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 EDTThe story for much of the past generation has been a familiar one for the U.S. economy, where the benefits of expansion flow mostly to the top and those at the bottom fall further behind.
Some experts think the coronavirus pandemic [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.”
...
———-
““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 assistanceJames Fontanella-Khan, Mark Vandevelde and Sujeet Indap in New York and James Politi in Washington
March 31, 2020, 10:13 pmSome of the most powerful groups on Wall Street are pressing the Trump administration to allow private equity-owned companies to access hundreds of billions of dollars in loan funds earmarked for US small businesses hit by the coronavirus pandemic.
White House and Treasury officials have been contacted about the issue by industry lobbyists and executives from major investment firms, according to seven people who advised on the discussions, or have spoken directly with the participants.
Congress last week authorised the Small Business Administration to dispense $350bn worth of rescue loans to companies with fewer than 500 workers that have been affected by the coronavirus pandemic.
The Wall Street groups are taking aim at the so-called affiliation rule, under which small businesses can be barred from accessing the rescue funds if they are backed by a private equity firm whose portfolio companies collectively have a workforce that exceeds the 500-person limit.
In a letter to Treasury Secretary Steven Mnuchin, seen by the Financial Times, one industry body said federal “regulations effectively prevent the small business portfolio companies owned by venture capital or private equity funds from accessing” the rescue programme.
“We see no reason why being owned in a fund structure should result in these businesses having less access to the capital needed to keep their employees on the payroll,” said the letter from Steve Nelson, chief executive of the Institutional Limited Partners Association, whose members include public pension funds that have invested in funds run by Apollo, Blackstone, and other big Wall Street firms.
The pleas echo a warning that private equity executives have delivered to officials at the Treasury and the White House, according to people familiar with the conversations: if their portfolio companies are locked out from the $2tn stimulus package [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].
...
—————
“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, 2020Ever since Congress voted to hand out $2 trillion in taxpayer money to those hardest hit by the coronavirus pandemic, American businesses have been scrambling for a piece of the action. Airlines, hotels, and restaurants—all of whose revenues have cratered in the wake of sweeping stay-home orders—have engaged in Hunger Games–like lobbying to cash in on the CARES Act, making their case for a share of the disaster relief. But among those angling for a federal handout [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.
———-
““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. ETBen Meng got the job of chief investment officer of CalPERS by convincing the trustees of the nation’s largest public pension fund that he could hit their target of a 7 percent annual return on investment by directing more of the fund’s billions into private equity.
Now, Mr. Meng is gone [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.
...
———–
“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 borrowersEven inside battle-scarred KKR & Co., entering the political fray was enough to stoke unease.
As several of the private equity titan’s portfolio companies got loans from an emergency U.S. program aimed at helping small businesses survive the coronavirus pandemic, executives at the firm’s New York headquarters issued a blunt message: Return the money to taxpayers.
Yet across the cash-rich private equity world, many firms pushed ahead, benefiting from the $669 billion Paycheck Protection Program run by the Small Business Administration and Treasury Department, according to lawyers and lenders with knowledge of the strategies. Now, some of those firms face the prospect of tough public scrutiny, as the Trump administration acquiesces to pressure from lawmakers to name borrowers who drew potentially forgivable loans from taxpayers.
After the government broadly excluded private equity firms from the program, dozens found ways to steer around the restrictions, often adjusting governance or ownership arrangements with portfolio companies in sectors including entertainment, fitness, sports and dermatology, the people said, asking not to be named discussing confidential arrangements.
What’s more, some portfolio companies also benefited from indirect taxpayer support after helping scores of related businesses apply for PPP loans, keeping revenue flowing, the people said.
The industry’s secret success in tapping SBA money risks stoking a new uproar in Washington. Publicly traded companies and hedge funds already faced a backlash for trying to lean on U.S. coffers, leading them to add to more than $38 billion in loans that have been returned or otherwise canceled. Unclear is how many private equity firms may soon be outed.
