises societal concerns. Education is a fundamental right and plays a critical role in shaping individuals and societies. Private equity investment in for-profit educational institutions has been associated with aggressive marketing tactics, high student loan debt, and a focus on profit rather than educational quality. The pursuit of financial returns in education should not come at the expense of educational standards, affordability, or equitable access to quality education.
The pie chart illustrates the areas of education that private equity has invested in. The alignment of private equity needs to the outcomes of education makes this a very problematic relationship.
Prison and Correctional Services:
The privatization of prisons and correctional services has been a contentious issue. The profit motive in this sector can create perverse incentives, potentially compromising the welfare and rehabilitation of inmates. Concerns have been raised about inadequate healthcare, overcrowding, and lower standards of safety and security. The societal goal of criminal justice should prioritize rehabilitation, reducing recidivism rates, and ensuring the fair treatment and well-being of individuals within the system.
It is worth noting that the exclusion of private equity from these industries does not imply that private investment or involvement cannot contribute positively. Instead, it emphasizes the need for strict regulations, transparency, and accountability to safeguard societal interests and prevent the prioritization of profit over social welfare.
In determining the suitability of private equity involvement in any industry, a comprehensive assessment of the potential social impacts, stakeholder engagement, and adherence to ethical principles should guide decision-making. Each industry presents its own unique challenges and complexities, necessitating a nuanced approach that balances financial considerations with social responsibility.
Conclusion:
While private equity investing can bring certain benefits, it is crucial to recognize and address its downsides for the betterment of society. The negative consequences, such as job losses, short-termism, and reduced transparency, have the potential to hinder socioeconomic progress and impede long-term sustainability. Policymakers, investors, and stakeholders must work collaboratively to strike a balance between profit generation and social responsibility, fostering an environment that encourages responsible investing and safeguards the well-being of employees and communities.
In particular, in Australia, there is a need for dramatic improvement around transparency, particularly cost, performance and valuation in the PE space. Making valid comparisons between private equity and public assets is a difficult process and most do not understand the hurdles involved. This makes it difficult for Advisors to provide appropriate recommendations or make adequate "like for Like" comparisions.
