Bill Totten's Weblog

Monday, November 12, 2007

Pirates of Private Equity

An insanely lucrative investment strategy finally faces public scrutiny

by Adam Doster

In These Times (October 29 2007)

Employees knew that Hastings Manufacturing Company, a family-owned auto-parts supplier thirty miles south of Grand Rapids, Michigan, was in deep water. Facing financial pressure, 375 employees - two-thirds of whom were in the United Auto Workers' (UAW) bargaining unit - conceded $1 million in benefits to save their company, relinquishing newly negotiated pay raises and agreeing to cover part of their own health care costs.

But according to UAW Local 138 Chief Steward Kim Townsend, who testified before the House Commercial and Administrative Law subcommittee in September, when Hastings' management declared bankruptcy and was taken over by the private equity firm Anderson Group in December 2005, the slicing didn't stop there. Sick days were cut in half, an existing two-tier wage system with a top rate of $13.49 an hour was maintained and the allotment for bargaining time was limited to two hours a month on company time. For retirees, the consequences were more dire, with pensions and health care coverage all but severed.

To market analysts, Hastings appears more profitable today. But its value stems not from innovation but from breaking obligations to the company's employees and retirees. "We make the same products", Townsend said at the hearing, "in the same building, with the same equipment, for the same customers as we did before the asset sale".

As the Hastings case exemplifies, mysterious financial entities known as private equity funds are laying waste to economies around the world. The firms that manage these funds grab up companies, strip them of their assets, gobble up the profits, and leave workers and local communities to pick over the detritus.

Supporters of private equity schemes argue that takeovers can improve businesses' financial performance. But the privacy under which fund managers operate makes monitoring and honest analysis difficult. And while only some people understand how this influential investment strategy works, moves are afoot in Congress to rein in these corporate predators, an indication that private equity firms won't lurk in the shadows forever.

Private equity funds are complicated entities. Essentially, they are unregulated pools of private capital raised and controlled by investment managers, otherwise known as "general partners". Typically, managers buy up undervalued companies, de-list them from public exchanges, restructure them through a variety of tactics, and then sell their stake in the leaner, more profitable business to interested buyers, other private equity firms or on the stock market through another Initial Public Offering (IPO). Advocates argue that squeezing inefficiencies out of underperforming companies not only creates a more vibrant economy but also yields returns that support projects from which all citizens benefit, including new construction or job creation.

For example, DaimlerChrysler made headlines this May when it sold a controlling interest in the scuffling but iconic Chrysler Group to Cerberus Capital Management for $7.4 billion. With the agreement, the German auto giant was left with a 19.9 percent stake in Chrysler but freed itself of its responsibility for pension and health care liabilities.

Most of these funds are financed by cash-rich institutional investors known as "limited partners" - pension funds, insurance companies, university endowments, wealthy individuals - that commit large sums of money for a fixed period of time, usually ten years. Because private equity funds can generate only so much capital from wealthy sponsors, most transactions are leveraged by debt financing, with the acquired company's assets used as collateral for the loans. Sometimes as much as eighty percent of the transaction value comes from this form of financing.

Private equity investors profit only when the firm sells the restructured companies, but the fiscal acumen of managers and the latitude offered by leverage can lead to returns of thirty percent or forty percent. While eighty percent of buyout profits flow to the limited partners, the managers retain the carried interest, or twenty percent of the gains realized by the fund. Fund managers also charge an additional two percent annual management fee, which can net them hundreds of millions of dollars alone after large buyouts.

Spurred primarily by strong stock prices and low interest rates that have led to massive liquidity growth in world markets, the private equity industry has exploded in recent years. According to Private Equity Intelligence, a London-based company that does research on the industry, these funds raised a record $406 billion in 2006. More than 170 funds each hold $1 billion or more in assets. They brokered $475 billion in deals last year alone, thirteen times more than five years ago. And while US companies are spearheading private equity's expansion, European-based funds raised some $90 billion in 2006, a 25 percent increase from the prior year. Indeed, private equity firms from both continents are now forming partnerships to fund large trans-Atlantic deals, a rare move just ten years ago.

The $4 billion IPO of prominent private equity firm Blackstone Group this March may have ushered in the next phase for the developing industry. Managers at major firms looking to raise new sources of capital and to augment the company's compensation package may publicly list portions of their business while at the same time preserving elements of their private managerial culture.

Other iterations, like the decision of the Carlyle Group (one of the most politically connected private equity firms) in September to sell a 7.5 percent share of its general partnership to an investment group owned by the government of Abu Dhabi, are sure to follow.

