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Heads We Win, Tails You Lose: The Fascist Philosophy Behind Private Equity’s Leveraged Buyout of Everything

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 [1]

* May of 2020: Amer­i­can bil­lion­aires got $434 rich­er dur­ing the pan­dem­ic [2]

* August of 2020: Amer­i­can bil­lion­aires got $637 rich­er dur­ing the pan­dem­ic [3]

* Sep­tem­ber of 2020: U.S. bil­lion­aires got $845 bil­lion rich­er since the start of the pan­dem­ic [4]/Wealth of US bil­lion­aires ris­es by near­ly a third dur­ing pan­dem­ic [5].

* 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 [6].

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 [5].

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 [7] 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 [8] and a major investor in tech­nol­o­gy [9] ...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 [10]:

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 EDT

The 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 [11] 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 [12] 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 [13], 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 [14] — 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 [15] 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 [16] 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 [17].

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.”

...

———-

“Wor­ries grow over a K‑shaped eco­nom­ic recov­ery that favors the wealthy” by Jeff Cox; CNBC; 09/04/2020 [10]

““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 [18]. 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 [15] 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 [19] in hid­den fees an unusu­al prof­it-shar­ing arrange­ments [20]. 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 [21]:

The Finan­cial Times

Pri­vate equi­ty groups seek US small busi­ness res­cue loans
Exclu­sive: Indus­try warns of mass job cuts if port­fo­lio com­pa­nies are denied assis­tance

James Fontanel­la-Khan, Mark Van­de­velde and Sujeet Indap in New York and James Poli­ti in Wash­ing­ton
March 31, 2020, 10:13 pm

Some 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 [22] 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 [23].

...

—————

“Pri­vate equi­ty groups seek US small busi­ness res­cue loans” by James Fontanel­la-Khan, Mark Van­de­velde and Sujeet Indap and James Poli­ti; Finan­cial Times; 03/31/2020 [21]

“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 [22] 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 [23], 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 [23].
...

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 [24]:

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, 2020

Ever 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 [25] is one of the wealth­i­est sec­tors of the Amer­i­can econ­o­my: pri­vate equi­ty. These firms not only have a record $1.5 tril­lion [26] in cash on the side­lines, wait­ing to be invest­ed, but their CEOs [27] 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 [28] and Apollo’s Leon Black ($7.5 bil­lion [29]), 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.

...

Even before the COVID cri­sis, there were ques­tions [30] 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 [31] 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 [32] 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 [33] 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 [34] in ear­ly 2019—right before CalPERS hired [35] 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 [36], 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 [37]. 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 [38] over any five-year peri­od in Amer­i­can his­to­ry.

“Pri­vate-equi­ty man­agers won the finan­cial cri­sis,” as Bloomberg [39] 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 [40] (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 [41], 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 [40] 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 [42], 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 [43] (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 [44] 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 [45] being doled out through the Trea­sury, an amount that the Fed said [46] 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 [47] 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 [48], 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 [49] 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 [23] and pow­er­ful Rep­re­sen­ta­tive Max­ine Waters [50], 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 [51] 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 [52], 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 [53] 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 [54] 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 [55], 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.

———-

“Too Big to Fail, COVID-19 Edi­tion: How Pri­vate Equi­ty Is Win­ning the Coro­n­avirus Cri­sis” by Bethany McLean; Van­i­ty Fair; 04/09/2020 [24]

“Pri­vate-equi­ty man­agers won the finan­cial cri­sis,” as Bloomberg [39] 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 [40] (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 [41], 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 [32] 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 [33] 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 [34] in ear­ly 2019—right before CalPERS hired [35] 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 [40] 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 [42], 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 [36], 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 [37]. 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 [38] 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 [56]:

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. ET

Ben 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 [57] — 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 [58]. 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 [59] 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.

...

———–

“March­ing Orders for the Next Invest­ment Chief of CalPERS: More Pri­vate Equi­ty” by Mary Williams Walsh; The New York Times; 10/19/2020 [56]

“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 [59] 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 [58]. 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 [60]:

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 bor­row­ers

Even 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.

...

————-

“Res­cue Cash Too Hot for KKR Proves Irre­sistible to Many PE Peers” by Heather Perl­berg; Bloomberg; 07/02/2020 [60]

“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:

...
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.
...

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:

...
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.
...

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 [61]:

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 [62] 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 [63] 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 [64] 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 [65] 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 [66] 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 [67] 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 [64], 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 [68].”) The Trump Labor Depart­ment rule is the ful­fill­ment of a long-deferred dream.

...

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 [69] 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.

————

“Let­ting Pri­vate Equi­ty Bil­lion­aires Rob Work­er Retire­ment Funds” by Robin Kaiser-Schat­zlein; The Amer­i­can Prospect; 06/18/2020 [61]

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:

...
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 [65] 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 [66] 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 [67] 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 [64], 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.
...

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 [39]:

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 CDT

Pri­vate 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 [70]—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 [71] 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 [72] 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 [73]. 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 [74] 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 [75] 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 [76], 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 [77]. 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 [78] 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.

...

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 [79] 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 [80], 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 [81]. 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 [82]. 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 [83] 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 [84] 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 [85] 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.

...

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 [86], known for its aggres­sive bets in the retail indus­try and relat­ed run-ins with cred­i­tors, has already recov­ered [87] 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

————

“Every­thing Is Pri­vate Equi­ty Now”; Bloomberg Busi­ness­week; 10/03/2019 [39]

“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 [78] 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.”

...

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 [84] from econ­o­mists Mar­tin Ols­son and Joacim Tag.
...

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 [80], 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 [81]. 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 [86], known for its aggres­sive bets in the retail indus­try and relat­ed run-ins with cred­i­tors, has already recov­ered [87] 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 [88]:

mattstoler.substack

Why Pri­vate Equi­ty Should Not Exist
(Big issue 7-30-2019)
Matt Stoller
Jul 30, 2019

Hi,

Wel­come to Big, a newslet­ter about the pol­i­tics of monop­oly. If you’d like to sign up, you can do so here [89]. 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 [90] to rein in PE. And Bernie Sanders is lead­ing protests [91] against PE acqui­si­tions. Per­haps as impor­tant are rum­blings on the right; Repub­li­can Sen­a­tor Mar­co Rubio’s released a report [92] 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.

...

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 [93] 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 [90] specif­i­cal­ly on pri­vate equi­ty, par­al­leled by a report on finan­cial pow­er [92] 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 [94] 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 [95] 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 [96], 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 [97], 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 [98], 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 [99] and ded­i­cat­ing their insur­ance port­fo­lios to PE deals. But I found this paper [78] 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 [90] 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 [100]. 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 [101]:

“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 [102]:

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 [103] 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.

...

———–

“Why Pri­vate Equi­ty Should Not Exist” by Matt Stoller; mattstoler.substack; 07/30/2019 [88]

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 [98], 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.
...

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 [104]. 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:

...
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.
...

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?