It’s been the same headline for months now:
* April of 2020: American billionaires have gotten $280 billion richer since the start of the COVID-19 pandemic
* May of 2020: American billionaires got $434 richer during the pandemic
* August of 2020: American billionaires got $637 richer during the pandemic
* September of 2020: U.S. billionaires got $845 billion richer since the start of the pandemic/Wealth of US billionaires rises by nearly a third during pandemic.
* October of 2020: US billionaires saw their net worth rise by almost $1 trillion between March and October — Jeff Bezos remains the richest, a study says.
From nearly the start of the COVID-19 pandemic it’s been clear that the public health disaster wasn’t a disaster for everyone, with the wealthiest individuals being not only largely insulated from the economic lockdown but in many cases well positioned to profit from it. The pandemic was turning into a giant transfer of wealth. But getting a sense of the scale of the massive transfer of wealth was going to take time. And time has indeed passed, with the wealth of US billionaires having risen by nearly a third since the start of the pandemic.
And that’s only as of September. At this rate the billionaires are on track to be trillion dollars richer by the end of the year. What kind of wealth gains are in store for the billionaires in 2021? Only time will tell. Time and the inevitable reports of trillions more dollars in billionaire wealth. It’s an absurd genuine societal catastrophe on top of all the other catastrophes. And that’s what it’s going to be crucial to keep in mind as this pandemic plays out that the emergence of a ‘heads we win, tails you lose’ billionaire class was never actually inevitable. There’s no law of nature that dictates we tolerate an ever increasing wealth gap. It’s a policy choice.
That’s why one of the major questions facing not just the US but the world at this point is what should be done about this egregious capture of wealth by a tiny sliver of the population. A tiny sliver that was already egregiously wealthy. And as the following article excerpts make clear, if we’re going to finally begin to ask the question of how to correct this yawning wealth gap there’s a very obvious target: the private equity industry, which has gone from a relatively tiny and obscure sector of finance pre-1980 to a behemoth that today powers the “shadow banking” sector of the economy using massive debt and brutal cost-cutting measures that often cross into the territory of corporate looting. Including the looting of a number of corporate pensions. In terms of addressing the gross and growing levels of inequality this seems like a good place to start.
As we’re going to see...
1. The long-hoped for “V‑shape” economic recovery from the pandemic is increasingly looking like a “K‑shaped” recovery where some sectors of the economy do well while others lag or languish. Guess who owns the bulk of the sectors of the economy poised to do well.
2. Back in March, when the economic lockdown was first wreaking havoc, the private equity was lobbying to get access to the US federal government’s Paycheck Protection Program (PPP) loan program that was explicitly set up for small businesses. Publicly, private equity lobbies for decrying the lack of access to the federal loans for small business own by private equity firms (which wouldn’t really make them small businesses). Privately, private equity firms were reportedly informing Congress that if they don’t get access to the loans they will be forced to engage in mass layoffs. The private equity industry was sitting on $2 trillion in cash at the time they were making this threat. Heads we win, tails you lose. Again and again.
3. At the same time the private equity lobby was threatening to engage in mass layoffs if it didn’t get access to the PPP loans it was also raising a disturbingly valid point for why the private equity industry should be bailed out by the federal government: public pension funds have become major investors in a number of private equity funds. For example, the California Public Employees’ Retirement System (CalPERS), put 27% of its assets in private equity firms in 2018–2019, amounting to almost $7 billion dollars that year alone. As we should expect, if we compare the annual returns of private equity-run investments the performance of private equity hasn’t remotely justified the often exorbitant private equity fees.
4. While Congress eventually put in place limits (with some exceptions) to private equity’s participation in the PPP, numerous private equity firms found various loopholes or arrangements used to justify taking loans anyway.
5. In June of this year, the Trump administration expanded the role of private equity in US retirement savings beyond pension funds when the Department of Labor announced that it would allow private equity firms to sell retirement products to individual 401k retirement accounts.
6. Just days ago, we learned that CalPERS is planning on depending even more on private equity investments in the future. Why? Well, as the chief executive of CalPERS put it, a study from CalPERS and its outside consultants showed that only private equity and other high risk investments like distressed debt were likely to yield the 7 percent annualized returns that CalPERS needs to meet its future obligations. Now, as we’ll see, this situation was arrived at in part due to the deeply unrealistic expectations of future stock market performance that not just CalPERS but a number of other pension funds have traditionally used for determining how much money needs to actually be invested to meet pension obligations, so relying on private equity and distressed debt is basically a gambit to correct for those unrealistic expectations. So the public is increasingly turning to private equity to address pension shortfalls instead of other far more sensible approaches like simply taxing the rich more to pay for those pensions.
7. Finally, we’ll take a look at a piece by economist Matt Stoller about the history and philosophy behind the rise of private equity. A history where loading companies with debt was characterized as beneficial because it would force managers to focus on cutting costs. And a history where the rise of the private equity movement in the 1980s was seeded by figures like Bill Simon and the nascent “law and economics movement” that represented the conservative backlash against the New Deal. As we’ll see, Simon viewed ruthlessness as a virtue and though the Republican Party of Richard Nixon and Gerald Ford was too ‘soft’. Not surprisingly, Simon’s views were quite popular with the budding “New Right” Republican class of 1978. Today’s Republican Party is almost entirely of the “New Right” strain. So when we look at the history of the rise of private equity we’re also looking at the history of the rise of the contemporary Republican Party’s extremist economic policies run almost exclusively for the benefit of big corporations and the super rich.
The K‑Shaped Recovery: The Latest Example of the “Heads I Win, Tails You Lose” Economy Run By and For the Rich
Ok, first, let’s start with a look at the emerging “K‑shaped” nature of the ongoing economic recovery. A ‘recovery’ in certain segments of the economy — in particular the technology sector, big banks, and big-box retail — and a general recovery in the stock market — which is almost entirely owned by the wealth — while mom-and-pop stores and service professionals lag. So it’s a “K‑shaped” recovery that private equity is extremely well poised to capitalize on. After all, private equity has been one of the major players in the big-box retail sector for yeas — often to the detriment of those stores as their new private equity owners loaded up on debt and a major investor in technology ...not so much mom-and-pop shops. So this really is turning into the kind of ‘recovery’ optimized to ensure the growing influence of private equity on the economy is going to not just continue growing but accelerating too. And as economist point out, it’s not like this K‑shaped recovery is a novel phenomena. The US economy has been increasing K‑shaped since the 1980s, with the real economy of regular workers comprising the lower half of the “K”, and financial markets making up the top half. So this just the latest K‑shaped recovery in an increasingly K‑shaped economy:
CNBC
Worries grow over a K‑shaped economic recovery that favors the wealthy
* As the economy struggles to shake off the pandemic effects, worries are growing that the recovery could look like a K.
* That would be one where growth continues but is uneven, split between sectors and income groups.
* One obvious area of concern is the dichotomy of the stock market vs the real economy, especially considering that 52% of the market is owned by the top 1% of earners.
* “Let’s not get lost on different letters of the alphabet,” Treasury Secretary Steven Mnuchin said. “There are certainly parts of the economy that need more work.”Jeff Cox
Published Fri, Sep 4 2020 1:41 PM EDT
Updated Sat, Sep 5 2020 5:35 PM EDTThe story for much of the past generation has been a familiar one for the U.S. economy, where the benefits of expansion flow mostly to the top and those at the bottom fall further behind.
Some experts think the coronavirus pandemic is only going to make matters worse.
Worries of a K‑shaped recovery are growing in the alphabet-obsessed economics profession. That would entail continued growth, but split sharply between industries and economic groups.
It’s a scenario where big-box retail and Wall Street banks benefit and mom-and-pop shops and restaurants and other service profession workers lag. Though not readily visible in GDP numbers for the next several quarters that will look gaudy in historical terms, the uneven benefits of the recovery pose longer-term risks for the national economic health.
“The K‑shaped recovery is just a reiteration of what we called the bifurcation of the economy during the Great Financial Crisis. It really is about the growing inequality since the early 1980s across the country and the economy,” said Joseph Brusuelas, chief economist at RSM. “When we talk K, the upper path of the K is clearly financial markets, the lower path is the real economy, and the two are separated.”
Indeed, one of the simplest ways to envision the current K pattern is by looking at the meteoric surge of the stock market since late March, compared to the rest of the economy. While the market soared to new heights, GDP plunged at its most ever at an annualized rate, unemployment, while falling, remains a problem particularly in lower income groups, and thousands of small businesses have failed during the pandemic.
That in itself exacerbates inequality at a time when 52% of stocks and mutual funds are owned by the top 1% of earners.
But it’s not just about asset ownership, it’s the nature of those assets.
The stock market gains have been largely the result of a handful of stocks. Excluding newcomer Salesforce.com, Apple, Microsoft and Home Depot have contributed more points to the Dow Jones Industrial Average this year than the other 27 stocks on the index combined.
That’s why Wall Street when looking for the proper letter — V, W, U or variations thereof — is beginning to see K as more of a possibility.
“The K‑shaped narrative is gaining traction as the tale of two recoveries conforms well with the ongoing outperformance of risk assets and real estate while front-line service sector jobs risk permanent elimination,” Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, said in a note.
The dominating stocks, in fact, help tell a story about a shifting economy that is leaving those behind with less access to the technology that will shape the recovery.
“We believe this is now settled and that we are seeing a ‘K‑shaped’ recovery,” wrote Marko Kolanovic, global head of macro quantitative and derivatives research at JPMorgan Chase.
Kolanovic, who has foreseen a number of major market changes, said the rapid evolution of society during the pandemic has triggered movements that have exacerbated inequality.
“The use of devices, cloud and internet services was bound to skyrocket while the rest of the economy took a nose dive (airlines, energy, shopping malls, offices, hospitality, etc.),” he said. “This has created enormous inequality not just in the performance of economic segments, but in society more broadly. On one side, tech fortunes reached all-time highs, while lower income, blue collar workers and those that cannot work remotely suffered the most.”
Federal Reserve Chairman Jerome Powell has bemoaned the momentum that lower earners had just begun to see prior to the pandemic.
That’s one of the reasons the central bank last week adopted a major policy shift in which it will allow inflation to run above the Fed’s 2% goal for a period of time after it has run below the mark. More than just a philosophical statement about inflation, codifying the approach allows the Fed to keep interest rates low even after the jobless rate drops below what had once been considered full employment.
Fed officials believe that keeping policy loose when the unemployment rate hit a 50-year low over the past year helped contribute to the wider distribution of income gains, and should be the approach going forward.
“It’s a good start that the Federal Reserve, based on two decades of structural change in the economy and a rapidly changing demographic structure in the United States, decided to walk back its long-held preference to act to preventatively against inflation, when expectations were clearly anchored,” Brusuelas said.
The Fed, though, has taken some of the blame for the inequality by implementing policies that seem to benefit asset holders and ignore the rest of the population. While loans to smaller businesses have been slow to get out, the central bank has been buying junk bonds and debt of big companies like Apple and Microsoft to support market functioning. The inflation pivot and an accompanying change on the approach to the unemployment rate, then, is seen as a way to focus policy more broadly.
A variety of paths
To be sure, the actual shape of the recovery depends on a number of factors, high among them the direction of the virus and the extent to which Congress and the White House come through with more fiscal aid.
This downturn is unique in that it did not follow one of the usual paths lower, such as a credit crunch or an asset bubble. Instead, this was a government-induced recession, a byproduct of efforts to contain the pandemic by purposely keeping people away from their jobs and subsequently greatly reducing the ability of businesses to operate.
That’s why predicting the path of recovery is difficult.
“Every business cycle since 1990 has been one where there’s been some ‘K’ characteristics to it,” said Steven Ricchiuto, U.S. chief economist at Mizuho Securities. “Because they’ve been credit cycles, rising waters don’t always lift all boats the same way. Some boats are tiny little lifeboats without much baggage, and some other boats have heavier bags that need more energy to lift. Those are the ones that have credit problems.”
In the current situation, credit is not the problem and the Fed has backstopped any of those issues that may arise through its myriad lending and liquidity facilities.
Ricchiuto sees a “more traditional recovery environment” that will turn into a “swoosh,” or one where an initial burst levels off. That also is a popular view.
“Clearly some areas are going to be slower to come back. That’s going to be true even when the vaccine comes about,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “I don’t buy into the K shape so much. I think it’s more a matter where there will be some industries that take an extra six to nine months to really pick up economic momentum. But once that happens, everything will go together in the same general trajectory.”
...
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““The K‑shaped recovery is just a reiteration of what we called the bifurcation of the economy during the Great Financial Crisis. It really is about the growing inequality since the early 1980s across the country and the economy,” said Joseph Brusuelas, chief economist at RSM. “When we talk K, the upper path of the K is clearly financial markets, the lower path is the real economy, and the two are separated.””
Here we go again. Again. Another K‑shaped economic recovery in a K‑shaped economy increasingly dominate by a financial sector that has exploded in size since the 1980s, the decade when President Reagan sent the US down the path of ‘supply-side’ economics and private equity exploded on the scene with debt-driven leveraged buy outs (LBOs). LBOs that, in many cases, destroyed and gutted the bought out companies. Four decades later private equity’s grip on the economy is bigger than ever, with a significant presence in the technology sector that happens to be the hot sector in the midst of this pandemic. The “top half of the K” is technology and finance, two pillars of today’s private equity industry:
...
The dominating stocks, in fact, help tell a story about a shifting economy that is leaving those behind with less access to the technology that will shape the recovery.“We believe this is now settled and that we are seeing a ‘K‑shaped’ recovery,” wrote Marko Kolanovic, global head of macro quantitative and derivatives research at JPMorgan Chase.
Kolanovic, who has foreseen a number of major market changes, said the rapid evolution of society during the pandemic has triggered movements that have exacerbated inequality.
“The use of devices, cloud and internet services was bound to skyrocket while the rest of the economy took a nose dive (airlines, energy, shopping malls, offices, hospitality, etc.),” he said. “This has created enormous inequality not just in the performance of economic segments, but in society more broadly. On one side, tech fortunes reached all-time highs, while lower income, blue collar workers and those that cannot work remotely suffered the most.”
...
And note that one of the side effect of the Federal Reserve’s historically low rates and plans to keep them low for an extended period of time is obviously going to be to make debt-based takeovers of companies even more capable of buy up companies. Low rates remain the right policy at this time but there’s going to be side-effects and one of those side-effects is likely to be private equity getting a much larger slice of ‘the pie’:
...
Federal Reserve Chairman Jerome Powell has bemoaned the momentum that lower earners had just begun to see prior to the pandemic.That’s one of the reasons the central bank last week adopted a major policy shift in which it will allow inflation to run above the Fed’s 2% goal for a period of time after it has run below the mark. More than just a philosophical statement about inflation, codifying the approach allows the Fed to keep interest rates low even after the jobless rate drops below what had once been considered full employment.
Fed officials believe that keeping policy loose when the unemployment rate hit a 50-year low over the past year helped contribute to the wider distribution of income gains, and should be the approach going forward.
“It’s a good start that the Federal Reserve, based on two decades of structural change in the economy and a rapidly changing demographic structure in the United States, decided to walk back its long-held preference to act to preventatively against inflation, when expectations were clearly anchored,” Brusuelas said.
...
It’s one of the many examples of the “heads we win, tails you lose” nature of the increasingly unequal US economy. In order to facilitate job creation to help people find jobs interest rates are going to have to be kept at levels that making buy up companies easier than ever. Too bad for those workers that private equity is notorious for inflicting vicious layoffs on the companies they buy.
Lend Us the Money or the Little Guy Gets It
As the following Financial Times article from March 31 of this year, right when the scale of the pandemic lockdown’s economic impact was being acknowledged and the US federal government was setting up the Paycheck Protection Program (PPP) designed specifically to assist small business, the “heads we win, tails you lose” nature of private equity’s position in the economy was on full display. The rescue package explicitly banned small business from participating if they are back by a private equity firm that collectively employs more than 500 people across their business holdings. So a small business backed by a small private equity firm could potentially apply for those loans but not if it’s backed by a giant like the Carlyle Group or Bain Capital.
In response, the private equity industry’s lobby publicly threatened mass layoffs of private equity-owned companies unless those companies — at least those with fewer than 500 employees — were also made eligible for the loans. Yep. The industry best known for hostile leveraged buyouts followed by gutting the debt-laden company and firing everyone wanted in on the small business emergency loans set up to prevent mass layoffs. As the article notes, the private equity industry was sitting on $2 trillion in unspent cash right at that time.
But that wasn’t the only “heads we win, tails you lose” argument made by the industry as the time. As one top private equity fund manager put it, “We need to act in the best interest of our own investors, which include pension funds.” And he had a point. The private equity industry is no longer just the a tool for the super-rich to capture the economy. It’s increasingly being used by pension funds — especially public pension funds — to earn the necessary yields that are no longer available from safer-investments like bonds due to the prevailing low interest rate environment.
It’s worth recalling at this point the various reports about private equity funds basically fleecing public pension investors in hidden fees an unusual profit-sharing arrangements. That’s who this industry group is using as their public face: the pension funds they’re screwing. The episode was a chilling a reminder that the private equity industry making these mass layoff blackmail threats are shameless in addition to ruthless. And shameless ruthlessness is a pretty potent combo for getting your way, at least in contemporary America, especially when combined with disingenuous grievances:
The Financial Times
Private equity groups seek US small business rescue loans
Exclusive: Industry warns of mass job cuts if portfolio companies are denied assistanceJames Fontanella-Khan, Mark Vandevelde and Sujeet Indap in New York and James Politi in Washington
March 31, 2020, 10:13 pmSome of the most powerful groups on Wall Street are pressing the Trump administration to allow private equity-owned companies to access hundreds of billions of dollars in loan funds earmarked for US small businesses hit by the coronavirus pandemic.
White House and Treasury officials have been contacted about the issue by industry lobbyists and executives from major investment firms, according to seven people who advised on the discussions, or have spoken directly with the participants.
Congress last week authorised the Small Business Administration to dispense $350bn worth of rescue loans to companies with fewer than 500 workers that have been affected by the coronavirus pandemic.
The Wall Street groups are taking aim at the so-called affiliation rule, under which small businesses can be barred from accessing the rescue funds if they are backed by a private equity firm whose portfolio companies collectively have a workforce that exceeds the 500-person limit.
In a letter to Treasury Secretary Steven Mnuchin, seen by the Financial Times, one industry body said federal “regulations effectively prevent the small business portfolio companies owned by venture capital or private equity funds from accessing” the rescue programme.
“We see no reason why being owned in a fund structure should result in these businesses having less access to the capital needed to keep their employees on the payroll,” said the letter from Steve Nelson, chief executive of the Institutional Limited Partners Association, whose members include public pension funds that have invested in funds run by Apollo, Blackstone, and other big Wall Street firms.
The pleas echo a warning that private equity executives have delivered to officials at the Treasury and the White House, according to people familiar with the conversations: if their portfolio companies are locked out from the $2tn stimulus package agreed last week, they will be forced to dismiss millions of workers to salvage their own investments.
“We need to act in the best interest of our own investors, which include pension funds,” said an adviser to one large private equity firm. “If the government wants to limit funding for companies we own just to punish the private equity industry, we will have to take drastic measures...That means cutting costs aggressively, and restructuring.”
The American Investment Council, which represents many leading private equity firms, said it would “continue to work with the administration, the Federal Reserve and Congress to request that federal programmes support all businesses, regardless of ownership structure, and their workers”.
Democrats have largely been opposed to helping out private equity firms as part of the coronavirus rescue. Critics say funds aimed at saving mom-and-pop companies should not be diverted to companies backed by investment firms that are sitting on more than $2tn in unspent cash.
But Nancy Pelosi, the California Democrat who serves as Speaker of the US House of Representatives, wrote to Mr Mnuchin on Tuesday to express concerns about helping small businesses backed by venture capital investors.
“Many small businesses in our district that employ fewer than 500 employees, particularly start-up companies with equity investors, have expressed concerns that an overly strict application of the Small Business Administration’s affiliation rule may exclude many from eligibility” for the so-called payroll protection loans, wrote Ms Pelosi.
...
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“The Wall Street groups are taking aim at the so-called affiliation rule, under which small businesses can be barred from accessing the rescue funds if they are backed by a private equity firm whose portfolio companies collectively have a workforce that exceeds the 500-person limit.”
It’s discrimination against really, really, really big big companies that own lots of other companies. That’s how the private equity giants are reacting to the small business rescue package that they couldn’t tap. As one letter sent to Steve Mnuchin put it, “We see no reason why being owned in a fund structure should result in these businesses having less access to the capital needed to keep their employees on the payroll.” This is, again, a group that was sitting on $2 trillion in unspent cash fighting for a chunk of the $350 billion small business rescue loans:
...
In a letter to Treasury Secretary Steven Mnuchin, seen by the Financial Times, one industry body said federal “regulations effectively prevent the small business portfolio companies owned by venture capital or private equity funds from accessing” the rescue programme.“We see no reason why being owned in a fund structure should result in these businesses having less access to the capital needed to keep their employees on the payroll,” said the letter from Steve Nelson, chief executive of the Institutional Limited Partners Association, whose members include public pension funds that have invested in funds run by Apollo, Blackstone, and other big Wall Street firms.
...
Democrats have largely been opposed to helping out private equity firms as part of the coronavirus rescue. Critics say funds aimed at saving mom-and-pop companies should not be diverted to companies backed by investment firms that are sitting on more than $2tn in unspent cash.
...
As shameless as the public lobbying campaign was, far more insidious was the private threats the industry was reportedly making to Congress. The threat to layoff millions of workers to protect their investments. And part of that threat involved the counter-threat: if they didn’t lay off the millions of employees the pension funds invested in private equity would suffer. Heads we win, tails you lose, again and again:
...
The pleas echo a warning that private equity executives have delivered to officials at the Treasury and the White House, according to people familiar with the conversations: if their portfolio companies are locked out from the $2tn stimulus package agreed last week, they will be forced to dismiss millions of workers to salvage their own investments.“We need to act in the best interest of our own investors, which include pension funds,” said an adviser to one large private equity firm. “If the government wants to limit funding for companies we own just to punish the private equity industry, we will have to take drastic measures...That means cutting costs aggressively, and restructuring.”
...
Also note that when the industry trumpets its comittment to act only in the best interests of its investors, that idea — that corporations should ONLY have the interests of investors in mind to the exclusion of all other interests including the public interest — was one of the founding philosophies of the private equity movement in the 70s and 80s, as we’ll see below. It is literally a movement dedicated to undermining the idea of the public good. It’s part of the reason the growing reliance of pensions on private equity is so perverse.
So what are the odds that the private equity industry prevails and gets to scoop up those small business loans? Well, while Democrats are the ones opposing allowing private equity to get those loans in the first place, there’s one particular Democrat who was on board with the idea of changing the eligibility rule and giving private equity-own small business access to the funds: House Speaker Nancy Pelosi, whose district includes Silicon Valley, a city filled with private equity-backed technology start-up companies. And note that the letter Pelosi wrote to the Small Business Administration arguing for giving private equity access to the PPP loans was co-signed by fellow Silicon Valley Democrat Ro Khanna, one of the most progressive members of Congress. It’s a sign of increasingly intertwined relationship between private equity and the technology sector:
...
But Nancy Pelosi, the California Democrat who serves as Speaker of the US House of Representatives, wrote to Mr Mnuchin on Tuesday to express concerns about helping small businesses backed by venture capital investors.“Many small businesses in our district that employ fewer than 500 employees, particularly start-up companies with equity investors, have expressed concerns that an overly strict application of the Small Business Administration’s affiliation rule may exclude many from eligibility” for the so-called payroll protection loans, wrote Ms Pelosi.
...
Also keep in mind that when the industry privately threatened Congress that it would engage in mass layoffs if it didn’t get access to those loans, that was implicitly a threat to lay off large numbers of the technology workers who happened to be Pelosi and Khanna’s constituents. So they really were doing their jobs representing their constituents when they wrote that letter, which is an example of the power of the “heads we win, tails you lose” nature of private equity’s control over the economy.
Head We Win, and Heads It Will Be. Because We are Too Big to Fail
But as we’ll see in the following Vanity Fair piece by Bethany McLean from April of this year, there’s another major reason California Democrats like Nancy Pelosi, Ro Khanna, and Maxine Waters supported the private equity industry’s calls for participation in the PPP: the California Public Employees’ Retirement System (CalPERS), has billions of dollars invested in private equity funds. And CalPERS is just the biggest of the growing number of pension systems that are becoming increasingly reliant private equity, which is the kind of situation that puts private equity in the same kind of systemic position as the behemoth banks that received billions in bailouts during the 2008 financial crisis: the ‘Too Big to Fail’ systemic position:
Vanity Fair
Too Big to Fail, COVID-19 Edition: How Private Equity Is Winning the Coronavirus Crisis
Private equity has made multibillionaires of executives like Blackstone’s Steve Schwarzman (net worth: $17.5 billion) and Apollo’s Leon Black ($7.5 billion). Thanks to the $2 trillion bipartisan bailout bill, the industry’s coronavirus losses will belong to all of us.
By Bethany McLean
April 9, 2020Ever since Congress voted to hand out $2 trillion in taxpayer money to those hardest hit by the coronavirus pandemic, American businesses have been scrambling for a piece of the action. Airlines, hotels, and restaurants—all of whose revenues have cratered in the wake of sweeping stay-home orders—have engaged in Hunger Games–like lobbying to cash in on the CARES Act, making their case for a share of the disaster relief. But among those angling for a federal handout is one of the wealthiest sectors of the American economy: private equity. These firms not only have a record $1.5 trillion in cash on the sidelines, waiting to be invested, but their CEOs are among America’s richest executives. So why should they be permitted to raid the federal Treasury in a time of crisis?
