Private Equity as Legibility Arbitrage

One thing struck me the other day as I was reading about private equity (PE) led ‘rollups’ and consolidations of different sectors: it’s all due to legibility and the increasing legibility crisis that comes with greater centralization and inequality. The basic private equity model here seems to be as follows:

Find a bunch of small businesses founded by normal people who want to sell and retire. These businesses are usually not large and make enough profit to ensure the owner a comfortable upper middle class -> slightly rich life. They will probably sell in the 2-10M range on a very low 2-5x multiple of profits. This means that the owner now has enough liquid cash to retire very comfortably and the PE firm gets a business with cashflow with a very low multiple compared to public markets The PE firm buys a reasonable number of such businesses and bundles them together into a big megabusiness which now has large revenue and profits The PE firm then tries to either (sometimes) sell the business to the public (via IPO or SPAC) or, usually, to find a much bigger acquirer who is willing to pay a substantially higher multiple on revenue and profits. The multiple difference effectively becomes the PE firm’s profit which can be very large – i.e. if you can buy a bunch of businesses over a year or two at 3x and then sell at a 10x multiple you can triple your money in a few years if done well.

Why does this work? On pure economics it seems nonsensical. Why should the exact same revenues and profits be valued differently depending on whether they are all founder-owned small businesses or whether they have been frankensteined into a bigger merged company.? From an economic efficiency perspective, it is almost certainly very bad. From a bunch of small companies managed by founder-owners who are extremely involved in the health of their firm (which they see as their life’s work) and who know all the details of the market and customer base, ownership transitions to a bunch of random PE finance guys who know nothing and do not care about whatever small business segment this is. Inevitably, this must lead to mismanagement and bad outcomes in the long run. Indeed, consumers tend to complain and objective quality gets worse after a PE takeover. Some of this might be due to financier rapacity but I think it’s mostly that PE-owned firms are likely to be badly run, since usually the new owners lack both the detailed knowledge and desire to actually run these firms well.

Some commenters such as Matt Stoller attribute this decline in consumer satisfaction and firm quality to the lack of competition – the idea being that the PE firms plan to buy out all the forms into one mega-firm, then once they have eliminated the competition, jack up prices and lower quality. I think this definitely happens but isn’t nearly the full story for two reasons: firstly, many of these PE firms are operating in sectors where there is little barrier to entry – if the monopolist becomes too predatory, new founders can just start businesses and outcompete within 5-10 years. Secondly, the avowed goal of all these PE-bought firms is not to compete in the market but to sell.

Why do they sell? Economically, again, this is irrational. If, given a choice between buying 10 well run small businesses at a low price and one very badly run business at a high price, why would anybody choose the latter? The answer, of course, is legibility.

The buyers in this market are large institutional investment firms – banks, hedge funds, other large PE firms. They have tens to hundreds of billions that they need to deploy in capital right now. They do not have the time nor inclination to find a random successful and well-run landscaping business in rural Montana and offer the founder $5m, even if this would in fact be the best possible investment they could make. At certain levels of AUM, it is just not worth it in time and effort to make investments under a floor of some amount of money. There is thus an economic gap – there is a large amount of profitable investments that could be made, but nobody could make them since they are too small for large players to be bothered with. These mutually profitable transactions are stifled by a lack of legibility.

This is where the PE firms come in. Effectively, their role is to profit off of this legibility arbitrage. If they can consolidate a number of businesses which themselves would be illegible to large institutional investors, but which, however, could be attractive to institutional investors if bundled together and presented in a way that they understand – i.e. professional slide decks put together by PE analysts in New York instead of some random dude who owns a business but has never had much truck for financial shenanigans, then the money will flow. The ‘profit’ that these PE companies make is almost entirely based on providing the legibility that makes the deal happen at all ¹. By standard economic factors, the PE firms should be expected to own most of this surplus because they stand at the narrowest point in the value chain – there are lots of small successful businesses that want to sell, and lots of large institutional investors with bank accounts swelled by proximity to the central bank and zero interest rates. There are not many PE firms with the skills and execution ability to pull these transactions off.

All of this makes sense, however, if we zoom out, what we see is large amounts of highly inefficient, likely negative-sum ² transactions happening due to a lack of legibility in the economy. These legibility costs are extremely high and it is partly due to this that finance as a whole suffers from severe diseconomies of scale. As financial centralization and inequality has increased over the past decades, this has led to increasingly large legibility constraints and costs on the economy, as more and more resources are allocated by fewer and fewer people who have not a whole lot of insight into the systems to which they are allocating capital. This predictably leads to poorer capital allocation overall, and the necessity to find negative sum workarounds like this to make transactions happen ².