Some have held meetings in recent days to discuss returning SBA money, according to people with knowledge of the talks. Spokesmen for the SBA and Treasury declined to comment or didn’t respond to messages seeking comment, including on whether companies that repay loans will be included in data to be made public.
Though people close to the private equity industry were willing to describe how firms accessed SBA loans, the identity of those that did so remains closely guarded because of the political sensitivities. More than a dozen private equity firms declined to comment or didn’t respond to messages seeking comment on whether their portfolio companies had sought or received loans. But representatives for some of the largest — KKR, Blackstone Group Inc., Apollo Global Management, Carlyle Group Inc., TPG and Ares Management — said companies they control did not use SBA money.
...
Broadly Disqualified
To be clear, Congress and the SBA intentionally stopped short of outright banning relief to companies backed by private equity investors. Authorities carved out exceptions for food-service and accommodation companies hit especially hard by the pandemic. Franchisees and affiliates of firms already licensed as Small Business Investment Companies also were allowed in.
But most companies backed by buyout firms appeared to be disqualified by rules against lending to borrowers with more than 500 employees, unless they met SBA standards for larger firms. Regulators tally such figures by adding all the headcount at businesses controlled by a private equity firm. If two businesses each employ 300 people, they could both be disqualified.
Defining whether a private equity firm controls a company isn’t always simple. Funds are known to take minority stakes with outsize influence over strategy. If a buyout firm wields enough clout on a board of directors to prevent a quorum or to block decisions, then that “negative control” can make the company ineligible for SBA support.
That’s prompted a variety of workarounds, according to people familiar with the strategies. For example, buyout firms ceded some board seats or gave up other rights to loosen their grip.
Ample Cash
Evidence of the strategies emerged in April when the SBA, in consultation with the Treasury, published guidance on a list of frequently asked questions. It noted shareholders who forfeit “rights to prevent a quorum or otherwise block action by the board of directors or shareholders” must do so “irrevocably” to satisfy the rules.
In other cases, buyout firms have gotten around the ban with more arcane steps, such as pledging not to add any more debt or giving up the power to make hiring and firing decisions, according to the people familiar with the arrangements.
The private equity industry lobbied to access the SBA program as it was being set up, but to little avail. “It shouldn’t matter if the companies are backed by investment from corporations, pension funds or others,” Drew Maloney, the president of the American Investment Council, private equity’s trade group, said at the time.
The program isn’t meant to help companies that have access to other sources of cash, Treasury Secretary Steven Mnuchin has said. SBA officials have urged the private equity industry — which currently has about $1.5 trillion in available cash — to help their portfolio companies. There’s also the moral hazard: Some companies were particularly vulnerable to the pandemic because private equity owners had loaded them up with debt to maximize profits.
Still, buyout firms argue there are restrictions on how much they can pump into troubled deals and privately lament that their business model is misunderstood.
Dental Relief
Some firms were able to get indirect taxpayer support because of the way they happened to structure investments in highly regulated industries. Take dentistry, for example.
Laws in most states prevent investors from owning dental practices outright, so buyout funds own a separate entity that provides related services. Ares and Leonard Green & Partners own Aspen Dental Management Inc., a provider of business and administrative support to dentists.
As the pandemic shut down dentistry, almost every practice affiliated with Aspen qualified for SBA financing, Chief Executive Officer Bob Fontana told staff in a message April 19. “Two weeks ago, we worked with practice owners to submit PPP loan applications,” he said at the time. “We’re thrilled to report that every loan request we submitted has been accepted.”
The funding helped reopen practices and return staff to work, a spokeswoman for Aspen said in an emailed statement. Aspen Dental itself didn’t seek SBA funding, she said. Aspen “provided certain payroll and operations data, as required in the loan applications, for those independent practices who chose to apply for the PPP loans.”