The reason is as simple as it is galling: while great private fortunes, such as that of Blackstone’s Stephen Schwarzman (net worth: $17.5 billion and Apollo’s Leon Black ($7.5 billion), have been made from private equity’s march through the world, its losses, to a remarkable degree, will belong to all of us. That’s because some of the major investors in private-equity funds are public pension plans; at Blackstone, roughly one-third of the firm’s money comes from retirement plans set up to provide for over 30 million working-class Americans, according to someone with knowledge of its portfolio. So if Blackstone’s investments crater, the teachers, firefighters, and health care workers who are counting on those investments to generate the returns necessary to pay their pensions will suffer. Think of private-equity firms as the banks of the corona crisis: They are, for better or worse, too big to fail.
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Even before the COVID crisis, there were questions about how well private-equity investments were actually performing. But that didn’t seem to matter, because low interest rates facilitated private equity in another way. Beleaguered pension funds, which suffered big losses in the financial crisis, could no longer count on decent returns from fixed investments, given how low interest rates have been kept by the Fed. Increasingly desperate to boost the portfolios of retiring workers, they too turned to private equity as their savior—urged on by private equity’s promises that it alone could deliver the necessary returns. In 2019, the American Investment Council (AIC), a lobbying group which represents private-equity giants like Blackstone, the Carlyle Group, Apollo Global Management, and KKR, declared that “in order to continue to provide the benefits they guarantee, pensions must continue to invest in private equity.”
In 2018, according to analytics firm eVestment, pension funds in the U.S. and the U.K. pumped 27% of their fresh allocations of money into private-equity funds, up from 25% the year before. America’s largest public pension plan, the California Public Employees’ Retirement System, or CalPERS, put almost $7 billion into private equity during the 2018–2019 fiscal year, according to Institutional Investor. “We need private equity, we need more of it, and we need it now,” chief investment officer Ben Meng said in early 2019—right before CalPERS hired a former private-equity guy, who began his career at Goldman Sachs, to head its private-equity efforts.
Driven partly by public pensions, the private-equity industry has mushroomed. In each of the past four years, according to data-provider Preqin, private-capital managers raised over $500 billion of new money to invest. The industry’s total assets under management have hit a record $4.1 trillion. The industry’s $1.5 trillion in cash on hand is also the highest on record—and more than double what it was five years ago, according to Preqin. The half decade from 2013 to 2018 saw the most private-equity deals over any five-year period in American history.
“Private-equity managers won the financial crisis,” as Bloomberg put it last fall. “Almost everything that’s happened since 2008 has tilted in their favor.” As a result, private equity is now wound into the very fabric of our economy. According to the Institutional Limited Partners Association (ILPA), a lobbying group which represents CalPERs and other public investors, businesses backed by private equity employ more than 8.8 million Americans at over 35,000 companies, accounting for a staggering 5% of the United States’ GDP. What’s more, the Milken Institute reported, even by mid-2018, private equity owned more companies than the number of businesses listed on all of the U.S. stock exchanges combined, and have accounted for a more significant source of financing than initial public offerings in many recent years. If private equity suffers, the blow will reverberate throughout the entire economy.
Which explains why ILPA wrote to Treasury Secretary Steven Mnuchin and Fed Chairman Jerome Powell last week, arguing that companies backed by private equity should be allowed to access the relief funds provided in the CARES Act. Otherwise, the ILPA warned in a previous letter, there would be “significant harm not only to employees that see their hours reduced or jobs eliminated, but also significantly reduced returns to the institutions providing retirement security through pensions, insurance policies and other investments that serve hundreds of thousands of Americans.” To make matters worse, ILPA added, provisions in many private-equity investments allow private-equity firms to make additional capital calls when times are tough. That means public pensions might be forced to dump their holdings in public-backed investments to provide private-equity firms with emergency cash—a move that could depress the stock market even further.
There are several pots of federal money that the private-equity industry is lobbying to access. (And not all private-equity firms care equally about all of the programs.) One is the so-called Paycheck Protection Program (PPP), set up to make $349 billion in government-guaranteed loans available to businesses with fewer than 500 employees. The problem is, existing rules at the Small Business Administration, which is overseeing the program, have been widely interpreted as excluding loaning money to most mom-and-pop businesses that are controlled by large parent companies—including private-equity firms. So private equity is pushing to waive those rules, arguing that small firms should not be penalized for having been bought out by big investors. (Many of the companies owned by mammoth private-equity firms like Blackstone are too big on their own to qualify for this bucket of money.)
The private-equity industry also wants the companies they have invested in to have access to the $454 billion being doled out through the Treasury, an amount that the Fed said could be leveraged into over $2 trillion. Because rules for access to this money weren’t specified in the CARES Act, as ILPA notes, the executive branch will have a fair amount of discretion over who gets access to the money—and private-equity firms want to take full advantage of that opening. “We’ll continue to work with the administration and Congress to request that federal programs support all businesses, regardless of ownership structure, and their workers,” says the AIC’s CEO, Drew Maloney.
The politics dictating whether the private-equity industry will get its wishes are surprising. Mnuchin is a former Goldman Sachs executive and hedge fund guy; Blackstone’s Schwarzman has ties to Trump; Jared Kushner ’s family business has gotten loans from Apollo, according to the Washington Post. Yet an exemption for the private-equity industry did not make its way into the CARES Act; according to Bloomberg, Senate Majority Leader Mitch McConnell is trying to pass a $250 billion boost to the PPP—without provisions opening it to private-equity-backed companies. On the other hand, Democrats, including House Speaker Nancy Pelosi and powerful Representative Maxine Waters, have weighed in loudly—on the industry’s behalf. “It is absolutely imperative,” Waters recently wrote in support of private equity, “that the relief…be extended to protect all workers, irrespective of the affiliations of their employers.” Translation: Workers shouldn’t suffer just because their bosses sold a controlling stake in their businesses to a bunch of greedy fat cats. As for Pelosi, she doesn’t want to see companies backed by venture capital excluded from federal relief, given her Silicon Valley constituents.
Restaurants and hotels owned by big chains have already received exemptions granting them access to the relief funds, regardless of how many people their parent companies employ. The allies of private equity hope that similar exemptions will soon be forthcoming for their firms.“We are in a wait-and-see mode,” Chris Hayes, the ILPA’s senior policy counsel, told me.
The fear, of course, is that private equity will do what private equity does best, which is pocket the money themselves rather than devoting it to the businesses they’ve invested in. The typical fee structure in private equity is the so-called 2 and 20, which means that a fund collects a fee of 2% of the total assets it manages, as well as 20% of any gains on its investments after a certain return is achieved. The industry also quietly helps itself to yet more money by having portfolio companies pay fees for consulting and financing services provided by, of course, their private-equity backers. If private equity is handed billions in taxpayer money, it could use some of it to pay themselves hefty fees today, then pocket even more of it down the road, when they sell their portfolio companies and collect their 20% of the taxpayer-enabled gains. The taxpayer handouts will also help private equity continue its relentless march through the global economy, snapping up troubled companies at bargain prices or extending high-priced credit as other investors, including hedge funds, are forced to sell off their holdings in the post-corona landscape.
Unfortunately, there isn’t really an alternative to providing private equity with federal funds. Like the big banks in 2008, private equity is holding us all hostage. But there are ways to make it work better. According to the CARES Act, companies can only receive loans from the Small Business Administration if they commit to preserving jobs. Waters, in her letter, argues for placing even more strings on the money taken by private-equity-backed companies. Not only should taxpayer funds not be used to pay management or consulting firms, she says, but companies that take the money should also, for instance, be required to include workers on their corporate boards and gradually increase their minimum wage to at least $15 an hour.
We could go even further. A loophole in the tax code currently allows private-equity financiers to pay taxes on their returns at the lower rate for capital gains, rather than the higher rate for personal income. We could close that, once and for all. We could also limit the deductibility of interest payments for tax purposes even more than President Donald Trump ’s new tax law already did, so companies aren’t encouraged to load up on debt. Rasmussen points out that after the financial crisis in 2008, the Federal Reserve set a limit on the amount of debt it considered prudent. Even so, he told me, a “large number of private-equity firms ignored that guidance and decided to put very high levels of leverage on their portfolio companies.” Maybe those firms should now be required to contribute more equity from their cash stockpiles, he suggests.
The big banks emerged from the financial crisis victorious, but also subject to a host of new regulations designed to reduce leverage and stabilize the economy. It’s essential that we do the same today. Given how much of the economy will rise and fall on the investments that private-equity funds manage, we may be forced to let them share the federal handout. But it doesn’t have to be a blank check.
———-
““Private-equity managers won the financial crisis,” as Bloomberg put it last fall. “Almost everything that’s happened since 2008 has tilted in their favor.” As a result, private equity is now wound into the very fabric of our economy. According to the Institutional Limited Partners Association (ILPA), a lobbying group which represents CalPERs and other public investors, businesses backed by private equity employ more than 8.8 million Americans at over 35,000 companies, accounting for a staggering 5% of the United States’ GDP. What’s more, the Milken Institute reported, even by mid-2018, private equity owned more companies than the number of businesses listed on all of the U.S. stock exchanges combined, and have accounted for a more significant source of financing than initial public offerings in many recent years. If private equity suffers, the blow will reverberate throughout the entire economy.”
Private Equity “won” the 2008 financial crisis and now own more companies than the number of businesses listed on all of the US stock exchanges combined. It’s another way of measuring the extent of the private equity industry’s capture of the economy over the last four decades. And now, thanks in part to the ultra-low interest rates that resulted from the 2008 financial crisis that private equity won, pension funds are increasingly reliant on private equity to fulfill their pension obligations. In other words, in addition to capturing more companies than are listed on all of the US stock markets, private equity captured the pension system too:
...
In 2018, according to analytics firm eVestment, pension funds in the U.S. and the U.K. pumped 27% of their fresh allocations of money into private-equity funds, up from 25% the year before. America’s largest public pension plan, the California Public Employees’ Retirement System, or CalPERS, put almost $7 billion into private equity during the 2018–2019 fiscal year, according to Institutional Investor. “We need private equity, we need more of it, and we need it now,” chief investment officer Ben Meng said in early 2019—right before CalPERS hired a former private-equity guy, who began his career at Goldman Sachs, to head its private-equity efforts.
...
And note one of the mechanistic ways the pension system’s reliance on private equity makes the threat of not bailing out private equity an even more potent threat: many private-equity funds have capital call provisions that could force pensions to dump other investments (including stocks) in order to shore up ailing private equity funds. So if those funds get distressed they can basically transfer that distress into different asset classes including the stock market:
...
Which explains why ILPA wrote to Treasury Secretary Steven Mnuchin and Fed Chairman Jerome Powell last week, arguing that companies backed by private equity should be allowed to access the relief funds provided in the CARES Act. Otherwise, the ILPA warned in a previous letter, there would be “significant harm not only to employees that see their hours reduced or jobs eliminated, but also significantly reduced returns to the institutions providing retirement security through pensions, insurance policies and other investments that serve hundreds of thousands of Americans.” To make matters worse, ILPA added, provisions in many private-equity investments allow private-equity firms to make additional capital calls when times are tough. That means public pensions might be forced to dump their holdings in public-backed investments to provide private-equity firms with emergency cash—a move that could depress the stock market even further.
...
Also note how the $1.5–2 trillion in cash that the industry had on on hand back in April was not just a record level for the sector but double what it was five years ago. It’s the kind of cash pile that suggests the sector was waiting for the next inevitable recession, when all sorts of companies would become available for purchase at fire sale prices:
...
Driven partly by public pensions, the private-equity industry has mushroomed. In each of the past four years, according to data-provider Preqin, private-capital managers raised over $500 billion of new money to invest. The industry’s total assets under management have hit a record $4.1 trillion. The industry’s $1.5 trillion in cash on hand is also the highest on record—and more than double what it was five years ago, according to Preqin. The half decade from 2013 to 2018 saw the most private-equity deals over any five-year period in American history.
...
Yes, this ‘Too Big to Fail’ sector of the economy was at historically high levels of preparedness to capitalize on a failing economy when the pandemic hit. It’s another reason we should expect private equity’s grip over the economy to be a historic highs too when this pandemic is over.
CalPERS to Private Equity: We’d Like to Double Down on Our Desperation Play Please
And as the following New York Times article from just days ago makes clear, another reason we should expect private equity to own even more of the economy at the end of this pandemic is simply because pension systems show no sign of shying away from private equity. And in the case pension giant CalPERS, the newly announced plan for the decade is to invest even more in private equity funds for the next decade. Doubling down on desperation. That’s the plan.
As the article describes, this is CalPERS’s plan despite the fact that a number of trustees have deep misgivings about the strategy and suspect they are being sold a bill of goods. Beyond that, the last CalPERS chief investment officer, Ben Meng, resigned in August after it was discovered he holds personal stakes in some of the same private equity funds CalPERS was investing in. And data shows that CalPERS’s private equity returns are consistently lower than industry benchmarks. But CalPERS is proceeding with the plan because they argue they have no choice. Private equity — or other risky investments like distressed debt — are the only investments that might be able to return to CalPERS the ~7% annualized returns it needs to meet its obligations. That’s what a study by CalPERS and an outside consultant concluded. Private equity has effectively captured CalPERS.
Also keep in mind that we can already predict the ongoing era of historically low interest rates that pushed CalPERS and other pension plans towards risky investments like private equity is probably going to continue for years to come. So when we see CalPERS actively plan on investing even more in private equity over this next decade of low interest rates because they feel they have no choice there’s probably quite a few more pension funds that will follow suit, if they aren’t already:
The New York Times
Marching Orders for the Next Investment Chief of CalPERS: More Private Equity
The nation’s biggest public pension fund is consistently short of the billions of dollars it needs to pay all retirees their pensions. It seeks higher returns.
By Mary Williams Walsh
Oct. 19, 2020, 5:00 a.m. ETBen Meng got the job of chief investment officer of CalPERS by convincing the trustees of the nation’s largest public pension fund that he could hit their target of a 7 percent annual return on investment by directing more of the fund’s billions into private equity.
Now, Mr. Meng is gone — only a year and a half after he started — and CalPERS, as the $410 billion California Public Employees’ Retirement System is known, is no closer to that goal. The fund is consistently short of the billions of dollars it needs to pay all retirees their pensions. And it continues to calculate that it can meet those obligations only if it gets the kind of big investment gains promised by private equity.
The strategy involves putting money into funds managed by firms such as the Blackstone Group and Carlyle, which buy companies and retool them with the goal of selling them or taking them public. Even as some of the fund’s trustees have misgivings — they say the private equity business is opaque, illiquid and carries high fees — they say they have little choice.
“Private equity isn’t my favorite asset class,” Theresa Taylor, the chair of the CalPERS board’s investment committee, said at a recent meeting. “It helps us achieve our 7 percent solution,” she said. “I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”
CalPERS, like many other pension funds, began putting money into private equity funds decades ago. But its reliance on such funds has increased in recent years, as low interest rates have made bonds less attractive and stocks have proven too volatile. Adding to the urgency are an aging population, expansive pension benefits that can’t be reduced and a major funding shortfall.
Mr. Meng’s abrupt departure in August, and CalPERS’s slow-moving search for a replacement, are delaying its plans to increase its private equity investments. Mr. Meng resigned after compliance staff noticed that he had personal stakes in some of the investment firms that he was committing CalPERS’s money to, most notably Blackstone. California state officials in that situation are supposed to recuse themselves, but Mr. Meng did not.
Some of the fund’s stakeholders, including cities, school districts and other public employers, worry that in the meantime, CalPERS’s trustees could react by putting new restrictions on investment chiefs, discouraging top candidates from applying for the job or otherwise making it harder for CalPERS to achieve its target rate of return. If investment returns fall short, local officials know they’ll have to make up the difference, dipping into their budgets to free up more money to send to the fund.
“It gets harder and harder each year,” said Brett McFadden, the superintendent of a large school district northeast of Sacramento. He has cut art, music and guidance counselors to get more money for the state pension systems every year. “These policies are being made in Sacramento, and I’m the one left holding the bag,” he said.
Marcie Frost, the chief executive of CalPERS, said that Mr. Meng’s departure would not prompt the board to change CalPERS’s investment strategy. She said a study by CalPERS and its outside consultants showed that private equity and distressed debt were the only asset classes powerful enough to boost the fund’s overall average gains up to 7 percent a year, over time.
“So we have to have a meaningful allocation to those,” she said, adding: “There are no guarantees that we’re going to be able to get 7 percent in the short term or, frankly, in the long term.”
Data show that CalPERS’s private equity returns are consistently lower than industry benchmarks, but private equity has still performed better than other assets and “has generated billions of dollars in additional returns as a result of our investments,” said Greg Ruiz, CalPERS’s managing investment director for private equity.
Mr. Meng was a big proponent of private equity, telling trustees that “only one asset class” would deliver the returns they sought and that the fund would need to direct more money into it. But while CalPERS sought, under him, to increase its private equity allocation to 8 percent of total assets, the holdings fell to 6.3 percent, in part because the private equity managers were returning money from previous investments and CalPERS did not jump to reinvest it. Overall, the fund had about $80 billion — or 21 percent of its assets — in private equity, real estate and other illiquid assets as of June 30, the end of its last fiscal year.
CalPERS has sometimes moved slowly on private equity partly because of its trustees’ qualms.
At one recent meeting, Ms. Taylor, the investment committee chair and formerly a senior union official, recalled that some of CalPERS’s private equity partners had bought Toys ‘R’ Us in 2005. The transaction loaded it up with $5 billion in debt just as the retailer’s bricks-and-mortar sales strategy was becoming antiquated, and the company went into a long, slow collapse that ended in liquidation and cost more than 30,000 jobs. “I’m hoping that we can get to a better strategy of mitigating some of these problems,” she said.
Other trustees questioned the validity of the internal benchmark CalPERS uses to evaluate its private equity investments, saying they didn’t believe the returns were all that good after fees were deducted.
“We’re going to be sold a bill of goods, and we’re going to believe what they say, because we want to believe it and we want to make higher returns,” said Margaret Brown, a trustee and retired capital investments director for a school district southeast of Los Angeles.
Still, the marching orders for CalPERS’s next investment chief are apparent: find ways to increase the pension giant’s investments in private equity funds.
Independent analysts have long urged public pension trustees to stop chasing higher returns and instead take a deep, hard look at how they got to be so underfunded in the first place. A growing school of thought blames the way they calculate their total obligations to retirees for understating the true number — specifically, how they translate the value of pensions due in the future into today’s dollars.
To do that, CalPERS uses the routine practice of discounting, which all financial institutions use and is based on the principle that money is worth more today than in the future. It requires the selection of an appropriate discount rate. CalPERS uses its target return on investment of 7 percent as its discount rate — a practice flatly rejected by financial economists, because 7 percent is associated with a high degree of risk, and CalPERS’s pensions are risk free. Economists say that CalPERS, and other public pension systems, should be using the rate associated with risk-free bonds like U.S. Treasury bonds. Doing it that way shows the tremendous intrinsic value of risk-free retirement income.
But by assuming a high so-called discount rate that matches its assumed rate of return, CalPERS makes its shortfall look much smaller on paper — which allows the fund to bill the state of California and its cities for smaller annual contributions than it would otherwise have to. That helps everybody balance their budgets more easily, but it has left the pension system chronically underfunded.
Public pension systems in California, including CalPERS, reported a combined shortfall of $352.5 billion as of 2018, using their high investment assumptions as discount rates, according to a compilation by the Stanford Institute for Economic Policy Research. But by replacing just that one assumption with what economists consider a valid discount rate, the institute showed that the funds were really $1 trillion short that year. If CalPERS suddenly started billing local governments accordingly, it would cause a crisis.
CalPERS stepped into this trap in 1999, at the end of a powerful bull market. On paper, it appeared to have far more money than it needed, and state lawmakers decided to increase public pensions after hearing from CalPERS officials it would not cost anything so long as the fund’s investments could produce 8.25 percent average annual gains.
Then the dot-com bubble burst, and the investment gains on paper that CalPERS had amassed melted away, leaving a shortfall. But the big pension increase was locked in because California law bars any reduction in public pensions. Similar things happened in many other states. Before long, the race was on for higher investment returns.
“Over the past 20 years, U.S. pension funds have set aggressive targets and failed to meet them,” said Kurt Winkelmann, a senior fellow for pension policy design at the University of Minnesota’s Heller-Hurwicz Economics Institute.
He recently compiled the investment returns of the 50 states’ pension systems from 2000 to 2018 and compared them with the states’ average targets during that period. It turned out that the actual returns were 1.7 percentage points per year less.
CalPERS’s investment results were even more off the mark, Mr. Winkelmann found. Its target averaged 7.7 percent over the 18-year time frame. But actual average returns were only 5.5 percent over that period, Mr. Winkelmann said.
...
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“The strategy involves putting money into funds managed by firms such as the Blackstone Group and Carlyle, which buy companies and retool them with the goal of selling them or taking them public. Even as some of the fund’s trustees have misgivings — they say the private equity business is opaque, illiquid and carries high fees — they say they have little choice.”
There’s no choice. That’s the conclusion CalPERS grimly arrived. And arrived at in the face of data showing the returns from private equity are consistently lower than industry benchmarks. It’s one thing to miss your benchmarks every few years but if the annualized average returns are lower that’s a giant fail. Compound interest works in the negative direction too. And according to a study of CalPERS’ private equity returns from 2000–2018, the target benchark of 7.7% annual returns actually came in at 5.5%. That adds up...or maybe ‘subtracts up’ is a better way to put it:
...
Data show that CalPERS’s private equity returns are consistently lower than industry benchmarks, but private equity has still performed better than other assets and “has generated billions of dollars in additional returns as a result of our investments,” said Greg Ruiz, CalPERS’s managing investment director for private equity....
At one recent meeting, Ms. Taylor, the investment committee chair and formerly a senior union official, recalled that some of CalPERS’s private equity partners had bought Toys ‘R’ Us in 2005. The transaction loaded it up with $5 billion in debt just as the retailer’s bricks-and-mortar sales strategy was becoming antiquated, and the company went into a long, slow collapse that ended in liquidation and cost more than 30,000 jobs. “I’m hoping that we can get to a better strategy of mitigating some of these problems,” she said.
Other trustees questioned the validity of the internal benchmark CalPERS uses to evaluate its private equity investments, saying they didn’t believe the returns were all that good after fees were deducted.
“We’re going to be sold a bill of goods, and we’re going to believe what they say, because we want to believe it and we want to make higher returns,” said Margaret Brown, a trustee and retired capital investments director for a school district southeast of Los Angeles.
...
“Over the past 20 years, U.S. pension funds have set aggressive targets and failed to meet them,” said Kurt Winkelmann, a senior fellow for pension policy design at the University of Minnesota’s Heller-Hurwicz Economics Institute.
He recently compiled the investment returns of the 50 states’ pension systems from 2000 to 2018 and compared them with the states’ average targets during that period. It turned out that the actual returns were 1.7 percentage points per year less.
CalPERS’s investment results were even more off the mark, Mr. Winkelmann found. Its target averaged 7.7 percent over the 18-year time frame. But actual average returns were only 5.5 percent over that period, Mr. Winkelmann said.
...
Even with that level of underperformance, private equity is still deemed to be better than the lower-yielding alternatives. It’s the kind of dynamic that only points to more and more pension money heading into private equity, and not just CalPERS’s money.
But also note the other factor that has created this perceived need for private equity investments: pensions are consistently underfunded, which is the fundamental factor driving the need for the relatively high returns private equity promises to deliver. And while the private equity industry can’t be blamed entirely for that situation, it’s not blameless either. Those consistent promises of 7%+ projected returns allow CalPERS to collect less money from the state and cities than is realistically required, resulting in a combined shortfall of $352.5 billion as of 2018 for California’s public pension systems:
...
“Private equity isn’t my favorite asset class,” Theresa Taylor, the chair of the CalPERS board’s investment committee, said at a recent meeting. “It helps us achieve our 7 percent solution,” she said. “I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”CalPERS, like many other pension funds, began putting money into private equity funds decades ago. But its reliance on such funds has increased in recent years, as low interest rates have made bonds less attractive and stocks have proven too volatile. Adding to the urgency are an aging population, expansive pension benefits that can’t be reduced and a major funding shortfall.
...
Independent analysts have long urged public pension trustees to stop chasing higher returns and instead take a deep, hard look at how they got to be so underfunded in the first place. A growing school of thought blames the way they calculate their total obligations to retirees for understating the true number — specifically, how they translate the value of pensions due in the future into today’s dollars.
To do that, CalPERS uses the routine practice of discounting, which all financial institutions use and is based on the principle that money is worth more today than in the future. It requires the selection of an appropriate discount rate. CalPERS uses its target return on investment of 7 percent as its discount rate — a practice flatly rejected by financial economists, because 7 percent is associated with a high degree of risk, and CalPERS’s pensions are risk free. Economists say that CalPERS, and other public pension systems, should be using the rate associated with risk-free bonds like U.S. Treasury bonds. Doing it that way shows the tremendous intrinsic value of risk-free retirement income.
But by assuming a high so-called discount rate that matches its assumed rate of return, CalPERS makes its shortfall look much smaller on paper — which allows the fund to bill the state of California and its cities for smaller annual contributions than it would otherwise have to. That helps everybody balance their budgets more easily, but it has left the pension system chronically underfunded.
Public pension systems in California, including CalPERS, reported a combined shortfall of $352.5 billion as of 2018, using their high investment assumptions as discount rates, according to a compilation by the Stanford Institute for Economic Policy Research. But by replacing just that one assumption with what economists consider a valid discount rate, the institute showed that the funds were really $1 trillion short that year. If CalPERS suddenly started billing local governments accordingly, it would cause a crisis.
