Does it Matter (How the Money is Made)?

Asset owners face dilemmas about whether the investment function ought to be an island unto itself, only concerned about the optimal risk/return profile for the portfolio, or whether other considerations ought to be factored into decision making.

Business models

An expansive look at that topic would need to cover a lot of ground.  Instead, let’s focus on a question that gets much less attention:  Are there business models in which you won’t invest?

As an example, consider the plight of newspapers.  Thirty years ago, their business models seemed unassailable.  Then the advent of the internet led to a decimation of the classified ad business (principally at the hands of Craigslist), a much more difficult display ad environment, and a drop in subscribers because of the availability of online news.  It became a downward spiral that led to the severe contraction of many previously powerful franchises and the demise of some.

But this posting isn’t about the plight of those newspapers.  They are introduced in order to look at the business models of some investment firms that identified a profit opportunity in the midst of the industry’s challenges.  With the assets available at cheap prices, those investors purchased newspaper companies, offering hope to the communities that the operations would survive.

But, over time, the real strategy revealed itself.  There was never any intention to create going concerns out of the struggling businesses.  In short order, employees were cut to the point of irrelevancy, local news was replaced by filler sourced elsewhere, and it became only a question of when the inevitable closure would occur.  Buying at a bargain price, dramatically lowering costs, and milking the business for short-term return rather than trying to sustain it were part of the plan all along.  Vulture capitalism, plain and simple.

When shutting the papers down, the investment firms invariably say that they couldn’t be run profitably, but that is preordained by the strategy employed.  Other kinds of buyers, managing for the long-term health of the business — and being responsive to the needs of the community — could have made it work.  But that was never the goal of the acquirers.

And so, the thematic question of the day:  As an asset owner, does it matter to you how the money is made, or just that the money is made?

Health care

Similar questions are increasingly being asked about investments in health care.  See, for example, a three-part series in the Wall Street Journal:

“You Can Thank Private Equity for That Enormous Doctor’s Bill: Private-equity investors have poured billions into healthcare but often game the system, hurting both doctors and patients” (link).

“As Hospitals Grow, So Does Your Bill: Consolidation across the hospital industry has contributed to the higher cost of healthcare” (link).

“What Happens When Your Insurer Is Also Your Doctor and Your Pharmacist: Health insurers like UnitedHealth Group are seeking to control many parts of our healthcare system, creating potential conflicts of interest” (link).

Or an article from Harvard Medical School that summarizes a study published in the Journal of the American Medical Association about “What Happens When Private Equity Takes Over a Hospital.”  The subtitle offers the conclusion:  “New analysis shows alarming increase in patient complications.”

There are many other examples that could be shared.  Repeating:  as an asset owner, does it matter to you how the money is made?

Private equity

Not all of the “additive for the investor, destructive for others” examples are related to private equity funds, but many of them are.  Despite the protestations of advocates, the standard PE fund structure does not incent behaviors meant to build a business for the long term.  The goal is to generate attractive returns and sell the company to someone else after a few years.

Often, a key part of generating those returns are leveraged payouts, including dividend recapitalizations and/or the sale and leaseback of company real estate.  Those moves can increase returns if the economic environment stays favorable, but they also increase the risk of subpar performance and even failure.  Over the last couple of decades, the economic and interest rate outlook have been supportive; a tougher environment for a prolonged period will likely result in more bankruptcies of companies that could have survived with a different ownership model.

But it’s not that a private equity investment is necessarily problematic.  Perpetual or multi-decade structures can provide better incentives than typical funds; investments marked by operating improvements rather than financial engineering live up to the promise of the form; KKR’s shared ownership initiative represents a change that could to lead to better employee relationships and stronger firms; and “private equity impact funds” can generate positive outcomes where others are trying to maximize profit with destructive business models.

As an example of the last point, there are some specialty private equity health care firms which have shown improvements in patient outcomes, bucking the general results seen elsewhere.  But their returns are lower.  Let’s say they are able to produce a low- to mid-teens rate of return, while other firms not focused on making a positive impact tell you that they expect to earn more than twenty percent.  In which one are you likely to invest?

Answering the question

Private equity investment in health care is increasingly a hot topic.  State and federal governments are talking about restricting or preventing PE investment for some kinds of companies, but the issue goes beyond that industry to the prevalence of destructive business models employed in service of delivering attractive returns to asset owners.  And therefore, asset owners are the ones who have to decide:

Does it matter how the money is made?

The blunt nature of that question might seem to indicate that there is an easy answer.  There is not, unless nothing matters under any circumstance.

Outside of that, where should the lines be drawn as to what kinds of business models are acceptable and which are not?  That’s a thorny issue smack dab in the middle of the intersection of investment, organizational, and mission/purpose beliefs.  Every organization needs to wrestle with competing ideas and interests to determine its stance.

Upon being named an Honorary Fellow of the Chartered Institute for Securities & Investment, John Kay offered some remarks about “the role of the professional.”  Toward the end, he quoted Émile Durkheim:

It is not possible for social function to exist without moral discipline.  Otherwise nothing remains but individual appetites.  And since they are by nature boundless and insatiable, if there is nothing to control them, they will not be able to control themselves.

Asset owners are in the unique position of deciding how capital gets allocated — to which strategies, organizations, and business models — in the process addressing foundational dilemmas like whether it matters how the money is made.