EQT: Private Equity with a Purpose

The primary factors driving the remarkable growth of private equity have been the industry's attractive and stable returns in combination with its active ownership model. Nevertheless, critics have been questioning whether the PE industry can maintain its historic returns, and challenging its fee and incentive structures as well as its notable lack of transparency and diversity. And the alleged systemic effects of the industry on social problems like income inequality and climate change have become large enough to create a perceived threat to PE's long‐term “license to operate.” In this article, the authors discuss the commitment of EQT, the publicly listed and Stockholm‐headquartered private markets firm (and eighth largest PE fundraiser in the world), to the “future‐proofing” of both its portfolio companies and the company itself. The company envisions itself as undertaking a “journey” toward sustainability and positive impact and, in so doing, furnishing a model that other PE firms might find useful in helping “future‐proof” the entire industry. As part of that commitment, EQT recently published a “Statement of Purpose” signed by its the board of directors that focuses a societal impact lens on its entire portfolio of companies and assets, reinforces its public commitments to diversity and other “clean and conscious” practices, and aims to leverage digital technologies to enhance financial returns and real‐world outcomes. Transparency and a mindset focused on achieving positive impact are the keys to PE's earning high and stable returns and to securing its long‐term license to operate.     

The Evolution of Private Equity Fund Terms Beyond 2 and 20

With the remarkable increases in the assets under management of private equity firms, the standard compensation arrangement of a 2% management fee plus 20% carried interest has raised concerns of a misalignment of interests between limited partners (LPs) and general partners (GPs). Using a proprietary data set that includes detailed fund terms of 210 PE buyout funds with vintage years between 1989 and 2012, the authors summarize the findings of their recent study of the evolution of fund terms. The authors report that PE fund terms have been remarkable mainly for their resistance to change, and that the only important force for bringing about reductions in percentage management fees has been the recent increase in fund sizes. But the modest cuts in management fees that have accompanied the increase in fund sizes have done little to address what appears to be a conflict of interest between LPs and GPs over the optimal PE fund size. As one possible solution to this conflict, the authors analyze a recent innovation by Bain Capital that involves considerably smaller management fees (say, 1%) and larger carried interest (as high as 30%). According to the authors, such terms have a good chance of becoming the new industry standard for two reasons: First, LPs have become increasingly “professionalized,” which has led to greater focus on GP compensation and ways of realigning their interests with LPs'. Second, the “signaling” benefits for those GPs willing to distinguish themselves by offering terms like “1 and 30” could encourage more GPs to move in this direction. In the authors' words, “For all but the most reputable and established PE firms, those GPs that do not offer the new terms may well be seen as signaling little confidence in their ability to do what they're being paid to do: namely, produce above‐market returns.”     

Morgan Stanley Roundtable on The State of Global Private Equity

In this discussion led by Alan Jones, Morgan Stanley's head of Global Private Equity, the University of Chicago's Steve Kaplan begins by surveying 25 years of academic research on private equity. Starting with Kaplan's own Ph.D. dissertation on leveraged buyouts during the 1980s, finance academics have provided a large and growing body of studies documenting the ability of private equity firms to make “sustainable” (that is, maintained over a three‐ or four‐year period) improvements in the operating performance of their portfolio companies, whether operating abroad or in the U.S. Even more impressive, the findings of Kaplan's new study (with Tim Jenkinson of Oxford and Bob Harris of the University of Virginia) suggest that these improvements have been large enough to enable PE funds raised between 1990 and 2008 to deliver returns to their limited partners that have averaged 300 to 400 basis points higher per year than the returns to the S&P 500. And given the “persistence” of PE fund returns—the tendency of the funds of the same PE firms to show up in the top quartile of performers year after year—that Kaplan has documented in earlier work, the performance of private equity seems notably different from that of mutual funds and hedge funds, where there has been little if any consistency in the returns provided by the top performers. Following Kaplan's overview of the research, four representatives of today's leading private equity firms explore questions like the following:

• ? How do the best PE firms, after paying premiums to acquire their portfolio companies and collecting large management fees, provide such consistently high returns to their limited partners?
• ? How did PE portfolio companies perform during the last recession, when many popular business publications were predicting the death of private equity—and what, if anything, does that tell us about how private equity adds value?
• ? What can PE firms do to avoid, or at least limit the damage from, the overpricing and overleveraging that tend to occur near the end of the boom‐and‐bust cycle that appears to be a permanent feature of private equity?

