Why I Think Private Equity May Be a Hidden Factor In The Sticky Inflation Problem

The theory goes as follows: when enough firms in an industry fall under common ownership, anti-competitive effects tend to arise, particularly lower output and higher costs. This happens because managers start caring that their competitors also deliver value to the common shareholders which reduces competition, and a monopolistic effect (through no explicit collusion) can emerge driving up prices.

This theory was posited about public stocks as soon as institutional ownership started to rise in the 80s. However, there has been little evidence of this among public stocks, and a large part of that is because even common owners of public equity don’t own enough shares to induce these effects.

If you look at the S&P 500 stocks, for example, quite a large number of them are mostly held by institutions. Here’s a chart of that.

As you can see, most of these stocks are >80% owned by institutions. The >100% institutional ownership is a head-scratcher, but a possible explanation for it is short-selling. Since short-selling involves borrowing shares to sell them, then coupled with delays in reporting, the same shares could be counted more than once. In case you are interested, these are the stocks with >100% institutional ownership.

And for good measure, these are the ones with <50% institutional ownership.

The point is that most S&P 500 stocks are owned by institutions. But isn’t that to be expected, due to ETFs and all? Yes, actually. If you look at which institutions tend to own a lot of shares of S&P 500 stocks, it’s the expected culprits.

Basically, the guys who make the ETFs. If you ask me, I’d say this is a good thing. It kind of prevents the common ownership problems because Vanguard and Blackrock profit from transaction fees and not stock gains. They therefore provide liquidity and make the market better overall.

The reason you will struggle to find evidence of the common ownership problem in public equity is that few institutions own enough shares of different companies to bring it into effect. Even Vanguard and Blackrock own sub-10% of anything in public markets. The same can’t be said of private equity.

Now, I haven’t done the leg work on this, and I’m not sure if and how anyone can. Maybe the Wall Street Journal and its ilk, or some very well-connected academic. The problem with private equity is that they don’t have much in the way of disclosure requirements. But the more I think about it, the more I believe that the common ownership problem could be a hidden factor in the inflation dynamics. Its mechanisms work better in private equity than in public markets.

Firstly, ownership concentration is higher. Private equity firms come to your neighborhood and slowly buy up every HVAC company, then join them up into one. The end product is one company owned by one (private equity) firm. Even if they do sell it, the ownership remains more or less concentrated. It is much easier to find owners with enough shares to get their way in the boardroom among private equity. As more and more private equity firms go around buying HVAC companies, the HVAC game stops being an HVAC game and starts being about which mega-HVAC company or cluster of HVAC companies will deliver the most profits to its shareholder(s). To the extent that this competition is not intense i.e. few PE firms bought the HVAC companies, and they don’t have much competition, then common ownership problems may arise.

Secondly, private equity can have complex and nuanced incentives. When you look at institutional ownership in public markets, most of those institutions are funds and therefore need to deliver returns to investors. There is only one overriding incentive driving each of these institutions, what differs is the time horizon. With private equity, incentives can be complicated. Say a private equity firm buys up several HVAC companies at high leverage, merges them into one, and needs to sell it as fast as possible but can’t find a ready buyer. Since their main interest is selling the company, and since they 100% own it, they may attempt to have the company perform well enough to attract buyers, but not too well as to price itself out to potential buyers. Even if they didn’t initially plan to sell it as fast as possible, they may find themselves in need of cash, and suddenly businesses they weren’t thinking of selling are on the chopping board.

Third, global private equity has grown significantly in recent years. This is the main reason why I think private equity may be a hidden inflationary factor. Concentrated ownership and complex incentives would not be inflationary if private equity hadn’t grown as much as it has in recent years. The problem is that as private equity was growing and buying up businesses, interest rates went up, and that made exiting difficult. The kind of companies private equity holds can only be sold to specific buyers. They are not big enough to be floated, or small enough to be sold to small investors. They need big investors looking to diversify their already considerable assets, or looking for outsized returns. These kinds of big fish don’t like to buy things using cash or assets but prefer loans, and at current interest rates, the kind of profits the businesses that private equity are selling generate would need to be very high to attract buyers. Either that or the businesses need to be dirt cheap. So private equity has difficult exit prospects, and their best option is to use their ownership status to drive up prices. Common ownership problems don’t require collusion to work. In this case, you have many PE firms experiencing the same pressure.

Some counterarguments. The severity of common ownership problems differs among industries. Also, for common ownership to produce anti-competitive effects, you need both concentrated ownership and ownership concentration (the same firms owning many competing firms). In my running example, the PE firm that owns a bunch of HVAC companies needs to own enough of them to produce these effects.

This is a hard idea to prove or disprove because of the kind of data you need to do the study. But I’ve not seen it anywhere which is a bit of a surprise so I thought I’d throw it out there (please share any material about this if you come across it).

I welcome any thoughts and feedback, positive or negative, about this.

See you on the next one,

Brian