...
Also keep in mind that we can’t really separate the issue of pension funding shortfalls and the struggling finances of states and cities from the US’s 40 year infatuation with supply-side economic philosophy celebrated tax cuts for the wealthy as a policy cure-all that created a decades-long tax rate race to the bottom for the wealthiest. A 40 year infatuation with supply-side economic policies that happened to fuel the rise of private equity.
Too Big to Lose Even When It Loses
So how was this fight over whether or not private equity could access the federal bailouts resolved? Well, in late April, the Small Business Administration (SBA) announced that private equity would not be allowed to tap those funds. But as the following Bloomberg article from July describes, while some of the biggest and most high profile/notorious private equity firms like Blackstone did indeed decide to forgo the federal funds, numerous private equity firms did so anyway. And while some private equity-owned business did have an exception and were allowed to access the funds — like food-service businesses — most private equity-owned business don’t have this loophole available. And yet numerous firms took the money anyway. How? Trickery and workarounds, more or less. Workarounds like ceded seats on the company board. In other words, the private equity firms effectively pretended to no longer control their own companies:
Bloomberg
Rescue Cash Too Hot for KKR Proves Irresistible to Many PE Peers
By Heather Perlberg
July 2, 2020, 3:00 AM CDT
Updated on July 2, 2020, 10:55 AM CDT
* Dozens of buyout firms are said to benefit from SBA’s lending
* Some may soon face scrutiny as government identifies borrowersEven inside battle-scarred KKR & Co., entering the political fray was enough to stoke unease.
As several of the private equity titan’s portfolio companies got loans from an emergency U.S. program aimed at helping small businesses survive the coronavirus pandemic, executives at the firm’s New York headquarters issued a blunt message: Return the money to taxpayers.
Yet across the cash-rich private equity world, many firms pushed ahead, benefiting from the $669 billion Paycheck Protection Program run by the Small Business Administration and Treasury Department, according to lawyers and lenders with knowledge of the strategies. Now, some of those firms face the prospect of tough public scrutiny, as the Trump administration acquiesces to pressure from lawmakers to name borrowers who drew potentially forgivable loans from taxpayers.
After the government broadly excluded private equity firms from the program, dozens found ways to steer around the restrictions, often adjusting governance or ownership arrangements with portfolio companies in sectors including entertainment, fitness, sports and dermatology, the people said, asking not to be named discussing confidential arrangements.
What’s more, some portfolio companies also benefited from indirect taxpayer support after helping scores of related businesses apply for PPP loans, keeping revenue flowing, the people said.
The industry’s secret success in tapping SBA money risks stoking a new uproar in Washington. Publicly traded companies and hedge funds already faced a backlash for trying to lean on U.S. coffers, leading them to add to more than $38 billion in loans that have been returned or otherwise canceled. Unclear is how many private equity firms may soon be outed.
Some have held meetings in recent days to discuss returning SBA money, according to people with knowledge of the talks. Spokesmen for the SBA and Treasury declined to comment or didn’t respond to messages seeking comment, including on whether companies that repay loans will be included in data to be made public.
Though people close to the private equity industry were willing to describe how firms accessed SBA loans, the identity of those that did so remains closely guarded because of the political sensitivities. More than a dozen private equity firms declined to comment or didn’t respond to messages seeking comment on whether their portfolio companies had sought or received loans. But representatives for some of the largest — KKR, Blackstone Group Inc., Apollo Global Management, Carlyle Group Inc., TPG and Ares Management — said companies they control did not use SBA money.
...
Broadly Disqualified
To be clear, Congress and the SBA intentionally stopped short of outright banning relief to companies backed by private equity investors. Authorities carved out exceptions for food-service and accommodation companies hit especially hard by the pandemic. Franchisees and affiliates of firms already licensed as Small Business Investment Companies also were allowed in.
But most companies backed by buyout firms appeared to be disqualified by rules against lending to borrowers with more than 500 employees, unless they met SBA standards for larger firms. Regulators tally such figures by adding all the headcount at businesses controlled by a private equity firm. If two businesses each employ 300 people, they could both be disqualified.
Defining whether a private equity firm controls a company isn’t always simple. Funds are known to take minority stakes with outsize influence over strategy. If a buyout firm wields enough clout on a board of directors to prevent a quorum or to block decisions, then that “negative control” can make the company ineligible for SBA support.
That’s prompted a variety of workarounds, according to people familiar with the strategies. For example, buyout firms ceded some board seats or gave up other rights to loosen their grip.
Ample Cash
Evidence of the strategies emerged in April when the SBA, in consultation with the Treasury, published guidance on a list of frequently asked questions. It noted shareholders who forfeit “rights to prevent a quorum or otherwise block action by the board of directors or shareholders” must do so “irrevocably” to satisfy the rules.
In other cases, buyout firms have gotten around the ban with more arcane steps, such as pledging not to add any more debt or giving up the power to make hiring and firing decisions, according to the people familiar with the arrangements.
The private equity industry lobbied to access the SBA program as it was being set up, but to little avail. “It shouldn’t matter if the companies are backed by investment from corporations, pension funds or others,” Drew Maloney, the president of the American Investment Council, private equity’s trade group, said at the time.
The program isn’t meant to help companies that have access to other sources of cash, Treasury Secretary Steven Mnuchin has said. SBA officials have urged the private equity industry — which currently has about $1.5 trillion in available cash — to help their portfolio companies. There’s also the moral hazard: Some companies were particularly vulnerable to the pandemic because private equity owners had loaded them up with debt to maximize profits.
Still, buyout firms argue there are restrictions on how much they can pump into troubled deals and privately lament that their business model is misunderstood.
Dental Relief
Some firms were able to get indirect taxpayer support because of the way they happened to structure investments in highly regulated industries. Take dentistry, for example.
Laws in most states prevent investors from owning dental practices outright, so buyout funds own a separate entity that provides related services. Ares and Leonard Green & Partners own Aspen Dental Management Inc., a provider of business and administrative support to dentists.
As the pandemic shut down dentistry, almost every practice affiliated with Aspen qualified for SBA financing, Chief Executive Officer Bob Fontana told staff in a message April 19. “Two weeks ago, we worked with practice owners to submit PPP loan applications,” he said at the time. “We’re thrilled to report that every loan request we submitted has been accepted.”
The funding helped reopen practices and return staff to work, a spokeswoman for Aspen said in an emailed statement. Aspen Dental itself didn’t seek SBA funding, she said. Aspen “provided certain payroll and operations data, as required in the loan applications, for those independent practices who chose to apply for the PPP loans.”
Back in Washington, lawmakers are taking a tough look at how the SBA money was deployed. They successfully pressed the Trump administration to reverse its position on withholding all data about companies that received PPP financing and agree to disclose company names and data for loans of more than $150,000, as well as details about smaller loans without personally identifiable information they consider to be proprietary.
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“After the government broadly excluded private equity firms from the program, dozens found ways to steer around the restrictions, often adjusting governance or ownership arrangements with portfolio companies in sectors including entertainment, fitness, sports and dermatology, the people said, asking not to be named discussing confidential arrangements.”
Yes, all of a sudden all sorts of private equity-owned and controlled companies ‘ceded control’ of the companies and that made the companies eligible for the funds. At least that was apparently what numerous private equity-owned firms concluded:
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Defining whether a private equity firm controls a company isn’t always simple. Funds are known to take minority stakes with outsize influence over strategy. If a buyout firm wields enough clout on a board of directors to prevent a quorum or to block decisions, then that “negative control” can make the company ineligible for SBA support.That’s prompted a variety of workarounds, according to people familiar with the strategies. For example, buyout firms ceded some board seats or gave up other rights to loosen their grip.
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It all raises a disturbing question: so given that private equity’s business model is heavily reliant on loading the companies they buy with debt, how many of the private equity-owned business that sought the PPP funds sought them in part because of the high debt loads their private equity-owners inflicted upon the companies made them highly fragile once the pandemic hit:
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The program isn’t meant to help companies that have access to other sources of cash, Treasury Secretary Steven Mnuchin has said. SBA officials have urged the private equity industry — which currently has about $1.5 trillion in available cash — to help their portfolio companies. There’s also the moral hazard: Some companies were particularly vulnerable to the pandemic because private equity owners had loaded them up with debt to maximize profits.
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It also raises the question of how much of the cash these private equity-owners had on hand came directly or indirectly from teh act of loading these companies up with debt.
Private Equity: It’s Not Just For Pensions. Anymore. Thanks to Trump’s Department of Labor
Well, at least this growing private equity pension nightmare — a nightmare where pensions seem to consistently underperform industry benchmarks — is limited to pension plans and hasn’t bled into the US’s 401k personal retirement accounts. Right? Well, not as of June, when the Department of Labor just issued an order that allows 401ks to invest in private equity funds for the first time ever. Private equity for the ‘little guy’. What could go wrong?
So what was the reasoning behind this move? The Labor Department asserts that private equity funds perform well and pointed to the fact that private equity funds have performed as well as public equity indices since at least 2006. What that reasoning didn’t factor in is the fact that private equity funds have high fees that can range anywhere from 7–20 percent. Again, that adds up. Low fees in the range of 0.21 to 0.6 percent are one of the main features of public equity indices. So the Department of Labor basically passed a rule that allows individual retirees to give private equity a bunch of fees:
The American Prospect
Letting Private Equity Billionaires Rob Worker Retirement Funds
A new Department of Labor rule allows private equity to get into 401(k) plans. One expert estimates a $13.7 billion annual wealth transfer from workers to Wall Street tycoons.
by Robin Kaiser-Schatzlein
June 18, 2020
On June 3, under the cover of viral chaos and civil unrest, the Department of Labor announced that it would allow private equity firms to sell products to individual retirement accounts, including 401(k)s. The impetus was President Trump’s vague, blustery, and deregulatory executive order to “remove barriers” to the “innovation, initiative, and drive of the American people.” But the Labor Department’s rule will do the opposite, exacerbating wealth inequality by sucking a huge pile of money out of the pockets of workers saving for retirement and shepherding it to the few fabulously wealthy owners of private equity firms.
By opening the floodgates to private equity, the Department of Labor will subject individual retirement accounts to private equity’s exorbitantly high fees, while providing roughly the same returns as low- and no-fee mutual funds. Experts suggest that this pointless payout to private equity from these fees––borne entirely by workers––might be in the ballpark of $13.7 billion per year.
Worker money already props up the private equity business model. CalPERS, one of the largest pension funds in the world, has been investing heavily in private equity firms that buy and sell distressed assets for years. Now, Trump’s Labor Department has given the green light for even more worker money to flow into an industry that frequently harms workers, by loading companies with debt, forcing them to cut labor costs to the bone, and frequently bankrupting them, while extracting the last bits of value.
The Department’s rationale for allowing retirement savers to buy products from private equity firms was that these funds perform well. Secretary of Labor Eugene Scalia said in a press statement that letting private equity funds develop products for retirement savers was to allow them to “gain access to alternative investments that often provide strong returns.” But experts disagree. Professor Ludovic Phalippou at the University of Oxford analyzed private equity funds from 2006 to 2015, and found that they don’t earn back the legendary sky-high returns. Rather, the “funds have returned about the same as public equity indices since at least 2006.” One main problem is that the high fees that private equity firms charge, which can range anywhere from 7 percent on the low end to 20 percent for private clients, diminish the returns to investors. These performance fees totaled about $230 billion over the period studied.
If private equity was to sell products to individual investors, their fees would likely be in the range that they charge California’s public-employee pension fund CalPERS, which Phalippou notes is about 7 percent. Eileen Appelbaum, co-director at the Center for Economic and Policy Research and an expert on private equity, told me she thinks 7 percent is at best a conservative estimate. The investments allowed by the government in 401(k) plans would be a “fund of funds,” or an investment fund composed of other private equity funds. This would likely tack on an extra percentage point. Then you add in the standard fee that a brokerage like Fidelity or Vanguard takes for managing the overall 401(k) (which are small and range from 0.21 percent to 0.6 percent, according to Investopedia), and the fees for a private equity product would be in the range of 8.2 to 8.6 percent. Compare this to the more standard index fund, which would have only a minuscule 0.21 to 0.6 percent fee.
The 401(k) market is currently a massive $6.2 trillion, and Appelbaum notes that only a little more than half of that market is invested in the kind of target-date funds and balance funds that the Labor Department made private equity firms currently eligible to sell into. (Target-date funds are often the default option for workers, making that a big potential prize for private equity.) She thinks that for the time being, most financial advisers will not feel comfortable selling private equity products to their clients. Sources indicate that Vanguard and Fidelity, two of the biggest advisers, have thus far declined to move retirement funds into private equity.
But even a small stake in such a giant market would be a windfall for private equity managers. Even if the market settles in at around 5 percent of all 401(k) funds, that would represent a still-giant pool of $171 billion. If 8 percent of this goes to private equity firm fees (less the broker fees), private equity will have charged workers $13.7 billion to deliver returns equal to or less than public equity markets. As Appelbaum notes, retirement savers will suffer from “having all this money taken out that they didn’t have taken out before.”
There are other disadvantages, says Appelbaum. Private equity investments are notoriously risky, lack the financial transparency of public firms, and typically force investors to commit their money for a decade. “There are a lot of downsides,” Appelbaum said. “For the extra risk you’re supposed to get extra reward. But here there is no extra reward.”
Another problem is that, even if the top quartile of glitzy private equity firms perform well (which Appelbaum suggests they often do), any retirement product would feature a blend of private equity funds, which likely would include the middling and loser funds, bringing down the prospective return without bringing down the industry-standard, sky-high fees. And as Barbara Roper of the Consumer Federation of America indicated to me, without strong protections for workers from being ripped off by financial advisers, they could easily be talked into these hazardous investments.
Appelbaum stresses that the creation and implementation of the private equity products is likely a little ways off. Financial firms aren’t likely to feel confident selling them right away. Private equity funds also need upfront investments of $5 million to $10 million, which will require asset managers to somehow pool 401(k)s into big investments; this is especially difficult given the speed with which workers change jobs and will need to withdraw funds that private equity firms want to lock up. “Frequent turnover in retirement plan investments makes private equity a particularly poor choice for most retirement savers,” Roper said. And currently, the economic shutdown has distracted private equity with a perverse problem: They have over $1.4 trillion in undeployed capital (known as “dry powder”) that they need to spend.
Nonetheless, private equity firms have been drooling over the tantalizing 401(k) market since at least 2013, Appelbaum says. (She wrote an oracular article in 2014 called “Private Equity Is Coming for Your Nest Egg.”) The Trump Labor Department rule is the fulfillment of a long-deferred dream.
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Democrats are starting to speak out about the Labor Department’s decision. Michael Gwin, spokesperson for Democratic presidential nominee Joe Biden, gave the Prospect this statement: “While Joe Biden steadfastly supports more equal access to retirement saving incentives and opportunities for wealth building, he staunchly opposes regulatory changes that will lead to skyrocketing fees and diminished retirement security for savers. This regulatory action is another example of President Trump putting the interests of Wall Street ahead of American workers and families.”
If private equity products won’t bring in extra returns for workers, what is the Trump administration after? It looks like they want to use workers’ money to pamper and fashion a new class of billionaires. Many of them, after all, are friends and donors of the administration.
This model has already been proven. Phalippou finds that as they got increasingly involved with pension funds, the number of private equity multibillionaires rose from three in 2005 to 22 in 2020. From studying the private equity industry, he suggests that the use of private equity is a wealth transfer that “might be one of the largest in the history of modern finance: from a few hundred million pension scheme members … to a few thousand people working in private equity.” Under the guidance of the Trump administration, it seems it can only get worse.
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“By opening the floodgates to private equity, the Department of Labor will subject individual retirement accounts to private equity’s exorbitantly high fees, while providing roughly the same returns as low- and no-fee mutual funds. Experts suggest that this pointless payout to private equity from these fees––borne entirely by workers––might be in the ballpark of $13.7 billion per year.”
The same returns as before but now with extra fees! That’s basically what Trump’s Department of Labor just unleashed upon US workers. No longer will workers be burdened with the ultra-low 0.21–0.6 percent fees charged by equity index funds:
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The Department’s rationale for allowing retirement savers to buy products from private equity firms was that these funds perform well. Secretary of Labor Eugene Scalia said in a press statement that letting private equity funds develop products for retirement savers was to allow them to “gain access to alternative investments that often provide strong returns.” But experts disagree. Professor Ludovic Phalippou at the University of Oxford analyzed private equity funds from 2006 to 2015, and found that they don’t earn back the legendary sky-high returns. Rather, the “funds have returned about the same as public equity indices since at least 2006.” One main problem is that the high fees that private equity firms charge, which can range anywhere from 7 percent on the low end to 20 percent for private clients, diminish the returns to investors. These performance fees totaled about $230 billion over the period studied.If private equity was to sell products to individual investors, their fees would likely be in the range that they charge California’s public-employee pension fund CalPERS, which Phalippou notes is about 7 percent. Eileen Appelbaum, co-director at the Center for Economic and Policy Research and an expert on private equity, told me she thinks 7 percent is at best a conservative estimate. The investments allowed by the government in 401(k) plans would be a “fund of funds,” or an investment fund composed of other private equity funds. This would likely tack on an extra percentage point. Then you add in the standard fee that a brokerage like Fidelity or Vanguard takes for managing the overall 401(k) (which are small and range from 0.21 percent to 0.6 percent, according to Investopedia), and the fees for a private equity product would be in the range of 8.2 to 8.6 percent. Compare this to the more standard index fund, which would have only a minuscule 0.21 to 0.6 percent fee.
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How will independent investors fair with this grand new retirement investment opportunity? Presumably about as well as pension funds...with consistently underperforming results that lag the industry benchmarks. Lucky them.
Private Parasites Taking Over the World
But as the following Bloomberg article from October of 2019 — right before the start of the coronavirus pandemic — makes clear, there’s another major reason we should be concerned about 401k investments in private equity fund: private equity is bad for business. Yes, it’s great of earning massive profits for the executives in the private equity firms. But as studies have shown, the business bought out by private equity are more fragile than their publicly held counter-parts, largely because they are typically purchased in a leveraged buy out that loads the company with debt. Additionally, the incentives for the new private equity owners to effectively gut a business and sell off its most valuable assets in the interest of making a quick profit is exceedingly high, in large part because of the massive leverage used to make the purchase. Beyond that, private equity can treat the businesses it owns effectively like virtual ATM, where they force the company to borrow money to pay its private equity owner special dividends. As the article also points out, the corporate debt levels a year ago were looking scarily high should another recession hit thanks in large part to private equity’s growing role in the economy over the last decade after it ‘won’ the 2008 financial crisis. And then, of course, the coronavirus pandemic hit and an even economic nightmare scenario we find ourselves in today emerged. So the more pensions and 401ks pile into private equity, the more cash private equity has on hand to effectively loot the economy even more than the present-day looting levels:
Bloomberg Businessweek
Everything Is Private Equity Now
Spurred by cheap loans and investors desperate to boost returns, buyout firms roam every corner of the corporate world.October 3, 2019, 3:00 AM CDT
Corrected October 8, 2019, 3:10 PM CDTPrivate equity managers won the financial crisis. A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized. Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving. Almost everything that’s happened since 2008 has tilted in their favor.
Low interest rates to finance deals? Check. A friendly political climate? Check. A long line of clients? Check.
The PE industry, which runs funds that can invest outside public markets, has trillions of dollars in assets under management. In a world where bonds are paying next to nothing—and some have negative yields—many big investors are desperate for the higher returns PE managers seem to be able to squeeze from the markets.
The business has made billionaires out of many of its founders. Funds have snapped up businesses from pet stores to doctors’ practices to newspapers. PE firms may also be deep into real estate, loans to businesses, and startup investments—but the heart of their craft is using debt to acquire companies and sell them later.
In the best cases, PE managers can nurture failing or underperforming companies and set them up for faster growth, creating outsize returns for investors that include pension funds and universities. But having once operated on the comfortable margins of Wall Street, private equity is now facing tougher questions from politicians, regulators, and activists. One of PE’s superpowers is that it’s hard for outsiders to see and understand the industry, so we set out to shed light on some of the ways it’s changing finance and the economy itself. —Jason Kelly
The Magic Formula Is Leverage ... and Fees
PE invests in a range of different assets, but the core of the business is the leveraged buyout
The basic idea is a little like house flipping: Take over a company that’s relatively cheap and spruce it up to make it more attractive to other buyers so you can sell it at a profit in a few years. The target might be a struggling public company or a small private business that can be combined—or “rolled up”—with others in the same industry.
1. A few things make PE different from other kinds of investing. First is the leverage. Acquisitions are typically financed with a lot of debt that ends up being owed by the acquired company. That means the PE firm and its investors can put in a comparatively small amount of cash, magnifying gains if they sell at a profit.
2. Second, it’s a hands-on investment. PE firms overhaul how a business is managed. Over the years, firms say they’ve shifted from brute-force cost-cutting and layoffs to McKinsey-style operational consulting and reorganization, with the aim of leaving companies better off than they found them. “When you grow businesses, you typically need more people,” said Blackstone Group Inc.’s Stephen Schwarzman at the Bloomberg Global Business Forum in September. Still, the business model has put PE at the forefront of the financialization of the economy—any business it touches is under pressure to realize value for far-flung investors. Quickly.
3. Finally, the fees are huge. Conventional money managers are lucky if they can get investors to pay them 1% of their assets a year. The traditional PE structure is “2 and 20”—a 2% annual fee, plus 20% of profits above a certain level. The 20 part, known as carried interest, is especially lucrative because it gets favorable tax treatment. —J.K.
The Returns Are Spectacular. But There Are Catches
For investors the draw of private equity is simple: Over the 25 years ended in March, PE funds returned more than 13% annualized, compared with about 9% for an equivalent investment in the S&P 500, according to an index created by investment firm Cambridge Associates LLC. Private equity fans say the funds can find value you can’t get in public markets, in part because private managers have more leeway to overhaul undervalued companies. “You cannot make transformational changes in a public company today,” said Neuberger Berman Group LLC managing director Tony Tutrone in a recent interview on Bloomberg TV. Big institutional investors such as pensions and university endowments also see a diversification benefit: PE funds don’t move in lockstep with broader markets.
But some say investors need to be more skeptical. “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest,” said billionaire investor Warren Buffett at Berkshire Hathaway Inc.’s annual meeting earlier this year. There are three main concerns.
• The value of private investments is hard to measure
Because private company shares aren’t being constantly bought and sold, you can’t look up their price by typing in a stock ticker. So private funds have some flexibility in valuing their holdings. Andrea Auerbach, Cambridge’s head of global private investments, says a measure that PE firms often use to assess a company’s performance—earnings before interest, taxes, depreciation, and amortization, or Ebitda—is often overstated using various adjustments. “It’s not an honest number anymore,” she says. Ultimately, though, there’s a limit to how much these valuations can inflate a PE fund’s returns. When the fund sells the investment, its true value is exactly whatever buyers are willing to pay.
Another concern is that the lack of trading in private investments may mask a fund’s volatility, giving the appearance of smoother returns over time and the illusion that illiquid assets are less risky, according to a 2019 report by asset manager AQR Capital Management, which runs funds that compete with private equity.
• Returns can be gamed
Private equity funds don’t immediately take all the money their clients have committed. Instead, they wait until they find an attractive investment. The internal rate of return is calculated from the time the investor money comes in. The shorter the period the investor capital is put to work, the higher the annualized rate of return. That opens up a chance to juice the figures. Funds can borrow money to make the initial investment and ask for the clients’ money a bit later, making it look as if they produced profits at a faster rate. “Over the last several years, more private equity funds have pursued this as a way to ensure their returns keep up with the Joneses,” Auerbach says. The American Investment Council, the trade group for PE, says short-term borrowing allows fund managers to react quickly to opportunities and sophisticated investors to use a variety of measures besides internal rate of return to evaluate PE performance.
• The best returns might be in the rearview mirror
Two decades ago an investor could pick a private equity fund at random and have a better than 75% chance of beating the stock market, according to a report by financial data company PitchBook. Since 2006 those odds have dropped to worse than a coin flip. “Not only are fewer managers beating the market but their level of outperformance has shrunk, too,” the report says.
One likely reason will be familiar to investors in mutual funds and hedge funds. When strategies succeed, more people pile in—and it gets harder and harder to find the kinds of bargains that fueled the early gains. There are now 8,000-plus PE-backed companies, almost double the number of their publicly listed counterparts. The PE playbook informs activist hedge funds and has been mimicked by pensions and sovereign funds. Some of PE’s secret sauce has been shared liberally in business school seminars and management books.
A deeper problem could be that the first generation of buyout managers wrung out the easiest profits. PE thinking pervades the corporate suite—few chief executive officers are now sitting around waiting for PE managers to tell them to sell underperforming divisions and cut costs. Auerbach says there are still good PE managers out there and all these changes have “forced evolution and innovation.” But it’s possible that a cosmic alignment of lax corporate management, cheap debt, and desperate-for-yield pensions created a moment that won’t be repeated soon. —Hema Parmar and Jason Kelly
Buyouts Push Companies to the Limit. Or Over It
If your company finds itself part of a PE portfolio, what should you expect? Research has shown that companies acquired through leveraged buyouts (LBOs) are more likely to depress worker wages and cut investments, not to mention have a higher risk of bankruptcy. Private equity owners benefit through fees and dividends, critics say, while the company is left to grapple with often debilitating debt.
Kristi Van Beckum worked as an assistant manager for Shopko Stores Inc. in Wisconsin when the chain of rural department stores was bought by PE firm Sun Capital Partners Inc. in a 2005 LBO. “When they took over, our payroll got drastically cut, our retirement plan got cut, and we saw a lot of turnover among executives,” she says.
