There is an ongoing debate about whether private equity adds value or simply extracts value. In the economic literature, benefits are better documented than extraction for a very simple reason: when value is created everybody is willing to share the data to show it. When value is extracted, much less so. On this episode, Kate and Luigi present an often overlooked story of how a private equity fund made millions through connections, lobbying, and a spectrum auction.
Luigi: Kate, not only did I lose my bet with you about the reopening of restaurants in New York, I lost it by a huge amount, because it seems that we’re going in the opposite direction. They were about to open, and now they announced they’re not going to open, and it seems that the country is moving in the opposite direction.
Kate: Yeah. I mean, the number of cases that we’re seeing is reaching a new high, and the California governor even is ordering everything shut down.
Luigi: And, as if the news is not bad enough, Kate is leaving us.
Kate: Yes, it’s true. This breaks my heart to say, but I resigned from Georgetown. It’s not just the podcast that I’m leaving, but next year I’m going to be starting as a first-year law student at Columbia Law. And this is a decision that I’ve been pondering for probably the better part of the last decade and finally decided that it was now or never. And if I really want to get everything out of my first year of law school, I think I need to commit fully to it.
Luigi: I fully appreciate that, but it’s with great sadness that I have to let you go. The fact that you resigned from Georgetown is not a big consolation to me, but—
Kate: The fact that I’m leaving Capitalisn’t isn’t a consolation to them, either.
Luigi: No, seriously, I think it’s a huge loss, and we are going to figure out a new solution to move forward, but it will be difficult without you.
Kate: Thank you, Luigi.
Luigi: Now, as a parting present, I am going to dedicate the last two episodes to things that are very dear to you.
Luigi: Number one, private equity and to what extent it is good or bad; and minority representation in the economics profession. Since you are leaving the profession, I want to give you this gift.
Kate: Thank you. Yeah, I was going to say the only thing you should add to that list is bankruptcy, but we just did an episode on bankruptcy, so you’re checking all the boxes.
Luigi: Exactly. Today, we’re going to talk about private equity but with a particular twist to it. There is a big debate about whether private equity adds value or simply extracts value. And, of course, not all private equity is created equal, but there are a lot of examples of the good cases. Why? Because everybody’s very eager to write cases in which private equity adds value, and this is fantastic. There are fewer examples of what we call rent extraction.
Kate: Yeah, and one of the reasons that it’s harder in the economics literature to document the downside of private equity, rather than the upside, is that when there’s upside, everyone shares in that, and the private-equity firms share the data. The portfolio companies share the data, and it’s easy to study. But when private-equity firms are extractive, then nobody’s willing to share the data, and we can’t study it.
Luigi: In this episode, we want to present you an example in which a couple of private-equity funds were able to make close to a billion dollars just being in the right place at the right time, adding no value whatsoever.
Kate: Well, I mean, they were in the right place at the right time, and they also had the help of some famous economists.
Luigi: We want to be very clear before we start the episode. We’re not saying that there was anything illegal going on. In fact, to some extent, this is the problem, because if making a billion dollars without adding value was illegal, it would be easy to stop it: just enforce the law. The fact is, it’s not illegal. And the question is, how do we stop it?
Kate: On today’s episode, we’re going to be talking about a case that involves private-equity firms exploiting information about the government coming in and instituting an auction that some other market participants didn’t have yet. That information was public, but they didn’t know it. And so, money that maybe should have gone into the coffers of the Treasury ended up partially going into the coffers of the private-equity funds. And this is really a case of capitalisn’t and one that strikes very close to home.
Luigi: This is Luigi Zingales from the University of Chicago.
Kate: And, recently from Georgetown University, this is Kate Waldock. Actually, I should say, from Columbia University, this is Kate Waldock. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.
Luigi: And, most importantly, what isn’t.
Let’s start with this idea of the spectrum auction. Now, first of all, I think most people know that in order to transmit data, to transmit radio signals, you need to have access to a spectrum.
