Because a buyout fund buys 100 percent of the company and controls it, it has often been argued that buyout funds reduce the problems created by a separation of ownership and control. Buyout funds are in full control of companies but minority shareholders. The majority of the shareholders are the investors in the funds. This new governance structure may introduce new agency conflicts and preserve some of the old ones. To understand whether buyout funds reduce overall agency conflicts, we need to better understand the relation between buyout funds and their investors. As a step in this direction, this paper describes the contracts between funds and investors and the return earned by investors.
The average fund charges the equivalent of 8 percent fees per year despite a return below that of the Standard and Poor's 500. This excessive rent raise the question of why does the marginal investor buy buyout funds? I explore one potential - and probably the most controversial - answer: some investors are fooled.
I show that the fee contracts are opaque and difficult to quantify. In addition, compensation contracts imply lower fees at first sight than in reality. What generate large fees are some details of the contracts, not the big headline. Investors may thus underestimate the impact of fees. I also show the different aspects of the fund raising prospectuses that can be misleading. I then discuss whether investors can learn or whether this situation may persist. Finally, to further understand the potential agency conflicts between buyout funds and their investors, I discuss a few features of buyout contracts that exacerbate conflicts of interest, rather than mitigate them. For example, several contract clauses provide steep incentives that distort the optimal timing of investments, their leverage, their size and the number of changes operated in portfolio companies.Phalippoustates
A large literature has pointed out that publicly owned companies may suffer from a separation of their ownership by dispersed shareholders and their day-to-day control by managers. This separation of ownership and control leads to a number of so-called agency conflicts, in which management may not act in the best interests of shareholders.
Because a private equity fund buys 100 percent of the company and controls it, it has often been argued that the arrangement will reduce these agency problems (Jensen, 1989; Shleifer and Vishny, 1997). But while private equity funds have full control of companies, the fund itself is acting on behalf of outside investors. In a typical scenario, a private equity buyout fund buys a company by borrowing money from banks and by using cash provided by a small group of large investors such as university endowments or pension funds. The companies targeted for buyout could be listed on a stock exchange (for example, Nabisco in 1989 or Hospital Corporation of America in 2006) or be privately held (Hertz Corp. bought from Ford in 2005 or Warner Music bought from Time Warner in 2004). This new private equity fund governance structure may ameliorate some agency conflicts, but it may also introduce new ones. As a step towards understanding whether private equity buyout funds reduce overall agency conflicts, this paper describes the contracts between funds and investors and the return earned by investors.
The paper sets the stage with a puzzle: the average performance of private equity funds is above that of the Standard and Poor’s 500 – the main public stock market index – before fees are charged, but below that benchmark after fees are charged. This fact leads naturally to a discussion of the institutional background of buyout funds, beginning with the compensation contracts between the fund and the investors. Next, it covers how buyout funds report their returns, explaining terms like “multiples” and “internal rates of return.”
The average private equity buyout fund charges the equivalent of 7 percent fees per year, despite a return below that of the Standard and Poor’s 500. Why are the payments to private equity funds so large? Why does the marginal investor buy buyout funds? I explore one potential – and probably the most controversial – answer; that is, some investors are fooled. I show that the fee contracts are opaque. The compensation contracts for buyout funds typically imply lower fees at first sight than actually occur. The larger fees are generated by what seem like minor details in these contracts. Investors may thus underestimate the impact of fees. I also show the different aspects of the fund raising prospectuses that can be misleading for investors. I then discuss whether investors in private equity funds learn over time or whether the “low performance – high fee” situation may be persistent. Finally, to further understand the potential agency conflicts between buyout funds and their investors, I discuss a few features of buyout contracts that exacerbate conflicts of interest, rather than mitigate them. For example, several contract clauses provide incentives that can distort the optimal timing of investments, of their leverage, and of their size.
The conclusion emphasizes that these problems with buyout funds should perhaps not be considered too surprising, given that similar issues arise in other common investment vehicles like many mutual funds and hedge funds.Pinto again? 'The Use of Economics in Defense of General Motors’ Decision Not to Fix Faulty Ignition Switches Demonstrates that Economics Is Not A Moral Theory' by Daniel Isaacs in (2015) Connecticut Law Review [PDF] comments
The General Motors’ Company recently faced problems with a faulty ignition switch. One might think that GM’s handling of its ignition problem was obviously disastrous, as it killed and maimed many innocent people. Leading law and economics scholar Eric Posner disagrees. He maintains that GM’s actions may have been reasonable if the cost to GM to fix the defect was less than the amount the ordinary person would pay to avoid the risk. His perspective is important and dangerous, because it will encourage similar behavior. Nonetheless, he offers an argument that on the surface seems persuasive. In this Essay I propose to show how Posner is wrong and what makes GM’s actions wrong. Moreover, I offer a different model to understand how companies like GM should approach similar problems.Isaacs states General Motors
engineers knew for years that the company installed faulty ignition switches in its vehicles. The switches, when jostled, caused the cars to stall, leaving drivers unable to maintain their speed and disabling air bags. Nevertheless, in meeting after meeting, and despite a toll of numerous deaths and many injuries, those with the authority and responsibility to fix the problem failed to act.
To most people, GM’s actions were clearly wrong. However, Eric Posner, a leading law and economics scholar, disagrees and argues that the public may be asking the wrong question in condemning GM. He maintains that his application of economics as a moral theory demonstrates that GM may have acted properly. He contends that a manufacturer’s decision as to whether to fix a defective component should turn on whether the cost of fixing the component exceeds what the “ordinary person” would pay to avoid the risk. That is, Posner asserts that if it would cost the manufacturer more than the amount the ordinary person would pay to avoid the risk, the manufacturer would be morally justified in keeping its defective product in the stream of commerce.