One of Sun Capital’s first moves as owner was to monetize Shopko’s most valuable asset, its real estate, by selling it for about $800 million and leasing back the space to its stores. That generated a short-term windfall but added to Shopko’s long-term rent costs. “A lot of stores that were once profitable started to show lower profits because they had to start paying rent,” Van Beckum says.
In 2019, Shopko said it could no longer service its debt and filed for bankruptcy, ultimately shuttering all of its more than 360 stores. Van Beckum was asked to stay on as a manager during her store’s liquidation and was promised severance and a closing bonus in return, she says. Weeks later, she received an email telling her that her severance claim wouldn’t be paid. Sun Capital has said money has been contributed to the bankruptcy plan that can pay such claims.
Private equity and hedge funds gained control of more than 80 retailers in the past decade, according to a July report by a group of progressive organizations including Americans for Financial Reform and United for Respect. And PE-owned merchants account for most of the biggest recent retail bankruptcies, including those of Gymboree, Payless, and Shopko in the past year alone. Those bankruptcies wiped out 1.3 million jobs—including positions at retailers and related jobs, such as at vendors—according to the report, which estimates that “Wall Street firms have destroyed eight times as many retail jobs as they have created in the past decade.”
Whether LBOs perform poorly because of debt, business strategy, or competition from Amazon.com Inc., research shows they fare worse than their public counterparts. A July paper by Brian Ayash and Mahdi Rastad of California Polytechnic State University examined almost 500 companies taken private from 1980 to 2006. It followed both the LBOs and a similar number of companies that stayed public for a period of 10 years. They found about 20% of the PE-owned companies filed for bankruptcy—10 times the rate of those that stayed public. Pile on debt, and employees lose, Ayash says. “The community loses. The government loses because it has to support the employees.” Who wins? “The funds do.”
Research by Eileen Appelbaum, co-director of the Center for Economic and Policy Research, says the problem isn’t leverage per se but too much of it. She points to guidance issued by the Federal Deposit Insurance Corp. in 2013 saying debt levels of more than six times earnings before interest, taxes, depreciation, and amortization, or Ebitda, “raises concerns for most industries.” A 2019 McKinsey report shows that median debt in private equity deals last year was just under the six times Ebitda threshold at 5.5, up from five in 2016.
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The retail industry was long a prime target for buyouts because of its reliable cash flow and the value of the real estate it owned. But the sector is no longer as suited to PE ownership amid ever-changing customer whims and the massive upheaval brought by Amazon, says Perry Mandarino, head of restructuring and co-head of investment banking at B. Riley FBR. “Private equity has successfully preserved companies across a number of sectors,” he says, “but the disruption in retail has proven difficult for even some of the most savvy investors to navigate. High leverage, especially in this difficult environment, can be fatal.”
The most notable recent example of that is Toys “R” Us Inc. When the children’s toy retailer filed for bankruptcy in 2017, it was paying almost $500 million a year to service the debt from its 2005 takeover by Bain Capital LP, Vornado Realty Trust, and Kohlberg Kravis Roberts & Co. After it was liquidated in March following poor holiday season sales, its owners became the target of protests by laid-off workers, as well as scrutiny from investors and criticism from elected officials. Later that year, KKR and Bain said they’d each contribute $10 million to a fund for workers who lost their jobs when the retailer collapsed. Senator Elizabeth Warren (D‑Mass.) introduced a bill in July that would limit payouts private equity owners could receive from troubled companies.
That kind of impact isn’t unique to retail, says Heather Slavkin Corzo, senior fellow at Americans for Financial Reform and director of capital market policies at the union federation AFL-CIO. “The massive growth of private equity over the past decade means that this industry’s influence, economic and political, has mushroomed,” she says. “It’s hardly an exaggeration to say that we are all stakeholders in private equity these days, one way or another.” —Lauren Coleman-Lochner and Eliza Ronalds-Hannon
After the Crisis, Rental Homes Became an Asset Class
Renting out houses used to be a relatively small-time business. Now rentals are what Wall Street calls an asset class—another investment like stocks or timberland, with tenants’ monthly checks showing up as yield in someone’s portfolio. About 1 million people may now live in homes owned by large landlords. This tectonic shift can be traced to the U.S. housing crisis.
Private equity companies including Blackstone Group Inc. had the money to gorge on foreclosed houses in the years after the crash and quickly applied their model to a whole new business. They used economies of scale, cost-cutting, and leverage to maximize profits on undervalued assets. The key was to create a standardized way to manage single-family homes, scattered from Atlanta to Las Vegas, almost as efficiently as apartment buildings. PE-backed landlords set up centralized 24/7 customer service centers and automated systems for rent collection and maintenance calls.
Blackstone-backed rental company Invitation Homes Inc. eventually went public, then merged with a landlord seeded by Starwood Capital Group and Colony Capital Inc. to create the U.S.’s largest single-family rental company, with more than 80,000 units. Invitation Homes owns less than 1% of the single-family rental stock, says Ken Caplan, Blackstone’s global co-head of real estate. “But it has raised the bar for professional service for the industry,” he says.
The aims of the landlords and the needs of their tenants often diverge, says Leilani Farha, the United Nations’ special rapporteur on the right to housing. Steady rent increases that make investors happy come out of tenants’ paychecks, straining household finances and making it harder to save for a down payment. Meanwhile, PE-backed companies’ sprawling portfolios of rental properties may limit the availability of entry-level houses that could be occupied by homeowners. Institutional landlords were 66% more likely than other operators to file eviction notices, according to Georgia Institute of Technology professor Elora Raymond, whose 2016 study of Fulton County, Ga., court records was published by the Federal Reserve Bank of Atlanta. Invitation Homes was less likely to file notices than its largest peers, according to the paper. A company spokesman says it works with tenants to avoid eviction and that its high renewal rates indicate customer satisfaction.
From Wall Street’s point of view, the model has worked beautifully. Invitation Homes has convinced stock market investors that it can manage operating costs. It also bought shrewdly, swallowing up starter homes in good school districts, anticipating that tight credit and anemic construction rates would push the U.S. toward what one industry analyst dubbed a rentership society. Sure enough, U.S. homeownership is near its lowest point in more than 50 years, allowing Invitation Homes to raise rents by more than 5%, on average, when tenants renew leases.
“The single-family rental companies have a perfect recipe,” says John Pawlowski, an analyst at Green Street Advisors LLC. “It’s a combination of solid economic growth in these Sun Belt markets and very few options out there on the ownership front.” Shares of Invitation Homes have gained almost 50% since the start of 2019. Blackstone has sold more than $4 billion in shares of it this year. Its remaining stake is worth about $1.7 billion. —Prashant Gopal and Patrick Clark
As Profits Grow, So Does Inequality
In July, Democratic presidential candidate Elizabeth Warren of Massachusetts likened the private equity industry to vampires. She struck a nerve: Even among Wall Street companies, PE stands out as a symbol of inequality in the U.S. “There’s this concentration of extreme wealth, and private equity is a huge part of that story,” says Charlie Eaton, an assistant professor of sociology at the University of California at Merced.
Income gains for the top 1% in the U.S. have been rising at a faster clip than for lower groups since 1980. Since that time, PE managers have steadily taken up a larger share of the highest income groups, including the richest 400 people, according to several research papers from the University of Chicago’s Steven Kaplan and Stanford’s Joshua Rauh. There are more private equity managers who make at least $100 million annually than investment bankers, top financial executives, and professional athletes combined, they found. The very structure of PE firms is particularly profitable for managers at the top; not only do they earn annual management fees, but they also get a cut of any profits.
Beyond that, PE may contribute to inequality in several ways. First, it offers investors higher returns than those available in public stocks and bonds markets. Yet, to enjoy those returns, it helps to already be rich. Private equity funds are open solely to “qualified” (read: high-net-worth) individual investors and to institutions such as endowments. Only some workers get indirect exposure via pension funds.
Second, PE puts pressure on the lower end of the wealth divide. Companies can be broken up, merged, or generally restructured to increase efficiency and productivity, which inevitably means job cuts. The result is that PE accelerates job polarization, or the growth of jobs at the highest and lowest skill and wage level while the middle erodes, according to research from economists Martin Olsson and Joacim Tag.
The imperative to make highly leveraged deals pay off may also encourage more predatory business practices. A study co-authored by UC Merced’s Eaton, for example, found that buyouts of private colleges lead to higher tuition, student debt, and law enforcement action for fraud, as well as lower graduation rates, loan-repayment rates, and graduate earnings. But the deals did increase profits.
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Critics and advocates of PE generally agree on at least one thing: When people are hurt by deals that turn companies upside down, there should be systems in place to assist them. “You don’t want to stand in the way of economic innovation,” says Gregory Brown, a finance professor at UNC Kenan-Flagler Business School. “But you would hope that people who get run over are helped.” —Katia Dmitrieva
Barbarians at the Gate Become the New Establishment
1970s
The U.S. Department of Labor relaxes regulations to allow pension funds to hold riskier investments. This opens up a new pool of money for buyout artists. Cousins Henry Kravis and George Roberts leave Bear Stearns with their mentor Jerome Kohlberg to form Kohlberg Kravis Roberts & Co.1980s
L.A. financier Michael Milken (above, second from left) turns junk bonds into a hot investment, which makes getting leverage easier. Former Lehman Brothers partners Pete Peterson and Stephen Schwarzman found Blackstone Group. KKR takes control of RJR Nabisco in a stunning $24 billion deal.1990s
Milken goes to jail for securities violations, and his firm, Drexel Burnham Lambert, collapses. But takeover artists are finding more tools for financing deals, as banker Jimmy Lee (pictured, third from left) popularizes leveraged loans at what’s now JPMorgan Chase & Co.2000s
Pensions for California state employees and Middle East sovereign funds pour money into record-setting funds that routinely surpass $15 billion apiece. Big deals of the era include Dollar General Corp. and Hilton Hotels. Several private equity firms themselves go public.2010s
After the financial crisis, Blackstone, Ares Capital, and Apollo Global expand their private credit businesses, providing financing to companies no longer served by big banks. Veteran PE executive Mitt Romney is the 2012 Republican presidential nominee. —J.K.Private Equity Is Getting Companies Hooked on Debt
Private equity couldn’t exist without debt. It’s the jet fuel that makes a corporate acquisition so lucrative for a turnaround investor. The more debt you can raise against a target company, the less cash you need to pay for it, and the higher your return on that cash once you sell.
Ultralow interest rates have made this fuel especially potent and easy to obtain. The market for leveraged loans—industry jargon for loans made to companies with less-than-stellar credit—has doubled in the past decade. Almost 40% of all such loans outstanding are to companies controlled by private equity, according to data from Dealogic.
Some leveraged loans are arranged by banks. But there’s also been a boom in private lenders, who may be willing to provide financing when banks or public debt markets won’t. All the while, bond and loan investors desperate for yield have accepted higher risks. As buyout titans have chased bigger and riskier deals, their target companies have been left with more fragile balance sheets, which gives management less room for error. This could set the stage for a rude awakening during the next recession.
“We’re seeing scary levels of leverage,” says Dan Zwirn, chief investment officer of alternative asset manager Arena Investors. “Private equity sponsors are all slamming against each other to get deals done.” Loans to companies with especially high debt loads now exceed peaks in 2007 and 2014, according to the U.S. Federal Reserve. And companies owned by private equity typically carry a higher debt load relative to their earnings and offer less transparency on their financial position than other corporate borrowers.
...
PE firms can use some of the companies they own as virtual ATMs—having the company borrow money to pay its owner special dividends. That allows the funds to recover their investment sooner than they typically would through a sale or an initial public offering. Sycamore Partners LLC, known for its aggressive bets in the retail industry and related run-ins with creditors, has already recovered about 80% of the money it put down to acquire Staples Inc. in 2017 through dividends mostly funded by debt. Carlyle Group, Hellman & Friedman, and Silver Lake have also saddled their portfolio companies with new debt to extract dividends this year. Representatives for the four private equity firms declined to comment.
Little bubbles have already started to pop, giving debt investors a glimpse of how quickly things can deteriorate. Bonds issued last year to finance Kohlberg Kravis Roberts & Co.’s deal to take private Envision Healthcare, a hospital staffing company, have already lost almost half their face value after initiatives in Washington to stop surprise medical bills spooked investors. (A representative for KKR declined to comment.) The debt of some other private equity-owned companies, including the largest Pizza Hut franchisee in the world and a phone recycling company, has also fallen in market value in recent months. “When you have people desperate for yield, buying lower-rated, poor-quality debt, the question is what’s going to make this stuff blow out,” says Zwirn. “And it will.” —Davide Scigliuzzo, Kelsey Butler, and Sally Bakewell
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“Everything Is Private Equity Now”; Bloomberg Businessweek; 10/03/2019
“Two decades ago an investor could pick a private equity fund at random and have a better than 75% chance of beating the stock market, according to a report by financial data company PitchBook. Since 2006 those odds have dropped to worse than a coin flip. “Not only are fewer managers beating the market but their level of outperformance has shrunk, too,” the report says.”
You can only keep re-looting an economy so many times before your looting-returns start declining. That’s the tragic lesson we appear to be watching play out. The ‘low hanging loot fruit’ has already been looted:
...
One likely reason will be familiar to investors in mutual funds and hedge funds. When strategies succeed, more people pile in—and it gets harder and harder to find the kinds of bargains that fueled the early gains. There are now 8,000-plus PE-backed companies, almost double the number of their publicly listed counterparts. The PE playbook informs activist hedge funds and has been mimicked by pensions and sovereign funds. Some of PE’s secret sauce has been shared liberally in business school seminars and management books.A deeper problem could be that the first generation of buyout managers wrung out the easiest profits. PE thinking pervades the corporate suite—few chief executive officers are now sitting around waiting for PE managers to tell them to sell underperforming divisions and cut costs. Auerbach says there are still good PE managers out there and all these changes have “forced evolution and innovation.” But it’s possible that a cosmic alignment of lax corporate management, cheap debt, and desperate-for-yield pensions created a moment that won’t be repeated soon. —Hema Parmar and Jason Kelly
...
But declining returns don’t mean we should expect private equity to shrink. It can still be plenty profitable...thanks to the profit-multiplying power of leveraged buyouts. Profitable to the private equity investors...not so much for society at large which ends up with job losses, debt-bloated companies that tend to fare worse than their publicly-held counterparts, and an exacerbation of economic inequality as new lower-paid employees replace the laid-off workers, assuming the company isn’t driven into bankruptcy from all the debt:
...
If your company finds itself part of a PE portfolio, what should you expect? Research has shown that companies acquired through leveraged buyouts (LBOs) are more likely to depress worker wages and cut investments, not to mention have a higher risk of bankruptcy. Private equity owners benefit through fees and dividends, critics say, while the company is left to grapple with often debilitating debt....
Private equity and hedge funds gained control of more than 80 retailers in the past decade, according to a July report by a group of progressive organizations including Americans for Financial Reform and United for Respect. And PE-owned merchants account for most of the biggest recent retail bankruptcies, including those of Gymboree, Payless, and Shopko in the past year alone. Those bankruptcies wiped out 1.3 million jobs—including positions at retailers and related jobs, such as at vendors—according to the report, which estimates that “Wall Street firms have destroyed eight times as many retail jobs as they have created in the past decade.”
Whether LBOs perform poorly because of debt, business strategy, or competition from Amazon.com Inc., research shows they fare worse than their public counterparts. A July paper by Brian Ayash and Mahdi Rastad of California Polytechnic State University examined almost 500 companies taken private from 1980 to 2006. It followed both the LBOs and a similar number of companies that stayed public for a period of 10 years. They found about 20% of the PE-owned companies filed for bankruptcy—10 times the rate of those that stayed public. Pile on debt, and employees lose, Ayash says. “The community loses. The government loses because it has to support the employees.” Who wins? “The funds do.”
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Beyond that, PE may contribute to inequality in several ways. First, it offers investors higher returns than those available in public stocks and bonds markets. Yet, to enjoy those returns, it helps to already be rich. Private equity funds are open solely to “qualified” (read: high-net-worth) individual investors and to institutions such as endowments. Only some workers get indirect exposure via pension funds.
Second, PE puts pressure on the lower end of the wealth divide. Companies can be broken up, merged, or generally restructured to increase efficiency and productivity, which inevitably means job cuts. The result is that PE accelerates job polarization, or the growth of jobs at the highest and lowest skill and wage level while the middle erodes, according to research from economists Martin Olsson and Joacim Tag.
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And check out the new method of fleecing the public that emerged as a direct consequence of the 2008 financial crisis and flood of distressed real estate available for private equity to scoop up at fire sale prices: Private equity has such a large stake in the home rental markets it now has the market power to just keep raising rents every year:
...
Private equity companies including Blackstone Group Inc. had the money to gorge on foreclosed houses in the years after the crash and quickly applied their model to a whole new business. They used economies of scale, cost-cutting, and leverage to maximize profits on undervalued assets. The key was to create a standardized way to manage single-family homes, scattered from Atlanta to Las Vegas, almost as efficiently as apartment buildings. PE-backed landlords set up centralized 24/7 customer service centers and automated systems for rent collection and maintenance calls.Blackstone-backed rental company Invitation Homes Inc. eventually went public, then merged with a landlord seeded by Starwood Capital Group and Colony Capital Inc. to create the U.S.’s largest single-family rental company, with more than 80,000 units. Invitation Homes owns less than 1% of the single-family rental stock, says Ken Caplan, Blackstone’s global co-head of real estate. “But it has raised the bar for professional service for the industry,” he says.
The aims of the landlords and the needs of their tenants often diverge, says Leilani Farha, the United Nations’ special rapporteur on the right to housing. Steady rent increases that make investors happy come out of tenants’ paychecks, straining household finances and making it harder to save for a down payment. Meanwhile, PE-backed companies’ sprawling portfolios of rental properties may limit the availability of entry-level houses that could be occupied by homeowners. Institutional landlords were 66% more likely than other operators to file eviction notices, according to Georgia Institute of Technology professor Elora Raymond, whose 2016 study of Fulton County, Ga., court records was published by the Federal Reserve Bank of Atlanta. Invitation Homes was less likely to file notices than its largest peers, according to the paper. A company spokesman says it works with tenants to avoid eviction and that its high renewal rates indicate customer satisfaction.
From Wall Street’s point of view, the model has worked beautifully. Invitation Homes has convinced stock market investors that it can manage operating costs. It also bought shrewdly, swallowing up starter homes in good school districts, anticipating that tight credit and anemic construction rates would push the U.S. toward what one industry analyst dubbed a rentership society. Sure enough, U.S. homeownership is near its lowest point in more than 50 years, allowing Invitation Homes to raise rents by more than 5%, on average, when tenants renew leases.
...
Finally, keep in mind this Bloomberg article was written in October of 2019 and warning about already scary levels of corporate debt thanks in large part to private equity. “Leveraged loans” (loans to companies with lower quality credit) have doubled over the past decade and almost 40% of that is held by private equity-owned companies:
...
Ultralow interest rates have made this fuel especially potent and easy to obtain. The market for leveraged loans—industry jargon for loans made to companies with less-than-stellar credit—has doubled in the past decade. Almost 40% of all such loans outstanding are to companies controlled by private equity, according to data from Dealogic.Some leveraged loans are arranged by banks. But there’s also been a boom in private lenders, who may be willing to provide financing when banks or public debt markets won’t. All the while, bond and loan investors desperate for yield have accepted higher risks. As buyout titans have chased bigger and riskier deals, their target companies have been left with more fragile balance sheets, which gives management less room for error. This could set the stage for a rude awakening during the next recession.
“We’re seeing scary levels of leverage,” says Dan Zwirn, chief investment officer of alternative asset manager Arena Investors. “Private equity sponsors are all slamming against each other to get deals done.” Loans to companies with especially high debt loads now exceed peaks in 2007 and 2014, according to the U.S. Federal Reserve. And companies owned by private equity typically carry a higher debt load relative to their earnings and offer less transparency on their financial position than other corporate borrowers.
...
PE firms can use some of the companies they own as virtual ATMs—having the company borrow money to pay its owner special dividends. That allows the funds to recover their investment sooner than they typically would through a sale or an initial public offering. Sycamore Partners LLC, known for its aggressive bets in the retail industry and related run-ins with creditors, has already recovered about 80% of the money it put down to acquire Staples Inc. in 2017 through dividends mostly funded by debt. Carlyle Group, Hellman & Friedman, and Silver Lake have also saddled their portfolio companies with new debt to extract dividends this year. Representatives for the four private equity firms declined to comment.
...
How many of the private equity-owned companies that took those PPP loans in 2020 were companies that were treated like virtual ATMS in 2019? It’s one of the many questions we should all be asking about the growing role private equity is place across society.
We Already Invited the Vampire Into the House. It Didn’t Go Well. How About We Kick Them Out?
And of all the questions we should be asking about private equity, perhaps the most important, and pressing, question is why on earth this is being allowed to happen? It’s literally an industry where the primary product they produce is corporate debt that get transferred into private profits. Why is this even allowed to exist? It’s a question economist Matt Stoller asked and answered in a piece that not only describes what private equity does but why. Why, philosophically, did such a destructive industry emerge in the first place. As Stoller describes, the rise if private equity was in part a reflection of the political rise of a particular individual who held an especially ruthless worldview that equated ruthlessness with morality: William (Bill) Simon, the top executive and bond trader as Salomon Brothers in the 1960s and 70s who went on to become a leader at the Treasury Department under Richard Nixon and Gerald Ford. Simon was so ruthless he was convinced the Republican Party of that era was too liberal and “soft”. Simon went on to become president of the hard right Olin Foundation, the key conservative foundation that was providing money to the nascent “law and economics” movement that arose as the conservative backlash against New Deal restrictions on financial and corporate power. A movement that championed the idea that business should solely responsible to shareholder interests, forget the rest of society. It was a movement that also championed the idea that loading corporations with debt would discipline wasteful corporate managers and end up placing ownership in the hands of those who would force managers to be attentive to efficient operation of the corporation. In other words, corporate debt could force the simultaneous ‘race to the bottom’ for things like worker pay and employment and ‘race to the top’ of society’s wealth, which is really a race for domination.
So private equity is basically the manifestation of the “law and economics” movement. Bill Simon even carried out the first large scale leveraged buyout in 1982 when he and two other investors borrowed heavily to buy Gibson from a struggling RCA for $80 million. The three put up $1 million themselves and borrowed the other $79 million. They immediately had Gibson issue a $900,000 “special dividend” to themselves. They then sold off Gibson’s real estate assets, gave the managers 20% of the shares (so they would be focused primarily on the stock price) and eighteen months later they took Gibson public during a bull market for $270 million. Simon himself made $70 million on a personal investment of $330,000. The leveraged buy now the ‘hot’ investment strategy and a new paradigm for corporate America was born. A paradigm that has almost exclusively benefitted a tiny percent of society and helped propel the United States into the corporate hell hole it is today:
mattstoler.substack
Why Private Equity Should Not Exist
(Big issue 7-30-2019)
Matt Stoller
Jul 30, 2019Hi,
Welcome to Big, a newsletter about the politics of monopoly. If you’d like to sign up, you can do so here. Or just read on…
Today I’m going to discuss address the nascent political attack on private equity, the financial model in commerce which more than any other defines the Western political landscape. The most important signal of this attack is in the Democratic Presidential campaign, where candidates are being pressured on what they will do about PE. Sure enough, Senator Elizabeth Warren, the standard bearer for sophisticated policy thinking, recently announced a plan to rein in PE. And Bernie Sanders is leading protests against PE acquisitions. Perhaps as important are rumblings on the right; Republican Senator Marco Rubio’s released a report in March attacking the control of the economy by financiers.
In other words, PE is starting to face some of the same headwinds that big tech is experiencing. I’m going to explain what private equity is and why it is facing these attacks. I’ll also go into a bit of history, how private equity, which used to be called the leveraged buy-out industry (LBO), was started by a Nixon administration official who oversaw the both the bankruptcy of New York City and the intellectual attack on antitrust in the 1970s. Finally I’ll also discuss what it would mean to eliminate PE from our economy and politics.
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Why Private Equity Should Not Exist
Earlier this month, a former Toys “R” Us employee named Sarah Woodhams confronted Democratic Presidential candidate Julian Castro. Woodhams told Castro about her experience at the corporation. She worked there for seven years, and then was laid off with no severance because a set of private equity firms bought the company and looted it. What she described is not an isolated instance, but an increasingly common one in America. Woodhams told Castro that “dozens of retail companies controlled by Wall Street have gone into bankruptcy, including RadioShack, Payless, and Kmart,” with 15,000 jobs alone in Pennsylvania having disappeared.
“Billionaires buy up these companies, make huge profits on our backs, and get away with it because there’s no financial regulation,” Sarah Woodhams explained. “As president, what will you do to hold private equity firms and hedge funds accountable for the destruction of our communities and livelihoods?”
Partly because of organizing by workers like Woodhams, partly because of the scale of the industry, private equity is becoming an important part of the political dialogue. Millions of workers working for companies controlled by PE funds. As I noted above, the debate is now hot; Elizabeth Warren released a plan specifically on private equity, paralleled by a report on financial power by Republican Marco Rubio in March. More importantly, Castro was confronted by an activist. Castro was embarrassed because he did not seem to know what PE was, so you can be sure the other Presidential candidates are preparing talking points on PE for their bosses. That’s a big deal, when even the mediocre politicians start to get it.
