Could Anything Be Better than Private Equity Profits?

Conservatives are finally rejecting the absurd logic of Wall Street’s excesses

In 2022, H.I.G. Capital, a private equity firm, acquired Pixelle Specialty Solutions, a paper and packaging manufacturer. Last Tuesday, they announced their intention to shutter their paper mill in Chillicothe, Ohio, which had been operating for more than 100 years. More than 800 workers would soon lose their jobs.

Or maybe not. On Wednesday, Ohio’s Republican governor, Mike DeWine, lamented the impending closure and promised assistance to the affected workers in finding new jobs. Gov. DeWine is a Republican from the Reagan and Gingrich eras, having represented Ohio in the House of Representatives from 1983 to 1991 and in the Senate from 1995 to 2007. He’s from the old establishment that would respond to private equity shutting down a 100-year-old plant with a press release declaring, “I am extremely disappointed.”

But Ohio’s new Republican senator, Bernie Moreno, represents a new type of conservative. One of the first bills he has co-sponsored is bipartisan legislation endorsed by the Teamsters to ensure that workers in a newly organized union achieve a first contract with their employer. On Thursday, rather than merely express extreme disappointment, he fired off a letter to H.I.G. demanding answers and announced a rally at the plant the next day.

On Friday, DeWine was at the rally alongside Moreno, and so was the president of the union local. This mill “survived the Civil War, survived World War 1, survived the Great Depression, survived World War 2,” said Moreno. “It has to be able to survive a private equity company.” That afternoon, Pixelle announced the plant would stay open at least through the end of the year. Saturday morning, Gov. DeWine posted a video on Twitter recounting the whole thing.

Welcome to the new world. Is it a better world?

The Wall Street view, long espoused by Republicans, holds that H.I.G. represents American capitalism at its best. H.I.G. is well positioned to ensure that its capital is deployed as efficiently as possible, delivering the maximum return to investors. If it can use creative financial engineering to “lever up” Pixelle with substantial debt, providing different risk-return profiles to creditors and equity holders, all the better. If shuttering the Chillicothe plant will help them to service that debt and boost the size of a special cash dividend they might want to distribute to their limited partners, well then thank goodness we have such sharp business minds on the case.

To be clear, I have no idea how much H.I.G. levered up this acquisition, or what special dividends it may or may not have paid. One of the key asymmetries in discussion of private equity’s behavior is that it can release only those facts that would tend to exculpate it, while obscuring the rest. Even basic information like the fees that funds charge and the returns they deliver is notoriously hard to establish.

But of course, the economists and pundits celebrating H.I.G.’s behavior as “efficient” and “productive” and so on don’t know the details either. They are simply assuming that whatever H.I.G. does to maximize shareholder return is in fact the most socially valuable outcome. (I once had two University of Chicago professors lecture me in the Wall Street Journal that the investment returns generated by a private equity firm are by definition the firm’s “social value,” even if the firm claims all those returns for itself as fees.)

The problem with Wall Street’s view is that it is absurd. Note, first and foremost, that only profit gets counted as socially valuable. Let’s say a company owned by a private equity firm earns $5 million in profit and can choose either to distribute that as $10,000 bonuses to its 500 employees or as a $5 million special dividend to the private equity firm. Is one use of the cash more valuable than the other? Should we definitely say that only the distribution to the firm and its investors is valuable, while spending the money on employees destroys that value? That’s the logic of the profit maximizers.

Underlying that logic is the assumption that the cash, returned to investors, is “capital” that will be reinvested in some higher-value use. That’s the argument made anytime someone questions the roughly $1 trillion spent annually by corporations on using excess cash to buy back shares of their own stock. As Cliff Asness tried to explain in the Journal:

Investors generally do not spend the money paid out in buybacks on champagne bubble baths or other forms of consumption. Rather, they reinvest it in other stocks and bonds. Buybacks thus facilitate a movement of capital from companies that don’t need it to those that do. That’s how markets are supposed to work.