As Jones notes in his opening comments, the practitioners' answers to such questions “should help investors distinguish between the alpha that the firms represented at this table have generated through active management from the ‘closet beta’ that critics say results when private equity firms simply create what amounts to a levered bet on the public equity markets.”     

Building a Bridge between Marketing and Finance

Corporate finance executives are often frustrated by spending proposals from their marketing colleagues but cannot seem to be able to quantify the putative benefits. Similarly, the marketing staff is frustrated by the finance team's inability to convert soft marketing metrics, such as “awareness” and “customer satisfaction” into financial forecasts. The challenge is that neither marketers nor finance executives have been able to articulate a single analytical framework which both explains how and why brands come to flourish or flounder and how brand growth contributes to the business's short and long term bottom line. Lacking an effective way to do this now, most managers default to using the hard data they do have, namely how marketing investment is likely to impact sales this quarter and next. This reinforces the widespread focus on quarterly EPS and reduces the perceived value of the marketing department to their ability to hit three month sales targets. This degraded view of marketing's contribution and the inability to link “soft” marketing metrics to longer term financial returns impedes building long‐term brand value. This article focuses on how advances in behavioral science and financial analytics offer an effective way to bridge this gap between marketing and finance. Building that bridge requires better measures of brand health and financial performance to allocate capital and marketing resources. Undoubtedly, brand building is both an art and a science. But, the finance people can develop an evidence‐based framework explaining how some of the “softer” investments such as brand building, contribute to the value of the firm.     

What Public Companies Can Learn from Private Equity Pay Plans

Studies of private equity pay, including one by current SEC commissioner Robert Jackson, have pointed to restrictions on equity sales as a key difference between private equity and public company pay. In this article, the author argues that there is another very important difference: equity compensation in PE pay plans is typically front loaded, with top executives of portfolio companies often required to buy shares, and receiving upfront option grants on three times the number of shares they purchase. Such front‐loaded equity compensation allows PE pay plans to avoid the unintended effects of the “competitive pay policy” that have been embraced by public companies for the past 50 years. Competitive pay—targeted, for example, to provide 50th percentile total compensation regardless of past performance—has the effect of creating a systematic “performance penalty,” rewarding poor performance with more shares and penalizing superior performance with fewer shares. The author's research shows that, for public companies during the past decade or so, the number of shares granted has fallen by 7% for each 10% increase in share prices—and that, primarily for this reason, the front loaded option grants used by PE firms have provided five times more incentive (“pay leverage”) than the average public company's annual series of equity grants. What's more, to the extent that PE pay has been guided by partnership and fixed‐sharing concepts rather than competitive pay, it is the spiritual heir to the value‐sharing concepts that guided public company pay in the first half of the 20th century. For 60 years, General Motors used value sharing in “economic profit”—10% of GM's profit above a 7% return on capital was the formula for the bonus pool for many years—as the basis for all incentive compensation. The author uses the GM history to highlight four ways to improve public company incentives and corporate governance.     

