Organizations and Markets

5 Comments Add your own

• 1. Bart  |  16 November 2007 at 3:33 am

  I’m a bit of a novice on this issue, but wouldn’t the question in PE and e’ship be whether asset ownership has a part to play? As far as I know of PE, these investors firstly see an opportunity in the undervaluation of a company, borrow a handsome some of money and buy it. Then they lend capital to the company and make sure they receive a respectable interest rate, plus they arrange a nice dividend on their shares. What’s more is they charge the company a management consultant fee for some instant cash flow (a rent?) at takeover (in the case of Dutch company VNU I thought it was 200m Euro for a 7.5 billion Euro takeover).

  The company’s equity is basically transfered to the investor and it is replaced by debt capital. In The Netherlands they even go so far in putting a company into debt, that by making use of a corporate tax exemption for loss-making companies they can just about keep operations afloat.

  Now in terms of e’ship, doesn’t it seem that PE would be closer to Kirzner’s ‘arbitrage entrepreneur’ than tied to actual asset ownership? Isn’t all the risk (and uncertainty for that matter) in PE transactions transferred to the company that is being taken over, and partly to society from a tax perspective? Can PE then best be defined by limiting it to an idea for a revenue model?
  Hope to receive some feedback on my thoughts

• 2. Peter Klein  |  16 November 2007 at 4:17 pm

  Bart, these are very good questions. I agree that ownership is a critical issue. Technically the investors in the PE fund are the owners, with the fund manager as their agent, himself appointing the managers of the portfolio companies do direct day-to-day operations. In Knightian terms, then, the investors in the PE fund are the entrepreneurs, with fund managers and portfolio company managers acting on their behalf. However, I’d say they are not quite Kirznerian entrepreneurs because the profit opportunities they seek — the difference between the post-reorganization value of the portfolio company (e.g., its market value in a reverse-LBO) and the cost to take it private in the first place — are not certain when investments are made. I don’t think the portfolio company is bearing this uncertainty; it is those who provide the equity used for the takeover who provide this role.

  Incidentally, the existence of a vibrant PE takeover market casts doubt on the Scharfstein (1988) view that there are too few disciplinary takeovers in equilibrium, because shareholders will refuse to tender their shares at anything less than the post-takeover value of those shares, leaving no residual gain for the raider. That result holds only in the case of perfect information. If the post-takeover value of the firm is uncertain, then the raider (or, more accurately, those who finance the raider) is an entrepreneur and his gains, if successful, represent pure entrepreneurial profit.

  What do you think?

• 3. Warren Miller  |  19 November 2007 at 9:10 am

  I will do my best to get to D.C. for at least one day of that conference, Peter. Someone’s gotta be the skunk at the PE garden party. :-)

  Seriously, in my line of work, I see a lot of acquisitions by PE funds. IMLTHO, there is far too much money chasing far too few sensibly-priced companies, and that’s pushing prices into the stratosphere. One of the major problems w/the PE funds is that they are following none of the valuation standards for closely-held companies. The most rigorous set of those can be seen at http://www.bvappraisers.org/standards/bvstandards.pdf. They have devised their own back-of-the-envelope set of standards called PEIGG (and pronounced, appropriately, ‘pig’). More is available @ http://www.peigg.org/valuations.html. Those interested in the “pig FAQs” can go to http://www.peigg.org/images/2007_March_PEIGG_VALUATION_FAQs.pdf. Please note the reference to “the market approach.” That’s where these folks have been hanging their hats to date – “the market” being what they paid in their own (mostly inflated) acquisitions. These guys and gals are no more capable of valuing their own portfolios than Enron was at valuing its own derivatives. That, in fact, is why we have SFAS 157.

  Moreover, if/when SFAS 157 (‘Fair Value Measurements’) finally goes into effect for non-public companies, these PE funds are going to HAVE to hire third-party professionals to value their portfolio companies because their auditors won’t dare accept the in-house valuations, which are doubtless being carried at their (inflated) purchase (read ‘market approach’) prices. That’s when all hell is going to break loose, esp. if the U.S. gets into a recession anytime in the next 12-24 months.

  To be sure, SFAS 157 is in the process of creating a different kind of trainwreck, what with its reliance on the perspectives of ‘exit pricing’ and ‘market participants.’ As those who follow this blog know, the heterogeneous nature of within-industry competitors leads to wide disparities in rates of return (ROR) among them. The further down the asset side of the balance sheet one goes, the more disparate the perceptions of value are going to be. And when they get to the ‘identifable intangible assets’ required by SFAS 141 (‘Business Combinations’), perceptions are guaranteed to be all over the map. All over the solar system, in fact. Therefore, the notion of ‘market participants’–which was, of course, dreamed up by a bunch of bean-counters (I’m a CPA, so I can say that) with no clue about the stream of research about sources of variation in ROR that began with Rumelt’s 1991 paper in SMJ –is about as bogus a construct as ‘one size fits all.’

  I know they have no clue because I asked two of the FASB Board members on 9/27/07 about that research and got the thousand-mile-stare-in-the-four-foot-room from both of them. That’s why valuation is too important an issue to be left to a bunch of accountants at the Fin’l Accounting Standards Board.

  In the meantime, we’re advising our clients to sell their businesses, one and all. When the air goes out of the PE balloon, it’s going to make the subprime meltdown look like a walk in the park. And it’ll be kind of fun watching these non-playing captains of industry with their 8- and 9-figure net worths whining about overpriced equities and wailing to Congress about the need for a bailout.

  Hope to see you in D.C., my friend.

  Warren

• 4. Vincent Poncet  |  20 November 2007 at 2:51 pm

  For sure, buying firms with credit is an entrepreuneur activity, but we need to understand that this activity could’nt be so huge without cheap credit given by central bank fiat money.

• 5. Bart  |  11 March 2008 at 9:16 am

  Peter,
  I promised to get back to you on this point, so la-di-da ;)
  I agree with the your argumentation. I like the Scharfstein quote, which in the discussion points to the dis-equilibrating force that is entrepreneurship. One can still wonder though whether having your uncertain investment hedged somewhere out there against a more certain bet (as is often done in practice) would be pejorative to the attribution of entrepreneurial to PE investment.

  I think the notion of entrepreneurship in large institutions or in wielding large amounts of credit is more subtly present.
  In a recent quick-scan of big bank blunders by securities watchdogs following the credit crisis I find an interesting case. The report basically states that banks that took a common sense approach to the employment of formal risk models, by regularly updating them to changing circumstances and by using “critical judgment” to employing model outcomes for decision making, actually performed better. Somehow this made me think of the application of superior judgment resulting in superior performance. Judgment is even used as a word in the report! Quite the entrepreneurial act in an uncertain circumstance, it would seem, though not so directly tied up with asset ownership. Although… you could consider senior bank members’ reputation as an asset in judgment calls under these circumstances
  What do we make of that?

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