The investment goals of private equity funds, fueled in part by naked self-interest, have steered more and more companies toward business models that favor short-term profits at the expense of workers and the public at large.

"You have these operators who don't see companies as producers of anything", says Kelly Candaele, a trustee of the Los Angeles City Employees' Retirement System, "but just as assets and liabilities that can be utilized through these various financial techniques to make money".

The International Trade Union Confederation, in its June report on the dangers of alternative investments, puts it this way: "The protagonists of financialization are more like termites. They leave nothing behind to yield new crops but destroy everything on their way."

One criticism of private equity firms is that a fund's general partners divest assets from buyout targets to increase profitability. Takeovers can result in worker layoffs and the disbanding of labor unions, factory or office closings, and the depletion of a company's pension and health care plans, as well as its resources for long-term research and development.

"Our concern", says Vineeta Anand, the chief research analyst in the AFL-CIO's Office of Investment, "is that people lose their jobs, they lose their benefits, they lose their retirement, all in one gulp". This stripping not only redistributes wealth from workers, customers and suppliers to the financiers brokering the deals, but it also has the potential to permanently eviscerate a company's value.

The amount of debt that target companies accumulate during a buyout raises concerns, as well. High-risk ventures increase pressure on companies to churn out tremendous quarterly profits. For struggling businesses, a logical way to reduce that debt and avoid bankruptcy is through more layoffs or health care cuts, exacerbating the pitfalls of a company's reorganization. "From a societal standpoint, it means we're putting our businesses at much more risk", says Dean Baker, co-director of the Center for Economic and Policy Research. "It certainly creates a lot of inefficiencies if you're subjecting firms to bankruptcy unnecessarily or getting them into heavily indebted situations where they can't undertake normal investment".

Challenging such high stakes leveraging is difficult because, unlike mutual funds and other investments, private equity funds have virtually no oversight from regulators like the Securities and Exchange Commission (SEC). This luxury allows funds to conceal what they invest in and how they restructure target companies. This means that it's less likely that firms will follow sound corporate governance policies or provide information to stakeholders, such as employees, community groups or even the funds' own investors, who might challenge their tactics.

Worse still, fund managers operate under tax laws that are lenient, to say the least. One loophole allows firms to claim tax relief on the interest payments used to buy target businesses. In essence, general partners employ subsidized leverage that allows them to bid more aggressively on businesses and receive far higher returns on their own equity than can public companies, all while skirting their tax burden.

Another loophole allows partners in private equity firms to benefit from a tax break on their earnings. The carried interest retained as compensation for netting a sizeable return is charged the capital gains rate of only fifteen percent, as opposed to the typical income tax rate of 35 percent. "While these managers of private equity and hedge funds make billions of dollars a year", says Anand, "they pay a [tax] rate that's less than half of what ordinary working people - firefighters, teachers, police officers - are paying".

Private equity firms justify the tax code in different ways. Primarily, they assert that even if carried interest makes up the bulk of the manager's compensation, the investments are usually held for more than a year, qualifying them as long-term capital gains. And the Private Equity Council argues, unconvincingly, that talented women and people of color would not have been attracted to the industry without the current carried interest policy, and thus any alteration would harm civil rights.

In reality, the tax breaks that helped propel the private equity boom have only intensified the nation's economic imbalance. According to Executive Excess 2007, a study released in August by the Institute for Policy Studies and United for a Fair Economy, the twenty highest-paid fund managers made an average of $657.5 million last year - 22,255 times the average annual US salary of $29,500.

"We already have this problem of great economic growth ... but with the share of national income going to wage earners shrinking, and with almost all of the new wealth being taken up by a small handful of people", says Representative Barney Frank (Democrat, Massachusetts), chairman of the House Financial Services Committee. "Private equity obviously has the potential to increase that [disparity]".

Some analysts think that the industry's bubble is slowly leaking, if not ready to burst. Financing for leveraged buyouts has reached a virtual standstill in the aftermath of the summer's credit crunch, necessitating a freeze on most private equity deals. Yet, buyout funds have already raised $139 billion globally in 2007, according to an August report by Private Equity Intelligence, and are on pace to exceed the $212 billion raised last year, signaling that the support of institutional investors remains high. These backers have a long-term investment horizon, as well, which means that fluctuations in the world's credit markets are less likely to cause alarm. While it's clear private equity firms will be forced to fork over more of their own money to engage in buyouts, these trends suggest that the firms will likely remain major financial players in the coming years.