Market Interest in Nonfinancial Information

During the past two decades, more and more companies have volunteered to provide “corporate social responsibility” or “sustainability” reports that include information about their environmental, social, and governance (ESG) policies and performance. Such reporting has come about largely in response to demands by a wide range of stakeholders for information about how the company's operations are affecting society in a number of different ways. But do investors really care about companies' ESG performance and policies? Using data from Bloomberg, the authors provide the first broadly based empirical evidence of investors' interest in ESG data. More specifically, the authors show how interest in the top 20 ESG metrics varies with geographical location (European vs. American), asset class (fixed income vs. equity), and firm type. At the aggregate market level, there is greater interest in environmental and governance information than in “social” information. U.S. investors are more interested than their European counterparts in governance and less interested in environmental information. Equity investors are interested in a wider range of nonfinancial information than are fixed income investors. And whereas sell‐side analysts are primarily interested in greenhouse gas emissions, money managers tend to focus on a broader set of metrics. Similarly, pension funds and hedge funds have shown interest in more nonfinancial metrics than insurance companies. The authors' bottom line: Companies need to recognize the growing market interest in nonfinancial information and ensure that they are providing it according to the specific information needs of market users.     

ESG Investing in Graham & Doddsville

The author describes how and why the world's best “business value investors” have long incorporated environmental, social, and governance (ESG) considerations into their investment decision‐making. As the main source of value in companies has increasingly shifted from tangible to intangible assets, many followers of Graham & Dodd have delivered exceptional investment results by taking an “earnings‐power” approach to identifying high‐quality businesses—businesses with enduring competitive advantages that are sustained through significant ongoing investment in their core capabilities and, increasingly, their important non‐investor “stakeholders.” While the ESG framework may be relatively new, it can be thought of as providing a lens through which to view the age‐old issue of “quality.” Graham & Dodd's 1934 classic guide to investing, Security Analysis, and Phil Fisher's 1958 bestseller, Common Stocks and Uncommon Profits, both identify a number of areas of analysis that would today be characterized as ESG. Regardless of whether they use the labels “E,” “S,” and “G,” investors who make judgments about earnings power and sustainable competitive advantage are routinely incorporating ESG considerations into their decision‐making. The challenge of assessing a company's sustainable competitive advantage requires analysis based on concepts such as customer franchise value, as well as intangibles like brands and intellectual property. For corporate managers communicating ESG priorities, and for investors analyzing ESG issues, the key is to focus on their relevance to the business. In this sense, corporate reporting on sustainability issues should be viewed as analogous to and an integral part of financial reporting, with a management focus on materiality and relevance (while avoiding a “promotional” approach) that is critical to credibility.     

Analysts' Roundtable on Integrating ESG into Investment Decision‐Making

In this third of the three discussions that took place at the SASB 2016 Symposium, practitioners of a broad range of investment approaches—active as well as passive in both equities and fixed‐income—explain how and why they use ESG information when evaluating companies and making their investment decisions. There was general agreement that successful ESG investing depends on integrating ESG factors with the methods and data of traditional “fundamental” financial statement analysis. And in support of this claim, a number of the panelists noted that some of the world's best “business value investors,” including Warren Buffett, have long incorporated environmental, social, and governance considerations into their investment decision‐making. In the analysis of such active fundamental investors, ESG concerns tend to show up as risk factors that can translate into higher costs of capital and lower values. And companies' effectiveness in managing such factors, as ref lected in high ESG scores and rankings, is viewed by many fundamental investors as an indicator of management “quality,” a reliable demonstration of the corporate commitment to investing in the company's future. Moreover, some fixed‐income investors are equally if not more concerned than equity investors about ESG exposures. ESG factors can have pronounced effects on performance by generating “tail risks” that can materialize in both going‐concern and default scenarios. And the rating agencies have long attempted to reflect some of these risks in their analysis, though with mixed success. What is relatively new, however, is the frequency with which fixed income investors are engaging companies on ESG topics. And even large institutional investors with heavily indexed portfolios have become more aggressive in engaging their portfolio companies on ESG issues. Although the traditional ESG filters used by such investors were designed mainly just to screen out tobacco, firearms, and other “sin” shares from equity portfolios, investors' interest in “tilting” their portfolios toward positive sustainability factors, in the form of lowcarbon and gender‐balanced ETFs and other kinds of “smart beta” portfolios, has gained considerable momentum.     