So what is private equity? In one sense, it’s a simple question to answer. A private equity fund is a large unregulated pool of money run by financiers who use that money to invest in and/or buy companies and restructure them. They seek to recoup gains through dividend pay-outs or later sales of the companies to strategic acquirers or back to the public markets through initial public offerings. But that doesn’t capture the scale of the model. There are also private equity-like businesses who scour the landscape for companies, buy them, and then use extractive techniques such as price gouging or legalized forms of complex fraud to generate cash by moving debt and assets like real estate among shell companies. PE funds also lend money and act as brokers, and are morphing into investment bank-like institutions. Some of them are public companies.
While the movement is couched in the language of business, using terms like strategy, business models returns of equity, innovation, and so forth, and proponents refer to it as an industry, private equity is not business. On a deeper level, private equity is the ultimate example of the collapse of the enlightenment concept of what ownership means. Ownership used to mean dominion over a resource, and responsibility for caretaking that resource. PE is a political movement whose goal is extend deep managerial controls from a small group of financiers over the producers in the economy. Private equity transforms corporations from institutions that house people and capital for the purpose of production into extractive institutions designed solely to shift cash to owners and leave the rest behind as trash. Like much of our political economy, the ideas behind it were developed in the 1970s and the actual implementation was operationalized during the Reagan era.
Now what I just described is of course not the rationale that private equity guys give for their model. According to them, PE takes underperforming companies and restructures them, delivering needed innovation for the economy. PE can also invest in early stages, helping to build new businesses with risky capital. There is some merit to the argument. Pools of capital can invest to improve companies, and many funds have built a company here and there. But only small-scale funds really do that, or such examples are exceptions to the rule or involve building highly financialized scalable businesses, like chain stores that roll up an industry (such as Staples, financed by Bain in the 1980s). At some level, having a pool of funds means being able to invest in anything, including building good businesses in a dynamic economy where creative destruction leads to better products and services. Unfortunately, these days PE emphasizes the “destruction” part of creative destruction.
The takeover of Toys “R” Us is a good example of what private equity really does. Bain Capital, KKR, and Vornado Realty Trust bought the public company in 2005, loading it up with debt. By 2007, though Toys “R” Us was still an immensely popular toy store, the company was spending 97% of its operating profit on debt service. Bain, KKR, and Vornado were technically the ‘owners’ of Toys “R” Us, but they were not liable for any of the debts of the company, or the pensions. Periodically, Toys “R” Us would pay fees to Bain and company, roughly $500 million in total. The toy store stopped innovating, stopped taking care of its stores, and cut costs as aggressively as possible so it could continue the payout. In 2017, the company finally went under, liquidating its stores and firing all of its workers without severance. A lot of people assume Amazon or Walmart killed Toys “R” Us, but it was selling massive numbers of toys until the very end (and toy suppliers are going to suffer as the market concentrates). What destroyed the company were financiers, and public policies that allowed the divorcing of ownership from responsibility.
The Origins of the Model: Building a “Counter-intelligentsia”
If there is a father to the private equity industry, it is a man named William Simon. Simon is perhaps one of the most important American political figures of the 1970s and early 1980s, a brilliant innovator in politics, financial, and in how ideas are produced in American politics. Simon was an accountant, a nerd, but also an apocalyptically oriented conservative financier who was a bond trader and top executive at Salomon Brothers in the 1960s and 1970s. Beyond ruthless, Simon believed in ruthlessness as a moral philosophy. He was, according to a friend, “a mean, nasty, tough bond trader who took no BS from anyone,” and would apparently wake up his children on weekend mornings with buckets of cold water. He was such a difficult person that he was invited onto the Citibank board of directors, and shortly thereafter, essentially kicked off.
In the early 1970s, Simon went into politics, a leader at the Treasury Department under Nixon and Ford. He oversaw not just Treasury but became the the ‘Energy Czar’ in charge of the oil crisis, and a key player in rejecting New York City’s 1975 request for funds to ward off bankruptcy. Simon, along with a few others like Pete Peterson, came out of the Nixon administration with a better reputation than he had going in, perceived as a neutral and competent technocrat. Simon saw both prosperity and poison in Nixon and Ford. He supported the attacks on New York City’s and the forced austerity by the Federal government, but he also despised Nixon’s attempted economy-wide price controls to deal with inflation.
After his time at the Treasury, Simon turned to intellectual organizing, because he believed that the Republicans were soft. Simon though Republicans, even when they had power, as Nixon or Ford of Governors like Nelson Rockefeller of New York, were still liberal, operating as conservative Phyllis Schafly put it, merely “an echo” of the Democrats. So he sought to finance thinkers in academia to restructure how elites did policy, or as he put it, a “counter-intelligentsia.” He became the President of the Olin Foundation, the key conservative foundation providing money to the nascent law and economics movement, the conservative intellectual backlash against New Deal controls on finance and corporate power. Law and economics wasn’t perceived of as a right-wing institutional framework, but a scientific one. Olin gave to Harvard Law to build out a law and economics program, and financial supremacy over corporations was accepted quickly in liberal citadels.
The law and economics movement helped build the intellectual edifice for PE, a model designed to restructure the American economy from the very beginning. In 1965, Henry Manne, a law and economics organizer, wrote about the “market for corporate control,” putting forth financial markets where corporations were bought and sold as the essential mechanisms for firing inefficient managers and replacing them with ones who would look out for the owners.
In 1965, Manne was ahead of his time, because most people thought American businesses were well-run. But in the 1970s, in an inflationary environment and as foreign imports began coming into the U.S. in force, this belief collapsed. In 1970, Milton Friedman put forward the shareholder value of the firm, a theory that the only reason for the corporation to exist is to maximize shareholder value. In 1976, Michael Jensen, the intellectual patron saint of PE, refined these concepts into a paper titled “Theory of the firm: Managerial behavior, agency costs and ownership structure,” arguing that loading up firms with debt would discipline wasteful management, and that placing ownership in the hands of a few would force managers to be attentive to efficient operation of the corporation.
The increasingly widespread belief that American corporations were mismanaged, inflationary chaos, and a crisis of confidence among liberals combined into what was a political revolution in commerce. William Simon was both both a participant in and a moral light for this revolution. In the mid-1970s, he (or his ghostwriter) put pen to paper, and wrote a book popular among members of “the new right” as the large class of 1978 Congressional Republicans (which included a young Newt Gingrich) was known. His book was called A Time for Truth, and along with Robert Bork’s Antitrust Paradox, it gave the New Right a language to marry morality and political economics. Reagan would run on New Right themes in 1980.
A Time for Truth reflected Simon’s hardcore attitude. It was a jeremiad, with terms tossed around like ‘economic dictatorship’, charges of Communism and fascism, and a screed about the perils of government. The book was introduced by the intellectual godfather of the right-wing, the Austrian economist, F.A. Hayek, who lauded it as “a brilliant and passionate book by a brilliant and passionate man.” Simon popularized the pseudo-scientific term, ‘capital shortage,’ or the the idea that businesses simply didn’t have the incentive to invest in factories because of government rules or fear of inflation. This led to inflation, lower productivity, and stagnation. The solution would be simple: cut capital gains taxes, cut government spending, reduce antitrust enforcement, and stop regulating through public institutions.
The Carter administration and Congressional Democrats took Simon’s advice, and slashed capital gains taxes, cutting the maximum rate to 28% from 49% in 1978. They deregulated trucking, finance, airplanes, and railroads. In addition, changes in pension laws enabled American retirement savings to flood into new vehicles, like venture capital and its cousin, what would first be known as leveraged buy-outs and then private equity. The Reagan administration’s further deregulation of finance enabled a long bull market in the 1980s as speculators took control of the economy. Shareholders no longer were content to leave their money in stocks that paid dividends, because they could now keep most of their capital gains. And the chaos unleashed by deregulation opened up the door to corporate restructuring of corporations who had been tightly controlled by public rules, but were now free to enter and exit new businesses.
In 1982, William Simon turned into a leader of the financial revolution. He pulled off the first large scale leveraged buyout, of a company called Gibson Greeting cards, a deal that shocked Wall Street. He and his partner paid $80 million for Gibson, buying the company from the struggling conglomerate RCA. The key was that they didn’t use their own money to buy the company, instead using Simon’s political credibility and connections to borrow much of the necessary $79 million from Barclays Bank and General Electric, only putting down $330,000 apiece. They immediately paid themselves a $900,000 special dividend from Gibson, made $4 million selling the company’s real estate assets, and gave 20% of the shares to the managers of the company as an incentive to keep the stock price in mind. Eighteen months later, they took Gibson public in a bull market, selling the company at $270 million. Simon cleared $70 million personally in a year and a half off an investment of $330,000, an insanely great return on such a small investment. Eyes popped all over Wall Street, and Gibson became the starting gun for the mergers and acquisitions PE craze of the 1980s.
Another business trend intersected with changes in policy encouraging financial dominance: the rise of management consulting. Like law and economics, management consultants rose in the late 1960s with pseudo-scientific theories about business, and they began treating corporations as financial portfolios, with subsidiaries of assets. Many of the organizers of private equity firms in the 1980s came from management consulting firms like the Boston Consulting Group and McKinsey. Mitt Romney was an early innovator around PE. He came from Bain, which was a consulting firm. To give you a sense of what that meant in terms of the philosophy of commerce, here’s Bain Consulting today, helping companies find ways to innovate around raising prices instead of productive techniques.
PE firms serve as transmitters of information across businesses, sort of disease vectors for price gouging and legal arbitrage. If a certain kind of price gouging strategy works in a pharmaceutical company, a private equity company can roll through the industry, buying up every possible candidate and quickly forcing the price gouging everywhere. In the defense sector, Transdigm serves this role, buying up aerospace spare parts makers with pricing power and jacking up prices, in effect spreading corrupt contracting arbitrage against the Pentagon much more rapidly than it would have spread otherwise.
More fundamentally, private equity was about getting rid of the slack that American managers had to look out for the long-term, slack that allowed them to fund research and experiment with productive techniques. PE replaced slack with brutal debt schedules and massive upside for higher stock prices, and no downside for the owner-financiers should the company fail. The goal is to eliminate production in favor of scalable profitable things like brands, patents, and tax loopholes, because producers — engineers, artists, workers — are cost centers. Production can also be eliminated by fissuring the workplace, such as the mass move to offshore production to lower cost countries in the 1980s onward. When I reported on the problem of financialization destroying our national security capacity, one of the manufacturers I talked to told me about how the “LBO boys” — or Leveraged Buy Out Boys — took apart factories in the midwest and shipped them to China.
There hasn’t been a lot of analysis of just how profitable private equity really is for investors or lenders, and I’m only touching on part of what is a very complex phenomenon. There are ways PE funds organize fees against pension funds, there’s self-dealing among banks and middlemen, and at this point large PE firms are buying insurance companies and dedicating their insurance portfolios to PE deals. But I found this paper by Brian Ayash and Mahdi Rastad quite useful. What Ayash and Rastad noted is that companies bought by private equity are ten times more likely than comparable companies to go bankrupt. And this makes sense. The goal in PE isn’t to create or to make a company more efficient, it is to find legal loopholes that allow the organizers of the fund to maximize their return and shift the risk to someone else, as quickly as possible. Bankruptcies are a natural result if you load up on risk, and because the bankruptcy code is complex, bankruptcy can even be an opportunity for the financier to restructure his/her investment and push the cost onto employees by seizing the pension.
Elizabeth Warren just put forward a fairly reasonable plan to address the problem. Under her plan, private equity funds who buy companies would themselves responsible for any debt those companies borrow, as well as the pension funds of their subsidiaries. PE firms could no longer pay themselves special fees and dividends, they would lose their special advantages in bankruptcy and in the tax code, and would have to disclose what they charge to investors. Effectively she reunifies ownership with responsibility. Investing would basically become once again about taking modest risks and reaping modest returns, rather than pillaging good companies. (I’d propose a couple of other changes as well, like raising capital gains taxes quite radically, and gutting golden parachutes. We also need to replace capital provided by PE with small business lending by government, as Marco Rubio is organizing. But I don’t want to demand too many policy changes. After all no sense in getting… greedy.)
Warren’s plan has generated some backlash, because she’s making a philosophical point about what kind of society we want to live in. I’ll focus on two quotes from Warren critics.
Steven Pearlstein in the Washington Post noted:
“Unfortunately, Warren’s fixes for these problems... would pretty much guarantee that nobody invests in or lends to private equity firms.”
Aaron Brown in Bloomberg said:
A 100% tax on fees doesn’t mean PE funds will work for free; in fact, they won’t work at all… If you strip doctors of all assets if a patient dies, you won’t improve healthcare; you’ll make surgeons and oncologists switch to cosmetic dermatology.”
Of course, Pearlstein and Brown are both in one sense right. Warren’s plan will largely eliminate private equity, or at least that which is based on legal arbitrage, which is nearly all of it. In another sense they are entirely missing the point. Brown calls PE firms doctors saving patients. But private equity, for Warren, is bad, a form of legalized fraud shifting money from the pockets of investors and workers to the pockets of financiers. It is also, as she knows, the model that best represents the destructive direction of American political economy over the past four decades.
And though it is not really on stage that often, private equity is an important part of our political debate, though the supporters of private equity in politics are so far quiet. And that is because private equity funds are important vectors for political donations.
In the second quarter, Joe Biden, Cory Booker, Pete Buttigieg, and Kamala Harris have all received donations from one or both of the leaders of the country’s top two private-equity firms, Blackstone and the Carlyle Group. Buttigieg received max donations from 11 high-level Blackstone employees, as well as money from Bain Capital and Neuberger Berman. Biden, Booker, and Gillibrand nabbed donations from employees at at least three of the top 15 private-equity firms.
PE funds are job sinecures for out of power elite Democrats and Republicans, a sort of shadow government of financiers who actually do the managing of American corporations while the government futzes around, paralyzed by the corruption PE barons organize.
What critics of PE are proposing is a profound restructuring of the philosophy of the American political economy, a return to excellence in production as the goal instead of excellence in manipulation. If critics succeeds, those who make and create will have their bargaining power increase radically, which will mean wage growth across the bottom and middle tier. Swaths of elite powerful people will lose power. It’ll be really jarring, because we aren’t used to a producer-focused economic order anymore. But it is what we need to do.
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“Why Private Equity Should Not Exist” by Matt Stoller; mattstoler.substack; 07/30/2019
“More fundamentally, private equity was about getting rid of the slack that American managers had to look out for the long-term, slack that allowed them to fund research and experiment with productive techniques. PE replaced slack with brutal debt schedules and massive upside for higher stock prices, and no downside for the owner-financiers should the company fail. The goal is to eliminate production in favor of scalable profitable things like brands, patents, and tax loopholes, because producers — engineers, artists, workers — are cost centers. Production can also be eliminated by fissuring the workplace, such as the mass move to offshore production to lower cost countries in the 1980s onward. When I reported on the problem of financialization destroying our national security capacity, one of the manufacturers I talked to told me about how the “LBO boys” — or Leveraged Buy Out Boys — took apart factories in the midwest and shipped them to China.”
PE replaced slack with brutal debt schedules and massive upside for higher stock prices, and no downside for the owner-financiers should the company fail. Heads we win. Tails you lose. To the most ruthless goes the spoils. The only thing should matter to company management is maximizing short-term returns for shareholders. Planning for the long-term or factoring in the public good was seen as bad. And the best way to ensure management would abide by these principles is to load the corporation up with debt so managers would have no choice but to focus on cutting costs (as opposed to cutting yields to the owners that forced all the new debt). That’s the philosophy that has taken over corporate America and it’s the philosophical foundation for the entire private equity movement:
...
In the early 1970s, Simon went into politics, a leader at the Treasury Department under Nixon and Ford. He oversaw not just Treasury but became the the ‘Energy Czar’ in charge of the oil crisis, and a key player in rejecting New York City’s 1975 request for funds to ward off bankruptcy. Simon, along with a few others like Pete Peterson, came out of the Nixon administration with a better reputation than he had going in, perceived as a neutral and competent technocrat. Simon saw both prosperity and poison in Nixon and Ford. He supported the attacks on New York City’s and the forced austerity by the Federal government, but he also despised Nixon’s attempted economy-wide price controls to deal with inflation.After his time at the Treasury, Simon turned to intellectual organizing, because he believed that the Republicans were soft. Simon though Republicans, even when they had power, as Nixon or Ford of Governors like Nelson Rockefeller of New York, were still liberal, operating as conservative Phyllis Schafly put it, merely “an echo” of the Democrats. So he sought to finance thinkers in academia to restructure how elites did policy, or as he put it, a “counter-intelligentsia.” He became the President of the Olin Foundation, the key conservative foundation providing money to the nascent law and economics movement, the conservative intellectual backlash against New Deal controls on finance and corporate power. Law and economics wasn’t perceived of as a right-wing institutional framework, but a scientific one. Olin gave to Harvard Law to build out a law and economics program, and financial supremacy over corporations was accepted quickly in liberal citadels.
The law and economics movement helped build the intellectual edifice for PE, a model designed to restructure the American economy from the very beginning. In 1965, Henry Manne, a law and economics organizer, wrote about the “market for corporate control,” putting forth financial markets where corporations were bought and sold as the essential mechanisms for firing inefficient managers and replacing them with ones who would look out for the owners.
In 1965, Manne was ahead of his time, because most people thought American businesses were well-run. But in the 1970s, in an inflationary environment and as foreign imports began coming into the U.S. in force, this belief collapsed. In 1970, Milton Friedman put forward the shareholder value of the firm, a theory that the only reason for the corporation to exist is to maximize shareholder value. In 1976, Michael Jensen, the intellectual patron saint of PE, refined these concepts into a paper titled “Theory of the firm: Managerial behavior, agency costs and ownership structure,” arguing that loading up firms with debt would discipline wasteful management, and that placing ownership in the hands of a few would force managers to be attentive to efficient operation of the corporation.
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And note how Simon’s book, A Time for Truth, that laid out his ruthless philosophy was so extreme that Austrian school economist Friedrich von Hayek wrote the introduction. It was a book that popularized the ‘supply-side’ ideas that have been used to justify all forms of tax and regulation cuts over the past four decades and look who just happened loved the book: the radical “New Right” wing of the Republican Party from the class of 1978. The New Right that is the overwhelming dominant force in the Republican Party today (it’s not so new anymore). It’s a reminder that the philosophy behind private equity didn’t just capture the minds of corporate board rooms. It also captured the Republican Party and propelled the party into the monstrous entity it is today:
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The increasingly widespread belief that American corporations were mismanaged, inflationary chaos, and a crisis of confidence among liberals combined into what was a political revolution in commerce. William Simon was both both a participant in and a moral light for this revolution. In the mid-1970s, he (or his ghostwriter) put pen to paper, and wrote a book popular among members of “the new right” as the large class of 1978 Congressional Republicans (which included a young Newt Gingrich) was known. His book was called A Time for Truth, and along with Robert Bork’s Antitrust Paradox, it gave the New Right a language to marry morality and political economics. Reagan would run on New Right themes in 1980.A Time for Truth reflected Simon’s hardcore attitude. It was a jeremiad, with terms tossed around like ‘economic dictatorship’, charges of Communism and fascism, and a screed about the perils of government. The book was introduced by the intellectual godfather of the right-wing, the Austrian economist, F.A. Hayek, who lauded it as “a brilliant and passionate book by a brilliant and passionate man.” Simon popularized the pseudo-scientific term, ‘capital shortage,’ or the the idea that businesses simply didn’t have the incentive to invest in factories because of government rules or fear of inflation. This led to inflation, lower productivity, and stagnation. The solution would be simple: cut capital gains taxes, cut government spending, reduce antitrust enforcement, and stop regulating through public institutions.
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And that’s all why we really need to ask ourselves: should the private equity industry even be allowed to exist? Does the general public share Bill Simon’s worldview? Do people really want a world where corporations care ONLY about short-term shareholder returns? Do people really want a world where leveraged buyouts are the tool of choice to allow the rich turn a quick profit buy effecting looting companies and profiting from their downfall? Do people really want a ‘Heads We Win. Tails You Lose” society? Because if not, private equity has to go, at least in its current form. And this is no longer just a question for the American public. This is now the global corporate philosophy.
Or we can just continue down our current path and allow private equity to take over effectively everything. Which will happen if it’s allowed to. That’s the nature of predatory systems. They will take it all if they can. That’s the philosophy. A philosophy where ruthlessness is a virtue. And that’s why the question of whether or not private equity should even be allowed to exist is also the question of whether or not we’ll finally address the pandemic of awful ideas that are continuing to loot the future or if we all just want to role over and let the most ruthless people on the planet continue taking it all. In other words, which one is really ‘too big to fail’: private equity or everyone else?
Banking with Bin Laden
@Pterrafractyl–
Indeed!
Great work.
This anticipates the shows I will be doing in the near future.
SARS Cov‑2 is, among other things, “The Wealth Concentration Virus”!
This is deliberate and pre-planned.
Details to follow.
Again, magnificent work!
Best,
Dave
Here’s a pair of articles that point towards what really should be a growing scandal for the Trump administration regarding the administration of the Paycheck Protection Program (PPP):
First, here’s a Forbes piece from back in July that gives us a sense of just how much money as being made the Wall Street banks that actually issued most of the PPP loans to small business: billions of dollars in fees were collected, with the biggest loan issuer, JP Morgan Chase, making over $800 million as of June 30. The bank told Forbes, “We will not make a profit from the program and remain fully committed to supporting underserved communities that have been economically impacted by the pandemic,” but then declined to elaborate.
Now, the fact that banks were profiting from the loans isn’t particularly surprising or necessarily scandalous. They presumably had to actually do work vetting applicants to issue the loans since many of the applicants presumably weren’t already clients with the banks.
But that doesn’t mean there isn’t a scandal here. Because as we’re going to see in the second Forbes article from last week, a new report released by a House of Representatives select committee that investigated how the eight largest banks issuing these loans were were actually carrying out the PPP program discovered that the Trump Treasury Department and Small Business Administration (SBA) gave guidance to the big banks to provide loans from the PPP to their “wealthy existing clients at the expense of truly struggling small businesses in underserved communities.” Wealthy existing clients that include private equity-owned companies. Wealthy existing clients that are presumably a lot easier to vet for the loans too.
And note that we are told the Trump administration encouraged, but didn’t order, these banks to prioritize wealthy existing clients. So while the banks can’t be blamed for the Trump administration giving them guidance to do the wrong thing, they can sure be blamed for following it. Or, at least, they can be blamed for following that advice if we hold corporations up to a higher moral standard than blindly pursuing maximal profits for shareholders, which, we’ll recall, happens to be the corporate philosophy behind the private equity movement.
Ok, first, here’s the Forbes piece from back in July that gives us an idea of just how much the largest banks processing PPP loans, along with some of the banks’ vague pledges to somehow not keep these profits:
“But faced with mounting criticism, some banks say they won’t keep any profits. Instead, they will donate what they have earned after factoring in the cost to process the loans.”
We’re not going to profit from this at all. Or at least not keep the profits we’ve already made. Trust us. That was the spin we were hearing from the banks back in July.
So did the banks ultimate donate all of their profits? That’s unclear at this point. But those banks that did end up donating their PPP profits are probably rather relieved they did so after the release of the House report last week that revealed that not only did the Trump Treasury Department and SBA actively encouraged big banks to provide loans from the PPP to their “wealthy existing clients at the expense of truly struggling small businesses in underserved communities,” but also revealed that all but one of the eight largest banks apparently took that advice, to the detriment of genuine small businesses which, in turn, resulted in a disproportionately negative impact on minority owned businesses:
“Documents obtained by the House Select Subcommittee on the Coronavirus Crisis show that the Treasury privately told lenders to “go to their existing customer base” when issuing PPP loans, the report says, and all but one of the eight banks involved in the investigation followed the guidance.”
Well, at least one bank seemed to demonstrate an inkling of a conscience (or more likely realized following such guidance was going to blow up in their faces). It’s progress. Painfully slow progress.
So which of those eight big banks decided not to follow the Trump administration’s ‘guidance’? As the House report describes, the eight banks they investigated were JPMorgan Chase (JPMorgan), Citibank (Citi), PNC Bank (PNC), Bank of America, U.S. Bank, Truist, Wells Fargo, and Santander. And while the part of the report that tells us seven of the eight banks followed the Trump administration’s guidance doesn’t say which bank was the odd man out, it’s clear from the rest of the report that this is U.S. Bank, which was the only one to allow non-customers to apply for loans on the first day of the PPP. Plus, the paragraph of the report that tells us seven of the eight banks followed the Trump administration’s guidance cites footnote 18 and that footnote cites letters given to the House subcommittee from the seven remaining banks but makes no mention of U.S. Bank.
But there’s another highly noteworthy revelation in the House report: when questioned about this ‘guidance’, the Treasury Department completely denied it. So it looks like this scandal includes a cover up:
That sure sounds like a cover up!
And it’s not like this is the kind of thing the Treasury Department wouldn’t be highly interested in covering up. Of course they denied this to Congress. It looks awful. Because it is awful. Especially the all the small businesses that couldn’t get a loan. Or, rather, former small businesses. They’re presumably not in business anymore.
@Dave: Here’s an article from January 3, of 2020, weeks before the global nature of the coronavirus pandemic was known, that points to another manner in which this pandemic was like manna from heaven for the private equity industry:
Thanks, in part, to the long-running historically low interest rates that are a consequence of the 2008 financial crisis, record levels of cash had been flowing into private equity funds since that’s one of the only investment classes remaining that has paid above average yields in recent years. Even hedge funds were averaging only 5.5% vs +14% for private equity.
But all of that money flowing into private equity was creating a problem: Too much money in private equity means too much competition and lower yields. That was one of the big fears facing the private equity sector heading into this pandemic. It was becoming a victim of its own success. Beyond that, most private equity funds have a 5 to 10 year investment time frame. So while funds could sit on cash for a while to wait for the right opportunity to invest, they can’t wait forever. They HAVE to find somewhere to invest.