Kate: The electromagnetic spectrum.
Luigi: Thank you.
Kate: I mean, not to be confused with the Spectrum Company.
Luigi: That’s true. Actually, in the old days, the spectrum was allocated by the FCC based on what used to be called a beauty contest, so different people made an argument to use the spectrum, and the FCC decided who got the spectrum or not. And then there was a noble idea—
Kate: Like noble or Nobel?
Luigi: That’s a good question because the way I pronounce it, nobody would be able to tell. But in fact, it’s both. It’s both. It was a noble and Nobel-worth idea, actually selling the frequency, selling the spectrum. This was Ronald Coase, but actually, I recently discovered, who developed an idea of a student at the University of Chicago, who made this proposal, kind of in fun. The idea, which goes under the name of the Coase Theorem, is that if you allow people to trade a right that is well-defined, the final allocation of this right would be efficient, no matter what the initial distribution is.
Kate: New Zealand was the first country to apply this idea in practice, and that was in 1989. And the United States joined in 1994. And, since then, hundreds of auctions have been run, raising close to $100 billion for the US government.
Luigi: So far, so good, right? This is a fantastic application of an economic idea to the policy practice that led to more efficient allocation and more money from the government. You can hardly find a success story like this.
Kate: Until we get to something called the incentive auction, which took place in 2016. The government had decided some of the spectrum was allocated toward broadcast TV, but not all of that spectrum was being used in the right ways. It was being used by people running reruns of Roseanne and stuff, and there were other companies that could put this to better use.
Luigi: What is Roseanne?
Kate: You don’t know what . . . It’s an old TV show.
Luigi: That’s exactly the point. TV’s disappearing, so I don’t even know the old TV shows. Honestly, less than 10 percent of the population is actually using broadcast. More and more people are using smartphones. More and more people are using tablets. They need a huge amount of spectrum for all this data to be delivered timely and effectively.
Kate: Right, so the idea behind this incentive auction was to take that broadband, or purchase the broadband from the TV broadcasting companies that weren’t really making good use of it, and then sell it back or auction it back to the telecom companies that would make better use of it.
Luigi: Now, the problem, as you can imagine, is how do you go about doing that? Just to make the thing very simple, imagine that some people have the license to farm a piece of government land, and then you realize that there might be oil underneath that land. You don’t want the people who have the concession for that land to also exploit the oil opportunity and become rich, basically at the expense of the taxpayers, because the final owners of that land are the taxpayers. What you want is to reclaim that land, pay out a fair amount to the people who have the license and who might have incurred costs to organize this, and then start drilling and get the oil out.
Now, maybe I used the wrong example, because these days nobody wants to drill for oil. But anyway, you get the point.
Kate: Also, I think if you have land and you happen to have oil underneath it, I think that you’re allowed to drill the oil, right?
Luigi: If you own the land, not if you have a concession to farm on the property, and that’s the reason why I use this example. Because you don’t own the spectrum. You have a license for a particular use of the spectrum, OK? That’s very important.
These guys were granted the rights to do broadcasting. They were not granted the right to do data transmission, which is a completely different activity with extremely different payoffs. Now, you could have the government say, “You, you, and you sell the right. I set the price, and then we auction those rights.” But the government does not know what is the most efficient allocation of resources.
The clever component of this double auction is, again, to use the Coase idea. By first selling and then auctioning it off, you ensure that the people with the lowest value for the use of that spectrum will sell first. There are two objectives here. Number one, you obtain an efficient allocation, because the ones with the lowest value are the ones who sell. Number two, you avoid potential litigation, because the eminent-domain route is always challenged in court, and this can take time. And so, there was quite some urgency in the industry by saying, after all, we need to have more spectrum, and so, that seemed a very appealing strategy.