Back in Washington, lawmakers are taking a tough look at how the SBA money was deployed. They successfully pressed the Trump administration to reverse its position on withholding all data about companies that received PPP financing and agree to disclose company names and data for loans of more than $150,000, as well as details about smaller loans without personally identifiable information they consider to be proprietary.
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“After the government broadly excluded private equity firms from the program, dozens found ways to steer around the restrictions, often adjusting governance or ownership arrangements with portfolio companies in sectors including entertainment, fitness, sports and dermatology, the people said, asking not to be named discussing confidential arrangements.”
Yes, all of a sudden all sorts of private equity-owned and controlled companies ‘ceded control’ of the companies and that made the companies eligible for the funds. At least that was apparently what numerous private equity-owned firms concluded:
...
Defining whether a private equity firm controls a company isn’t always simple. Funds are known to take minority stakes with outsize influence over strategy. If a buyout firm wields enough clout on a board of directors to prevent a quorum or to block decisions, then that “negative control” can make the company ineligible for SBA support.That’s prompted a variety of workarounds, according to people familiar with the strategies. For example, buyout firms ceded some board seats or gave up other rights to loosen their grip.
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It all raises a disturbing question: so given that private equity’s business model is heavily reliant on loading the companies they buy with debt, how many of the private equity-owned business that sought the PPP funds sought them in part because of the high debt loads their private equity-owners inflicted upon the companies made them highly fragile once the pandemic hit:
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The program isn’t meant to help companies that have access to other sources of cash, Treasury Secretary Steven Mnuchin has said. SBA officials have urged the private equity industry — which currently has about $1.5 trillion in available cash — to help their portfolio companies. There’s also the moral hazard: Some companies were particularly vulnerable to the pandemic because private equity owners had loaded them up with debt to maximize profits.
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It also raises the question of how much of the cash these private equity-owners had on hand came directly or indirectly from teh act of loading these companies up with debt.
Private Equity: It’s Not Just For Pensions. Anymore. Thanks to Trump’s Department of Labor
Well, at least this growing private equity pension nightmare — a nightmare where pensions seem to consistently underperform industry benchmarks — is limited to pension plans and hasn’t bled into the US’s 401k personal retirement accounts. Right? Well, not as of June, when the Department of Labor just issued an order that allows 401ks to invest in private equity funds for the first time ever. Private equity for the ‘little guy’. What could go wrong?
So what was the reasoning behind this move? The Labor Department asserts that private equity funds perform well and pointed to the fact that private equity funds have performed as well as public equity indices since at least 2006. What that reasoning didn’t factor in is the fact that private equity funds have high fees that can range anywhere from 7–20 percent. Again, that adds up. Low fees in the range of 0.21 to 0.6 percent are one of the main features of public equity indices. So the Department of Labor basically passed a rule that allows individual retirees to give private equity a bunch of fees [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.
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Democrats are starting to speak out about the Labor Department’s decision. Michael Gwin, spokesperson for Democratic presidential nominee Joe Biden, gave the Prospect this statement: “While Joe Biden steadfastly supports more equal access to retirement saving incentives and opportunities for wealth building, he staunchly opposes regulatory changes that will lead to skyrocketing fees and diminished retirement security for savers. This regulatory action is another example of President Trump putting the interests of Wall Street ahead of American workers and families.”
If private equity products won’t bring in extra returns for workers, what is the Trump administration after? It looks like they want to use workers’ money to pamper and fashion a new class of billionaires. Many of them, after all, are friends and donors [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.
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“By opening the floodgates to private equity, the Department of Labor will subject individual retirement accounts to private equity’s exorbitantly high fees, while providing roughly the same returns as low- and no-fee mutual funds. Experts suggest that this pointless payout to private equity from these fees––borne entirely by workers––might be in the ballpark of $13.7 billion per year.”
The same returns as before but now with extra fees! That’s basically what Trump’s Department of Labor just unleashed upon US workers. No longer will workers be burdened with the ultra-low 0.21–0.6 percent fees charged by equity index funds:
...
