There’s been a bias against VC in the US; investment is low

There’s been a bias against VC in the US; investment is low

New Delhi: It ain’t broke, so don’t fix it. That’s what Steven N. Kaplan, a Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business, says about corporate governance in the US. Kaplan testified to the US Senate finance committee and the US House financial services committee about his research, which focuses on corporate governance, private equity (PE), and mergers and acquisitions.

In an interview, he says capitalist economies face a crisis every 20-30 years. While the private sector has to share some of the blame, it is the regulators who have to make the system work better. Edited excerpts:

Why are buyouts rare in emerging markets?

Entrepreneurs don’t like to give up control, especially family businesses. They want to grow with the economy, so I imagine this is why they are holding on to their stake. That will continue happening for some time, particularly where the IPO (initial public offering) markets are strong.

Unlike the US, businesses in India want the same multiples from PE as those they would get in the stock markets. What are your views on this?

It means it’s hard to deploy capital and get the returns that some investors would like. When you talk to LPs (limited partners), they all want to invest in Asia and to some extent Latin America. The problem is when everybody wants to invest in one area, a lot of capital comes in, prices get higher and (it) becomes very hard to make money. That’s what happened in the US during the dot-com boom. People went crazy, put too much money hoping that the high market values would rescue them.

Few exits in India have been impressive. Why?

PE needs to remain invested for at least four-five years. Many PEs have not exited right now. But the real question is how healthy are the companies they are invested in.

You have strong views on executive pay and testified about it in front of the US Senate.

There is a view in the US that CEOs are paid too much. CEOs are usually paid for performance and fired if they don’t perform. It is completely wrong to say they are not paid for performance. There was a case recently where the CEO of Pfizer (Inc.) left because of fatigue—although he wasn’t fired, he may as well have been. Fact No. 2 is, CEO pay is down about 50% since the year 2000.

So you think the view that CEOs and bankers are paid too much is misguided?

Yes, this is the CEOs of all S&P 500 companies in the US. Everyone keeps complaining about (executive pay) going up. The average has gone down 50% and the median has gone down 20%, so the view (that) the boards are doing a terrible job is just dead wrong. They still do make a lot of money—there’s no doubt about that. But lawyers make a lot of money, as do bankers, investors and, in some sense, their job (the financiers and CEOs) has got a huge amount harder in recent times, and the other jobs really haven’t. This attention and criticism is really misguided.

Then the discussions sort of went away—now everybody is overpaid.The bankers, the hedge funds, the PE and the CEOs, but no one seems to be complaining, and I don’t know why.

The fact is that you’ve seen in the US, and in other countries, because of technology, globalization and just scale, people at the top have seen their pay go up. Some view that boards are controlled by the CEOs and they are misbehaving, but it really is an economically driven phenomenon. It is not the problem that people think it is.

Then the other view is that bankers were paid to take risk, which in a way caused the financial crisis.... I’m also not convinced by that one. Lehman Brothers (Holdings Inc.) and Bear Stearns (Companies Inc.) in particular—where the executives owned hundreds of millions of dollars of stock in these companies—they had a lot to lose from taking these risks than they had to gain.

The system, they got it wrong and a lot of other people got it wrong. It wasn’t the pay as much as it was a confluence of a lot of other factors that led to the crisis. It’s hard to imagine it’s the pay in the US and the UK—really, there are banks everywhere and some of those people weren’t paid a lot.

Do you think the regulators did not know what was going on?

In a capitalist system you get crises like that. You go back to the Depression, people made big mistakes that precipitated the Depression and it was all their own money. There were no options, there were no bonuses.

It happened in 1907, 1873, 1893, 1929, 1990 and 2008. There have been panics and crises in the US, the developed markets, every 20-30 years and very different compensation regimes. It’s a little bit different every time—things are going well, people keep investing, everyone is optimistic, everyone joins in. This is what the capitalist system does—it does great things on average but every so often it ends up in a horrible mess.

Do you think smart people in the financial services are always ahead of the regulators?

You should ask why the crisis happened—there was a lot of liquidity in the system, which we think helped increase asset prices. There was money coming in from—the developing markets into the developed markets, which also pushed asset prices up.

You had, in the US, regulation which actually encouraged investment in housing in lower- and middle-income people. It was telling us that they want lower- and middle-income people to have mortgages. The money supply was very high, you had capital coming in from outside the US. Then the ratings agencies mis-rated some of this stuff, their models were wrongâ€"whether that was an innocent mistake or they had incentive to do this is hard to say.

The regulators also allowed the investment bankers (to) increase their leverage substantially. So the regulators had it right, then they got it wrong. They said they could go from 10:1 leverage to 20:1 leverage. It’s not like you can absolve the private sector from any of the blame but a lot of people made mistakes. That is normally what happens when there is a crisis.

Is there a bubble emerging in the emerging markets?

Not in India. In China... I don’t know. If it was easy to find out there was a bubble, there wouldn’t be a bubble. Why it’s hard to tell is because in both places there is a huge amount of growth... That is why there is a lot of capital in both places. It’s hard to tell whether it is the right amount or the wrong amount.

So if you ask me if things are overvalued, I’m not quite sure what the difference is between there being a bubble or something being overvalued.

That’s a hard question. In some senses, a market is never right, it’s always wrong, but they are always moving in the right direction. They are half the time overvalued, and the other half they are undervalued. And it’s a question of when things become really overvalued....but how can you tell?

Is venture capital (VC) in the US in a crisis?

The US venture funds’ returns have been sort of equal to the returns on the stock markets, which is considered very disappointing by investors. There has been a bias against VC, so the amount of money going into VC in the US (is) quite low. So this is probably a good time to invest in VC in the US, because there isn’t a lot of money there.