Kate: Right. Just to be clear, on the first side of this auction, you got a bunch of television broadcasters. Now, Luigi’s right, they don’t technically own them, but they own a license to use them for, say, 15 years, and they might not really want to use them for 15 years anymore. The government’s holding an auction to purchase some component of the spectrum back, and whoever’s willing to sell at the lowest price.
For example, there were some colleges who owned part of the spectrum just in case they wanted to transmit their class information, which, actually, now I think would be useful for them, but it was being used by college radio stations and stuff, not put to the best use. And so, there were some of these low-cost or low-benefit operators that were willing to sell back the spectrum to the government.
Luigi: The auction was divided into two. The second stage is a normal auction, in which you have a certain number of spectrums in different cities and you sell that spectrum to the highest bidder, and the other bidders were basically users of data transmitters, and so on and so forth.
Kate: Yeah, so AT&T and Sprint and T-Mobile would be potential purchasers. Maybe they weren’t the exact purchasers, but those types of companies.
Luigi: Exactly. The first stage is called the reverse auction, where you are buying those rights from whoever used to own them. And there was this bunch of students at Townsend University. They got granted this right, many, many years ago. They ended up selling for $1.8 million and they were very happy. But, this is an important point, these guys did not sell in the auction. They ended up selling to a private-equity firm.
And this is the interesting part. In between the time the FCC released the National Broadcasting Plan, in March 2010, and the time when Congress finally approved the law that authorized the FCC to create a double auction, three private-equity firms started to enter big time and buy those licenses, in market after market after market.
LocusPoint, which is controlled by Blackstone; NRJ, which is controlled by Fortress; and OTA, which is controlled by MSD Capital, which is basically the Michael Dell Private Equity Fund. In particular, for NRJ and OTA, one bought 15 licenses, the other 23. NRJ made roughly half a billion dollars when they eventually they sold in the reverse auction, and OTA made only $400 million. Between the two of them, they made almost a billion dollars, and what value do they add?
Kate: I’m not a spectrum/telecom expert, but my guess would be that they weren’t adding much value here. If you think about it, the way that this auction should work well, if it goes as planned, is that the TV broadcasters sell their spectrum rights to the government, and then the government sells them later on to the telecom companies.
What was actually happening was that the broadcasters were selling their rights to private-equity firms. Private-equity firms were selling those rights to the government, and then the government was selling them to telecom companies. And so, they were kind of inserting themselves in this intermediate phase and capturing those rents for essentially just holding onto a defunct TV station for a couple of years.
Luigi: When they bought those licenses, it was not clear that the government would allow a double auction; in particular, they would not allow the reverse auction. By the time they started to sell them out, this had become the letter of the law. In between, what did they do? They lobbied. Thanks to opensecrets.org, we were able to establish that Blackstone, Fortress and Dell all spent money lobbying for what is called the Middle Class Tax Relief and Job Creation Act of 2012.
Now, if you wonder what this has to do with the reverse auction, the reverse auction was stuck in this bill. This bill was about something else. With this law of the land, every holder of the initial licenses was pretty secure in its right. And before, there was some uncertainty, because the FCC could have taken those licenses and just reimbursed the license holders for their expenses, which would not have been great. These guys saw the opportunity to lobby the government and secure a right, and they took full advantage of it.
Kate: You can imagine it being a little bit difficult if you have a situation in which OTA purchased a couple of television stations in the middle of 2011. This is before Congress approved the incentive auction in 2012, and then the incentive auction didn’t take place until a couple of years later.
And so, if you’re looking back, if you’re, let’s say, the SEC or something, and you’re trying to find evidence of wrongdoing on the part of a private-equity firm, they held onto this TV station for almost five, six years. And so, can you really pinpoint that specific strategy? It’s easy for them to argue that they just wanted to purchase some TV stations and operate the TV station.
Luigi: Actually, to be honest, they sold all the licenses afterwards. It was pretty clear that it was an arbitrage situation. What is more problematic is, there is a paper that documents that not only did they play this strategy, but they also used their market power to push up the prices at which those licenses were bought back.