Also keep in mind that part of what makes private equity appealing as an investment for things like pension funds seeking a combination of higher-yields but also ‘safe’ investments is that private equity has the capacity to do well when the rest of the economy is doing poorly. Which makes sense...when economies weaken that inevitably creates all sorts of buying opportunities for with cash to spend.
So at the start of this year, the whole private equity industry was sitting on a historic pile of cash but facing the prospect of no great buying opportunities and possibly very a disappointing upcoming decade if the industry is forced to spend all that cash on already-overpriced investments....unless there’s a new recession that creates all sorts of new buying opportunities. And that’s why the coronavirus pandemic really was like manna from financial heaven for private equity:
“Still, all of these firms are working with a shot clock. Private-equity investments have a lifecycle of five to 10 years, and money managers need to get that capital out the door within a certain time frame. But Bain said much of Preqin’s estimated $1.5 trillion total is “fresh” capital that still has time to be invested.”
Too much money chasing too few remaining opportunities and the clock is ticking. That was the challenge facing the industry right before the pandemic-induced global economic implosion. And then, all of a sudden, the whole world turned into a fire sale. A fire sale that promises to keep interest rates even lower for even longer.
So instead of facing questions about how the industry is going to invest an abundance of cash without an abundance of investment opportunities, the new question is just how much of the economy isn’t going to be owned by private equity a decade from now.
Oh look at that: Over the past couple of months the private equity industry has started doing exactly the thing people fear private equity for doing. Yes, private equity firms or now forcing the companies they own to load up on debt for the purpose of paying dividends back their private equity owners. This always happens to some degree but as of mid-September nearly 24 percent of the money raised in the US loan market had been used to fund dividends to private equity investors, compared to 4 percent average over the past two years. So there was a sudden 600% jump in these “dividend recapitalisations” last month and the trend was just getting started.
And as the second excerpt below demonstrates, part of what’s driving this is a willingness by bond investors to accept what are known as payment-in-kind (PIK) bonds. PIKs are especially risky bonds that pay relatively high rate but with terms that allow the borrower to pay interest with additional borrowing. So lenders get extra high interest rates at the cost of elevating the risk their borrower will be driven into bankruptcy in order to finance the loan. So private equity firms are getting the companies they own to borrow money using special loans that make companies extra vulnerable to bankruptcy in order to pay out dividends to the private equity owners. Which, again, is why people hate and fear the private equity industry:
“So far in September, almost 24 per cent of money raised in the US loan market has been used to fund dividends to private equity owners, up from an average of less than 4 per cent over the past two years. That would be the highest proportion since the beginning of 2015, according to monthly data from S&P Global Market Intelligence.”
Have we already hit the “bust out” phase of the private equity cycle, or is that yet to come? It’s sure feeling like it at least started. But as the second article, from just a couple days ago, make clear, if this is the “bust out” phase — where companies are basically stripped of their value and allowed to collapse — the private equity industry is going to have a lot of help pulling it off. Help from all the bond investors willing to buy the high-risk payment-in-kind (PIK) bonds that are poised to make this exploding debt blow up even bigger down the line:
“A duo of highly-indebted borrowers are seeking to raise a combined $1bn through so-called PIK toggle deals, in which issuers are allowed to defer interest payments. The structure allows companies to pay interest using more debt, leading the amount that ultimately needs to be paid at the bond’s maturity to balloon.”
The structure allows companies to pay interest using more debt. What could go wrong?
And note that these aren’t obscure relatively tiny private equity firms doing this. Apollo and Platinum Equity are giants in the industry. In the case of the Apollo-own Aspen Insurance, half of the $500 million is set aside for a dividend. And for Platinum, all of the $500 million raised by Multi-color Corporation will go to the private equity owners:
Whether or not we’ve entered the ‘bust out’ phase for the private equity industry as a whole, Apollo and Platinum Equity have clearly decided to start ‘busting out’ their holdings. And finding willing partners in the yield-hungry bond investors willing to hold the bag. As long as there are enough investors willing to buy these ‘bust out’ bonds more of them are going to be issued.
So when all of this blows up and we see a major corporate debt crisis that threatens to cripple the global economy and calls for major bailouts grow, that the private equity industry — which will no doubt be pining for those bailouts — it’s going to be important to keep in mind that the upcoming corporate debt crisis is the private equity industry bailout.
This is rich: Henry Kavis — the co-founder of notorious private equity giant Kohlberg Kravis Roberts (KKR), President Trump’s first choice for the job of Treasury Secretary to in November of 2016, and someone who is widely seen as an inspiration for Gordon Gecko’s character in the movie Wall Street who championed the “greed is good” mentality — just gave an interview with Bloomberg about his take on the impact of the coronavirus pandemic. Kravis talks about the extreme and seemingly irrational volatility in the markets and the massive swings up or down for no apparent reason. And then he ends with the type of comment that we should expect to hear a lot more of as the private equity industry pounces on this crisis to grow bigger than ever: Kravis claims the pandemic has made him more empathetic.
Now, as we’ll see in the second excerpts below from back in May, KKR was calling the crisis an “inflection point” for its business an even better opportunity for the firm to expand than the 2008 financial crisis. Think about that: the business that has seen explosive debt-fueled growth for decades and is now a private equity giant is hitting an inflection point now. It’s predicting even more explosive growth for years to come.
And in the third excerpt below, we learn that KKR did indeed make record investments of $5.5 billion in the second quarter of this year and top that record with $6.2 billion in the third quarter. KKR really has been expanding at an even faster pace than during the 2008 financial crisis as they predicted. So let’s hope Henry Kravis and the rest of the private equity chiefs really are somehow growing a conscience and become genuinely empathetic people, because if current trends hold the private equity chiefs are going to be everyone’s boss once this is over:
““When we shut down our offices in the U.S. on about March 12, I was wondering, ‘What are we going to do, how are we going to even keep busy?’” Kravis, 76, said. “As it turned out, we’ve probably had the busiest year and (most) productive year that we’ve had almost ever.””
Oh what a surprise. The vulture capital industry benefited from a global crisis. Who could have seen that coming. But hey, at least the top vultures are reportedly growing a heart:
Let’s hope that new found patience and empathy applies to all the employees slated to be laid off by the firms gobbled up by KKR this year. And all the firms that are going to be scoop up at rock-bottom prices in years to come. Because as KKR warned us back in may, this crisis represents an inflection point for the firm and a greater opportunity than 2008. The sky’s the limit! For KKR. The limits are much lower for the rest of us:
“Scott Nuttall, co-president of KKR, said during an earnings call that the possibilities for the firm to expand are even greater now than during the last financial crisis.”
It’s the greatest opportunity in history. For KKR. Everyone else is basically f*cked but KKR and the rest of the private equity giants are doing juuust fiiine. Better than ever, in fact. Note how KKR raised $10 billion alone from March through May! When the pandemic was just getting underway. Heads we win. Tails you lose:
And note how KKR was “finding opportunities to provide liquidity to struggling companies.” It wasn’t with low-interest loans. It was from companies selling off subsidiaries to KKR. That’s how the company is providing liquidity:
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Did things turn out the way KKR was predicting back in May? The two straight quarters of record investments KKR just announced give us our answer:
“This year “is on pace to be the most active deployment and fundraising year in our history,” co-Chief Executive Officers Henry Kravis and George Roberts said in the statement.”
Well, we can’t say they didn’t warn us. From the beginning of the outbreak it was clear this was a historic opportunity for the private equity industry...just as every economic crisis is an opportunity for the industry. This crisis just happens to be historic. Heads we historically win. Tails you historically lose. But don’t worry, now that we’ve ruthlessly captured everything we’re finally learning to have empathy, so we’ll feel extra bad as we squeeze you rubes for everything you have.
President Trump has been touting the third quarter GDP growth numbers that just came out a couple of days ago. And it’s no surprise he would be celebrating the numbers. There was, as expected, a record 33.1% annualized GDP growth in the quarter, the kind of number that could be considered beyond spectacular if we were to ignore the context of the the number and the fact that it was preceded by a record contraction of 32.9% in the second quarter. And as the following Politico excerpt mentions, when you first contract an economy by 32.9%, a 33.1% rebound doesn’t actually get you back to where you were before. You would need 46% growth for that and a 63% gain would have been required in the third quarter to get the GDP back to the level where it likely would have been if COVID never happened and previous growth rates were maintained. It’s a sign of how deep an economic hole the US finds itself in the midst of this election.
But as the following article also notes, if there’s one thing that made that record 33.1% annualized possible in the third quarter it was the trillions in federal stimulus. That was the crucial ingredient. A crucial ingredient that has been systematically blocked from happening again by the Republican-controlled Senate, which chose to focus on confirming Amy Coney Barrett to the Supreme Court instead of making a second stimulus bill happen. Recall how we’re already hearing from Republican insiders that prioritizing of Barrett’s Supreme Court nomination over the stimulus bill was simply out of desire to fill that seat. It was also an opportunistic ploy that allowed the Senate GOP to ‘keep its powder dry’ should Joe Biden win the White House in anticipation of the GOP reverting back to its austerity-focused fixation on cutting federal spending at all costs, just like it did following the 2008 financial crisis.
It’s one of the many underappreciated stories of the this election cycle : the GOP Senate has already shifted into economic sabotage mode, which is why economists aren’t expecting more spectacular (and needed) quarters comings up:
““From a numbers perspective, you would need 46 percent growth in the third quarter just to get back to where we were,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics. Getting the economy back to where it would have been without Covid-19 would have taken a 63 percent gain in the third quarter.”
It’s basic math: If your GDP drops by a third, you’re going to need to grow by a lot more than a third (50%) to get back to what you were and even higher to get back to where you should have been if growth had continued. There’s A LOT more ground to be made up. Ground that won’t be made up without the further stimulus the GOP is already blocking. It’s why the major point of celebration with these new GDP growth numbers is really a celebration that fiscal policy works. We already knew but bit it’s a major confirmation. Just having the federal government give everyone money is actually very sound policy in a situation like this. Hooray! That’s a good thing! Too bad the Republicans in the Senate won’t allow us to keep doing this great policy.
So when we read that economists warn that the biggest risk facing the US economy right now is the risk of inadequate fiscal stimulus bills, they’re telling us that the biggest risk to the economy is the Republican holding onto the Senate:
But as the following Reuters piece also reminds us, it’s not enough to implement policies that simply rebound the GDP. Where that GDP rebound takes place and who benefits is far more important. After all, if we have a rebound where the super-rich and private equity are the primary beneficiaries while the general public languishes that would obviously be an mega-disaster, regardless of how high those GDP growth numbers end up being. In fact, one could argue that a full GDP rebound that ended up being concentrated in just bank accounts of the rich would be the worst possible outcome. A rebound that makes America’s wealth divide even more of chasm — the ‘K‑shaped’ recovery scenario where the rich get richer and the poor get poorer and stay poorer — isn’t really a rebound. It’s economic plundering. And thus far, the current rebound that Trump is asking us to celebrate is looking a lot like a ‘V’ for the very rich and an ‘E’ recovery for everyone else, if ‘E’ stands for an extended economic emergency and evictions:
“If present conditions persist, and without a new round of federal relief, as many as 40 million people could be at risk of eviction in coming months, according to the Aspen Institute, a think tank. In a typical year, 3.6 million eviction cases are filed.”
If we can’t expect new federal fiscal stimulus, what can we expect? 40 million evictions in coming months, that’s what. And all those evictions will be taking place while the high end housing market remains so hot people are buying houses sight unseen. A ‘night and day’ recovery, where it’s ‘Morning in America’ for the wealthy, and just ‘Mourning’ for the rest of us:
And as long as the Republicans retain control of the Senate this ‘night and day’ recovery is exactly what we should continue to expect. Regardless of who wins the White House. Sure, Senate Republicans will probably be a little less Grinch-like with the fiscal stimulus if Trump wins the White House only because they won’t be quite as incentivized to sabotage the economy for political reasons. But when you’re the GOP — party of, by, and for the predatory super-rich — only don’t need political reasons as a motivation to sabotage the economy. The ‘K‑shaped’ nature of current recovery, with the rich getting richer and the poor getting poorer, is reason itself to continue the sabotaging the economy. A ‘night and day’ recovery is just an extension of the GOP’s long-term ‘trickle-down’ economic agenda that’s been carried out for decades now. Much like Trump’s tax cut scam with ‘night and day’ benefits. If the GOP sees an opportunity to make the rich richer and the poor poorer that’s not an opportunity it’s going to pass up. 40 years of empirical evidence proves this beyond a shadow of a doubt. Putting the poors in their place (and fooling them into accepting it) is kind of the meta-point of the contemporary GOP.
So as we enter the post-Election period — a period where discussion of what a ‘post-Trump’ GOP might look like whether or not Trump wins or loses the election — it’s going to be important to keep in mind that we’re currently all living in the middle of merely the latest example of why the upcoming talk about the nature of a ‘post-Trump’ GOP should really be a discussion about a ‘post-GOP’ America. What kind of country could liberals and conservatives build together without a major party dedicated to making the rich richer and the poor poorer? There would still be some sort of conservative party, just not one that operates at the behest of billionaires suffering from a financial hoarding syndrome. What kind of country could the US become? It’s a fun thought. A fun, hopefully not too quaint for 2020, thought.
Here’s a quick story about the largely unrecognized role private equity firms played in the US 2020 elections. Just a relative handful of private equity. Recall how the US electronic voting/tabulating machine industry is largely an oligopoly controlled today by three companies. Hart InterCivic, Dominion, and ES&S. As the following Axios article points out, all three of these voting system giants are owned by private equity. Hart InterCivic was purchased by Enlightenment Capital this summer. Enlightment Capital’s two lead partners have a history of significant donations to Democratic Party candidates. One of Enlightenment Capital’s lead partners, Devin Talbott, is Strobe Talbott’s son. Devin used to work the Cohen Group, a merchant bank founded by former defense secretary William Cohen.
ES&S been backed for decades by private equity firm McCarthy Capital, whose current president and managing partner has a history of Republican donations. Recall how ES&S was run by Chuck Hagel until he left to run for the Nebraskan US Senate seat in the 1996 election and he won...and kept shares in ES&S as a senator. Old school election scandals of yesteryear. Quaint.
The third member of the oligopoly is Dominion, acquired in mid-2018 by Staple Street Capital, a mid-market buyout firm co-founded by two guys from the Carlyle Groups. Stephen D. Owens became a Managing Director the Carlyle Group before co-founding Staple Street Capital. And Hootan Yaghoobzadeh was a Senior Vice President at Cerberus Capital and worked at the Carlyle group before that. Recall how Cerberus’s founder and CEO, Stephen A Feinberg, is a major Republican donor and close Trump ally. Dominion bought Diebold’s Premier Election Systems in 2010. So any ‘bugs’ in Diebold’s voting machine were passed along to Dominion.
So private equity basically owned and operated the electronic voting infrastructure that ran the US 2020 election. Fun fact:
“The Canada-founded and Denver-based company was acquired in mid-2018 by Staple Street Capital, a mid-market buyout firm co-founded by Carlyle Group and Cerberus vets.”
That’s who owns Dominion Voting Systems. Staple Street Capital, a private equity group co-founded by Carlyle Group and Cerberus vets. Staple Street and its co-investors who can remain mysteries thanks to the opaque transparency rules for the private equity industry. And the rest of the electronic voting machine oligopoly is owned by private equity too.
So when President Trump tweets that Dominion cheated against him, it’s a good time to bring up the fact that entire electronic voting machine industry in the US is dominated by a private equity owned oligopoly. And since private equity is notoriously opaque, with ownership or investor identities often unclear and written in a notebook somewhere, we can confidently say that we don’t really know who ultimately owns any of the major voting machine companies. It’s a private equity ‘feature’.
Here’s a potentially great (potentially horribly great) example of why the growing reliance of pension funds on private equity investments is a recipe for disaster. Well, disaster for the public. For the private equity industry’s wealthy investors it’s more a recipe for avoiding disaster by passing that disaster along to the public:
It turns out the growing mega-hacking hacking scandal that his the US government and thousands of corporations involving SolarWinds has a private equity angle. A private-equity-scamming-public-pensions angle. Maybe. Either that or it’s a story about private equity investors getting incredibly lucky at the expense of a public pension plan.
On December 7, shortly before the SolarWinds hacking scandal was made public by the US government, two major private equity investors in SolarWinds sold a $315 million stake in the company to a Canadian public pension fund, the Canada Public Pension Plan Investment Board (CPPIB). 10 days after this sale the SolarWinds stock was already down 15 percent. As we’ll see in the second article excerpt below, the SolarsWinds stock is down around 26% this week. The two private equity firms, Silver Lake and Thoma Bravo, owned together roughly 75 percent of SolarWinds at the end up September and three members of each firm sit on SolarWinds’s board, which means these were the primary investors in SolarWinds who dumped that stock on a public pension plan right before this meltdown. Both Silver Lake and Thoma Bravo sold 5.8 percent of their shares in SolarWinds during this transaction, so it was still only a relatively small portion of their total stake in the firm sold to the CPPIB which is an indication of just how much exposure these two private equity entities have to the SolarWinds scandal.
How was this ill fated transaction orchestrated? Well, it also turns out that the CPPIB has has committed $1.7bn to four Silver Lake funds since 2004 and $1.1bn to five Thoma Bravo funds since 2014. So these were the same private equity investors that the CPPIB has been teaming up with for years and trusting to invest CPPIB funds in good faith who basically set the CPPIB to take to cushion the financial blow of this hack.
Of course, Silver Lake and Thoma Bravo are claiming that they knew nothing about the hack when they executed the sale of the stake on December 7. It was all just really bad luck for CPPIB and really great luck for Silver Lake and Thoma Bravo. Which would also make it a random coincidence that SolarWinds got a new CEO on Dec 9, two days after this stock sale. The timelines we’re being told is as follows:
Dec 7: the #15 million in SolarWinds stock is sold to CPPIB
Dec 8: FireEye, the cybersecurity firm, first announced that it was hacked.
Dec 9: SolarWinds gets a new CEO
Dec 12: SolarWinds is informed it was hacked by FireEye
Dec 14: SolarWinds publicly acknowledges it was hacked.
Based on this timeline, the defense of Silver Lake and Thoma Bravo is based on the timeline where FireEye informs SolarWinds about the hack on December 12 and not earlier. FireEye itself claims that it didn’t inform SolarWinds until December 12, so FireEye is backing up SolarWinds on this timeline. But, again, it sure is interesting that a new CEO was put in place just three days before SolarWinds allegedly first learned about the hack from FireEye. Also a coincidence? That’s what we are asked to believe. Heads we win, tails you lose. This only looks bad but there’s a good explanation:
“Institutional investors often cultivate long-term relationships with private equity sponsors in the hope of receiving side-benefits such as early access to new funds and the ability to co-invest in deals. CPPIB has committed $1.7bn to four Silver Lake funds since 2004 and $1.1bn to five Thoma Bravo funds since 2014, according to data from PitchBook.”
The CPPIB clearly trusts Silver Lake and Thoma Bravo. Years of investing billions with them demonstrates that trust. So was this misplaced trust? Or did the Silver Lake and Thoma Bravo merely get really, really lucky at the expense of the CPPIB? That’s the big question surrounding these trades. A question that comes down to whether or not SolarWinds really didn’t have any idea about the hack before the Dec 7 trade. Because if SolarWinds knew about it, Silver Lake and Thoma Bravo must have known too since they each have three executives sitting on the SolarWinds board:
But all parties involved are assuring us that SolarWinds had no idea about the hack until FireEye informed them on December 12, five days after the stock sale. And that includes the CPPIB itself, which released statement to Axios on Friday expressing its full confidence in Silver Lake and Thoma Bravo and an expectation that the private equity firms will continue to give CPPIB exceptional value going forward. So it will be interesting to see if there’s any meaningful investigation of this potential insider trading/client abuse scandal because the potentially abused client is already convinced no investigation is necessary. Heads we win, tails you lose. And we assure you everything is above board here:
“Per an 8‑K filing, SolarWinds says its CEO was first informed of the situation, by FireEye, on Dec. 12.”
December 12. That’s the date SolarWinds is giving for when its CEP was first informed of the situation by FireEye. It’s worth noting that this answer from CEO doesn’t address whether or not SolarWinds was already made aware of the hack through other means.
We also aren’t told by the CPPIB whether or not they knew about the new CEO announcement that was came two days after their $315 million investment. But the CPPIB told Axios it had complete :
Keep in mind that part of what makes this situation look so bad for Silver Lake and Thoma Bravo is that the two firms basically run SolarWinds. There’s nothing SolarWinds would know or do that Silver Lake and Thoma Bravo didn’t fully know about and agree to. So questions like the question of whether or not SolarWinds know about the hack before FireEye told them on December 12 double as questions of whether Silver Lake and Thoma Bravo knew about the hack before December 12. We’ll see what, if any, investigation happens.
And who knows, maybe it really was just bad luck for the CPPIB and great luck for Silver Lake and Thoma Bravo. It’s possible. Heads we win, tails you lose, because that’s how damn lucky we are. The only non-cheating form of ‘heads we win, tails you lose’. Hopefully that’s what happened here. Because otherwise the Canadian public is likely going to get ‘unlikely’ like this a lot more in the future.
Here’s a Financial Times article about the “K‑shaped” nature of pandemic economic in the US, where the biggest and strongest companies are getting bigger and strong while the smaller and weaker companies get smaller and weaker or die off completely. In many cases the pandemic exacerbated and accelerated existing trends, like the growing importance of the digital sector of the economy and online retail at the expense of brick-and-mortar enterprises. Some companies that rely heavily on brick-and-mortar retail have done well this year and seen their market share grow, but that’s primarily just the existing giants like Walmart, Costco, and Home Depot. The giants grew while the little guy perished. That’s one of the mega-trends of 2020.
The pandemic also created a situation where large firms with good credit can retain access to historically low interest rates and borrow massively. Large public companies with investment-grade credit ratings led a record $2.5 trillion of corporate borrowing this year. At the same time, one study found that the kinds of loans small businesses rely on from banks become much harder to acquire this year as banks tightened lending standards. Recall how Republican Senator Pat Toomey demanded that a Federal Reserve program that could act as a lender of “last resort” for small and mid-sized businesses be permanently ended as a price of getting his support for the COVID relief bill.
It’s a reflection of the “K‑shaped” nature of the recovery when it comes to big vs small businesses: the strong are given the best cushions money can buy while the small and weak get their credit cut off and then the GOP sucker-punches small business by pulling the “last resort” financial safety-net for no reason. Or as Blackstone CEO Steve Schwarzman put it, “I think it’s going to turn out to be another one of those acceleration moments,” in reference to the 2008 financial crisis where firms like Blackstone came out larger than ever. It’s another way of looking at the impact of the pandemic, where existing pre-pandemic trends are getting exacerbated and accelerated. Things are accelerating. Accelerating to new debt-fueled heights if you’re on top or accelerating into the ground for everyone else:
“Just as Blackstone had been “a huge winner coming out of the global financial crisis”, chief executive Steve Schwarzman told analysts who follow the private equity group recently, “I think it’s going to turn out to be another one of those acceleration moments.””
Another “acceleration moment” is upon us. That’s how Blackstone’s CEO sees the situation and he should know. The “acceleration moment” the private equity giant has experienced for over a decade now following the 2008 financial crisis is accelerating some more. But it’s not just Blackstone experiencing this “acceleration moment”, and these “acceleration moments” didn’t start with the 2008 crisis. Large corporations in the US have had a growing share of the overall economy for decades now. It’s been a mega-meta-trend in the US ever since it decided to embrace Reaganomics and supply-side economic policies. And now that mega-meta-trend is getting turbocharged by a pandemic that is systematically consolidating the position of largest industry leaders at the same time small and weaker players are systematically driven out of business:
And it’s a trend that showed up crystal clear in the 2020 bank lending trends, where corporations borrowed a record $2.5 trillion and yet, in the first half of the year, virtually ALL of the additional bank lending was being given to large corporations with strong credit-lines. Big corporations were given a golden credit card at the same time their smaller or weaker competitors found it harder to borrow:
And note the way the pandemic’s turbocharging of this trend of more and more industry consolidation — where only the top leaders in each sector survive as their competition perishes or are forced to let themselves get bought out — is spun by Mohsin Meghji, chief executive of the ‘restructuring advisory’ group M‑III Partners, which is the kind of business that makes its money when other businesses are going through things like bankruptcy. He described the scenario of the pandemic driving the weaker competitors out of business as a good thing for the American economy. Why? Because, argues Meghji, many of the weaker competitions should have been driven out of business years ago, and once they are finally driven out of business the remaining survivors will the the strongest. And therefore, by consolidating the industry into an oligopoly, this will create competition by creating clarity in the sector:
Killing off all the smaller and weaker competition with be good for the American economy and increase competition. These are the kinds of arguments we should expect to hear more and more as the economic fallout continues.
Now, keep in mind that Meghji is echoing an argument often heard in the financial sector that the historically low interest rates following the financial crisis has created ‘zombie’ companies that are only viable because of the cheap cost of borrowing and it would have been better to raise rates and just let them die off (creating an even deep Great Recession). And to some extent it’s going to be true that historically low interest rates have allowed for companies to survive that wouldn’t have otherwise been able to survive without years of cheap borrowing costs, albeit to different degrees in different sectors of the economy. But it’s obviously not always going to be the the case that the weaker companies — those that can’t survive a pandemic economy because they aren’t blessed with the stellar credit of their larger competitors — are ‘zombie’ companies that have no viable future and are just burning cash. And for private equity — where buying distressed companies that have a viable future and turning them around is supposed to be at the heart of what the industry does — they aren’t just interested in buying the remnants of ‘zombie’ companies. Healthy firms in the midst of a credit squeeze are going to be the juiciest targets. But expect to hear all sorts of excuses about how the upcoming economy-wide consolidation is actually a good thing because it’s so long-overdue. Oligopolies tends to have effective PR.
