Sunday, October 22, 2006

Private Equity and Venture Capital Firms Acting Anti-Competitively?

An interesting story last week suggested that the Justice Department was investigating private equity firms for possible anti-competitive behavior.

Just this last spring, a student of mine at Tuck did an independent study on the incentives and potential for cooperative behavior in the private equity and venture capital arenas. How's that for prescience?

Justice's focus appears to be on private equity firms and their behavior in auctions for companies (by the way, I have a paper with exactly that title: "Auctions of Companies", Economic Inquiry Vol 39 Issue 1 January 2001). Judging from the news reports, the investigation focuses on behavior by the firms that could reduce competition in the auctions and result in lower prices. This reminds me a bit of claims that the major audit firms were not aggressively competing against one another in bidding for audit jobs, since they realized that they were in a repeated game with the same players. Certainly there are good arguments from game theory to suggest that in a repeated context there are numerous strategies that evoke ongoing cooperative behavior and overcome any tendency to the classic "prisoners' dilemma." One strategy that has gotten a lot of play in theory is "tit for tat." In the private equity world, this would mean that if one firm were to bid aggressively for a company in one auction, then in the next auction a competitive private equity firm would bid aggressively just to punish the first firm. Of course, in the Middle East tit-for-tat seems to cause unrelenting cycles of escalating retaliation...

This is also nothing more than an interesting theoretical possibility without any convincing empirical evidence. And the story can be applied to almost every industrial setting where a relatively small number of firms compete with one another in a repeated context. So at this point it sounds like a Justice Dept. fishing trip.

My student and I were more interested in other areas where cooperation would pay. This story goes back to work by John Lott and myself: "Externalities and Corporate Objectives in a World with Diversified Shareholder/Consumers," Journal of Financial and Quantitative Analysis, March 1996.

Suppose one venture capital firm has investments in two portfolio companies, which we will call A and B. What if A and B have some competitive fronts, or even more interesting, areas where there are complementarities? Then the venture capitalist should internalize those externalities and make sure that the two firms act so as to maximize their JOINT value rather than maximizing values independent of one another. If the two firms are interacting competitively, then joint value maximization could be contrary to consumer welfare, but if the two firms interact with complementarities, then joint value maximization would enhance consumer welfare.

Or to take it another step, suppose there are two venture capital firms, VC1 and VC2. And suppose that, through the syndication process, each venture capital firm has investments in both of the client firms A and B. Typically in these situations, one VC firm takes the lead investment role in each syndication. So VC1 might be the lead in Firm A and VC2 would be the lead in Firm B. On the surface, since the two VCs would have unequal stakes in the two clients, they would not each have incentives to maximize joint value of A and B. However, if VC1 runs Firm A as to maximize value of A at the loss of value to Firm B, VC2 will suffer. Similarly if VC2 runs B so as to destroy value at client Firm A, then VC1 will suffer. The two VCs might see that they would both be better off if they managed their clients with an eye to joint maximization. As with the private equity firms, any such coordination like this is much more likely to arise if VC1 and VC2 are in repeated syndications.

In 1953, the US government brought suit against 17 investment banking firms (US v. Morgan et al), alleging that they had used the syndication system as a means to perpetuate their coordination in investment banking. The case was lost, with the judge concluding that the defendants had acted independently and that the syndication system had an efficiency role to play.

My prediction is that history will repeat itself. Maybe this time we will be spared the cost of an extensive fishing trip. On the other hand, maybe the guys in Justice agree with me on something: A bad day fishing is better than a good day at work.

The Media Cascading into Falsehoods Once Again?

There are numerous reports in both newspapers and on the radio (I haven't had the TV on, but no doubt it is there too) of an American diplomat who supposedly said on Al Jazeera that the US has been "arrogant and stupid" in Iraq.

The only problem is that the diplomat was speaking in Arabic (good to hear that they can do that!) and Arabic can be tough to translate into English.

So do we think that every media outlet that passes this story on has had their own translator check the accuracy of the translation? Or is everyone just assuming that since someone ran the first story, and then someone else respectable ran the story, that it must be right?