If, in this process of reverse auction, I strategically withdraw some licenses in some markets, this inevitably leads to a higher valuation of those licenses. And so, I end up forcing the government to pay more for the licenses than they should.
How do we know, or how do the researchers of this paper know, that they did it strategically? Because they saw they did not sell some of those rights in the auction, but they sold them immediately afterward at a lower price. Really, if you had a purpose in keeping those licenses, you would not have sold them at a lower price immediately afterwards.
Kate: Yeah, I’m trying to come up with a good example. It’s not really monopolistic pricing, because they’re not the only holders of this option, but there’s a similar spirit in the sense that if you restrict the supply, then the prices will go up.
Luigi: Actually, it’s very similar to what is called, in jargon, a short squeeze. When people sell short commodities or even shares, if you buy too much of the quantity, you basically have market power that blocks the ability of the people that lent you the shares to buy them back at a market price, because you set the price. You have all the supply, you set the price. And so, you force the short seller into a gigantic squeeze that sends the price through the roof.
My understanding of the commodity markets is that this is illegal. Now, I don’t know the rules in this market. I suspect, because they’re not being prosecuted, that this was legal. But I think the idea is the same, that you use market power to obtain a higher price.
Kate: The issue at hand here is that you have television broadcasting companies and just organizations. Some of them are student groups and some of them are just local broadcasters playing reruns of Roseanne. They’re not experts in knowing the law. They are not reading FCC regulations every day, and so they didn’t really notice in 2010 and 2011 when these issues first became talked about. Whereas a private-equity firm or a hedge fund, that’s part of their specialty. Maybe that’s not their entire specialty, but part of their job is to understand what’s going on with regulation and to exploit opportunities where they exist.
And so, if some of those initial TV broadcasting companies had known that the law was going to change . . . The Wall Street Journal a few years ago did a piece on this, and they interviewed some of those initial TV broadcasting companies. And some of them said, “Look, if I had known that I could sell back to the government at a much higher price, I would have held on to my TV station, but I just didn’t have that information.” And so, what these private-equity companies were essentially trying to exploit was their superior information and understanding of regulation over the knowledge of these TV broadcasters.
Luigi: And, to be clear here, I’m not a lawyer, but I don’t think that there is any violation of insider-trading law, because this insider-trading law does not apply for assets that are not regularly traded. It’s as if I get to know in advance that the train will stop near a neighborhood, and the house prices in that neighborhood will go up, and I buy on that information. That’s not necessarily insider trading. And you can say that there is some value, because the information is then reflected eventually in market prices.
The problem is that the amount of reward here seems to be quite disproportionate to the benefit they bring. And it’s particularly hurtful, because the losers are not just the students who had a dinky TV station. The losers are all the taxpayers. The government easily could have raised $10 billion more in this auction. This was basically $10 billion of taxpayers’ money that was literally pissed away.
Kate: Yeah, and I think that’s what makes this so compelling on one hand, but also frustrating, because people get pissed when funds are misappropriated and misused by government officials. If a senator is bribed, everyone’s going to be up in arms, and they’re going to get angry about that.
Even in the case of the Disney Company, which we talked about a long time ago. Even though, at first, some of the Disney licenses and monopoly rights went unnoticed, eventually a lot of people got really angry about it. And you still hear people complaining about Disney’s rights today.
But something like this, like the spectrum auction, it’s pretty esoteric. It’s pretty obscure. And so, you’re not going to have regular people complaining about this and writing letters to their senators and congressmen every day to prevent this sort of behavior from happening. And so, it is sort of the taxpayers being robbed in a sneaky way that’s not going to attract any attention.
Luigi: The problem is, what role does the economics profession play in this? Because we started with the economics profession being heroes. Ronald Coase had this fantastic idea that changed the way we regulate the spectrum all over the world and raised an enormous amount of funds for taxpayers. I think that that is the success story. However, with it comes a bias that most of us in the economics profession tend to add, which is that we focus only on, or mostly on. efficiency and not distribution.
