There is no shortage of debate about the effects of globalization. It is one of the most interesting debates in the fields of international business, development economics, and public policy. And the main issue of contention centers on the gains from globalization. Scholars have long tried to figure out whether, and how, countries (both their firms and their citizens) benefit from the opening of markets to global trade and investment.

Academic research has highlighted the role that open economies can play in allowing nations to specialize in its areas of comparative advantage, and how globalization leads to the exchange of knowledge across borders. The argument is that each country possesses differing stocks of knowledge, capital, and labor, and that globalization and free trade allow for the most efficient employment and allocation of those resources. Moreover, interaction through trade and investment encourages the spread of knowledge across countries, thereby allowing countries to catch-up (economically and technologically) with their trading/investment partners. Although there is some evidence that increased globalization leads to greater specialization, reduced costs for parties involved, and greater information exchange, it remains an open question whether developed or developing countries benefit more from the cross-country interaction brought about by globalization.

On one hand, theory suggests that developing countries should benefit disproportionately from globalization. Those who subscribe to this view argue that investment in developing countries by firms in developed countries raises wages in host countries and, as such, the standard of living; that foreign competition imposes discipline upon local firms through intense competitive pressure, thereby raising the competitiveness of surviving local firms; and that foreign entrants provide a means for local firms to gain insight into the advanced technological knowledge that they lack. Similarly, engaging in trade (either through export or import) with developed countries allows firms in developing countries to learn from sophisticated foreign buyers, suppliers, and competitors. For all these reasons, scholars argue, globalization should provide real economic benefits for developing countries, and those who subscribe to this view therefore see globalization as a means of promoting equality and social welfare.

On the other hand, however, are reasons to question the supposed benefits of globalization to developing countries. For one thing, there is scant evidence to support the view that developing countries benefit disproportionately from globalization. In fact, some research even finds evidence that developed countries benefit more from globalization. This might be the case if foreign competition net-net displaces more jobs than it creates, thereby limiting benefits to a small minority of the population, or if economic openness leads firms from developed countries to invest, subcontract, and export their low-value-added activities to developing countries. If developed countries can dump their low-growth, labor-intensive businesses onto developing countries, they may focus their efforts on innovation - developing new technologies to exploit high-value-added activities for which the prospects for growth are considerably greater. In this sense then, we might plausibly expect growth to be greater for developed countries than developing countries as a result of globalization. Supporters of this view do not see globalization as welfare enhancing, but rather as an insidious force that marginalizes the poor and propagates exploitation. But even in this case, the developing country benefits through increased growth and better standards of living. It just so happens that the developed country benefits more.

In any event, while it may be some time before we are able to accurately parse out and gauge the precise gains from globalization (and I think we’re doing a good job and we are getting pretty close), unfortunately the debate is marred and distorted by political ideology (and a good dose of political reality) that is difficult to separate from the phenomenon itself. For example, one of the concerns that we read about with increasing frequency has to do with the supposed outsourcing of jobs from the U.S. to other countries. Factory closures make headlines, as do the shut down of call centers that have been moved overseas.

The problem is that the losses associated with globalization are concentrated and its gains are diffuse. When factories shut down, hundreds, and sometimes thousands, of employees lose their jobs in one geographical area (let’s say Youngstown, Ohio). However, an equivalent (or perhaps a greater) number of jobs may have been created. But those offsetting jobs created are not geographically concentrated. Jobs may be created in the service sector in Northern California, Boston, DC, etc. and the human capital may be redirected toward other, more value-added, activities in those disparate locations. This is a positive economic outcome of globalization that improves social welfare. We only hear about the job losses in Youngstown, Ohio though because a collective of concentrated people make more noise than a dispersed, unconnected set of people. Those folks in Youngstown, Ohio therefore get the attention of lawmakers, …and the public.

In all fairness to the politicians, it’s got to be difficult to go to Youngstown and try to extol the virtues of globalization to a constituency that just lost its jobs. Those folks who lost their jobs are looking for some explanations, and often someone to blame. And oh yeah, they also vote. If they are, or were, part of a union, those job losses carry even greater political influence. Politicians (in an effort to preserve their position and remain in office) often will take action in order to show their constituents that they are on their side. And in many cases, this can lead to protectionist overreactions.

I am afraid that this is happening with the current administration’s dealings with China. It’s no surprise too that in addition to all that, it’s much easier to blame someone else for your problems rather than taking a difficult look inward. With the U.S. economy slowing and the manufacturing sector currently in recession, it’s much easier to blame China than to recognize the benefits provided by integrating China into the global economy through its accession to the WTO.

