[Private equity has made one-fifth of the market effectively
invisible to investors, the media, and regulators.]
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THE SECRETIVE INDUSTRY DEVOURING THE U.S. ECONOMY  
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Rogé Karma
October 30, 2023
The Atlantic
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_ Private equity has made one-fifth of the market effectively
invisible to investors, the media, and regulators. _

Wall Street Bull, by thenails (licensed under CC BY 2.0)

 

The publicly traded company is disappearing. In 1996, about 8,000
firms were listed in the U.S. stock market. Since then, the national
economy has grown by nearly $20 trillion. The population has increased
by 70 million people. And yet, today, the number of American public
companies stands at fewer than 4,000
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How can that be?

One answer is that the private-equity industry is devouring them. When
a private-equity fund buys a publicly traded company, it takes the
company private—hence the name. (If the company has not yet gone
public, the acquisition keeps that from happening.) This gives the
fund total control, which in theory allows it to find ways to boost
profits so that it can sell the company for a big payday a few years
later. In practice, going private can have more troubling
consequences. The thing about public companies is that they’re,
well, public. By law, they have to disclose information about their
finances, operations, business risks, and legal liabilities. Taking a
company private exempts it from those requirements.

That may not have been such a big deal when private equity was a niche
industry. Today, however, it’s anything but. In 2000, private-equity
firms managed about 4 percent of total U.S. corporate equity. By 2021,
that number was closer to 20 percent. In other words, private equity
has been growing nearly five times faster than the U.S. economy as a
whole.

James Surowiecki: The method in the market’s madness
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Elisabeth de Fontenay, a law professor at Duke University who studies
corporate finance, told me that if current trends continue, “we
could end up with a completely opaque economy.”

This should alarm you even if you’ve never bought a stock in your
life. One-fifth of the market has been made effectively invisible to
investors, the media, and regulators. Information as basic as who
actually owns a company, how it makes its money, or whether it is
profitable is “disappearing indefinitely into private equity
darkness,” as the Harvard Law professor John Coates writes in his
book _The Problem of Twelve_
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This is not a recipe for corporate responsibility or economic
stability. A private economy is one in which companies can more easily
get away with wrongdoing and an economic crisis can take everyone by
surprise. And to a startling degree, a private economy is what we
already have.

America learned the hard way what happens when corporations operate
in the dark. Before the Great Depression, the whole U.S. economy
functioned sort of like the crypto market in 2021. Companies could
raise however much money they wanted from whomever they wanted. They
could claim almost anything about their finances or business model.
Investors often had no good way of knowing whether they were being
defrauded, let alone whether to expect a good return.

Then came the worst economic crisis in U.S. history. From October to
December of 1929, the stock market lost 50 percent of its value, with
more losses to come. Thousands of banks collapsed, wiping out the
savings of millions of Americans. Unemployment spiked to 25 percent.
The Great Depression generated a crisis of confidence for American
capitalism. Public hearings revealed just how rampant corporate fraud
had become before the crash. In response, Congress passed the
Securities Act of 1933 and the Securities Exchange Act of 1934. These
laws launched a regime of “full and fair disclosure” and created a
new government agency, the Securities and Exchange Commission, to
enforce it. Now if companies wanted to raise money from the public,
they would have to disclose a wide array of information to the public.
This would include basic details about the company’s operations and
finances, plus a comprehensive list of major risks facing the company,
plans for complying with current and future regulations, and
documentation of outstanding legal liabilities. All of these
disclosures would be reviewed for accuracy by the SEC.

This regime created a new social contract for American capitalism:
scale in exchange for transparency. Private companies were limited to
100 investors, putting a hard limit on how quickly they could grow.
Any business that wanted to raise serious capital from the public had
to submit itself to the new reporting laws. Over the next half
century, this disclosure regime would underwrite the longest period of
economic growth and prosperity in U.S. history. But it didn’t last.
Beginning in the “Greed Is Good” 1980s, a wave of deregulatory
reforms made it easier for private companies to raise capital. Most
important was the National Securities Markets Improvement Act of 1996,
which allowed private funds to raise an unlimited amount of money from
an unlimited number of institutional investors. The law created a
loophole that effectively broke the scale-for-transparency bargain.
Tellingly, 1997 was the year the number
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public companies in America peaked.

From the November 2018 issue: The death of the IPO
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“Suddenly, private companies could raise all the money they want
without even thinking about an IPO,” De Fontenay said. “That
completely undermined the incentives companies had to go public.”
Indeed, from 1980 to 2000, an average of 310 companies went public
every year; from 2001 to 2022, only 118 did. The number briefly shot
up during the coronavirus pandemic but has since fallen. (Over the
same time period, the rate of mergers and acquisitions soared
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which also helps explain the decline in public companies.)