Do Private Equity Funds Increase Firm Value? Evidence from Japanese Leveraged Buyouts

The author summarizes the findings of his recent study of 62 buyouts of listed Japanese companies by both Japanese and “foreign” private equity funds that were transacted between 2000 and 2007. Roughly half of the author's sample of transactions were accomplished by means of takeover bids by PE funds, and such deals were transacted at prices that represented a premium (of roughly 12%) to current market values. Most of the other PE transactions were privately negotiated deals in which the purchase prices involved discounts (of about 15% on average) to current value. For both sets of deals, however, the announcements of such buyouts were associated, on average, with a significantly positive stock market reaction. By the cutoff date of the study (May 2010), 30 of the 62 acquired firms had realized “exits.” Those companies (though not the others) experienced significant average improvements in operating performance; and the extent of such improvements were roughly consistent with the size of the positive market reaction to the buyout announcements. The test results suggest that the value increases can be attributed to the more efficient use of assets and reduction of operating costs. Meanwhile, there was no evidence suggesting that the acquired firms cut back on their research and development, capital investments, or employee wages and growth. What's more, examination of the operating performance of the 30 companies after their exits showed no deterioration in profitability or investment spending.     

The Capital Structure of PE‐Funded Companies (and How New Debt Instruments and Investors Are Expanding Their Debt Capacity)

The capital structures and financial policies of companies controlled by private equity firms are notably different from those of public companies. The concentration of ownership and intense monitoring of leveraged buyouts by their largest investors (that is, the partners of the PE firms who sit on their boards), along with the contractual requirement of PE funds to return their capital within seven to ten years, have resulted in capital structures that are far more leveraged than those of their publicly traded counterparts, but also considerably more provisional and “opportunistic.” Whereas the average U.S. public company has long operated with roughly 30% debt and 70% equity, today's typical private‐equity sponsored company is initially capitalized with an “upside‐down” structure of 70% debt and just 30% equity, and then often charged with working down its debt as quickly as possible. Although banks supplied most of the debt for the first wave of LBOs in the 1980s, the remarkable growth of the private equity industry in the past 25 years has been supported by the parallel development of a new leveraged acquisition finance market. This financing innovation has led to a general movement away from a bankcentered funding base to one comprising a relatively new set of institutional investors, including business development corporations and hedge funds. Such investors have shown a strong appetite for new debt instruments and risks that banks have been unwilling or, thanks to increased capital requirements and other regulatory burdens, prohibited from taking on. Notable among these new instruments are second‐lien loans and uni‐tranche debt—instruments that, by shifting the allocation of claims on the debtor's cash flow and assets in ways consistent with the preferences of these new investors, have had the effect of increasing the debt capacity of their portfolio companies. And such increases in debt capacity have in turn enabled private equity funds—now sitting on near‐record amounts of capital from their limited partners—to bid higher prices and compete more effectively in today's intensely competitive M&A market, in which high target acquisition purchase prices are being fueled by a strong stock market and increased competition from corporate acquirers.     

Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers*

In this article, the authors summarize the findings of their recent study of the hedging activities of 92 North American gold mining companies during the period 1989‐1999. The aim of the study was to answer two questions: (1) Did such hedging activities increase corporate cash flows? (2) And if yes, were such increases the result of management's ability to anticipate price movements when adjusting their hedge ratios? Although the author's answer to the first question is “yes,” their answer to the second is “no.” More specifically, the authors concluded that:

• ? During the 1989‐1999 period, the gold derivatives market was characterized by a persistent positive risk premium— that is, a positive spread between the forward price and the realized future spot price—that caused short forward positions to generate positive cash flows. The gold mining companies that hedged their future gold production realized an average total cash flow gain of $11 million, or $24 per ounce of gold hedged, per year, as compared to average annual net income of only $3.5 million. Because of the positive risk premium, short derivatives positions did not generate significant losses even during those subperiods of the study when the gold price increased.
• ? There was considerable volatility in corporate hedge ratios during the period of the study, which is consistent with managers incorporating market views into their hedging programs and attempting to time the market by hedging selectively. But after attempting to distinguish between derivatives activities designed to hedge and those designed to profit from a view, the authors conclude that corporate efforts to time the market through selective hedging were largely if not completely futile. In fact, the companies' adjustments of hedge ratios appeared to consistently lag instead of leading the market.