To assuage mounting criticism and threats of legislative provisions, some private equity managers have taken steps toward self-regulation. In July, a British industry group led by former Morgan Stanley International Chairman Sir David Walker issued a report that claimed private equity firms have been "needlessly secretive", and suggested British companies be made to supply annual reports that would include information on the top partners, the performance of their funds, their fees and their investors. But even Walker's modest proposals were met with trepidation by managers on both sides of the Atlantic, proving they want no part of policies that may encumber their techniques or alter their pay scale. And without such intervention, private equity's shrewd executives will continue to push workers' benefits and long-term investment to the back burner while profiting from a regressive tax code that strips the government of cash for crucial public programs.

"As these companies grow larger and more powerful, and control more of the economic activity of society", says Candaele, "I think it's inevitable that some sort of regulatory process has to take place".

Major labor unions from across the globe have been on the front line of the emergent regulation battle, publishing detailed reports, staging actions and issuing public statements, warning working people about how the private equity industry is endangering their jobs and their pensions. "The labor movement is ratcheting up their involvement in this and hiring professionals to understand this world, [which] is really key", says Candaele. "There's an informational mismatch when you're dealing with all these money managers ... and the labor movement needs to know much more about how finance works in order to be competitive and to help the broader population deal with and understand these dynamics".

Now some legislators are also stepping up to the plate. In Europe, the Party of European Socialists (PES) - the European Union's second largest voting bloc - has mounted resistance. Claiming that the industry's methods conflict with the expectations and values of European social market economies, PES has advocated for tougher disclosure requirements, and changes to corporate governance and taxation rules. Although the European Union is the most rational arena for proposals, progress is slow, mainly because the European Commission - the executive branch of the European Union - has been supportive of private equity investment, and other voting blocs have been slow to join the fight.

Elsewhere in Europe, individual countries are implementing new regulations. In August, German Chancellor Angela Merkel released plans to curb "undesirable economic" activities by requiring funds to elaborate on their aims if they seek to raise stakes in companies beyond ten percent, and to disclose how they finance bids. In France, President Nicolas Sarkozy has given his finance minister until October to draft a proposal for making fund managers release more information about the financial products they trade.

In the United States, Democrats have followed suit. "I think it is very likely that financial innovation has outstripped regulation and that we need to upgrade the regulation", says Frank. While some in the party are wary that piecemeal laws might derail more thorough tax reforms (or that some of their corporate donations may dry up if the industry is targeted), prominent Democrats have focused on closing the egregious tax loopholes that benefit equity fund managers.

In June, Representative Sander Levin (Democrat, Michigan) introduced a bill that would apply income tax rates to carried interest. A similar bill in the Senate, sponsored by Senators Max Baucus (Democrat, Montana) and Charles Grassley (Republican, Iowa), among others, would more than double the taxes paid by private equity firms like Blackstone that go public. The recent instability in credit markets should generate more urgency to guarantee the industry is subject to oversight, as well.

Legislators have also begun to create transnational partnerships in an attempt to control globalized firms. In one sign of cooperation, PES and the Democrats sent a letter to Merkel and President Bush before April's G8 Summit, calling on them to uphold workers' rights, establish measures for transparency and launch a task force to suggest additional regulatory action.

But to ensure that these financial transactions benefit society at large, many critics think these humble legislative efforts should be supplemented by more comprehensive reforms. Congress could restrict the amount of debt a firm can accrue during acquisitions and incentivize long-term investments, thereby providing much-needed credit stability. Restrictions on forming unions could be eased and workers could have more input in buyout negotiations. And to even the playing field with publicly traded companies, lawmakers could write or amend legislation that would subject private firms to more rigorous monitoring.

Pension holders can also do their part by pressuring pension trustees to invest in socially conscious funds. Candaele points to Yucaipa American Alliance Fund, a group run by billionaire Ronald Burkle, that earns high returns while maintaining solid relationships with organized labor. "There are a lot of ways to make money", he says, "and one of the obligations for trustees is to look at what managers are doing with the money you're investing".

Private equity firms will balk at such suggestions, claiming regulation will inhibit their contributions to the economy. To demolish that argument, Frank says, one only needs to look back in history.

"People who want to [counter] this argument - that if you regulate markets, you're going to interfere with their function - should read the debates over the establishment of the Securities and Exchange Commission in the 1930s", he says. "Then they won't have to think of new things to say. They can just quote them."


Adam Doster is a freelance writer based in Chicago. He is a frequent contributor to In These Times.

Bill Totten


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