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.
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How will independent investors fair with this grand new retirement investment opportunity? Presumably about as well as pension funds...with consistently underperforming results that lag the industry benchmarks. Lucky them.
Private Parasites Taking Over the World
But as the following Bloomberg article from October of 2019 — right before the start of the coronavirus pandemic — makes clear, there’s another major reason we should be concerned about 401k investments in private equity fund: private equity is bad for business. Yes, it’s great of earning massive profits for the executives in the private equity firms. But as studies have shown, the business bought out by private equity are more fragile than their publicly held counter-parts, largely because they are typically purchased in a leveraged buy out that loads the company with debt. Additionally, the incentives for the new private equity owners to effectively gut a business and sell off its most valuable assets in the interest of making a quick profit is exceedingly high, in large part because of the massive leverage used to make the purchase. Beyond that, private equity can treat the businesses it owns effectively like virtual ATM, where they force the company to borrow money to pay its private equity owner special dividends. As the article also points out, the corporate debt levels a year ago were looking scarily high should another recession hit thanks in large part to private equity’s growing role in the economy over the last decade after it ‘won’ the 2008 financial crisis. And then, of course, the coronavirus pandemic hit and an even economic nightmare scenario we find ourselves in today emerged. So the more pensions and 401ks pile into private equity, the more cash private equity has on hand to effectively loot the economy even more than the present-day looting levels [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 CDTPrivate equity managers won the financial crisis. A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized. Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving. Almost everything that’s happened since 2008 has tilted in their favor.
Low interest rates to finance deals? Check. A friendly political climate? Check. A long line of clients? Check.
The PE industry, which runs funds that can invest outside public markets, has trillions of dollars in assets under management. In a world where bonds are paying next to nothing—and some have negative yields [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.
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The retail industry was long a prime target for buyouts because of its reliable cash flow and the value of the real estate it owned. But the sector is no longer as suited to PE ownership amid ever-changing customer whims and the massive upheaval brought by Amazon, says Perry Mandarino, head of restructuring and co-head of investment banking at B. Riley FBR. “Private equity has successfully preserved companies across a number of sectors,” he says, “but the disruption in retail has proven difficult for even some of the most savvy investors to navigate. High leverage, especially in this difficult environment, can be fatal.”
The most notable recent example of that is Toys “R” Us Inc. When the children’s toy retailer filed for bankruptcy in 2017, it was paying almost $500 million a year to service the debt from its 2005 takeover by Bain Capital LP, Vornado Realty Trust, and Kohlberg Kravis Roberts & Co. After it was liquidated in March following poor holiday season sales, its owners became the target of protests by laid-off workers, as well as scrutiny from investors and criticism from elected officials. Later that year, KKR and Bain said they’d each contribute $10 million to a fund for workers who lost their jobs when the retailer collapsed. Senator Elizabeth Warren (D‑Mass.) introduced a bill in July that would limit payouts [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.