I disagree, and maintain that economics is a poor tool for making normative decisions like the ones GM faced. Economics does have the advantage of giving definitive answers to difficult questions, and Posner’s argument has some facial appeal. The problem is that he and GM are wrong and other businesses may be following GM’s lead in using economics to make normative decisions. That is why Posner’s perspective is so important and yet dangerous. GM’s lawyers say that everyone was responsible, but no one took action. However, economics is not a measure of human responsibility to others or to society and it is, therefore, a poor tool for making the normative decisions that GM faced.
... Posner argues that we should not be so quick to condemn GM for its failure to recall its cars with faulty ignition systems. Based on economic theory, he maintains that GM may have acted properly. While Posner maintains that it is hard to know whether GM acted reasonably or not, his economic argument as to how to analyze the question is flawed. His argument is based on the hypothetical amount that people would pay to avoid the risk of death as a result of GM’s faulty ignition system. Posner also argues that the public should not focus on the claim that it would have cost GM fifty-seven cents per car to fix the ignition switch defect. Instead, he calculates that the risk of being killed as a result of a faulty ignition switch is extraordinarily low, “.0000007 . . . . [t]hat’s less than one in a million.” He reasons that during the same time period the defect increased the risk of death in 2002 “(by .0000007) from .0000567 [in other GM cars] to .0000574.”
He then applied:
a concept known as the “value of a statistical life,” which is derived from studies of how much people need to be paid in order to accept a slightly greater risk of death. . . . The current standard is $7 million. The $7 million figure implies that an ordinary person would be willing to pay about $5 to avoid a .0000007 risk of death in a given year.
Doing the math, Posner calculates that GM “should have fixed the ignition switch if the cost was less than $5 per car, multiplied by the number of years left in the car’s useful life.” Based on the value of a statistical life analysis, Posner argues that GM should have paid “$40, or $5 per car multiplied by the average eight years of remaining time on the road.” GM claims that in 2007 it would have cost $50 to fix each car, so Posner recognizes that: GM may have known of the problem as early as 2001 but believed that a design change fixed the problem. It revisited the issue in 2004 after receiving a complaint from a customer that the vehicle ‘can be keyed off with knee while driving.’ In 2005 engineers concluded that possible fixes were too costly or inadequate, and later GM told dealers to tell customers to remove heavy items from key rings. Also in 2005, a fatal accident occurred that may have been caused by the ignition switch problem. In 2006 GM began installing modified ignition switches in 2007 models. Over the ensuing years, more fatal accidents occurred and GM conducted additional investigations.
Posner concluded that although “it’s close . . . if it cost $50 to repair an ignition switch, then GM acted reasonably by saving this money rather than recalling cars for the sake of a benefit of $40.”...
Posner’s argument with respect to the proper moral theory GM managers should have applied in determining whether to recall the faulty ignition systems is flawed for three main reasons. First, with respect to a known defect, like the one at issue at GM, the analysis should not be based on the amount “the ordinary person” would pay to avoid the risk compared with the cost to the employer to make the repair. GM was not dealing with random events. Instead, Posner is considering a known defect that manifested in personal injuries and deaths. The rate of injury and cost of repair are immaterial when the actions at issue are known ones, as they were in the case of GM’s actions concerning the faulty ignition switch. For example, if I were to swing a bat in a public space (even if I were blindfolded) I would not know who I am going to hit, but eventually, I am likely to injure someone. When I do, factors such as my costs of not swinging the bat, the amount of time people are in the area, or the amount of money people would pay to avoid the risk of being hit are irrelevant to the question of whether I am morally justified in swinging the bat. Once GM knew that the ignition switch was defective, and that it could cause the airbags to fail to deploy, Posner’s cost-based analysis is, at best, a barometer of the improper behavior—a measure of how bad the action is—but it is irrelevant to the moral questions the company faced because he offers a measure that begins above the threshold line of unethical behavior. As a matter of business ethics, if a company knows that a component is defective, and is on notice that the defect caused injury, it should fix the defect—or not sell the product—not balance the cost of fixing the defect against the amount the average person would pay to avoid the risk so as to see whether it should do so as Posner advocates.
Second, Posner does not claim that GM actually conducted a hypothetical “value of a statistical life” analysis with respect to the GM customers who purchased vehicles with faulty ignition switches; and he recognizes that his calculations exclude the costs of personal injuries, the damage to property, and the possibility that GM knew about the defect earlier than it claims. Similarly, it is odd that Posner accepts 2007 as the date to conduct the risk benefit analysis, when GM appears to have known about the problem much earlier.
Third, no one appears to have actually disclosed the risk of death or injury to GM’s customers before they purchased their vehicles or actually paid them to avoid the risk. Specifically, it does not appear that GM told potential purchasers that their cars may stall in the middle of an intersection, that their airbags would not deploy, and that GM may have known that a faulty ignition switch would cause injuries or death to some of them and that they, for a price, could avoid the risk by purchasing a product that did not contain the defect.
Relying on Posner’s economic theory is akin to holding someone to a hypothetical contract that provides that where the cost to the company of repairing a known defect is less than the amount the consumer would pay to avoid the risk, the manufacturer would have no duty to make the repair.