In information cascades, you will frequently have everyone coming to the same wrong conclusion, even when their own private information suggests a different conclusion. The situation above could be a perfect example: a reporter who knows a little Arabic might check the actual words, but if they are not expert, then they will put more weight on the cascade of everyone else saying the original translation was right than on their own opinion. The result? A cascade of the same story, with the same translation.

Friday, October 13, 2006

Record Breaking, and Deadly, Early Snow

An update: A state of emergency in the Buffalo area from the record early snowfall, and tragically, three deaths attributed to the snow. Health care workers had to bring dialysis patients in to the hospital and bring other medical supplies to people who could not get out.

Two Feet of Snow in October!

Ah, how I wish I were in Buffalo today, getting socked by lake effect snow. Brings me right back to home in the good old UP of Michigan. Soon we will be getting some snow in NH as well, but we don't get blizzards out here like we did in the UP. I still remember one snowstorm that stranded hundreds of cars along US 41 for at least a whole day.

By the way, if climate change reduces the severity and frequency of snowstorms like this in the large metropolitan areas of the Northeastern US, do the financial savings and reduced lives lost (how many people die from heart attacks every year shoveling snow?) count as a benefit?

An Admirable Peace Prize

The 2006 Nobel Peace Prize has been awarded to economist Muhammad Yunus and the pioneering microfinance organization, Grameen Bank. This is wonderful. Microfinance is a great institutional innovation that helps get capital, in small amounts, to entrepreneurs who can help eliminate poverty and provide goods and services in developing areas of the world. A good number of Tuck's MBA students are interested in microfinance. While it will be hard to get mainstream capital markets involved in any large way in microfinance, the point of developments like these is that they do not need to be huge to have a significant effect.

Wednesday, October 11, 2006

Two Papers for the Price of One

I was meeting with a very famous economist last week, lamenting the deterioration in coverage of business news by the Wall Street Journal. My guest said, yes, one of his friends laughs about getting two papers for the price of one with the WSJ: the traditionally conservative opinions on the editorial page, and now increasingly, a liberal slant towards the news in the rest of the paper.

This blog of mine started with my observations of poor reporting in the WSJ's front page story on the British Petroleum "corner" of the US propane market. I will now add another observation to the database, this time from the October 6 edition, an article on the front page entitled,"How Quiet Moves by a Publisher Sway Billions in Drug Spending." Ominously, this is noted as the fourth in a series titled "Health Care Goldmines. Middlemen Strike it Rich." Not off to a very good start with those leading words, are we now?

Since the WSJ online is a subscription service, and I don't have an account, I don't know of any way to link to the article. I apologize for that, but using the title and the author and date you could easily find it.

My apologies to the writer, Barbara Martinez, if I appear a little harsh here.

But this article is one of the more breathless juvenile attempts at creating (not exposing) a business scandal that I have ever seen. I really expect more from what was once the world's leading economics and business newspaper.

The thrust of the story and situation, as best I can fathom, is as follows: One company, First DataBank, has historically collected data on average wholesale prices for pharmaceuticals. These data were used in setting a benchmark that determined what retail pharmacies would be paid by insurers when the pharmacies dispensed drugs to individuals. From the sounds of it, the average wholesale price (AWP) would be used as a base, from which an insurer would tack on a margin to compensate the pharmacy. The higher the AWP, the higher the compensation for the pharmacy,

That is all well and good. The main claim, from a court case in Boston, is that First DataBank was collecting shoddy data -- that in the past several years, only one firm was being surveyed, the drug wholesaler McKesson. A second claim seems to be that First DataBank raised its reported average wholesale price around 2002 -- and since there was not really a valid survey being conducted at the time, any such raise of the reported AWP would be unjustified. The article, by innuendo, attempts to rope McKesson into this business. McKesson would not appear to benefit directly from any increase in the AWP. Its customers, the pharmacies, conceivably could benefit from an increase in AWP that was not actually caused by a real increase in wholesale prices, for the pharmacies would get more compensation but would not be paying more at the wholesale level. I suppose you could say that McKesson would benefit indirectly, if its customers were to benefit. There are no claims anywhere in the article that First DataBank and McKesson were colluding actively to raise AWP. There are some emails reported in the article, including one from some unnamed McKesson manager, saying "that is awesome" about how pharmacies would get higher compensation.