Also keep in mind that if ‘good for the economy’ is defined purely in terms of corporate profits, then, yes, it’s possible that a massive pandemic-driven consolidation of the US economy into even fewer hands really will be ‘good’ for the US economy. Of course, by that definition, wealth consolidation in general is as ‘good’ for the economy and the entire mega-meta-trend of wealth-capture that’s been going on for decades has indeed been ‘great’ for the economy. One great ‘acceleration moment’ that’s been going on for decades and just keeps accelerating.
The story of Robinhood and GameStop — where small time day traders on a Reddit message board used the power of social media and the deep public antipathy towards the super-rich to trigger a runaway short-squeeze in GameStop’s stock and billions of dollars in losses for the hedge funds shorting the stock — is one of those rare feel good stories where the little guy seemed to finally get the better of Wall Street for once. But one of the obvious questions raised by the story was whether or not the ‘little guy’ investors using social media to organize collective runs on stocks were, themselves, being manipulated by other Wall Street players. And while, at this point, we don’t have evidence that the populist campaign to buy GameStop stocks were somehow being driven by large investors, we also shouldn’t be too shocked if we do end up learning about powerful interests who wanted to see this social media experiment succeed. Especially since some of the most powerful private equity firms on Wall Street were major investors in GameStop and now their holdings are worth billions of dollars more:
“But even as the crusade continues, this isn’t a simple story of the little guy winning. The entities that own the majority of GameStop stock are also humongous investment firms and private equity. These entities, such as Fidelity and BlackRock, all own millions of GameStop shares each. Individual day traders spending a few hundred or thousand dollars on GME stock are making a bit of much-needed money, but these institutional funds’ positions are now in the billions.”
The little guy won at the expense of Wall Street. It’s the feel-good part of this story. The only problem is the little guy won to the benefit of some of the biggest players out there too, like private equity giant BlackRock. And, importantly, this is also going to be true for the rest of the stocks out there that end up being targeted by future populist short-squeezes. The biggest winners are inevitably going to be the biggest shareholders and the biggest shareholders of companies in today’s economy are inevitably big investors. That’s just the nature of the obscene concentration of wealth in modern America. The inevitable winners of any short-squeezes are going to be major shareholders who will ultimately be the super-rich:
Again, we don’t have any evidence that these financial giants actively used anonymous social media accounts to orchestrate this populist short-squeeze. But we can be pretty sure they’re thinking about it now. Why wouldn’t they? All they would potentially need is a few influential personalities on these stock trading social media boards to get the narrative going again. For all we know, we just saw the dawning of a new era of social-media-driven market manipulation that’s only just getting started.
At the same time, the idea of using genuine grassroots collective actions by small-time investors to bankrupt a hedge fund and dilute the dangerous concentrations of wealth is indeed quite appealing. If social media can really be used to make things at least a little less rigged in favor of the super-rich that should probably be seen as a positive development. So it’s going to be interesting to see what the future holds for online social-media driven populist investment campaigns.
Still, keep in mind that if a society relies on the collective actions of the little guy to out-rig the big guy in highly-manipulated financial markets as a means of addressing the broader issue of obscene socioeconomic inequality, that’s still closer to a peasant revolt than a real democracy. Actually taxing the super-rich in ways they can’t dodge, breaking up the grotesque concentrations of wealth, and finally regulating the routine market manipulation carried out by the hedge fund industry is probably going to be a lot more effective, and won’t end up accidentally making billions more for BlackRock.
Here’s a set of articles about an emerging trend in the private equity industry: special purpose acquisition companies (SPACs). It turns out SPACs are the new hot thing, with record filings in 2020, and the “king of SPACs” just happens to be Chamath Palihapitiya, the Silicon Valley investor who announced that he’s interested in running against Gavin Newsom in California’s gubernatorial recall race. Running as a populist. Sort of. The kind of populist who talks like a leftist with social justice concerns but is also calling for eliminating the state income tax. The kind of leftist who recently said the surge in the value of Bitcoin was a sign of the fragility of the financial system and the coming replacement of the dollar as the global reserve currency with a cryptocurrency ‘stablecoin’. The recall effort Palihapitiya has jumped into appears to be a far right project with heavy backing from the QAnon community, so we have a Silicon Valley investor who has been building his ‘public maverick’ cred in recent years playing a major role in facilitating a far right recall effort so he can run a ‘populist’ campaign against the Democratic governor. The red flags are bountiful.
Palihapitiya’s career in Silicon Valley was mostly work in the venture capital side of things with some years working on the technology side at AOL and Facebook. Following a stint at AOL in 2004, Palihapitiya got his start in Silicon Valley’s investment community at the Mayfield venture capital fund in 2005 before jumping over to Facebook in 2007 to be senior executive to work on their messaging service. He left Facebook to start his venture capital fund Social Capital in 2011. As we’ve seen, he’s been striking an increasingly populist tone in recent year. Recall how, in 2017, he told audiences that he felt Facebook and social media are tearing society apart and exploiting human psychology. Growing up as a poor immigrant in Canada, he’s also spoken positively of things like social safety-nets and the role they played in his life. He even said in 2016 that he would have thrown Peter Thiel off the boards of companies he owns over Thiel’s backing of Donald Trump.
So Palihapitiya has branded himself as another ‘candid’ Silicon Valley personality who is highly critical of the system that has made him a billionaire. But as we’ll see, he’s simultaneously got a history of railing against government and pushing ‘small government’ market-based policy solutions that sound a lot like libertarianism. And he just happens to owe his success greatly to Peter Thiel, who introduced him to the ‘PayPal Mafia’ network of investors when he was setting up his venture capital fund Social Capital in 2011. It appears that Palihapitiya is either loved or hated in the Silicon Valley investor community which makes his association with Thiel’s PayPal Mafia network all the more significant because he needs them for money. The broader possible investment community that comes with SPACs are reportedly part of the appeal they have to Palihapitiya and his polarizing views in Silicon Valley would play into that desire. That’s why it’s important that Thiel’s network of co-investors loves him and, more importantly, invests in him. That’s his based of support.
We can be assured that California’s right-wing business community is going to have an interest in cultivating business-friendly ‘left-wing’ political forces which is part of why this is an important story. Recall PayPal Mafia alum and LinkedIn founder Reid Hoffman, who also has a history of publicly supporting Democrats while railing against government bureaucracy and advocating for a hyper-capitalist pervasive gig economy. A global gig economy powered by a kind of super LinkedIn. And now we find what appears to be another libertarian wolf in sheep’s clothing fueling a far right recall campaign while putting forward a populist persona. And this libertarian wolf is the king of SPACs, one of the hottest trends in finance.
So what exactly are SPACs? Well, they’re sort like a hybrid of private equity and publicly traded companies: investors buy shares in a newly formed company, but that company has no purpose other than to merge with another company with the eventual goal of bringing the merged company to the public with an IPO. Compared to traditional private equity, SPAC deals draw from a much larger pool of potential investors, have fewer regulations than a traditional IPO, and the founding investors tend to get a larger share of the resulting publicly traded company with fewer investments. So SPACs are basically an alternative model to the private equity industry and one that is arguably a better alternative, hence the record year for SPACs:
“The 28 filings for new special purpose acquisition companies (SPACs) underscore their growing appeal on Wall Street. SPACs raised a record $82 billion last year, and the trend has gathered further steam in the early weeks of 2021.”
2020 was a record year for SPACS and 2021 is on track for another record. Wall Street loves these blank check shell companies. Because it’s a better investment to buy a private company than buy public stock. In the context of the historic stock market mega-bull run of the last decade that even COVID couldn’t stop, the fact that financial circles have record interest in blindly buying private companies to sell on the stock market in IPOs is a market signal in terms of where we are in terms of stock valuations relative to fundamentals. It’s also a sign of how much more advantageous the rules for SPACs are compared to the alternative investment options that the private equity industry routinely deals with. And that’s why, as the following PitchBook article makes clear, if SPACs are experiencing record inflows it’s probably the private equity industry we can thank:
“SPACs essentially function as shell companies, with no operations of their own. They first raise capital from outside investors in an IPO, and then later use the proceeds of that offering to acquire a private company in a reverse merger. The target company is still subject to certain regulatory reviews, but the process offers a simpler path onto the public market than the usual IPO roadshow—particularly now, when travel and in-person meetings are much more difficult. SPACs have existed since the 1990s but only began to come into vogue in recent years.”
Shell companies that exist exclusively merge with other companies and then go public, but allow for investors from a much broader group than traditional private equity. You can see why private equity would be interested:
SPACs are where it’s at. At least right now when stocks are near record highs and it’s a great time to engage in an IPO.
And as the following Jacobin article describes, the ‘king of SPACs’ is currently attempting to unseat the governor of California under a banner of populism. Populism that, upon closer scrutiny, appears to be a lot of traditional libertarianism and ‘market-based’ policy solution, but solid with a genuinely much more empathetic messenger in Palihapitiya.
He talks a great game about how the system is rigged by the powerful against the masses and how this needs to change. And then he proposes solutions that make the powerful more powerful. It’s either some serious political confusion or fundamentally right-wing populist campaign that has taken on a leftish veneer. And given that Palihapitiya career as a venture capitalist was propelled by his relationship with Peter Thiel and his plans for California involve eliminating the state income tax, we should probably be suspecting the worst:
“Palihapitiya is known as the king of SPACs, which are shell companies used as vehicles to take other companies public. SPACs are a cheaper and faster alternative to the initial public offering (IPO) route but come with more risks for investors who effectively go in blind since the companies are formed without specific targets in mind. In the 1980s, they were known as “blank check companies” and were hotbeds for fraud, though the rules surrounding them have been tightened since.”
The king of SPACs wants to become governor of California. He’s talking a populist game. But he also talks like a corporatist libertarian who at best presents a ‘Third Way’-style center-Right collection of policy prescriptions while pumping Bitcoin, railing against ‘big government’ and advocating a government shut down. Even his proposals for California include eliminating California’s income tax:
And to top it all, we find that Palihapitiya was an early investor in Peter Thiel’s Palantir, with Thiel also investing in Palihapitiya’s venture capital firm, Social Capital, and introducing Palihapitiya to “other PayPal executives” which is presumably a term for the PayPal Mafia Silicon Valley network:
So when we learn that Thiel has been investing in Palihapitiya’s venture capital firms, keep in mind that there’s a good chance this broader PayPal Mafia network of obscenely wealthy people have played a major role in financing Palihapitiya investments, in addition to Thiel. That’s part of why Thiel’s introduction of Palihapitiya to the ‘other PayPal executives’ is potentially a very significant detail in Palihapitiya’s career path from senior Facebook executive to “king of SPACs” and a big part of why the voters of California should be extremely wary of this ‘populist’ libertarian financier claiming to be looking out for the little guy. That’s the network that’s providing him a base of financial security while he rails against Silicon Valley.
And as the following May 2020 profile of Palihapitiya in Instituational Investor describes, his growing reputation as a vocal insider critic of the financial system that drives Silicon Valley has and harsh social media critic has made his relationships with the PayPal mafia network of investors all the more valuable. Because a lot of the rest of the Silicon Valley investment community hates him for his comments. So Palihapitiya is seeming to wage a populist insider Silicon Valley crusade with the backing of Thiel and the PayPal Mafia. It’s the kind of arrangement that should, at a minimum, give one pause. But as the following article also makes clear, Palihapitiya is very serious about talking his populist game. Palihapitiya explains that it’s only been in the last few yers that he’s felt free to express his contrarian views critical of the investment community and how things like expected short-term investment returns skew business decision-making in a negative way. But now he’s free to share how he really feels, which is apparently a feeling that the system needs profound change. Now, as we now know, that kind of profound change includes policies like eliminating California’s income tax, which gives us a sense of the kind of policy solutions. But as this profile of Palihapitiya from May fo 2020 makes clear, he’s very much interested in cultivating a public persona of being highly critical of the systemic inequities exemplified by Silicon Valley and very much interested in social reform. He wants to be the kind of change agent that advocates for fundamental change, which is why the foundations of his true ideological orientation are important questions yet to be answered:
“Palihapitiya still believes that reform is coming — but probably not until 2024. “Right now we are going to go through two or three years of pain. And then I think going into 2024 and out of it, we’ll have a political change, we’ll have an ideological change.””
An ideological change is coming to America in 2024. That’s the prediction of Chamath Palihapitiya in this May 2020. An ideological change that he clearly has an interest in catalyzing. The guy has ambition. And until 2024, he predicts simultaneous deflation with asset inflation (very plausible and an extension of the trend we’ve seen for a while in the US) with the possibility of massive civil conflict. But instead of blaming that massive civil conflict on Donald Trump and the militant far right, he appears to blame the Federal Reserve’s monetary policies and pines for a next generation of leadership that avoid this massive civil conflict:
And more general, Palihapitiya has spent the last few year rebranding himself as a critic of his own class. The Silicon Valley venture capitalist class. It’s part of what’s led to his image as a polarizing figure who has half of Silicon Valley not wanting to talk to him and the other half, with PayPal Mafia half, financing his rise as a venture capitalist:
And then, around 2018, a number of executives left his Social Capital fund at the same time Palihapitiya cut off additional outside funding and began talking about changing how the fund was ran and making the investment decisions in isolation. This break from the venture capital fundraising was apparently was freed Palihapitiya to start becoming more vocal about his concerns with the systemic problems of venture capital:
And yet, while Palihapitiya stopped taking venture capital money in 2018, he apparently started taking in billions of dollars in “blank-check IPO” SPAC money right at this time. So he didn’t break off outside funding. He just shifted from venture capital funding to SPAC funding. Which, in theory, does allow a broader field of potential investors. But it’s still mostly just really, really rich people and probably largely the same people who would have invested through the venture capital anyway. In other words, largely cosmetic:
And that’s the disturbingly fascinating developing story of Chamath Palihapitiya and his quest to recall Gavin Newsom and run California. He’s gone from one of Silicon Valley’s venture capital shining stars to the ‘king of SPACs’ and one of Silicon Valley’s venture capital biggest critics. So he is in theory free of Silicon Valley’s oligarchic influences now that he’s jumped from VC to SPACS, and yet he’s chosen to support a far right recall effort on a platform of eliminated the state income tax. This doesn’t look good for the prospects of Palihapitiya actually doing good if he’s given power. The recent history of businessment promising to ‘shake up’ politics isn’t exactly great.
So now that SPACs are a hot new investment vehicle, and one that democratizes finances as Palihapitiya puts it, we have a timely reminder in Palihapitiya that even if SPACs free up people like Palihapitiya from having to care what the rest of Silicon Valley investment community thinks (in theory), it doesn’t free them of their ideologies. That requires a different kind of investment.
With all of the growing interesting in special purpose acquisition companies (SPACs) in the venture capital industry — where companies are incorporated for the sole purpose of buying up existing companies — here’s an article about another alternative form of investment that investors are flocking towards: secondary private market sales, where the shares of a privately held companies are sold to other investors in privately arranged transactions.
Secondary private market transactions have the obviously advantage over buying publicly traded shares in that you can buy shares in privately held companies, especially before they go public. But there’s a distinct disadvantage to buying publicly traded shared: the disclosure rules are far more lenient for the sale of privately held shares. Lenient in the sense that much less needs to be revealed to the buyer about the company’s internal finances. In other words, when shares are traded in a privately held company it’s a lot easier for a seller to unload the shares without revealing problems with the company’s finances. So the secondary private market is tempting to buyers looking to purchase shares of companies early before they have their IPOs, but also tempting to sellers who can unload shares with fewer disclosures. All in all, we can see why there’s growing interest in the sector. It potentially gives buyers and sellers an edge. Specifically, buyers and sellers who possess an information edge have a big potential advantage in this unregulated sector.
But there’s another significant new development in this sector: multiple groups are planning on creating what amounts to secondary private market exchanges, in the hopes of creating the private market equivalent of the Nasdaq or New York Stock Exchange. Brokerages where anyone can go by buy privately-owned shares. The market already exists, but it’s currently split up between dozens of different brokers. What we’re seeing now is the push to consolidate that market place, and therefore capture all of those fees.
To get a sense of the scale of this market, according to a Financial Times analysis, there are an estimated 546 “unicorn” private companies with a collective value of $1.8 trillion. So just the “unicorns” alone have trillions in privately held shares that can potentially be privately traded. Now consider the much larger universe of private non-unicorn companies and factor in that this is a market where companies don’t have to disclose their finances in the same way publicly traded companies do. But some of those non-unicorns are obviously yet-to-be-discovered unicorns that are probably a great bargain if you can get your hands on those privately-held shares. So we have the makings of a marketplace comprised of juicy “unicorns” and yet-to-be-discovered unicorns hidden in a sea of lemons. And minimal transparency rules. As the article describes, the demand for privately held shares is huge and growing. It’s the supply that’s the problem. And these markets could facilitate growing the supply of available privately held shares by providing those shareholders ready access to market with a huge supply-demand imbalance. The opportunity for IPO prices without the actual IPO. What could possibly go wrong?
One such company working to create a private share Nasdaq, Carta, has the backing of Silicon Valley investor Marc Andreessen. Another, Zanbato, is backed by JP Morgan. Zanbato’s plans are somewhat less populist than Carta’s, and limited to acting as a central matchmaker for more than 100 banks and brokers executing orders on behalf of clients. Even Nasdaq itself is reportedly working on some sort of private share marketplace. Carta’s founder, Henry Ward, says he envisions his private share exchange as allowing companies to raise capital while remaining private forever. So the growth of the private secondary market is, in some sense, the emergence of a new regulatory loophole to allow companies to avoid the regulations of publicly traded companies.
The overall trend in the ultra-hot IPO market is clear. Barring regulation, the direct sales of private-held shares is coming one way or another. Which means, in reality, we’re looking at an emergence of a new barely regulated stock market driven by the market dynamics of obfuscation and deception and everyone plays ‘find-the-hidden-unicorn’:
“Until recently, private secondary markets resembled “that guy with a trenchcoat that’s selling you watches in Times Square”, says Inderpal Singh, who leads a private secondary market project at the start-up marketplace AngelList. “In the last year, there’s been a big shift.””
Yes, until last year, the private secondary markets resembled “that guy with a trenchcoat that’s selling you watches in Times Square”. This is the sector of finance that’s exploding now, with a growing number of companies promising to bring those ‘guy with a trenchcoat that’s selling you watches in Times Square’ services to the broader public. They’re even lobbying the SEC to relax restrictions on who can purchase shares in private companies. Again, what could go wrong?
And notice how Carta’s CEO, Henry Ward, talks about his dream of creating a system where companies can access capital markets while remaining private indefinitely. And Carta investor Marc Andreessen speaks of how companies don’t have to be public or private and that’s there’s a ‘third way’. This is the third way: private companies funded in the private secondary markets markets made available to the public:
But these private secondary market exchanges like CartaX are still going to have disclosure requirements of their own. In the case of the CartaX exchange, it forces companies to share two years of financial statements prepared using generally accepted account principles, which grants them a regulatory exemption that allows for an unlimited number of a accredited investors to use their platform:
So Carta is requiring some degree of public disclosure by these companies, but only because that’s the price they had to pay to get a regulatory exemption on the number of people, which is an exemption they would obviously need to make the exchange open to the broader public. It’s an important detail because it raises the question of what happens if that security regulation is relaxed. Like, what if the two year disclosure is dropped entirely or exotic accounting rules are allowed by the SEC in order to quality for the exemption that grants unlimited investors to access the exchange? Will Carta similarly relax its disclosure rules? Drop them entirely? We don’t know. But the fact that Carta’s two year disclosure requirement was put in place to gain that securities exemption, and not out of a dedication to greater-than-required-transparency, doesn’t bode well.
And that points to what is probably the most ominous aspect of this story: it’s a financial industry story so we know it’s going to get worse. As bad is this idea sounds now, it’s going to get a lot worse. Regulators will be lobbied, legislators bribed, and whatever else that is required to make this ‘third configuration’ publicly-financed private company a reality will transpire. Something will be done to turn the private secondary marketplace of shares into a ticking financial time bomb that makes a select few fortunes before blowing up while the public holds the bag.
We know that’s what will happen because that’s the only thing that happens when concentrated wealth captures the economy and politics to the extent that it has done so in the US. New exotic ways to break the rules and blow up bubbles are devised. A bunch of ‘innovators’ make obscene bubble fortunes. Whatever safeguards to the public that happen to be put in place will be eventually removed and then it will all blow up in a manner than was obviously inevitable with no one held accountable and the public holding the bag. It’s the latest iteration of that same old story. That same old story that somehow never gets old.
Here’s an interesting story about private equity in the coal industry that has suddenly become much more topical in light of the Texas winter blackout disaster:
It turns out private equity has been busy buying up coal plants of late. It’s a rather unexpected shakeup for an industry that’s long been seen as a dying legacy that humanity needs to phase out and replace with renewables. So why is are private equity companies so interested in a dying industry? Because coal tends to play a special role in the US electrical grid: backup power.
Yes, it turns out that states with harsh winters like Pennsylvania and Michigan have coal powered electrical plants that are paid to essentially not operate but be ready to operate at a moment’s notice. These payments are called capacity payments, and grid operators tend to favor coal powered plants that keep a large stockpile of coal on hand for these payments.
Now, it’s worth noting that in the case of Texas and the blackouts, there was no issue with the backup power segment of the power market because there is no backup segement of the Texas power market. Instead of paying energy operators capacity payments to ensure there’s enough power available under high-stress periods, Texas lifted the maximum price that producers could charge to $9,000/megawatt-hour and assumed that allowing such exorbitant prices would ensure there’s enough capacity. So this issue with private equity buying up the backup power capacity of the electrical grid excludes Texas because Texas has an even more insane market design.
And as we’ll see, there’s another reason private equity has shown a new interest in coal. Sadly for coal workers, it’s the same reason private equity shows an interest in all sorts of dying industry: it’s a new opportunity to load the companies up with debt to pay out dividends to the private equity shareholders. So private equity is basically trying to capture the market for these potentially lucrative capacity payments by buying up companies in a doomed industry and then accelerating the doom by loading the companies up with debt:
“The so-called capacity payments are given out in most U.S. power markets, and regulators tend to favor coal-fired generators that store heaps of coal on site when other power sources might be disrupted. In the Pennsylvania, Jersey, Maryland Power Pool (PJM), which has the largest standby market, capacity revenue payments average more than $100 per megawatt per day — an insurance policy that costs about $9 billion a year and aims to make sure the grid’s 65 million customers avoid blackouts during heat waves and Arctic blasts.”
A power insurance market that pays out $9 billion a year in capacity payments for the states of Pennsylvania, Jersey, Maryland alone. That’s the scale of this sector of electricity market the private equity industry is trying to corner.
And the fact that coal plants are the kind of thing a lot of activist shareholders reject over ethical concerns only makes it that much easier for private equity to succeed. They’re lack of ethical constraint allows them to go where other investors won’t:
But the capacity payments are just one of factors enticing private equity to enter thes sector. The fact that they can load up these companies with debt to pay themselves dividends. It’s an oldie but a goodie:
But there are still risks with these kinds of investments. Risks like regulatory changes intended to phase out coal entirely. But as we saw, the industry has its ways of transferring those risks to others while locking in the gains. It’s the creditors who finance these debt-fuel dividends who are assuming that regulatory risk:
Finally, note how the prevailing ultra-low interest rates are helping to fuel this trend: As long as the bonds issued by these private-equity-owned coal companies (to pay out dividends) are paying rates higher than the current historically-low treasury rates, there’s going to be demand for those bonds:
And keep in mind that, should rates on US treasuries rise, the rates offered on these coal company bonds are going to have to rise too, further indebting these companies. In other words, while the trend of buying up coal companies and loading them up on debt is certainly concerning, it’s going to become a lot more concerning in the future as rates rise. At least concerning to those bond holders who financed the dividends.
And that points towards a larger concern that we should keep in mind about what private equity has been up to in recent years as the rates on US Treasuries are at a 1‑year high and threaten to go higher in the future: the private private equity sector has had an unprecedented opportunity to load up the companies they own with debt at historically low interest rates. And when an industry that exists for the purpose of buying up companies — typically using lots of debt following by loading those companies up with even more debt to pay out dividends — has access to record low borrowing costs, we should expect record high borrowing from the these private-equity owned companies. Record high borrowing that’s only going to get more expensive as rates rise. It’s the kind of dynamic to could wreak havoc across all sectors of the economy with heavy private equity ownership, not just the coal industry.
Finally, keep in mind that an industry that’s notorious for gutting the companies it owns and driving them into the ground probably isn’t the best industry to rely on for backup power capacity.
Here’s a pair of articles about a growing pandemic-fueled trend in the insurance industry. A trend that, if critics are correct, is only going to result in the private equity industry finding a new source of profits to exploit, with the individual life insurance and annuity policy holders paying the price:
First, here’s a report about a new insurance industry survey showing a significant uptick in life insurance policy sales over the past year, presumably as a result of the pandemic. At the same time, the survey notes that life insurance coverage for US citizens is at the lowest point since the survey was started in 1960, with just 52% of Americans owning a life insurance policy out of their workplace coverage (workplace coverage that is inadequate for many families). About 40% of the US adult population falls into the categories of being uninsured or underinsured according to this survey, with the cost of life insurance cited as one of the chief reasons people are going without it. So it sounds like the a pandemic managed to increase the demand for life insurance, but that jump in new policies doesn’t fully reflect the rise demand for life insurance because a large portion of the populace can’t afford it even if they want it:
“Limra researchers found there’s a historical basis for pandemic fears causing families to make life insurance a priority. Based on data from the country’s top three mutual life insurance companies, the number of policies sold, on average, increased 58% in 1919 — the year after the flu pandemic of 1918.”