Or, as our Chicago professors suggested:

If a company would be worth $100 million in five years under current management, but a buyout fund takes over, improves the management, and increases the value to $120 million, an additional $20 million of wealth has been created. To the extent that company is more efficient, this means the extra $20 million will be invested elsewhere in the economy.

See, if you give the money to workers in the form of wages, they’ll probably just waste it on buying things their families need. But if you distribute it back to the already wealthiest people, they will surely send it right back into even more productive uses creating even better jobs for more people! Or maybe it gets spent on a yacht.

One need not post stories of the most absurd parties that the wealthy throw for themselves to make the point that not every dollar returned to an investor necessarily gets redeployed in the most socially productive way possible. As we’ve shown previously at American Compass, there’s no reason to believe the money gets reinvested at all. In recent decades, we have seen a dramatic outflow from the real economy back into financial markets, with investment as a share of GDP steadily declining, amounting to a shortfall in the trillions of dollars.

So it may in fact be the case that keeping the Chillicothe plant open is the more socially valuable use of the capital. Certainly, it could be the case that taking some more time to find a resolution besides shuttering it is worthwhile. But what’s most important here, for our purposes, is to recognize the rethinking within the Republican Party about its own free-market assumptions, when it will use the bully pulpit of national politics, and how that might affect decision-making by the H.I.G. Capitals of the world that would traditionally have expected the GOP to carry their water, express extreme disappointment, and then use taxpayer dollars to try and help those left behind.

The market fundamentalists will be appalled by the idea that political pressure could infect business decisions. That way lies the Road to Serfdom, get ready for the Killing Fields, and so on. After all, didn’t Adam Smith say in The Wealth of Nations that “it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”? And didn’t Milton Friedman explain that “The Social Responsibility of Business Is to Increase Its Profits”?

Well, yes. But before Smith wrote The Wealth of Nations he wrote The Theory of Moral Sentiments, in which he observed that nature had endowed mankind “not only with a desire of being approved of, but with a desire of being what ought to be approved of; or of being what he himself approves of in other men. The first desire could only have made him wish to appear to be fit for society. The second was necessary in order to render him anxious to be really fit.” And in his famous essay on profit, Friedman included the caveat that the desire “to make as much money as possible” must be constrained by “the basic rules of the society, both those embodied in law and those embodied in ethical custom.”

Perhaps Smith misjudged the human character. But I think, more likely, the legal, economic, and social pressures that once supported business leaders in their virtue have given way to ones that discourage or outright prohibit it. In a world where political leaders echoed a social ethic that applauded levering up companies and shutting down hundred-year-old factories to make an extra buck, business leaders convinced themselves that such behavior was indeed virtuous, certainly within the constraints “embodied in ethical custom.” Entire think tanks dedicated themselves to making the case that such conduct was the sine qua non for combatting poverty.

Contesting such claims in theory and in specific instances is not the road to socialism but the essence of the politics necessary to a well-functioning capitalism. Politics has the benefit of facing the test of common sense. One can hear the questions now: “Oh, so now we have to keep the buggy-whip factories open?” But of course, keeping a buggy-whip factory open indefinitely and pushing a private equity firm to not so quickly shutter a seemingly healthy specialty-papers producer are two different things, and while a law might have trouble distinguishing between them, a politician and his constituents will not. Perhaps it will still turn out that the Chillicothe plant is no longer economically viable. At least now all options will have been explored, hopefully some accommodations will be made for those affected, and the next private equity firm planning this route will think harder and prepare better.

Some laws might be nice too. American Compass has proposed changes in the tax treatment of debt, to eliminate the special treatment given to the strategy of levering up, and in the tax treatment of profits from these investments, to discourage the special treatment given to the profession of buying and selling assets. We’ve proposed much greater transparency into the practices of these firms and limits on the fees they can charge. And we’ve proposed reordering priorities in bankruptcy so that workers get compensated before the creditors who made risky loans. Expect to see conservatives who no longer equate private equity profits with social value to begin taking a hard look at ideas like those.

- Oren