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Critics and advocates of PE generally agree on at least one thing: When people are hurt by deals that turn companies upside down, there should be systems in place to assist them. “You don’t want to stand in the way of economic innovation,” says Gregory Brown, a finance professor at UNC Kenan-Flagler Business School. “But you would hope that people who get run over are helped.” —Katia Dmitrieva
Barbarians at the Gate Become the New Establishment
1970s
The U.S. Department of Labor relaxes regulations to allow pension funds to hold riskier investments. This opens up a new pool of money for buyout artists. Cousins Henry Kravis and George Roberts leave Bear Stearns with their mentor Jerome Kohlberg to form Kohlberg Kravis Roberts & Co.1980s
L.A. financier Michael Milken (above, second from left) turns junk bonds into a hot investment, which makes getting leverage easier. Former Lehman Brothers partners Pete Peterson and Stephen Schwarzman found Blackstone Group. KKR takes control of RJR Nabisco in a stunning $24 billion deal.1990s
Milken goes to jail for securities violations, and his firm, Drexel Burnham Lambert, collapses. But takeover artists are finding more tools for financing deals, as banker Jimmy Lee (pictured, third from left) popularizes leveraged loans at what’s now JPMorgan Chase & Co.2000s
Pensions for California state employees and Middle East sovereign funds pour money into record-setting funds that routinely surpass $15 billion apiece. Big deals of the era include Dollar General Corp. and Hilton Hotels. Several private equity firms themselves go public.2010s
After the financial crisis, Blackstone, Ares Capital, and Apollo Global expand their private credit businesses, providing financing to companies no longer served by big banks. Veteran PE executive Mitt Romney is the 2012 Republican presidential nominee. —J.K.Private Equity Is Getting Companies Hooked on Debt
Private equity couldn’t exist without debt. It’s the jet fuel that makes a corporate acquisition so lucrative for a turnaround investor. The more debt you can raise against a target company, the less cash you need to pay for it, and the higher your return on that cash once you sell.
Ultralow interest rates have made this fuel especially potent and easy to obtain. The market for leveraged loans—industry jargon for loans made to companies with less-than-stellar credit—has doubled in the past decade. Almost 40% of all such loans outstanding are to companies controlled by private equity, according to data from Dealogic.
Some leveraged loans are arranged by banks. But there’s also been a boom in private lenders, who may be willing to provide financing when banks or public debt markets won’t. All the while, bond and loan investors desperate for yield have accepted higher risks. As buyout titans have chased bigger and riskier deals, their target companies have been left with more fragile balance sheets, which gives management less room for error. This could set the stage for a rude awakening during the next recession.
“We’re seeing scary levels of leverage,” says Dan Zwirn, chief investment officer of alternative asset manager Arena Investors. “Private equity sponsors are all slamming against each other to get deals done.” Loans to companies with especially high debt loads now exceed peaks in 2007 and 2014, according to the U.S. Federal Reserve. And companies owned by private equity typically carry a higher debt load relative to their earnings and offer less transparency on their financial position than other corporate borrowers.
...
PE firms can use some of the companies they own as virtual ATMs—having the company borrow money to pay its owner special dividends. That allows the funds to recover their investment sooner than they typically would through a sale or an initial public offering. Sycamore Partners LLC [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
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“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:
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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:
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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:
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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.
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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, 2019Hi,
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.
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Why Private Equity Should Not Exist
Earlier this month, a former Toys “R” Us employee named Sarah Woodhams confronted Democratic Presidential candidate Julian Castro. Woodhams told Castro about her experience at the corporation. She worked there for seven years, and then was laid off with no severance because a set of private equity firms bought the company and looted it. What she described is not an isolated instance, but an increasingly common one in America. Woodhams told Castro [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.
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“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:
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In the early 1970s, Simon went into politics, a leader at the Treasury Department under Nixon and Ford. He oversaw not just Treasury but became the the ‘Energy Czar’ in charge of the oil crisis, and a key player in rejecting New York City’s 1975 request for funds to ward off bankruptcy. Simon, along with a few others like Pete Peterson, came out of the Nixon administration with a better reputation than he had going in, perceived as a neutral and competent technocrat. Simon saw both prosperity and poison in Nixon and Ford. He supported the attacks on New York City’s and the forced austerity by the Federal government, but he also despised Nixon’s attempted economy-wide price controls to deal with inflation.After his time at the Treasury, Simon turned to intellectual organizing, because he believed that the Republicans were soft. Simon though Republicans, even when they had power, as Nixon or Ford of Governors like Nelson Rockefeller of New York, were still liberal, operating as conservative Phyllis Schafly put it, merely “an echo” of the Democrats. So he sought to finance thinkers in academia to restructure how elites did policy, or as he put it, a “counter-intelligentsia.” He became the President of the Olin Foundation, the key conservative foundation providing money to the nascent law and economics movement, the conservative intellectual backlash against New Deal controls on finance and corporate power. Law and economics wasn’t perceived of as a right-wing institutional framework, but a scientific one. Olin gave to Harvard Law to build out a law and economics program, and financial supremacy over corporations was accepted quickly in liberal citadels.