There’s nothing quite like a deadly pandemic to remind people of their own mortality. And almost half the US populace is uninsured or underinsured, with the lack of affordability being one of the top reasons:
So is there some hope around the corner for that large group of US adults who simply can’t afford decent life insurance? Not really. But it sounds like there’s plenty of hope for the private equity industry to increase its profits by buying up life insurance companies and squeezing them for whatever profits they can get:
“Critics are concerned the buyers will wring profits from customers — via higher costs — to boost returns for their investors. Consumers may have owned such insurance for years and depend on a certain price for their financial plans.”
With the new private-equity owners of these life insurance policies attempt to raise fees to maximize profits or lower fees to be nice to the policy holders? Hmmm...which of those options will the private equity industry choose? It’s such a mystery:
And note the tepid consolation from Fitch analyst: it’s not like ALL the private equity buyouts in the life insurance sector are inherently bad? It’s not exactly reassuring. Also, recall how the credit rating industry played a major role in fueling the 2008 financial crisis by systematically understating the risks associated with mortage-backed securities and these underlying conflicts of interest in the industry continue to this day. So when we hear a Fitch analyst assure us that there really shouldn’t be THAT big of a concern about the financial stability of these new private equity owners, it’s the kind of reassurance we should take with a big grain a salt. As the 2008 financial crisis made clear, the business model of the credit ratings agencies are to provide credit ratings in exchange for a fee. Not necessarily accurate credit ratings:
Also note how, while we are being told that the new private equity owners won’t have an incentive to abuse their new clients because that would damage their reputation and hinder their ability to get new business, that logic doesn’t apply when it’s solely legacy policies that are purchased. There aren’t going to be any new clients to worry about in that case:
Finally, note how part of the explanation for why we shouldn’t be too concern about the financial stability of these new private-equity-owned insurance companies is that the private equity firms can leverage the insurance pools. And while it is true that ‘risk pooling’ is an established way for individual insurance companies to lower their costs by pooling their risks together, these risk pools could also be turned into financial time-bombs if the companies in the pool are collectively trying to juice their profits with risky investements. And yet we’re also told that private equity firms might be able to achieve higher yields than traditional insurance companies because private equity firms can be invested across a broader range of assets that earn higher returns than traditional bonds. It’s another way of saying private equity can earn higher returns than traditional insurance companies because private equity can invest in riskier assets. What could possibly go wrong?
So it looks like we’re seeing the development of a life insurance marketplace where private-equity-owned insurance companies can increase profits by making higher-risk investments than traditional insurance companies while ostensibly mitigating the elevated risk by pooling their higher-risk investments together.
Now, in fairness, pooling assets does reduce net risk. But that’s only true as long as there aren’t systemic risks affecting all of the assets like we saw with the 2008 financial crisis and the systematic underpricing of risk in the mortgage-backed securities market. And that points to one of the biggest risks created by this new life insurance industry trend: life insurance policies are slated to become much more exposed to the systemic risks of the US financial system.
In other words, if you happen to have a large life insurance policy that you are hoping will be there for your descendents, the odds of your life insurance policy actually being paid out to your family will be a lot higher if you can managed to get all that dying taken care of before the next financial crisis. No rush. Well, ok, there’s actually a bit of a rush. But don’t rush it too much.
The New York Times has an article about a business trend that, in once sense, is like an annual article that gets written every year. But in another sense, it’s a very unusual article about a very unusual occurence. And it’s the fact that this is an article about a very unusual occurence that’s also business as unusual that is perhaps the most significant:
It turns out CEO pay at publicly traded US companies remained essentially undented by the pandemic-induced economic shock of 2020. Workers were frozen or fired. But it was the status quo for CEO compensation. Same as last year. And the year before that. And a couple of decades before that too. Sky high. Same as always in the modern post-Reagan age for America: Heads we win, tails you lose. Especially during a pandemic.
So what’s the explanation given for keeping CEO compensation packages at their already absurd levels even during a global pandemic? Part of it has to do with the nature of modern executive compensation packages: much of the executive pay comes in the form of stock options which have similarly defied the pandemic and near records highs. So in that sense this is another aspect of how we’ve systematically rigged the US economy for economic capture by the executive class by creating a society that requires a booming stock market for everyone — to keep 401ks financed, etc — while systematically handing out large chunks of the ownership of that stock market directly to executives. It’s like we’ve structured society into a giant golden parachute.
But we’re also told in the story about how corporate boards viewed the pandemic as an ‘Act of God’ and justified maintaining high pay even in the middle of mass layoffs by arguing that it really wasn’t anyone’s fault.
So we can now answer the question of whether or not a global pandemic that shutters much of the global economy for a year can make a real dent in executive pay. And that answer is no. It’s the kind of question we never should have had to ask, were it not for the collective actions of executive compensation boards for large corporations seemingly everywhere:
“The coronavirus plunged the world into an economic crisis, sent the U.S. unemployment rate skyrocketing and left millions of Americans struggling to make ends meet. Yet at many of the companies hit hardest by the pandemic, the executives in charge were showered with riches.”
Heads we win, tails we win, pandemics we win. It’s all about winning. Winning by greater and greater margins over the past four decades:
How much winning is too much winning? It’s the question corporate America probably doesn’t want the rest of the country to ask. It’s the kind question that could raise a whole host of other unpleasant questions. Unpleasant questions like what it is that the CEOs actually do with their time that provides genuine value to these corporations on par with their compensation? Like, what are some examples a genuinely innovative or impressive decisions being made by these figures that played crucial roles in the success of the companies and/or benefited society at large? Like, are there any examples that could be listed for all the top executives where they made a decision demonstrating real wisdom or insight that couldn’t easily have been made by a range of other people at the company? Do such wise decision ever happen for people in these position being paid massive small and large fortunes each year? If so, how often are these wise decisions made? Like once a week? Once a year at least, right?
It all points towards one of the interesting ironies in modern America: the class of super-rich who most transparently deserve their wealth are movies stars and professional athletes. Not because being a movie star or professional athlete should necessarily make one super-rich, but at least in those professions you have a sense of the service they provide in exchange for that wealth. Very wealthy doctors at least hopefully provided a lot of good medicine/incredible plastic surgery in return. What genuine service to these companies did these highest paid executives actually provide last year that could warrants pay on this scale? We have absolutely no idea. Think about it: we just read an article about how executive pay continued its multi-decade surge despite an economically-crippling pandemic and the primary reason given in the article for why this pay was so high were the excuses given for why executive compensation boards felt like it was unfair to punish the executives for a pandemic that was seen as an act of God...
...and yet there’s almost never an explanation given from corporations for why the corporate executive pay was that high on the first place. Companies can just point to ‘the market’ for CEO pay and observe that ‘everybody’ is paying really high compensation packages and justify almost any absurd compensation package based on that.
Sure, compensation in the form of stock options and historically high stock prices have played a role in this trend, but this is clearly not something driven just by stocks. And when a country structures its society around an ever-rising stock market — which is exactly what the US has done by shifting to a 401k-centric retirement model — we can’t treat stock options as just an incentive too. It’s part of the rigging. Plus, it’s not like stock options are free for the rest of the investors. It points towards a fundamentally broken marketplace for CEOs that’s operating more like an unchecked union for the executive class. As long as all the executive compensation boards grossly over-pay their executives, it’s no one’s fault. Just blame ‘the market’ for executives.
At least with some of the top executives, like Jeff Bezos, they can claim to have started the company. Not that there still aren’t major issues with own US-style modern capitalism systemically shunts almost all of the value generated by everyone into the hands of the ‘ownership class, but at least some of them can make a legacy claim about started the company. What about executives who just kind of rose through the ranks or got recruited to be a CEO? What novel value are they actually providing? It’s in increasingly important question. Increasingly important because the more the CEO-to-average-pay ratio grows the more important the question becomes.
Even worse, as the executive class and investor classes capture greater and greater shares of the overall stock market, the natural market counter-force for this trend — the corporate owners putting a stop to executive over-compensation — can get blunted. It’s corporate compensation incest, which means we can’t just hope that ‘activist shareholders’ are going to reverse this.
It points towards an interesting tool that could be used by society at large solutions for addressing this issue: create the social expectation that companies actually provide to the rest of society a general description of the actual services provided by the highest paid officers in the company for the past year. Like, what did these people actually do that was in any way significant? Could creating such an expectation that companies actually attempt to justify their executive compensation packages to the general public actually shame companies into reigning in these absurd pay packages? Industries can be incredibly complex that require specialized knowledge and experience that only a few people have. It’s not like there isn’t a case to be made for why a CEO could justify a high pay. But when the growth in CEO pay surges past the pay of everyone else decade after decade, some public justification for why that’s happening should be seen as a basic required for the integrity and logic of capitalism to keep working. If the general public stops believing the people who own the economy basically earned that ownership, that’s kind of an existential threat to something like capitalism. Or at least supposed to be in a free society.
Along those lines, if we were to apply this expectation to And L Brands to explain why Andrew Meslow was paid $18.5 million during a year when he cut office staff and temporarily closed most of the company’s stores...
... note that there is one major service Andrew Meslow provides that his predecessor, Leslie H. Wexner, couldn’t provide the company: Meslow can honestly claim to NOT be one of the closest figures to Jeffrey Epstein and arguably the secret sources of Epstein’s wealth. Which is something Wexner can’t quite claim. So in that sense, Meslow really has provided his company an enormous service. Although it seems like there should be a lot of people who could provide that service. Maybe Meslow knows a ton about firing people extra-profitably and that’s the great service he provided. Who knows, but it would be nice to hear even an attempt at an explanation one of these years.
Jonathan Gray, president and chief operation officer of private equity giant Blackstone, recently held a results call that included some pretty remarkable statements about a growing trend in the industry that Gray is predicting will be growing much more going forward that represents a fundamental shift in the private equity industry’s business model. A shift away from a focus on debt-driven shorter-term acquisitions with an eye on making a quick profit towards more a ‘Berkshire Hathaway’ business model of long-term ownership of companies.
To put it in industry jargon terms, ‘alternative asset managers’ (private equity firms) are increasingly creating non-private equity investment funds called “perpetual capital” funds, which are basically funds where investors are not interested in cashing out any time soon in favor of long-term investments that can generate an income. Which is basically antithetical to the short-term ‘borrow, buy on leverage, and sell for a quick profit’ model that has been generating the industry turbo-charged returns in recent decades. It’s also obviously potentially very tempting to pension funds that might value consistency over net-returns, although we’re also told that these long-term investments shouldn’t expect the same kind of rates of return as the prevailing higher-risk/higher-reward private equity model. It’s like an investment product that offers some of the rates of return of high quality corporate bonds for the perpetual capital fund investors, but instead of buying the bond they’re buying the corporation and milking it for a steady revenue stream.
It sounds like Blackstone has been leading the industry in perpetual capital, opening a number of funds over the last 7 years with a focus on real estate investments. But other firms have been using perpetual capital for purchases of life insurance and annuity companies. So while the private equity industry has been increasingly shaping the global economy for decades, that presence might be more strongly felt as giants like Blackstone become Berkshire Hawathway-like long-term owners of a growing portfolio of companies.
And perhaps more importantly, that means private equity firms like Blackstone will have the ability to impose its traditional cut-throated management attitude — and least when it comes to employees vs investors — on a growing number of large employers for decades to come. It’s an ‘alternative asset management’ industry capture of corporate decision-making.
What is driving this change in the long-standing private equity business model? Well, on the one hand, the industry is telling us that investors appreciate the steady income streams that can come with long-term investments. At the same time, as the article notes, it’s possible this shift is a reflection of asset manager’s changing expectations about the long-term viability of maintaining the private equity industry’s relatively high annual returns. Recall how much of the explanation we’ve heard for why pension funds are increasingly invested in private equity is due to the historically low rates of returns available elsewhere. So if it is the case that the private equity industry is facing a future if lower expected returns, that effectively doubles as a warning to pension funds unless these perpetual capital funds can fill the gap. Let’s hope that’s possible but it sure sucks that we have to hope the private equity industry — which is like the legal manifestation of a scammy/predatory economic model — does well on its new perpetual capital business model to save the pension funds. It was always one of the tragic parts of tying the fate of peoples’ retirements to an industry that primarily exists to make the rich richer.
We’re also told that the COVID pandemic played a role in this historic industry shift from short-term to long-term investment in the sense that the pandemic limited the ability of private equity firms to exit out of their investments. But at the same time, the experience gave private equity giants like Blackstone a new appreciation on the value of patient long-term investors who are willing to sit on an investment until better opportunities to sell emerge. And let’s not forget that the private equity industry has exploded during the pandemic in part because it is an industry incredibly well-positioned to benefit from the economic turmoil of the pandemic. So part of the shift to perpetual capital may be due to the pandemic causing the industry to recognize the perks of long-term investment funds over the traditional ‘turnaround’ model. But it’s also the case that the industry is sitting on records amount of cash, in part because investors gave it record amounts of cash because they know it’s the industry that always wins in our ‘heads we win, tails you lose’ economy and the pandemic created a whole bunch of new economic losers.
So it sounds like the private equity industry — an industry with a traditional business model of leveraged debt and fast turn-arounds — is hitting some sort of saturation point. Too much cash. Not enough investment options. And lots of investors who now need to be convinced that these forced changes to the industry business model are in their best interests too:
“As the process of investing gets longer and harder, alternative-asset managers may be admitting that they can no longer guarantee the high-octane returns they used to produce. At the same time, they are discovering that it may pay to be patient.”
Yeah, you can’t just keep shoveling record amounts of investor money into the private equity ‘alternative asset management’ space year after year and expect to find endless opportunities for the traditional ‘turnaround’ model. New types of asset management will need to be invented to come up with things to do with all that money and “perpetual capital” is how they going to do it. Now we know how the obscene amounts of money flowing into the private equity space will be used. It will spill over into the long-term capture of more and more of the economy:
But as the following Forbes piece notes, Blackstone didn’t just jump into the ‘perpetual capital’ business yesterday. Their core real estate perpetual capital fund was started seven years ago and now has $77 billion in assets under management. And Blackstone is just the biggest example in a trend that’s already well underway across the industry, with perpetual capital funds gobbling up companies in industries like life insurance and annuities:
“This quarter’s earnings were aided by an ongoing push into perpetual capital—essentially, fee-generating assets that can be held for an unlimited time horizon, with no rush to return cash to LPs. It’s a type of investment that’s booming in popularity across the private equity sector. To explain the appeal, Gray continued his botanical metaphor.”
Fee-generating assets that can be held for an unlimited time horizon. It’s certainly different from the ‘turnaround’ model. And while there’s no shortage of significant problems with the impact the ‘turnaround’ model has the economy and society — with its focus on aggressive cost-cutting and short-term thinking — it remains to be seen if having the industry get into long-term investing will make the situation better. It might just translate into making the short-term thinking the industry is known for into the long-term thinking of one employer after another across the economy. In perpetuity. Or at least until the assets are no longer generating enough income, at which point they can be ‘turned around’ (stripped and gutted) and sold back to the public under the traditional model.
There was a recent Bloomberg article about the history of the Colonial Pipeline and the various changes in ownership it underwent over the decades leading up to the great ransomware hack of 2021. The article contained some fun facts about the ownership history of the pipeline that could be important to keep in mind now that the private equity industry is setting its sights on the ‘perpetual capital’ model of investing, where investments that pay steady income streams are held over long periods of time instead of the tradition ‘turnaround’ model. Because not only are the Koch brothers the largest investors in the pipeline, but more recent investors include private equity funds managing on behalf of pension funds, including a state-run Korean pension fund. And it sounds like the pipeline has been treated like a financial asset over the past decade — paying out almost all profits as dividends — at the expense of maintenance and reinvestments. Like cybersecurity investments, presumably.
Yes, the pipeline that supplied about 45% of the gas to US East Coast was run like a cash cow. It’s part of the problem with having retirement systems dependent on making the kind of high returns previously only available to wealthy private equity investors. The real needs of the pensioners act as cover for the greed of the rest of the investors and can provide moral cover for cash cow treatments of infrastructure. After all, if you’re going to treat a piece of critical infrastructure like a cash cow, it helps if at least some of that cash is going to a sympathetic group like pensioners. And based on the cybersecurity experts, less than 25% of the US oil and gas industry has adequate cybersecurity in place. And if the Colonial model of ownership of infrastructure by pension funds via private equity catches on the way it looks like it will in coming years (the ‘perpetual capital’ model), we could end up with a lot more pension funds invested in pipelines and other large private infrastructure projects because that’s where the steady income streams can be found. The little guy is going to be increasingly co-invested with whales like Charles Koch in America’s privatized infrastructure landscape. But also increasingly signing up for old liabilities that haven’t been addressed because the infrastructure was being treated like a cash cow:
“Some have also accused Colonial, like much of the rest of the industry, of insufficient attention to cybersecurity. Matias Katz, founder of the cybersecurity firm Byos, estimates that less than 25% of the U.S. oil and gas industry has adequate cybersecurity in place.”
The wealthiest industry on the planet can’t be bothered to invest in cybersecurity. Or basic safety. But hey, at least the investors got their 10% annual returns in dividends. Priorities:
The Koch brothers (now just Charles Koch) are the largest of the investors getting these hefty annual dividends. But pension funds hungry for regular annual returns have been drawn to the sector too. It’s a trend that’s poised to just keep growing:
It represents another aspect of the systemic risks associated with the explosive growth of the private equity sector. The asset-stripping ‘turnaround’ mindset the industry is known for is going to be increasingly applied to critical infrastructure.
Remember those reports from back in December about the surge in “dividend recapitalizations” in the private equity industry, where private equity-owned companies borrow money in the US corporate bond markets almost exclusively for the purpose of paying their private equity owners dividend. Well, it sounds like that trend has moved on to Europe. A combination of ultra-low borrowing rates and investors hungry for yield has fueled a growth of corporate bond for the purpose of dividend recapitalizations. Corporate junk bonds in many cases. As the article makes clear, there doesn’t appear to be a lot of strong economic logic behind this kind of bond issuance beyond pure opportunism: rates are low, investors are hungry for highest-yielding bonds, and they don’t really care if they’re buying bonds in companies that are undermining their own futures purely to pay out dividends to private equity investors. That’s what’s driving the people buying these bonds and the people selling them. The stars have aligned for opportunistic debt-fueled looting so that’s what’s happening. It’s the magic of capitalism in action:
““It’s easier to keep adding debt when business multiples are so high as the market still thinks there is plenty of equity below the bonds,” said Benbow at Aegon. “Obviously when the cycle turns and the market cheapens up you realize that there is little to no equity left.””
Yes, all this corporate debt is obviously going to be a problem when the economy eventually weakens. But for now, there’s an opportunity. As long as bond investors are happy to buy bonds that will do nothing other than imperil the finances of these companies, private equity investors will be happy to issue them. We’ll worry about the future in the future:
Now, in fairness, much of this situation has arises as a result of the still historically low central bank interest rates that has created this incredible demand for anything that pays higher rates. It’s a central bank policy designed to assets like junk bonds more tempting to investors. And that’s great as long as those junk bonds are being used to help invest in businesses, or simply keep them afloat during a rough period. But issuing bonds to pay out dividends is just looting. Note how even Lion Capital is acknowledging that “we were being opportunistic” when they had Alain Afflelou SA issue a bunch of bonds to pay Lion a 135 million euro dividend. It points to one of the fundamental problems with the private equity ‘turnaround’ business model: The long-term future health of these companies is kind of beside the point:
We don’t know when the next economic downturn is coming. But based on this trend, we know that future downturn is going to be worse than it needed to be. Well, not worse for the private equity investors who got all those dividends.
Check out the new kid on the private equity block: China. Or rather, Chinese cities. Yes, it turns out that China has been on a kind of municipal private-equity binge in recent years. Nearly every major Chinese city has set up local investment funds with the encouragement of Chinese authorities, with more than 1,000 government-guided investment funds having popped up since 2015.
But unlike the traditional private-equity business model, which are typically focused on maximizing shareholder returns at any cost, these city-run funds are more interested in attracting new businesses to the local area to increase the tax base. At the same time, many of these city-backed funds are still forced to team up with traditional private-sector funds to carry out these investments due to a lack of in-house investment talent. So there’s a growing situation in China’s private equity markets where the public investors — the cities — have a fundamentally different set of priorities than their private-sector partners. This is leading to some grousing by these private-sector partners, and yet it sounds like it’s the cities that have the most clout because they have most of the money to investment. It also sounds like this approach to investing has worked out reasonably well for these cities. At least no major debacles so far. So China appears to be experimenting with a public private-equity model that priorities local prosperity over investor profits and it’s at least kind of working so far:
“More than 1,000 government-guided funds have cropped up across China since 2015. By late 2020 they managed some 9.4trn yuan, according to China Venture, a research firm. A national fund focused on upgrading manufacturing technology held 147bn yuan at the last count. One specialising in microchips exceeded 200bn yuan in 2019. Almost every city of note across China operates its own fund. A municipal fund in Shenzhen says it has more than 400bn yuan in assets under management, making it the largest city-level manager of its kind. In the northern city of Tianjin, the Haihe River Industry Fund is putting to work 100bn yuan along with another 400bn yuan from other investors.
Every major city gets its own investment fund. That’s the state of contemporary ‘communism’ in China, which is really operating on a state-run capitalism model. And it’s that model of state-run capitalism that is getting put to the test in a big way with the emergence of this city-fund trend. Will private-sector investors be satisfied partnering with city-funds that have a different set of priorities? So far so good, although the fact that the city-funds are the ones bringing all the cash to the table presumably has a lot to do with it:
It’s going to be interesting to see how this plays out. Given the simplistic portrayals of China as a ‘communist’ nation, it’s easy to forget that one of the biggest threats China poses to ‘the West’ is providing the world an example of a different kind of economic model. Yes, the Chinese government’s political model is obviously completely authoritarian in nature. It’s not exactly appealing. But as China moves more and more towards a state-run capitalist system, its political model is becoming more and more decoupled from its economic model and easier for other nations to emulate. But for the billions of people in the developing world living under some form of capitalism or another, the Chinese model of state-run capitalism really does present itself as a viable alternative model to West’s full-throated embrace of a cut-throat private sector as the cure all for nearly all needs. It’s not as if capitalism hasn’t been a disaster for the global poor. Countries around the world have sovereign wealth funds, after all. China is effectively creating city-level sovereign wealth funds and running them with a ‘community profits’ mind-set. That seems like something that could be done elsewhere.
With that in mind, it’s also worth noting the findings just released on a new report on the investing philosophies guiding the worlds sovereign wealth funds: in addition to finding an explosion of sovereign wealth fund investments in private equity projects, the report found less than 1 in 5 sovereign wealth funds actually have formal environmental, social and governance (ESG) policies in place:
“Only one in five, or 19%, of the world’s sovereign wealth funds (SWFs) have formal environmental, social and governance (ESG) policies in place, according to a new report by alternatives data provider Preqin. and law firm Baker McKenzie.”
Only 19% of the funds set up to invest on behalf of entire nations formally care about anything other than making as much money as possible. For the other 81%, it’s presumably just about investing in whatever brings the best financial returns. It’s one of those fun fact that people in the future are going to look back on after we’ve allowed capitalism to collapse the biosphere and tear societies apart.
And with a median allocation of nearly 10% of sovereign wealth fund assets in private equity investments and that number only growing, we can be confident that whatever type of influence these sovereign wealth funds decide to exert on their investments will likely be significantly felt. These funds have the clout that comes with size. So should that 81% of sovereign wealth funds that currently like an ESG policy eventually put on in place, a whole lot of positive impacts could potentially be channeled through that ownership. There’s no reason the recent story about an activist investment fund forcing major pro-environmental changes at Exxon couldn’t be replicated elsewhere with all these sovereign wealth investments:
So that’s the layout of a fascinating clash of models in the private equity space that’s currently unfolding globally. We have an explosion of government-guided funds in China operating under a ‘maximal indirect profit for the city’ model focused on bringing business to the city. At the same time, sovereign wealth funds around the globe are continuing to pile into private equity, but largely still operating under a socially irresponsible ‘profit for profit’s sake’ kind of traditional investment model. The two models aren’t exactly in direct competition with each other as long as there remains a democracy vs autocracy divide between China and West. But as the West continues its decades-long lurch away from meaningful democracy and close and closer towards an embrace of anti-democratic far right fascism world views, that competition between the economic models of China and the West really does become much more of a direct comparison.
That’s part of what makes this such a grimly fascinating trend: as China continues to evolve its economy more and more towards a form of state-run capitalism, the West continues to move away from democracy and closer towards a civilization almost entirely captured by a model of short-term rapacious profit-maximalizing capitalism. If trends continue, the economic contrasts of these two models are only going to grow in importance because the democracy gap will have withered away. It’s the kind of dynamic that’s going to be increasingly important to keep in mind as the global far right fixation on China continues to fester all. In other words, an authoritarian China that embraces capitalism isn’t a threat to Western fascism because of some sort of profound disagreement with Chinese authoritarianism. The Chinese model is a existential threat because the Chinese model of authoritarian capitalism has been demonstrably better as delivering very real economic gains to the masses than the crony capitalism of the West over the past couple of generations and that’s going to be a painful contrast to deal with after the far right pushes the West into the post-democracy future it has planned for us. The world is inevitably watching.