“Breach of Trust in Hostile Takeovers”

Homes are seen next to a closed factory on Oct. 20, 2011 in Reading, Penn, a city that once boasted numerous industries and the nation’s largest railroad company

Photograph by Spencer Platt/Getty Images.

Anthony Gardner writes for Bloomberg View that the Bain Capital mode of doing business created privatized gains and socialized losses through a variety of mechanisms. Josh Barro defends the Bain model.

I think critiques of private equity that rely too heavily on the charge that they exploit the tax deductibility of corporate debt are fairly weak. The tax code is full of ill-advised loopholes and deductions. But just because I think the mortgage interest tax deduction should be done away with doesn’t mean I think people are doing something wrong when they take advantage of it. I take advantage of it myself.

The strong case against private equity comes from an old 1988 paper from Lawrence Summers and Andrei Schleifer titled “Breach of Trust in Hostile Takeovers” which mostly uses ‘80s terminology rather than contemporary PE lingo.

Their starting point is Ronald Coase’s observation that the existence of companies (“firms”) is left a bit mysterious by econ 101 reasoning. Why don’t free agents just contract with one another for services as a means of economic cooperation? One reason, he argues convincingly, is that trying to spell out each and every obligation in contractual terms would be both laborious and absurdly inflexible. If you think about the way your workplace actually functions, people have roles and obligations vis-a-vis each other that are considerably richer and more nuanced than what’s spelled out in legal documents. These roles evolve over time in various ways, but they also have some stability to them. The point is to create a space of collaborative endeavor that isn’t dominated by constant lawyerly bickering.

Summers & Shleifer observe that this often creates substantial arbitrage opportunities. You can buy up a company and then exploit your formal rights as owner to the hilt completely ignoring inumerable tacit bargains and promises. Indeed, since you the new owner didn’t actually make the promises you may feel that you’re not bound by them.

The big socialized loss in the case of this kind of “breach of trust” scenario is loss of trust and economy-wide loss of ability of managers and workers to form flexible implicit arrangements with one another. Summers and Shleifer write that it’s difficult to assess the systematic impact of this because to do so “we must analyze a world in which people trust each other less, workers are not loyal to firms, and spot market transactions are more common than they are at this time.” That’s a difficult task. But we do know something about what an economy like that looks like. It looks like Greece or Italy where firms are much smaller and less productive in part as a coping mechanism in a low-trust environment. Interestingly, since the time “Breach of Trust” was published, American firm size has gone into decline. I don’t know that there’s an ironclad policy remedy to this. Preventing hostile takeovers altogether creates other bad problems and attempting to legislate which implicit promises can’t be broken would be paradoxical. At a minimum, it strongly suggests that insofar as the availability of the carried interest loophole tends to channel smart greedy hardworking people into private equity rather than conventional corporate management we’re needlessly exacerbating an underlying weakness in our social fabric.