Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

Private equity firms claim to make companies more efficient and profitable, in part because they are the direct owners of these companies. In theory, separating owners (shareholders) and managers should resolve the vested interests that the latter have in increasing their own financial compensation rather than the price of the companies’ stocks. (This is the main reason why the overriding objective for the contemporary asset manager is to maximize shareholder value, as measured by the shares’ price.) Critics, however, say that private equity firms have a deleterious impact on companies: their aim is to cut costs in the short term, for example by firing workers and reducing investment, in order to make a quick profit selling the business, at the expense of long-term corporate health.

The owners of private equity firms are called general partners (GPs). The funds they use to buy companies come from investors such as pension funds, foundations, insurance companies and wealthy individuals. Public and private pension funds contribute about a third of the value of the total funds PE firms invest. All these types of investors are called limited partners (LPs). They commit their money for a fixed time, say ten years, during which time they usually cannot withdraw funds. However, a good deal of PE firms’ investment funds can be classified as debt, used to buy the equity stakes in the anticipation of repaying it with gains in equity value. PE firms are often criticized for placing that debt on the balance sheets of the companies they buy, while continuing to extract dividends from the companies rather than service the debt. KKR’s first high-profile acquisition, the leveraged buyout of cereal and tobacco group RJR Nabisco in 1988, captured in the book and film Barbarians at the Gate , 24loaded the Shredded Wheat manufacturer with debt from which it never fully recovered, but launched the PE firm on its continuing global expansion. PE firms have become particularly adept at borrowing to acquire a firm and then arranging a ‘special dividend’, often for a similar sum, which ensures a rapid profit from the deal even if the borrowings, transferred to the acquired firm, depress its resale price or even doom its existence. The PE firm TA Associates demonstrated how far this technique could be stretched when in 2014 it secured a $1.77 billion ‘syndication loan’ (a type made possible by banks immediately securitizing and reselling them) against drug-testing firm Millennium Laboratories – and immediately arranged a $1.29 billion special dividend. The transaction conformed to all rules imposed after 2008 to prevent ‘asset-stripping’ by private acquirers. When Millennium declared bankruptcy the following year, a court indemnified TA and other shareholders (the firm’s former managers) against any effort by creditors to claw back the dividend, even after it was revealed that the owners and their loan arrangers had not informed them that its biggest client, the US government, had successfully sued it for $256 million over fraudulent tests. 25

HOW FINANCE EXTRACTS VALUE

How does finance extract value? There are broadly three related answers: by inserting a wedge, in the form of transaction costs, between providers and receivers of finance; through monopoly power, especially in the case of banks; and with high charges relative to risks run, notably in fund management.

In certain areas of the economy, such transaction costs are regarded as reducing efficiency and destroying value, not creating it. Governments are accused of inefficiency whenever they impose an income tax – which puts a wedge between what people receive for work and the value they place on leisure – or when they try to finance social security through a payroll tax, which disconnects wage costs from total labour costs. When they secure a pay rise for their members, trade unions are accused of increasing workers’ pay while their contribution to production remains the same.

As far as banks are concerned, their efficiency as useful intermediaries between borrowers and lenders might reasonably be judged by their ability to narrow the ‘wedge’, or cost gap, between the two. Maximum efficiency, friction-free capitalism, would in theory be reached when the interest differential disappears. Yet the ‘indirect’ measure of financial intermediation services adopted by national accounts (FISIM, explained in Chapter 4) assumes that a rise in added value will be reflected in a wider wedge (or, if the wedge narrows, by increased fees and charges through which intermediaries can obtain payment directly). The point, of course, is not to eliminate interest but – if interest is the price of financial intermediation – to make sure that it reflects increased efficiencies in the system, driven by appropriate investments in technological change, as some fintech (financial technology) developments have done.

Banks stand in sharp contrast to supermarkets. As we have seen, the cost of financial services probably rose in the twentieth century, despite the dramatic growth of the financial industry, suggesting that financial consumers did not benefit from economies of scale in the same way as they did with supermarkets, epitomized by Walmart in the US and Tesco in the UK. A large part of the explanation for the difference is the monopolistic – or more strictly, oligopolistic – nature of banking.

In 2010, five big US banks controlled over 96 per cent of the derivative contracts in place. 26In the UK, ten financial institutions accounted for 85 per cent of over-the-counter derivatives turnover in 2016, and 77 per cent of foreign exchange turnover. 27Only the biggest banks can take the risk of large-scale writing and trading in derivatives, since they need a comfortable cushion of equity between the value of their assets and liabilities to stay solvent if asset prices fall. Only a few banks worldwide have grown big enough to sustain the high risks of proprietary trading – trading on their own account rather than for a client – and to be worthy of state-supported rescue if the risks prove too great.

As a result, there are few banks with whom governments and large corporations can place new bond or share issues and expect subsequent market-making in those securities. The paucity of players, even in large financial centres such as London and New York, inevitably gives each bank considerable price-setting power, irrespective of whether or not they collude among themselves to do so. In retail markets, minimum core capital requirements for banks (raised after 2008, to 4.5 per cent of risk-weighted assets in 2013, 5.5 per cent in 2015 and 6 per cent from 2016) 28and the need for prudential regulation limits the number of banking licences that governments and central banks can issue, and confers significant market power on the few banks who hold such licences. This power enabled banks to secure 40 per cent of total US corporate profits in 2002 (up from 13 per cent in 1985). They still enjoyed 23 per cent in 2010 and almost 30 per cent in 2012 – just two years after rebounding after a brief plunge to 10 per cent in 2008, in a period when corporate profits were growing much faster than labour income or GDP. 29

The high degree of monopoly in wholesale and retail banking is closely linked to its continuing ability to extract rents from the private and public sectors, even when these were shrinking in the aftermath of the 2008 crash. In the UK, since the financial crisis regulators have aimed to promote new banks and alternative forms of financial intermediation, such as peer-to-peer lending, in order to spur competition. The handful of new banks started in the UK since the crisis are somewhat optimistically called ‘challenger banks’ – a challenge that so far has not put much of a dent in the oligopoly of UK ‘high street’ banks. Nor are alternative forms of financial intermediation effective substitutes for the dominant banks. Only licensed banks can create money through loans, 30as distinct from merely shifting money between savers and borrowers. Once banks’ profitability has been swelled by the market power that allows them to extract rents from other sectors, their top employees can in turn exert internal labour-market power to channel a share of those rents to themselves, helping to give the financial sector its unique and entrenched bonus culture.