So there are several things that really bug me about this story. The naivete is striking. Here is one example: "Between the manufacturer and the end user stand a variety of middlemen who take their cuts." Standing alone, that may not be too bad. In the context of the article, it shows a view of middlemen as parasites that should be driven out of any college freshman's mind by their introductory economics course. Another example of naivete is a paragraph that attempts to show how pharmacies have been profiting in the last few years. The paragraph mixes stock returns with Walgreen's doubling of net income and ends with "Share prices of the three major PBMs (pharmacy benefit managers) are also sharply up over the past few years." I love to get reports written by students like that; they are so much fun to tear apart. "Sharply up?" Is that some scientific term, "sharply up?" Are they up relative to a relevant index? Up relative to zero?

Another major point of mine is that I think the reporter simply has the whole story wrong. I find it very difficult to believe that contracts of any significance were as reliant on the AWP as the article asserts. It is just very hard to believe that billions of dollars of reimbursement are based on such poor data. The article mentions that AWPs are not taken seriously in the industry, with some referring to AWP as "ain't what's paid." So the data are a joke, but billions of dollars ride on it. If this is true, then THAT is the story! Why would insurers be using such a terrible metric for their reimbursement schemes, a metric that is not only inaccurate but subject to manipulation because only one company is being sampled. Rather than a story on middlemen making profits, we should have a story on stupidity in the insurance and reimbursement industry.

A third point is the needless and slanted language throughout the whole story. I have already pointed out the headline and the title of the series. Here are just a few more juicy quotes:

"For years, a little known unit...played a powerful role...

"The new prices had the effect of fattening the profits...

" Now a tentative legal settlement, reached quietly in a Boston court...

"Even as patients face higher co-payments...many pharmacies and PBMs are prospering...

"Documents ... suggest that McKesson had a key part...

Wow. I am just breathless from the excitement of reading this. A little known unit, playing a powerful role, fattening profits, a quiet settlement, companies prospering while patients pay more, a wholesaler playing a key part...

When is the movie coming out? Will it star Meryl Streep?

Come on, Wall street Journal. I expect bias and slanting on the editorial page, and I love it. But nobody can complain because it is known to be opinion. But to have this kind of reporting on the front page? I expect better.

Tuesday, October 03, 2006

Raising High before Smiting Down

Last night at Tuck, yours truly was on a panel discussing climate change. It was fun, and we had Professors Richard Howarth and Walter Sinott-Armstrong from "up the street" here as well.

I detect a certain cockiness in some of the climate change scientist crowd, and it infects even the more casual observers of the science. A telltale remark is along the lines of, "Well, 1000 scientists believe it to be right, so how can we argue?" (Now what exactly "it" is that is right is of course very interesting. I said numerous times that I believe some climate change has occurred and that humans are likely responsible for some of it, but people still asked me after what it would take to make me believe...)

So if a 1000 scientists believe a paradigm or theory to be absolutely true, that is the end of the story right?

Just in my short academic career, I can think of three paradigms in economics that have been overturned quite dramatically. At least two of them were characterized before the fall of extreme confidence in the paradigm -- yes, cockiness.

Two examples come from finance. The Capital Asset Pricing Model in the 70s and early 80s was held to be the key to understanding asset pricing, in particular the cross section of stock market returns. It is now dead.

A second related one comes from finance as well -- versions of market efficiency, especially that rational investors determine prices and that any inefficiencies in prices would be quickly eliminated. Now I and others can still argue this one pretty well, but there is no doubt that two decades of empirical studies on stock market pricing anomalies, along with experimental work on behavioral economics and finance, has removed the aura of invincibility around strong forms of market efficiency.

A third one is outside of my area a bit, but a colleague suggested it this morning: the death of structural equation macroeconomic modeling upon the development of the rational expectations critique by Robert Lucas. The Lucas critique effectively brought a whole industry of macro modeling to a stop.

So let's be a little respectful of the scientific process. The beauty of these examples is that knowledge does evolve: that even in a discipline as self-sure as the finance profession, a steady stream of contrary theory and evidence, even when produced by a small set of contrarians (think Richard Thaler of behavior finance), can lead to upheavals in the fundamental structure of theory.