     

The Future of Private Equity

A distinguished University of Chicago financial economist and longtime observer of private equity markets responds to questions like the following:

• ? With a track record that now stretches in some cases almost 30 years, what have private equity firms accomplished? What effects have they had on the performance of the companies they invest in, and have they been good for the economy?
• ? How will highly leveraged PE portfolio companies fare during the current downturn, especially with over $400 billion of loans coming due in the next three to five years?
• ? With PE firms now sitting on an estimated $500 billion in capital and leveraged loan markets shut down, are the firms now contemplating new kinds of investment that require less debt?
• ? If and when the industry makes a comeback, do you expect any major changes that might allow us to avoid another boom‐and‐bust cycle? Have the PE firms or their investors made any obvious mistakes that contribute to such cycles, and are they now showing any signs of having learned from those mistakes?

Despite the current problems, the operating capabilities of the best PE firms, together with their ability to manage high leverage and the increased receptiveness of public company CEOs and boards to PE investments, have all helped establish private equity as “a permanent asset class.” Although many of the deals done in 2006 and 2007 were probably overpriced, the “cov‐lite” deal structures, deferred repayments of principal, and larger coverage ratios have afforded more room for reworking troubled deals. As a result of that flexibility, and of the kinds of companies that get taken private in leveraged deals in the first place, most troubled PE portfolio companies should end up being restructured efficiently, thereby limiting the damage to the overall economy. Part of the restructuring process involves the use of the PE industry's huge stockpile of capital to purchase distressed debt and inject new equity into troubled deals (in many cases, their own). At the same time the PE firms have been working hard to rescue their own deals, some have been taking significant minority positions in public companies, while gaining some measure of control. Finally, to limit overpriced and overlev‐eraged deals in the future, and so avoid the boom‐and‐bust cycle that appears to have become a predictable part of the industry, the discussion explores the possibility that the limited partners and debt providers that supply most of the capital for PE investments will insist on larger commitments of equity by sponsors to their own funds and individual deals.     

Director Quality and Firm Performance

Many financial economists argue that the board of directors' efficacy in the monitoring of managerial behavior depends upon the quality of the directors. Assuming that there is a link between the stock performance of target firms and the quality of their directors, we empirically categorize directors receiving additional directorships following a takeover as “above average” and “below average.” We then follow the stock performance of firms hiring new directors for three years after their hiring. We match the two categories of directors with the performance of hiring firms after a director's appointment. Accounting for other contemporaneous effects, we regress the hiring firms' post‐performance on director quality and other attributes. The results indicate that directors of “above average” quality are related to hiring firms with “above average” post‐performance.     

Responsible Investors: Who They Are,What They Want

This article by a long‐time partner in Domini Social Investments, a well‐known socially responsible investment firm, begins by describing four different approaches that institutional investors have currently adopted as they account for environmental, social, and governance (ESG) considerations in their investment decisions: (1) the incorporation of internationally accepted ESG norms and standards (as set forth in, for example, the FTSE4Good Indexes); (2) the use of industry‐specific ESG ratings and rankings (such as those used for the Dow Jones Sustainability Indexes); (3) the integration of ESG considerations into stock valuation (as advocated, for example, in the Principles of Responsible Investment); and (4) the identification of companies whose business models successfully address the most pressing societal needs (often referred to as “impact investing”). The article then seeks to answer the question: what corporate ESG programs and policies can be most effectively used by managers seeking to attract institutional investors using these different approaches? The author describes three kinds of corporate ESG programs. In one approach, corporate managers focus on strengthening relations with non‐investor stakeholders, including employees, the environment, and local communities. In the second approach, corporations seek to create “shared value” by emphasizing products and services that help address society's most pressing needs. The third approach focuses on identifying and addressing the firm's industry‐specific ESG performance indicators (KPIs) that are most material to stockholders and other stakeholders. Given institutional investors' growing commitment to the incorporation of ESG concerns, corporate managers should understand the range of investors' approaches to ESG and how to account for them in their strategic planning. At the same time, they are encouraged to develop comprehensive ESG policies and goals, devote adequate resources to their implementation, and communicate efforts effectively to these investors and to the public.     