I do not believe that introducing protectionist policy helps us in the near term or the long run. It can only instigate reactionary policy by China, and any other trading partner against whom we seek protection. With respect to China, I sometimes think it might be better to let China collapse under the weight of its U.S. foreign reserves as the dollar depreciates. Basically, China lent us lots of money to buy its cheap goods in order to artificially inflate exports. As the dollars they collect in exchange for those exported goods decrease in value, it’s like watching those loans slowly approach default. If China wants to be in the business of giving away its products, well then by all means, why not oblige?

Anyhow, China-specific policy is a little too far afield from the original intent of this blog, and I’m not a China expert. Rather, the intent of this blog is to discuss the effects of globalization more generally. As an international business scholar, I’ve studied, and have been fortunate enough to witness first hand, the benefits that globalization and free trade can provide economies that become more integrated in the global economy. Sure, it can be tough, really tough, for those folks in Youngstown that lose their jobs. And it would suck to have to face those folks to explain this when they’ve lost everything. However, I do not think that resorting to protectionism is the right way to go. Rather, I think that a well-developed, and well-administered, trade adjustment assistance (TAA) program represents a more effective way to respond to the challenges posed by globalization.

Globalization is coming whether we like it or not. We can either respond by adopting distorting protectionist policies, or by allowing our economy to do what it does best - respond flexibly to changes in the external environment - coupled with the implementation of TAA programs that aids both manufacturing and service workers displaced by foreign competition re-train and re-deploy in the next best alternative use. Personally, I prefer the latter.   

Just to clarify. Yes, I believe that private equity funds serve an important purpose in well-functioning, efficient capital markets (see the blog below explaining why). However, this is not to say that I believe that all private equity deals are destined for success. In fact, my hunch (although I have no hard data on this, and hard data is difficult to obtain for privately held companies) is that LBO’s do not fare much better than the average acquisition. That is, most likely fail. So it came as a surprise to me that one of my students suggested that since I extolled the virtues of private equity, I must surely believe that the volume of private equity deals over the past several years are rational, sound, and bound to succeed.

This is not the case. In fact, if anything, I believe the opposite. Again, so that there is no confusion about this, I absolutely believe that private equity funds serve a purpose in healthy, well-functioning equity markets. However, I do believe that the increasing number of private equity deals of late is an exemplar of excess. Over the past few years, excess liquidity in global capital markets has been driving such deals. I refer to this as the phenomenon of stupid money chasing stupid deals. But I don’t necessarily blame the private equity firms for this. Rather, the blame falls squarely on the beast that feeds the machine. For example, if I’m a private equity manager and institutions are throwing money at me (whether the source of that money is domestic institutions, recycled petrodollars, or foreign central banks), I’m going to make deals. As a private equity manager, that’s what I’m in business to do, and with cash on hand, that’s exactly what I will do. Not only that, but besides the cash infusions that I’m getting on a regular basis, I have banks that are willing to lend me $10 or more for every $1 that I pony up. Crazy! Well if that’s the case, then heck, why not, I can buy firms with little cash, lever the heck out of them and pay myself a nice dividend in the process. Given the sheer amount of global liquidity, it’s only rationale to expect this outcome - increased private equity activity.

Now, will all these ventures be successful? Likely not. With most private equity firms flush with cash as a result of the global liquidity glut (caused by historically low interest rates and a change in attitudes toward risk) and with only a finite number of targets to buy, increased competition among LBO funds (and industry acquirers) for the same handful of firms has led many buyers to overpay. Moreover, with creditors offering enough debt to hang oneself with, many targets will become overextended. And if you buy into the arguments of Edward Altman and Nouriel Roubini (as I do), as credit contracts due to central banks tightening the screws on lending, as the housing market slows in the US, and as consumers buckle under the weight of their own personal debt, we should expect businesses to falter. That is, we should see corporate default rates rise from about the 0.6% observed in 2006 to its historical average of around 2.6%.

Unfortunately, if such defaults do occur - that is, if the highly levered firms that the LBO funds have taken private cannot meet there debt obligations - it will not be the private equity firms left holding the bag. Rather, it will be the investors in those funds (whose returns will be diminished) and the holders of the corporate debt that will bear the brunt of the costs.

For those of you following the Executive Compensation story (see blog below), the new SEC CEO pay disclosure rules are in effect and we are just starting to witness their output. The NY Times published an interesting article today about some of the complexities inhered in the disclosures (see article here). The article finds them not only difficult to interpret, but difficult to compare to past disclosures. These complexities have not stopped the eye-popping, attention-grabbing headlines (see this article on Alan Mulally’s pay from the Ford Motor Co.). This is likely only the beginning. Let the media frenzy begin…

It will be interesting to see if the new disclosure rules eventually bring clarity, and how the they ultimately impact pay, …if at all.