Meanwhile, private equity has matured into a multitrillion-dollar
industry, devoted to making short-term profits from highly leveraged
transactions, operating with almost no regulatory or public scrutiny.
Not all private-equity deals end in calamity, of course, and not all
public companies are paragons of civic virtue. But the secrecy in
which private-equity firms operate emboldens them to act more
recklessly—and makes it much harder to hold them accountable when
they do. Private-equity investment in nursing homes, to take just one
example, has grown
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about $5 billion at the turn of the century to more than $100 billion
today. The results have not been pretty. The industry seems to have
recognized that it could improve profit margins by cutting back on
staffing while relying more on psychoactive medication. Stories abound
of patients being rushed
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the hospital after being overprescribed opioids, of bedside call
buttons so poorly attended
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residents suffer in silence while waiting for help, of nurses
being pressured
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while sick with COVID. A 2021 study concluded
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private-equity ownership was associated with about 22,500 premature
nursing-home deaths from 2005 to 2017—_before_ the wave of death
and misery wrought by the pandemic.

Eventually, the public got wind of what was happening. The pandemic
death count focused attention on the industry. Journalists and
watchdog groups exposed the worst of the behaviors. Policy makers and
regulators, at long last, began to take action. But by then, much of
the damage had been done. “If we had some form of disclosure, we
probably would have seen regulatory action a decade earlier,” Coates
told me. “But instead, we’ve had 10-plus years of experimentation
and abuse without anyone knowing.”

Something similar could be said about any number of industries,
including higher education
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and grocery stores
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Across the economy, private-equity firms are known for laying off
workers, evading regulations, reducing the quality of services,
and bankrupting companies
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ensuring that their own partners are paid handsomely. The veil of
secrecy makes all of this easier to execute and harder to stop.

Private-equity funds dispute many of the criticisms of the industry.
They argue that the horror stories are exaggerated and that a handful
of problematic firms shouldn’t tarnish the rest of the industry,
which is doing great work. Freed from onerous disclosure requirements,
they claim, private companies can build more dynamic, flexible
businesses that generate greater returns for shareholders. But the
lack of public information makes verifying these claims
difficult. Most
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private-equity funds slightly outperformed the stock market on average
prior to the early 2000s, they no longer do so. When you take into
account their high fees, they appear to be a worse investment than a
simple index fund.

“These companies basically get to write their own stories,” says
Alyssa Giachino, the research director at the Private Equity
Stakeholder Project. “They produce their own reports. They come up
with their own numbers. And there’s no one making sure they are
telling the truth.”

In the roaring ’20s, the lack of corporate disclosure allowed a
massive financial crisis to build up without anyone noticing. A
century later, the growth of a new shadow economy could pose similar
risks.

The hallmark of a private-equity deal is the so-called leveraged
buyout. Funds take on massive amounts of debt to buy companies, with
the goal of reselling in a few years at a profit. If all of that debt
becomes hard to pay back—because of, say, an economic downturn or
rising interest rates—a wave of defaults could ripple through the
financial system. In fact, this has happened before: The original
leveraged buyout mania of the 1980s helped spark
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1989 stock-market crash. Since then, private equity has grown into a
$12 trillion industry and has begun raising much of its money from
unregulated, nonbank lenders, many of which are owned by the same
private-equity funds taking out loans in the first place.

Meanwhile, interest rates have reached a 20-year high, posing a
direct threat
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private equity’s debt-heavy business model. In response, many
private-equity funds have migrated toward even riskier forms
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backroom financing. Many of these involve taking on even more debt
on the assumption
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market conditions will soon improve enough to restore profitability.
If that doesn’t happen—and many of these big deals fail—the
implications could be massive.

Joe Nocera and Bethany McLean: What financial engineering does to
hospitals
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The industry counters that private markets are a better place for
risky deals precisely because they have fewer ties to the real
economy. A traditional bank has a bunch of ordinary depositors,
whereas if a private-equity firm goes bust, the losers are
institutional investors: pension funds, university endowments, wealthy
fund managers. Bad, but not catastrophic. The problem, once again, is
that no one knows how true that story is. Banks have to disclose
information to regulators about how much they’re lending, how much
capital they’re holding, and how their loans are performing. Private
lenders sidestep all of that, meaning that regulators can’t know
what risks exist in the system or how tied they are
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the real economy.

“Everything could be just fine,” says Ana Arsov, a managing
director at Moody’s Investors Service who leads research on private
lending. “But the point is that we don’t have the information we
need to assess risk. Who is making these loans? How big are they? What
are the terms? We just don’t know. So the worry is that the leverage
in the system might grow and grow and grow without anyone noticing.
And we really don’t know what the effects could be if something goes
wrong.”

The government appears to be at least somewhat aware
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this problem. In August, the SEC proposed
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new rule requiring private-equity fund advisers to give more
information to their investors. That’s better than nothing, but it
hardly addresses the bad behavior or systemic risk. Nearly a century
ago, Congress concluded that the nation’s economic system could not
survive as long as its most powerful companies were left to operate in
the shadows. It took the worst economic cataclysm in American history
to learn that lesson. The question now is what it will take to learn
it again.

_Never miss a story from The Atlantic. Subscribe for in-depth
reporting and analysis.
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_Support for this project was provided by the William and Flora
Hewlett Foundation._

_Rogé Karma [[link removed]] is a
staff writer at The Atlantic._

* Wall Street
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* private equity
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