Predators and scavengers play vital roles in healthy ecosystems by culling weak individuals. But the process can be pretty repulsive to watch.
Similarly, private equity firms and corporate raiders can play vital roles in market economies by reorganizing or shutting down businesses that fail to create value. This frees up resources for other uses. It isn’t pretty, either.
The role of private equity has come to the fore as part of the bloodletting among Republican candidates over the record of Mitt Romney and his former investment firm, Bain Capital. But the issue is much broader than one executive or company and of longer term than one primary campaign.
There are times when such firms destroy value for society as a whole, even though they themselves benefit. The knotty problem is that it often isn’t easy to tell, even after the fact.
Some companies get into trouble because they are badly managed or because circumstances change so drastically that activities that worked at one time no longer do. If their managers cannot make necessary changes, someone else must do it.
If the company in question is a corporation, the theory is that stockholders, acting through the board of directors they elect to represent them, can hire new managers to turn the company around. Boards themselves, however, are often part of the problem. And stockholders may prefer to bail out of their investments, taking whatever cash they can rather than wait for an uncertain outcome.
The best option often is for someone else to take over the company. Such reorganizations or turnarounds usually involve financial restructuring, such as negotiating debt reductions, raising new capital or going through bankruptcy. They may involve selling off unneeded assets. They usually mean firing employees.
Many of those laid off naturally see themselves as victims of the new owners. Some realize the firm might have gone under without drastic changes.
But it is natural to resent someone who is the visible proximate cause of your hardship.
The new owners may make a pretty penny if their efforts succeed. But often they have assumed much risk. Many deals turn sour. If the takeover or turnaround business is sufficiently competitive, economic theory says the returns will be justified
In this scenario, which often occurs in the real world, the outcome is positive for society, even if adverse for those laid off, for original stockholders who lost most of their investment and for former suppliers, customers or others affected by the changes. Needed changes have been made, and resources end up being used more efficiently.
But one also can identify myriad cases where a takeover is good for some parties to the deal but does much greater harm to others, and with a negative outcome for society as a whole.
To those with quasi-religious faith that markets never fail, this outcome is impossible. There is, however, enormous evidence in the real world that markets can and do fail.
Some takeovers clearly are necessary and benefit society.
Some clearly are rapacious acts representing gross market failure. But most fall into a gray area where overall costs and benefits are hard to determine.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
