FDL Book Salon Welcomes Eileen Appelbaum and Rosemary Batt, Private Equity at Work: When Wall Street Manages Main Street
A couple weeks ago, Burger King announced a merger with the Canadian coffee-and-donuts chain Tim Hortons. Well, not actually Burger King, but 3G Capital, the private equity firm that owns a 70% stake in the fast food chain. This was 3G Capital’s second big deal in recent months, having also purchased the venerable H.J. Heinz ketchup company. And to secure the deal, 3G Capital paid a substantial amount in shares to Scout Capital Management and Highfields Capital Management, who were buying up Tim Hortons stock in preparation for their own private equity takeover.
Nothing about this is unusual. As researchers Eileen Applebaum (Center for Economics and Policy Research) and Rosemary Batt (Cornell University) explain in their important book Private Equity at Work, 2,797 private equity firms in the United States have investments in 17,744 companies, directly impacting the employment of 7.5 million workers, according to the latest statistics. They are highly focused in retail, food service, health care and really wherever money can be plucked.
And they should be called private debt firms. General partners in private equity barely put up any of their own money at all in their deals, loading up they companies they take over with large amounts of debt. They do this because it expands their potential profits, and because our tax system advantages debt over equity. The acquired company becomes wholly responsible for paying back the debt, usually out of cash flow that would otherwise get plowed back into worker benefits or expansion.
What’s in it for the companies? Private equity fund managers say they’re merely filling a role banks won’t, providing pools of capital to businesses that would not otherwise receive them. But considering that the businesses often get field-stripped in the exchange, maybe this isn’t the kind of generosity they actually desire.
Applebaum and Batt fill the book with dozens of case studies. On a few occasions, private equity firms do use their size advantages and an army of private consultants to rehabilitate struggling companies and sell them off to better situations. (One wonders whether the company could just hire the consultants themselves, rather than enduring a debt-fueled buyout to get the advice.)
But these turnarounds represent a small subset of the acquisitions; private equity usually takes over successful, growing firms and extracts their value. “The success of any individual portfolio company is of secondary concern to private equity managers,” the authors write. Private equity firms have lots of ways to make money: tax arbitrage, “dividend recapitalizations,” management fees and other bits of financial engineering that does nothing for the acquired company but saddle them with more debt.
In fact, private equity firms almost always advise companies to deal with that debt by cutting costs, through wage cuts, layoffs or plant closings. Statistics show that acquired companies have higher employment growth prior to acquisition. Job destruction outpaces job creation in private equity-owned firms, and wages typically fall post-buyout as well. Essentially, gains get shifted from workers to fund managers.
Lest you think this is only a problem for workers, we all subsidize private equity – whether through general partners taking their share of investment gains as “carried interest,” which has a lower tax rate than ordinary earnings, when firms offload pension liabilities on the government’s Pension Benefit Guaranty Corporation. The authors rightly call this “taxpayer-financed capitalism.”
Applebaum and Batt explain the unique structure of private equity, where general partners run the portfolio companies, and the limited partners, who front most of the equity, remain silent. These investors make 10-year unbreakable commitments to private equity funds, pay a 2 percent management fee, and have no voting rights or even the ability to transparently understand the decision-making process. So private equity operates like a funhouse-mirror version of the “investors as managers” concept of shareholder value: the limited partners put up most of the money, sacrifice liquidity and take most of the risk, but the general partners call the shots, and take most of the profits.
Incredibly, over one-third of these limited partners are public pension and Taft-Hartley union pension funds. So the same labor leaders decrying outsourcing and job loss – in part from private equity – are the ones investing in and reaping profits from their firms, like a snake eating its own tail.
It’s not at all clear what pension funds and other limited partners actually gain from their investments. They claim to stake private equity because of outsized returns. Yet, as Applebaum and Batt write, “reports that private equity funds outperform the market come almost entirely from industry sources.” In actuality, only the top funds do really well, and those are essentially closed to new investors. In most cases, investors would be better off with a plain vanilla index fund, where they could pull their money out at any time.
I learned something on just about every page of this book. The private equity model reflects the Wall Street-ization of the economy, which can transform every business – retail, manufacturing, whatever – into a financial firm. As they employ debt as a method of profit, they increase the risk throughout the financial system, weaponizing traditional banking. This has become a troubling norm for how corporations fund themselves – leveraged loans are at a post-crisis high, and there are signs of a bubble forming in mid-market buyouts, where private equity has focused since the financial crisis. Over a trillion dollars in “dry powder” sits uninvested in private equity funds. More money pushes up deal prices, which will undoubtedly lead to more financial games and more debt-laden portfolio purchases.
Applebaum and Batt thoroughly survey the history of private equity, and the consequences for investors, workers and the overall economy. They close with a number of recommendations, including overhauling the private equity general partner compensation model, limiting the excessive debt placed on portfolio companies, prohibiting asset-stripping, adding employee protections and increasing transparency. You can draw your own conclusions on whether a business model that is “highly remunerative but socially unproductive” should be mended, or simply ended.
Given the ubiquity of private equity, we should all get to know how they work and what consequences they trigger. This book is a public service in that regard. Welcome Eileen Applebaum and Rosemary Batt to FDL.
[As a courtesy to our guests, please keep comments to the book and be respectful of dissenting opinions. Please take other conversations to a previous thread. – bev]