Thursday, July 12, 2007

Moody's criticism of Private Equity: Part 2 of 2

Arguments for and against taking companies private:

There are two related issues that are somewhat buried in the article. One is reporting pressure. I am usually a little leery of when companies want to do something that reduces their level of transparency to investors, citing the costs of reporting etc. (case in point: Sarbox.) My reasoning being that if they do not want to be open and upfront about their activities, they are probably doing something that will not withstand public scrutiny. On the other side of the issue, the need to report earnings quarterly (and meet or beat expectations) does put undue pressure on companies. (Case in point: The statistically abnormally large number of companies that beat expectations by one penny. Managers have a strong incentive to avoid negative earnings surprises.)

The second issue here is investing horizon. Generally, equity is seen as a longer-horizon investment than debt, simply because equity is long-lived. However the PE guys claim that the stock market induces short-termism because of quarterly reporting and scrutiny. Moody's disagrees with that.
On the other hand, (and this reminds me of my grandfather's joke: Economists have to have many hands because they keep saying "on the other hand.."!) academics have long posited, and tested the theory that debt is what induces short-termism. The reason is that the threat of bankruptcy associated with being unable to keep up payments leads firms to often pass up very profitable projects which are even slightly risky.
(This is called the debt overhang problem relating to companies - not countries - definition in the bottom paragraph).

To summarize, reporting pressure is a very real consequence of listing a company. However the argument that debt has a longer investing horizon, in my opinion, is bogus. Surely there are ways to manage the short-termism induced by reporting pressures by clearly indicating that long-term beneficial actions are being taken by the company!

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