The law and economics movement helped build the intellectual edifice for PE, a model designed to restructure the American economy from the very beginning. In 1965, Henry Manne, a law and economics organizer, wrote about the “market for corporate control,” putting forth financial markets where corporations were bought and sold as the essential mechanisms for firing inefficient managers and replacing them with ones who would look out for the owners.
In 1965, Manne was ahead of his time, because most people thought American businesses were well-run. But in the 1970s, in an inflationary environment and as foreign imports began coming into the U.S. in force, this belief collapsed. In 1970, Milton Friedman put forward the shareholder value of the firm, a theory that the only reason for the corporation to exist is to maximize shareholder value. In 1976, Michael Jensen, the intellectual patron saint of PE, refined these concepts into a paper titled “Theory of the firm: Managerial behavior, agency costs and ownership structure,” arguing that loading up firms with debt would discipline wasteful management, and that placing ownership in the hands of a few would force managers to be attentive to efficient operation of the corporation.
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And note how Simon’s book, A Time for Truth, that laid out his ruthless philosophy was so extreme that Austrian school economist Friedrich von Hayek wrote the introduction. It was a book that popularized the ‘supply-side’ ideas that have been used to justify all forms of tax and regulation cuts over the past four decades and look who just happened loved the book: the radical “New Right” wing of the Republican Party from the class of 1978 [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:
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The increasingly widespread belief that American corporations were mismanaged, inflationary chaos, and a crisis of confidence among liberals combined into what was a political revolution in commerce. William Simon was both both a participant in and a moral light for this revolution. In the mid-1970s, he (or his ghostwriter) put pen to paper, and wrote a book popular among members of “the new right” as the large class of 1978 Congressional Republicans (which included a young Newt Gingrich) was known. His book was called A Time for Truth, and along with Robert Bork’s Antitrust Paradox, it gave the New Right a language to marry morality and political economics. Reagan would run on New Right themes in 1980.A Time for Truth reflected Simon’s hardcore attitude. It was a jeremiad, with terms tossed around like ‘economic dictatorship’, charges of Communism and fascism, and a screed about the perils of government. The book was introduced by the intellectual godfather of the right-wing, the Austrian economist, F.A. Hayek, who lauded it as “a brilliant and passionate book by a brilliant and passionate man.” Simon popularized the pseudo-scientific term, ‘capital shortage,’ or the the idea that businesses simply didn’t have the incentive to invest in factories because of government rules or fear of inflation. This led to inflation, lower productivity, and stagnation. The solution would be simple: cut capital gains taxes, cut government spending, reduce antitrust enforcement, and stop regulating through public institutions.
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And that’s all why we really need to ask ourselves: should the private equity industry even be allowed to exist? Does the general public share Bill Simon’s worldview? Do people really want a world where corporations care ONLY about short-term shareholder returns? Do people really want a world where leveraged buyouts are the tool of choice to allow the rich turn a quick profit buy effecting looting companies and profiting from their downfall? Do people really want a ‘Heads We Win. Tails You Lose” society? Because if not, private equity has to go, at least in its current form. And this is no longer just a question for the American public. This is now the global corporate philosophy.
Or we can just continue down our current path and allow private equity to take over effectively everything. Which will happen if it’s allowed to. That’s the nature of predatory systems. They will take it all if they can. That’s the philosophy. A philosophy where ruthlessness is a virtue. And that’s why the question of whether or not private equity should even be allowed to exist is also the question of whether or not we’ll finally address the pandemic of awful ideas that are continuing to loot the future or if we all just want to role over and let the most ruthless people on the planet continue taking it all. In other words, which one is really ‘too big to fail’: private equity or everyone else?