Is private equity merely maximising private benefit at social cost?

The role of private equity in welfare and public goods is a matter of intense debate. The ideologues on the right are as ardent supporters of it as those on the left are equally vehement critics. The empirical evidence on the effects of PE in these sectors is clear. It leads to operational efficiency improvements and higher profits for the owners, but at the cost of those these service providers are supposed to serve. In other words, private profiteering at the cost of its customers!

Jonathan Ford points to two exhibits in this regard from nursing care homes and higher education in the US. The first is a study by Atul Gupta, Sabrina Howell, Constantine Yannelis, and Abhinav Gupta (see also this paper version) on the impact of private equity investments in old aged care and nursing home business. They examined 118 US PE deals involving 1674 care homes covering seven million unique patients between 2000 and 2017 and found that while the PE firms gained by enhancing efficiencies, they came at the cost of patients. 

Their rigorous empirical study paints a disturbing portrait of private equity ownership in healthcare in the context of nursing homes, a $166 bn and rapidly growing industry in the US. They write,

The past two decades have seen a dramatic increase in private equity investment in healthcare, a sector in which intensive government subsidy and market frictions could lead high-powered for-profit incentives to be misaligned with the social goals of quality care at a reasonable cost... We find that going to a private equity-owned nursing home increases the probability of death during the stay and the following 90 days by 1.8 percentage points, about 10% of the mean. In the context of the health economics literature, this is a large effect. This estimate implies about 21,000 lives and 205,000 life-years lost due to private equity ownership of nursing homes during our sample period. The mortality effect is concentrated among older patients, especially those with relatively low disease burdens. This effect is robust to a battery of specification checks... Hence, we interpret this as the effect of a change in ownership, and not driven by consolidation or corporatization. Using a conventional value of a life-year from the literature, we value this mortality cost at about $27 billion in 2016 dollars. To put the magnitude of this mortality cost in perspective, it far exceeds the total reimbursements received by private equity nursing homes from Medicare in our sample (about $17 billion). In contrast with a narrative in which private equity ownership improves the efficiency of care provision, we find that the amount billed per stay increases by 19%, the vast majority of which is billed to taxpayers... our results suggest that private equity owners may breach implicit contracts with stakeholders to maximize profits.

They examined three channels to identify the possible mechanisms driving this mortality effect,

The first is composed of measures of patient well-being. We find that going to a private equity-owned nursing home increases the probability of taking anti-psychotic medications by 50%. These drugs are increasingly discouraged in the elderly due to their association with greater mortality. We also find differential worsening of pain and declining mobility for patients at private equity owned homes. The next two channels employ facility-level data, where we use a differences-in-differences research design... We find that private equity ownership leads to a 3% decline in the per-patient availability of front line caregivers such as Certified Nursing Assistants (CNAs) and Licensed Practical Nurses (LPNs). These nurses provide the most time-intensive caregiving, for example helping patients to use the toilet and cleaning to minimize infection risk. The fact that older but relatively less sick patients drive the mortality result is consistent with a decline in low-skill caregiving. The elevated use of anti-psychotics discussed earlier may also be partly explained as a substitution response to lower nurse availability... Finally, we find negative effects on facility Five Star ratings, which are constructed by CMS to provide summary information on quality of care. For all the facility-level results, we provide evidence on dynamic effects to support the parallel trends assumption.

Another paper by Charlie Eaton, Constantine Yannelis, and Sabrina Howell looked at private equity investments in US higher education institutions. They too find private profiteering but with very large costs on pretty much all fronts among students and taxpayers - "higher tuition and per-student debt". They write,

We employ novel data on 88 deals in which private equity firms acquire independent, privatelyowned schools. These deals are associated with 557 school-level ownership changes, of which 218 occur after the deal through acquisitions. Private equity-owned school systems establish an additional 437 new schools. Using regressions with school and year fixed effects as well as a matching estimator, we confirm findings from the existing literature that private equity ownership leads to higher profits; in our data, profits triple after a buyout... The higher revenue that we observe comes partly from a $1,600 increase in tuition, which is approximately half average total tuition at community colleges. It also comes from almost 50 percent higher enrollment. Reliance on federal aid increases after private equity buyouts and approaches the 90 percent of revenue threshold that is the statutory limit. Per-student borrowing and per-student federal grants increase by about 12 and 14 percent of their respective means... We find sharp declines in student graduation rates, loan repayment rates, and labor market earnings after private equity buyouts (the declines are 13, 5.6, and 5.8 percent of their respective means). Enhanced recruiting and reduced instructional quality can reconcile the otherwise puzzling combination of higher enrollment despite higher tuition and deteriorating student outcomes. Private equity-owned schools have twice the share of employees in sales as other for-profits. We show that education inputs, including the ratio of faculty to students, the share of spending devoted to instruction, decline after the buyout. 

