The Moral Arbitrage Driving Wall Street Profits

Squeezing ‘inefficient’ businesses run for greater purpose will generate cash, but not value

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A peculiar pattern has emerged over the past decade in the investment strategies of Wall Street’s private equity firms. Once known for buying out struggling industrial giants and major consumer brands, then for specializing them in obscure materials and business services, the acquisitions passing across the ticker these days evince a new, distinctive strategy: veterinary practices, funeral homes, campgrounds, youth residential treatment services, youth sports, professional sports. These are not businesses in need of sophisticated managers to generate greater value. They are opportunities for moral arbitrage.

The “deal thesis,” as it’s called in the industry, is to find a business being run with compassion, ideally as a passion, and squeeze. At the time of acquisition, the business’s value will be calculated from its existing cash flow, which might not be very high. But what if you immediately fire the guy who has been on staff too long, raise prices to the highest the market will bear, skimp on quality when the customers have no choice, and then convince them at emotionally vulnerable moments to make purchases they don’t need? Cash flow surges. You can use it to pay off the debt you issued to buy the company. The rest is profit.

As Matthew Crawford wrote about the youth-sports gambit, “if people’s time, attention and hopes for their kids’ futures are being funneled together at some site of shared activity, private equity sees this as an opportunity to position itself at that site and establish new extractive mechanisms.” Reading that sentence, I thought, I bet private equity is getting involved in college prep too and did a quick search for “private equity buying up SAT tutors.” I was not thinking big enough. In fact, one private equity firm now owns the ACT outright and another owns the company that was administering the SAT.

Of course, the quintessential illustration is health care, where private equity has invested at least $750 billion over the past decade. Annual deals for physician practices increased from fewer than 100 in 2012 to nearly 500 in 2021 alone, and one-quarter of metro areas in the U.S. now have more than 30% of doctors controlled by a single PE firm. Private equity owns nearly 500 hospitals, which tend to charge more and deliver worse patient outcomes. Between 5 and 10% of nursing homes are now owned by private equity too, delivering price increases, staffing cuts, and higher mortality. 

One of the most dumbfoundingly egregious examples comes from the $9 billion that two PE giants spent purchasing emergency-room staffing firms in hopes of driving profits through surprise medical billing. As the Wall Street Journal reported, the deals were souring because “they underestimated the potentially dire effects of pending federal legislation meant to end surprise billing, which could ratchet down all-important insurance reimbursement rates at the staffing companies.” The $28 million spent creating a group called “Doctor Patient Unity” to lobby against the legislation was a real drag on profits too.

Undoubtedly, some finance enthusiasts would dispute this application of normative judgment to the pursuit of efficiency. Back in 2020, when American Compass first published Coin-Flip Capitalism to critique the absurdity of the PE and hedge fund industries, leading experts from the University of Chicago took to the Wall Street Journal to lecture us that shareholder gains and “social value” were synonymous. The profits generated by the transactions were by definition “social return.” But this is true only if one believes all social value in an economic arrangement is codified from the start in explicit transactions with dollar values attached, so that dollar values increasing must mean social value increasing as well.

That’s not remotely true, as a young economics professor named Larry Summers pointed out all the way back in 1988, in a paper called “Breach of Trust in Hostile Takeovers” that he coauthored with Andrei Shleifer. “Corporations represent a nexus of contracts, some implicit, between shareholders and stakeholders,” they observed, and “hostile takeovers facilitate opportunistic behavior at the expense of stakeholders,” which “enable shareholders to transfer wealth from stakeholders to themselves more so than to create wealth.” One should not assume that increases in valuation after mergers and acquisitions represent the creation of any real value. As “between the value-creating and value-redistributing effects of hostile takeovers,” they argued, “the latter are likely to be of dominant importance.”

Their analysis applied across all industries, even in ones that might seem ripe for productive acquisitions: airlines, oil companies, and so on. The effect should be an order of magnitude larger in industries where much of the “inefficiency” identified on a spreadsheet represents a conscious choice to forego profit in pursuit of other values entirely. The entrepreneur thinks of something new to sell. The rentier looks at something someone already provides for free, or something no one needs, and thinks I bet we could charge for that.

When Congressman Chip Roy, policy chair of the House Freedom Caucus, saw the news this week that Texas institution Shipley Do-Nuts had been acquired by yet another private equity firm, this one in Beverly Hills, he responded, “I’m sick of this crap. Tax policy should be modified away from the paper-pushers and toward the families and people who sweat it out and know a community.  And yes I know the arguments against that position… and I don’t care.”

Conservatives are coming to understand that the “arguments against that position” are little more than market fundamentalist dogma that collapses with even the barest scrutiny. If conservatism stands for anything, it is the proposition that what matters and is worth defending is not measured mainly in dollars. Whether a conservative economics can reassert itself in the face of so many dollars remains to be seen.