Kate, can you explain to our listeners what this idea is of focusing mostly on efficiency and not distribution?
Kate: No. I would put it differently. I think economists like to focus on theory, and theories don’t always play out in terms of practical realities. I can see why economists are thinking about the best way to structure this auction. And they’re like, “You know what? It should involve these two different components.” But they weren’t thinking about the fact that private-equity firms could just kind of sneak their way in and insert themselves into this auction process as a third component. And so, even though in theory they may have been correct, they weren’t really looking at the whole practical picture of how markets work.
Luigi: I think, actually, both stories can be true at the same time. And, unfortunately, they’re going in the same direction. When it comes to promoting this idea, the idea of this reverse auction got huge endorsement by all the most famous economists. In April 2011, 112 economists, including seven Nobel prize winners, sent a letter to President Obama advocating for the incentive auction. And all their words were how efficient it is to use the market to reallocate these property rights, very much in the Coase Theorem tradition. No trace, at least that I could find, of worry that in the process the government was leaving too much money on the table. Why? Because my interpretation, and you might disagree, Kate, my interpretation is we tend to focus on efficiency and distribution is kind of second order, but sometimes it’s not second order. Actually, maybe most of the time it’s not second order.
Kate: Yeah, so, if distribution is just who ends up getting what at the end of the day, then you call it distribution. I call it practical reality, but I think we’re arguing the same thing.
Luigi: And, true to our disclaimer, I’m not an expert on auctions, but I think that there was a very simple way to prevent this problem. The very simple way was to give the government a right of first refusal for every transaction that had taken place recently where the broadcaster was selling the licenses to third parties.
If I don’t want to be too intrusive and force eminent-domain application, force you to sell, at least I can come in, and if I see the students selling a license for $1.8 million and I know that we’re going to do the auction and we’re going to value that much, much more, why don’t I have the right of first refusal and buy that auction? That is one simple requirement.
The other is to not allow some players to have multiple licenses, especially financial players. Because if you are a broadcaster, I can see why you want to have multiple channels at the same time. But if you’re not a broadcaster, you’re purely a financial player, I don’t see why the FCC should authorize those sales. In my understanding, all those sales were filed with the FCC because you have to clear . . . The FCC has to give the authorization. There was a simple way to stop it, and nobody thought of that, at least not that we know.
Kate: I agree with your simple ways, Luigi, but just to be the devil’s advocate here, there are practical realities that make some of those simple ways more challenging. And one is that Congress and any sort of regulatory body, they just take a really long time. The FCC first released this idea of the incentive auction, the National Broadcasting Plan, in 2010, and it wasn’t until seven years later that the first auctions actually took place. And so, you said you could just disqualify any transactions that happened recently, but does recently encompass seven years ago? It’s hard to really define that window.
Luigi: Actually, I don’t think so. Since the moment the FCC published its plan in 2010, it was pretty clear what the intentions of the FCC were. The FCC could ask or could restrict transactions from that moment, knowing that eventually they will have this intention. There’s no sign, at least I don’t see any sign, that these concerns were even raised.
Kate: Yeah, I think that’s a good point. They could have held some sort of FCC review that said any transactions that take place after 2010 have to be approved by the FCC, and they have to be operational transactions. They have to be companies that really want to engage in operating TV broadcasting companies, not just private-equity firms that are going to hold on to these licenses for five years.
Luigi: But this is where the problem arises, in my view. Nobody has an interest in standing up for the taxpayers. If you really advocate very strongly for this, who are you going to benefit? Some hypothetical taxpayers that will never thank you. On the other hand, if you are, at the very minimum, silent on the topic, there are a lot of people who make a lot of money. They might be happy with you just because they made a lot of money.