One of the most attractive feature for PE investments in such sectors comes from their taxpayer support and the potential to maximise the capture of that support,

We exploit a 2007 student loan borrowing limit expansion to test whether private equity-owned schools are more responsive to changes in federal loan guarantees. Relative to other institutions, private equity-owned schools respond to the increase by raising tuition faster than other for-profit schools, which induces higher levels of borrowing. Superior capture of government aid is thus a channel through which high-powered incentives of private equity ownership translate to higher profits. This is a purely rent-seeking phenomenon and is unambiguously not in students’ or taxpayers’ interest.

Worst off all, PE ownership is associated with law breaking,

An important further piece of evidence is that we find dramatic increases in law enforcement actions after buyouts, most of which stem from accusations of recruiting rule violations, such as quotas for sales staff, and misrepresentations of student loan terms, graduation rates, and student employment outcomes.

On PE's value creation and how they continue to attract customers despite declining quality of service delivery, they write, 

Our results shed light on how private equity creates value. This is an especially interesting question in the context of private-to-private transactions, which make up over 90 percent of private equity deal value and 99 percent of volume. When a private equity investor takes a public firm private, agency conflicts decline as control becomes more tightly bound to ownership. The mechanisms may be more nuanced in a private-to-private transaction. Compared to the pre-existing, private owners, private equity owners have higher-powered incentives to maximize firm value because fund managers are compensated through a call option-like share of the profits, employ substantial amounts of leverage, usually aim to liquidate investments within a short time frame, and do not have existing relationships with target firm stakeholders. 

Private equity is often treated as a monolith, either praised for creating value or maligned for supposed “strip and flip” strategies. Together, the existing literature and our results suggest that there is important heterogeneity. When incentives between investors and consumers are aligned, quality improvements should accompany firm value creation. In contrast, for-profit colleges feature severe information frictions and misaligned incentives. There is low price elasticity of demand, in part because tuition is not salient; students often enroll with zero up-front costs. Education quality is extremely opaque, allowing for reducing instructional resources while pursuing misleading marketing and recruiting strategies. The for-profit target population is vulnerable to these approaches because it is extremely socioeconomically disadvantaged. While dropouts may increase when instructional resources decline, rolling admissions enable rapid enrollment of new students. The required recruiting expenditures, especially with new sales technology adoption, may be lower than the cost of retaining existing students. The sector also features intensive government subsidy, separating revenue from the consumer. 

In particular, the expansion of federal student loan programs since the early 1990s created opportunities to increase firm value through implicit contract violations. As a new owner, the private equity investor may be well-positioned to take advantage of these opportunities for value creation. In order to establish the school, previous owners may have had to commit to implicit contracts with stakeholders; in exchange for government revenue, they would provide a valuable education. Their inability or unwillingness to take advantage of new opportunities is related to the reason why in settings such as healthcare and education, where consumers depend on implicit contracts with the firm, many service providers are nonprofit. Glaeser and Shleifer discuss how in such settings weaker incentives to maximize profits or increase value for investors can make nonprofit status optimal. This mechanism requires consumers to rationally choose nonprofit firms over for-profit ones. It may be infeasible for consumers to make this choice when subsidy separates revenue from the consumer and quality is hard to observe.

All this increasingly leads to the conclusion that large private investors and large private enterprises cannot be trusted to deliver high quality public services (health, education, prisons, skills training, court services etc). The goal of marrying high-powered for-profit incentives with the social goals of quality care at a reasonable cost may be an impossible challenge. This also means that ESG investing (leveraging large pools of private capital) and private equity (large chains) are more likely to be value subtracting and detrimental to the cause of development.

In light of the above, the case for philanthropic and concessional capital, and smaller social impact enterprises (both non-profits and for-profits), leading the private sector side in the development cause could not be more compelling.