If you’re reading this blog, I probably don’t need to define what private equity is for you. But just in case, private equity firms are those that raise capital in order to buy public firms and take them private. Moreover, we’re all familiar with the role that private equity plays in our capital markets. Most of us would likely agree that they play a beneficial role, and that the market for corporate control keeps managers in check. Severely underperforming managers need to be very afraid that their firm will be acquired and that they’ll end up without a job. And although many of the benefits that private equity provides are well known and agreed upon among many parties, in this post I’d like to focus on one function that seems to be overlooked and is increasingly on the rise - the role that private equity plays in the strategic reorientation of firms.

Private equity and LBO funds (I will use them interchangeably here) have a long and well-known history. You know you’re mainstream when you’ve been portrayed not just in popular books (e.g., Barbarians at the Gate) but also in Hollywood movies (e.g., Wall Street). The common view of private equity is of a fund that buys firms that have overextended themselves by diversifying themselves into disparate, unrelated businesses. In extreme cases, such diversification destroys shareholder value (widely known in academic circles as the diversification discount - where diversified firms trade at a discount to their individual parts). Private equity firms traditionally bought over-diversified firms to sell them off as parts, where chopping up the individual businesses fetch more than it costs to purchase the whole firm. This is the type of activity that characterized the late 1970’s and early 1980’s activity that brought an end to conglomerates.

Another private equity story we’re familiar with is the one in which the private equity firm buys a target with excess cash and/or little debt. Private equity firms in this case will often buy the firm, take on a large amount of debt and use that debt to focus the firm (while at the same time, using that debt to pay themselves a dividend). The theory here is that debt imposes discipline on the firm because it leaves little room for managerial error and/or malfeasance. This works in much the same way that college debt, in that it incentivizes students to become productive after graduation (after all, the debt has to be paid back somehow and how can it be paid off when someone is goofing off traveling around the country in a car and/or working at a bar at a ski slope in Aspen). 

Private equity firms also exploit arbitrage opportunities that exist in capital markets. Often, they will buy firms in old, mature industries that have solid cash flows but limited growth potential. I call this the non-sexy industry acquisition. That is, they buy firms in industries that are not that sexy but in which the businesses are not yet dead. It could be that these firms are attractive targets because public equity markets apply too great a discount rate to firms in non-sexy, mature industries. After all, investors love growth.

There are several other explanations that we’ve heard driving private equity purchases as well. For example, the argument has been made that in strong, efficient capital markets (like the US), firms need not rely on banks for capital. Capital is abundant and available from institutions, individuals, banks, etc. Therefore, the benefit that firms formerly received from being public don’t necessarily exist anymore (e.g., the ability to raise capital due to some status or reputation effect). In addition, pundits point out that with the advent of Sarbanes-Oxley legislation, being public has become so costly that it does not necessarily pay to be public anymore. Specifically, by taking firms private, all associated compliance costs (e.g., especially 404 compliance) goes straight to the bottom line. Not only that, but many of the requirements associated with being a public firm goes away - so we can fire many of our lawyers, accountants, public relations folks, etc. Therefore, private equity activity in recent years has been geared toward taking advantage of these additional costs to being "public" by taking firms for which it is too costly to be public private.

All these are explanations that we’ve all heard, and that probably make some sense. I, however, believe that there is another explanation for the increase in private equity activity. In particular, if we agree that equity markets are increasingly short-term focused given the nature of the changes to shareholders that has occurred in the last half century (see my previous post on executive compensation), some private equity activity has been undertaken in order to give their targets the opportunity to engage in a long-term focused strategic reorientation that the equity markets will not perceive as beneficial. If investors are not particularly good at valuing long-term investments made by firms (as recent research in behavioral economics suggests), then there must be some way for firms to make those difficult, and sometimes painful, long-term decisions without incurring the penalties that the market is likely to impose (from which the firm may not recover). Therefore, private equity firms may be good at identifying firms that are undervalued by investors who do not see the value of its strategic makeover. This is one factor that could be behind the findings of Lerner and Cao. That is, they find that firms that are re-floated in the public markets after being taken private generally outperform the market. In essence, firms that are taken private are stronger after they are re-floated.

This latter explanation supports a view of private equity funds as more than simply a group of financial wonks that identify minor, technical arbitrage opportunities in equity markets and pounce on them like their arb trader/hedge fund counterparts. Moreover, they fill more than just a role as sales folks and valuation experts like their I-Banking brethren. Rather, private equity funds can be viewed as a collection of pricing experts and strategic generalists with the financial skills to not only identify arbitrage opportunities and accurately value firms, but also the management skills to help its targets pursue, realize and capitalize on their value-added strategy. This is a very valuable function.

So to the list of benefits that private equity firms provide to healthy, functioning capital markets I’d like to add their role in taking firms private to allow them to strategically re-orient themselves away from the microscopic, short-termist scrutiny of the public equity markets. This explanation is not often recognized, but no less important than the rest.