I think maybe the thing we should mention is, economists benefited by being the advisors of everybody. They weren’t a neutral party to that. Because, at the end of the day, they got a lot of reputation, money and fame as a result of that. They pushed it, and they also benefited.
Kate: We should also keep in mind that economists influence policy and they advise regulators, but they also work for hedge funds and private-equity firms, and they have their own consulting companies. And in order to ensure that there’s nothing shady going on in the background, everyone should be very transparent about what sort of advising they’re doing and who they’re talking to.
Luigi: And I don’t have any ax to grind with any of these people, just that I think that it’s a bit strange that the same people that write the letters to lobby are then advisors to the private-equity firms that made the transactions. That connection is problematic. And, when asked about this connection, at least one of them was completely flippant and said, “Oh, our affiliation does not mean anything and blah, blah.”
It was not even recognized that there might be a problem here, which I think is a problem itself. If you don’t think there is a problem, then we do have a problem. If you know that there is a potential problem and you take precautions, it’s great. But if you don’t and you pretend there is none, I think that’s a problem. That’s my view.
Kate: But something that stresses me out, Luigi, is that this is not just an issue with spectrum. It’s quite pervasive, this idea that the government controls the allocation of resources, it hands out licenses for certain sorts of resources, it allows some entrance into a market and not others. And every time that happens, you’re kind of creating room for exploitation. And in some situations, you can institute a rule that says whoever’s trying to exploit the system, they can’t trade and they can’t benefit from these government licenses. But most of the time, it’s really hard to track them down. And, as you said, there isn’t much political appetite to really get into the weeds and prevent these things from happening. And so, how can we come up with a blanket rule that prevents situations like this?
Luigi: I don’t think we can come up with a blanket rule, but I think the lesson here is that we have to be very careful when ideology, lobbying, and monetary incentives all go in the same direction. Because here, at least the way I read it, is we economists are all happy because we applied some fundamental principle we believe in very strongly, which is that the market reallocates things properly.
The people who have the financial incentive, the private-equity firms, don’t care about the efficiency of the system, they care about making money. And so, they find all these economists who are willing to go out of their way to say this is the best way to do it. And they say, we don’t care about whether it’s the best way, we’ll make a lot of money. And, by the way, we actually use some of these statements to push our agenda and get in the middle. That, unfortunately, happens more often than not, and I think it’s a very powerful mix that creates a lot of the distortion we observe in the world today.
Kate: Yeah, I agree that blanket solutions are probably hard to come by. But part of what really helps the situation, maybe not really helps, but helps somewhat, is to bring all of this to light. We should try our best to reward the journalists and the blogs and the reporters who dig through financial statements and uncover this information, because it’s hard to know how Michael Dell’s personal family trust fund actually makes money. But if you spend a lot of time chipping away at it, you might discover that they’re just engaging in regulatory arbitrage, and that information should be made public.
Luigi: Yeah, the problem is, in this particular case, most of the broadcasters made money as well, so they want to be pretty silent. And so, the reason why you don’t see it anywhere, except in some remote and obscure academic literature, is because of that. Everybody was invited to the table and everybody ate the taxpayer’s lunch.
Luigi: This is interesting, because at the same time, it’s the best of capitalism and the worst of capitalism. The best of capitalism is the idea of using the price system to allocate resources in a way that is efficient. The problem is that, very often, when this is not done with the proper rules, you end up redistributing resources to a few rich people at the cost of everybody else. And I think that that is the distortion that is fueled by the lobbying, by the connections, that makes the system unfair and unappealing.
Kate: I think that the government should have, and maybe they already have this person, in which case, good for the government, but I think the government should have someone called the criminal mastermind general, who ought to work for a hedge fund or in private equity and make a killing, but has the civic spirit. Where, instead, they just think of all the potential loopholes that can be exploited and then they make sure that they’re closed from the government’s perspective.
Luigi: I think, Kate, this is going to be your career after you become a lawyer. That’s your perfect job.
Kate: This is my dream job.