Texas Roundtable on: The Future of Graduate Business School Education

A small group of academics and practitioners discuss the challenges now facing today's business schools. First and foremost is the challenge now being mounted by “online” courses to the traditional methods of classroom lecture and discussion, supplemented in some cases by apprenticeships and other kinds of “experiential” learning. How will traditional universities burdened with high and rising fixed costs for buildings and faculty compete with very low‐cost competitors—programs that reportedly have enabled star lecturers to reach audiences that, in some cases, have exceeded 100,000 students? In assessing the seriousness of the challenge, the panelists start by attempting to articulate what is valuable in current business school education—valuable enough to enable the best business schools to command as much as $175,000 for two‐year (or shorter) programs that confer MBAs. Much of the discussion focuses on establishing the relative importance of the disciplines, or body of knowledge, that are taught in business schools, as compared to the development of “collaborative” habits and interpersonal skills aimed at enabling students to make more effective use of their knowledge within large organizations. Some of the panelists, notably Jeff Sandefer, founder of the (now ten‐year old) Acton School of Business, argue that far too much of today's business school curriculum is devoted to the classroom and conventional learning. And many of the changes in the top business schools during the past decade appear to reflect Sandefer's charges. But, to the extent there is a consensus among the other panelists, it is that the best business schools will continue to try to accomplish both of these goals, though with varying degrees of effectiveness, while most schools attempt to maintain their specialized capabilities, and carve out distinctive niches based on them. For some schools, such specialization is likely to mean continued emphasis on theory and classroom learning—though almost certainly with more attention to practical application and collaborative decision‐making. For other schools, the main focus will continue to be the development of general management and leadership skills.     

Performance Measurement for Nonprofits

The capital market for financing charitable work is far from efficient, and could be improved dramatically. Donors and the nonprofit agencies they fund do not share a standard set of measures and procedures to evaluate performance. Lacking measures of impact, donors—a group that includes government agencies, foundations, corporate CSR programs, and individuals—and charity “watchdogs” often focus on available information that typically has one main focus: the overhead expenses reported by nonprofits in public disclosures. The problem, however, is that the use of overhead expense as a proxy for operational efficiency and effectiveness has many shortcomings. There is no shared understanding of what expenses constitute overhead; overhead spending says nothing about the quality of a nonprofit's programs; and an excessive focus on this single dimension can cause management to underinvest in infrastructure. Management of nonprofits should be encouraged to communicate the results of their key programs—in particular, their impact on the communities they serve. For example, for at least their largest programs, nonprofits could describe the key performance indicators established at outset of their programs, and how they are currently performing against these benchmarks. A substantive management discussion that includes an explanation for any underperformance, and the corrective actions being taken, would help other agencies avoid similar pitfalls while providing potential donors with valuable information that improves not only their decision‐making, but the “efficiency” of the entire market for charitable giving.     

THE REVOLUTION IN CORPORATE RISK MANAGEMENT: A DECADE OF INNOVATIONS IN PROCESS AND PRODUCTS

The explosion of corporate risk management programs in the early 1990s was a hasty and ill‐conceived reaction by U.S. corporations to the great “derivatives disasters” of that period. Anxious to avoid the fate of Barings and Procter & Gamble, most top executives were more concerned about crisis management than risk management. Many companies quickly installed (often outrageously priced) value‐at‐risk (VaR) systems without paying much attention to how such systems fit their specific business requirements. Focused myopically on loss avoidance and technical risk measurement issues, the corporate risk management revolution of the '90s thus got underway in a disorganized, ad hoc fashion, producing a curious amalgam of policies and procedures with no clear link to the corporate mission of maximizing value. But as the risk management revolution unfolded over the last decade, the result has been the “convergence” of different risk management perspectives, processes, and products. The most visible sign of such convergence is a fairly recent development called “alternative risk transfer,” or ART. ART forms consist of the large and growing collection of new risk transfer and financing products now being offered by insurance and reinsurance companies. As just one example, a new class of security known as “contingent capital” gives a company the option over a specified period—say, the next five years—to issue new equity or debt at a pre‐negotiated price. And to hold down their cost, such “pre‐loss” financing options are typically designed to be “triggered” only when the firm is most likely to need an infusion of new capital to avoid underinvestment or financial distress. But underlying—and to a large extent driving—this convergence of insurance and capital markets is a more fundamental kind of convergence: the integration of risk management with corporate financing decisions. As first corporate finance theorists and now practitioners have come to realize, decisions about a company's optimal capital structure and the design of its securities cannot be made without first taking account of the firm's risks and its opportunities for managing them. Indeed, this article argues that a comprehensive, value‐maximizing approach to corporate finance must begin with a risk management strategy that incorporates the full range of available risk management products, including the new risk finance products as well as established risk transfer instruments like interest rate and currency derivatives. The challenge confronting today's CFO is to maximize firm value by choosing the mixture of securities and risk management products and solutions that gives the company access to capital at the lowest possible cost.     

The Strange and Futile World of Trade Wars

U.S. President Donald Trump has a misguided, mercantilist view of international trade. He believes that an external (or “trade”) deficit is a “problem,” and that this deficit is caused by foreigners engaging in unfair trade practices. Accordingly, the president and his followers feel that the U.S. is being—and has long been—victimized by foreigners. The reality, however, is that the negative external balance in the U.S. is neither a “problem” nor is it attributable to foreigners engaging in nefarious activities. The U.S.'s negative external balance, which the country has registered every year since 1975, is “made in the USA.” External balances are always and everywhere homegrown; they are the reflection and the result of the relationship between domestic savings and domestic investment. And it is the gap between a country's savings and domestic investment that is the fundamental driver and determinant of its external balance. Specifically, the current account balance, or “trade deficit,” is the sum of the private savings‐investment gap and the public savings‐investment gap, or what is known as the “fiscal balance.” From 1972 until the end of 2018, for example, the cumulative private sector savings‐investment gap in the U.S. was a positive $12.8 trillion; that is, U.S. companies and individuals collectively saved—that is, earned and retained—some $12.8 trillion more than they consumed and invested domestically. But this positive balance was completely overshadowed by the cumulative negative government gap—or cumulative fiscal deficits—of $24.2 trillion during this 47‐year period. And thus the U.S. as a whole experienced a savings‐investment gap of negative $11.4 trillion that is entirely attributable to the country's fiscal deficits. What's more, the fact that the U.S. recorded a cumulative current account deficit of $11.5 trillion during this period confirms that the U.S. external deficits simply mirror what is happening in the U.S. domestic economy, just as the savings‐investment identity suggests. And, of course, the savings‐investment identity holds true for all countries, even those with significant external surpluses. Japan and China have both long experienced savings surpluses, and both have run current account surpluses that have mirrored their positive savings‐investment gaps. If the U.S. mercantilists understood what causes trade and current account deficits, they would direct their ire at profligate government spending rather than at foreigners. But they don't understand. And the leader of the mercantilists, President Trump, is flying blind and presiding over ever‐expanding fiscal deficits—which will only ensure that the current account deficits not just continue, but get bigger.